Regions Financial Corp (RF) — Q4 2022 Earnings Call Transcript

Thank you, Christine. Welcome to Regions fourth 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 of our website. These disclosures cover our presentation materials, prepared comments and Q&A. With that, I’ll now turn the call over to John.

Thank you, Dana, and good morning, everyone. We appreciate you joining our call today. Let me begin by saying that we’re very pleased with our fourth quarter and full year results. Earlier this morning, we reported full year earnings of $2.1 billion, reflecting record pretax pre-provision income of $3.1 billion, adjusted positive operating leverage of 7% and industry-leading returns on both average tangible common equity and total shareholder return. Our results speak to and underscore the comprehensive work that’s taken place over the past decade to position the Company to generate consistent, sustainable long-term performance. We have enhanced our credit, interest rate and operational risk management processes and platforms while sharpening our focus on risk-adjusted returns and capital allocation. We made investments in markets, technology, talent and capabilities to diversify our revenue base and enhance our offerings to customers. For example, investments in our treasury management products and services led to record revenue this year. Similarly, our Wealth Management segment also generated record revenue despite volatile market conditions. And now we’re seeing positive results of our comprehensive strategy. Over the course of the year, we grew revenue and average loans while prudently managing expenses, further illustrating the successful execution of our strategic plan. So, as we enter 2023, it is from a position of strength. Our business customers have strong balance sheets. They have benefited from population migration and many continue to carry more liquidity than in the past. Our consumer customer base remains healthy. Deposit balances remain strong and credit card payments remain elevated. The job market continues to be solid with approximately two open jobs available for each unemployed person across the Regions’ footprint. We have a robust credit risk management framework, and a disciplined and dynamic approach to managing concentration risk. Our portfolios are more balanced and diverse than at any point in the past. We have a strong balance sheet that’s well positioned to perform in an array of economic conditions. We have a solid capital and liquidity position to support balance sheet growth and strategic investments. And most importantly, we have a solid strategic plan, an outstanding team and a proven track record of successful execution. So as we look ahead, although there is uncertainty, we feel good about how we’re positioned. Now, Dave will provide some highlights regarding the quarter.

Thank you, John. Let’s start with the balance sheet. Average loans increased 1% sequentially or 9% year-over-year. Average business loans increased 2% compared to the prior quarter, reflecting high-quality broad-based growth. Average consumer loans declined 1% as growth in mortgage, interbank and credit card was offset by the strategic sale of consumer loans late in the third quarter and continued runoff of exit portfolios. Looking forward, we expect 2023 ending loan growth of approximately 4%. From a deposit standpoint, as expected, deposits continued to normalize during the quarter, consistent with a rapidly rising rate environment. Average total consumer balances were modestly lower, primarily driven by higher balance customers seeking marginal investment alternatives. Meanwhile, the median consumer balance remains relatively stable, still about 50% above pre-pandemic levels. Normalization was more pronounced in average corporate and commercial deposits, which were down 2% during the quarter. As anticipated, our business clients continue to optimize the level and structure of their liquidity position. We experienced remixing away from noninterest-bearing deposits to other options, both on and off balance sheet, including those offered through our treasury management platform. Ending deposit balances have declined approximately $7 billion year-over-year, in line with our previously provided 2022 expectations. Looking forward, we do anticipate further deposit declines of approximately $3 billion to $5 billion in the first half of 2023, reflecting continued Federal Reserve balance sheet normalization, seasonal trends and late-cycle rate-seeking behavior. We expect to experience stabilization of deposit balances midyear with the potential for modest growth in the second half of the year. Our deliberate approach to managing liquidity allows for deposit normalization and growth in the balance sheet without the need for material wholesale borrowings in the near term. So, let’s shift to net interest income and margin. Reflecting our asset-sensitive profile, net interest income grew to a record $1.4 billion this quarter, representing an 11% increase while reported net interest margin increased 46 basis points to 3.99%, its highest level in the last 15 years. While deposit repricing continues to accelerate, the cycle-to-date beta remains low at 14%. Importantly, our guidance for 2023 assumes a 35% full-cycle beta by year-end. There is uncertainty regarding full cycle deposit betas for the industry. However, we remain confident that our deposit composition will provide a meaningful competitive advantage. Growth in net interest income is expected to continue until the Federal Reserve reaches the end of its tightening cycle. Once the Fed pauses, we would expect deposit costs to continue increasing for a couple more quarters. This equates to 1% to 3% net interest income growth in the first quarter and 13% to 15% growth in 2023, assuming the December 31 forward rate curve. Earlier in 2022, we added a meaningful amount of hedges focused on protecting 2024 and 2025. The swaps become effective in the latter half of 2023 and 2024 and generally have a term of three years. Activity in the fourth quarter focused on extending that protection beyond 2025. We will look for attractive opportunities to continue to expand this protection. We have constructed the balance sheet to support a net interest margin range of 3.6% to 4% over the coming years, even if interest rates move back towards 1%. If rates remain elevated, our reported net interest margin is projected to surpass the high end of the range until deposits fully reprice. So, let’s take a look at fee revenue and expense. Reported noninterest income includes $50 million of insurance proceeds related to a third quarter regulatory settlement. Excluding that, adjusted noninterest income declined 9% from the prior quarter as stability in wealth management income and a modest increase in card and ATM fees were offset by declines in other categories, mainly mortgage and capital markets. Service charges declined 3% due primarily to three fewer days in the fourth quarter versus the third. We expect to offer a grace period feature to cover overdrafts around midyear 2023, and when combined with our previously implemented enhancements, will result in full year service charges of approximately $550 million. Within capital markets, increases in M&A fees were offset by declines in all other categories, including a negative $11 million CVA and DVA adjustment. Despite an increase in servicing income, elevated interest rates and seasonally lower production drove total mortgage income lower during the quarter. With respect to outlook, we expect full year 2023 adjusted total revenue to be up 8% to 10% compared to 2022. Let’s move on to noninterest expense. Reported professional and legal expenses declined significantly, driven by charges related to the settlement of a regulatory matter in the third quarter. Excluding this and other adjusted items, adjusted noninterest expenses increased 2% compared to the prior quarter. Salaries and benefits increased 2%, primarily due to an increase in associate headcount during the fourth quarter and higher benefits expense. Equipment and software expenses increased 4%, reflecting increased technology investments. The fourth quarter level does provide a reasonable quarterly run rate for 2023. We expect full year 2023 adjusted noninterest expenses to be up 4.5% to 5.5%, and we expect to generate positive adjusted operating leverage of approximately 4%. From an asset quality standpoint, overall credit performance remains broadly stable while experiencing expected normalization. Net charge-offs were 29 basis points in the quarter. Excluding the impact of the third quarter consumer loan sale, adjusted full year net charge-offs were 22 basis points. Nonperforming loans remained relatively stable quarter-over-quarter and were below pre-pandemic levels. Provision expense was $112 million this quarter. While the allowance for credit loss ratio remained unchanged at 1.63%, the increase to the allowance was due primarily to economic conditions, normalizing credit from historically low levels and loan growth. These increases were partially offset by the elimination of the hurricane-related reserves established last quarter. Just to remind you, we believe our normalized charge-offs based on our current book of business should range from 35 to 45 basis points on an annual basis. However, due to the strength of the consumer and to businesses, we expect our full year 2023 net charge-off ratio to be in the range of 25 to 35 basis points. From a capital standpoint, we ended the quarter with a common equity Tier 1 ratio at an estimated 9.6%, reflecting solid capital generation through earnings, partially offset by continued loan growth. Given the uncertain economic outlook, we plan to manage capital levels near the upper end of our 9.25% to 9.75% operating range over the near term. So, in closing, we delivered strong results in 2022, despite volatile economic conditions. We are in some of the strongest markets in the country, and while we remain vigilant to indicators of potential market contraction, we will continue to be a source of stability to our customers. Pretax, pre-provision income remains strong, expenses are well controlled, credit remains broadly stable, and capital and liquidity are solid. And with that, we’ll move to the Q&A portion of the call.

Regarding your deposit beta, specifically the 35% beta assumption by year-end '23, could you help us understand your assumption about the noninterest-bearing mix as a percentage of total deposits? How do you expect that to trend throughout the year? What factors are influencing that assumption?

Yes, John, this is David. Currently, we have 39% noninterest-bearing deposits. We typically have a higher percentage of noninterest-bearing deposits compared to most others, which is a characteristic of our deposit base. We had indicated that we expect deposit runoff this year to be in the range of $3 billion to $5 billion. For our guidance, we've adjusted our expectations for noninterest-bearing deposits accordingly, so the percentage of noninterest-bearing deposits is anticipated to decline somewhat during the year. This is reflected in our guidance, though there may be some variations in the mix of noninterest-bearing deposits, which is the most stringent expectation we have. That's the basis for what we included in our guidance. I’m not sure if there are any follow-up questions on that.

Okay. No, that’s helpful. And I think the other color on the beta provides some of the additional detail. But just separately, if I could just hop over to credit for my follow-up. Can you give us a little bit of color around what drove the increase in charge-offs in the quarter? It looks like that may have been in C&I, but I want to get a little bit of color around what you’re seeing there? Are you seeing any stresses in certain pockets of your loan categories that you’re watching that are starting to generate some losses? And then also what drove the 14% increase in the criticized loans? Thanks.

Yes, we did notice a slight increase in business services charge-offs this quarter related to a few credits. We have pinpointed several areas in the portfolio where we are observing heightened stress, including office, healthcare, consumer discretionary, senior housing, and particularly small trucking. There is also an uptick in classified loans. Regarding your second question, we are experiencing some normalization in the portfolio. Classified loans are rising to levels that align with what we would consider more normal, and the changes are occurring in the five sectors mentioned, along with some miscellaneous items in the portfolio. Additionally, inflationary pressures and rising rates are impacting specific customers. Overall, we remain confident about credit quality, and as David mentioned, we are projecting charge-offs to be between 25 to 35 basis points in 2023.

And John, I’ll add. If you look at page 19, we tried to help you with the areas that John just mentioned in terms of the higher risk segments. And you can see on that page, the strength of the allowance to cover those increases in the criticized level that we have listed in the supplement. And we don’t necessarily have a loss in every one of those that migrated into criticized. But what we do see, we have already embedded in the reserve, and it’s factored in, as John mentioned, in our guidance of 25 to 35 in charge-offs for 2023.

Yes. Thanks, David. I appreciate that. If I could just ask one more on that, on the reserve, you pretty much kept it stable this quarter. Could you maybe discuss the likelihood of incremental builds here, or do you think it fairly represents the scenarios of outlook that you’re looking at here?

Well, we certainly believe that it represents what we think is the loss content that exists today. Obviously, every quarter, we have to reassess the economy and the quality of the portfolio at those times. So, we think we have it covered. The only build that you would see from this standpoint that we know of would be related to new loan growth. And we’re going to have some of that. We said we would grow loans about 4% end to end during the year. So, we’ll need to provide for that. But we think at 1.63% is a good coverage ratio for the risk that we have in the portfolio.

Based on our current economic assumptions.

I would like to follow up on the funding aspect of the balance sheet. Could you explain how you have maintained a favorable loan-to-deposit ratio? Additionally, could you clarify your plans for your wholesale debt footprint, particularly regarding long-term debt, and what that means for your securities portfolio moving forward? Thank you.

Yes. So, we continue to have one of the lowest loan deposit ratios. I think you were leading to that. We’re in great markets. We continue to work on growing accounts, whether it be checking accounts or operating accounts. That’s the hallmark of our whole franchise. This is the strength of that deposit base. So, we will continue to leverage that deposit base in terms of our funding mix. At least for the first half of the year, we don’t see the need to go into any wholesale borrowings. We have plenty of access to that, should we need it. Most of our peers, I think, have already tapped wholesale funding. So, we’re being able to leverage that and that’s where we give you the pretty strong guide in terms of our NII growth for the year of 13% to 15%. So, we’ll see what the deposit flows are. As we mentioned to John earlier, the deposit outflows we see that we put in our guide is $3 billion to $5 billion. Now remember, we said 5 to 10, this past year we were at 7. So, we’ve been estimating it pretty well, and we’re taking to offer our guide all of that out of NIB. So, we’ll see what happens during the year. But you don’t expect us to be looking for wholesale funding until at least the second half of the year.

Okay. And then, just a follow-up. You’re going to do that grace period, and we saw you reiterate the $550 million of service charges. Can you just kind of just give an update on the state of the consumer there and behavioral changes and any other learnings and findings that kind of continue to make you confident in upholding that $550 zone of service charges?

Yes. We are seeing consumers maintaining healthy deposit levels. Spending has increased slightly, but it seems to be managed very carefully by our customers. Overall, we feel positive about the health of consumers. Regarding overdrafts and the changes we've implemented to assist customers, we have observed a approximately 20% decrease in the number of customers overdrawing their accounts each month, which is encouraging. Our primary goal is to help customers manage their finances more effectively. Overall, we are optimistic about our guidance and the positive impact our changes have had on our customers.

Yes. Ken, let me add to that. Embedded in the service charges is treasury management, and treasury management has had a fantastic year. If you look at the fourth quarter for treasury management, we were up 7% fourth quarter of '22 to fourth quarter '21. If you look at the entire year, we were up 9% in TM. So, that’s been a positive to us that’s helped bolster that downward trend of service charges due to all the account changes that we’ve made and will be a strength for us going into 2023 and gives us confidence, as John mentioned, that we can meet the $550 in service charges for the year.

Just a big picture strategic question. Obviously, you’ve done an amazing job growing the interest income and getting the rate call right. It seems like 3 for 3 here. But I guess the flip side is the kind of revenue mix has become more dependent on rates and the balance sheet, right, as we think about the fee composition. So, anyway, long story short, the question is what strategic opportunities do you have to grow the fee revenues and maybe something that’s more from an acquisition point of view to accelerate that?

We have been actively pursuing nonbank acquisitions, particularly to enhance our capital markets capabilities. Despite experiencing a somewhat soft fourth quarter, we are pleased with how these capital markets investments are helping us strengthen customer relationships and significantly increase noninterest revenues over the past six to seven years. Additionally, we are excited about our investments in the consumer sector, such as the acquisition of Ascentium Capital, which is part of our Corporate Banking group, and interbank, which allows us to expand loans to homeowners. The mortgage servicing rights we acquired have also been beneficial. In the wealth management area, our acquisitions have provided modest but helpful contributions, and we are still seeking further opportunities there. We are positioning ourselves to continue growing capital, and we will make additional investments when the right opportunities present themselves. You can expect us to build on the initiatives we have already undertaken.

Yes. Matt, let me add that the ability to grow net interest income is a positive development. We understand that this reduces the proportion of noninterest revenue overall. However, we take pride in how we have managed our balance sheet. More importantly, our goal is to reduce the volatility in that area. If you consider our hedging capabilities, we are securing what we believe to be a strong margin range of $3.60 to $3.90 over time, regardless of changes in the rate environment. This provides us with significant stability. Therefore, if having higher net interest income results in a slightly lower percentage of noninterest revenue compared to historical levels, we are fine with that. As John mentioned, we plan to utilize our capital for some nonbank acquisitions, similar to what we have done previously, though nothing too large, to strengthen our noninterest revenue streams and enhance our resilience in various environments.

Understood. That’s helpful. And then just somewhat related, I’ve been asking a lot of your peers the same question, but you all seem to be building capital kind of well beyond what I would have thought that you would need. And you talked about kind of the upper end to 9.25%, 9.75% CET1, and that’s not new. But I guess the question is, why are you and others potentially all building what seems to be well in excess of what you need for CCAR? Are you anticipating something from CCAR changing? Is there kind of pressure behind the scenes from rating agencies, regulators or are just all the banks deciding on their own to be a little more conservative given the cycle where we are? Thank you.

Yes. Well, Matt, we can’t speak for the other banks. I would say for us, it is a bit of an uncertain time. We think there potentially are opportunities to continue to make nonbank acquisitions will arise. We were fortunate enough to make three in a short period of time at the end of 2021. And just operating at the upper end of our range gives us some flexibility, and we’d like to continue to maintain that given the uncertain environment that we’re operating in.

If you examine the CCAR degradation in capital, it was among the lowest in our peer group. Therefore, we do not require capital to manage the risk present in our balance sheet; we are primarily seeking opportunistic opportunities. Additionally, having a bit more capital does not negatively affect our returns. We achieved over 30% return on tangible common equity, so maintaining the upper end of 9.75 will not have any significant impact.

A couple of questions. One, just on the loan growth outlook, I know you indicated you expect ending balances to be about 4% up year-on-year. Could you give us a sense as to how you’re thinking through the dynamics of which pieces of the loan growth are likely to accelerate, be on the high side, lower side? And then, how much longer that runoff portfolio is going to impact the numbers? Thanks.

We anticipate that loan growth will moderate due to the general slowdown in the economy. Our growth potential seems to be concentrated in the corporate banking sector, as we expect an increase in line utilization. There may also be some potential in real estate, where we saw growth primarily in multifamily housing, which we remain pleased with. Our concentration of investor real estate is one of the lowest among our peers, and we plan to use our capital wisely with the right customers, particularly in multifamily projects. On the consumer side, our Interbank acquisition from late 2021 is performing well, and we anticipate further growth opportunities from it. The mortgage sector may face challenges again in 2023 due to the rate environment, though there has been some stabilization, which may provide us with slight growth opportunities in consumer services. Additionally, we have several runoff portfolios; by the end of this year, we expect not to be discussing exit portfolios any longer.

I would just add, despite the fact that we expect a small business customer to be under some pressure in more challenged economy, we’re seeing real opportunity through the Ascentium Capital platform, making loans to businesses on business essential equipment. We’re able to leverage that platform, which is very specialized in nature through our branch system into our existing customer base, and over 35% of our branches in 2022 originated a loan through the Ascentium Capital. We’ll see more of that grow, I think, and again, another opportunity to leverage an acquisition into our existing customer base.

Yes. I wanted to follow up to better understand Ascentium and its impact on your business. Specifically, what is the average size of an Ascentium loan? Is it more typical of small or medium-sized businesses, or could you provide some additional insights on that?

Yes, it is a small business. The loans are made for equipment that is essential for operations. The idea is that the business owner is likely to prioritize paying this loan because they need the equipment to run their business. The average loan amount is approximately $75,000, with terms averaging between 3 to 4 years.

Okay, great. And then, just lastly, a follow-up on the funding question that came up earlier. I mean, we’re hearing from others that borrowing from federal home loan banks is interesting, even though the base rate sticker price might look a little higher. You obviously get some dividend back from the swap you also get the fact that you don’t have to pay the FDIC. So, I’m just wondering is it at all attractive to you at some point to lean in more there or not?

I think we need to assess that more closely when the time comes. We still have opportunities available. We’ve seen $2 billion to $3 billion in corporate deposits leave our balance sheet as clients look for higher rates that we weren't willing to offer. These clients are still with us; they have their operating accounts here but have shifted their excess cash elsewhere. Thus, there's a chance to reconnect with those customers before we consider seeking other wholesale funding. We have multiple options available, including term debt that could assist us with the FDIC. We will need to evaluate the overall cost of all our options at that time, which, as I mentioned earlier, will likely be in the second half of the year.

Right. You haven’t needed that at this stage. Got it. Thanks so much. I appreciate it.

So, it’s hard to pick apart anything in this quarter, results were fantastic. I guess, the one question I get from people is, as we start to see maybe some normalization in credit is how do you really highlight for folks how much different your franchise is today versus pre-cycle? I know you’ve laid some of that out in mid-quarter presentations, the shift to investment grade and so forth. But how would you combat that pushback from some folks?

I think balance and diversity is the first thing I would point to when you look at pre-Great Recession our balance sheet, whether it be on the right side or the left side, assets or liabilities, we had concentrations in certain asset classes, and we were very dependent on interest-bearing deposits for funding. If you look at the reshaping of our balance sheet over time, our liability side of the balance sheet, I think, is really strong and provides, as we've talked about, a foundation for our outperformance, and we expect that will continue. On the asset side of the balance sheet, we have only less than 10% of our outstandings are in investor real estate. That’s down significantly from pre-crisis levels. And we also, I think, have been very committed to concentration in risk management. We have a very active and ongoing credit risk management process, which we believe will produce much better results than we had previously delivered. We’re committed to consistent sustainable long-term performance, and that requires that we manage credit risk well. At the end of the day, I know we’ve got to deliver, and we intend to do that, but we think we’re well positioned.

I would add that we also developed, not too long ago, a new tool. We call it our click, which didn’t mean anything to you. But what it does is it analyzes the cash flows of each of our customers. And we’ve built that to give us an idea of product and service that a customer may need from us that they don’t have. What we found is it gave us such good information on cash flows every month that it gave us an earlier indicator of potential credit stress. And that’s part of what you’re seeing when you see us move things into criticized categories. We can be more proactive because we have better information to manage credit risk management through that tool.

I think we can conclude by saying we’re awfully proud of our 2022 results and the momentum that we’re carrying into 2023. We’ve worked hard over the last 10 years to remake our business and to build a balance sheet and income statement and importantly, a culture of risk management that will allow us to deliver consistent, sustainable performance. And we think we’re seeing that now. We’re going to continue to focus on organic growth and investing in our business, and we believe we’ll continue to deliver the kinds of results that you’ve seen in 2022. So, thank you for your interest in our company, and have a great weekend.