Zions Bancorporation N.A (ZION) — Q2 2021 Earnings Call Transcript

Thanks very much, James, and welcome to all of you who have joined our call this evening. I'm going to start on Slide 3. We are really pleased with the overall results for the quarter, particularly on the credit quality front, where we experienced net recoveries of previously charged-off loans. We saw loan activity, excluding PPP loans, that was more encouraging, and we've become somewhat more optimistic about the loan growth prospects for the future. We accelerated the purchases of securities during the quarter, resulting in linked-quarter growth in that portfolio that was roughly double that of the prior quarter. We plan to continue that pace in the near term. Deposit growth was strong with essentially all of the growth coming from noninterest-bearing deposits. And despite the increase in securities purchases, our money market investments increased relative to total assets. We continue to streamline the organization, allowing operational expenses to remain relatively flat.

Thank you, Harris, and good evening to everyone. Turning to Slide 8. As a precursor to discussing the Paycheck Protection Program, or PPP loans, our adjusted pre-provision net revenue was $290 million in the second quarter. This is net of the effects of the previously noted IPO. You'll notice that the bar is leading to two portions. The bottom portion of the bar represents what we think of as generally recurring income, while the top portion of the bar denotes the PPNR we've received from PPP loans. Of course, we recognize that income from this source will decline. Nevertheless, our ability to outperform by a factor of 3x the industry origination of PPP loans has resulted in significant benefits to our communities as well as hundreds of thousands of individuals and families. Of course, our earnings from the PPP program have bolstered profitability during the pandemic and produced capital that ultimately benefits our shareholders. PPNR from the program has equaled $262 million so far, and there remains $137 million in capitalized income that will be realized over time.

Thank you, Scott, and good evening, everyone. More than three-quarters of our revenue is net interest income, which is significantly influenced by loan and deposit balances and growth. As such, I'll begin my comments on Slide 12 with a review of those two categories. While average loans were down in the second quarter by nearly 2% when compared to the first quarter, we are starting to see slight improvement in our C&I, owner-occupied, home equity and our bank card portfolios. Excluding PPP loans, average loans were down 1% from the prior quarter and down $2.4 billion or approximately 5% from the prior year period. As Harris noted earlier, and it's worth repeating, period-end loans, excluding PPP loans, were essentially flat from the first quarter. Within the loan portfolio, average non-PPP commercial loans were down $172 million or less than 1% from the prior quarter, while period-end commercial loans increased nearly 1%. Within the commercial real estate category, construction and land development loans increased on a period-end basis by 5.4% compared to the prior quarter and term CRE declined less than 1%. Overall, the total commercial real estate portfolio grew 0.4% when compared to the prior quarter. Average consumer loans declined $437 million or 4.1% from the prior quarter. Unlike last quarter, when consumer loans were down in each category, in the second quarter, we saw growth in three categories: home equity, construction and other commercial real estate, and bank card. We saw a 5.4% decline in residential mortgages when compared to the prior quarter due to continued refinancing activity, although the attrition rate slowed as the quarter progressed. And in the PPP loan portfolio, we continue to see paydowns and process forgiveness totaling $2.4 billion in the quarter. The average balance of PPP loans decreased 3% compared to the prior quarter.

To start, regarding the security investments, I understand that you increased security investments this quarter and intend to maintain this heightened level moving forward. While you're not investing in the 10-year treasury, with yields around 1.2% on the treasury side, I'm concerned that the securities you're purchasing may also be experiencing falling yields. Could you elaborate on the investments you are currently making? Specifically, how do their yields compare to your average purchase yield in the second quarter?

I'll start by saying that you've noticed the significant rise in the 10-year rates, which have indeed dropped. As you mentioned, we don't invest in the 10-year. Our focus is more on the 3- to 5-year range. We typically place securities there, and we've been investing in swaps as well. I want to highlight that our Asset & Liability Management Committee carefully considers timing; we don't have a set program for daily or weekly purchases. Given the significant decline in yields, we plan to slow our purchasing with the expectation that we can make up for it later in the quarter.

Got it. Okay. I think that helps a little bit. Maybe just as a related follow-up. Your guidance on net interest income showing moderate increases seems to be the most positive change. Is that due to a shift in your approach to investing in securities, or is it attributed to changes in your outlook for loan yields or something else?

Yes. There's a lot mixed into that. As you know, the balance sheet is a pretty complicated thing. But one of the things that we are observing, and I would say, particularly versus a year ago, gaining confidence in is sort of the stickiness of the deposits that are showing up on our balance sheet and all of the relationships that go along with those. Scott did a nice job of explaining how the new depositors that are coming into the bank were really trying to integrate them and make them as sticky as possible. And as a result, it feels like this balance sheet growth is a little more permanent than I would have speculated a year ago. And what all of that means is that, yes, we can be a little more confident in how we're investing that cash. So that's part of it. But the other is, as I said, there are some green shoots to loan growth, which is highly speculative and a lot of things can change in the next year. But generally speaking, the optimism in our footprint really feels like it's improving. And so there's an element of a little bit of kind of core balance sheet growth in that outlook as well.

Just on your NII guidance. I was just curious how much of that moderate growth is going to be driven by securities purchases versus loan growth. It sounds like you're starting to see some green shoots on the loan growth side. If rates continue to sit here or fall further, you decide not to allocate cash to securities, what's the risk to that NII guide is basically what I'm asking?

You're correct that the outlook is somewhat dependent on rates, and there are many factors that can alter it. As noted earlier, we have over $10 billion in cash earning the overnight rate, which gives us significant capacity for continued investment. We are maintaining a relatively short duration, so while the yield may not be ideal, it's higher than 10 or 15 basis points if we look at a 3 to 5 year horizon. We're being careful in our approach. There is some risk associated with interest rates and loan growth. This 4-quarter outlook represents our best estimate based on our current position and our expectations for the future.

Thank you. I'd like to ask a quick follow-up regarding capital. You've mentioned your capacity to accelerate buybacks in the latter half of the year. With peer capital ratios expected to decline over time, can you share your current CET1 ratio target and your timeline for reaching it? I understand there is capital dedicated to supporting loan growth, but it appears you have significant potential for buybacks. How quickly do you anticipate adjusting that to meet your new target?

I'll begin with that, and Harris will share his thoughts as well. We have consistently stated that we aim for a capital position that is slightly better than average with a risk profile that is slightly below average. This remains our objective. As you mentioned, if the economy rebounds and business activity resumes, leading to adjustments in capital ratios, we would anticipate aligning ours as well. However, the pace of these adjustments will depend on the Board and other approvals.

I agree with that. I would like to mention that we currently have quite a bit of room, but as others lower their targets, I don’t anticipate us engaging in a race to see how low we can set these ratios. I'm closely observing global events, particularly in commercial real estate. While it’s stable at the moment, as leases expire and the market adjusts, it will be an area to watch closely. There is considerable risk present, even if we're not observing it manifest as losses currently. I expect we will want to take a more conservative approach compared to others, but we do have substantial room to maneuver, and we will be focusing on that.

I guess just one first question on loan growth. You've heard from your peers as well around green shoots on loan growth. Obviously, you guys had flat balances quarter-over-quarter. Just give us some color in terms of what gives you optimism that this trend that you've seen recently is sustainable? And would appreciate if you could put some numbers around what modest slight loan growth for the back half means?

This is Scott McLean. I'm happy to address that. Over the past couple of quarters, we have noted that when your portfolio is experiencing a decline, it's important to first achieve a couple of flat quarters before you can anticipate growth. While many of our peers project increases in the latter half of the year, we are just pleased to see a stabilization in the second quarter, indicating we are not facing the same declines. This gives us hope that we can transition towards growth. We are clearly witnessing increased activity among our clients. A significant factor driving loan growth will be the small and medium-sized businesses as they rebuild their working capital. These businesses previously cut back on investments in inventory and receivables. Given the pressures from inflation and supply chains, we are observing businesses focused on rebuilding their inventory as sales rise. This should result in increased utilization, which is currently at historical lows, as Paul mentioned. Additionally, I would like to highlight that we are proactively positioning our owner-occupied and HELOC financings during late spring, summer, and fall, as these products cater directly to our primary clients and we believe there is considerable demand potential with the right structure.

Just to add a footnote to that. What we're using is some reasonably aggressive introductory kind of teaser rate pricing. And that should produce some growth in those couple of portfolios, which are really important portfolios for us. So it may in the very short term, the volume impact will be offset by some of the rate impact. But the rates will be significantly better than the rates we're getting on cash at the Fed.

Got it. And just as a follow-up to that, like the two things that we've heard from other banks, we are sharing loan growth with customer liquidity and supply chain constraints impact on inventories. Are either of those easing? Like if you could give an update based on your customers where liquidity stands and are they seeing some easing of supply chain constraints?

Yes. Our customer base, just as it is for most banks and throughout the economy, has a lot of liquidity. It's reflected in the low utilization rates. But there is no softening in the concerns about supply chain or concerns about inflation. Those concerns are real. They're certainly remaining steady, if not building in terms of the minds of business owners.

It's encouraging to see effective management of core expenses, and I'm aware that you're making progress with the systems as you approach Phase III. As we navigate the current environment and move beyond the COVID-related spending towards the final stages of Future Core, are we getting closer to seeing a shift in expenses that could lead to net benefits? Or do we still have some underlying development to complete before we can truly observe a boost in productivity?

Yes, it's Scott. I'll...

Okay. Yes. Excellent.

Yes, happy to address that. We'll see a slight increase this year on our expenses related to our future core project over last year by about $3 million or $4 million built into our forecast. And then next year, we'll actually see some softening. But in 2023, when we go live with our deposit application, that's where we'll see a little bit of a bump up to be followed quickly by a pretty nice drop off. So all in all, expenses related to technology and future core specifically should be very manageable in 2022. And the only reason there's an increase in '23 is that when you put a major system into production, it pulls forward a lot of expenses in that year. And then there's about a 20% falloff in that related cost in the following year. So there'll be a one-year kind of increase in '23. And then just the question is, how do we divert those now available technology dollars to other technologies? I'm not sure we'll have to divert all of them to other technologies, but the demand for technology spend will probably always continue to be very high. But we certainly will be past the elephant in the room, which is paying for a completely new core system, something the rest of the industry in its entirety has in front of it.

I have a follow-up question, Paul. You mentioned that there are fluctuations in your rate sensitivity related to noninterest-bearing deposits, but we are currently facing the impact of lower near-term rates. Has there been any change in your hedging strategy? Have you added or terminated any positions to adapt to this situation, or are you allowing it to progress as planned despite the current volatility?

Thank you for your question. We haven't terminated anything yet. While we have done that in the past, we haven't taken that action this time. Given the recent rally, it's definitely something we will be monitoring. As for adding to our portfolio, we have significantly increased our securities portfolio, growing it by several billion dollars over the past year. We expect to continue this growth. We are also closely monitoring swaps; we added $0.5 billion in notional value of forward-starting swaps last quarter. The yield curve reached a level we felt more comfortable with, although it has since shifted away from that. We are paying attention to both investment portfolio duration-adding products and swaps as we manage our interest rate sensitivity, which, as you've noted, is heavily influenced by strong deposit growth, especially in demand deposits.

Just on the loan growth, I heard you in terms of noting some flattening that you saw in balances in the second quarter. And I get your expectation for slightly to moderately increasing over the next 12 months. Just in terms of that inflection in terms of how should we think about loan growth resuming? Are you implying that next quarter is when we should see some growth and you expect a steady strengthening from that point? Or is it still something that's kind of back-end loaded on your next 12-month outlook?

If I could start on that one. John, as you know, we try really hard not to make sort of quarter-by-quarter outlook, which is why we do our sort of four quarters out. And so I don't want to get overly precise on timing. But as we said, we sort of saw a flattening of period end balances this quarter. That felt pretty good. We saw an uptick in utilization. That felt pretty good. So we need some more affirming evidence, right? But I would stay focused on where we're going to be a year from now as opposed to trying to speculate on what's going to happen in the third quarter.

Okay. That's helpful. And then on the, I guess, two quick things on the expense front, two-part question. One, just in terms of the completion of the core project in 2023, do you just have the timing in 2023 when do you expect that to complete if you can give us an update there? And then separately, because I know this obviously dovetails into your expense expectations. Can you give us your updated thoughts on your long-term efficiency ratio level? I know you're running around 59 range this quarter. Where do you see the longer-term trend for the bank as you look out?

This is Scott. Let me clarify my earlier comments about the core transformation expenses. I previously spoke about it in a general way, so I'll be more specific now and then hand it over to Paul or Harris if they want to discuss the long-term efficiency ratio. Essentially, our expenses for Future Core, which is our core transformation project, are expected to be around $45 million in 2020 and 2021, with a slight decrease in 2022. By 2023, these expenses will increase to the low 50s as we launch the new system, and then they will decrease by about $7 million to $8 million the following year. These fluctuations are not drastically large, but they will allow us to reallocate funds after 2023. In 2023, the conversion will not happen all at once; we will be transitioning various affiliates to the new deposit system throughout the year. However, by the second half of 2023, we should be progressing smoothly.

Regarding longer-term efficiency ratios, the outlook is heavily influenced by the rate environment. A 25 basis points change in margin translates to several hundred million dollars annually for us, significantly impacting our efficiency ratio. Given the current rate landscape, I anticipate M&A activity will remain consistent with what we've observed over the last several months for an extended period. It's likely we'll hover around the low 60s, and I hope we can maintain that. However, I believe inflation is here to stay rather than being a temporary issue. We're experiencing wage pressures in this competitive labor market, making it challenging to fill positions. For instance, I recently heard about an employee who received a job offer with a 50% pay increase without even going through an interview. I foresee a prolonged phase of inflation that could lead to rising interest rates and improve our margins, but it might also introduce other challenges. It's unlikely that this rate environment will persist indefinitely. If it does, we may struggle; if not, we could find ourselves back in the 50s, which would be more typical. However, the outcome is heavily contingent on the rate environment, making it difficult to predict.

Great. I wanted to talk about credit quality, which is excellent, and it's probably some of the best in the peer group. But as you look out next year, what is a new normal for net charge-offs through the cycle with all the derisking that you guys have done?

What we have communicated over the past two to three years is our goal to rank in the top tier of the industry regarding charge-offs. I believe that will be the case moving forward. It’s challenging to pinpoint the exact figure, especially since there have been times when we've experienced minimal charge-offs or even net recoveries, which isn't sustainable long-term. However, I anticipate that our charge-offs will likely fall within the 15 to 20 basis point range, reflecting a more typical scenario in line with our balance sheet management.

Got it. That's helpful. And then just a follow-up to that. Just the allowance for credit losses dropped to 1.22% ex-PPP. And I look to the CECL day 1, I think it was about 1.08%, but just given more confidence in the economic outlook and the changes to the credit risk profile, do you think that the allowance for credit losses could go below that January 1 level?

Let's see. Paul, do you have any thoughts about that? I look like you're...

Yes, this is Paul. I'll start with that. Under CECL, the allowance for credit losses is heavily influenced by the economic outlook, taking into account the size and underlying risk of the portfolio. This quarter, we observed another release driven primarily by a rapidly improving economic outlook. It's a complex process we must navigate each quarter, making it challenging to predict whether the allowance could decrease significantly or even increase from current levels due to the numerous assumptions involved. I realize this may not provide the clarity you're seeking, but honestly, we don't know until we reach each quarter. We then evaluate the risk at the end of the quarter and determine the allowance loan by loan from the ground up.

I want to go back to a comment earlier in the call about the degree of confidence in the size of the balance sheet versus a year ago. I wonder if you could elaborate that specific to the deposits. We've heard some of your peers talk about some of the transitory deposits that may or may not burn down over time. But just looking for a few comments to build on your comments before about the confidence of the balance sheet.

Sure. I'll begin by saying that our deposit growth compared to average growth is looking quite positive. It appears that our deposit growth is somewhat stronger, with contributions from both new and existing customers. We leverage extensive analytics, having participated in the CCAR and LCR frameworks for some time. The developments in our liquidity stress testing have provided valuable insights into how our customer accounts operate. We've observed that new customers are actively using their accounts, and existing customers are increasing their utilization of deposit accounts. This trend indicates greater stickiness in our deposits. A year ago, I anticipated that the deposits generated from the PPP program would be spent relatively quickly, as these funds had to be held on our balance sheet. To my surprise, our customers have demonstrated remarkable resilience and have adjusted their cash flow management effectively. This has turned into a strong credit story, as they have learned to manage their cash flows while maintaining liquidity. Consequently, funds that I expected to be used have remained on our balance sheet. Now, a year later, our deposits are significantly higher than my initial expectations. In summary, through time, experience, and informed analytics on the operational metrics behind our deposits, we are becoming increasingly confident that these deposits will persist longer than previously anticipated.

Maybe just one housekeeping on the tax rate. Is this a good tax rate going forward in the future?

Well, that's highly speculative, I would say. Based on the current law, I think we're in pretty good shape, but that could change, as you know.

I had a question just with regard to the energy portfolio, further decline this quarter, which I suppose it isn't really surprised. But I'm curious how the increase in commodity prices is maybe starting to show itself, if at all, among your E&P borrowers from an exploration perspective and whether the expectation would be that cash flows are so strong at this point as they've delevered that they would actually draw down on lines for that purpose or that they would fund it more out of cash flow?

Yes. Thank you for the question. This is Scott McLean again. The rise in commodity prices has clearly benefited the entire energy sector. Our balance, excluding PPP loans, is largely stable, but we anticipate some growth. Upstream companies are returning to the field and increasing drilling activity, which will be financed in part through cash flow and also through utilization. About half of the banks that previously participated in energy lending have pulled out, so funding will mainly come from bank revolvers and cash flow. We expect to see revolving balances for upstream companies increase over time. Additionally, credit quality has been improving, and we expect this trend to continue.

You just addressed my question on energy. But maybe kind of looking at the portfolio more holistically, are there other areas that you guys are emphasizing or deemphasizing more than others? Harris mentioned some concerns around CRE, maybe some teaser rates around HELOC, you mentioned municipal in the past. Are there other areas of the loan book that you guys are maybe more or less bullish on as we kind of contemplate your loan growth guidance over the next 12 months?

I guess one thing I talked a little bit about CRE, and I mean, I expect that probably continues to grow but very, very modestly. The municipal portfolio, we're seeing a more competitive environment out there, and that's probably slowed us down a little bit. And so, we'll see what happens with that, but that's been a growth driver, which I think will probably be growing at a slower pace. I think that owner-occupied commercial real estate is likely to see some decent growth. It's something that we're really promoting, as I mentioned before.

I would like to mention that we have observed a decline in our 1- to 4-family mortgages on the balance sheet over several quarters. These are essentially jump mortgages. We are beginning to see a shift in our mix, moving back toward originating more held for investment loans. It's uncertain whether this trend will stabilize in the current or next quarter, but if we review the past five or six years, approximately 25% of our loan growth has been attributed to 1- to 4-family mortgages. This is a strong product for us and represents a solid business opportunity. We anticipate that growth in this area will return, although it may take another quarter or two before we see a flattening and subsequent upward movement.

Yes. So those are, I was going to say just fundamentally just commercial C&I more generally as companies. I think as Scott aptly pointed out that there are a lot of opportunities for companies to be building inventory and kind of getting back to something closer to normal, and I think that's going to result in some loan demand.

As it relates to C&I loan growth, you discussed several external factors that may help in seeing some green shoots. But is there anything you can do internally to try to get loan growth to pick up? Is there an opportunity for you to adjust your underwriting, be more aggressive on price? Anything that Zions itself can do? Just try to help reaccelerate that C&I loan growth.

We are using aggressive introductory rates to take advantage of our low-cost funding. Our goal is to build a portfolio that will be priced normally as we progress through the year, but we aim to establish balances earlier to enhance our income even at lower introductory rates. This is our primary focus. We are not easing our underwriting standards, as we believe they should remain stable. However, we do see opportunities to competitively price loans in the short term.

I would like to add that the key factor is the amount of time our bankers spend reaching out to clients, and they are actively doing that. They are currently engaging with clients both virtually and in person more than before. Ultimately, this aspect is not something that can be extensively detailed in an analyst report, but it is essential for driving loan growth.

This is Michael. I want to mention that we have adjusted our temporary guidance on underwriting from the peak of COVID to align more closely with pre-COVID underwriting standards. We have returned to a pre-COVID perspective on how to assess new risk.

Just with the balance sheet continue to grow here, and obviously, you're seeking to be on the capital management side. Kind of curious as to leverage ratio went down this quarter, how low are you willing to go on that ratio with buybacks, potentially with the low to mid-7% range be acceptable to you guys?

Sorry, the question was on the leverage ratio?

Yes. Would you go down to like below to mid-7% range?

I'm going to provide a more detailed answer than your question might suggest. The response depends on the risk associated with the assets on our balance sheet. Currently, we hold many PPP loans that we consider to have minimal credit risk, along with various overnight investments that also carry little to no credit risk. Consequently, our approach to capitalization involves maintaining capital in line with the risks present in our balance sheet. This applies to both our risk-adjusted ratios and leverage ratio. As long as we are not adding significant incremental risk, I believe we are not overly concerned about a slight decline in the leverage ratio at this point.

Yes. I don't think that's likely to become a binding constraint for us. We'll worry about other things before we do that.

I'm curious, as it relates to COVID, is the Delta variant having any impact on confidence levels of your commercial customers yet, right? Are they just starting to pay attention to this or not? And maybe for Michael, as it relates to your reserve, is the potential impact from Delta embedded in the economic outlook that you used this quarter to establish the reserve?

Yes, go ahead, Michael. Maybe you take this.

Yes, I was just going to say, it might be a little too early to understand the impact to our borrowing community. But we did have a discussion about the Delta variant. We will probably have a discussion in Q3 about it. It would end up in the qualitative area of the ACL.

Yes. I believe it might be too early to identify any significant concerns from our customers regarding the Delta variant. Current infection rates are still around 10% of what they peaked at. With a large portion of the population vaccinated, I think this will encourage younger individuals to get vaccinated, which is my hope. Additionally, as we start to determine the requirements for boosters, I hope that everyone will cooperate. However, I don't see any signs at this time that our commercial customers are losing confidence in the recovery.