Zions Bancorporation N.A (ZION) — Q2 2018 Earnings Call Transcript

Thank you, and good evening. We welcome you to this conference call to discuss our 2018 second quarter earnings. For our agenda today, Harris Simmons, Chairman and Chief Executive Officer, will provide a brief overview of key strategic and financial objectives; after which Paul Burdiss, our Chief Financial Officer, will provide additional detail on Zions' financial condition, wrapping up with our financial outlook over the next four quarters. Additional executives with us in the room today include Scott McLean, President and Chief Operating Officer; Ed Schreiber, Chief Risk Officer; and Michael Morris, Chief Credit Officer. Referencing slide 2, I would like to remind you that during this call, we will be making forward-looking statements, although actual results may differ materially. We encourage you to review the disclaimer in the press release or the slide deck dealing with forward-looking information, which applies equally to statements made during this call. A copy of the full release as well as the slide deck are available at zionsbancorporation.com. We will be referring to the slides during this call. The earnings release, the related slide presentation and this earnings call contain several references to non-GAAP measures, including pre-provision net revenue and the efficiency ratio, which are common industry terms used by investors and financial services analysts. The use of such non-GAAP measures are believed by management to be of substantial interest to the consumers of these financial disclosures and are used prominently throughout our disclosures. A full reconciliation of the difference between such measures and GAAP financials is provided within the published documents, and participants are encouraged to carefully review this reconciliation. We intend to limit the length of this call to one hour. During the question-and-answer section of this call, we ask you to limit your questions to one primary and one related follow-up question to enable other participants to ask questions. With that, I will now turn the time over to Harris Simmons. Harris?

Thank you very much, James. We welcome all of you to our call today to discuss our second quarter results. The results of the quarter were strong, relative to year ago results. On slide 3, you can see the improvement of earnings to $0.89 per share, up from $0.73 in the year ago period. There are a couple of notable items that affected the EPS growth. First, in the year ago period, there was about $0.05 per share of interest recoveries, which we called out at that point as somewhat unusual in nature. At least, the dollar amount of the recoveries in that quarter was unusual and indeed in the second quarter of 2018, we had only a fraction of a penny per share of that same income. Secondly, the change in the tax rate had a materially positive impact on the earnings, relative to a year ago period, which was worth about $0.11. Adjusting for those two items, in an effort to make results more comparable, we experienced about a 12% increase in EPS over the prior year period. Earnings per share for the second quarter of 2018 continued the trend of strong growth with solid pre-provision net revenue growth. Although non-interest expense was higher than expectations and we acknowledge it was somewhat higher than our outlook from a year ago, we've experienced a stronger expansion in profitability, better credit quality and stronger EPS growth than previously expected. The increase in non-interest expense is primarily due to incentive compensation, which we’ll discuss in more detail later. But I'll say upfront that we still expect adjusted non-interest expense to increase slightly from 2017. Slide 4 highlights two key profitability metrics, return on assets and return on tangible common equity. We have slightly increased the leverage of the balance sheet, but we expect to do more over the next several quarters. Let me take this opportunity to address our return of capital, both in the form of share repurchases and common stock dividends as well as our progress on the consolidation of our holding company with and into our bank subsidiary. As I suspect almost all of you are aware, in May, the Economic Growth, Regulatory Relief and Consumer Protection Act was signed into law. Later, on July 6, banking regulators issued interagency guidance, which indicated Zions would no longer be part of the CCAR DFAST framework and other requirements referred to collectively as enhanced prudential standards, which we are no longer subject to. Additionally, just last Wednesday, the Financial Stability Oversight Council announced the proposed decision to grant Zions’ appeal for relief from the designation as a systemically important financial institution. Finally, our merger of the Bank Holding Company with and into the bank has been approved by the Office of the Comptroller of the Currency and the FDIC. We have yet to hold a shareholder meeting. We expect to announce the date of that meeting shortly. But once shareholders weigh in and assuming their vote is favorable, these regulatory changes should result in the merger of the holding company into the bank, combined with these regulatory changes, should result in significantly less duplication of regulatory exams as well as increased flexibility for the board and returning capital to you. We are particularly pleased with these developments. These, combined with our goal of achieving positive operating leverage, should result in further expansion of our return on tangible common equity. We remain focused on achieving competitive returns on our assets relative to peers. One of the real highlights of the second quarter of 2018 and really dating back more than a year now is the continued strong improvement in credit quality. On slide 5, you'll see the strong trends depicted on the chart in the right with classified loans declining a particularly strong 31% from the year ago period. Improvement in oil and gas loans accounted for more than 90% of the improvement over the prior year. We experienced net credit recoveries of $12 million or 11 basis points of loans annualized. Net charge-offs through the last four quarters were only 3 basis points. We expect that credit recoveries, which were $25 million in the quarter, will remain a beneficial factor in the remaining months of 2018 and will contribute to what we expect will be a low overall rate of net charge-offs for the full year. Additionally, as you can see from the allowance ratios, we are still maintaining a strong coverage of non-performing assets and other problem credit metrics. The allowance increased slightly from the prior quarter, entirely due to an adjustment in our qualitative factors to reflect stresses that we can see in the broad economy, such as the discussion and implementation of tariffs and the adverse impacts that can have on certain industries, but that have not yet resulted in visible deterioration of our credit quality measures. Additionally, periodically, we refine our risk rating models and reflected in the second quarter results was a modest increase to the allowance for credit loss from such a refinement. The other major theme that has developed over the past three years is strong and relatively consistent growth in pre-provision net revenue as depicted on slide 6. Adjusted for the items listed in the tables in the end of this slide deck or our earnings release, and also adjusting for the larger interest income recoveries, which we characterize as being interest recoveries in excess of $1 million per loan, our pre-provision net revenue increased 7% from the year ago quarter. As we've been saying for a while now, the growth rate of 20% plus that we had experienced for a period of time would likely slow because we had harvested the quicker fixes, including deploying cash into securities, consolidating loan and deposit operation centers and some other simplification initiatives. We've said and continue to expect the pre-provision net revenue growth rate to be in the high single digits, without giving consideration to additional interest rate increases by the Federal Open Market Committee. We have momentum in several areas of revenue growth, including several areas of lending, such as residential mortgage, owner-occupied and municipal lending as well as trust and wealth management and other select areas within fee income. Partially offsetting those items, we've experienced a meaningful slowdown in term commercial real estate lending. As we mentioned on last quarter's earnings call, the market pricing of such loans has tightened meaningfully relative to pricing in 2017. We've also seen some erosion of terms and conditions in the marketplace. This combination has given us some pause in aggressively pushing for growth in that portfolio. Stepping back from the details and looking towards the future, we remain comfortable about achieving our loan growth, the growth rate targets in the mid-single digits. Even with what may be relatively stable term commercial real estate balances, we've experienced success in hiring many relationship managers. In fact, approximately two-thirds of employees added during the past year have been relationship managers or support staff required to facilitate loan and deposit growth. Although that has a near-term effect on expense growth, we are optimistic about the prospects for revenue growth from healthy loan growth. Slide 7 is a list of our key objectives for 2018 and ’19 and our commitment to shareholders. We remain focused on simplification as well as growth, which includes balance sheet, revenue, pre-provision net revenue and earnings per share growth. We're committed to continuing to achieve positive operating leverage. We have momentum in many areas of revenue generation and we have an economic tailwind with rising interest rates and strong customer sentiment. We’re targeting high single-digit growth of pre-provision net revenue without the assistance of benchmark interest rate increases. We believe we've built a very strong risk management infrastructure and as such, we expect to reduce the level of volatility and credit quality and overall net charge-offs during the next downturn, whenever that may be. We continue to invest significantly in technology improvements, which includes the substantial overhaul to our core operating systems, but also includes the adoption of many products that we expect will keep Zions competitive and our customers’ information safe. We remain committed to further improvement and simplification of our operational processes. Although we have already accomplished a great deal of operational and financial simplification, we believe there is still much we can accomplish, which we believe will result in an improved efficiency ratio, balance sheet profitability and better satisfaction for customers and employees. In 2015, we indicated that we were going to be targeting much more substantial returns on capital than what could be seen at that time. As I just mentioned, there's still room for improvement, some of which should be achieved as we rightsize our capital structure. But we've also come a long way since 2015. Regarding returns of capital, we've increased that from approximately 20% of earnings to a ratio of approximately 90% during the past four quarters. We view an increase of balance sheet leverage as appropriate, particularly given the reduction of the risk profile of the company, the decision on the magnitude, timing and form of capital return as a board-level decision. Recently, many other CCAR banks revealed the specifics of their capital plans. In our communication, we opted to give the board the appropriate flexibility to make its decision. However, I'm comfortable in saying that we intend to raise our payout to a greater ratio than in the past and that we recognize the common equity tier 1 ratio on particular needs to move down toward the pure median. Finally, we remain committed to a community-centric banking approach, maintaining the local approach to banking, separate brands, etc., that have helped us to win awards, such as best bank in Orange County, San Diego County, best bank in Nevada and various others. That is really a reflection of the satisfaction with our customers’ experience and customer profile, which is particularly attractive. With that overview, I'll turn the time over to Paul Burdiss to review some of the financials in additional detail. Paul?

Thank you, Harris, and good evening, everyone. Thanks for joining us. I’ll begin slide 8. For the second quarter of 2018, Zions’ net interest income continued to demonstrate growth, relative to the prior year period. Excluding interest recoveries of $16 million a year ago and $1 million in the current quarter, net interest income increased $35 million to $547 million, up approximately 7%. With respect to revenue drivers, slide 9 shows our average loan growth of just less than 5%, relative to the year ago period. Average deposits increased slightly from the year ago period and increased 7% annualized from the prior quarter. Thus far, we've been able to achieve this with a relatively modest increase in deposit costs. Slide 10 depicts year-over-year loan balance growth of about 4% point to point, with the size of the circles on the chart representing the relative size of the portfolio components. This loan growth was adversely impacted by attrition in the term commercial real estate and national real estate loan portfolios of about $320 million. We experienced consistent growth trends in one to four family, owner occupied and home equity. Oil and gas loans have increased modestly, resulting from a relatively strong increase in upstream and midstream loans and a more than $100 million decline in energy services. Municipal loan growth has also continued to be strong during the past year. We've hired a number of staff to help us grow in that area, which is focused on smaller municipalities and essential services of those cities. We've maintained strong credit quality standards and feel comfortable with that growth. Commercial real estate, including the construction and term portfolios, declined slightly due to the reasons Harris has already articulated. In the guidance portion of the slide, we've moved term commercial real estate to generally stable from moderate to strong. We remain comfortable with our loan growth outlook for moderate growth, which is to be interpreted as a mid-single digit annual rate of growth. Slide 11 breaks down key rate and cost components of our net interest margin. The top line is loan yield, which increased to 4.57%, of which about 1 basis point is related to interest recoveries. Relative to the prior quarter, the yield on the securities portfolio decreased slightly, largely due to greater prepayments, particularly in our Small Business Administration loan-backed securities. Securities premium amortization in the quarter was $36 million, up from $33 million in the prior quarter. The duration of the securities portfolio was 3.5 years at June 30, 2018 and after shocking the portfolio by increasing the yield curve 200 basis points across the curve, there was no material change to the portfolio duration in our models. The cost of total deposits and borrowed funds increased 7 basis points in the quarter to 40 basis points, resulting in a funding beta of about 25% for both the year-over-year and linked quarter periods. As a reminder, in this case, beta refers to the change in the cost of deposits and borrowings relative to the change in the cost of the federal funds target rate. The total year-over-year deposit data was about 14% and was 23% for the linked quarter, as we began to utilize additional strategies to retain existing and attract new deposit relationships as well as bring deposits on the balance sheet that had previously been swept off into money market and other funds. Cumulatively, since the beginning of the rising rate environment, we've experienced a total deposit beta of 7%. We still see good pricing stability and customer growth in the smaller and operational accounts, while larger dollar accounts have been the most sensitive, as one might expect. All of these elements combined to result in a net interest margin of 3.56% for the quarter, which increased 4 basis points from the year ago period. However, excluding the interest recoveries that we've previously highlighted and the effect of corporate tax reform on fully taxable equivalent revenue and yield, the net interest margin expanded 16 basis points over the year ago period, which reflects a NIM beta of approximately 20% or roughly 5 basis points of net interest margin expansion for each quarter point of benchmark rate increases. We believe this may temper moderately during the next year, as competition for loans and deposits intensifies. Next, a brief review of non-interest income on slide 12. Customer related fees increased 3% over the prior year to $125 million. Several line items experienced favorable improvement relative to the year ago period, including corporate trust, loan and card fees and capital markets activities. Non-interest expense on slide 13 increased to $428 million from $405 million in the year ago quarter. However, using our calculated, adjusted non-interest expense, which adjusts for items such as severance, provision for unfunded lending commitments and other similar items, non-interest expense increased $22 million to $421 million from $399 million in the year ago period or about 5%. A portion of the increase relates to additional compensation that we announced in conjunction with the Tax Cut and Jobs Act, which will be paid to most employees making less than $100,000 a year. Those items account for about $3 million of the year-over-year increase. As detailed in the press release, about $8 million is attributable to increased salary expense, which reflects annual merit and cost of living adjustments, which are generally reflected in the second quarter of each year and the increase in the number of employees, which Harris explained earlier. Incentive compensation increased by $11 million, as a result of improved financial performance and the continued improvement in the absolute level of credit quality. Turning to slide 14, the efficiency ratio was 60.9%, compared to the year ago period of 61%, when excluding the interest recoveries previously detailed. We reiterate our commitment to achieve an efficiency ratio below 60% for the full year 2019, excluding the possible benefits of rate increases. Finally, on slide 15, you see our financial outlook for the next 12 months, relative to the second quarter of 2018. One note, in the interest of simplifying our tax rate disclosure, we're attempting to give an outlook for the tax rate that includes the effects of stock-based compensation. This reduced the effective tax rate by 1.4 percentage points in the second quarter. Our outlook assumes no further option exercises in the second half of the year. In the interest of opening up the line for questions, I won't read the rest of the slide to you, but I will be happy to take questions regarding our outlook or any other matters. This concludes our prepared remarks. Would you please open the line for questions?

I guess maybe just starting off, in terms of loan growth. Obviously, your 12-month outlook really hasn't changed. It’s still moderately increasing, but just I would love to kind of reconcile that with Harris's comments in the press release and in the presentation, just about how things are getting more competitive in commercial real estate? Or obviously, this quarter's loan growth looks like it was a little bit on the weaker side. Like why did it get better? Like, how, just if feels like the underlying trends are getting more negative, but the guidance is not. So I’m just trying to reconcile those pieces.

Sure, Ken. This is Scott. Harris, why don’t I jump in here and then you jump on top.

Yeah. That's fine.

Okay. Ken, if you look at slide 19, it will help you structure a response. The top panel of slide 19 shows loan growth by affiliate and type. I want to highlight the far right column, which totals up the figures. I will discuss the comments on commercial real estate later, but first, let's look at the overall picture. We're maintaining our guidance because the far right column shows about $500 million in growth from commercial and industrial and owner-occupied loans, which is a significant portion. If you look down, one to four family loans also show around $500 million, and when you add home equity loans, these constitute our residential financing activities. Further down, municipal loans are also at $500 million. These are three strong segments. In general, the portfolio is healthy, with these three being solid pillars for growth. Additionally, we’ve mentioned previously that we expected energy to begin growing again around this time, and it is indeed starting to contribute. While Harris commented on marketplace trends and what we’re observing, we believe commercial real estate will grow too, both in construction and development and commercial real estate term lending. The primary components for us remain commercial and industrial and owner-occupied lending, our residential finance business with one to four family and home equity loans, and municipal lending, which continues to perform well. We anticipate positive contributions from energy and commercial real estate as well. That’s why we are not changing our guidance. It’s not unusual for us to experience a couple of softer quarters each year, which is part of how we've achieved mid-single-digit growth over the past three years. Regarding the commercial real estate comments made by Harris, it’s widely recognized that pricing in that market has become more competitive with non-bank lenders taking on more risk, and terms have become slightly more flexible. Nonetheless, we have managed to gain positive momentum in that area in the past, as we have with construction and development.

Can I just add that my comment was meant to highlight the findings of anyone reviewing the numbers, particularly that commercial real estate has been a significant area of drag. A year ago, we noted that pricing had expanded, which presented opportunities. However, the market is now tougher, and we need to be more selective in choosing deals that make sense. While I don't want to overemphasize this point, it is where we have faced some challenges. On a positive note, I am encouraged by growth we are seeing in areas like municipal and owner-occupied properties. I still believe we will reach the targets we set, but it will be less dependent on commercial real estate than we initially expected.

As a follow-up question regarding expenses, is the current quarter's figure, whether reported or adjusted, the appropriate level to consider moving forward? Your guidance seems unchanged, but are there any specific unusual or elevated items that will be excluded?

Paul, do you want to tackle that?

Yeah. Yeah. Ken, I would focus on, if I could, rather than just trying to look at the current quarter, we've identified several items that are impacting our expenses this quarter. But as you correctly point out, we haven't changed our outlook we've provided. And so, we expect to remain along that same trajectory and I would point out, as I think pretty consistently what we've been saying is that largely, our expenses are going to hopefully be in a spot or we intend for those to be in a spot where we are continuing to create positive operating leverage and you’ve seen our revenues grow pretty substantially over the last year. So we are not changing our expense outlook, particularly over the next four quarters, Ken. So I would focus on that.

On the capital deployment side, can you talk to us a little bit more about what the timing and the board decision could be? When is your board meeting and what are some of the considerations there, factoring in here. I know, Harris you mentioned you felt it was prudent to give the board the flexibility there. So what are they considering actually that, in terms of, is it the form or the timing or how can we think about?

I can share that you'll receive more information soon as they will be meeting at the end of next week. One reason we wanted to let them handle this is due to the imminent meeting. We certainly have a proposal prepared, and I believe they will be open to it. From management's viewpoint, we anticipate a continued increase in capital distribution. I think I'll leave it at that, but more updates are coming shortly.

Is your board meeting a typically scheduled board meeting or would it?

Yeah. It's a regularly scheduled board meeting. Yes.

And then I’ll let my follow-up also be on the same capital topic, but can you just remind us of what your CET1 target is from a longer term perspective and how do you view that in context of how quickly you’d like to get there. Thanks.

I previously mentioned that I would like to see our metrics slightly above the median. As we continue to reduce risk on our balance sheet, aiming for the median seems to align with our general target. This target may shift slightly, but we will have greater flexibility now that we have some relief from CCAR and DFAST. We will still utilize stress testing, and we plan to apply it more effectively than before to identify risks and weaknesses, ensuring our capital targets are sound. The execution of our plans should be more adaptable than in the past, and we will maintain communication with regulators. We anticipate completing this merger by the end of the third quarter, which will align with the OCC's direction. We expect to have a bit more flexibility to fine-tune our approach from quarter to quarter. That is my current perspective on the matter. Paul, do you have anything to add?

I want to emphasize, John, something that Harris mentioned earlier, which is our expectation for an increase in our payout compared to previous levels. As Harris noted, we will be discussing this in an upcoming board meeting. This aligns with our consistent narrative, John. We believe we have more capital than necessary based on our stress test outcomes. We have expressed our view that our capital ratio should ideally be above the median as we assess the risks on our balance sheet. While the timing to achieve this may be somewhat flexible, I am optimistic that the board will consider a plan to reach this goal in the near to medium term.

Paul, two balance sheet questions for you. First, on the right side of the balance here, it looks like you did start to see some of that mix shift into deposits and out of some of the higher cost wholesales funding. Can you help us understand how much of that you saw and how much more of an opportunity that can still be from here?

There was only a small amount of that this quarter, and I would estimate it in the hundreds of millions. In terms of our balance sheet, it wasn’t a significant change. I believe you are referring to the initiative we've discussed before, which involves creating a product to help bring some of our clients’ off-balance sheet funds back onto our balance sheet. We’ve seen some success in that area, but it’s still a bit too early to detect a substantial impact. Does that answer your question, Ken?

Well, do you think it can be a big meaningful impact? And is it the type of thing where you expect that you could see big take-up or is it more of a gradual type of thing?

I think the opportunity, as I think we've previously articulated, is kind of in that $1 billion range. But we'll see.

And on the asset side, you mentioned the small business securities amortization, can you help us understand the yields in the securities book were down a few basis points, how much of a burden was that on the securities yield and what's just happening in terms of new money coming on versus what's rolling off underneath the surface?

Yeah. Overall, these are kind of box card numbers. Overall, the increase in the premium amortization was worth about 8 basis points on the overall securities portfolio yield. And a lot of that came from the SBA portfolio. As a reminder, the SBA portfolio was about $2 billion, generally variable rate that is prime-based, but it has a kind of a 10% premium attached to it. So, relatively small changes in that prepayment rate can have fairly large changes in the premium amortization, and that's what we saw this quarter. Hopefully, that answers your question.

Well, the second part was just, what's the front book, back book doing underneath that? What are you getting new money yields versus what's rolling off, as you're investing today?

The new money yields are clearly more than 50 basis points better than where it is rolling off, and it's actually even better than that.

Just a quick one on credit. The qualitative adjustment you mentioned, did I hear that was the entire amount of the provision for the quarter? And if so, did that also account for the provision for unfunded commitments as well?

No, there were several adjustments that went into that. As you correctly pointed out, we consider the allowance for credit losses in the aggregate. There was the allowance for loan lease losses and the provision for unfunded lending commitments. But that qualitative piece was just one aspect of that, if that's what you're asking.

Yes. And any particular areas on which you became more punitive in your models this quarter?

Well, again, on the qualitative piece, we observed macroeconomic trends. As I think we said in the press release, things, for example, heightened trade tensions may create stress in the portfolio, or as interest rates rise, that may produce some credit stress on our borrowers. So it was things like that and again nothing gigantic, but we're just in an environment where it feels like nothing can go wrong with respect to credit because credit has been so good and improving for so long. Management, I think, is really trying to understand where the risks are in the portfolio. I understand what those incurred losses are in the portfolio and reserve accordingly.

So no particular product type that particularly got hit this time?

The portfolio, kind of, strictly speaking across the board, both geographically and by product continues to perform very, very well.

I want to touch on loan growth here. It was up 5%, but your unfunded commitments were up 10% year-over-year. Wondering what's driving the difference there, whether it's customer sentiment or if it's the way originations are weighted towards municipals or construction?

This is Scott. The increase in unfunded is primarily related to our construction loan portfolio, which will bode well for fundings over the next couple of quarters. I would not say there was any other real material change.

And then with regard to CECL, just wondering, do you have any updated thoughts on CECL and if you have any thoughts as to how it could impact your capital plans down the road?

CECL is a developing topic. I certainly like to think that the work that our team here is kind of second to none in the industry in terms of ensuring that we have the appropriate kind of models and processes to be able to develop that. We're not in a position, because of the, I'm sure you're probably pretty familiar with it, but because of the diversity of assumptions required, we are kind of working with regulatory agencies and industry groups to kind of understand and try to triangulate on some assumption sets that make sense in the context of what makes sense for the industry because we're particularly worried, I'm particularly worried, about the comparability of financial results after CECL is implemented. This diversity of assumptions is going to make a really big difference across banks. And so our expectation is in 2019, we'll start to see a little more quantitative disclosures around this, but for now, we are paying a lot of attention to it.

You talked about hiring relationship managers and producers over the last year. If you have this number, how many of those have you hired just in 2018, versus the comparable period last year?

Well, maybe, I'll think that, Jennifer. This is James. One of the things that we looked at was with the revenue growth producers, meaning, relationship managers, deposit folks, treasury management and what we found is that there was a little over 100 new employees that were hired in the affiliates over the last year and about 70% of those were revenue generators or the support staff. And so it's just a very solid mix of a lot of revenue growth opportunities we think in the future from these new individuals.

Jennifer, this is Scott. I would say, there's some especially new highly experienced additions we've made in key growth markets like Dallas and Denver, and those are the two that I would point out.

Was there an outsized amount hired in the second quarter?

It's been an ongoing process, Jennifer, I would say. And so I think some of them – certainly, some of them came on in the second quarter. We actually did see a bump up in the month of June.

And Jennifer, the non-relationship manager sort of hires, I would characterize as principally technology-related and areas related to our technology, our technology investment priorities and also information security and those kinds of areas. So that's where you would see the increases. We're continuing to find ways to economize in all of our back office activities through our simplification initiatives, and so we're very specific about where we're adding people around revenue growth and technology.

Just wanted to ask a follow-up just on loan growth, as you were pointing out, Scott, going through the slide 19. Can you talk about just what was happening in commercial and industrial ex-oil and gas, both at Zions and Amegy year-over-year and at Amegy particularly, the last quarter as well?

Yeah. This is on page 19. And I really wouldn't have a specific comment for you. There are ebbs and flows in this, and I wouldn't comment about anything necessarily specific about it. So I'm pretty familiar with both, and I'm not sure there's a trend we're necessarily seeing that would be especially setting some sort of new path or trajectory. Those are two, as you know, historically strong commercial and industrial affiliates for us. So I anticipate that they will continue to be that way. And we look at owner-occupied really quite frankly as the same. So in terms of year-over-year, we look at both of those lines as kind of a combined line, doesn't really change your question, but we do look at them together.

And even when considering the previous quarter at Amegy, is what we observed just significant paydowns and a few credits, or are there no conclusions or comments to draw from that?

We will look into it. We can follow up with you, but my guess is that there were probably several large payoffs.

I’ll just add that it can fluctuate. I mean, the week to week, the number can routinely change by about $100 million in any given week in commercial and industrial. So, over the course of the quarter, you'd hope to see growth, but there is some volatility over time.

And just as my follow-up, in terms of the pending merger of the holding company into the bank, in terms of cost, I know that there are some efficiencies and you will eliminate some redundancies as it relates to your exams. Are there any actual cost savings out of the gate from that or is it really a question of, sort of moving people's attention to different duties and different things within the bank?

There will be modest real cost savings regarding the initial impact. The main advantage lies in gaining certainty over regulatory interpretations. Having two regulators addressing the same issues often results in frustration, making it harder to get things done. The focus is on regulatory efficiency and obtaining clear answers quickly on specific issues. This doesn't guarantee that we'll always feel satisfied; there will be times we might wish one regulator had been more lenient than the other. It's not about one being superior to the other, but anytime you have two referees making calls on the same play, there can be differing opinions that may delay the process.

I wanted to first follow up on John's questions on capital return. Is there any reason that you guys would need to first resolve the holding company consolidation, or should improved capital return happen relatively soon after the board meeting?

Yeah. I think I expect we'll see – as I said earlier, very quickly after the board meeting, some announcements around what we expect and at least in the short term. So, no, the merger isn't something we have to wait for to start creating a little better clarity around capital return.

And then separately on the expense guidance for Paul, how do you define low single digit? Is this around 2 to 3 percent? And is there an assumption for the removal of the holding FDIC surcharge in your guidance?

It is 2% to 3% and my expectation is that and hope is that the diff will achieve its target ratio by the end of the year and that we would see some benefit from that.

Okay. Is that in your 4Q assumption?

It is.

Can you share what that assumption is?

It’s about $7 million.

My first question is the flexibility in terms of your liquidity, as you no longer have to comply with liquidity coverage ratio or living will. Paul, if you could remind us what are your HQLA-eligible securities and given Harris’s earlier remarks on balance sheet efficiency and profitability, how you can see the composition of your balance sheet evolve over time as your prudential regulatory structure has already changed?

Erika, I would remind you that the liquidity coverage ratio was never really a constraint for us and the reason largely is the composition of our deposits. While we have a lot of commercial deposits, they’re largely operational in nature and therefore received, on a relative basis, kind of favorable treatment under the liquidity coverage ratio. Our constraint is and has been actually liquidity stress testing, and while the requirement for liquidity stress testing, kind of, the official regulatory requirement under the - and hence prudential standards is no longer applicable, we find the liquidity stress has to be a very useful management tool, hence reported on a regular basis all the way up to the board. So in fact, I would not expect to see a big change in the way we are managing our book. I will say philosophically, the securities portfolio exists first for liquidity and second to manage interest rate risk. That's been true and that's going to continue to be true. So I do not see a change in the composition of that book.

My follow-up question is related to Ken's earlier inquiries. Can you share more about the deposits you aim to bring back to your balance sheet? Specifically, how does the rate compare to your current funding sources? I noticed that time deposits have increased significantly, and there is also the option of wholesale funding. Please help us understand what rate would be required for $1 billion to be attracted.

Yeah. I'm just going to make one real quick, Erika, follow-up on the liquidity conversation. Portfolio composition is going to be driven by changes in the rest of the balance sheet, not by changing the way we manage our liquidity. I just wanted to kind of close the loop on that. As it relates to those kind of alternative vehicles for our client investments, those are going to have a rate, Erika, that is frankly pretty close to market rate, a little better than. We wouldn’t offer it if it weren't profitable to us but not massively profitable and nothing like we would see from kind of a core money market or a savings account. These are going to be, because they are targeted towards our larger and more sophisticated clients, they're going to have a rate that looks much more like a capital markets rate attached to it. That's true in terms of rate and beta.

Erika, this is Scott. I want to add that I believe Paul is absolutely correct. It will all be beneficial over time, but it will really depend on how successful we are when we bring off balance sheet funds back on. Our bankers are becoming more skilled at attracting large deposits that are not currently in money market funds. If we succeed in this area, we will create an even more favorable experience than merely returning off balance sheet funds to the balance sheet.

But the point is, we're paying for the money and we would rather pay our clients than pay others. We are a relationship-driven company and we want to make sure that we kind of continue to deepen those relationships everywhere we can.

You talked about pressure on pricing structure in Term commercial real estate. Can you give us a bit more detail, both on the structures that you’re seeing in the market that you don't like and you want to stay away from and on the pricing compression that's been taking place, just help us size that?

This is Michael Morris. I’ll fill that one. We're seeing probably 25, 30 basis points of pricing pressure above and beyond typically where we like to go. We're seeing burnoffs of guarantees sooner during construction and sometimes early in the stabilization period. And I would say those are two of the bigger drivers, maybe a little bit longer ammo here and there on select product types.

Geoffrey, as you know, Michael Morris is our Chief Credit Officer.

Paul, I just wanted to go back to deposit costs and I guess kind of the outlook for deposit costs for the next few quarters, as you bring more of these sweep accounts on to the balance sheet and we've got the June rate hike and most likely get a September rate hike.

I'm not certain if there will be a rate increase in June, but September seems probable. I don't anticipate a change in the overall beta of our funding because we are essentially substituting floating rate wholesale funds with floating rate client funds. Therefore, I don't expect the overall deposit beta to change. The main concern for us, as we've discussed before, isn't our deposit rate beta, but rather migration—specifically the movement out of demand deposit accounts and interest-bearing accounts and into other interest-bearing accounts. This migration is a key indicator of rate sensitivity that we are closely monitoring. In my prepared remarks, I mentioned that we've observed an overall funding beta of about 25% in the last quarter and over the past year. Our deposit betas have been lower than that. I hope this clarifies my perspective. Essentially, we are replacing wholesale funds with client funds that have similar rate sensitivity characteristics.

And then just one follow-up on the commercial real estate loan yields, they were up 25 basis points sequentially. I’m just wondering something unusual was there.

I think the number one thing is the recovery, interest recovery in the prior quarter is the number one driver. Those interest recoveries – this is James Abbott, those interest recoveries did not recur in the second quarter of ’18. They were absolutely present in the second quarter of ’17 and the first quarter of ‘18.

And then I would say overall it’s Michael again. Overall, construction gross loan yields are up a bit quarter-over-quarter.

Would you say this as a good commercial real estate loan yield, going forward continuing?

I'm trying to think of anything notable, but I can't really identify anything particularly extraordinary occurring this quarter. As Michael mentioned, the mix has shifted slightly with a decrease in commercial real estate and a slight increase in construction. I think there is some change in loan composition that's also contributing to this, but we will take a closer look at that.

Related to the fee income area and other service charges and deposit service charges, kind of lackluster growth, not just this quarter, but actually the past several years and if there's any way we can kind of see any kind of changes in that kind of trajectory.

Yeah. This is Scott. I think we certainly can talk about the individual elements, but customer fees in general were muted this quarter over this quarter last year, muted by about 200 basis points to growth because of an accounting change we made last year. So we're just – as we're managing the book of fee income, we're right on top of our mid-single digit growth rate.

And then just the derivative of prior questions, the incentive fee or the – that was paid this quarter related to performance, can you give us some details on what that performance entailed, whether it's on credit quality or financial performance?

Yeah. This is Paul. I’ll start and invite Harris or Scott to jump in. I want to be clear that it wasn’t incentive compensation that was paid this quarter. It’s the accrual of incentive compensation over the course of a year. A lot of this was sort of annual compensation and our annual program that is largely predicated on the profitability of the company. So as we tried to say in our prepared remarks, our number one credit quality continues to be very good and in fact better than expectations, but the other is revenue growth. We've had more, I’d say, interest rating and other increases, which have helped us increase overall revenues above and beyond what we were expecting at the beginning of the year. And I think those were the key components of that change. Harris or Scott, would you like to? I would like to add that we continue to believe our expense trajectory is aligned with the full-year projections we provided. The company's rate of process improvement, along with various significant projects, is simplifying our operations. This overall progress is what led us to slightly enhance the incentive compensation line this quarter.

The only thing I'd add is, it's just to remind us all that incentive comp, by its nature, is variable. And so if profitability generally isn’t materializing improvements in it, we would expect to see that the trends flatten in incentive comp. So there's kind of some self-correcting element to it as well.

Thanks for taking the follow-up. Just a quick one on the adjusted expense guidance. It seems like it actually implied a little bit of a step down in the expense run rate in the back half of the year for you to hit that 3% level on the upper end of your range. So if that FDIC surcharge doesn't come down in 4Q, are there other ways you could still hit that guidance for the year or anything that can get you that $7 million in expense reduction you might need to get there?

I think Harris just talked about one of the key ones.

The biggest factor we have here, Dave, is that while it’s not absolute, it's a reality that there are various types of incentives. Some are closely linked to specific production types, influenced by credit quality and other factors. However, much of the incentive pool is mainly shaped by overall profitability trends, which impacts annual bonuses for senior personnel. This will be adjusted carefully, but if we are not meeting the underlying trends we aim for, a portion of that will certainly affect management compensation.

I was only going to say, in addition to that, there is a lot of kind of current moving underneath the top of the water here as it relates to expenses and I know those of you who follow us all the time and I know you do, know that while we are cutting in places, we are also investing in other places. So there are other levers I believe as it relates to acceleration or decelerating some of the investments that we're making. That can help to manage that overall level of expense.

This is Scott. I want to add one final thing to punctuate Harris’s comment, he’s not talking in the theoretical. If you look at our last three years’ financial results, you know and you can see that we took incentive compensation down, related to hitting targets that we were very specific about. So we have demonstrated, maybe better than anybody else in the industry, a willingness to do that. So we're serious about it.

Looking ahead to 2019, there will be an additional $7 million in expense savings each quarter as the surcharge comes to an end. Do you believe that this low single-digit range is suitable for next year as well?

Well, right now, we've provided an outlook for the next four quarters. So that's all sort of a corporate in there, Dave. We’ll get to 2019 when we get there. We don't like to get out too far ahead of our skis.

Sonia, this is James Abbott here. We do have three more questions in queue. We're going to do the best we can to get to them, but if we can ask those of you who are going to ask questions, if we can be quick about them and we will try to be superfast in our responses as well.

Hey, guys. You’ve addressed all my questions. I’ll make it easy for you. Thank you.

This should be a quick one. Paul, you talked about trying to get your Tier 1 common to peer levels. Where would you say the peer levels are at today?

Well, we do peer reviews. If you look at our, kind of annual proxy statement, we disclose who we think our peers are. And so if you kind of go that, through that list and calculate a median capital ratio, I think you'll find it in sort of a 10.5% common equity tier 1 range. And as we said, we wouldn't necessarily drill our capital down to that level. We believe over time that at least in the near term, it would be sort of a pure plus kind of level.

I want to make it clear that our approach is not just about aiming for the median. There's a significant amount of work underway behind the scenes. We feel confident that through our internal stress testing and other measures, we can reach that level. I just want to clarify that this is not the way we establish our goals.

And I know the Zions' way is to be methodical, I know that, but it's a lot of capital to eventually return. And I'm just curious how aggressive you want to be and how aggressive you think you can be.

Well, discussion for next week with our board, as I said earlier. We are certainly leaning toward continuing to be more aggressive.

This quarter, your cash yield is actually approaching your securities yield. And over the last couple of years, you've actually – you extended the duration of your balance sheet. Is there any desire to maybe shift a little bit to maybe shorten the duration of the balance sheet in order to take advantage of some of the movements or expectations in the short end of the yield curve?

Well, I'll say that it is a kind of an ongoing part of our ALCO discussion to think about the duration of the securities portfolio. Clearly, as the yield curve flattens, when we embarked on this journey three years ago, we had a lot of cash and the yield curve was relatively steep relatively, certainly compared to now. So, as you go back and do the math, I think you'll see pretty clear that at the time and in the place, we've absolutely made the right decision to maximize that earnings stream and value for shareholders. Now that the yield curve is a lot flatter to your point, we actually have been, as we think about buying, we've actually been buying shorter duration stuff. So for example, a year ago, we would have been had probably a heavier mix of 15-year pass throughs, and the stuff we're buying today would be shorter, and we will continue to look at that duration, again, given the shape of the curve and kind of what our duration dollar buys us, if you will. That's clearly something that we need to continue to talk about and we'll continue to talk about it.

Thank you, everyone for joining our call today. We appreciate your attendance and we thank everyone for your great questions. We look forward to seeing you at a conference sometime soon. And if you have any further follow-up questions, I’ll be around tonight and throughout the day tomorrow. Thank you so much.