Regions Financial Corporation (NYSE:RF) Q3 2023 Earnings Call Transcript

Regions Financial Corporation (NYSE:RF) Q3 2023 Earnings Call Transcript October 20, 2023

Regions Financial Corporation misses on earnings expectations. Reported EPS is $0.49 EPS, expectations were $0.58.

Operator: Good morning and welcome to the Regions Financial Corporation’s Quarterly Earnings Call. My name is Christine and I will be your operator for today’s call. I would like to remind everyone that all participants’ online have been placed on listen-only. At the end of the call, there will be a question-and-answer session. [Operator Instructions] I will now turn the call over to Dana Nolan to begin.

Dana Nolan: Thank you, Christine. Welcome to Regions’ third quarter 2023 earnings call. John and David will provide high-level commentary regarding the quarter. Earnings documents, which include our forward-looking statement disclaimer and non-GAAP information are available in the Investor Relations section of our website. These disclosures cover our presentation materials, prepared comments and Q&A. I will now turn the call over to John.

John Turner: Thank you, Dana, and good morning everyone. We appreciate you joining our call today. Earlier this morning, we reported earnings of $465 million, resulting in earnings per share of $0.49. And while we have some unusual items in our results this quarter, our core performance remains strong, and we continue to have one of the best return on average tangible common equity ratios in our peer group at 21%. During the quarter, we continued to experience elevated levels of check-related fraud. Our third quarter results reflect an incremental $53 million in losses stemming from a second fraud scheme, which also began in the second quarter, but was unknown to us at the time. This scheme manifested itself in delayed returns, and as a result, has had a much longer tail.

After adjusting our countermeasures to identify potential fraud instances more quickly, the volume of new fraud claims has slowed. Although difficult to project, based on what we know today, we expect quarterly fraud losses to come down significantly and to be approximately $25 million in the fourth quarter. Based upon the increases we are seeing in check fraud across the industry, in fact, based on data we have, we indicate losses are up about 40% year-over-year. We expect future fraud losses to normalize in the $25 million per quarter range in 2024. Although the industry faces headwinds from lingering economic and regulatory uncertainty, we continue to benefit from our strong and diverse balance sheet with solid capital, robust liquidity, and prudent credit risk management.

Our proactive hedging strategies have positioned us for success in any interest rate environment. And our granular deposit base and relationship banking approach continue to serve us well. We spent over a decade de-risking our balance sheet and are well positioned to manage the proposed regulatory changes without significant impact to our business model. We remain committed to appropriate risk-adjusted returns, and now is not the time to stretch for growth. We are focused on supporting existing customers where we have a relationship and a proven history. We have a great team with a proven track record of executing our strategy with focus and discipline. I’m confident in our ability to adapt to the changing regulatory and economic landscape, while continuing to generate top quartile returns through the cycle.

Now, David will provide some highlights regarding the quarter.

David Turner : Thank you, John. Let’s start with the balance sheet. Average and ending loans remain relatively stable quarter-over-quarter. Within the business portfolio, average loans were stable, while ending loans decreased 1%. As John mentioned, we are being judicious in reserving our capital for business where we can have a full relationship. Client sentiment varies across industries with some continuing to expect growth, while others have a more muted outlook. Commercial commitments are down 1% compared to the second quarter. Average and ending consumer loans increased 1% as growth in mortgage and EnerBank was partially offset by declines in home equity and runoff exit portfolios. Subsequent to quarter-end, we executed a sale of our remaining GreenSky portfolio of approximately $300 million, which represents one of our consumer exit portfolios.

The economics of the transaction are relatively neutral, but will create approximately 14 basis points of incremental charge-offs in the fourth quarter, offset by the related reserve release. Looking forward, we expect 2023 ending loan growth to be in the low single digits. From a deposit standpoint, the modest deposit declines were in line with expectations, largely driven by late cycle rate-seeking behavior. We continue to experience remixing out of non-interest bearing or NIB products and ended the quarter with NIB representing 35% of total deposits. Given the current rate environment, we expect the percentage to ultimately level off in a low 30% range. While some customers find alternatives in other investment channels outside of regions, many are moving to our CDs and money market accounts.

We also continue to provide off-balance sheet opportunities through our wealth management platform and in the corporate banking segment via money market mutual fund solutions. In the case of corporate clients, overall liquidity under management has remained stable quarter-over-quarter. Acquisition and retention of high primacy and operating relationships are strong, reflecting our focus to sustain and extend our deposit advantage through cycles. Looking forward, the higher rate environment, a tightening Federal Reserve, and heightened competition will likely continue to constrain deposit growth and pressure costs for the industry through year-end and into early 2024. Accordingly, we expect deposits to be stable, to modestly lower in the fourth quarter, and we expect continued remixing into interest bearing categories.

So let’s shift to net interest income. Net interest income declined by 6.5% in the third quarter, reflecting the anticipated normalization from elevated net interest income and margin levels back towards a sustainable longer term range. The decline is driven by deposit cost normalization, the start of the active period on $6 billion of incremental hedging, as well as a one-time leverage lease residual value adjustment. As the Federal Reserve nears the end of its tightening cycle, net interest income is supported by elevated floating rate loan and cash yields at higher market interest rates and fixed rate asset turnover from the maturity of lower yielding loans and securities. Deposit costs continue to increase through a combination of re-pricing and remixing, increasing the cycle to-date interest bearing deposit beta to 34%.

Historically, this behavior persists for a few quarters after the Fed stops moving interest rates. While we expect the pace of re-pricing to moderate, a higher federal funds rate over an extended period will cause remixing from low cost deposits to persist, ultimately pushing deposit betas higher than previously anticipated. We now project the cycle to-date beta to increase to near 40% by year-end. Regardless, we remain confident that our deposit composition will provide a meaningful competitive advantage for regions when compared to the broader industry. If the Fed remains on hold, fourth quarter net interest income is expected to decline approximately 5%, driven by continued deposit and funding cost normalization and the beginning of the active hedging period on another $3 billion of previously transacted forward starting swaps.

Net interest income is projected to grow approximately 11% in 2023 when compared to 2022. As we look to 2024, higher rates for longer likely extends the period of deposit cost and mix normalization. We expect net interest income trends to stabilize over the first half of the year and grow over the back half of the year. The balance sheet hedging program is an important source of earning stability in today’s uncertain environment. Hedges added to date create a net interest income profile that is well protected and mostly neutral to changes in interest rates through 2025. While we do not anticipate adding any point to the hedging position over the coming quarters, we continue to look for opportunities to add protection at attractive rate levels in outer years through the use of derivatives or securities.

During the third quarter, we added $1.5 billion of forward starting swaps and $500 million of forward starting rate collars. Let’s take a look at fee revenue and expense. Adjusted non-interest income decreased 2% from the prior quarter, as modest increases in mortgage and wealth management income were offset by declines primarily in service charges and capital markets. The increase in mortgage income was driven by higher servicing income associated with a bulk purchase of the rights to service $6.2 billion of residential mortgage loans closed early in the quarter. Service charges declined 7%, reflecting the run rate impact of the company’s overdraft grace feature implemented late in the second quarter. Based on our experience to-date, as well as our expectation for another record year in treasury management, we now expect full year service charges of approximately $590 million.

Total capital markets income decreased $4 million. Excluding the impact of CVA and DVA, capital markets income decreased 13% sequentially, as increases in M&A fees were offset by declines in other categories. We had a negative $3 million CVA and DVA adjustment during the quarter versus the $9 million negative adjustment in the prior quarter. With respect to the outlook, we now expect full year 2023 adjusted total revenue to be up 5% to 6% compared to 2022. Let’s move on to non-interest expense. Adjusted non-interest expense decreased 2% compared to the prior quarter and includes the previously noted elevated operational losses. Excluding the incremental fraud experienced in both the second and third quarters, adjusted non-interest expenses increased 1% sequentially.

Salaries and benefits decreased 2%, driven primarily by lower incentives and payroll taxes, while other non-interest expense increased 12%, driven primarily by a $7 million pension settlement charge. We remain committed to prudently managing expenses in order to fund investments in our business. We will continue to refine our expense base, focusing on our largest categories, which includes salaries and benefits, occupancy and vendor spend. We expect full year 2023 adjusted non-interest expenses to be up 9.5%. Excluding the $135 million of incremental operational losses experienced in the past two quarters, we expect adjusted non-interest expenses to be up approximately 6% in 2023 when compared to 2022. From an asset quality standpoint, overall credit performance continues to normalize as expected.

Net charge-offs increased 7 basis points to 40 basis points due to elevated charge-offs related to a solar program we’ve since discontinued at EnerBank, as well as lower commercial recoveries versus the second quarter. Non-performing loans, business services criticized loans, and total delinquencies also increased. Non-performing loans as a percentage of total loans increased 15 basis points in the quarter due primarily to a large collateralized information credit. Provision expense was $145 million or $44 million in excess of net charge-offs. The allowance for credit loss ratio increased 5 basis points to 1.70%, while the allowance as a percentage of non-performing loans declined to 261%. The increase to our allowance is due primarily to adverse risk migration and continued credit quality normalization, as well as a build in qualitative adjustments for incremental risk in certain portfolios, including office, multifamily and select markets and EnerBank.

It’s also worth noting the outcome of the most recent Shared National Credit Exam is reflected in our results. The allowance on the office portfolio increased from 2.7% to 3.1%. Importantly, the vast majority of our office exposure is in Class A properties located primarily within the Sunbelt and non-Gateway markets. Overall, we continue to feel good about the composition of our office book and do not expect any meaningful loss in this portfolio. We expect net charge-offs will continue to normalize, including this quarter’s charge-offs, but excluding the 14 basis point impact on our fourth quarter GreenSky loan sale, we expect full year 2023 adjusted net charge-off ratio to be slightly above 35 basis points. In the third quarter, two anticipated notices of proposed rulemakings were issued.

While we plan to provide feedback through the comment process on both, we are well positioned to absorb the ultimate impacts without major changes to our business. With respect to Basel III end-gain, as proposed, we estimate a low to mid-single digit increase in risk-weighted assets under the expanded risk-based approach in addition to the phase-in of AOCI into regulatory capital. Regarding minimum long-term debt, we estimate a need to issue approximately $6 billion of long-term debt over the course of several years. We view this amount to be manageable, resulting in a modest drag on earnings. Importantly, the proposal provides clarity on the evolution of the regulatory environment and supports our decision to maintain our common equity Tier 1 ratio around 10% over the near term, as this level should provide sufficient flexibility to meet the proposed changes along the implementation timeline, while supporting strategic growth objectives.

Despite the current macroeconomic and geopolitical uncertainty, as well as the continued evolution of the regulatory framework, we expect that share repurchases will resume in the near term. And finally, we have a slide summarizing our expectations, which we have addressed throughout the prepared comments. With that, we’ll move to the Q&A portion of the call.

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Q&A Session

Operator: Thank you. [Operator Instructions]. Please hold while we compile the Q&A roster. Thank you. Our first question comes from Scott Siefers with Piper Sandler. Please proceed with your question.

Scott Siefers: Good morning, everyone. Thank you for taking the question. I wanted to start out just on the NII trajectory. When we talk about NII stabilizing in the first half of the ’24, I guess, we might be suggesting that it could continue to compress a bit after the fourth quarter’s dip. So maybe just thinking if you can help us to sort of size any potential pressure beyond year-end ‘23, and then additionally your thoughts on what would allow it to resume growing in the second half of next year.

David Turner: Yes. Hey Scott. This is David. So you’re right. You will see some pressure in the fourth quarter in particular as we see continued remixing of non-interest bearing deposits going into interest bearing, given higher for longer rates. And due to the fact that we have $3 billion of notional interest rate swaps that become live in the fourth quarter, that alone cost about $20 million in NII. So you’ll see an adjustment, not as big as you just saw relative to net interest margin decline, but you’ll see some decline in the fourth quarter. When we get to the third quarter, while we do have an additional $2.5 billion of interest rate swaps that become live then, we think the remixing will start slowing. We think there is somewhere between $3 billion and $5 billion worth of remixing of non-interest bearing deposits into interest bearing, and that’s going back into study in our consumers in particular, and how much they had in their accounts relative to their spend.

And where that $3 billion to $5 billion gets you back to where they were from a pre-pandemic standpoint. So we have confidence that we should see this starting to slow after the fourth quarter. There’ll be, like I said, a little pressure in the first quarter because of the new derivatives coming on. That number will affect us about $10 million to $15 million in the first quarter, then we don’t have any more after that. So we start stabilizing from there. When we get to the second half of the year, we can start to grow. If I kind of cut to the chase on the end game, we think after all is said and done, we can support – our margin should bottom out around $3.50, perhaps a bit higher than that. So you’re not going to see the kind – you can’t take the change that you just saw and continue to extrapolate that all the way through the end of the second quarter.

You’ll have a bigger change in the fourth, a smaller change in the first and negligible change in the second quarter. So the balance sheet, what’s important in all that is the balance sheet continues to re-price. We have about $15 billion worth of fixed rate securities and loans that re-priced. And the front book, back book impacts are about 250 basis points and we continue to have had that. The problem is it’s been overwhelmed by the move of non-interest bearing deposits into interest bearing. And as I just mentioned, that should start to slow. And so I think, again, our margin bottoming out, kind of in that $3.50 just slightly better than that, is really the relevant point here.

Scott Siefers: Okay. Perfect. Thank you for that color. And then I guess just on the notion of deposits and betas. I know we’re thinking about a 40% beta through the end of the year, but maybe thoughts on how things could trend into next year if we indeed have just sort of some drag on price. How much more pressure could we see once rates peak? How might that level off?