Banner Corp (BANR) 2017 Q2 法說會逐字稿

Good day and welcome to the Banner Corporation conference call and webcast. [Operation Instructions) I would now like to turn the conference over to Mr. Mark Grescovich, President and CEO of Banner Corporation. Please go ahead.

Thank you Jasmine and good morning everyone. I would also like to welcome you to the second quarter 2017 earnings call for Banner Corporation. As is customary, joining me on the call today is Rick Barton, our Chief Credit Officer; Lloyd Baker, our Chief Financial Officer of the corporation and Peter Conner, our Chief Financial Officer of Banner Bank. Lloyd, if you could take a moment and read our forward-looking safe harbor statement.

Good morning. Our presentation today discusses Banner's business outlook and will include forward-looking statements. Those statements include descriptions of management's plans, objectives or goals for future operations, products or services, forecasts of financial or other performance measures, and statements about Banner's general outlook for economic and other conditions. We may also make forward-looking statements in the question-and-answer period following management's discussion. These forward-looking statements are subject to a number of risks and uncertainties and actual results may differ materially from those discussed today.

Information on the risk factors that could cause actual results to differ are available from the earnings press release that was released yesterday, and it recently filed Form 10-K for the year ended December 31, 2016. Forward-looking statements are effective only as of the date they are made and Banner assumes no obligations to update information concerning its expectations. Thank you, go ahead Mark.

Thanks Lloyd. As announced, Banner Corporation reported a net profit available to common shareholders of $25.5 million or $0.77 per diluted share for the quarter ended June 30, 2017. This compared to a net profit to common shareholders of $0.72 per share for the first quarter of 2017 and $0.61 per share for the second quarter of 2016. Excluding the impact of merger and acquisition expenses, gains and losses on the sale of securities and changes in fair value of financial instruments, earnings increased 13% to $ 25.9 million for the second quarter of 2017 from $23 million in the second quarter of 2016.

Because of the hard work of our employees throughout the company, we are successfully executing on our strategies and priorities to deliver sustainable profitability and revenue growth to Banner.

Our core operating performance continued to reflect the success of our proven client acquisition strategies which are producing strong core revenue and we are benefiting from the successful integration of our recent acquisitions, which has had a dramatic impact on the scale and reach of the company and are providing a great opportunity for revenue growth.

Our second quarter 2017 performance clearly demonstrates that our strategic plan is effective and we continue building shareholder value. Second quarter 2017 core revenue was $122.9 million, an increase of 7% compared to the second quarter of 2016. We benefited from a larger and improved earning asset mix, a net interest margin that remained above 4% and good mortgage banking and deposit fee revenue.

Overall, this resulted in a return on average assets of 1.01% for the second quarter of 2017. Once again, our performance this quarter reflects continued execution on our super community bank strategy, that is: Growing new client relationships, adding to core funding position by growing core deposits and promoting client loyalty and advocacy through our responsive service model while augmenting our growth with opportunistic acquisitions.

To that point, our core deposits increased 8% compared to June 30, 2016. Also, our non-interest bearing deposits increased 8% from a year ago as well, representing strong organic generation of new client relationships. Our organic net client growth in these product categories is now 93% since December 31, 2009. Reflective of this solid performance coupled with our strong tangible common equity ratio of 10.46%. We issued a core dividend in the quarter of $0.25 per share, and a special dividend of $1 per share. In a few moments, Lloyd Baker and Peter Conner will discuss our operating performance in more detail.

While we have been effectively executing on our strategies to protect our net interest margin, grow client relationships, deliver sustainable profitability and prudently invest our capital, we have also focused on maintaining the improved risk profile Banner. Again this quarter, our credit quality metrics reflect a moderate risk profile. As expected, due to the addition of new loans in the migration of acquired loans out of the discounted loan portfolio, we recorded a $2 million provision for loan losses during the second quarter.

A t the end of the quarter, our ratio of allowance for loan and lease losses to total loans was 1.17% and our total non-performing assets totalled 0.24%. In a moment Rick Barton, our Chief Credit Officer will discuss the credit metrics of the company, and provide some context around the loan portfolio and our success at maintaining a moderate credit risk profile.

In the quarter and throughout the preceding 7 years, we continue to invest in our franchise. We have added talented commercial and retail banking personnel to our company, and we have invested in further developing and integrating all our bankers into Banner's proven credit and sales culture. We have also made significant investments and our risk management [90] infrastructure positioning the company for continued growth and scale. While these investments have increased our core operating expenses, they have resulted in core revenue growth, strong customer acquisition, year-over-year growth in the loan portfolio, strong deposit fee income and positive year-over-year operating leverage.

Further, we have received marketplace recognition of our progress and our value proposition. As J.D. Power and Associates rank Banner the #1 bank in the Northwest for client satisfaction. The 3rd year, we have won this award. In the small business administration named Banner Bank Community Lender of the Year for the Seattle and Spokane District for 2 consecutive years and this year named Banner Bank Regional Lender of the Year for the 2nd consecutive year.

Also Banner ranked #29 out of 100 in the Forbes 2017 best banks in America. The successful execution of our organic growth plan augmented with strategic acquisitions and our persistent focus on improving the risk profile of Banner has now resulted in 25 consecutive quarters of profitability and our tangible book value increased to $31.20 per share versus $30.86 per share at June 30, 2016.

Finally, as announced this morning, we made a strategic and economic decision to sell our 7 branches in Utah and focus our future investments on the West Coast.

I'll now turn the call over to Rick Barton to discuss trends in our loan portfolio. Rick?

Thanks, Mark. Credit quality at Banner during the second quarter of 2017 remained stable, as it has over the last several quarters. Our portfolio's moderate risk profile is clearly demonstrated by the credit metrics that I will now briefly recap. Before doing so, however, I want to repeat the comment we have made in our last several presentations that the company's credit metrics are at historically favorable levels and are unlikely to improve further.

Delinquent loans were 0.44% compared to 0.51% last quarter and 0.52% a year ago. This type of fluctuation is to be expected when delinquencies are at low levels. The company's level of adversely classified assets remains low and decreased slightly during the quarter. Nonperforming assets increased 3 basis points during the quarter to 0.24% of total assets. Again, this type of fluctuation is common when a metric is at a low level.

Not reflected in these totals are the remaining nonperforming loans of $9 million acquired from Siuslaw and AmericanWest Banks, which are not reportable under purchase accounting rules. If we were to include the acquired nonperforming loans at our nonperforming asset totals, the ratio of nonperforming assets to total assets will still be a modest 30 basis points.

Performing troubled debt restructures declined 18 basis points of total loans, down from 23 basis points in the linked quarter. Gross charge-offs during the quarter were $1.6 million versus $2.1 million last quarter. After loan loss recoveries of $1.7 million, that cannot be considered to be recurring. The company was in a modest net recovery position for the quarter.

The allowance for loan and lease loss provision for the second quarter was again $2 million. After this provision and the quarter's net recovery position just discussed. The loan losses for the company now totals $88.6 million and is 1.17% of total loans leveled with the linked quarter. The remaining net accounting mark against acquired loans is $26 million, which provides an additional level of protection against loan losses. Loans increased by $131 million from the linked quarter and $226 million when compared to June 30, 2016. Quarter-over-quarter increases in commercial business and agricultural loans accounted for $92 million of the growth. The growth in business loans reflects both marketing successes by our bankers and good economic activity in our markets.

The increase in agricultural loans is a typical seasonal increase. Also increasing during the quarter were multifamily loans $34 million, home equity lines of credit $34 million and 1- to- 4 family construction loans $14 million. Permanent commercial real estate loans decreased by $37 million during the quarters, as several significant loans were paid as borrowers took advantage of attractive loan structures and interest rates.

All other loan categories as shown in our press release had nominal increases or decreases. Overall, on an annualized basis, the company's loan portfolio grew by approximately 7%. And as noted in the press release, our loan origination pipelines indicate the potential for significant future loan growth. In summary, Banner's loan portfolio and credit metrics were marked by stability during the just completed quarter, further seasoning the portfolios moderate risk profile. With that, I'll turn the stage over to Lloyd for his comments.

Thank you, Rick and good morning again everyone. As Mark has noted Peter Connor, our Chief Financial Officer for Banner Bank is again with us here today. And after a few general remarks from me, Peter will provide more detailed insight into the second quarter results. Again this quarter, our core operations were very consistent with the trends we have reported for a number of periods, in fact, for a number of years.

Banner Corporation second quarter and year-to-date 2017 operating results continue to reflect successful execution on our strategic initiatives, including significant benefits as a result of the acquisition of AmericanWest Bank, as well as meaningfully increased regulatory cost, as a result of our approach to and subsequent breach of the $10 billion in total asset threshold. Our financial performance in the quarter was driven by strong revenue generation, reflecting the increased scale of the company, additional client acquisition and a continued positive operating environment. We had an expected increase in revenues compared to the immediately preceding quarter, as a result of normal seasonal patterns, as well as the full impact of the renewed releveraging of the balance sheet as we crossed the $10 billion threshold. And compared to the same quarter a year earlier, growth in average earning asset balances coupled with an expanded net interest margin and growth in non-interest income allowed our revenues from core operations to increase by 7% year-over-year.

Similar to previous periods, fully appreciating Banner's core operating results for each of the periods presented requires a clear understanding of the impact of the merger and acquisition related expenses on last year's performance, as well as the valuation adjustments for certain financial instruments that we carry at fair value, and win material gains and loss on the sale investment securities.

In the second quarter of 2017, Banner reported net income of $25.5 million or $0.77 per diluted share. This amount was net of $650,000 of charges for the valuation adjustments for financial instruments and $54,000 net loss on the sale of securities, which together, net of related tax effects reduced earnings for the quarter by $0.01 per diluted share. Fair value adjustments and securities transactions had a similar $0.01 per diluted share negative effect on the immediately preceding quarter and reduced earnings by just 3% per diluted share for the first 6 months of 2017.

By comparison, acquisition-related expenses were $2.4 million in the second quarter of 2016, which along with $377,000 of fair value charges and $380,000 of securities losses, reduced earnings net of taxes by $0.06 per diluted share for that quarter. For the first 6 months a year ago, acquisition-related expenses were much larger $9.2 million, where fair value charges and securities losses combined were $1.4 million, all of which together net of tax effects reduced earnings by $0.18 per diluted share for that 6-month period.

Excluding the acquisition-related expenses, fair value adjustments and securities gains and losses, our earnings from core operations were $25.9 million or $0.78 per diluted share for the current quarter, compared to $24.2 million or $0.73 per share for the immediately preceding quarter, and $23 million or $0.67 per diluted share in the second quarter a year ago. For the first 6 months of 2017, our earnings from core operations were $50.1 million or a $1.52 per diluted share compared to $45.1 million or $1.32 per diluted share in 2016.

As a result of these increases in total earnings from core operations as well as the reduction in average shares outstanding as a result of stock repurchases in the second half of last year, our earnings per share from core operations increased by 16% and 15% respectively compared to the same quarter and 6-month periods a year earlier.

As we have done in previous earnings releases, again this quarter we have included a reconciliation of earnings from core operations and other non-GAAP financial information in our press release, which I encourage you to review. As I noted, underlying this earnings growth, our revenues from core operations which is revenues excluding the gains and losses on sales of securities and fair value adjustments were strong and at $122.9 million for the quarter ended June 30, 2017, were 7% greater than the same quarter a year ago.

The solid core revenue generation continues to reflect the successful execution of our super community bank business model and the increasing value of the Banner franchise. Second quarter net interest income before provision for loan losses was particularly strong at $99.7 million, compared to $94.9 million in the preceding quarter and increased 7% compared to $93.1 million in the second quarter a year ago, reflecting the increased earning asset balances and a stronger net interest margin. Similarly, our net interest income for the 6 months of 2017 was 6% greater than the same period a year earlier.

Our reported net interest margin increased to 4.33% for the quarter ended June 30, 2017, an 8-basis point increase from the preceding quarter and 13 basis points above the second quarter a year ago. More important, excluding the impact of acquisition accounting, our contractual net interest margin for the second quarter of 2017 was 4.18% compared to 4.15% in the preceding quarter and 4.01% in the second quarter a year ago. Again this quarter, loan yields and net interest margin were positively impacted by increased market interest rates, while deposit pricing remained generally unchanged.

In addition, the timing worked well for us as we releveraged the balance sheet above the $10 billion mark with first quarter purchases that boosted yields on the securities portfolio. Deposit fees and service charges rebounded to $13.2 million in the second quarter from $12.2 million in the preceding quarter in line with our seasonal expectations. Deposit fees and service charges increased 8% compared to the same quarter a year earlier, a direct result of growth in core deposit accounts and related transaction activity.

As noted in the press release, mortgage banking revenues increased to $6.8 million for the second quarter compared to $4.6 million for the first quarter and $5.6 million in the second quarter a year ago. The increase in mortgage banking revenues compared to the preceding quarter reflected in expected seasonal pattern for 1-to-4 family loan origination, dampen somewhat by the adverse effect of higher interest rates.

In addition, gains on the sale of multi- family loans increased significantly in the current quarter with good volume and improved margins for loan sales compared to the first quarter. Total noninterest operating expenses were $81.9 million in the second quarter, compared to $78.1 million in the preceding quarter and $79.9 million in the second quarter of 2016. In total, non-interest expenses were in line with our expectations, although there were some unusual items in the preceding quarter, which Peter will address in his comments that make comparison a bit more challenging.

I will leave most of the balance sheet discussion to Peter as well. However, I do want to remind you that we had particularly strong first quarter deposit growth and that which was not entirely in line with our normal seasonal experience, which generally results in modest first and second quarter balance growth, with stronger growth usually concentrated in the second half of the year. As a result, core deposit balances were essentially unchanged at the end of the second quarter compared to the immediately preceding quarter, but they were 8% greater than the same date a year earlier.

Finally, I believe it's worth noting that despite the strong earnings, our tangible book value per share decreased to $31.21 at June 30, 2017 compared to $31.68 at March 31, 2017, as a result of the $1 per share special dividend and the $0.25 per share regular dividend declared in June. However, notwithstanding those dividends and other regular dividends that together totaled a $1.96 per share as well as stock repurchases that we executed in the second half of last year. Banner's tangible book value per share increased by $0.35 over the 12-month period from June 30, 2016 to 2017.

This concludes my prepared remarks. In summary, Banner Corporation had another good quarter and a very encouraging start to the first half of 2017. As always, I'd look forward to your questions. But first, Peter will add some more color on the quarter.

Thank you Lloyd and good morning everyone. I will provide some additional detail on the elements of our second quarter financial results. As Mark and Lloyd noted and as we announced in our earnings release, we reported net income of $0.77 per share for the second quarter. The $0.05 per share increase from the prior quarter was due to the following items: Net interest income increased $0.10 due to a combination of higher loan yields and growth in the average investment portfolio balance as a result of the releveraging included in the first quarter. Non-interest income increased $0.03 due to increased mortgage and multifamily loan gain on sale income coupled with growth in deposit fees. Noninterest expense increased $0.08 due to credit related expense recoveries in the prior quarter and increases in compensation in the second quarter. There were no earnings per share impact due to changes in share count or the effective tax rates.

Assets grew $130 million in the second quarter to $10.2 billion. Investment portfolio grew $41 million to $1.7 billion at quarter-end. However, the average investment portfolio balance increased to $265 million or 20% over the prior quarter due to releveraging activity in the first quarter. Growth in the average investment portfolio balance coupled with a 5-basis point increase in average securities yield, resulted in $1.8 million in additional investment portfolio related interest income in the second quarter.

Total loans increased to $131 million from the prior quarter-end due to growth in (inaudible) loans among the seasonal increases in agricultural lend usage. On a combined basis, loans held for sale and nonearning assets declined $40 million in the prior quarter.

As Lloyd mentioned, (inaudible) were flat compared to prior quarter. The change from the seasonal pattern of modest growth company normally experiences in the second quarter. This break from normal to positive seasonality was due to the outflow of funds that's coming from inflows in prior quarters related to the proceeds from the sale of 2 commercial client owned businesses.

Total time deposits grew $61 million due to the issuance of references, which in total represents 3% of total deposits at the end of the quarter. The total cost to deposits was 15 basis points, up 1 basis point from the prior quarter due to a higher mix of CDs.

Net interest income increased $4.8 million due to the increase in loan yields and an increase in the average investment portfolio balances discussed earlier. Loan yields were positively affected by $1.3 million increase in acquired loan accretion interest income recorded in the second quarter compared to the first quarter. Loan yields increased 18 basis points to 4.98% in the second quarter. Accretion accounted for 16 basis points of the loan yield in the second quarter compared to 9 basis points in the previous quarter. The contractual loan yield excluding accretion increased 11 basis points. The net interest margin increased 80 basis points to 4.33%. The effects of purchase accounting including both loan accretion and time deposit premium amortization accounted for 15 basis points of the net interest margin in the second quarter compared to 10 basis points in the previous quarter.

The contractual margin including the effects of purchase accounting increased 3 basis points in the second quarter. Core non-interest income, excluding gains and losses on securities sales and fair value adjustments on securities and debt instruments carried a fair value, increased $1.6 million from the prior quarter. The increase was driven by increased mortgage and multifamily gains on sale, coupled with growth in deposit fees. The growth in fee income in the second quarter was partially offset by a $2.5 million gain on the sale of special asset loan in the first quarter. [OE] income increased 33% in the second quarter as a result of a onetime gain on an insured beneficiary.

Noninterest expenses increased $3.8 million in the second quarter from the previous quarter. Personnel expense increased $3 million due to the impact of bank wide annual merit increases, one time market adjustment increases, increased loan and deposit commission expense, and staff growth across the banks' risk management and compliance infrastructure associated with processing the $10 billion asset threshold. In addition, the bank experienced an increase in health care costs due to a higher claims experience in the second quarter. Professional services expense reflects ongoing consulting engagements, facilitating the enhancement of the bank's compliance and DFAST capabilities. However, this line item decline $865,000 from the previous quarter, primarily due to reduction in the amount of outside auto expense from the prior quarter.

Real estate operations expense increased due to the gains on OREO sales reported as a credit to expense in the first quarter. Miscellaneous expense increased in the second quarter as a result of $1.2 million credit to expense in the first quarter from a partial release of the unfunded loan commitment reserves associated with a single borrower. This concludes my prepared remarks. Mark?

Thank you, Peter and Lloyd, and Rick for your comments. That concludes our prepared remarks, and Jasmin will now open the call and welcome your questions.

(Operator Instructions) The first question comes from Jeff Rulis with D.A. Davidson.

Peter, quick question on the expense side. Could you keep us up-to-date on the -- I guess your identified DFAST cost of the $4 million to $5 million, and how far -- how much your spend incurred to date?

As you've mentioned, our expectation for the total run rate cost of the fully implemented DFAST and end compliance infrastructure is expected around $5 million a year, once it's fully implemented. Through the second quarter, we've recognized approximately 70% of that $5 million bill. So if you think about the quarterly effect, there's another $1 million to go approximately in the quarterly run rate.

And just to clarify that, you expected all to be incurred by the end of this ...

Yes. So where -- there is some lumpiness to the professional services related to the compliance in DFAST that will remain elevated in the third quarter, and then begin to diminish in the fourth quarter. The personnel component of that of course is going to be a permanent increase along with some ongoing software and outside consulting expenses that will be part of the permanent program, but we do anticipate a decline in the consulting engagements that are going on now related to those enhancements in the fourth quarter.

Okay. I guess I wasn't aware of that, there is maybe. So the bill to $ 5 million occurs this year, but thereafter there could be a modest, at least for that cost alone, there could be a modest decline?

Yes. I'd characterize it as very modest and it only show up in the professional services.

And then, Mark, just a question on the strategy of the kind of the Utah branch. I think you've indicated in the past that you continue to look at that footprint since acquisition. I guess, how does that sync up with the other strategy of ramping scale to offset the $10 billion cost and maybe just characterize what led to the Utah sale?

Sure. This is Mark. Thanks you for the question, Jeff. First of all, let me just say, as I've said in the past that we actually like the market quite a bit. We like the business climate in the State of Utah and the staff that we have with the branches there and our commercial banking staff, I think is very solid. However, as I've indicated before, our business model works best when we have scale and we didn't see a path to achieve that scale in a reasonable timeframe. So we made a decision that to exit the market there and focus our investment and management oversight into the West Coast.

Okay. Just a couple of quick follow-ups. Is that early or late in the quarter of Q4. Do you expect to see a gain. And lastly, is there any other portions of the footprint, potentially Southern California that you would see that -- that could also be at -- not at risk, but under watch for additional disposal of other assets?

Jeff, this is Mark. I'll answer the second part of your question and then ask Peter to comment on the economics and timing of the economics. First of all, as I said in other parts of our footprint, we're very excited about the economies there, and we feel like we have some excellent banking staff there to take advantage of the marketplace. And quite frankly, there are multiple options for scale improvement specifically in California and the Northwest that we feel will be in a position to take advantage of.

Jeff, this is Peter. In terms of the timing, so we anticipate the closing to occur early in the fourth quarter. As noted in the press release, there is $260 million of loans and approximately $180 million of deposits, so all go away with the transaction. We also expect to record a net gain on sale of approximately at $11 million after accounting for the breakdowns of the related goodwill core deposit intangible in net operating losses associated with that part of the franchise. And in terms of the economics, the business was somewhat dilutive to the rest of the organization in terms of the traditional efficiency metrics, although with such a small component of the overall organization, we don't anticipate any material changes to our overall efficiency ratio once the transaction is completed.

And there maybe more specifically, on the expense side of things, is there a expected may be not all in Q4, but carry forward of cost saves from exposing of that?

Yes, obviously, all the direct expenses associated with operating of branches goes away. There is a portion of overhead that also will go away with the divestiture, although we will retain some of the existing overhead for the rest of the organization as additional capacity to run the rest of the organization. In terms of the net income, impact of the company, I'd estimate approximately a $1 million of net income after tax decline in the company's consolidated results, once Utah goes away. But as I said earlier, there will be no impact to the overall efficiency ratio or other return metrics.

The next question comes from the line of Tim O'Brien of Sandler O'Neill.

Another question for Peter, state municipal business use taxes that line item was down, I didn't catch when you were going item-by-line item on the call discussion there was that, can you give a little color on why that was relative to trailing five quarters?

We incurred a refund from the State of Washington that was recognized in the second quarter. This was actually a multiyear effort of reconciling and assessing our B&O tax obligation, going back a few years when that credit was recorded in the second quarter. I would anticipate our B&O taxes to resume a normal level that we saw in the first quarter going forward.

How big was that credit?

I don't have a precise number with me, Tim, but it was approximately $500,000.

Great. And then the other question that I had for you, can you give a little bit of color, there was a downgrade this quarter I didn't catch, you said it was a commercial loan I think, or the $3.8 million increase in non-accruals, what's the story behind that?

Tim, this is Rick Barton, I'll address that one. That was in the commercial portfolio, that was centered in a credit that we've been working on for some time. It's something that I would consider to be an outlier from the rest of the portfolio, given the business it is in, and quite frankly, when you've got nonperforming assets below a 0.25% or 1%, some fluctuation like that should be expected.

And just qualitatively, did you guys set aside any specific reserve against that credit qualitatively, you don't have to give me the number if you don't want to?

We assessed it in our normal reserving process and feel that were appropriately reserved.

So no specific reserves against that credit?

We have reserves that are associated formulaic with all credits, but nothing specific beyond that.

The next question comes from Matthew Clark of Piper Jaffray.

Just curious on the run rate of expenses, you talked about the step up for crossing $10 billion, that's kind of baked in the outlook, but just curious about the comp line and whether or not there was anything unusual there this quarter or, and how you think about the overall run rate of expense in the second half of the year?

Yes, good morning Matt, it's Peter. The comp expense line as I mentioned in my prepared remarks, increased due to normal seasonal mere increases that are generally done annually in the second quarter, coupled with some one-time market adjustment increases and then additional staff growth, primarily related to enhancements in our risk management infrastructure. Going forward, we still expect some additional building compensation as we complete the build out of the DFAST and compliance infrastructure. Also, the other element of the second quarter when I highlighted the fact that we had approximately $800,000 of increased one deposit commission expense in the second quarter versus the first quarter, and that was due to an increase in the loan and deposit production in the second quarter, and so part of that growth is variable comp related to production activities. But going forward, the interest paid are more modest growth in compensation as we go forward and complete the build out of some of those staff roles and the compliance infrastructure.

Okay. And then any updated guidance in getting to your targeted efficiency ratio range, I think you talked about in the past 62% to 65%?

Yes, so maybe obviously the efficiency ratio of the function of revenue growth and expense growth, we do anticipate continued improvement in the efficiency ratio, is a function of the growth in our core deposits and continued growth in fee income. I do want to note that in the second quarter we regenerated approximately $1.2 million in multifamily gains on sale, that was a result of selling approximately $110 million in loans in the second quarter, but it's also a function of hedging program we put in place on multifamily in the second quarter, which we will have the benefit of reducing the volatility in multifamily fee income going forward. So we expect a more recurring and regular pattern of multifamily income going forward that will benefit the noninterest income line, but our expectation is, as we were going to a bit of an S-curve here in building out the compliance infrastructure, so we're going to see somewhat of a slowdown in our normal pace of efficiency ratio improvement and that, that will accelerate again beginning in the fourth quarter and into 2018.

Okay. And then just on the balance sheet leverage strategy, securities portfolio, I think flat link quarter obviously, on an average basis that reduced your loans to earning assets this quarter, I guess where do we stand in that build out that we're largely done here or is that going to continue -- should continuously -- securities grow from here?

We're largely done, you will see an increase proportionate to the total asset growth of the company, but it's going to be very modest going forward.

Okay. And then last one just on capital management around share repurchase, any appetite there, you guys obviously did the special dividend, but also curious about your thoughts on M&A of late?

M&A of late? Do you have any specific references, there has been a number of.

No, just for yourselves, I guess, any, just updated thoughts on the M&A landscape and what you are might be looking at and things you're considering or is it fairly quiet?

Well, first and foremost I say, you watched our tangible book value increase year-over-year and the company has had very solid earnings. So we make these decisions on capital deployment based on the same cascading effect and strategically that we have said in the past which is first and foremost, is investment in the franchise, second is, preferably M&A scale in markets that will add additional density for us and then we would look finally to special dividends and/or stock repurchases and quite frankly, we've done both. The stock repurchase last year and the recent special dividend that we've done now. So that's kind of the deployment of capital philosophy. Going forward when you consider M&A, as you might suspect there isn't quite a bit of activity out there, in terms of potential combinations and we're going to stay focused on our organic business model, and should opportunistic situations arise within the footprint that we're concentrated in on the West Coast, we hope to take advantage of that.

The next question comes from Jacque Bullen of KBW.

Looking to the [hillock] growth that you had in the quarter. When those loans booked, do they fund immediately or is there more utilization that could come in the third quarter and beyond?

Well, there always is some immediate funding when a hillock goes on, because quite often it's refinancing and other hillock or in conjunction with some other specific activities that a client is undertaking. It's rare for something to be drawn down a 100%. So I think you could anticipate that there would be some additional drawdowns in the future.

Okay. So kind of a nice benefit that you could get going forward from that portfolio of growth?

Yes, Jacque.

And then are you offering any incentives to either customers or your lenders in order to generate the added business?

We do have a campaign -- hillock program and there is some incentives. The loan program itself has a fixed initial rate for a period of time and then it reprices to a prime based adjustable spread, after that initial rate is over. So the loans come [honored] they put on it on a fixed rate that we do enjoy repricing benefit when that initial 6-week period is over, and of course there is some incentive costs that goes with that campaign that's paid out in the form of loan commissions in our compensation expense line item.

Jacque this is Mark. We run campaigns all the time on specific products that we want to try and attract into the market across our existing relationships.

And then, on average how long is that fixed rate period for?

Depends on that particular campaign, but it's anywhere from 1 to 2 years typically.

Okay. And there is a changing rate environment have anything to do with the focus here or was it another driver?

It's just part of our general retail business model to offer that product to our regional customers. I will note that -- as we mentioned interest rates that we enjoy and it improved loan yield margin of 11 basis points over the prior quarter, and that's directly a function of the two rate hikes in March and June, and the effects on our floating rate loan portfolio, which is approximately 33% of the total book. And within that 33% of the total loan book, 25% of loans are tied to Prime, and another 9% tied to short-term Libor. So we are enjoying the benefits of the Fed activity.

You took my next question right out of my mouth. So, understanding that the June rate increase, obviously you didn't have very long with that. Can we anticipate additional increases in rates next quarter in terms of the loan book?

I think that's fair, all things equal and we only have 2 weeks of the rate hike in the second quarter results, and a full quarter of higher rates in the third quarter. We will see some modest improvement in the loan yields. Again, I wouldn't characterize it as dramatic, but we do expect to have a modest benefit going into of the third quarter of the rate hike.

Jacque, this is Lloyd. Two other things that I think you should consider in connection with that. First, in addition to the rate hike in the second quarter, we had some pretty robust activity in our construction portfolios, in terms of loans, home sales and loans paying off and that accelerates recognition of some deferred fees, that was a contributor to the loan yield along with the rate hike. And second, the caveat, you know me very well, the caveat is out of course is what's going to happen with deposit pricing, but as I noted in my comments to date, we haven't seen any meaningful adjustment in deposit pricing in the cost of funds. And that's of course supported significantly by the fact that we've had great success growing noninterest bearing accounts. But at some point in time, it's likely there is going to be some funding pressures as well. To this point, the rate movements have all been beneficial to us.

Okay. So the high velocity of turnover in the construction that we've discussed in the past that drove a portion of the linked quarter increase in core loan yields?

Yes, it was a good quarter for turnover in that portfolio.

Okay. Just an apples-to-apples basis, do you have a sense for what kind of a core increase in loan yields would have been in the quarter if construction activity would have been similar?

No. Not up the top of my head.

You don't want to be my work for me LIoyd?

This is just me being cautious. Yes. The last rate hike was midway through June. And yes, we should benefit from that, but let's not get overly enthusiastic about that.

Okay, fair enough. And then just one last quick one. The multifamily increase in the held for investment portfolio in the quarter. Is that related to the decrease in commercial real estate, meaning that for quite some time, we watched the on balance sheet multifamily balances decline and they were up just a little bit in 1Q, but they were up more significantly in 2Q, as commercial real estate has declined, has that increased your appetite for balance sheet multifamily?

I think that while there is some linkage between the two categories. They operate independently of one another, and is more driven by the fact that -- as we go through the construction cycle on the multifamily construction loans. One of those goes to permanent, and the client elects to keep the permanent loan with the bank for a period of time, you'll see lumpy increases in the multifamily category, and that's what happened in this quarter.

Okay. So we could see it's more that going forward?

Occasionally, yes.

The next question comes from Don Worthington of Raymond James.

In terms of the gain on sale, or I guess just mortgage banking revenue, I think Peter commented on the multifamily piece. But in terms of single family, mortgage banking income where you kind of see that going in the second half?

So, just to give a better color on mortgage component of the gain on sale. Mortgage generated about $200 million production in the second quarter compared to $175 million in the first quarter. We saw a pretty significant shift in the mix of [Refi] purchase between the first and second quarter. Refi line was 36% of the total production in the first quarter, and dropped to 22% in the second quarter. And the reason we still have the increase was that be the significant growth in the purchase activity in our mortgage business. Mortgage is a seasonal business, we typically have growth in the second and third quarters. And then it begins to diminish in the fourth quarter due to weather primarily in a specific [northwest]. So pipelines and the trajectory through the third quarter look very similar to what we experienced in the second quarter comes with mortgage production.

Relatively small increase in FHLB advances in the quarter from $50 million probably to smooth the gap between loan growth and deposit growth, but what type of maturity was that?

We typically ladder our FHLB advances with the combination of overnight advances and term advances that typically are 12 months or less.

And I guess one last question. How much exposure you have to the retail sector and in your commercial lending and whether you've seen any weakness there recently?

Don, this is Rick, I'll try to take that question. And we'll take a look at what we consider to be our core retail outstandings. The C&I portion of that is slightly over $100 million or about 1.5% of the loan portfolio and about 10% of risk-based capital. If you take a look at the brick and mortar portion of the retail portfolio, that is about 12% of the portfolio, split about 9% in investor real estate and 3% in owner-occupied real estate. So on a combined basis, about 13% of the portfolio is linked to core retail. And the only other thing I might point out is that the average loan size is under a $0.5 million. So that's not made up of large exposures.

(Operator Instructions) We have a follow-up question from Tim O'Brien of Sandler O'Neill.

One follow-up question for Peter. You might have touched on this, the service charges, the increase in service charges this quarter is at $13.2 million. Was there some seasonality in that? You described the seasonality there, what's the seasonality trends, what are the seasonality trend suggests in the third quarter on that number? Do you expect that number to be seasonally higher again, based on historic trends?

Yes, Tim, this is Peter, we do typically see some improvement in the third quarter on the overall (inaudible) base and coming with that is associated deposit fees. These are also a function of our success in growing accounts in the second quarter and acquisition benefit on the number of accounts that generate the fee. So, it's a combination of good, consistent account generation along with some seasonality that we normally see in the second quarter that typically continues into the third quarter.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Mark Grescovich for any closing remarks.

Thank you. As we've stated, we're pleased with our solid second quarter 2017 performance and see it as evidence that we're making substantial and sustainable progress on a disciplined strategic plan to build shareholder value by executing on our super community bank model, a growing market share, strengthening our deposit franchise, improving our core operating performance, maintaining a moderate of risk profile and prudently deploying excess capital. I'd like to thank all my colleagues who are driving the solid performance for our company. Thank you all for your interest in Banner and joining the call today. We look forward to reporting our results to you again in the future. Thank you, everyone. Have a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.