PNC Financial Services Group Inc (PNC) — Q3 2022 Transcript

Thanks, Bryan, and good morning, everybody. As you've seen, we delivered another strong quarter, generating $1.6 billion of net income or $3.78 per share. The combination of continued growth in our commercial and consumer loan books and higher rates drove net interest income 14% higher and our net interest margin increased 32 basis points. By the way, that's the largest sequential increase in NIM in more than a decade. Non-interest income was also up modestly, reflecting strong private equity performance and a record quarter in loan syndications, partially offset by weaker M&A activity. We remained disciplined on the expense front, resulting in seven percentage points of positive operating leverage. Our credit quality was largely unchanged in the quarter. While we have not seen any meaningful deterioration in credit quality taking place, our provision of $241 million reflects our slightly weaker economic expectations. Our capital levels remain solid, and we returned $1.7 billion of capital to shareholders during the quarter through share repurchases and dividends. We continue to make good progress on our strategic priorities. Our new and acquired markets performed particularly well across all lines of business, and we see significant untapped opportunities across these markets. We also continue to invest in our payments capabilities to provide differentiated value. We recently acquired Linga, enhancing our capabilities to better serve restaurant and retail clients, particularly in the small business space. And during the quarter, we made enhancements across our retail platform to drive customer convenience and retention. For example, we recently announced a partnership with Allpoint to give our customers surcharge-free access to 41,000 additional ATMs from coast to coast. With this partnership, PNC now offers customers surcharge-free access to more than 60,000 PNC and partner ATMs across the country. In AMG we saw positive quarterly flows of $4 billion, driven by both the private bank and institutional asset management. We are recruiting top talent and remain focused on taking share in all of our markets. In summary, in the third quarter, we executed well as a national Main Street bank, and we are in a position of strength as we look to the future. As always, I want to thank our employees for their hard work in the third quarter and for everything they do to deliver for our customers, communities, and our shareholders. And with that, I'll turn it over to Rob to provide more detail about our financial results.

Thanks, Bill, and good morning, everyone. Our balance sheet is on Slide 3 and is presented on an average basis. During the quarter, loan balances were $313 billion, an increase of $8 billion or 3%. Investment securities grew approximately $2 billion or 2%. Cash balances at the Federal Reserve decreased $8 billion, and our deposit balances averaged $439 billion, a decline of $7 billion or 2%. However, spot deposits were down $2.6 billion or less than 1% as lower consumer deposits were partially offset by growth in commercial deposits. At the end of the third quarter, our loan-to-deposit ratio was 72% and remains well below our pre-pandemic levels. Average borrowed funds increased $8.6 billion as we bolstered our liquidity through Federal Home Loan Bank borrowings. During the quarter, we increased our borrowings with the home loan bank by $20 billion on a spot basis. We continue to be well positioned with significant capital flexibility. During the quarter, we returned $1.7 billion of capital to shareholders through approximately $600 million of common dividends and $1.1 billion of share repurchases or 6.7 million shares. And as of September 30, 2022, our CET1 ratio was estimated to be 9.3%. Slide 4 shows our loans in more detail. During the third quarter, we delivered solid loan growth across our expanded franchise. Loan balances averaged $313 billion, an increase of $8 billion or 3% compared to the second quarter, reflecting growth in both commercial and consumer loans. On a spot basis, loans grew $4.6 billion or 1%. Commercial loans grew $3.1 billion as strong new production more than offset the syndication of the $5 billion of high-quality short-term loans that were expected to mature in the second half of the year. Consumer loans increased $1.5 billion driven by higher residential mortgage and home equity balances, partially offset by lower auto loans. And loan yields increased 69 basis points compared to the second quarter, driven by higher interest rates. Slide 5 covers our deposits in more detail. Although average deposits declined $7 billion or 2% compared to the second quarter, spot deposits were $438 billion and declined less than 1% compared to June 30. Commercial deposits grew $1.7 billion or 1% on a spot basis, and consumer deposits declined $4.3 billion or 2%, reflecting inflationary pressures and seasonally higher spending. Given the rising interest rate environment, we've begun to see a mix shift from non-interest-bearing into interest-bearing, particularly within our commercial deposits and expect this to continue over time. However, to date, our consolidated deposit portfolio mix has remained relatively stable with 2/3 interest-bearing and 1/3 non-interest bearing. Overall, our rate paid on interest-bearing deposits increased 33 basis points linked quarter to 45 basis points. As of September 30, our cumulative beta was 22%, and we estimate it will increase to approximately 30% by year-end. Slide 6 details our securities portfolio. On an average basis, our securities grew $2 billion or 2% during the quarter, as we replaced maturities with higher-yielding securities. The yield on our securities portfolio increased 21 basis points to 2.1%, driven by higher reinvestment yields as well as lower premium amortization. And during the quarter, new purchase yields exceeded 4%. Throughout the course of the year, we've repositioned our securities portfolio. And as of September 30, we had 66% of our securities classified as held to maturity. While interest rates have continued to increase, this repositioning has reduced the rate of change in our accumulated other comprehensive income. At the end of the third quarter, our accumulated other comprehensive loss was $10.5 billion, and as you know, is not included in our regulatory capital. And importantly, we expect this amount to fully accrete back over the remaining lives of the securities and swaps. As of September 30, we estimate that approximately 5% of accumulated other comprehensive income will accrete back per quarter going forward. Turning to the income statement on Slide 7. As you can see, third quarter 2022 reported net income was $1.6 billion or $3.78 per share. Revenue was up $433 million or 8% compared with the second quarter. Expenses increased $36 million or 1%, resulting in 7% positive operating leverage linked quarter. Provision was $241 million in the third quarter, reflecting a slightly weaker economic outlook, which impacted our macroeconomic scenarios and weightings, and our effective tax rate was 19.1%. Turning to Slide 8. We highlight our revenue trends. As you can see, total revenue for the third quarter was $5.5 billion, an increase of 8% or $433 million linked quarter. Net interest income of $3.5 billion was up $424 million or 14%. The benefit of higher yields on interest-earning assets and increased loan balances was partially offset by higher funding costs. And as a result, net interest margin increased 32 basis points to 2.82%. Third quarter non-interest income of $2.1 billion increased $9 million as lower fee income was offset by an increase in other non-interest income. The decline in fee revenue was driven by lower activity in our capital markets, mortgage, and asset management businesses, which was somewhat offset by continued strong performance in our lending and deposit services as well as our card and cash management fees. Growth in other non-interest income reflected higher private equity revenue as well as a $13 million positive Visa derivative fair value adjustment in the third quarter compared to a negative adjustment of $16 million in the second quarter. Turning to Slide 9. Our third quarter expenses continue to be well managed and were up 1% linked quarter. The growth reflected increased personnel expense to support business growth as well as one additional day in the quarter. As we previously stated, we have a goal to reduce costs by $300 million in 2022 through our continuous improvement program. We're now nine months into the year, and we've completed actions related to capturing more than 80% of our annual goal. And as a result, we remain confident we will achieve our full-year objectives. As you know, this program funds a significant portion of our ongoing business and technology investments. Our credit metrics are presented on Slide 10. And non-performing loans of $2.1 billion increased $22 million or 1% compared to June 30 and continue to represent less than 1% of total loans. Total delinquencies were $1.6 billion on September 30 at $115 million or 8% increase linked quarter. The increase was driven by elevated levels of administrative delinquencies, the majority of which have already been or are in the process of being resolved. Net charge-offs for loans and leases were $119 million, an increase of $36 million linked quarter, primarily driven by higher commercial loan net charge-offs. Our annualized net charge-offs to average loans continue to be historically low at 15 basis points. Provision for the third quarter was $241 million compared to $36 million in the second quarter. The increase reflected slightly weaker economic expectations, which impacted our macroeconomic scenarios and weightings. And during the third quarter, our allowance for credit losses remained essentially stable. Our reserves now totals $5.3 billion and continued to be 1.7% of total loans. In summary, PNC reported a strong third quarter. In regard to our view of the overall economy, we expect moderate growth in the fourth quarter, resulting in 1.8% GDP growth for the full year 2022. We also expect the Fed to raise rates by an additional 125 basis points in the fourth quarter with a 75 basis point increase in November and a 50 basis point increase in December. Looking at the fourth quarter of 2022 compared to the third quarter of 2022, we expect average loan balances to increase approximately 1%. Net interest income to be up 6% to 8%, fee income to be stable to down 1%; other non-interest income to be between $200 million and $250 million, excluding net securities and Visa activity. Taking our guidance for all components of revenue into consideration, we expect total revenue to increase approximately 2%. We expect total non-interest expense to be stable to up 1%. Fourth quarter net charge-offs to be between $125 million and $175 million, and we expect our effective tax rate to be approximately 18.5%. And with that, Bill and I are ready to take your questions.

On the funding side, I know you saw your deposit balances pull back again on a linked-quarter basis in both average and EOP. I wonder if you can give us a little bit of color on your thoughts there on deposit growth in coming quarters as rates continue to rise and you see some mix in your funding?

John, it's Rob. Yes, so on deposits, we saw a decline in the quarter, less so on a spot basis. Actually, commercial deposits grew there at the end of the quarter, but down quarter-over-quarter. When we look forward to the next quarter, we sort of see stable to down. On the consumer side, we do expect some downward trends just reflecting what we've seen lately, which is largely spend related, somewhat seasonal, but also the inflationary pressures. And then on the commercial side, we're calling it stable. Typically, seasonally, we see commercial increase and so far in the quarter, we have seen increases. But there's a lot of forces working against that with quantitative tightening and everything that's going on. So, we're calling for stable overall, down maybe a little bit.

Okay. That's helpful. And related to that, Rob, can you just maybe update us on how you're thinking about deposit betas in terms of your net interest income expectations and how you're thinking about the margin.

Yes, sure. Sure. So as I mentioned in my prepared remarks, our betas are running right now at around 22%. We expect it to go to 30% by year-end.

Right. Okay. And then in terms of the margin trajectory, just to see if you can help us with that. How we should think about that as well?

Well, I think in terms of the margin, we saw a nice increase, obviously, in the third quarter. We won't see that equivalent jump necessarily in the fourth quarter, but as the Fed continues to raise rates, we will continue to see some margin expansion.

Okay. And then if I could just ask one more. On the buybacks, $1.1 billion for the quarter came in above your $750 million guidance. Maybe if you could just talk about expectations, the likelihood of it being $750 for next quarter? Or could you surpass that again if you have the opportunity given the share price?

Yes. So, we have been active repurchasers of our shares. We've been operating under the stressed capital buffer framework, which allows us a lot of flexibility. We pointed to $700 or $750 as sort of our average purchase rate, which is roughly about what we've done since we reinstated our share repurchases following the acquisition of BBVA. So that's just a rule of thumb. We can do more. We can do less as conditions were. And so going forward, we'll see. We will be purchasers of our shares in the fourth quarter, the amount of which will be determined based on conditions.

Maybe, Rob, I was just curious if you could talk sort of broadly or at a top level about your ability to sustain positive NII momentum once the Fed stops raising rates. And I think some of the factors or puts and takes will be sort of self-evident, but I would just be curious to hear in your words what you think the big movers are each way.

Well, I mean, I think you said it. I think it's somewhat self-evident. As the Fed continues to raise rates, we will see increases in NII. Obviously, we'll see some higher expenses on the funding part, which gets to the margin. But it will continue to go up as the Fed rates continue to raise rates; at which point they stop doing that, then things will slow down, but that's probably into '23 as we take a look at our forecast.

It's going to be a bit of a mechanical exercise. So if you assume the Fed is done, if you look at past cycles, you'll see banks continue to increase rates as deposits get scarce. So, there's a little bit of beta creation. Offsetting that, more than offsetting that in our case, because the short-dated nature of our securities book is the roll down of the securities that mature and then get redeployed to then higher yields. Right? So, it will be that fight against where the deposit prices go once the Fed stops versus the roll down of the book and the re-price of the yields on the book.

Which is self-evident, yes.

Okay. Perfect. And then if I can go back to Rob, your comments from the last question on purchase. So I guess just sort of curious, when you think of sort of the conditions and why you order wouldn't keep up the third quarter's more elevated level. It looks like you guys are among the very few that still has very good capacity to repurchase. What are you thinking? Was it just like the stock price in the third quarter? Or are you sort of just there's enough uncertainty in the macro? Or does like TCE begin to enter into the equation in addition to regulatory capital levels? What are those conditions that you guys are weighing?

Yes, sure.

Yes.

I'd say all of the above other than maybe the TCE, that's not as much of a driver because it's not part of our regulatory capital.

Can you guys share with us? We're hearing some commentary in the commercial real estate markets that loan availability is becoming tighter, particularly to equity REITs. And you guys obviously are players in the commercial real estate market. Can you tell us what you're seeing and the risk you're assessing and what the outlook is for your commercial real estate loan book?

Just a general comment. Our exposure to REIT has grown as some of the capital markets opportunities have declined. But some REITs are risky and some aren't depending on what their underlying property types are. And we price for risk and decline risk when it's the right thing to do.

Very good. Credit remains strong, and your non-performing asset ratios are solid. I noticed in your detailed report—one of the best available—there were increases in C&I non-performing loans, along with a rise in the 30- to 89-day category. In your press release, you mentioned some processing issues. Can you provide more details about those line items?

Yes. Sure. Want me to go ahead? Yes, on the delinquencies, Gerard, and I mentioned it in my comments, the increase was entirely driven by administrative delinquencies, which have largely been resolved. So delinquencies adjusted for that are essentially flat, maybe even down a little bit. On the non-performers, they are up a little bit. But as you know, we're coming up off of such, such low, low levels that some increase is inevitable and doesn't necessarily reflect a broader move.

It also jumps around.

Yes, that's right.

One follow-up regarding net interest income. Last quarter, Bill, you mentioned that you expect rates to continue on an upward trajectory. You also indicated that you have an existing set of swaps and decided to hold off for now. I'm curious if you could clarify your approach as we potentially reach the peak of the rate cycle and how the current swaps interact with your natural asset sensitivity. Additionally, can you continue to achieve sequential growth in net interest income after the fourth quarter as we move into next year?

You have raised several important points in your question. Let's begin with the swaps. You may have noticed the figures, around $4 billion and $5 billion, that we reported this quarter. In terms of our overall exposure to interest rates, we are essentially flat and possibly even more asset sensitive compared to six months ago. We deliberately chose not to invest heavily in this market, allowing certain assets to mature without adding new investments. Currently, our bond portfolio has a duration of 4.6 years, while our swap book has durations of 2.5 or 6.2 years. Consequently, these will mature quickly, with yields that are currently at one-handles, being replaced today at rates above 4.5%, assuming no changes occur. This presents a significant opportunity for re-pricing that portfolio, as well as an opportunity to extend duration at the appropriate time, though I believe that time has not yet arrived.

So, can you help us understand how quickly the current portfolio rolls down? As we move forward, should we expect a lesser burden from the 10-Q, considering where rates are from that roll down going forward? Is that what you're implying?

Yes. I mean the duration of the swap books 2.3 years, Rob saying, so it's all bullet maturity. So I'm guessing you're going to see a 30-year.

Okay. Got it. And at this point, you're at the point where you're out to protect further out down the road, your point, Bill, is just that you'll see how that develops at that point at which time you decide, okay, we now have to think about the downside risk?

Yes. So, we are today much more exposed to down rates than we are to operate. We make lots of money when rates go up or even if they stay just where they are here. We're underinvested, we're asset sensitive. The pieces of that you shouldn't get too hung up on. The exposure we have has fairly short maturities, both on the swap side and on the bond side. And so simply staying where we are gives us the opportunity to reinvest what matures at higher yields, whether that's swaps rolling off or bonds rolling off, and we're going to do that. We will also, at some point, add to get rid of some of the asset sensitivity. We're just not doing that yet.

Does Rob get a raise because you became more asset-sensitive in the last six months?

We'll take that as an off-line item.

Okay. I guess no good deed goes unpunished. Your growth rate for net interest income is slower in the fourth quarter than in the third quarter, so just following up on that question. Do you think your fourth quarter net interest income will peak, or do you expect it to increase from there? It could potentially go lower due to factors like the lag in deposit pricing or deposits running off in the second quarter. There are also other considerations, such as reinvesting swaps and securities. So, will it go higher after the fourth quarter, or is it uncertain what the likelihood is?

Yes.

Okay. And why did you go more asset-sensitive six months ago? I mean that's different than your peers?

Yes. I've had ongoing discussions with our economics team. It was clear that significantly higher rates and inflation were on the horizon. If the current situation aligns with our predictions from six months ago, then there's no need to make any purchases. Was that really any more complicated than that?

Okay. And then why are deposit betas for you and really the industry outperforming? What have people gotten wrong in their modeling? When you look at your model, what hasn't taken place? Or is it just yet to take place?

Yes, I don't know the answer to that, Mike. I mean the consumer money is stickier than everybody.

That's the answer. That's relative to our expectations the consumers moved more slowly than we would have thought.

Yes. Corporates are kind of doing what you would otherwise expect depending on their size. Money market yields are doing what you'd otherwise expect, so you have a set of boundaries on competition from money funds have a set of boundaries and competition from high-rate deposit accounts, the online deposit accounts. So it's really just the re-pricing of the core consumer just occurs slower than I think the industry assumed.

Bill, you said that you don't think it's time to add duration yet. Can you give some color on the trigger you're looking for?

I believe we're getting close, but I still think we'll see a sell-off at the longer end of the curve. My main expectation is that reducing inflation will be challenging. Even if we see a two handle on it, I believe the Fed will eventually pause. However, inflation is likely to remain persistent, which should lead to a flattening of the curve. Therefore, it’s difficult to justify locking in term rates right now and potentially experiencing negative carry in three months.

Or longer.

No, you'd go negative in three months based on foresight. So, we need to see some semblance of when and how the Fed is going to stop and whether or not inflation is really move towards two or just kind of gotten down to the low 3s and sticks there, which is what I'm afraid might happen.

Understood. That's really helpful. Separately, many banks talked about deposit growth that they're generating under QE as their expectation that it would be sticky. Some others were less certain. Can you speak to that dynamic broadly at the industry level? And then maybe specifically, whether you expect PNC's interest-bearing versus non-interest-bearing deposits to ultimately remix back to pre-COVID levels?

Yes, for the industry, it's quite clear. I would say that following the influx of liquidity and deposits in the system, we will likely see those decrease. In terms of the balance between interest-bearing and non-interest-bearing deposits, there will be a shift. We're beginning to observe this on the corporate side, but for our core deposits, the ratio remains consistent at 33% non-interest-bearing and two-thirds interest-bearing.

Got it. And on your debt as a percentage of your overall funding that ticked up a little bit this quarter, but it's still below 4Q '19. Is it reasonable to expect that's going to remix back to pre-COVID levels?

At some point, you would expect that to happen. This depends on your expectations for liquidity from the deposit side, but I'm uncertain about the timeline for that.

Okay. That helps. And then finally, when the tailoring rules were coming together, you guys did a good job of articulating why Main Street banks like yourselves don't pose systemic risk to the financial system. Can you speak to some of what's happening now and how you're positioned for the risk that regulatory scrutiny could intensify somewhat for the super regionals?

So on the TLAC and SPOE issue.

Yes.

Yes. Well, just a couple of thoughts. I mean one is, obviously, there's a lot of conversation about it. But at this point, there's no formal proposals or anything to look at. So from our view, it's just observations and speculation. If we observe what's in place with the G-SIBs, our conclusion is it's not necessary for large regional banks, to your point, we thought that came through in the tailoring 95% plus of what we do is within the bank.

99%.

That's 95% plus. So again, a simple structure, and it's unclear to us why an SPOE would need to be on top of what's already in place with the FDIC and the deposit insurance fund. So that has us a bit perplexed.

I was hoping to get some color on the health of your borrowers at this point and maybe if there's any unwillingness to lend into certain asset class at this point. I'm hearing more and more on the construction side, the banks are pulling back. We just love any updates that you have on the commercial and the consumer side?

I'm not sure what you're referring to regarding construction. Generally, we haven't noticed any changes in our credit book. We're seeing increases in credit card balances, which is positive, indicating that people are starting to use credit. However, we haven't observed any decline in the performance of the book. Regarding our lending practices, we don't modify our credit criteria. We adhere to specific criteria for lending and may adjust prices in certain asset classes where prices are rising. For example, in auto lending, the spreads are currently too tight compared to our desired lending parameters. I can't think of any other instances.

No, no. And we operate, as you know, mostly in the higher point of the spectrum in terms of credit quality. So investment grade and prime space and consumer approach is the same.

But if it's real estate construction, we've been active in the multifamily side. If you're looking at sort of smaller real estate...

Higher risk, yes, we were never there.

We were never in that business to begin with. Yes. That's kind of a smaller bank activity.

All right. Maybe just one follow-up. I appreciate the fourth quarter guide. I think as it relates to PPNR for the full year, it seems like even with the fourth quarter guide, maybe being a little bit softer than where consensus was, you guys are squarely within the ranges for full-year revenue and non-interest expense. Is that the way we should be reading it?

Yes.

Yes.

This is Nathan Stein on behalf of Matt O'Connor. So 3Q capital markets fees came down versus the really strong 2Q levels, but I think that makes sense just given the macro backdrop. Can you talk about the capital markets outlook from here?

Sure. Well, the decline in the third quarter was more than just the macroeconomic backdrop. It was off of elevated levels of our Harris Williams unit in the second quarter, which were in effect. We did most of our activity in the first half in the second quarter with Harris Williams. So we knew that, we called that, and we put that into our guidance. And then just going forward in terms of our capital markets view, Harris Williams is the biggest component. Their pipeline is very big. The degree to which they do more or less deals remains to be seen. Our view for the broader category is flattish to down and recognizing there could be some upside or downside depending on the macroeconomic factors you talk about.

Inside of that space, we actually had a record quarter in loan syndications. And we had a record quarter in middle market loan originations, which is related to that. So there's actually a lot of activity, particularly as the bond markets are drying up that benefits us. Harris Williams just was a big number in the second quarter. So when you're going off of that base, it's not as if the core underlying business, ex-Harris Williams is strong and it's actually doing quite well. And the M&A market at the moment is tough.

Just real quick on the capital markets revenue on the Harris Williams, can you just remind us what the comp ratio is in that business? And then separately, I just want to see if you can maybe walk through a bit of the outlook for the other larger line items in non-interest income, including the asset management and cash management and others.

Yes. Your question is about the fees. In the Harris Williams category, our efficiency ratio is probably around the mid-70s, give or take. Regarding the outlook for the fees, asset management is likely to face some challenges. The situation in the equity markets is variable, so we expect some pressure there. Mortgage is also included in that. Card and cash management should remain strong with solid fundamentals, continuing to expand steadily. As for capital markets, I mentioned it before. We see it as stable, but there is potential for better performance if there’s deal activity. The pipeline is available, but it’s uncertain whether this will happen in the next 90 days.

Thank you.