美國合眾銀行 (USB) 2023 Q1 法說會逐字稿

Welcome to the U.S. Bancorp First Quarter 2023 Earnings Conference Call. Following a review of the results, there will be a formal question-and-answer session. (Operator Instructions) This call will be recorded and available for replay beginning today at approximately 11:00 a.m. Central Time.

I will now turn the conference call over to George Andersen, Senior Vice President & Director of Investor Relations for U.S. Bancorp.

Thank you, Brad, and good morning, everyone. With me today are Andy Cecere, our Chairman, President and Chief Executive Officer; and Terry Dolan, our Vice Chair and Chief Financial Officer. During the prepared remarks, Andy and Terry will be referencing a slide presentation. A copy of the presentation as well as our earnings release and supplemental analyst schedules are available on our website at usbank.com.

I would like to remind you that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today's presentation, in our press release, our Form 10-K and its subsequent reports on file with the SEC. Following their prepared remarks, Andy and Terry will take any questions that you have.

I will now turn the call over to Andy.

Thanks, George. Good morning, everyone, and thank you for joining our call. I'll begin on Slide 3.

In the first quarter, we reported earnings per share of $1.04, which includes $0.12 per share of charges related to the MUFG Union Bank acquisition. Excluding those notable items, earnings per share was $1.16. We achieved record net revenue of $7.2 billion for the quarter.

Following our successful close of Union Bank acquisition in December of 2022, first quarter results reflected a full year's benefit of the acquired franchise, continued growth in earning assets, net interest margin expansion and higher noninterest income led by stronger commercial product and mortgage banking fee revenues.

Slide 4 details our reported and adjusted income statement results as well as the end-of-period and average balances and other performance metrics. On the right, you'll see the credit quality remains strong but is starting to normalize as expected. Our charge-off ratio of 30 basis points as adjusted is well below pre-COVID levels and reflective of our disciplined risk management culture.

The CET1 ratio, our binding regulatory constraint, was 8.5% at the end of the quarter and is consistent with our target capital ratio. We expect to exceed 9.0% later this year as we accrete capital back quickly over the next few quarters and continue to focus on risk-weighted asset optimization initiatives.

Slide 5 provides key performance metrics. Excluding notable items, our return on average assets was 1.15% and our return on average common equity was 15.7%. Our return on tangible common equity was 24.3% on an adjusted basis.

Slide 6 provides both a high-level timeline and general update on our planned conversion of Union Bank. Integration efforts have been progressing well. And we remain on track for a successful main systems conversion over the upcoming Memorial Day weekend. We anticipate a full transition of all accounts by the second half of the year.

Turning to Slide 7. The industry disruption early in March has reinforced the importance of maintaining a well-diversified business with an appropriate risk profile. We maintain a resilient and diversified deposit base. Over half of our deposits are insured and 80% of the uninsured deposits are retail or operational in nature. Our diversified funding sources, ample liquidity levels and strong credit quality, supported by disciplined underwriting standards, are all hallmarks of our approach to risk management.

I'll now turn the call over to Terry, who can provide more detail on the balance sheet strength and the first quarter earnings results.

Thanks, Andy. Turning to Slide 8. A key strength of the bank is our well-diversified deposit base, which remains a stable source of low-cost funding.

As a reminder, following the completion of our acquisition of Union Bank last quarter, our end-of-period deposits totaled $525 billion, including approximately $80 billion of deposits from Union Bank. As we discussed last quarter, $9 billion of Union Bank acquired deposits were transitory in nature with $4 billion returned to MUFG in the fourth quarter and an additional $4.7 billion that moved back to MUFG in the first quarter of this year.

In addition, $1.1 billion of acquired deposits were included in the branch sale, were related to PurePoint, a broker deposit gathering mechanism that we discontinued. Importantly, prior to the events of March 8, we saw expected deposit outflow largely consistent with seasonal patterns reflective of our business mix, including our large trust business.

From March 8 through the end of the quarter, deposit balances were relatively stable, down only 0.6% as inflows from new customers were slightly offset by the impact of clients diversifying their deposits and seeking yield and money market funds consistent with broader industry trends. During this period, we saw an increase in money market funds of approximately $10 billion within our Wealth Management and Investment Services businesses.

We expect the competition for deposits to remain high for the industry in 2023. Our cumulative deposit beta through the first quarter was approximately 34%. And we expect that to increase to about 40% by the end of this rate cycle, generally in line with our previous expectations.

Slide 9 provides additional detail on the composition of our highly diversified deposit base. As the slide shows, our deposit balances are composed of a broad mix of consumer, corporate and commercial customers that we support with an expansive branch distribution network and mobile capabilities across our national footprint. Our deposit base reflects the wide range of customers and industries that our company serve.

At March 31, our percent of insured deposits to total deposits was 51%. Approximately 80% of our uninsured deposits are composed of operational wholesale trust and retail deposits that are stickier either because they are contractually bound or tied to treasury management services and trust activities provided to corporate and institutional clients. Combined with our consumer-based deposits, the stability of our funding source is sound.

Moving to Slide 10. U.S. Bank's total available liquidity as of March 31 was $315 billion, representing 126% of our uninsured deposits. As of March -- as of December 31, our liquidity coverage ratio was 122%. As mentioned, our strong debt ratings reflect our diversified business profile, well-collateralized credit exposure, healthy capital and liquidity profiles and disciplined asset liability management framework. These attributes work in concert with our strong balance sheet optimization and management practices to ensure strength and stability of our balance sheet.

Slide 11 provides details on the composition of our investment securities portfolio. Over the last 5 quarters and well ahead of the most recent banking disruption, we reduced the size of our investment securities portfolio from 30% to 25% of total assets while increasing cash levels. In preparation for and as part of the completion of our acquisition of Union Bank, we repositioned our balance sheet by selling fixed rate loans and investment securities, paid off borrowings and increased cash balances in response to economic uncertainty, industry dynamics, rising interest rates and increased market volatility.

At March 31, approximately 90% of the securities in our investment portfolio are backed and are sponsored by the U.S. federal government with 55% of securities designated as held-to-maturity and 45% designated as available-for-sale. Further, available-for-sale unrealized losses as a percentage of our investment securities portfolio improved in the first quarter. And total AOCI improved by 11% on a linked-quarter basis.

Turning to Slide 12. As a reminder, following the completion of our acquisition of Union Bank, our CET1 capital ratio declined from 9.7% at the end of the third quarter of 2022 to 8.4% as of December 31, which reflected the impacts of balance sheet optimization and purchase accounting adjustments that will accrete back into capital over the next few years. Strategically, we continue to be encouraged about the financial merits of this deal and the synergistic benefits we expect to realize as a combined institution.

As Andy mentioned earlier, our CET1 capital ratio at March 31 was 8.5%. The 10 basis point increase from year-end reflected 20 basis points of capital accretion, offset by the transitional impact of CECL of 10 basis points. As of March 31, we expect to accrete approximately 20 to 25 basis points of capital per quarter as we complete the Union Bank integration and realize cost synergies. Importantly, this does not include the impacts of planned RWA optimization initiatives mentioned earlier.

Turning to Slide 13. Total end-of-period loans were $388 billion, which was flat on a linked-quarter basis and up 21.6% year-over-year. Commercial real estate loans represent approximately 14% of our total loan portfolio with CRE office exposure representing approximately 2% of total loans and only 1% of total commitments. Leverage lending balances are not a significant component of our loan portfolio.

Slide 14 shows credit quality trends, which continue to be strong, but as expected, are started -- are starting to normalize across the portfolio. The ratio of nonperforming assets to loans and other real estate was 0.3% at March 31 compared with 0.26% at December 31 and 0.25% a year ago. Our first quarter net charge-offs of 0.30% as adjusted increased 7 basis points versus the fourth quarter level of 0.23% as adjusted and was higher when compared to the first quarter of 2022, which was a level of 0.21%.

Our allowance for credit losses as of March 31 totaled $7.5 billion or 1.94% of period-end loans. As the chart on the upper right side of this slide demonstrates, our credit performance through the cycle serves as a key differentiator for the bank.

Slide 15 provides a detailed earnings summary for the quarter. In the first quarter, we earned $1.16 per diluted share, excluding $0.12 of notable items related to the recent acquisition of Union Bank.

Slide 16 highlights revenue trends for the quarter. Net revenue totaled $7.2 billion in the first quarter, which included a full quarter of revenue contribution from Union Bank of $832 million, primarily representing net interest income.

Net interest income grew 7.9% on a linked-quarter basis and 45.9% year-over-year, driven by earning asset growth and continued net interest margin expansion, which benefited from rising interest rates. Noninterest income as adjusted increased 2.7% compared to the fourth quarter, driven by higher commercial product revenue, mortgage banking revenue and trust and investment management fees, partially offset by losses of $32 million from securities sales.

Turning to Slide 17. Adjusted noninterest expense for the company totaled $4.3 billion in the first quarter, including $546 million from Union Bank. Noninterest expense as adjusted increased 9.1% on a linked-quarter basis, largely driven by the impact of 2 additional months of Union Bank's operating expenses, core deposit intangible amortization and higher compensation and other noninterest expenses.

I will now provide second quarter and updated full year 2023 forward-looking guidance on Slide 18. Starting with the second quarter of 2023 guidance, we expect average earning assets of between $600 billion and $605 billion in the second quarter and a net interest margin of approximately 3%. Total revenue as adjusted is estimated to be in the range of $7.1 billion to $7.3 billion, including approximately $85 million of purchase accounting accretion.

Total noninterest expense as adjusted is expected to be in the range of $4.3 billion to $4.4 billion, inclusive of approximately $120 million of core deposit intangible amortization related to Union Bank. Our tax rate is expected to be approximately 23% on a taxable-equivalent basis. To date, we have incurred $573 million in merger and integration costs and anticipated charges of between -- and anticipate charges of between $250 million and $300 million for the second quarter. We continue to estimate total merger and integration costs of approximately $1.4 billion, consistent with earlier guidance.

I will now provide updated guidance for the full year. For 2023, average earning assets are now expected to be in the range of $600 billion to $610 billion. We expect the net interest margin to be between 3.0% to 3.05% for the full year. Total revenue as adjusted is now expected to be in the range of $28.5 million to $30.5 billion, inclusive of approximately $350 million of full year purchase accounting accretion.

Total noninterest expense as adjusted for the year is expected to be in the range of $17.0 billion to $17.5 billion, inclusive of approximately $500 million of core deposit intangible amortization related to Union Bank. Our estimated full year income tax rate on a taxable-equivalent basis is now expected to be approximately 23.0%. We continue to expect to have $900 million to $1 billion of merger and integration charges in 2023.

I will now hand it back to Andy for closing remarks.

Thanks, Terry. Events of the past few weeks have certainly raised questions about the overall health of the banking industry and the economic outlook. The business of banking involves taking balanced risks, and these risks must be carefully managed, appropriately regulated and prudently mitigated.

At U.S. Bank, we are focused on the strength and stability of our balance sheet. Our investment in risk management practice is guided by our core principle that includes always doing the right thing for the many stakeholders, communities and constituents we serve. A key strength of our institution is our high-quality and diversified business mix and deposit base.

The combination of a mix of consumer, corporate and commercial customers with significant operational deposits, broad geographic reach and a full breadth and depth of product and service offerings serves as a key differentiator for the bank. Our high debt ratings, resilient liquidity profile, available funding sources and strong earnings capacity enable us to deliver industry-leading regulatory stress test results and contribute to our resiliency during times of uncertainty.

As we continue to work to ensure a successful conversion of Union Bank next month, we are already seeing the benefits of increased scale and market share as we bring our enhanced digital capabilities and broad and diverse product set to the Union Bank customer base. Our reputation as a prudent risk manager has been earned through our performance over many cycles. And we have never been more focused on the strength and stability of our balance sheet.

Let me close by thanking our employees for all that they do on a daily basis for our customers, communities and shareholders. We have shown incredible strength and stability during these challenging times. And I am more confident than ever in our ability to continue to deliver exceptional client service, superior product offerings in a rapidly changing environment.

We'll now open the call for Q&A.

(Operator Instructions) And we'll go to Scott Siefers, Piper Sandler.

Lots of noise in the deposit flows in the first quarter. I guess, moving forward, what would your expectations be for total deposit flows or balances and then the mix of noninterest-bearing to total as we sort of get through this cycle?

Yes. Our expectation is that if you end up just looking at the industry, there's going to be pressure on deposits and high competition. We think we'll fare quite well with respect to that. To the extent that we see changes in deposits, it will be kind of based upon that competition, so -- but I would say relatively stable.

And then coming to your second question, the mix of NIBs as an example in roughly the fourth quarter was about 25%, 26%, in that ballpark. It's 25%. And we think it's kind of hitting that kind of stable level, keeping in mind that we have a lot of operational deposits tied to our -- both our corporate and our corporate trust businesses. And that kind of helps to sustain it. So it's a combination of things, Scott.

Okay. Perfect. And then was hoping we could talk for a second about just the categorization and when you guys would expect to be a Category II bank. I think there's a lot of chatter going around, especially in light of that report from a couple of days ago. So maybe just in sort of clear terms, when would you expect to be a Category II bank? Will that be due to your asset size or thanks to the Fed's flexibility to designate you as one? And then how would you guys get there by that time?

Yes. Our trajectory with respect to Category II is no earlier than the end of 2024. And that will be -- I think that will be more driven by whether the Fed makes that decision or not rather than asset size. Again, as we kind of manage the company, we're going to be -- continue to be very focused on profitable loan growth and things like that. So we get there when we get there. But that -- our expectation right now is no sooner than the end of 2024.

Okay. Perfect. And you guys feel like you're prepared to get there by that time basically?

Yes. It will be a combination of a couple of things we talked about, the -- just the capital generation from earnings. And then of course, that is helped by the Union Bank transaction. And then we're very focused on capital management. We have to be just -- because of the Category II, we'll be very focused on risk-weighted asset optimization and making sure that we're focused on profitable growth.

Next, we'll go to Erika Najarian with UBS.

I guess, the question for USB is I don't think your investors doubt the through-the-cycle credit outperformance or even the PPNR strength. It's well noted that the adjustment to your revenue outlook was very minimal relative to peers. I think the big question that investors have is you're starting from 8.5% CET1. You note earnings power and capital -- organic capital generation of 20 to 25 basis points.

But as we anticipate Cat II, and you're telling us that the Fed could decide and not your asset size necessarily could decide when that line is, what is the new endpoint of CET1 in your view? Because as we think about going into that new category, I don't think investors think that 8.5% to 9% is the right bogey. And then the sort of the sub-question to that, Andy, is, is your priority getting to a higher capital level faster? And if so, how are you thinking about dividend growth this year?

So Erika, good question. And so I'm just going to go from the beginning. I think that would be helpful. So as you know, we were well above 9% and came down to 8.4% as a result of the Union Bank transaction. The Union Bank transaction is a terrific transaction. We're exceeding our revenue expectations. We are coming under on our expense expectations. The accretion is greater than we expected. So the value of the franchise is positive for sure.

As we think about the Category II, I have three or four factors I think about. Number one is the earnings accretion that we talked about, which is strong and growing. And we'll become even more accretive as we get through the cost takeout component of the Union Bank integration. Number two is we have a number of initiatives across the board for risk-weighted asset optimization.

Those are things like credit transfers, risk transfers, a number of things to optimize the balance sheet that I think we ought to be focused on and are very focused on to your question. And I think with those two things, as I mentioned, we expect to exceed 9% by the end of this year. That, coupled with our AOC burn-down and additional accretion as we go into 2024, makes me comfortable that we are prepared with whatever event occurs as it relates to Category II in the timing, as Terry mentioned, no later -- no earlier than at the end of 2024.

Yes. A couple of things that I would maybe add because that's right-on. Coming back to AOCI, that burn will be kind of a function of a lot of different things. We have been very proactive in terms of repositioning the AFS portfolio, looking at asset sales and securitizations -- or asset sales, security sales, et cetera. Again, to give you some sense, the duration of that investment portfolio -- of the AFS portfolio has gone from a little over 4.5% in the fourth quarter to about 3.8% in -- at the end of the first quarter.

So we're going to continue to shorten the duration. And that's going to help us with respect to managing AOCI. And then in addition to that, we have been essentially reducing the volatility of AOCI to up interest rate environments through hedging activities. So it's a combination of a variety of things that we're going to go through.

And is 9.5%, 10% an appropriate new bogey as we think about the shift change for next year on Cat II?

So Erika, as you know, the...

Go ahead.

Yes, the regulators are going through an analysis and a process right now to think about how capital levels ought to be in the industry across the board with a Basel IV endgame and whatever are changes to categorization that occurs. So we are waiting for that, as you are, to understand what the new environment will look like. But the plan that we have in place is assuming what you -- what Terry just discussed.

And just if I could sneak in one last one in, one of your peers closest to you in size said the TLAC was pretty much done and dusted. I noticed that you mentioned your superior debt rating several times. Clearly, the debt markets are still a little bit dislocated. But how should we think about the wholesale funding stack from here?

I noticed on a period-end basis, short-term borrowings went up by $25 billion. Terry, as you potentially anticipate TLAC, how should we think about your senior debt issuance plans or really sort of hold that level of borrowings until there's a little bit more -- less dislocation in the senior debt market?

Yes. Again, TLAC is one of those things that we're going to learn more as we kind of go over the course of the next 12 months. I think the real question is not whether or not TLAC will exist. Because I do believe and we're expecting that it will be something that gets put into place. But how does that get calibrated for the regional banks, reflecting the risk profile that we have relative to the G-SIBs?

And there's a wide range of estimates that are out there. When we end up looking at that, maybe one reasonable estimate would be based upon the foreign bank operators and kind of levels of TLAC. If that is the case for us, I think it would be very manageable. It would be within a range that we would be able to manage to. And then that just gives us flexibility with respect to how we utilize that within the bank.

And next, we can go to Mike Mayo with Wells Fargo Securities.

Well, your P/E, [having believed] consensus, is close to 7 and the market is around 20. So your relative P/E is one of the lowest in history. So I would posit that the market is concerned about something other than earnings. So going back, I guess, the simple question for you, Andy, is will U.S. Bancorp need to issue capital? And how confident are you about that? And on the other side, are buybacks potentially an option once you get to 9% CET1?

And the reason I bring that up is you've seen the front page articles and papers. If you're forced to recognize the unrealized securities losses and you do a burn-down and then people come up with all sorts of numbers and -- would you be forced to realize that? We heard Congress talk about these issues. Could you be forced to incorporate that as part of the current stress test? Could the Fed force your hand sooner? Any color you can give? What's your confidence that you might need to issue capital over the next year or so?

Thanks, Mike. So as I said, I'm -- that is not part of our thinking as we sit today. I'm confident that our earnings accretion, our RWA optimization, our AOC burn-down will all get us to a point that we will be at the appropriate capital levels. And I can assure you that it's a high-focus area for myself and the entire management team, including Terry. So that is something we're very focused on.

Now as it relates to buybacks, I will tell you, as we all know, there's a lot of capital changes that are likely to occur from a regulatory standpoint. So we're not going to do anything until we have more clarity around that, which we hope to have in the second half of the year. But the focus on getting to the appropriate capital levels as quickly as possible, accreting capital and building that capital base is priority one.

Yes. And Mike, the thing that I would add to that, we're going to learn with respect to exactly how moving to Category II and the inclusion in unrealized losses gets incorporated into the CCAR process. But just as a reminder, we have a pretty significant amount of buffer that already exists just based upon our credit performance and our PPNR performance because of the earnings capacity. We continue to reduce the volatility of AOCI to rising interest rates. We're doing that through pay-fixed hedges and just shortening the duration and things that I talked about earlier.

I think there's very likely that they will incorporate a higher rate environment into the CCAR process. I will tell you that we've done lots of scenarios that look at a stagflation sort of environment. And we actually perform better in that environment because the revenue streams tend to hold up, given our mix of business, et cetera. So we're taking a lot of that into consideration. And like Andy said, we feel pretty confident that we don't have to go through a capital raise.

As part of this year's stress test, would they include the unrealized securities losses since that would incorporate the 9-quarter time horizon or no?

No. That is not required in the CCAR analysis as a condition of the way the deal was structured.

And then last short one, your noninterest-bearing deposits, I know you brought that up before, it certainly went down more than average this quarter. But you're not guiding your margin down too much. You said 3% to 3.05% versus, I guess, 3.1% this quarter. Why wouldn't you be guiding that down even further, given the decline in noninterest-bearing deposits quarter-over-quarter?

Yes. It's a couple of different things. One is again if you end up just looking at the mix of total deposits, we again think that total deposits will be relatively stable and that the mix of NIB will be relatively stable around that 25%, up or down.

Part of the decline in this particular quarter ties back to some of the seasonal flows, which are part of our trust business but also the deposits that we knew were going to go out the door to MUFG because of closing down the PurePoint, et cetera. All of those things kind of tie in to the reason why we saw the decline this quarter.

Next, we can go to John McDonald with Autonomous Research.

Wanted to ask on the idea of getting above 9% by the end of the year on CET1. Does that rely on the RWA mitigation opportunities? Or is that just kind of the 20 to 25 basis points that Terry mentioned before the RWA benefit? Is that something that will help you next year? Can you talk a little bit about that?

Yes. We think that the capital generation, the accretion that we'll see of the 20 to 25 is core earnings capability. So it does not rely on those RWAs. So the RWA optimization that we will go through will be above and beyond that. That's a part of that overall capital strategy that Andy talked about earlier.

The benefits of that should happen and help you towards the end of this year, maybe into next year as you work towards end of '24 capital target?

Yes, it will help us both this year as well as into next year, absolutely. As you know, John, we've been kind of preparing for Cat II for well over a year. We put a lot of things in place in the third and fourth quarter. We took some actions in the fourth quarter. And we'll utilize a lot of those tools, if you will, as part of the RWA optimization process that we're going to go through.

Yes. And just to clarify, Terry, this doesn't happen prior to the end of '24, even with the Fed, right? The Fed would tell you on January 2024 that it would take effect by the end of 2024, right? So it's not like they're going to tell you any color there, correct?

That is correct.

Okay. And then any idea of the pace of AOCI burn-down? Obviously, the AOCI came down 11% this quarter with the help of rates. But in a world where rates are not coming down, what's the natural kind of burn-off pace that you might expect for that over a year or 2? Any help on that and just kind of reminding us of the duration again?

Yes. The -- well, again, the duration of the AFS portfolio right now is about 3.8 years. So just -- if you kind of take that into consideration, the burn-down will still be fairly reasonable, even without interest rates. And again, we've put some hedges into place in order to dampen the effect of rising interest rates with respect to AOCI.

And next, we can go to John Pancari with Evercore.

On the -- back to the RWA optimization, can you maybe give us a little more color on what you're looking at there? I know you mentioned credit transfers and risk transfers. But maybe if you can kind of flesh that out a little bit and maybe give us an idea of the magnitude of the benefit that you see potentially materializing as a result of the RWA actions? And then lastly, is other business or portfolio sales or divestitures considered within that?

The second part of the question was?

Their business sales.

Business sales. Yes, at least at this particular point in time, obviously, we'll look at a lot of different things in terms of businesses that we may look at to sell. I mean, that portfolio optimization is something we're always doing. And we've done that a number of different times over the last several years. So that obviously will be something we'll look at. But we have a sizable mortgage servicing rights portfolio. We'll take a look at selling portions of that, where that makes sense. We'll look at asset securitization like we did in the fourth quarter.

There are a whole variety of risk transfer sort of structures that both we put -- we have put into place and where we have on the shelf and ready to kind of start moving forward on when we can. So I think it's a whole variety of different things that we will take a look at as well as balancing the mix toward growth in, what I would say, less capital-intensive businesses as opposed to capital-intensive businesses. So it will be a whole combination of things as we move forward, John.

And do you have a way to help us estimate the magnitude in terms of how you're thinking about that targeted contribution from the RWA optimization strategy?

So the strategies that we have in place are reflected in the guidance that we provided. So that would not change that. And we'll continue to update that guidance, given the economic conditions and rates and the scenarios that we see. But as Terry mentioned, this is a priority for us. And we have a number of initiatives underway, which is the appropriate thing to do. Because I think capital for all banks is going to be more precious as we think about the forward regulatory environment.

Got it. And then just one more for me. And I know you mentioned in terms of other regulatory changes potentially coming down the pipe. You're already in the advanced phase of proposed rulemaking on the TLAC. And can you just talk about the other potential regulatory changes you see coming down the down the pipe? I know you had mentioned the AOCI efforts. But can you talk about potentially around FDIC or stress capital buffer, liquidity rules, anything on that front worth commenting on?

Yes. I mean, it could be a number of different things. I mean, we talked about TLAC, I mean, just levels of capital. You hear them talking about domestically significantly important banks. So increasing the level of the stress capital buffer is another piece of it. I think another one will be around LCR. And then in the CCAR process, I think that they'll incorporate, I would say, multiple -- kind of go back to what they used to do, they'll have kind of multiple scenarios.

But one will be kind of, what I would say, a traditional sort of stress test, where unemployment goes up and rates come down. Another one will be more, I think, some form of stagflation, where rates stay relatively high and you experience the credit loss stress. And again, we've run a variety of different scenarios. And I think we feel like we would be able to withstand either one of those just based upon our risk profile.

Next, we can go to Gerard Cassidy with RBC.

I have a narrower question. I think it was on Slide 8, you guys talked about the impacts of deposits following March 8. The inflows that you referenced, did that come primarily in the Union Bank franchise? Because obviously, it was physically located in California. I know you guys have been in California as well. And then second, was it more commercial versus consumer or more interest-bearing versus noninterest-bearing?

Yes. Maybe in terms of mix, so right after March 8, we actually saw a lot of account customer opening more so on the commercial corporate side. I would say probably 70% on that side as opposed to on the consumer side of the equation, we saw inflows. But again, that ended up getting offset by kind of seasonal flows within corporate trust as the rest of the month kind of progressed.

The other thing that I would say is that when I look at deposit, net new customer accounts in -- specifically in California and the consumer side, we actually saw a nice increase or pop in March relative to previous months. So I think that we're actually probably seeing some benefits associated with that. And I think that addresses the questions that you had.

And then over the years, you guys have always done quite well, and underwriting your loan portfolio, you show up well in the CCAR tests over the years on credit. And so you don't have a very big exposure to commercial real estate. And I always find it interesting to talk to banks that don't have big exposures to a potential credit area that could be problem. What are you guys seeing in that commercial real estate area, particularly in the office portfolio? Any color would be helpful.

Sure, Gerard. So first of all, the rest of the portfolio is very stable. If you look at our charge-off rates and non-accruals and so forth and the numbers around credit metrics, the rest of the portfolio is stable and starting to normalize but normalizing as we expected. I do think the area of focus for all of us is office within real estate. And I do think there's some activity occurring there with tenants' behavior changes, sponsor behavior changes. That is going to cause some pressure in the industry because of maybe an acceleration of what we thought was going to be a little longer process occurring more rapidly.

So you can imagine that we're very focused on it as well. We have not put on a lot of CRE office over the last many years. We've been very, very conservative around that. So as you say, we don't have a large exposure. But I do think it's an area of a lot of emphasis and focus because I do think there are going to be pressures occurring.

Next, we can go to Ebrahim Poonawala with Bank of America.

I had a follow-up question. I think you briefly mentioned about, I think, AOCI hedges against if rates spiked. I was wondering, Terry, if you can elaborate on that. We've seen the 5-year come back again in the last few weeks. Just what's the downside risk to capital or just an increase in AOCI if rates spiked another 50 basis points? And just talk to us in terms of the extent to which you expect to hedge against that.

Yes. So again, we've been taking a number of different actions in order to kind of dampen the effect. As I said, selling securities, where appropriate, shortening the duration, which we did very nicely, I guess, in the first quarter, and then putting in place pay-fixed swaps against the long end of the curve, so dampening the effect of a movement up of rates in both, for example, in the 5- and 10-year sort of space. We -- if rates moved up 50 basis points, obviously, AOCI would be impacted to some extent. But we've dampened that quite a bit over the course of the last couple of quarters.

Understood. And just going back to deposit betas, I think you talked about 40% relative to 34% this quarter. I mean, I'm sure you all do a ton of analysis on where terminal betas might end up. But what's the downside risk? I mean, we've obviously had a shock to the system, Fed funds being 5%-plus. What's the risk? How do you handicap the risk of that 40% beta actually turning out to be something much higher, maybe closer to 50%?

Yes. We've done a lot of different analysis. And I mean, you are right. The competition for deposits is getting stronger. We've kind of taken that into consideration. We're seeing over 5% in some markets. Generally, it is smaller banks where that is occurring, community markets, those sorts of things. And that's because for those entities, that's their primary source of funding. And so that's going to occur. But all of that has been kind of taken into consideration in terms of looking at that 40% deposit beta.

If you end up looking at our business, again in terms of who we end up competing against, et cetera, but what we end up looking at and tracking is, especially on the institutional corporate side of the equation, is money market rates and those sorts of things. Right now, that's kind of in the high 4s. And our deposit pricing is very competitive with that, which is why it gives us confidence with respect to both flows and the deposit betas that we've articulated.

But I mean, you don't see a major shift in consumer and retail deposit pricing today versus maybe at the start of the year?

Yes, it's going to depend. I mean, obviously, it depends upon the rate environment. I mean, if the Fed, for example, goes up another 50 or 100 basis points from here, that would put more pressure on deposit betas. But if you end up looking at the market implied or even up a bit, I still feel pretty comfortable with where we're at.

And next, we can go to Matt O'Connor with Deutsche Bank.

It's Deutsche Bank. You've got very strong reserves-to-loans on a stated basis. I guess, first, can you remind us what the impact is if you adjust it for the Union Bank loans that were marked at fair value when you took them on, if you have that handy?

Yes, I missed the first part of the question. Andy, do you...

I think, Mike, you're trying to understand -- or Matt, you're trying to understand the -- if Union Bank has an impact on our reserve-to-loans ratio and what it is. I don't think it has a major impact.

Not a significant one.

Okay. And then just broadly speaking, like as you think about the rest of the year, I mean, you're obviously taking a best guess on reserves at the current period. But what are your thoughts on...

Sorry, it's hard to hear you.

Sorry. Can you hear me better now?

That's better. Yes, thank you, Matt.

Okay, sorry about that. I was just asking about the outlook for the loan loss reserves from here in your base case.

Yes. So our expectation is that, again, Andy has talked about the fact that we're preparing for any economic sort of outcome that might exist. I think if you end up looking at the consensus in the marketplace, some form of recession, probably a softer or moderate sort of recession late this year, early next year. And if you look at the market implied, I would kind of tie into that.

When we go through our reserving process, we look at multiple scenarios. We weigh it to the conservative side. We look at five different scenarios. We make assumptions with respect to that. Only 35% of it's weighted towards what I would call the base case and the rest of it is downside. So we feel pretty good about where the reserve levels are. Obviously, if we saw economic shock above and beyond kind of what is being expected, that might be a little bit different. But we feel pretty good about how we're thinking about it.

Okay. Great. And then maybe if I could just squeeze in on spending trends throughout 1Q, you guys, through your payments business, obviously see a lot. Just any observations on kind of trends throughout the quarter and maybe any comments so far in April?

Yes. In our payments business, we continue to see pretty strong sales, 10-plus percent, for example, in our payments merchant processing business, a very strong mid- to high single digits with respect to our corporate payments business. The -- if you end up -- comparing any of these things to pre pandemic is through the roof.

So we continue to see a good spend in the business. I would say that after the market disruption, there was a bit more softness in retail sales, which we're going to continue to watch. It's really too early to tell whether or not that's a trend or whether that was really some of the concerns around the market disruption. But we'll continue to watch that. Andy, what would you add?

Yes. And that is still growing, Matt. But it's just growing at a lower rate, particularly in retail. Airline spend continues to be very, very high, which is a little bit of the reason that we have a differential between sales growth and revenue growth. Because the airline spread is a little thinner. So travel continues to be strong. Retail came down a bit but still growing.

Next, we can go to Chris Kotowski with Oppenheimer & Co.

You've given us a lot of good detail on the AFS side. I just wonder if you could discuss a little bit how you anticipate managing the held-to-maturity portfolio. Do you also plan to let that kind of burn down and shorten? And I'm curious just given that, that's a lot of mortgage-backed and that they're principal payments each month, how quickly does that portfolio burn down? Or do you see the need to maintain a lot of duration there just in case we get another decline in rates?

Yes. I mean, obviously, we look at both sides of the equation. The burn-down on the HTM side, just simply because of the nature of it, is really more tied to how quickly you see payoffs and what the duration of that ends up looking at. I think as we look at the size of the investment portfolio, et cetera, we'll take into consideration what level of duration we want to have in that -- in the HTM portfolio. But that's going to be more a function of just pay-downs and payoffs over time.

Yes. But I mean, just I guess, question directionally in the next couple of quarters, there's -- you'd probably let the duration shorten and the size of the portfolio burn-down left to your own devices?

Yes, absolutely, yes.

Next, we have Ken Usdin with Jefferies.

First question, I just want to ask you on credit. On an adjusted basis, your charge-offs were 30 basis points this quarter. And per the comments you made earlier about CRE and some of the data we see in the release about delinquencies and NPAs increasing, what's your outlook for charge-offs as we go forward versus the 30 basis points that we saw in the first?

Yes. I mean, our expectation is that 30 basis will continue to normalize throughout the year and into 2024, probably on a similar sort of pace. I think it's 23 basis points in the fourth quarter. So I think that, that will continue to kind of move up as the year progresses, just part of normalization.

Yes, understood on that. Okay. And then just coming back to the full year guide, obviously, you made a modest adjustment, which is well expected, given the change in the rate outlook. We can back into that, I think, it's mostly on the NII side, just given that, that's where seemingly some of the changes were versus the prior outlook. But can you just kind of refresh us and just give us kind of just some underlying thoughts of NII growth versus fee growth and any changes you had on -- if any, on the fee side versus your prior outlook?

To your point, most of the changes were in NII. And it's a function of the rate curve, the rate environment, the expectation about rate increases as well as the deposit pricing that Terry made reference to and the beta approaching 40%. So most of the change was in NII.

Okay. And then so just last follow-up, so then embedded in your fee outlook for the year is pretty decent growth, it would seem then. And are you expecting that to still be mostly driven by the payments business? Or are there other areas that you're expecting to see some good growth in?

We have a great diversity of revenue sources and they're all doing well. So payments is up, approaching double digits, 9% on a year-over-year basis. As Terry talked about, spend levels are good. We have had a bang of a quarter in our commercial products group across the categories. And that is doing just terrifically in this environment and just driving revenue growth as well. Trust is doing well, so -- and mortgage. So that's the value of a diverse revenue stream. There are many different sources of revenue and fee income.

Next, we can go to Vivek Juneja with JPMorgan.

A couple of just clarifications, I think you all mentioned that accretion from the deal, Andy, is going better than you had expected. Any -- I know you've talked a lot, just trying to pull this all together. Where are you seeing it better thus far?

Yes, so -- and we talked about this, Vivek, in the fourth quarter that the expectation of that 8% going to 11% and the return is actually better. So if I look at it in the big picture, when we initially thought about the deal, Union Bank had a $2.9 billion-or-so revenue base and a $2.6-or-so billion -- $2.3 billion expense base, so $600 million PPNR. And you look at the first quarter, and it's double that. So the revenues are stronger, principally because of the value of deposits in this rate environment. The expenses are a little less. And our expectations on our efficiencies are continuing to be on plan. So all that adds up to a higher accretion.

Net higher accretion is -- the net purchase accounting is actually negative, given the core deposit intangibles. So it's very strong.

Right. And that's before you even finish the integration that you -- I mean, that's not until second quarter anyway?

Yes.

That's right.

That's correct.

Next, we can go to Erika Najarian with UBS.

Yes, sorry to prolong the call, I just had one follow-up question. Andy, I asked the question in a compound way, so I apologize. But if you think about accreting to over 9% CET1 by year-end, how would you stack rank dividend growth as a priority?

Dividend growth continues to be a priority, Erika. So our expectation is we would have continued growth in the dividend. The dividend growth number is not hugely material to the capital accretion math. If you go through the numbers on that, that is a relatively small component of a negative downturn in capital. So that expectation that I talked about includes the expectation of a strong dividend.

And next, we'll go to Mike Mayo with Wells Fargo Securities.

Last quarter, you mentioned your reserves were for an environment with 6% unemployment. I was wondering if you had an update for that. And given CECL accounting, does that mean your reserving is done before the recession has even started? Or how do you think about that? And what about the release of reserves to the extent you stay down this low charge-off range even with some of the normalization?

Yes. Well, I think we'll wait and see what ends up happening, given the uncertainty that's in the economy regarding the last bit of it. But yes, I know we had said that it was the weighted average. At the peak, it was -- peak quarter was about a little over 6%. It's about 5.9% today is kind of what our weighted average case kind of comes up to, so very similar to what we had before.

Okay. And your outlook for the economy, soft recession, hard landing, kind of what you're thinking?

So Mike, we expect a soft recession, a moderate recession in the later half of this year. But as Terry mentioned, our CECL accounting is assuming a sort of a 2/3 downturn, 1/3 base case. So we are reserved to a little bit more downward scenario.

And we have no further questions at this time. I will now turn it back to George Andersen. Please continue.

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