The Chairman and CEO of KeyCorp, Chris Gorman, welcomed listeners to the Second Quarter 2023 Earnings Conference Call and discussed the company's strategic priorities. He highlighted the successes of the Consumer Bank, which is growing relationship households at an annualized rate of 5%, and the Commercial business, which is expanding relationships and raising capital for clients. The company raised $25 billion of capital for their clients in the quarter, placing 18% of the capital on their balance sheet. M&A revenue is up from the first half of 2022, and investment banking fees are expected to be up in the second half of the year.

Key focuses heavily on having their clients' primary operating account, which is reflected in the quality and diversity of their deposit base. This quarter, their deposits increased by $1 billion and they have seen continued growth in July. Going forward, they will benefit from a net interest income opportunity of $900 million annually by 2025 and are proactively managing their balance sheet and capital allocation. Additionally, their fee-based businesses make up 40% of their revenue.

In order to normalize capital markets, the company will utilize its platform to increase fee income and reduce its balance sheet. Credit losses have been low across the industry, but as the business cycle progresses, asset quality will become more important. The company has limited exposure to high-risk categories and two-thirds of its commercial real estate exposure is in multifamily, including affordable housing. The company has also implemented a company-wide effort to improve efficiency, which has resulted in a $200 million annualized benefit.

Chris has expressed confidence in the long-term outlook of their business. For the second quarter, net income from continuing operations was $0.27 per common share, which was down from the prior quarter due to additional post-tax provision expense and notable post-tax expenses. Average loans for the quarter were $120.7 billion, up 11% from the year ago period. Total cost of deposits was 149 basis points in Q2 and their cumulative deposit beta was 39% since the Fed began raising interest rates in March 2022. They remain focused on balance sheet management to minimize the total cost of funds.

In the second quarter of 2023, average deposits totaled $142.9 billion, a 3% decrease from the year prior, due to higher spend due to inflation, normalization from elevated pandemic levels, and changing client behaviors due to higher rates. Taxable equivalent net interest income was $986 million, a 11% decrease from the year prior and prior quarters, with a net interest margin of 2.12%. The net interest margin was negatively impacted by higher interest-bearing deposit costs, a shift in funding mix to higher cost deposits, growth in wholesale borrowings, and a reduction in net interest income from the swap portfolio and short-dated treasuries.

Key has begun to benefit from the maturity of their short-dated swap book, and expects to benefit more significantly as they move forward. They have taken a measured but opportunistic approach to locking in this potential benefit. Non-interest income for the second quarter of 2023 was $609 million, down from the year ago period due to lower investment banking and debt placement fees, and service charges on deposit accounts. Total non-interest expense for the quarter was $1.076 billion, down $2 million from the year ago period and down $100 million from last quarter.

Net occupancy expense and business service and professional fees decreased in the second quarter compared to the year ago quarter, while technology expense and personnel expense increased. Personnel expense decreased compared to the prior quarter, and other expense included restructuring charges. Credit quality remains solid, with net charge-offs at 17 basis points of average loans and the allowance for credit losses at 1.49%. The Common Equity Tier 1 ratio is 9.2%, and there were no open market share repurchases or material share repurchases in the second quarter. AOCI mark is expected to decrease.

AOCI marks are expected to decline by the end of 2025, with an appropriate comments and phase-in period. Balance sheet trends are tracking as anticipated, with average loans down 1-3% and average deposits remaining relatively stable in the third and fourth quarters. Net interest income is expected to decline 4-6% in the third quarter and remain flat to down 2% in the fourth quarter, with a Fed funds rate reaching 5.5% in the third quarter and remaining flat through year-end. These assumptions are fluid and will continue to affect the outlook.

The guidance for the third and fourth quarter of 2023 is that net interest income will be down 12-14%, fees down 7-9%, expenses remaining relatively stable, net charge-offs of 25-30 basis points for the year, and a GAAP tax rate of 18-19%. The factors that will allow the pace of NII degradation to slow in the second half, and especially the fourth quarter, are not specified.

Clark Khayat explains that the 212 NIM would have been 285 without the swaps and treasuries in the quarter, and that the fundamentals of the business are consistent with a continued decline. He states that the rate expectation has changed, with a one hike and a flat rate through the end of the year, resulting in a higher beta and a bigger drag from the swaps and treasuries. Khayat also mentions that these two factors are moderating, with deposit balances stabilizing and the slope of the beta increase flattening. Finally, he mentions that the treasury portfolio will begin to mature in the third quarter, leading to a flattening of the NII and NIM trajectory going into the fourth quarter.

The company is looking at a yield pickup of almost 5% by the end of 2024, with $9 million US treasuries maturing in the quarter and $10.3 billion of swaps between now and the end of 2024. This would result in an NII pickup of $900 million, which is higher than the previous rate environment. Slide 9 in the deck is intended to provide transparency on the treasuries and swaps, and the betas and funding costs are not included.

Clark Khayat states that given the relatively stable interest rates, they feel confident in their guidance for the back half of the year, which implies a negative 12% year-over-year. He also mentions that their deposit betas are in line with the peer group, and they are currently facing headwinds due to swaps and treasuries.

Christopher Gorman discussed the need to focus on expenses and the potential to flex expense leverage in the back half of the year. He also discussed the need to pay close attention to the duration, granularity, and composition of the deposit base, as well as the potential for loan-to-deposit ratios to decrease in the future. He noted that last year, loans grew by high double digits and were on track to grow 6-9%, before the events of March.

Chris Gorman, the Chairman of the Board, is confident in the sustainability of the company's dividend policy. The Board is managing the company for the long-term and prioritizes capital to support clients and prospects, as well as to pay dividends. Last week, the Board approved a $0.205 third quarter dividend. The company is also looking to reduce their balance sheet and right-size their expense base for the future asset base.

Chris Gorman discussed the company's long-term perspective on the dividend, and their ability to build capital. He mentioned the AOCI burn down, and the importance of a well-positioned credit book to avoid capital losses. He also noted that the company is back to its upper teens point of investment banking originations, and that this has the potential to generate more business in the investment bank.

Chris Gorman explains that the mix of debt distributed in the second quarter was mostly investment grade, which was not great for investment banking fees, but important for keeping the velocity of their balance sheet. He is encouraged by the M&A backlog being up year-over-year and the fact that clients are proceeding with transactions that have been percolating for some time. He also mentions Laurel Road and the cost factors associated with the debt moratorium.

Chris Gorman and Clark Khayat discuss the Laurel Road platform and their asset-light model for securitizing and distributing loans. They have pivoted their platform to include digital services such as checking accounts, cards, and mortgages. Additionally, they have acquired GradFin to help people understand public service loan forgiveness and income-based debt repayment. They plan to continue to distribute debt, particularly on the consumer side.

Chris Gorman and Clark Khayat discussed the trade-off of sacrificing loan growth to lower the LDR, and the move to a fee-generating model. John Pancari then asked what could prevent the realization of the $900 million of NII pickup from treasury and swap maturities, and what risks could get in the way.

Clark Khayat explains that the rate available when treasuries and swaps mature is the single biggest factor in the $720 million to $900 million increase. He also notes that the decision to reinvest, use as replacement funding, or hold in cash treasuries is relatively neutral. He also notes that lower beta expectations at the end of Q1 have increased the opportunity, and that any incremental progress made in optimizing non-strategic businesses or other optimization could lead to potential incremental downside to the loan numbers.

Chris Gorman of the company is responding to Matt O'Connor of Deutsche Bank's questions about the company's CET1 target of 9-9.5%, which is lower than that of their peers. Gorman explains that the target is appropriate for their business mix, which includes a large amount of investment grade C&I loans and consumer loans with high FICO scores. He also states that they will wait and see what comes out in the near future before reevaluating their target. Gorman then goes on to say that they are looking at RWA optimization, but that he is most comfortable directing O'Connor to the guidance they have given around loans.

Clark Khayat and Chris Gorman discussed the potential to optimize non-deposit funding and credit reserves, respectively. Khayat believes that there is room to reduce reliance on wholesale funding, while Gorman believes that CECL is forward-looking and the impact of banks tightening down on credit has not yet been factored into the market. Gorman is being conservative in his outlook and is focusing on leveraged investments and cash flows that could be impacted by a slowing economy.

Chris Gorman and Manan Gosalia discussed the need for ACL ratios to move higher, with Gorman asserting that they had already reserved what they needed to. Mike Mayo then asked about NII guidance, and Khayat responded that it would be relatively flat in the third quarter and start to trend up. Mayo noted that this would be the lowest core margin since the global financial crisis, and asked why it was so low. Khayat replied that NII would be around $937 million in the third quarter and $927 million in the fourth quarter, with a possible increase of 1/4 by the end of the year.

Clark Khayat and Mike Mayo discuss the potential improvement of the NIM and NII for the coming year. Khayat explains that the higher credit quality of their loan book leads to lower yields and therefore a lower NII. Mayo then asks if the NII will go up by a quarter by the end of the year, to which Khayat clarifies that it will be annualized as of the first quarter of 2025.

Mike Mayo and Chris Gorman discuss the factors that could help increase NIM from 2% to 3%, such as reducing wholesale funding and loan spreads. Gorman then expresses his confidence in the investment banking industry for the second half of the year, noting that people who have put deals on hold for a year will either start to happen or move on.

Erika Najarian is asking Chris Gorman and Clark Khayat about the sustainability of the dividend, given the current balance sheet setup. She questions whether the efficiency ratio reflects the potential of the business, and what discussions will be had with the Board to ensure the potential of the franchise is reflected in earnings power.

Chris Gorman and Clark discussed the company's challenge of under-earning due to their liability-sensitive balance sheet position. The company is confident that they will be over-earning when the position unwinds and rolls down. Gorman then talked about the company's commercial mortgage servicing portfolio of $630 billion and the special servicing segment within that business, which has likely picked up due to the challenges in the commercial real estate market.

Chris Gorman explains how his business is a great business because it generates deposits through escrows and is countercyclical. He explains that they are the named special servicer when a large complex debt financing is put together and they receive a ticking fee. He also mentions that more than two-thirds of what is in active special servicing is office, which is a challenge for Key. Gerard Cassidy then asks Chris what they are doing to get out in front of any potential challenges if the economy does lead to more delinquencies and defaults.

Chris Gorman is not ruling out the possibility of rightsizing the dividend, but is comfortable with the current dividend payout and trajectory of the business. Steven Alexopoulos asked if the green shoots in capital markets are necessary to deliver the 2%-4% and 4%-6% fee income guide. Gorman answered that there are other factors that could provide cushion if IDDs fees don't come back.

Chris Gorman and Steven Alexopoulos discussed the impact of investment banking fees on the company's performance as well as the need to manage the balance sheet and interest rate risk differently in order to maintain a higher NIM and dividend payout ratio. Clark Khayat suggested being more dynamic in their thinking when it comes to putting on certain positions. The call concluded with Gorman thanking the participants and providing contact information for any follow-up questions.

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This summary was generated with AI and may contain some inaccuracies.