Citizens Financial Group Inc (CFG) 2020 Q4 法說會逐字稿

Good morning, everyone, and welcome to the Citizens Financial Group Fourth Quarter and Full Year 2020 Earnings Conference Call. My name is Allen, and I'll be your operator for today. (Operator Instructions) As a reminder, this event is being recorded.

Now I'll turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations. Kristin, you may begin.

Thank you, Allen. Good morning, everyone, and thank you for joining us. First, this morning, our Chairman and CEO, Bruce Van Saun; and CFO, John Woods, will provide an overview of fourth quarter and full year results, referencing our presentation, which you can find on our Investor Relations website. After the presentation, we'll be happy to take questions. Brendan Coughlin, Head of Consumer Banking; and Don McCree, Head of Commercial Banking, are also here to provide additional color.

Our comments today will include forward-looking statements, which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on Page 2 of the presentation. We also reference non-GAAP financial measures, so it's important to review our GAAP results on Page 3 of the presentation and the reconciliation in the appendix.

With that, I will hand over to Bruce.

Okay. Thanks, Kristin. Good morning, everyone, and thanks for joining our call today. We are pleased with the financial performance that we delivered for the fourth quarter and for the full year as we proved adaptable and resilient given the unprecedented challenges of 2020. We continue to demonstrate the diversification and resilience of our business model as our Mortgage and Capital Markets businesses delivered strong fourth quarter performance.

We remain highly focused on taking care of customers with our retail branches opened and our teams working on the next round of PPP loans. We feel we're managing our risks well, and we continue to make progress on our strategic initiatives, which will position us well for future growth and for franchise value.

I'll comment briefly on a few of the financial headlines, and then I'll let John take you through the details. Our underlying Q4 EPS was $1.04. Our ROTCE was 12.9%. Both are up from a year ago quarter. And we delivered 2% operating leverage year-on-year. Note that the full year operating leverage was 4% and our PPNR growth was 12%.

Q4 credit provision was $124 million versus $110 million a year ago on a pre-CECL basis as the normalization of provision to more front book origination levels helped drive our strong returns.

On the capital front, we maintained a strong ACL ratio of 2.24%, ex PPP loans, and our CET1 ratio was 10%. This strong capital and reserve position gives us a great deal of capital management flexibility in 2021. We announced a $750 million share purchase authorization today, and we'll commence activity during the quarter. We also will look to put our capital and ample liquidity position to work in finding attractive opportunities for loan growth.

Our credit metrics all are trending favorable. with NCOs, NPAs and criticized assets all lower in the quarter and a further drop in customers in forbearance. We continue to allocate additional reserves to the industry segments most affected by the pandemic and lockdowns, and we feel that our coverage overall is very strong.

With respect to our guidance for 2021, we assume a steadily improving economy and GDP growth of around 5%. Relative to current consensus, we see slightly higher revenue, expenses and PPNR as well as much better performance on credit. We see NCOs at 50 to 65 basis points for 2021, which is relative to 56 basis points in 2020. Provision will be less than charge-offs, though how big the reserve release will be is dependent on the path of economic recovery.

Big picture, we will transition to slightly lower PPNR in 2021 given our outperformance in mortgage in 2020, but this will be more than made up for by lower credit costs as our earnings and returns bounce back towards pre-COVID levels.

So all in all, a very strong year of execution and delivery for all stakeholders by Citizens in 2020, and we feel we are well positioned to do well in 2021 and continue our journey towards becoming a top-performing bank.

I'd like to end my remarks by thanking our colleagues for rising to the occasion and delivering a great effort in 2020. We know we can count on you again in the new year.

With that, I'll turn it over to John.

Thanks, Bruce, and good morning, everyone. Let's start with a brief overview of our headlines for the quarter. This was an outstanding quarter for Citizens with strong fee income, good expense discipline, improving credit and continued steady execution against our strategic initiatives.

For the full year, we delivered record underlying PPNR, up 12% against the challenging backdrop, driven by record fee income, up 24%, with record results across Mortgage, Capital Markets and Wealth. We achieved the ambitious TOP 6 goal to deliver approximately $225 million of run rate expense savings, including approximately $140 million of in-year benefits, which supported our ongoing investments in strategic initiatives and financial performance targets. To this end, we improved our efficiency ratio over 200 basis points to 56% by delivering 4% positive operating leverage for the year.

We expect further expense benefit of approximately $205 million to $225 million in 2021, which puts the program on track to deliver a total pretax run rate benefit of $400 million to $425 million by the end of 2021. Strong loan growth of around 6% reflects increased demand in education and point-of-sale financing as well as PPP loans. Average deposits grew even faster at 13%, a result of government stimulus impact on consumers and commercial clients building liquidity.

ROTCE for the full year was 7.5%, which includes a negative 5.4% impact associated with our reserve build under CECL. Our ACL at year-end 2020 more than doubled compared with last year, but our year-end CET1 ratio of 10% was unchanged on the year. Strong PPNR funded the ACL build, 6% loan growth and stable dividends. And finally, our tangible book value per share was $32.72 at quarter end, up 2% compared with a year ago.

Next, I'll refer to just a couple of slides and give you some key takeaways for the fourth quarter and then outline our outlook for 2021 and the first quarter. We reported underlying net income of $480 million, EPS of $1.04 and revenue of $1.7 billion. Our underlying ROTCE was 12.9%, up around 400 basis points as a result of our strong revenue performance, expense discipline and improvements in credit as the economy recovers.

Net interest income, on Slide 6, was down only 1% linked quarter due to lower commercial loan balances and lower NIM. However, despite the challenging rate backdrop, our margin held up well with the 8 basis point decline linked quarter driven by a 9 basis point impact from elevated cash balances from strong deposit flows.

Lower asset yields were offset by our improved funding mix as we grew low-cost deposits with DDA up 4%, and we continue to lower interest-bearing deposit costs, down 8 basis points to 27 basis points.

Given the recent stimulus, we expect continued strong deposit flows in the first quarter, so elevated cash will continue to impact margin in the near term. We will remain proactive in pricing down deposits and pursuing attractive loan growth opportunities in areas like point-of-sale finance and education as well as in attractive commercial segments.

On Slides 7 and 8, we delivered solid fee results again this quarter, reflecting our ongoing efforts to invest in and diversify our revenue streams. Mortgage fees were down approximately 30% this quarter due to declines in margins and volumes from exceptional levels last quarter. However, mortgage fees were nevertheless more than double the levels from a year ago, which continues to provide good revenue diversification benefit in this low rate environment.

Capital Markets fees hit record levels, up 52% linked quarter and 33% year-on-year, driven by strong results from M&A advisory and accelerating activity in loan syndications.

Foreign exchange and interest rate products revenue was also strong, up 30% linked quarter, with higher customer activity levels tied to increased variable rate loan originations. We delivered positive operating leverage of 2% year-over-year and improved our efficiency ratio to 56.8% as expenses were well controlled.

Average core loans, on Slide 10, were down 1% linked quarter, reflecting commercial payoffs and decline in line utilization to about 32% versus a historical average of roughly 37%. This was partially offset by growth in retail and in our education, mortgage and point-of-sale finance portfolios. Looking at year-over-year trends, core loans were up approximately 4% due to PPP, education and mortgage.

On Slide 11, deposit flows have been elevated, especially in low-cost categories, and our liquidity ratios remain strong. Average deposits were up 3% linked quarter and 16% year-over-year as consumers and small businesses benefited from government stimulus and clients built liquidity. We are very pleased with our progress on deposit costs, which declined 24% or 6 basis points to 19 basis points during the quarter. Interest-bearing deposit costs were down 8 basis points to 27 basis points.

We continue to drive a shift towards lower-cost categories with average DDA growth of 4% on a linked quarter basis and 42% year-over-year. We expect to drive interest-bearing deposit costs down to the low to mid-teens by the end of the year as we execute our deposit playbook to manage costs down across all channels while improving our overall funding mix.

Moving on to credit on Slide 12. Our metrics were positive this quarter. Net charge-offs were down 9 basis points to 61 basis points linked quarter. This is at the lower end of our guidance, given better-than-expected improvement in commercial. Commercial charge-offs this quarter primarily came from segments most impacted by COVID-19, such as retail, casual dining and energy.

Nonaccrual loans decreased 20% linked quarter with a $302 million decrease in commercial, driven by charge-offs, return to accrual and repayment activity. In addition, our commercial criticized loans decreased 18% from $5.7 billion in 3Q to $4.6 billion in 4Q.

Given the performance of the portfolio and improvement in the macroeconomic outlook, our reserves came down slightly but remain robust, ending the quarter at 2.24%, excluding PPP loans, compared with 2.29% at the end of the third quarter. This primarily reflects net charge-offs exceeding reserving needs for new loan originations.

We have some detailed credit slides in the appendix for your reference, but I'll note that our reserve coverage for commercial, excluding PPP, was 2.5% at the end of the year, slightly up from the third quarter. And within that, our coverage for identified sectors of concern increased to a prudent 8.2% at the end of the year from 7.7% at the end of the third quarter. The benefit to reserves from an improving macroeconomic backdrop offset qualitative overlays and further built reserves on these areas of concern.

We remain -- we maintained excellent balance sheet strength, as shown on Slide 13, increasing our CET1 ratio from 9.8% in 3Q to 10% at the end of the year, which is at the top of our target operating range. Given positive credit trends and capital strength, our Board of Directors has authorized the company to repurchase up to $750 million of common stock beginning in the first quarter of 2021.

Before I move on to our outlook, let me highlight some exciting things that are happening across the company on Slide 15. On the consumer side, we are focused on national expansion in the Citizens Access, integrating some of our lending businesses to further develop our national value proposition. We recently announced the expansion of our national point-of-sale offering for merchants through our Citizens Pay offering, and we are continuing to add new merchants through our point-of-sale platform as we expand into new verticals.

We are very excited about an announcement expected next week with a major retailer to provide payment options for their customers who want a transparent and predictable way to finance purchases through a fully digital experience.

In addition, we are making great strides in our digital transformation, having launched our new mobile app on Android in the fourth quarter and iOS just this month. We've seen our active mobile households increased 15% year-over-year, and the majority of our deposit transactions continue to be executed outside the branch.

In commercial, we have built out a robust corporate finance advisory model, and we continue to rank near the top of our peers in customer satisfaction as we help our customers navigate this challenging environment.

And now for some high-level commentary on the outlook for 2021 on Slide 16. We expect NII will be down slightly, given NIM expected to be down in the high single digits compared to 2020, which should be largely offset by loan growth. Loans should be up mid- to high single digits on a spot basis with acceleration in the back half of the year with average loans up approximately 2%. Overall, interest-earning assets should be up about 1.5% to 2%. This assumes elevated cash levels come down gradually over the course of 2021.

Fee income is expected to be down high single digits off the record 2020 level, reflecting lower mortgage banking fees from 2020 record levels. At the same time, we expect good performance in Capital Markets, Wealth and other categories that were impacted by COVID-19 last year.

Noninterest expense is expected to be up just 1.5% to 2%, given benefits from our TOP program, partly offset by higher volume-related expenses in Mortgage and reinvestment in strategic initiatives. We expect net charge-offs will be in the range of 50 to 65 basis points of average loans with a meaningful reserve release through provision.

Now let's go to the outlook for the first quarter on Slide 17. We expect NII to be down slightly due to day count. Both earning assets and NIM are expected to be broadly stable. Fee income is expected to be down high single digits, reflecting lower mortgage banking fees as margins continue to tighten as well as seasonal impacts.

Noninterest expense is expected to be up 2% to 3%, reflecting seasonality in compensation. We expect net charge-offs to be in the range of 50 to 60 basis points of average loans. We also expect another quarter with provision less than charge-offs based on expected loan growth levels and macroeconomic trends.

To wrap up, this was a strong quarter for Citizens and a good finish to the year as we continue to navigate successfully through the COVID-19 crisis and demonstrate the resilience of our franchise. We are well positioned to have another strong year in 2021.

With that, I'll hand it back over to Bruce.

All right. Thank you, John. And operator, let's open it up to some Q&A.

(Operator Instructions) Our first question will come from the line of Scott Siefers with Piper Sandler.

Let's see, Bruce, for you or one of the other members of the management team, just any visibility or further color you could give on to the expectation for loan growth to accelerate later in the year? I certainly understand sort of the expectation. But as we look at the HA data, et cetera, there's just not a lot of visibility from the outside. So I would be curious to hear any thoughts that you have and kind of what gives you confidence into that trajectory?

Sure. Well, let me kind of tee it up, and then I'll ask Don to talk about commercial and Brendan to talk about consumer. But what I would say is that on the commercial side, there's a lot of cash on the sidelines with investors with PE funds that is looking for opportunities to go to work. We're seeing M&A pipelines. We had a record quarter for M&A in the fourth quarter, and we see good pipelines coming into the year. So I think related to kind of increased transactions and money going into the market, that should spur some financing opportunities. So that would probably be the big thing.

The other thing is that line draws are at historic lows. We're probably running at 32%, 33%, and we -- historically, we're at 37%. We briefly touched 50% when everybody drew down their cash at the height of the COVID worries. So I think as the economy picks up, we should start to see more real investment in the economy, which also gives us some expectation that the second half could see that line utilization pull up a bit.

And then on the consumer side, we just have such a broad array of portfolios and lending opportunities, many of which benefit from the low rate environment. So mortgage should still continue to see a heavy level of originations. And the student loan refinancing business has also been strong, and we would expect to see that continue as well.

We talk about our point-of-sale financing business with Citizens Pay. We've continued to grow the customer base and see some real opportunities for that business as well. So I'll stop there. That's kind of the headlines.

And maybe, Don, you could talk a little deeper about commercial.

Yes. I'd say first thing to note is client activity is really high right now. And the conversations across the entire -- or I'd say, 90% of the client base are at completely different levels than they were 6 months ago. So everybody was hunkered down in their bunkers trying to build liquidity, trying to refinance their balance sheets, and that was the theme for 2020.

I think Bruce said it correctly, I think as we get into the back end of 2021, and we begin to get some economic recovery, which I think will happen, we think a lot of those conversations will turn into transactions. And we're seeing really record M&A pipelines. We're seeing record Capital Markets pipelines right now. And we're seeing just a tone of clients looking to take advantage of what could be a recovering economy.

And remember that the good news here is that a lot of the companies that we were worried about 6 months ago now have huge cash balances on their balance sheet. So we've moved beyond the credit concerns and now into the opportunistic activities of individual CEOs and individual Boards of how do they want to climb out of the pandemic. And I just am seeing a very different level of confidence everywhere, except for very small business, which I hope the stimulus package will begin to build that confidence in the smaller companies, too.

Yes. Great. Brendan, how about consumer?

Yes. Sure. I guess I'll just start on a quick point on credit. We continue to have confidence that the health of the consumer is relatively strong. And while we're not out of the woods, all indicators suggest strength, which gives us confidence to lend money out into the economy. Our forbearance levels are as low as they've been, which is predominantly dominated by mortgage where we have great CLTV coverage and our delinquency rates are the lowest they've been in quite some time. So you put that together and it gives us from a banking perspective confidence that the consumer area is a safe place to stimulate growth.

Just hitting on a couple of the assets. Bruce mentioned mortgage. We expect a run-up in originations next year. As John pointed out, margins will come down, but we'll see some balance sheet growth as we project the mortgage markets to potentially hit around $3.5 trillion, which is a bit up year-over-year, which is very strong. Student loan refinancing, a lot like mortgage in a down rate environment has a little bit of a boom. So our normalized quarterly originations for student loan refi was about $350 million prior to rates ticking down. In Q4, we hit $811 million. So we continue to see a very strong uptick in demand there, which, by the way, is an incredibly strong customer for the future of this franchise, a young 30s, high-credit profile customer that we've got a lot of aspirations to grow the rest of the bank.

Point-of-sale in 2020, the non-Apple part of the portfolio basically tripled in its size with all the new partners that we brought onboard, and we continue to expect that to be the case with strong growth in 2021.

And lastly, I'd just say our auto business has printed some of the highest returns we've seen in quite some time through the back half of this year. And while we still think that we are in a reasonably good spot for concentration long term and want to moderate growth in auto, we opportunistically, given the cash that we have on hand, see some opportunities for very moderate growth in auto to suck up some of the excess cash that we have on hand with a very short duration asset that will burn off pretty quickly. So all in all, we're pretty confident in the ability to drive pretty substantial consumer growth next year.

Okay. Thanks for the questions, Scott.

Your next question will come from the line of Matt O'Connor with Deutsche Bank.

There's obviously been very strong deposit growth for the industry, including at Citizens, but do you have any sense of how much of that might be sticky kind of longer term here? Obviously, you've invested in the treasury management business, which arguably has brought in some deposits. But how do you frame kind of what might be sticky versus what will leave when central banks start to unwind a bit?

Yes. I'll jump in there, Matt. And yes, we have seen significant deposit flows, and we do think some of this will stick around. It just gave us the opportunity to optimize on the deposit side, where we have significant rundown going on in the term deposit side of things, and you're seeing DDA increase. And it gives us an opportunity to interact with those customers more deeply. But we do think a good portion of these deposits will be sticky. You've got like the balance parking has held on longer than we thought. Stimulus will rise, and we suspect that some of it will run down.

And as you think about cash balances in 2021, we do expect cash balances to come down gradually over the year. But that's not all due to deposits running off. It's really us optimizing our deposits and deploying those deposits into loan growth throughout the year. So a good portion of it will stick around.

John, let me add one point on the consumer side. When you scrape away the surge deposits, the last 3 years leading up to COVID, we have been performing top of peer set on low-cost deposits. And when we try to scrape that away in 2021, we believe that's still the case. And so -- and that's driven by underlying health of consumer engagement metrics and the consumer bank. And so I believe we're in a very strong position, putting all the COVID surge deposit aside, to continue to outperform peers for at least the next 12 months.

Yes. Let me just add one thing that on the commercial side, our treasury sales were up 31% last year on the back of a lot of the investments that we've made over the last 4 to 5 years in that business. So not all of that will result in DDA growth, but some of it will, some of it will be fees and some of it will be DDA. So we're seeing sales momentum on the treasury side, which is quite healthy.

And somewhat related, what's your appetite to add securities either at these yields or what price point going forward? Obviously, you're optimistic on growing loans, which is going to absorb some of the deposits and liquidity, as you mentioned. So how are you thinking about the securities book where we are seeing some banks grow it quite meaningfully even as rates have come down for mortgage box?

Yes. Thanks for that, Matt. I mean we've been patient on this through, call it, the second half of 2020 and have held off and allowed cash balances to rise like many have as well. And in part, the reason for that was given the levels for mortgage backs, which is where we primarily operate in our securities book, the levels there were not attractive.

As you get into the early part of 2021, the levels have improved a little bit. And so we may find ourselves considering investing the cash flows that we otherwise would get back on prepayments. Let's say, in -- later in the quarter, February or March, we may find ourselves investing some of that in January, sort of a pre-investment, if you will, and then stop and see where that plays out. But you won't see us going in heavily reinvesting all of this cash in long-term mortgage-backed securities.

I mean I think that to the extent that we want to capture a little bit of this rate rise early in the quarter, we've done a little bit of that, and we may do a little more if rates continue to hang in or possibly rise.

But it's more of a dollar cost averaging situation and put a little bit to work and wait and see rather than piling all this cash into securities at these levels.

And I would just add, Matt, that to me, it's really terrific that we have this much cash because, a, it pre funds the loan growth, and that's really where we're targeting. It's -- the loan growth will be better than securities growth in our view. And it also allows us to take a reasonably aggressive pricing actions to drive some of the balances away. So we've got our game plan here. If we see a little flex up in securities rates, we're ready to engage. But at this point, we're being fairly disciplined and cautious.

Your next question will come from the line of Erika Najarian with Bank of America.

My first question, Bruce, is on the buyback process for this year. I heard you loud and clear that the Board authorized $750 million. And so I guess this is a 2-part question. Number one, are you opting in or opting out participating in this year's stress test? And if opting out, does that give you leeway in terms of your repurchase size? And what is the timing of that $750 million?

Sure. Maybe I'll start, and John can add some color. But we haven't made the determination yet as to whether we'll opt in or opt out. And there's some nuances that could be tailwinds for us. And then also the bloated balance sheets and the Fed's model runs expenses based on the size of your balance sheet, that could be a headwind. So we're kind of calibrating that. We have to make a decision by February 15.

It's been extended to March 15.

March 15.

Or April 5.

Okay. Great. Thanks for that last-minute color, John. Gives us a little more time to mull it over. But regardless of whether we opt in or opt out, we have plenty of flexibility here to buy back our stock, and I think we can be reasonably aggressive. The thing that's more of the limiter for us is going to be our capital range, which is our internal targets of 9.75% to 10%, not really worried about hitting the stress capital buffer.

So we set the program up with a big enough size that I think we can neutralize the earnings after the RWA growth. And there's some wildcards as to how big the reserve release could be. So I think we have a decent amount of authorization to cover that if we get favorability on that.

So we would expect most of this would be executed this year, but it could easily go over into next year. And some of that depends on the amount of loan growth and the amount of the reserve release. Any color, John?

Yes. No, I think that's right. I mean -- and they just gave us a little bit of flexibility there in terms of -- I think it's now April 5. We can take our time and determine whether it makes sense to opt in.

But I think Bruce laid it out well in terms of the trade-offs. It's really -- we've seen some changes in the Fed model that would help our PPNR profile and the fact that we keep generating high levels of PPNR is good as it relates to how they forecast as we understand it off some of the history. So that -- those are all positives that might lean us towards opting in. But then as Bruce articulated, we also now understand that all of this cash that we're holding shows up in total assets, and then we understand that the model basically converts that into expenses that we're somehow going to incur.

And so we're going to have to, frankly, just put pen to paper here and calculate what the -- we think the benefits are of opting in. We'll also get to see the scenario and evaluate all of that. But more importantly, the SCB is not our constraint, and it's basically our operating levels. And so it's sort of an academic exercise in a lot of ways in terms of whether we opt in or not this coming year. And I think Bruce handled the buyback question.

Got it. And my second question is on your noninterest expense outlook. Really appreciate Slide 28, which breaks down how you've budgeted getting from 2020 to 2021. And I guess my question here is, is this 1.5% to 2% outlook fully reflective of what sounds like a more optimistic outlook for second half loan growth as well as mortgage volumes?

And if any of those components disappoint, does that slide you at the lower end of the range or out of the range? I guess I'm just thinking if revenues disappoint, what would this look like?

Yes. I mean I think we always maintain flexibility to tamp down expenses if we're not seeing the revenues come through. Obviously, earlier in the year, you have visibility and make that call, you're going to have a bigger impact on the expense base in the current year. You can see on that slide, Erika, that there's volume-driven expenses that would be the first ones to adjust, and they could adjust even lower than that range. But then some of the strategic investments that we're making, we can space those out a bit as well. And then we could always go back to the well and look to upsize the TOP program again.

So I think there's a number of avenues we have and levers that we can pull if it came to that. At this point, however, we're pretty sanguine that the economy is going to be recovering. And it will be a little slower going in the first half of the year, but actually pick up quite nicely in the second half year. So that's the call that we're making.

Yes. I might just jump in and add that mortgages create a fair bit of variability on the expense line. And if you just kind of normalize for mortgage expenses, noninterest expense is flat really from 2019 to 2020 to 2021. So I think that's an important point.

Ex the mortgage growth.

Yes, ex the mortgage growth, if you just kind of normalize it back to 2019 levels. And that sort of allows us to, on an ex mortgage basis, be continuing to drive positive operating leverage throughout each of those years, which is important.

Your next question will come from the line of John Pancari with Evercore ISI.

Wanted to see if you could, Bruce, possibly give us your updated thoughts on M&A. Just given your capital levels and given the opportunities you're starting to see develop on the banking side and on the capital markets, I wanted to get your thoughts on -- both on the whole bank side as well as nonbanks, particularly, I know you've mentioned the Capital Markets opportunity. So interested if you're exploring, deepening your banking capabilities on that front.

Sure. Well, it was a relatively quiet year for us in 2020, not for lack of trying. Certainly looked at a number of things and had a number of conversations. But we remain very disciplined buyers in terms of the financial profile that we need to see and then also the strategic and cultural fit. And so we'll continue to, I think, have outreach and engage in those dialogues, and we'll see if we can get some things done in '21.

Just in terms of our focus, we've been consistently focused over the last several years on augmenting our capabilities in terms of acquiring fee-based businesses, so we can do more for our customers. That was one of the gaps that we had from the IPO days was that we weren't at scale in certain activities that are quite important and are important to our customers.

So I think we've pretty much addressed the Mortgage area. We've yet to fully address the Wealth opportunity. And so we're still active in conversations in the Wealth space. And then also in M&A, we've gone a long way towards cementing that capability here, but there could be selective opportunities for us to augment our industry vertical approach with some boutique acquisitions.

In terms of whole bank, we, I think, see what's going on that there's a race for scale. And there may be some things that turn out to be interesting there. But we've been quite disciplined in our approach there, and we've really just prioritized organic growth, prioritized the growth of our digital bank. And we'd have to see something that made a lot of sense from a financial standpoint, customer base, capabilities, geography for us to move in that direction. But we're certainly open to it, and we'll kind of keep the periscope out and see if there's anything that makes sense.

That's helpful. And then separately, on the -- regarding your merchant partnerships, just wondering if you can give us an update there on how they've been performing? Have they been performing as expected when it comes to the returns from those programs? And are you expecting to add more this year?

I'll ask Brendan to handle that one. Brendan?

Yes. Short answer is yes, they have. When you look at the credit performance of the merchant business, again, while we're not out of the woods on the environment around us, the delinquency on that asset has been flat to down, and the percentage of those customers that found their way into forbearance is negligible. And so that portfolio is operating essentially like there's no recession going on around us, and that's a lot driven by the positive select of the customer base and the frictionless digital experience that we created that the payment gets automatically drafted out of the customer's account every month. And so we're very encouraged by those signs of credit performance.

The returns of the business are credit card like, but the risk profile seems to be lower than credit card like. So you're getting outsized returns from the portfolio than you otherwise would expect. So we're excited about that.

As I mentioned, we're also excited about the growth that we generated in 2021. We had 2 or 3 key partners entering the year. We're going to exit the year with 10 to 12. And as John teased, in about a week's time, we'll have a relatively large announcement about another big partnership that we've got in play.

And with the introduction of Citizens Pay, which is sort of our new platform that really takes that business to the next level, we're very, very encouraged by the opportunity in the marketplace and our first-mover advantage. You're seeing more and more talk about this in the industry. Retailers and merchants are now looking at this as a way that they can dramatically improve their sales in a down economy. And so we're getting more and more inbound calls from companies looking for us to help them reengineer their sales process and try to give them a revenue boost. So we're very excited about this. We think it's a very distinctive part of Citizens, and we remain poised to capitalize on the opportunity.

Your next question will come from the line of Gerard Cassidy with RBC.

John, can you share with us -- obviously, you guys have been very clear about the outlook for credit, which is good for 2021, and loan loss reserve releasing that you and your peers are very likely to see because of the improving economy, especially in the second half of the year. Can you tell us where you think the loan loss reserve to loans will get to? Because if I recall, based on your data, I think the post-CECL reserve level on January 1, 2020, was 1.47%. You're obviously well above that. Do you think that's -- is that a targeted area that we should kind of look to in the future or will it be something higher?

Yes. I mean I think -- it's a good question, Gerard. I mean I think that it's a good sort of anchor point. When you look back at something in the neighborhood of 1.45% on day 1 CECL, the one thing that we think about regarding that 1.45% is that we hadn't had a credit cycle for close to, I guess, around a decade leading into that 1.45%. So there was a probability weighting that would expect a credit cycle to happen some time over the horizon of the CECL sort of projection. And so in some ways, we think that what's going on now there's -- the decks are getting cleared out. We certainly had a cycle, and we're going through one.

And so in terms of the resting point for our coverage ratios, it's unlikely to be higher than that. I mean I think it would be in that neighborhood. There are some arguments that would suggest that maybe it could be a little lower, but maybe given mix and other things, it could be a little higher. But you got to think about all those things that we wouldn't expect it to be much higher than that.

And in terms of timing, I mean, your guess is possibly as good as mine, but we do think that things improve pretty significantly here in 2021. We're going to move relatively down pretty significantly from our current levels, which are quite high. As you get into the end of the year, we're going to be heading towards that level that I talked about.

The timing of that is really what -- given CECL, it happens pretty quickly. I mean if the economic environment continues to improve, and when you think about it, we got an improved economic environment just here in January that wasn't even reflected in our results for the fourth quarter. If that trajectory continues, we could start heading towards that level as you get towards the end of the year.

Yes. I would just add to that, though. I think, Gerard, you have to look at this really over time. And I think we'll get part of the way, so that we'll be somewhere between where we are in that 1.45%, or as John said, maybe slightly better, 1.45% resting place. A lot has to play out in terms of economic recovery and how much stimulus and all of that.

So I think we'll make strides certainly below 2% and on the way towards getting down there, but it will be somewhere in the middle. And we'll have to see how things play out.

Very good. We like that trajectory for you and your peers. A bigger picture question for you, Bruce. Your outlook is quite optimistic, which we concur with. So we're with you on what we expect as well from you and your peers. When you go down the elevator at night, what's the risk that you worry about? Because there just seems to be so many positives over the next 12 months potentially for all the banks, including your own. And I always worry about something out in the field, like obviously, nobody knew the pandemic was going to be as bad as it was. But what do you worry about when you go down the elevator at night?

Yes. I guess we're getting increasing comfort that with the vaccinations, with the stimulus that the economic outlook is improving and that we will have recovery next year. So I wouldn't -- that may have been a big worry in 2020. I think it's less worry today going down the elevator. I think you go back to managing other risks. For example, the whole cyber and fraud risk that's out there is something that is top of mind. And we -- all the banks are spending a hell of a lot of time making sure that our customer assets are safe and the way we're running things, data is safe, et cetera. So that is, I think, a big focal point for us and other banks, and I'd kind of keep that at really the top of the list at this point.

Anything else, Brendan? I guess competition would be the next thing is that certainly, we've faced intense competition for -- since the IPO from all comers, from the mega banks, from peers, from smaller banks, from nonbanks, fintechs. And so continuing to really delight our customers and do a great job for our customers, so they have no desire to switch. Given all the competition that's out there, it's one of the reasons that we've been really motivated to go out and invest in technology and invest in customer experience, invest in new capabilities, so we can do more for our customers really to cement those customer relationships. And so if I had to pick a close second, that would probably be the second thing on my list.

Guys, anything else you'd add?

I just think that the industry going through such a transformation, accelerated by COVID with digital, just the speed and pace of executing on a very substantial change, I feel exceptionally confident about where we're positioned. The market is moving fast. And I think the banks that can execute the best on that will be in the winner circle at the end of the next 2 years' time. And we're making the right investments, I think, but it's a quite sizable (inaudible)...

Changed management, that's probably #3, yes.

I agree.

Thanks for the question, Gerard.

Your next question will come from the line of Ken Usdin with Jefferies.

This is Amanda Larsen on for Ken. John, can you talk about what's embedded in your NII guide for PPP income in '21 and how that compares to '20? Maybe just touch on the income earned in 4Q and the amount of forgiveness in dollars and notional.

Sure. Yes, I mean I think when you -- big picture, 2021 and 2020 are pretty similar on the NII line. And there's really based upon -- there might have been a little drop off coming from round 1 had round 2 not come in. But when -- just the way we -- our outlook for round 2, which has started in earnest actually and is going quite well for us over the last 24 hours, and Brendan may actually give us a few comments on that. But in general, pretty similar profile from 2021 compared to 2020.

Forgiveness, the way we account, as you may know, in round 1, we have been amortizing over the 2-year period in round 1, the deferred fees. And so the farther you get into this 2-year period, the less -- the lower the impact on forgiveness. And so forgiveness is actually not a very big impact in 4Q, and it won't either be in 1Q or 2Q as well. It's pretty stable. And so that's basically the best way to talk about that.

I just -- maybe we could pivot, and Brendan, you could just offer a view on the latest PPP program because we're up and running and accepting apps and we're off to a terrific start yesterday.

Yes. Absolutely. And the latest round of PPP started yesterday, as Bruce and John mentioned. Embedded in our outlook has less than half of the originations that we saw in the first round. The first day was exceptionally strong. We executed incredibly well. We ended overnight with a little bit shy of 14,000 applications. Technology worked really, really well and pushed up a little bit over $1 billion in application dollars.

So TBD on the funding, but that's heavily, heavily driven by PPP round 1 borrowers. And so we've got confidence the conversion rate will be pretty high existing customers of ours. So we're very, very pleased by our performance on day 1, and we expect demand to be pretty strong over the next couple of weeks here. So we'll know more in the coming weeks on the size. And if this pushes up higher than we thought, TBD, it's hard to get a full gauge on the demand given the state of our small businesses, but all signs from day 1 are very positive.

Okay. Great. And then for my next question, I guess, it seems to be a trend that most banks are guiding to costs higher than consensus expectations for '21, largely driven by investment spend. Would you characterize your investment spend as an acceleration or a pull forward of future strategic initiatives as a result of the pandemic or something else? Or do you believe the $125 million in strategic initiatives is a reasonable amount of new spend for a typical year? And I have a quick follow-up after that if I can stay on.

Yes. We -- I think we have worked really hard over the years to try to protect our investment spend in strategic initiatives. So TOP has been a big contributor of delivering positive operating leverage, but it also allows us to self-fund the things that we need to keep positioning us for future growth and growth in our top line. So I think that $125 million is -- feels right. And I think the banks that are going to come out of the pandemic well are the ones that are continuing to look for opportunities to advantage their position in areas where they see opportunity and where they have strength.

Okay. That makes sense. And then do you have an expectation for nonrecurring expenses or charges you may incur as a result of the upsized TOP 6 in '21?

Yes. John, why don't you take that, the reported versus the underlying difference.

Yes. I mean I think the answer to that is yes, but at a lesser pace and magnitude that you would have seen in 2020 and much of that would be likely concentrated in the first half and tapering off. So a lot of the costs associated with our activity in 2021 have actually been incurred in 2020. But again, there'll be a little bit more in the first half but tapering off throughout the year and have a lower magnitude year-over-year.

Your next question will come from the line of Ken Zerbe with Morgan Stanley.

Actually, just staying on the NIM topic. If I got all the numbers right, it sounds like your full year NIM guidance is, call it, roughly 2.80%, your first quarter is 2.75%, which means over the course of the year, it should -- your NIM should actually improve pretty noticeably. Can you just talk about the drivers there? Is it either -- I mean -- and how much of the drivers are the lower cash balances you expect versus the higher 10-year assumption?

Yes. I'll go ahead and take that. I mean I think we do expect that cash balances will dissipate throughout 2021. As we mentioned earlier, we are aggressively running down our term deposit levels and optimizing deposits in general. So you're going to get a nice mix shift in deposits that would drive some positive contribution towards net interest margin.

And then just pricing outside of mix, our interest-bearing deposit costs, we expect to fall. We're at 27 basis points in the fourth quarter. We expect to drive that into the low to mid-teens by the end of the year, and that will happen, again, also gradually quarter-by-quarter as you go throughout the year.

And then the other item I'd highlight is that the long end of the curve, we've got some steepening going on, maybe not as much as earlier in the month, but certainly still some steepening that has occurred and more steepening that we think will likely occur over 2021. So therefore, that front book, back book drag that's been happening starts to -- the magnitude of that starts to also moderate as we put more money to work through loan growth. So those are the drivers that I would highlight throughout 2020.

If I can add to that, too, Ken. I mean I think we're trying to show what the NIM is ex the excess cash. And it's quite significant. It's 17 basis points higher. And actually, Q3 to Q4, we were up 1 basis point.

But I think the analyst community has been very, very, very focused, almost to the point of being obsessed with NIM. The NIM number with these elevated cash becomes a little less clear. And so trying to think about NII really as the beacon here. We're focused on managing NII. We're focused on trying to hold the underlying NIM. And then when we have all this cash, how do we put it to work smartly, how do we get loan growth, be cautious on securities, as we discussed earlier, but really try to keep NII performing well. That's the shift, I think, that we're feeling here inside Citizens.

Completely makes sense. And then just a separate follow-up question. Your NCO guidance, if you're already at 61 basis points, and your guidance is for that sort of 50 to 65, how do you see that playing out? I mean should charge-offs stay relatively stable sort of over the course of the year? Or do you expect any particular quarter like second quarter or third quarter to be a little more elevated at sort of a hill shape versus a steady-state charge-offs?

Well, yes, it's a little bit volatile on the commercial side as we saw back in Q3. So you can get hit with a tall tree and the numbers can move around a little bit. But generally speaking, right now, we've got really great trends in all the credit metrics on the commercial side. So I think the first half of the year looks really good, where you have the most visibility.

I think going out into the second half of the year, you've got to see what's -- how fast do we get to life as we knew it from the vaccinations? And then how does that positively benefit commercial real estate? If it goes well, then you can continue to see subdued levels. If you see some issues come to the surface because things go a little less well, then I think that's a room for potential increase, but still, I think, within -- under control -- kind of in the realm of being under control.

And then on the consumer side, we have kind of all-time great metrics in terms of delinquencies and performance. And we have had folks come out of forbearance. And interestingly, 94% of those people coming out of forbearance are current. And so we've been able to cross that bridge and not disturb the kind of really good credit metrics we have.

There's -- certainly now with additional stimulus and being targeted for the industries and the people working in those industries most affected by COVID, there's more hope and ability for those folks to get back on their feet. So you could see -- we -- I think we're thinking that pre this last round of stimulus and talk about more stimulus that we could see an uptick in the second half of the year. But I think it's less clear that we're actually going to see that, and that can continue to kick out into the future than maybe just go away.

So I'd say we're pretty sanguine at this point, but you have to expect the unexpected. So that's why we have the range that we do.

Your next question will come from the line of Saul Martinez with UBS.

I just want to sharpen the pencil a little bit on an earlier response to Amanda's question, but what specifically are you assuming for PPP forgiveness on round 1 and new origination on round 2 in your mid- to high single-digit EOP loan growth? And -- because it would seem like even the net number is something of a headwind in 2021. So if you can just help us fill in the gaps there.

Yes. I'll go ahead and just talk through that. I mean I think, as I mentioned, year-over-year, the contribution to NII in 2020 from the PPP round 1 will be similar to the contribution we expect in 2021 from round 1 and round 2 together on the NII line.

And the forgiveness piece which was potentially quite significant in 2020 is now no longer so because we recognize a portion of all of those deferred fees every quarter as you click through. Every quarter that goes by, we've been recognizing in NII a portion of what one might accelerate upon forgiveness, such that as you get through the first quarter, the numbers are not that great. They're single-digit millions. And so from that perspective, forgiveness is not a big story anymore with respect to at least the way we account for things and we amortize this stuff pretty ratably over the 2-year period. So the contribution is stable year-over-year.

Yes. And I would just put a little color on that is that the first program kind of stays level with the second half in the first half of next year. And that it's the second -- the new PPP program that kind of prevents a falloff in the second half of the year. So if you want to think about it that way, we're kind of at relatively stable revenue levels on the existing programs through the first half of the year. We would have had a falloff, but now that we have the new PPP, we kind of avoid having that falloff.

Yes. One other point...

I guess my -- if I could just interject a little bit here because we're kind of running out of time, sorry to interrupt. But I guess my question -- that's helpful color. My question was on loan growth, though, not NII, the mid- to high single digits. It does -- it would -- presumably, that has some forgiveness on the $4.5 billion and an accelerated runoff of that, which is a headwind, but you also have some new origination on round 2. I guess my question is, net-net, how much of a headwind is that embedded into your mid- to high single-digit loan growth?

Yes. Just roughly, like in terms of dollars, it's -- as Brendan mentioned earlier, it's less than half of our originations on the front end. So when you think about -- our average spot loan balances are about $4 billion at the end of 2020 on this program. That falls to something in the neighborhood of $2 billion to $2.5 billion by the end of 2021. So you can basically get a sense for the fact that we're making up for that with the other categories.

So there's still no real headwind, essentially. Okay.

Well, there's a headwind. We're overcoming it with the other categories outside of PPP. There's a shrinkage in loan growth year-over-year that we have to overcome with other categories.

So there's about -- yes. So there's about a $1.5 to $2 billion headwind net, i.e., forgiveness. How much is being -- how much of the round 1 is coming down versus how much new origination on round 2, net-net, that is a headwind?

Net-net...

And that's one of the reasons that we're guiding to the high spot loan growth, but average loan growth is less. That's one of the reasons.

Right. Okay. Okay. Because it would seem that if I think about 1Q, you're not going to -- it doesn't seem like there would be much growth. And it would be fairly minimal in the first half of the year, which would imply the second half acceleration that, on the surface, seems extremely rapid in the third and fourth quarter with annualized loan growth being -- I don't know the exact number, but being very, very rapid. And it just -- it seems -- I mean, I hear everything you say, but it does seem like you're really giving yourselves and the banks a lot of the benefit of the doubt that the economic recovery really will translate into very, very rapid loan growth. So I'm just curious if you -- how strong would you disagree with that logic?

Well, we're standing by the guidance we're giving. And I think you have to recall, we went through each of the portfolios earlier in the call, and we have probably more sales out in terms of an ability to capture loan growth than our peers, and we've demonstrated that consistently since the IPO.

I'd say on the consumer side, I -- while an economic recovery is expected and will help, the originations that we've embedded in our guidance, we're ramping them up right now. And today's economic (inaudible), I don't know that we're betting on a massive upswing that's fully dependent on our loan growth. I think we can deliver -- we're going to start delivering it right now.

And due to time constraints, we have time for one more question, which will come from the line of Bill Carcache with Wolfe Research.

I had a question on your capital targets. By our math, your stress capital buffer was around 376 basis points in the December stress test, up about 40 basis points from the June stress test, and that suggests required capital of around 8.25% or less, which is a fair amount below your target range. So my question is, could we see your target range come down over time? I believe you mentioned, John, that the SCB is not your constraint, but rather your operating levels. Could you expand on that?

Yes. I'll just start off, and Bruce may add in here. But yes, I mean, I think our current target is 9.75% to 10%, and the implied levels from SCB would be well below that. From the middle part of the year from the June test, we had an SCB of 3.4%. You add that to the required minimum of 4.5%, and you get a 7.9%. That's the official SCB unless and until the Fed decides to change it, and they have up until March 31 to do that.

If I could just interject, we think that's too high because they're not modeling PPNR correctly.

Correct.

It should be much lower than that even at 7%. It does come back to prudence, though, and conservatism. So...

I mean I think target levels from where we want to see our ratings shake out, what we view in terms of managing the risks of the platform would be well north of the 7.9%. So it just doesn't come into play in a lot of ways, even though we do think it's too high.

So yes, I mean, I think the other point I would make, we've said over the years that we don't think our platform is any riskier than our peer sets. And if the economic environment and the group believes if capital levels decline over time as we clear the decks post-pandemic, we wouldn't see our capital levels needing to be higher than the average of our peers. And so who knows? We'll see. But right now, our Board and management and Bruce have worked on this target range, which we believe have served us well and allowing us to navigate through the pandemic and provide flexibility.

In good times and bad.

Yes, in good times and bad. That's a good way to describe it.

Yes. Thanks.

Got it. That's helpful. If I could squeeze in one last one. I wanted to follow up on your comments around the securities portfolio. Can you discuss what kind of reinvestment rates you're seeing relative to the 1.95% that we saw this quarter? I was hoping you could discuss how much curve steepening we would need to see for the downward pressure from reinvestment rates to abate, particularly since it looks like some of the dynamics around QE have led agency MBS spreads to turn negative. And you guys have a pretty sizable portion of your investment portfolio in the asset class.

Yes. I mean reinvestment yields are in the, call it, the 1.20% to 1.30% range. And that's creating a call it, 50 to 60 basis point front book, back book drag given what's running off. The back book runoff is in, call it, 1.80% to 1.85% range. So -- and that's been a phenomenon that's been occurring over the last couple of quarters.

We are watching OASs. OASs were positive last quarter. Even though yields are up, OASs have tightened a little bit this quarter. As I also mentioned earlier, we get about $800 million of cash flow a month. And from time to time, we'll invest cash flows in advance of coming months, and we did a little bit of that in June. But we're not going to put a lot of cash to work in this kind of rate environment unless and until yields begin to rise a bit more and OASs look a bit more favorable. So we're doing a little bit of investing there to get ahead of some things, but not a lot.

Okay. Is that all at this point?

There are no further questions in queue.

Okay. Great. So thanks, everyone, for dialing in today. We certainly appreciate your interest and support. Have a great day. Stay well, everyone.

And ladies and gentlemen, that will conclude your conference call for today. Thank you for your participation and for using AT&T event teleconferencing. You may now disconnect.