Zions Bancorporation N.A (ZION) — Q3 2018 Earnings Call Transcript

Thank you, and good evening everyone on the call. We welcome you to this conference call to discuss our 2018 third 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 today are Scott McLean, President and Chief Operating Officer; Ed Schreiber, Chief Risk Officer; and Michael Morris, our 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. This 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 is 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 1 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 turn the time now over to Harris Simmons.

Thank you very much, James, and we welcome all of you to our call today to discuss our 2018 third quarter results. The results of the quarter were strong relative to the year-ago results. Slide 3 is a summary of several key highlights. At a high level, perhaps most importantly, we are pleased with the strongly positive operating leverage with noninterest expense nearly flat relative to the prior year while net revenues increased in the mid single-digit range. Much of what we're doing is designed to push the tremendous operating leverage that we've experienced during the past 3.5 years and the future years. Loan growth was relatively healthy in a quarter that can often experience a slowdown due to seasonal reasons. We are encouraged with our deposit costs exhibiting relatively low increases compared to benchmark rates. More encouraging was further growth in average non-interest-bearing deposits, something that’s not easily accomplished when interest rates are rising. Our credit quality profile continues to improve at a rapid rate; remarkably, the trailing 12-month net charge-offs ratio was only 1 basis point. Finally, relative to the prior quarter, we increased the dollars of capital returned to shareholders. While we intend to further reduce the capital ratios to better reflect the risk profile of the company, we still have one of the very strongest capital levels within the regional bank space with a common equity Tier 1 ratio of 12.1%. Before we dig into the numbers, within the famous simplification and streamlining, I would also like to note that we completed our merger of the holding company with and into the Bank, reducing organizational complexity and eliminating duplicate regulatory oversight. On Slide 4, you can see the improvement of earnings rising to a dollar four per share from $0.72 per share in the year-ago period. Although we don't provide the so-called core EPS figure, we do highlight some items that affected the earnings per share that we view as episodic, which are not sustainable in the long run and were listed on the slide. Much of the variance is due to continued improvement in credit quality including interest recoveries, the net interest margin as well as negative provisions for credit losses. We benefited particularly from the relatively rapid improvement in the quality of loans to the oil and gas sector. We still have some expected benefits left from this source, but we are nearing the end of that favorable impact. Earnings per share for the third quarter of 2018 continued the trend of strong growth by my calculations. If one eliminates the effective interest recoveries and negative provisions for loan losses, and holds the tax rate constant with the year-ago period, our EPS growth was in the high teens relative to the third quarter last year. Slide number 5 highlights two key profitability metrics, return on assets and return on tangible common equity. We are happy to see the return on assets at about 1.3%, even after adjusting for items, and for the return on tangible common equity to expand to exceed 14%. We continue to work hard to further strengthen these measures, and with higher capital distributions, we expect the return on tangible common equity to continue to strengthen. Pre-provision net revenue, as depicted on Slide Six, has performed particularly well, rising 16% over the past year and nearly doubling since we embarked on our efficiency initiative in late 2014. Adjusted for the items noted on the slide, our pre-provision net revenue increased 15% from the year-ago quarter. We 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're seeing momentum in several areas of revenue growth including several areas of lending such as residential mortgage, owner-occupied properties, and municipal lending. In trust and wealth management and other select areas within fee income. Meanwhile, costs, both interest-bearing liability and non-interest bearing expense have been relatively well contained. On Slide seven, you'll see the strong credit trends depicted on the chart on the right with classified loans declining a very strong 37% from the year-ago period and 17% from the prior quarter. Improvement in oil and gas loans was a major reason for the improvement. For the third quarter, we experienced net credit recoveries of $1 million or about one basis point of loans annualized. Net charge-offs for the last four quarters were only 1 basis point of average loans. We expect the low overall rate of net charge-offs in the months ahead assuming current economic conditions remain generally stable. Additionally, as you can see from the allowance ratios, we're still maintaining strong coverage of nonperforming assets and other problem credit metrics. We continued to adjust upward our qualitative factors to reflect stressors that can be observed in the economy generally, such as the implementation of tariffs, higher interest rates and the effect that they may have on certain borrowers, and higher oil and gas prices which may reduce profit margins for certain commercial businesses, dragging on consumer spending, etc. Quantitatively, however, we've not seen credit deterioration within the risk portfolio types. Slide 8 is a list of our key objectives for 2018 and 2019 and our commitment to shareholders. We presented this slide in prior earnings calls and industry conferences throughout the year. So I will avoid reading the slide to you, but I'm pleased with the progress we've made on many of these initiatives, all of which set us up to increase our return of capital to shareholders. We increased that rate from about 20% of earnings to more than 110%. 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 is a board-level decision, and to preempt the question of the board meets later this week to discuss, among other things, capital returns such as share buybacks and common stock dividends. With that overview, I will turn the time over to Paul Burdiss to review our financials and additional detail.

Thank you, Harris, and good evening, everyone. Thank you for joining us. I will begin on Slide 9. For the third of 2018, net interest income continued to demonstrate growth relative to the prior period. Excluding interest recoveries as detailed on the slide, net interest income increased $40 million to $562 million, up approximately 8%. With respect to the revenue components, I'll start with volume and move to rate in just a moment. Slide 10 shows our average loan growth of 3.5% relative to the year-ago period. Although not listed on the slide, the growth in the third quarter relative to the second quarter was an annualized 5%, with strength weighted towards the end of the quarter. Average deposits increased about 3% from the year-ago period and increased an annualized 5% from the prior quarter. Thus far, we've been able to achieve this growth of balances with a relatively modest increase in deposit costs. This speaks to the granularity and overall quality of our deposit franchise as we discussed in detail at our Investor Day this past March. Examining loan growth a bit closer, Slide 11 depicts our year-over-year period and loan balance growth by portfolio type with the size of the circles representing the relative size of the portfolio. For most categories, we experienced solid and consistent growth. There are three areas where we've experienced slight attrition. In the commercial real estate space, loan growth was adversely impacted by slight attrition in the term CRE and national real estate portfolios of about $240 million. Within non-oil and gas C&I loans relative to the prior quarter, we experienced an annualized attrition rate of about 4% on our larger loans, that is loans with balances greater than or equal to $5 million, while we experienced an annualized growth rate of about 4% on smaller lots. The incremental competitive pressure on larger commercial loans seems to be coming from capital markets activity and some loosening of credit standards among competitors, including unregulated senior debt funds. We experienced relatively consistent growth trends in one to four family and home equity loans, and experienced a slight uptick in the growth rate of owner-occupied, which are generally small business loans underwritten based upon the cash flow of the borrower and secured by real estate. Oil and gas loans have increased moderately, resulting primarily from a relatively strong increase in upstream and midstream loans, while oilfield services declined slightly. Municipal loan growth has also continued to be strong over the past year. To repeat what I mentioned on last quarter's call, we’ve hired staff to help us grow in this area, which is focused on smaller municipalities and essential services of those cities. We've maintained strong credit quality standards and feel comfortable with the growth and expect growth to remain strong in this area. Although we are optimistic in the near term about the growth of loans based upon a relatively strong economic backdrop, an improvement in small business loan growth and review of pipeline, we're also seeing some factors that may result in some growth pressures including debt funds and capital markets that are highly competitive for pricing and for term, which affects our larger loans and underwriting standards that are softening within loans remaining in the banking industry as noted in the recent additions of the senior loan officer survey. Slide 12 breaks down key rate and cost components of our net interest margin. The top line is loan yield, which increased to 4.71%, of which about 2 basis points are related to the previously mentioned interest recoveries. The yield, excluding interest recoveries, has increased about 40 basis points over the past year, which is a loan yield change of slightly more than 50% relative to the change in the federal funds rate. Relative to the prior quarter, the yield on securities increased slightly. The shorter duration of the investment portfolio in combination with new security purchases, which were accretive to the yield of the portfolio, helped drive the yield overall in the investment portfolio. While the premium amortization is very difficult to forecast, assuming stability in that area, we expect the yield on the securities portfolio to move higher at a moderate pace over the next several quarters and years based upon the yield of securities we are purchasing. The cost of total deposits and borrowed funds increased 5 basis points in the quarter to 0.45% or 45 basis points, resulting in a funding beta of about 30% for the year-over-year figure. 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 beta was about 21% relative to the prior quarter, which was 29%. Cumulatively since the beginning of the rising rate environment, we’ve experienced a total deposit beta of about 11%. These elements combined to result in a net interest margin of 3.63% for the quarter, which increased 7 basis points from the prior quarter and 18 basis points from the year-ago period. Excluding interest recoveries in excess of $1 million per loan, that ended net interest margin beta was 21% over the prior year and 26% over the prior quarter. We believe it is reasonable to expect deposit competition to intensify somewhat over the next several quarters. If so, the net interest margin beta may be modestly less sensitive when compared to the recent quarter. Next, a brief review of noninterest income on Slide 13. Customer related fees increased 2.5% over the prior year to $125 million. The primary source of income that increased and decreased are listed on the page. We continue to work hard to increase our fee income, although the fees from treasury management are influenced to a degree by deposits and market rates for earnings credit applied to those balances, which in a rising rate environment creates slight headwind in our fee income trend. Similarly, the fee income realized from mortgage banking activity tends to be a little countercyclical; slowing and possibly decreasing as the economy strengthens due to the effects of higher rates and refinancing activity. Noninterest expense on Slide 14 increased to $420 million from $413 million in the year-ago quarter. However, adjusted noninterest expense, which is just for items such as severance, provision for unfunded lending commitments, and other similar items, was very stable at $416 million versus $414 million in the year-ago period. 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 per year. These items account for about a $3 million increase over the year-ago quarter. With the holding company merger in the rearview mirror along with other items in the professional and legal line item, we experienced a slight decline in those line items, and we expect the quarterly level to remain a bit lower than it had been during the past year or so. Also, as noted on the slide, we had a one-time adjustment to our FDIC deposit insurance costs in the third quarter, assuming the deposit insurance fund reaches 1.35% and the insurance surcharge is removed. Considering our issuance of $500 million of senior unsecured debt late in the third quarter and the movement of other unsecured debt out of the holding company and into the Bank, as the Bank and Holding Company is now merged, this would result in lower insurance costs relative to other secured funding. As a result, we expect our FDIC insurance expense in the fourth quarter to be about $7 million. Turning to Slide 15, the efficiency ratio was 58.8% compared to the year-ago period of 62.3%. We reiterate our commitment to achieve an efficiency ratio below 60%, while the full-year 2019 excluding the possible benefits of rate increases. Finally, on Slide 16, this depicts our financial outlook for the next 12 months relative to the third quarter of 2018. In the interest of opening the line up for questions, I won't read the rest of the slide to you, but we will be happy to take questions about any of these items. This concludes our prepared remarks. Latif, would you please open the line for questions. Thank you.

Hey, good afternoon, guys.

Hi, Dave.

Just the question on capital. Now that you guys are effectively out of that stock, you've got more clarity and control everywhere, where do capital levels go from here? I know you talked about bringing the CET1 ratio down to just above peer levels in the next six quarters or so. It seems like that would imply a decent step up in the buyback going forward, especially if loan growth is maybe not a solid mid-single in terms of growth going forward. Is that a fair statement? And any rough sense as to what that means in terms of dollars over the next year?

Well, it's certainly a fair statement. You've done the math appropriately there. I mean, we are simply reluctant to be too specific about it because our Board hasn’t made a decision yet, and I don’t want to front run them. But it would certainly be our view that that kind of target is still achievable, and that’s the discussion that we will be having with the Board here at the end of this week.

Okay. That’s fair. I appreciate that. And then, I guess, some of your peers have talked about reducing ratios over time as well and are talking about lower levels than where they are today. I know your discussions have talked about based on where your peer capital ratios are today. So if we're talking about lower peer ratios over the next six to eight quarters, are you guys still thinking about walking your ratios down as well versus the targets that you've been talking about in the last quarter or so? Does that make sense?

Yes. I would like to clarify that we will not primarily base our capital ratios on the positions of our peers. We will continue to conduct stress testing, likely on a quarterly basis, to inform our discussions with the Board. While the results may guide our decisions, we are not in a competition to achieve the lowest possible capital ratio. Our goal is to maintain an appropriate level. Given the unpredictable nature of the current cycle and what the recoveries may entail, we do not want to be unprepared in a downturn. This is our approach moving forward. We will use stress testing to guide our conversations with the Board. Currently, we believe we have enough flexibility to align closely with the peer median.

Okay, great. Thanks, guys.

Good afternoon.

Hi, John.

On the loan growth front in terms of your guidance, I know that you softened it a bit there. Could you give us just a little more clarity around what you're actually seeing that’s driving you to push that lever, like what type of competitive pressures on terms and pricing, and then what types of portfolios are you seeing that happen? Thanks.

I want to share an example from Colorado that I came across recently. I heard about a 3-year, $30 million commercial real estate deal that entered the CMBS market. It's structured as a 10-year interest-only, covenant-light deal, and that's not the type of transaction we intend to pursue. That's one example. I’m not sure if Michael has anything else to add about this.

Well, sometimes with owner-occupied, you don't really know what industries are that are growing, but owner-occupied is a focus for the company. We like what comes with it in terms of ancillary business and relationships, so we are very pleased to see that category grow.

Okay.

John, this is Scott. I would just add that the area of our portfolio or activities that are the most volatile is really the larger transactions, like the CRE term credit that Harris described. We'll see this in the larger energy credits as well, which have experienced more payoffs than we anticipated there. But generally, it's just some remaining problem credits that are paying down, so that’s actually a good thing. But as you know, we don’t have a big exposure to larger loans, but the exposure we do have is just more volatile because of the conditions that have been described. If you look at Slide 20 in the deck, what you see is really solid growth year-over-year, and a real bright spot is our smaller affiliates in Colorado, Arizona, Commerzbank in Washington and Nevada. They represent about 25% of the company, and they’re producing about 50% of the loan growth. So that's really a healthy thing. As Michael noted, by loan type, owner-occupied is C&I and collectively that's growing nicely. Our mortgage-related business, whether it’s one to four family or the HELOC portfolio, are growing nicely. And then we're actually seeing some growth coming from energy again. So it's a nice mix of loans by type, and it's coming broadly across the company, particularly from our smaller affiliates.

Thanks, Scott. That clarifies things. Now, I have a follow-up question. Given the potential for change, how do you plan to boost your loan growth? It seems that aside from a downturn in the credit cycle, the competitive landscape is unlikely to shift much. Assuming the competition remains intense, is there a reason to believe that your loan growth will improve from this point?

I think it's hard to know. The third quarter was a good solid quarter for us, and the fourth quarter is generally a good quarter. So it's hard to know. I think the reason we lightened our guidance just a little bit is because of the volatility in these larger loan transactions; they’re just lumpier. And that's what we were trying to say.

I get it. Thank you. And we favor the better credit anyway. So thank you.

Great. Thanks. I guess the first question in terms of your average balances on the liability side looks like you paid down a fair amount of borrowed funds in the quarter, called maybe $800 million, $900 million. Can you just remind us what that is? And should that borrowed fund stay relatively constant, just given the more moderate pace of asset growth?

Yes, this is Paul. We use borrowed funds as a balancing mechanism of the balance sheet as we think about overall loan growth and what we are doing with the investment portfolio. That ends up being what it needs to be. A lot of that, as you know, are home loan bank borrowings, and we're becoming more active in the senior note market. You saw that issuance this past quarter. I would expect to see the composition of that funding change over time similar to what you saw here over the last quarter.

Got you. Okay. Perfect. And then just as a follow-up question separately, can you just remind us how big is the municipal loan portfolio right now? And what are your designs on growth in that over time? Thanks.

Yes, right. As you can see on Slide 12 of our press release, the current municipal loan portfolio is about $1.5 billion. That's grown from about $1 billion a year ago. And we are going to continue to expect to see growth as we invest in that business.

Got it. Okay.

Thank you.

Hi. Good morning, good afternoon for others. Sorry about that. Just wanted to ask a follow-up question to John's line of questioning. I guess, as we think about where the non-banks aren't playing, how would you help us size your portfolio in terms of what you think is a more defensible business from the non-banks, whether it's the municipalities or owner-occupied or part of your real estate portfolio?

I would say that we are in a relatively good position because a significant portion of our portfolios consists of generally smaller credits. We are not a major player in corporate banking. We are focusing on municipal credits from smaller municipalities where we believe we can create additional value for both them and us. A lot of our work involves owner-occupied properties, particularly small to midsize businesses. This is also true for our commercial and industrial portfolio. We have a solid standing with deals typically ranging from $1 million to $5 million or $6 million or $7 million. These deals usually don't make it into loan funds or get picked up by online lenders. Our main competitors in this space are community banks and other regional banks.

Erika, this is James Abbott. We do have some slides in our Investor Day materials back from March that give you kind of the sense of the size of the commercial loan portfolios, so the small loans versus the medium-sized and large-sized loan. So that’s a resource that you could potentially utilize. We do have a very substantial portion of our C&I portfolio, for example, is loans that are less than $5 million in balance. And we did see very good growth out of that during the quarter, linked quarter, annualized a little over 4%. It was very strong performance while some of the larger stuff did decline.

Got it. And just a follow-up on the color that you provided with regards to margin expectations going forward. We hear you loud and clear on the deposit side. I’m wondering if you could give us a sense on what spreads are looking like right now and whether or not sort of the lower burden as a non-SIFI changes your strategy about securities or investment?

Yes. Erika, this is Paul. That is a lot in there. Deposit beta we talked about maybe don’t need to get into that too much more. Loan spreads have been generally behaving, keeping in mind sort of where we operate, and your conversation about kind of the average size of loans impacts our ability to fund loan spreads. I will say the composition of the portfolio change a little bit. For example, if you are looking at our portfolio from year ago, we had more commercial real estate relative to residential mortgage than we do today. The spreads, as you know, are very different among these products, residential mortgage having a tighter spread. So while generally, on a deal-by-deal basis, we had some success maintaining spreads, we are seeing a slightly different composition of the portfolio, which is impacting overall loan spreads. As it relates to the size of the investment portfolio, it's true that we are no longer subject to the LCR; our biggest constraint is our liquidity stress testing as opposed to the LCR. I'm not forecasting or predicting a big change in the composition or investment portfolio because that liquidity stress testing continues to be a really important part of the way we're managing our balance sheet. So overall, as I said in my prepared remarks, we've had, if I can use the term, a pretty decent relative to expectations – a pretty decent net interest margin beta. As you know, we have a slide back in the appendix that provides a little more detail on the interest sensitivity, particularly on the asset side of the book relative to market rate. Our performance has been in line with our modeling and our expectation. Looking ahead again, considering deposit beta, we don’t squeeze as many basis points out of a fed tightening as we have over the past year and a half. Yet, we expect to continue to see modest margin expansion as the Federal Reserve continues to raise rates.

Got it. Thank you.

Okay.

Thanks. Good afternoon, guys. Just a follow-up on the deposit side. I noticed you had good year-over-year growth of 3%, and non-interest bearing was actually stable, so even amidst this, deposit pricing pressure. Can you just give us a little color in terms of where you're getting that incremental growth from, and your continued belief in the stability, especially of that non-interest-bearing where we are starting to see that really come down a lot in other peers? Thanks.

Yes. Ken, this is Paul. I will start, and Harris and Scott can build in. If you go back to our Investor Day, we talked a lot about the composition of our deposit book. The fact that it's very granular, very operating in nature. If you think about deposits in terms of operating deposits and kind of core-to-core investment deposits, our proportion of those operating deposits is actually pretty high. All that being said, the stickiness of our DDA has actually been quite a pleasant surprise for me. I want that to sound negative, but our interest rate risk modeling actually anticipates that we will have more migration out of DDA than we’ve experienced. But I think the fact that our DDA has been so sticky is a really an indication of the strength of the deposit base and kind of overall strength that provides the organization.

This is Scott. I would like to mention that our ratio of non-interest-bearing deposits to total deposits has been nearly industry-leading for several decades, currently standing at 45%. Most of our competitors are in the mid to low 30s or high 20s. Even prior to 2008, our ratio of non-interest-bearing to total deposits was quite favorable, which is due to the reasons Paul explained. Additionally, about 65% of our 24-day products reinforces that these are operational balances for generally smaller businesses.

Makes sense. Thanks, Scott. And these are the follow-up to that. Can you detail just is it the consumer side versus the corporate that's been growing? Because there's also been a lot of talk about the stickiness of consumer not being as much of a focus for you guys. But a big part of the banking system, it is. So what side of the bank is growing into when it comes to deposits for you guys? Thanks.

Yes, it's mostly non-personnel, so it's related to commercial deposits.

Okay, got it. So it feeds to Scott's point. Thanks a lot.

Hey, everybody. Want to start with Paul at expenses. You did seem to be running at the low end of the 2% to 3% range that you previously talked about. Do you think that’s sustainable going forward?

Look, we are and have been really investing in our business. I’m really proud that the organization has really come together and we are creating opportunities to change, if you will, the composition of the way that we're investing in the business. So we are saving money in some spots and we're investing money in other spots. As we look ahead and just kind of 2019 and beyond, we are right in the middle of our budgeting process. We are very focused on expense control, and we are very focused on positive operating leverage. So, yes, in the near-term, I absolutely think it's sustainable.

Okay, great. And then just one other one for Harris. Given the valuation of Zions stock here and now that you're officially out of CCAR, do you have an appetite as Chairman of the Board to accelerate buybacks and get to the targets more quickly?

Yes, I do. I'm just one of eleven votes. I don't want to lead that discussion prematurely. However, I believe valuation is certainly something we need to consider. A positive aspect of the current stock market situation is that we have a significant amount of capital available. This is what I am thinking about.

Okay, great. Thanks for the color.

Thank you. Can you hear me?

Yes. Hi, Jennifer.

Hi, Harris, just wondering if you can talk about the level of lending competition you are seeing and kind of compare and contrast that to what we saw right before the last downturn?

I believe there is still a significant amount of liquidity and cash available, making the competition for earning assets quite intense. It's difficult to draw a direct comparison to the period before the last downturn, which was heavily influenced by the housing market and a high demand for developer credit. Currently, there seems to be more discipline in lending practices, both within our company and throughout the industry. This aspect likely marks a fundamental difference compared to previous times. Nonetheless, we are witnessing substantial growth; while it may not directly affect our operations in leverage lending, major players are indeed facing competitive pressures from hedge funds, loan funds, and others, which raises some concerns about where potential issues may arise in the future.

This is Ed Schreiber. I wanted to add to some of Harris' comments and focus on our book. When you examine what we've accomplished over the past few years, the balance sheet has been simplified. More importantly, with Michael Morris, our Chief Credit Officer, and his team, we’ve developed a program that has been demonstrated through the oil and gas cycle. We believe in positioning the company as a positive outlier in the next cycle. If you look at any forecast, the way we’re positioning the company from an asset quality perspective indicates that we are in good shape and will likely be a positive outlier in this next cycle.

Thank you very much.

Hello. Thank you for the question. First, I would like some clarification. In your prepared remarks, you mentioned the effect of simplifying the corporate structure on expenses. Could you please remind us of the expected benefits from that and how you quantify them?

Yes, I didn't provide specific numbers. However, what I mentioned was that we've observed some increase in the professional services area recently, and we anticipate that the ongoing rate may be slightly lower. This was an important point in my prepared remarks. It's important to note that there hasn't been much activity at the holding company level. Almost all assets, operations, and employees have been concentrated at the bank level for quite some time. Therefore, while this does streamline the organization, I don't expect to see a significant change in our operating expenses.

And then on the deposit side, I guess you're somewhat unusual in operating separate brands and separate banks if you like in different geographies. How much flexibility is that giving you to adjust pricing in different markets, and how much variation are you seeing in competition if you compare the main markets you’re in?

We price locally, and the decisions regarding deposit pricing are made by local management teams who have incentives to minimize their funding costs. Additionally, we have internal transfer pricing, as any larger bank would, to compensate them for the funds they're raising, and they aim to achieve a spread on both sides of the balance sheet. I'm not sure what else I can add to that.

Yes, this is Paul. If I could, I would probably ascribe more value to sort of the local nature of the banks as opposed to the local brand of the banks. Your question was really around the brand, but I think the value is really around the way we run in the autonomy of the local groups and being able to react specifically to what the client needs at a very, very local level, I think is providing a lot of flexibility for us as we think about deposit pricing.

Great. Thanks very much.

Yes.

Thanks for taking the question. With high single-digit PPNR, how low do you think the efficiency ratio can go?

I don’t know. It sounds like a game of limbo.

I will just start in that.

Scott?

As I said, we are really focused not necessarily on efficiency ratio as the end goal. We are really focused on positive operating leverage. If we can continue to achieve that, we’re going to continue to see very strong PPNR growth and continue to grind that efficiency ratio lower.

I would like to point out that we've discussed the deposit base and the loan mix, which differs from that of some of our competitors. Operating expenses are somewhat higher, and we expect this to be reflected in the deposit performance we are currently seeing. While this does create some challenges, my hope is that we can reduce our efficiency ratio to the mid-50s over the next few years; that would be my general goal.

I would just add to that, this is Scott, that going back to Steven's questions about the expense growth rate of 2% to 3%, I mean, basically we’re building our plan around that expense trajectory that we’ve talked about, and that involves investing actively in the businesses that we are trying to grow and investing actively in technology. We are not just sitting back, cutting costs everywhere and not investing in the future. We’ve been investing heavily in the future over the last three or four years, both in terms of technology and in terms of businesses we are trying to grow with hiring new bankers, etc.

Thank you.

Good afternoon. On the loan growth front, particularly on residential and also on oil and gas, just wondering what are your thoughts for growth going forward in both those categories, and also what are you retaining with regard to residential mortgages these days?

Our mortgage business is quite distinct from that of the major mortgage lenders in the country. Essentially, we operate as a private banking firm, though we also have a significant consumer segment. Approximately half of our mortgages cater to small business owners, who are typically not first-time home buyers. Although our mortgage volume has decreased slightly this year compared to last year, it's not nearly as significant as the decline reported by the broader industry. We remain optimistic about our mortgage operations, retaining around 60% to 70% of what we originate, with the aim of keeping all loans under 10 years. We are set to launch a new online digital application process that we believe will significantly impact our business. While we may not be a major player, this innovation will be transformative for us, and it is currently in the pilot phase, with plans for rollout next year. On the energy book, it's about $2.2 billion in outstandings right now. It got down to about $2 billion, went from $3 billion to $2 billion, that was the contraction. Just in the last couple of quarters it's grown back to about $2.2 billion. I think 10% to 15% kind of growth in that portfolio would not be unusual at all. It's basically reserve base lending and midstream. There's virtually no growth coming from our services business, and we have consciously held back in that area.

Okay. That's helpful. And then, with regard to securities balances here, I know on EOP basis, they're flat. Just wondering, what are your expectations for those balances going forward?

This is Paul. I am not expecting a big change in the size or the composition, although that may change as deposit growth ebbs and flows and loan growth ebbs and flows. But generally speaking, I expect that portfolio to remain relatively stable, its overall size.

Alright, thank you very much.

Thank you.

Thanks. I have three quick questions. One, is the warrants that were outstanding were causing some dilution as the stock price was going up. The share count dropped pretty precipitously this quarter. Was some of that the benefit of reversing out of some of that impact?

This quarter, if you examine the average share price from one quarter to the next, despite fluctuations, the average likely hasn't changed significantly. Much of the positive effects you are observing can be attributed to the share repurchase activity.

I think in the quarter, Marty, it's about 0.5 million shares is all the difference that you read, but obviously we will have to see what the stock price does in the fourth quarter here, but if it stays where it is, it will be a more substantial improvement on diluted shares.

Okay. And then, Paul, you were talking about the FDIC costs and I was kind of hearing that because you had consolidated and you've done some debt, that maybe your FDIC costs are just going to go down without kind of the surcharge going away. Could you just maybe explain the number, what it was this quarter, next quarter, and what do you expect it to be as that rolls forward?

Yes, Marty. I probably wasn't as articulated as I could have been as I went through that part of the prepared remarks, but you are right. There are a couple of things impacting FDIC this quarter. The key one is we had this incremental accrual of $3.7 million that shows up in the third quarter, but it was kind of a one-time thing, an isolated event; it's not going to happen again next quarter. The other aspect is we issued unsecured debt in the third quarter and then we had a little bit of debt that was holding company notes that have now been assumed by the bank. As you know, unsecured debt gets very favorable treatment under the FDIC calculator. So there's also going to be an incremental benefit of that, and that’s probably going to be close to a $1 million a quarter. The other big one of course is the FDIC surcharge, that will affect us as it affects everyone else. Just as a reminder, for us that FDIC surcharge is a little under $6 million a quarter.

Perfect. And then the last quick question is, your biggest portfolio is C&I, excluding oil and gas, and it's declining, so it's tough to see the momentum building in the portfolio without one still kind of seeing a modest decline. Almost all of that decline, back on Page 20, is coming out of Amegy. So I was just curious what was the loan type or the decisioning around because it was a big number in this quarter, but it was actually, it looks like, it's been consistent over the past several quarters. So just curious what was causing that decline.

So I will start, and then I will ask Scott and Michael and whoever else wants to make a comment. Marty, when thinking about C&I, I would also include owner-occupied in that. I think owner-occupied is a really important aspect. It just, as you know, happens to be secured by commercial real estate, but it's really sort of a commercial loan disguised as a commercial real estate loan because it's owner-occupied. If you combine C&I and owner-occupied, there has actually been growth over the course of the last year. So, Scott or Michael, would you like to add anything to that?

No. I would just echo what you said, but I would also point to Amegy's growth in owner-occupied. So there has been growth in the Texas market in C&I and we always include owner-occupied under the C&I umbrella as Paul mentioned.

I would like to add that the portfolio has a greater exposure to larger transactions compared to most of our other portfolios. In the commercial and industrial space, the volatility we discussed earlier in the call is certainly something you will see in that non-oil and gas C&I area.

Right. Thanks.

Thank you.

Thank you, everyone. We had an exceptional quarter. Looking at your Investor Day slides, it appears that your primary bank accounts for just under a third of total bank assets. Are you noticing any repercussions? Historically, after consolidations like those of Regions, Synovus, and the former Barnett and UCBI, it takes several quarters for the directors to reestablish connections and for the salary structures across individual banks to align with a unified bank. Can you explain why you performed so well this quarter? It’s truly impressive, but the stock seems to need some adjustment.

You broke up in the last phrase there.

If I had to make a bet, I would have expected the stock to have risen last quarter based on your impressive numbers. You're excelling in terms of return on assets and return on equity, but there seems to be significant downward pressure on the stock due to this consolidation. Can you provide any insights on that?

Well, I don’t know if it was from the consolidation. I would say it's tough enough to manage a bank without having to manage the market.

Right. No, no, no, I understand. I know and it's a guess, but are you seeing any fallout from the individuals that were part of these individual banks that you all put together?

No, I mean, fundamentally the answer is no. We have enough employees on any given day. People do get picked off by others, and we sometimes bring in new people as well. However, the management ranks of the company have remained very stable.

And so they're paid the same way and the incentives are the same?

Yes, fundamentally there hasn't been a lot of change. Most of the customer-facing employees in the company report to the local market CEOs, whom we refer to as affiliate CEOs. This group has remained extremely stable. Therefore, we haven't encountered the types of issues typically associated with changes like this. The consolidation had minimal impact on customer-facing personnel, although it did affect some back office functions. However, we have been cautious about the revenue drivers.

In fact, this is James. I will just jump in here. We've got just a couple of minutes left, and I'd say, one that Harris, you've mentioned many times in the conference appearances, we made this decision to consolidate because of the feedback we're getting from the frontline employees to help make their lives simpler. Let's take two more questions in a lightning round for these last two, and then we will be at our time limit.

Hi. Good afternoon. Just a follow-up on the capital return discussion. Could you talk about your appetite for acquisitions, whether whole bank or loan portfolios or business lines?

Well, I think we've said for some time, we never say never. It's not something that is a strategic priority in any sense. We will be opportunistic, I guess, if something was a great fit. But it's not something that we spend a lot of time thinking about.

Thanks, Lana.

Thanks very much. I had to jump off for a while. Harris, I thought I heard you mention 55 or mid-50s; I guess, in efficiency ratio, it doesn't seem like that would be necessarily in the near term anyway top line driven. Are you feeling better about the scope for expense saves here on the back of some of the charter consolidation or vis-à-vis your improvement in terms of your regulatory situation?

Well, when I just talk about mid-50s, I used the word aspirational, and I'm not suggesting that’s going to happen in the next few quarters. But I think I do think that that's achievable with kind of our business model and if the economy continues to remain reasonably healthy, I think that we will continue to see revenue growth driven by kind of reasonable loan growth. I think we worry a little in the short run about competitive pressures on some of the larger deals as we mentioned. But that's not fundamentally what our major part of this franchise is. I think over time, as we continue to focus on what I think our sweet spot is, I think it's not an unreasonable kind of goal.

Appreciate the color. Thank you.

Okay, this is James Abbott. Thank you, Latif, for leading the question-and-answer session. I appreciate everyone for joining the call today. Please feel free to reach out to me if you have any further questions or comments; my contact information is included in the press release. We look forward to seeing many of you at upcoming industry conferences for the rest of the year. Thank you once more for your participation, and I wish you a pleasant evening.