Regions Financial Corp (RF) — Q1 2022 Earnings Call Transcript

Thank you, Jamaria. Welcome to Regions' first quarter 2022 earnings call. John and David will provide high-level commentary regarding the quarter. Earnings documents, which include our forward-looking statement disclaimer and non-GAAP information, are available in the Investor Relations section on our website. These disclosures cover our presentation materials, prepared comments and Q&A. I will now turn the call over to John.

Thank you, Dana, and good morning, everyone. We appreciate you joining our call today. We are very pleased with our first quarter results. Earlier this morning, we reported earnings of $524 million, resulting in earnings per share of $0.55. Despite the challenging geopolitical backdrop and elevated inflation, we remain optimistic about 2022. We have a strong balance sheet, positioned to withstand an array of economic conditions. Business customers, for the most part, have adapted and are prospering in the new operating environment. New loan commitments and pipelines remain strong and utilization rates continue to increase. The consumer remains healthy. Net population migration inflows in our markets remain robust, and the majority of our footprint has returned to equal or better than pre-pandemic employment levels. Asset quality remains strong with virtually all credit-related metrics improving in the quarter, and net charge-offs remain below historical levels. The integration of Sabal, EnerBank and Clearsight are progressing as planned, and we're excited about their growing contributions. Additionally, we continue to make investments in talent and technology to support strategic growth initiatives. We kicked off 2022 with a strong start and expect to continue building on that momentum. We have a solid strategic plan, an outstanding team and a proven track record of successful execution. Now, Dave will provide you with some select highlights regarding the quarter.

Thank you, John. Let's start with the balance sheet. Average loans grew 1.5%, while ending loans grew 2% during the quarter. Average business loans increased 3%, reflecting broad-based growth in corporate, middle market and real estate lending across our diversified and specialized portfolios. While still below pre-pandemic levels, commercial loan line utilization levels ended the quarter at approximately 43.9%, increasing 160 basis points over the prior quarter. Loan production also remained strong with linked quarter commitments up approximately $1.6 billion. Average consumer loans declined 1% as increases in mortgages and other consumer loans were offset by declines in other categories. Within other consumer, EnerBank interbank loans grew approximately 2% compared to the fourth quarter. Looking forward, we expect full year 2022 average loan balances to grow 4% to 5% compared to 2021. And excluding PPP loans and consumer exit portfolios, we expect full year average loan balances to grow 9% to 10%. As for deposits, although the pace of deposit growth has slowed, balances continued to increase seasonally this quarter to new record levels. Average consumer and wealth management deposits increased compared to the fourth quarter, while corporate deposits remained relatively stable. We are continuing to analyze our deposit base and pandemic-related deposit increases. Approximately 35% of the increase or $15 billion is expected to be more stable with behavior similar to our core consumer deposit book. This segment is historically quite granular and generally rate insensitive and therefore, can be relied upon to support longer-term asset growth through the rate cycle. The remaining 65% of the deposit increases is a mixture of commercial and other customer types that are expected to be more rate-sensitive or that we are less certain about their long-term behavior. We assume this segment may have an all-in beta of roughly 70%. This elevated beta assumption includes relationship repricing and some balances shifting from noninterest to interest-bearing categories. It also reflects a range of $5 billion to $10 billion of balance reductions attributable to tightening monetary policy. The combination of these segments and our legacy deposit base represents significant upside for us as rates increase. So let's shift to net interest income and margin. Net interest income was stable quarter-over-quarter. Excluding reduced contributions from PPP, net interest income grew 2% benefiting from solid loan growth and rising interest rates. Net interest income from PPP loans decreased $27 million from the prior quarter and will be less of a contributor going forward. Approximately 93% of estimated PPP fees have been recognized. Cash averaged $27 billion during the quarter; and when combined with PPP, reduced the first quarter's reported margin by 58 basis points. Our adjusted margin was 3.43%, higher by 9 basis points versus the fourth quarter. The path for net interest income enters the second quarter with strong momentum from both balance sheet growth and higher interest rates. Excluding PPP, average loan balances grew 2% in the first quarter and a similar amount of growth is expected next quarter. Roughly $1.5 billion of securities were also added late in the quarter, further benefiting future periods. The recent run-up in rates has certainly validated our decision to wait to deploy into securities. And while not included in our current outlook, additional securities would provide incremental benefits. Higher short and long-term interest rates provided additional lift to net interest income in the first quarter. We expect total net interest income to increase 5% to 7% in the second quarter and to accelerate throughout the year, such that the fourth quarter net interest income is expected to be approximately 15% higher than our first quarter. Regions' balance sheet is positioned to benefit meaningfully from higher interest rates. Over the first 100 basis points of rate tightening, each 25 basis point increase in the Federal funds rate is projected to add between $60 million and $80 million over a full 12-month period. This benefit is supported by a large proportion of stable deposit funding and a significant amount of earning assets held in cash, which compares favorably to the industry overall. Over a longer horizon, a more normal interest rate environment or roughly a 2.5% Fed funds rate will support our net interest margin goal of approximately 3.75%. While we have purposefully retained leverage to higher interest rates during this period of low rates, we will attempt to manage a more normal interest rate risk profile as the interest rate environment normalizes. The Fed's aggressive path for interest rates gives us the opportunity to protect net interest income at attractive levels. We have begun this process by adding $4.7 billion year-to-date of forward starting receive fixed swaps and $1.5 billion of spot-starting securities. This represents approximately 30% of the total hedging amount needed this cycle. Now let's take a look at fee revenue and expense. Adjusted noninterest income decreased 5% from the prior quarter, primarily due to reduced HR asset valuations as well as lower capital markets and card and ATM fees. Within capital markets, M&A advisory activity was muted by seasonality as well as the timing of transactions. Pipelines remain robust, but some deals have been pushed to later in the year. Additionally, debt and the real estate capital markets were impacted by uncertainty surrounding rates, geopolitical tensions and volatility in credit spreads. However, we are seeing some stabilization in the loan and fixed income markets and anticipate conditions will improve in the coming quarters. Further, the reduction in real estate capital markets activity was offset by the addition of Sabal Capital Partners for the full quarter. Similar to the corporate fixed income market, refinance demand has been softer than expected in our agency, multifamily finance business as investors assess a significant move in interest rates. We continue to expect capital markets to generate quarterly revenue of $90 million to $110 million, excluding the impact of CVA and DVA. While we expect to be near the lower end of the range next quarter, we expect activity to pick up in the second half of the year. Card and ATM fees reflect seasonally lower interchange on both debit and credit cards. Additionally, debit card fees were further impacted by fewer days in the quarter. Mortgage income remained relatively stable and included approximately $12 million in gains associated with previously repurchased Ginnie Mae loans sold during the quarter. While mortgage income is anticipated to decline relative to 2021, it is still expected to remain a key contributor to fee revenue. Wealth management income also remained stable this quarter despite elevated market volatility. Service charges were stable during the quarter despite seasonal declines in NSF and overdraft-related fees. The first phase of previously announced NSF and overdraft policy changes were effective at the end of the first quarter, and the remaining changes will be implemented over the second and third quarters. These changes, when combined with the previously implemented changes, are expected to result in full year 2022 service charges of approximately $600 million and full year 2023 service charges of approximately $575 million. We expect 2022 adjusted total revenue to be up 4.5% to 5.5% compared to the prior year, driven primarily by growth in net interest income. This growth includes the impact of lower PPP-related revenue and the anticipated impact of NSF and overdraft changes. Finally, let's move on to noninterest expense. Adjusted noninterest expenses decreased 4% in the quarter driven by lower salaries and benefits expense as well as professional and legal fees. Salaries and benefits decreased 5%, primarily due to lower incentive compensation despite higher payroll taxes and 401(k) expense. Salaries and benefits also include the favorable impact of lower HR asset valuations. Professional and legal fees decreased significantly as elevated fees associated with our bolt-on M&A activity in the fourth quarter did not repeat. We will continue to prudently manage expenses while investing in technology, products and people to grow our business. As a result, our core expense base will grow. We expect 2022 adjusted noninterest expenses to be up 3% to 4% compared to 2021. Importantly, this includes the full year impact of recent acquisitions as well as anticipated inflationary impacts. We remain committed to generating positive operating leverage in 2022. Overall credit performance remained strong. Annualized net charge-offs increased 1 basis point to 21 basis points. Nonperforming loans continued to improve during the quarter and remain below pre-pandemic levels at just 37 basis points of total loans. Our allowance for credit losses decreased 12 basis points to 1.67% of total loans, while the allowance as a percentage of nonperforming loans increased 97 percentage points to 446%. The decline in the allowance reflects ongoing improvement in asset quality and continued resolution of pandemic issues, partially offset by loan growth and general economic volatility associated primarily with inflation and geopolitical unrest. The allowance reduction resulted in a net $36 million benefit to the provision. We expect credit losses to slowly begin to normalize in the back half of 2022 and currently expect full year net charge-offs to be in the 20 basis point to 30 basis point range. With respect to capital, we ended the quarter with our common equity Tier 1 ratio modestly lower at an estimated 9.4%, and we expect to maintain it near the midpoint of our 9.25% to 9.75% operating range. So wrapping up on the next slide are our updated 2022 expectations, which we've already addressed. I do want to point out that these expectations do not include any additional security purchases. So that certainly provides the opportunity for incremental benefit. In closing, as John mentioned, we began 2022 with great momentum. And despite geopolitical tensions and market uncertainty, we remain well positioned for growth as the economic recovery continues. Pre-tax, pre-provision income remained strong. Expenses are well controlled. Credit risk is relatively benign. Capital and liquidity are solid, and we are optimistic about the pace of the economic recovery in our markets.

Hey, good morning, John. Good morning, David. I was hoping maybe you can talk about expectations for deposit growth, which came in better than expected and particularly as pertains to the surge deposits. Can you talk about the trade-off between keeping these deposits and the potential for a higher beta? David, you highlighted potential for a $5 billion to $10 billion reduction. Can you clarify how much you expect for these to stick around and what it means for deposit growth?

Sure. So we had expected the $5 billion to $10 billion of deposits to start flowing out in the first quarter. We have maintained some pretty conservative deposit assumptions. But if you look at the growth and where it came from, it was in our consumer book. We continue to grow accounts and continue to have a high level of primacy with our retail customers, so our deposit base is our competitive advantage, and it's been that way for a long time. We're looking to leverage that as we get into this higher rate environment. As you think about the surge deposits, we have one-third that we think are going to be fairly similar to our legacy deposits in terms of beta, price insensitive. Then we have the other one-third that we think are much higher beta, 80% to 100% beta. Those are corporate deposits that you could characterize as non-operational deposits that are probably going to look for a better home or a higher rate as time goes on. We'll see what happens after this next rate increase, but we've expected that to either reprice or really flow out of the bank. Then you have another one-third, which are stimulus-receiving deposits, small business-type deposits. That one is a little harder to predict. We do have a higher beta on it, not as high as the second group. In any event, if we're wrong on the $5 billion to $10 billion, it's likely that we've maintained our deposits at a higher level. Over time, if we see that, then that gives us a little bit of comfort to be able to take some of our excess cash that we have, some $26 billion sitting on the balance sheet, to deploy that into the securities book. But our guidance that we're giving you does not have that deployed intentionally.

Got it. And if we could dig a little bit into the new hedging program. So David, I don't know if Darren is in the room. You guys were the masters of adding swaps in a timely manner last cycle, and now you've begun this new program. Can you maybe just talk about thoughts regarding locking in here, particularly using forward starters? Why is this the right decision at this point in the cycle for Regions?

I'll go ahead and start, and then Darren is here. You hit on a key word, and that is forward starting. We aim to get our margin to the optimum level and then layer in protection for that margin over time. If you look at where we put the first $4.7 billion in, that's at a receive fixed rate of 2.32%. Those are largely going to be effective for 2024. So we intentionally had them forward starting because we believe there is risk at that point in the cycle that rates could go the other way, and we want to be able to protect that. If we're wrong, then it happens to not reverse and go lower; then we haven't lost anything. We haven't given up any of our net interest income or margin at that point. These are all 5-year duration just like they were last cycle. When you do it forward starting, you can take advantage of pricing. They're not all that expensive to get into, and we're not giving up our asset sensitivity today. That's important.

The only thing I would add is that Page 8 of the deck really shows the path of the net interest margin, which underscores what David is saying. We're going to enjoy nice margin expansion as the Fed is tightening policy, but we have a very disciplined approach to manage that exposure as rates push higher. As David said, the probability of a downturn at some point, if the Fed has to push higher, increases over time. So we want to be cognizant of that and as we get delivered those higher rates, put in that protection and manage the downside risk in those out years.

Other banks seem to be spending their rate-driven incremental net interest income or at least some of it, whereas you've kept your 2022 cost guidance unchanged. So why do you think that is? And with this higher NII outlook, how confident are you that you can expand on your positive operating leverage this year and next year?

Well, kind of leveraging the comments just before, the way we structured the balance sheet, our NII will be growing nicely throughout the year but really strong in the fourth quarter, which sets up a really strong 2023. We're still asset sensitive through that time period, and so we should have a nice tailwind in terms of revenue growth. We pride ourselves on being able to control our costs. We did a good job this quarter. There is that HR valuation asset that benefited us by $14 million. So you need to add that back to level set. But in any event, we continue to leverage our continuous improvement program to stay focused on how we get better every day and how we could leverage technology and process improvements to keep our costs down because we are taking our savings and reinvesting those savings in things like digital, talent, continuing to hire people to grow. We had mentioned that the vast majority of our growth in expenses this year are related to the three acquisitions that we closed in the fourth quarter of '21. We continue to work at all levels to try and keep our costs under control and generate positive operating leverage, which we believe we will have in 2022.

David, in Slide 6, you give us the difference in the net interest margins based upon what's weighing down your margin today with the PPP loans and excess cash. Can you share with us on the excess cash portion, where does the Fed funds rate need to go where you're not going to need to have that bullet point anymore because it will match your reported margin?

Well, it really gets back to the deposit expectations. We've maintained this excess cash to be prepared to, to the extent the surge deposits do seek other alternatives, and we have to pay that out. Obviously, we're getting 100% beta on the cash while we wait, but being patient has benefited us. Putting that into the securities book earlier would have really cost us. We did put a little bit of that to work this quarter, $1.5 billion at about a 2.80% carry. If we were to do it today, it would be even higher. In the 3.5% range. It’s important for us to understand what the surge deposit flows are going to do relative to what the Fed rate movements are going to be. I think over a fairly short period, our cash will get down to our normalized level, which is $1 billion to $2 billion. We won't have to have this disclosure, and of course, PPP will run off for the most part after this year; we won't have to talk about that one either.

My first question is a follow-up to Ryan's questioning. The way you wrote out Slide 14, it seems like your NII guide includes both a $5 billion to $10 billion potential accretion of deposits and 70% beta. Is that an indication of what you think it would take to retain these deposits? Should it be one or the other?

Yes, yes. Don't duplicate that. The $5 billion to $10 billion is baked into the $70 billion. So if we're wrong, our beta will be lower. Thus far, as I mentioned on Ryan's question, we thought these particular $5 billion to $10 billion worth of deposits would start flowing out in the first quarter, they did not. We still think that's going to happen. Perhaps it's just delayed a little bit, waiting for the next move, which we believe is going to be 50 basis points, by the way, in May. We think those are largely corporate non-operational deposits that are going to seek a higher return than we're willing to pay. They're probably going to move off the balance sheet in that case.

I wanted to ask about EnerBank. The economic environment has changed quite a bit since you guys acquired them. Have your views changed at all with regards to the loan outlook for EnerBank or any consideration maybe further tightening the underwriting standards given a much higher rate environment?

No. We're very bullish on EnerBank. We’re excited about the fact that we closed that in the fourth quarter. If you look at our growth of EnerBank, this quarter it was 2%. Obviously, if you annualize that, it’s 8%, which is below the guide that we gave you, and the big driver there is seasonality. This first quarter is a low watermark for them. You'll see that pick up. This is a prime book. We're really excited about the carry that we can get there and the margin. We are ahead of schedule on where we thought we would be. We feel good about the credit quality, in particular, being paid for the risk that we're taking and a nice return for our shareholders on the capital deployed in that book.

Yes, Matt. This is John. I would just say, so far, not a lot of change. Generally speaking, our customer base, as we look at deposit balances and the impact of COVID and relief dollars on customer deposit balances, we saw, on average, even in the lowest balance segment, about a 30% increase in pre-pandemic deposit balances, and we are still seeing customers maintain that level of excess liquidity as evidenced by the fact that our deposit balances actually grew quarter-over-quarter.

Okay. That's helpful. And then I guess on the commercial side, you had a big drop in nonperforming loans, big drop in the criticized assets. Was that anything specific like a couple of borrowers or sectors or? It has been improving for some time, but it's gotten quite low.

Yes. No, I think it's broad-based, and we continue to see improvement in credit quality across the book, a reduction in criticized loans, classified loans and nonperforming assets. I think it reflects the work that our teams have continued to do working with our customers closely to evaluate the risk in our portfolios to exit certain relationships, portfolios and businesses where we see increased amounts of risk, and we're not getting an appropriate return. If I had to point to any business where our portfolios saw improvement, it would be restaurant as we continue to work out of that portfolio and hotel as the economy recovers through the pandemic.

Just a follow-up on the fee side. Now that you're getting close to the implementation of your changes to the deposit products, you're continuing to reiterate your service charges expectations for '22 and '23; service charges are probably better than people expected in the first quarter. I just wanted to kind of get your updated views on your confidence that you've got the right outlook and as you start to implement the products in place, what are your early takeaways from this view?

Yes. Our service charges were a little better than anticipated. I'll say that we put in some changes at the end of the first quarter, and you'll see more changes coming in the second and third. So it's too early to change our guidance from last quarter. We reiterated it this quarter, which was $600 million for service charges in '22 and $575 million in the next year. As we go through and see the impact of these changes, we'll update that, whichever way it might go.

On the expense side, what type of expense flexibility do you have if the revenue backdrop comes in weaker than expected this year? And do you still think that you're implying about 150 basis points of positive operating leverage in your guidance? Is that sustainable if the revenue backdrop gets tougher?

Well, you saw a pretty good quarter this quarter; again, make sure you add back the $14 million on the HR to get level set. The reason we were down is our revenue was down in certain areas like capital markets that tend to be more variable in terms of the cost relative to the revenue, like M&A. If you don't have M&A transactions and you don't have the compensation that goes with the deal. It depends on where the revenue challenges come from, John. If we're seeing it in places like that, then we should have lower compensation in mortgage. If we don't see the mortgage production that we think, then you'll see lower compensation for that as well. We do have some mechanisms to address revenue if it's lower than we thought. We still feel confident with the operating leverage number that you mentioned, and we are committed to having operating leverage over time.

Following up on your response to both Gerard and Betsy, I appreciate your comments around how it doesn't make any fundamental economic sense to mark securities to fair value on the left-hand side of your balance sheet without also marking the deposits to fair value on the right side. And so fundamentally, available for sale OCI hits are nothing more than accounting noise. How would you respond to the idea that in the recession, bank stocks are going to trade down to tangible book value? While it may not matter fundamentally, it is something that investors care about.

Yes. This whole concept of tangible book value came about in the recession. To the extent we have a recession, the rate environment is likely to go the other way, and securities will be worth that much more. If you want to mark the entire balance sheet to fair value, that would be reasonable, especially in trying times. But the notion of tangible book value, in my opinion, is really not a going concern issue. It’s a failure notion. I get that some might think otherwise, but the bigger issue is you're marking one element of the entire balance sheet. So, again, I think that is important to remember.

Thank you very much. I think that's all the questions we had. So thank you all for your time today. Thanks for your interest in Regions. Have a great weekend.