Regions Financial Corp

NYSE:RF

Earnings Call Transcript 2022-Q1

[Operator]

Good morning, and welcome to the Regions Financial Corporation's quarterly earnings call. My name is Jamaria, and I will be your operator for today's call. I would like to remind everyone that all participant phone lines have been placed on listen-only. At the end of the call, there will be a question-and-answer session. [Operator Instructions]

I will now turn the call over to Dana Nolan to begin.

[Dana Nolan]

Thank you, Jamaria. Welcome to Regions first quarter 2022 earnings call. John and David will provide high-level commentary regarding the quarter. Earnings documents, which include our forward-looking statement disclaimer and non-GAAP information, are available in the Investor Relations section on our website. These disclosures cover our presentation materials, prepared comments and Q&A.

I will now turn the call over to John.

[John Turner, President & CEO]

Thank you, Dana, and good morning, everyone. We appreciate you joining our call today. We are very pleased with our first quarter results. Earlier this morning, we reported earnings of $524 million, resulting in earnings per share of $0.55. Despite the challenging geopolitical backdrop and elevated inflation, we remain optimistic about 2022. We have a strong balance sheet, positioned to withstand an array of economic conditions. Business customers, for the most part, have adapted and are prospering in the new operating environment.

New loan commitments and pipelines remain strong and utilization rates continue to increase. The consumer remains healthy. Net population migration inflows in our markets remain robust, and the majority of our footprint has returned to equal or better than pre-pandemic employment levels. Asset quality remains strong with virtually all credit-related metrics improving in the quarter, and net charge-offs remain below historical levels.

The integration of Sabal, EnerBank and Clearsight are progressing as planned, and we're excited about their growing contributions. Additionally, we continue to make investments in talent and technology to support strategic growth initiatives. We kicked off 2022 with a strong start and expect to continue building on that momentum. We have a solid strategic plan, an outstanding team and a proven track record of successful execution.

Now, Dave will provide you with some select highlights regarding the quarter.

[David Turner, CFO]

Thank you, John. Let's start with the balance sheet. Average loans grew 1.5%, while ending loans grew 2% during the quarter. Average business loans increased 3%, reflecting broad-based growth in corporate, middle market and real estate lending across our diversified and specialized portfolios. While still below pre-pandemic levels, commercial loan line utilization levels ended the quarter at approximately 43.9%, increasing 160 basis points over the prior quarter. Loan production also remained strong with linked quarter commitments up approximately $1.6 billion. Average consumer loans declined 1% as increases in mortgage and other consumer were offset by declines in other categories.

Within other consumer, EnerBank interbank loans grew approximately 2% compared to the fourth quarter. Looking forward, we expect full year 2022 average loan balances to grow 4% to 5% compared to 2021. And excluding PPP loans and consumer exit portfolios, we expect full year average loan balances to grow 9% to 10%. So let's turn to deposits.

Although the pace of deposit growth has slowed, balances continued to increase seasonally this quarter to new record levels. Average consumer and wealth management deposits increased compared to the fourth quarter, while corporate deposits remained relatively stable. We are continuing to analyze our deposit base and pandemic-related deposit increases. Approximately 35% of the increase or $15 billion is expected to be more stable with behavior similar to our core consumer deposit book. This segment is historically quite granular and generally rate insensitive and therefore, can be relied upon to support longer-term asset growth through the rate cycle.

The remaining 65% of the deposit increases is a mixture of commercial and other customer types that are expected to be more rate sensitive or that we are less certain about their long-term behavior. We assume this segment may have all-in beta of roughly 70%. This elevated beta assumption includes relationship repricing and some balances shifting from noninterest to interest-bearing categories.

It also reflects a range of $5 billion to $10 billion of balance reduction attributable to tightening monetary policy. The combination of these segments and our legacy deposit base represents significant upside for us as rates increase.

So let's shift to net interest income and margin. Net interest income was stable quarter-over-quarter. Excluding reduced contributions from PPP, net interest income grew 2% benefiting from solid loan growth and rising interest rates. Net interest income from PPP loans decreased $27 million from the prior quarter and will be less of a contributor going forward. Approximately 93% of estimated PPP fees have been recognized.

Cash averaged $27 billion during the quarter; and when combined with PPP, reduced first quarter's reported margin by 58 basis points. Our adjusted margin was 3.43%, higher by 9 basis points versus the fourth quarter. The path for net interest income enters the second quarter with strong momentum from both balance sheet growth and higher interest rates. Excluding PPP, average loan balances grew 2% in the first quarter and a similar amount of growth is expected next quarter.

Roughly $1.5 billion of securities were also added late in the quarter, further benefiting future periods. The recent run-up in rates has certainly validated our decision to wait to deploy into securities. And while not included in our current outlook, additional securities would provide incremental benefit. Higher short- and long-term interest rates provided additional lift to net interest income in the first quarter. And these benefits are expected to expand in the coming quarters.

Total net interest income is projected to increase 5% to 7% in the second quarter and is expected to accelerate throughout the year such that the fourth quarter net interest income is expected to be approximately 15% higher than our first quarter. Regions' balance sheet is positioned to benefit meaningfully from higher interest rates. Over the first 100 basis points of rate tightening, each 25 basis point increase in the Federal funds rate is projected to add between $60 million and $80 million over a full 12-month period. This benefit is supported by a large proportion of stable deposit funding and a significant amount of earning assets held in cash, which compares favorably to the industry overall.

Over a longer horizon, a more normal interest rate environment or roughly a 2.5% Fed funds rate will support our net interest margin goal of approximately 3.75%. While we have purposefully retained leverage to higher interest rates during a period of low rates, we will attempt to manage a more normal interest rate risk profile as interest rate environment normalizes.

The Fed's aggressive path for interest rates gives us the opportunity to protect NII at attractive levels. We have begun this process by adding $4.7 billion year-to-date of forward starting receive fixed swaps and $1.5 billion of spot-starting securities. This represents approximately 30% of the total hedging amount needed this cycle.

Now let's take a look at fee revenue and expense. Adjusted noninterest income decreased 5% from the prior quarter, primarily due to reduced HR asset valuations as well as lower capital markets and card and ATM fees. Within capital markets, M&A advisory activity was muted by seasonality as well as the timing of transactions. Pipelines remain robust, but some deals have been pushed to later in the year. Additionally, debt and the real estate capital markets were impacted by uncertainty surrounding rates, geopolitical tensions and volatility in credit spreads. However, we are seeing some stabilization in the loan and fixed income markets and anticipate conditions will improve in coming quarters.

Further, the reduction in real estate capital markets activity was offset by the addition of Sabal Capital Partners for the full quarter. Similar to the corporate fixed income market, refinance demand has been softer than expected in our agency, multifamily finance business as investors assess a significant move in interest rates. We continue to expect capital markets to generate quarterly revenue of $90 million to $110 million, excluding the impact of CVA and DVA. While we expect to be near the lower end of the range next quarter, we expect activity to pick up in the second half of the year.

Card and ATM fees reflect seasonally lower interchange on both debit and credit cards, in addition, debit card fees were further impacted by fewer days in the quarter. Mortgage income remained relatively stable and included approximately $12 million in gains associated with previously repurchased Ginnie Mae loans sold during the quarter. While mortgage is anticipated to decline relative to 2021, it is still expected to remain a key contributor to fee revenue.

Wealth management income also remained stable this quarter despite elevated market volatility. Service charges were also stable during the quarter despite seasonal declines in NSF and overdraft related fees. The first phase of previously announced NSF and overdraft policy changes were effective at the end of the first quarter, and the remaining changes will be implemented over the second and third quarters. These changes, when combined with the previously implemented changes are expected to result in full year 2022 service charges of approximately $600 million and full year 2023 service charges of approximately $575 million. We expect 2022 adjusted total revenue to be up 4.5% to 5.5% compared to the prior year, driven primarily by growth in net interest income. This growth includes the impact of lower PPP-related revenue and the anticipated impact of NSF and overdraft changes.

So let's move on to noninterest expense. Adjusted noninterest expenses decreased 4% in the quarter driven by lower salaries and benefits expense and professional and legal fees. Salaries and benefits decreased 5%, primarily due to lower incentive compensation despite higher payroll taxes and 401(k) expense. Salaries and benefits also include the favorable impact of lower HR asset valuations. Professional and legal fees decreased significantly as elevated fees associated with our bolt-on M&A activity in the fourth quarter did not repeat.

We will continue to prudently manage expenses while investing in technology, products and people to grow our business. As a result, our core expense base will grow. We expect 2022 adjusted noninterest expenses to be up 3% to 4% compared to 2021. Importantly, this includes the full year impact of recent acquisitions as well as anticipated inflationary impacts. We remain committed to generating positive operating leverage in 2022.

Overall credit performance remained strong. Annualized net charge-offs increased 1 basis point to 21 basis points. Nonperforming loans continued to improve during the quarter and remain below pre-pandemic levels at just 37 basis points of total loans.

Our allowance for credit losses decreased 12 basis points to 1.67% of total loans, while the allowance as a percentage of nonperforming loans increased 97 percentage points to 446%. The decline in the allowance reflects ongoing improvement in asset quality and continued resolution of pandemic issues, partially offset by loan growth and general economic volatility associated primarily with inflation and geopolitical unrest. The allowance reduction resulted in a net $36 million benefit to the provision. We expect credit losses to slowly begin to normalize in the back half of 2022 and currently expect full year net charge-offs to be in the 20 basis point to 30 basis point range.

With respect to capital, we ended the quarter with our common equity Tier 1 ratio modestly lower at an estimated 9.4%, and we expect to maintain it near the midpoint of our 9.25% to 9.75% operating range. So wrapping up on the next slide are our updated 2022 expectations, which we've already addressed. I do want to point out that these expectations do not include any additional security purchases. So that certainly provides the opportunity for incremental benefit.

In closing, as John mentioned, we began 2022 with great momentum. And despite geopolitical tensions and market uncertainty, we remain well positioned for growth as the economic recovery continues. Pre-tax, pre-provision income remained strong. Expenses are well controlled. Credit risk is relatively benign. Capital and liquidity are solid, and we are optimistic about the pace of the economic recovery in our markets.

With that, we're happy to take your questions.

[Operator]

[Operator Instructions]. Your first question comes from the line of Ryan Nash with Goldman Sachs.

[Ryan Nash, Goldman Sachs]

Hey, good morning, John. Good morning, David. I was hoping maybe you can talk about expectations for deposit growth, which came in better than expected and particularly as it pertains to the surge deposits. So maybe just how you're thinking about the trade-off between keeping some of these deposits and the potential for a higher beta? And I think, David, you highlighted potential for a $5 billion to $10 billion reduction. Can you maybe just clarify how much you expect for these to stick around and what it means for deposit growth?

[David Turner, CFO]

Sure. So we were -- we had expected the $5 billion to $10 billion of deposits to start flowing out in the first quarter. We have maintained some pretty conservative deposit assumptions. But if you look at the growth and where it came from, it was in our consumer book. We continue to grow accounts and continue to be -- have a high level of primacy with our retail customers and so our deposit base is our competitive advantage, and it's been that way for a long time, and we're looking to leverage that as we get into this higher rate environment.

As you think about the surge deposits, we have 1/3 of those that we think are going to be fairly similar to our legacy deposits in terms of beta, price insensitive then we have the other 1/3 on the other end, we think are much higher beta, 80% to 100% beta. Those are corporate deposits that are -- you could characterize those as non-operational deposits that are probably going to look for a better home or a higher rate as time goes by.

We'll see what happens after this next rate increase, but we've expected that to either reprice or really flow out of the bank. And then you have in the middle, which is another 1/3 deposits that are stimulus-receiving deposits, small-business-type deposits. That one is a little harder to predict. We do have a higher beta on it, not as high as the second group. But any event, if we're wrong on the $5 billion to $10 billion, it's likely that we've maintained our deposits at a higher level. And over time, if we see that, then that gives us a little bit of comfort to be able to take some of our excess cash that we have, some $26 billion sitting on the balance sheet to deploy that into the securities book. But our guidance that we're giving you does not have that deployed intentionally.

[Ryan Nash, Goldman Sachs]

Got it. And if we could dig a little bit into the the new hedging program. So David, I don't know if Darren is in the room, I guess, you guys were the masters of adding swaps in a timely manner last cycle, and now you've begun this new program. So I think the market is having a little bit of trouble understanding why banks are adding swaps at this part of the cycle. And I think all of us understand. So can you maybe just talk about thoughts regarding locking in here, particularly using forward starters? And I think you talked about another 10 to 12 of additions. Can you maybe just talk about pacing and why this is the right decision at this point in the cycle for Regions?

[David Turner, CFO]

I'll go ahead and start, and then [Darren] is here, I think he can add to it. But you hit on a key word, and that is forward starting. And so what we're trying to do is get our margin to the optimum level and then layer in protection for that margin over time. So if you look at where we put the first, call it, $4.7 billion in that's at a receive fixed rate of 2.32. Those are largely going to be effective for 2024. So we intentionally had them forward starting because we believe there is risk at that point in the cycle that actually rates could go the other way, and we want to be able to protect that.

If we're wrong, then it happens to not reverse and go lower, then we haven't lost anything. We haven't given up any of our net interest income or margin at that point. These are all 5-year duration just like they were last cycle. And so when you do it forward starting, you can take advantage of pricing. They're not all that expensive to get into, and we're not giving up our asset sensitivity today. That's important. We are becoming and maintain our sensitivity. And if you -- on the comments just a minute ago, the way we're structured in the balance sheet is to benefit, in particular, at the back end such that our NII in the fourth quarter should be up 15% from the first quarter. And it's just the nature of how our sensitivity is structured at this point in time. [Darren], anything you want to add to that?

[Unidentified Company Representative]

The only thing I would add is, David said it well, Page 8 of the deck just really shows the path of the net interest margin, which really underscores what David is saying. We're going to enjoy nice margin expansion as the Fed is tightening policy, but we have a very disciplined approach to manage that exposure as rates push higher.

As David said, the probability of a downturn at some point if the Fed has to push higher increases over time. And so we want to be cognizant of that and as we get delivered those higher rates, put in that protection and really manage the downside risk in those out years.

[Operator]

Your next question will come from the line of Christopher Spahr with Wells Fargo.

[Christopher Spahr, Wells Fargo]

Other banks seem to be spending their rate-driven incremental net interest income or at least some of it, whereas you've kept your 2022 cost guidance unchanged. So why do you think that is? And with this higher NII outlook, how confident are you that you can expand on your positive operating leverage this year, next year?

[David Turner, CFO]

Well, kind of leveraging the comments just before, the way we structured the balance sheet, our NII will be growing nicely in the -- throughout the year but are really strong in the fourth quarter, which sets up a really strong 2023. We're still asset sensitive through that time period. And so we should have a nice tailwind in terms of revenue growth. We pride ourselves on being able to control our cost. We did a good job this quarter. There is that HR valuation asset that benefited us by $14 million. So you need to add that back to kind of get us level set.

But in any event, we continue to leverage our continuous improvement program to stay focused on how we get better every day and how we could leverage technology and process improvements so that we can keep our costs down because we are taking our savings and reinvesting those savings in things like digital, talent, continuing to hire people so that we can grow. We had mentioned that the vast majority of our growth in expenses this year are related to the 3 acquisitions that we closed in the fourth quarter of '21.

So we've had a little bit of inflation we've had to deal with. And so we're continuing to work at all levels to try and keep our costs under control and generate positive operating leverage, which we believe we will have in 2022. We didn't have it this quarter, but we will when you get to -- when you look at the whole year and expect to have that going forward in '23.

[Operator]

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

[Gerard Cassidy, RBC]

David, in slide deck, Slide 6, you give us the difference in the net interest margins based upon what's weighing down your margin today with the PPP loans and the excess cash. Can you share with us on the excess cash portion, where does the Fed funds rate need to go where you're not going to need to have that bullet point anymore because it will match your reported margin?

[David Turner, CFO]

Well, it really gets back to the deposit expectations. So we've maintained this excess cash to be prepared to the extent the surge deposits do seek other alternatives, and we have to pay that out. Obviously, we're getting 100% beta on the cash while we wait, but being patient has benefited us. Putting that into the securities book earlier would have really cost us. And we did put a little bit of that to work this quarter. $1.5 billion of that at about 2.80% carry. If we were to do it today, it would be even higher. And so in the 3.5% range. So I think it's important for us to understand what the surge deposit flows are going to do relative to what the Fed rate movements are going to be. And I think over a fairly short period of time, our cash will get down to our normalized level, which is $1 billion to $2 billion. And then we won't have to have this disclosure. And of course, PPP will run off for the most part after this year, we won't have to talk about that one either.

[Gerard Cassidy, RBC]

Very good. And then as a follow-up, especially talking to you with your background as an accountant. Can you share with us your thoughts about AOCI? We all understand it's an accounting issue and it's only for the securities portfolio. Obviously, you, similar to your peers, had a big negative number this quarter, which took down tangible book value per share and book value per share, again, similar to your peers, so you're not standing out. But at what point does it become an issue for banks?

And again, I know it doesn't go through your CET1 ratio like it does for the advanced approach banks. Do we have to ever get concerned about it if it keeps on -- the AOCI keeps on getting larger on the negative side?

[David Turner, CFO]

So I'll try to answer this without getting upset. I think the -- I think that count on....

[Gerard Cassidy, RBC]

David, I didn't ask you about CECL.

[David Turner, CFO]

So you've hit on 2 of them, 4 core accounting standards relative to what we're doing. But any event, we have to file a gap. So OCI does not -- the change in OCI relative to securities gains doesn't affect our thinking whatsoever. We manage the company based on regulatory -- our capital based on the regulatory rules in 4 category 4 banks like Regions and most of our peers. That's excluded from the regulatory calculation.

Importantly, it's also excluded from the rating agencies. So they carve out the change in OCI relative to securities, not pension or other things, but securities they carve out. And what's frustrating about it is that nobody talks about measuring the fair value of our deposit base, which is where the cash came from to go by the securities. And so we're marking one element of a balance sheet through capital and that's just not how we manage the company. And so it's really irrelevant. It's done because it's easy to do. We can go get a quote.

But the fair value of the deposits, in particular for Regions because of the primacy, because of the granularity, the fair value of our deposits are shooting through the roof. You just don't see that manifest itself on the balance sheet. You will see it manifest itself in growing NII and net interest margin. This is the time period we've been waiting for rates to rise. So the fact that OCI is working against tangible book value, we could care less.

[Operator]

Your next question will come from the line of Erika Najarian UBS.

[Erika Najarian, UBS]

My first question is a follow-up to Ryan's questioning. The way you wrote out Slide 14, it seems like that your NII guide includes both a $5 billion to $10 billion potential accretion of deposits and 70% beta. I guess I'm asking if that's -- if I'm reading that correctly, isn't it -- should it be one or the other? In other words, if they stick around, it might have a 70% beta. Does that make sense?

[David Turner, CFO]

Yes. Yes. Don't duplicate that. The $5 billion to $10 billion is baked into the $70 billion. So if we're wrong, our beta will be lower thus far, as I mentioned on Ryan's question, we thought deposits, these particular $5 billion to $10 billion worth of deposits would start flowing out in the first quarter, they did not. We still think that's going to happen. Perhaps it's just delayed a little bit, waiting for the next move, which we believe is going to be 50 basis points, by the way, in May.

And we think those with are largely corporate non-operational deposits are going to seek a higher return than we're willing to pay. And they're probably going to move off the balance sheet in that case. So this really doesn't -- this is not going to be a big deal to us. We've been planning for it all along.

[Erika Najarian, UBS]

Got it. And as we think about your NII guide, David, what type of earning asset growth should we assume? Again, it goes back to the deposit question, right, because your outlook has felt very conservative since you first put it out. But what interest asset growth range should we assume lies underneath this NII guide?

[David Turner, CFO]

Yes. So you have to take the pieces and look at it. So there's not an appreciable change there. We've got 2 things working. One, we ought to have pretty good loan growth, as we mentioned, ex PPP and runoff portfolios, that's 9% to 10% growth in the loan balances. But then we've got the $5 billion to $10 billion of deposits going the other way, and so the cash will come down. So it's not as much of an earning asset change as it mix and what to carry what the yield is on the net assets that we -- the earning assets that we do have.

And so we should see our margin continuing to increase. We're trying to give you the guide by telling you that by the time we get to the fourth quarter, our NII is 15% higher than where we are today kind of cutting to the chase because there's a lot of moving parts there.

[Operator]

Your next question will come from the line of Peter Winter with Wedbush Securities.

[Peter Winter, Wedbush Securities]

I wanted to ask about EnerBank. The economic environment has changed quite a bit since you guys acquired them. And I was wondering, have your views changed at all with regards to the loan outlook for EnerBank or any consideration may be further tightening the underwriting standards given a much higher rate environment.

[David Turner, CFO]

No. We're very bullish on EnerBank. We're excited about the fact that we closed that in the fourth quarter. If you look at our growth of EnerBank, this quarter it was 2%. Obviously, if you annualize that it's 8%, which is below the guide that we gave you and the big driver there is seasonality. So it's the -- this first quarter is a low watermark for them. You'll see that pick up. This is a prime book.

We're really excited about the carry that we can get there and the margin. We are ahead of schedule on where we thought we would be. And so, Peter, absolutely not. We are looking to that to be a good component of our growth. And again, we feel good about the credit quality, in particular, being paid for the risk that we're taking and a nice return for our shareholders on the capital deployed in that book.

[Peter Winter, Wedbush Securities]

Got it. And then if I could just ask about the capital management strategies going forward just between bolt-on acquisitions which have really increased profitability versus buybacks. I saw yesterday, you've got the $2.5 billion buyback. The question is how aggressive will you be? Or is it just being opportunistic and just want to have that authorization in place?

[David Turner, CFO]

Sure. So let's go back through how we think about capital deployment. First and foremost, our capital is there for organic growth, it is to support our business. As I mentioned, ex PPP and runoff, we got loans growing 9% to 10%. That's where we want our capital to go first and foremost. The second is we want to make sure we pay an appropriate dividend to our shareholders. Our guide is 35% to 45% of earnings in the form of a dividend.

So as earnings grow so will the dividend. We then think about nonbank acquisitions and the 3 we closed in the fourth quarter are great examples. We have a whole team continuing to look and work with our 3 business segment leaders on how we can provide products and services that we don't have to our customers. So we'll continue to do that. And then we use share repurchases as the mechanism to maintain capital at the optimum level and that optimum level is informed by things like CCAR and how we think about risk in our book. Of course, we just filed our CCAR submission in April.

We'll hear back end of June on that. And yes, we did ask the Board and received approval for a $2.5 billion share repurchase program over the next couple of years. The control factor there, Peter, is CET1 that needs to be in the range of 9.25% to 9.75%. That's what our risk profile tells us we need to have CET1 in that range. We're targeting the middle of it at 9.5%. And so we won't buy shares back if it takes us outside of our operating range even if the price were right, which is where you're going opportunistically. I think that's just to help us manage our capital at the optimum level because that informs the denominator of our return on capital calculation, which we think is critically important to our shareholders.

[Peter Winter, Wedbush Securities]

Great. Really helpful. And just 1 housekeeping. Just how much was the credit interest recovery this quarter in net interest income?

[David Turner, CFO]

I didn't commit that to memory. Hold on just a minute, I'll tell you. It's at the bottom of page. Which is the slide?

[John Turner, President & CEO]

No, that's not the number he's asking.

[David Turner, CFO]

Peter, we'll get that to you. You're talking about the impact to NII, right? Interest recovery in NII.

[Peter Winter, Wedbush Securities]

Yes.

[David Turner, CFO]

We'll look -- somebody look that up. We'll get to you in a minute.

[Operator]

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

[Matt O'Connor, Deutsche Bank]

You did mention earlier about some consideration in your reserves for inflation. And I do want to ask, you always talk about your average account size being a bit smaller than some of your peers. And I guess, logic would have it that that customer base might be a little more impacted by inflation, by rising energy gas prices? And just wondering what you're seeing on some of those, call it, leading indicators. It would be helpful.

[John Turner, President & CEO]

Yes, Matt, this is John. I would just say, so far, not a lot of change. Generally speaking, our customer base, as we look at deposit balances and the impact of COVID and relief dollars on customer deposit balances, we saw, on average, even in the lowest balance segment, about a 30% increase in -- 30% to 40% increase in pre-pandemic deposit balances, and we are still seeing customers maintain that level of excess liquidity as evidenced by the fact that our deposit balances actually grew quarter-over-quarter. We do are aware of the impact of inflation or the likely impact of inflation on our customer base. It is a more mass market customer base, as we've talked about before, 60% of our consumer deposit customers are in the mass market. So there will be some impact, and we're certainly watching for that, but we haven't seen it yet.

[Matt O'Connor, Deutsche Bank]

Okay. That's helpful. And then I guess on the other side of the loan book and the commercial side, you had a big drop in nonperforming loans, big drop in the criticized assets. Was that anything specific like a couple of borrowers or sectors or? It has been improving for some time, but it's gotten quite low.

[John Turner, President & CEO]

Yes. No, I think it's broad-based, and we continue to see improvement in credit quality across the book, a reduction in criticized loans, classified loans and nonperforming assets. And I think it reflects the work that our teams have continued to do working with our customers closely to evaluate the risk in our portfolios to exit certain relationships, portfolios and businesses where we feel like that we are -- see increased amounts of risk, we're not getting an appropriate return. If I had to point to any business where our businesses, portfolios where we saw improvement it would be restaurant as we continue to work out of that portfolio and hotel as the economy recovers through the pandemic.

[Operator]

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

[Ken Usdin, Jefferies]

Just a follow-up on the fee side. Now that you're getting close to the implementation of your changes to the deposit products. And you're continuing to reiterate your service charges expectations for '22 and '23, service charge is actually probably better than people expected in the first quarter. So I just wanted to kind of get your updated views on your confidence that you've got the right outlook and as you start to put the products in place, like what are your early takeaways from the continuation of that view?

[David Turner, CFO]

Yes. So our service charges were a little better than anticipated. I will say that we put in some changes at the end of the first quarter, you'll see more change coming in the second and third. So it's too early to change our guidance that we gave you last quarter. We reiterated it this quarter, which was $600 million for service charges in '22 and $575 million in the next year. As we go through and see what the impact is for these changes, we'll update that, whichever way it might go. And we'll probably have a better feel for the year 2022 next earnings call. But right now, it's probably too early to change.

[Ken Usdin, Jefferies]

Yes. Understood. Okay. And then one just follow-up on credit. To follow up on Matt's question about your provisioning thoughts. But can you just talk about, as you talked about normalization of losses starting to happen towards the back half of the year, what parts of the portfolio are you expecting to see charge-offs increase in first? And what areas are you just noticing that potential change in terms of delinquencies and loss rates

[David Turner, CFO]

Well, I think that we lowered our range 20 basis points to 30 basis points. As we think about risk going forward, there's certainly the consumer -- on the consumer side of the house, there's been a lot of stimulus money. I think we feel pretty good about the consumer, but that's an area we need to watch closely to see what that starts to move first.

The second piece of that would be small business. I think small business is an area that probably has, on a relative basis, incremental risk. The issue is we're just not seeing any of that right now. John had mentioned all of our asset quality indicators are getting better. We believe our normalized loss rate is likely to be lower than our history because of our derisking that we just mentioned in our whole credit book. So we feel pretty good about that. I think the leverage book, we want to watch closely as well as we see rates increasing and what kind of pressure might that put on the leverage portfolios. So those would be 2 or 3 that we watch. I do want to get back, Peter, you asked about the recovery that was an NII. It's $4 million this quarter. I want to close that out.

[Operator]

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

[John Pancari, Evercore ISI]

On the expense side, I want to see if I can kind of ask the opposite of Chris Spahr's question earlier. Wondering what type of expense flexibility you may have if the revenue backdrop comes in weaker than expected this year? And do you still think that you're implying about 150 basis points of positive operating leverage in your guidance. Is that sustainable if the revenue backdrop gets tougher?

[David Turner, CFO]

Well, so you saw a pretty good quarter this quarter, again, make sure you add back the $14 million on the HR to get level set there. The reason we were down is because our revenue was down in certain areas like capital markets that has a tendency to be more variable in terms of the cost relative to the revenue. Things like M&A. If you don't have M&A transactions and you don't have the compensation that goes with the deal. So it depends where the revenue challenges come from, John. If we're seeing it in places like that, then we should have lower compensation mortgage.

If we don't have the mortgage production that we think then you're going to see lower compensation for that as well. So we do have some mechanism to take care of revenue if it's lower than we thought. Now a big driver of our change in -- we've changed, I guess, 2 times now, our revenue outlook has been because of the rate environment and just more carry there.

So if we have if we don't get the rate increases, the forwards implied at March 31, which is what's baked into our guidance, then we're probably going to have lower incentive compensation. So there are puts and takes there. We still feel confident with the operating leverage number that you just mentioned. That's exactly what's baked into our guidance. And we will -- we are committed to having operating leverage over time.

[John Pancari, Evercore ISI]

Okay, David. That's helpful. And then on the loan side, as you look at the remainder of the year in terms of overall growth drivers, where do you see the strongest loan generation coming out of both on the commercial side and the consumer side. What are the biggest drivers of growth over the remainder of this year as you look at the economic backdrop?

[John Turner, President & CEO]

John, this is John Turner. Our growth in the last quarter, and frankly, over the last, I guess, 2 or 3 quarters has been broad-based across all 3 segments. So we're experiencing growth in our corporate banking business, our middle market commercial business and our real estate business. We're seeing customers access lines of credit and increasing rates to both rebuild inventories and to adjust to increasing costs associated with inventory. So obviously, increases in line utilization or both inventory and cost driven.

We're also seeing some CapEx, which I'm excited about across a number of different industries. Customers are investing in expansion activities. Some of it is for modernization and recognition of a much tighter labor market. In Alabama, unemployment is 2.9%; in Georgia, it's 3.1%; Florida and Tennessee, it’s 3.2%. So we're at full employment across some very good markets. As a result, customers are looking for ways to modernize and to continue to borrow.

Growth in the portfolio. It's come in healthcare. It's come in transportation. It's come in our technology and defense sectors and asset-based lending. In the real estate business, we've seen some growth in homebuilder as markets are, again, continuing to expand as a result of consistent in migration of people, also seeing some growth in our real estate investment trust business, which has been an important portfolio for us in a really highly performing portfolio. We are optimistic about our ability to continue to grow through the balance of the year, and we expect that growth to be fairly broad-based.

[Operator]

Your next question will come from the line of Betsy Graseck with Morgan Stanley.

[Betsy Graseck, Morgan Stanley]

I had a couple of questions. One is I just want to make sure I understand how you are positioning yourself for the surge deposit activity that you outlined on Slide 5. I know you put the expected beta of 40% to 60% for the mid stable, mid-beta and 80% to 100% for the least stable, higher beta. Is that your indication to us of what you think it would take to retain these deposits? And would you go after them or are you saying, look, we think it would retain this and we're not going to go after them or it depends on how it progresses. Could you just give us some color on that?

[David Turner, CFO]

I think if you look at the -- if you're on that Page 5, let's start with the right-hand side. Those are the higher beta 80% to 100%. I'd characterize those as non-operational corporate deposits. These are deposits that are parked here that probably are going to seek a better avenue, a better yield than we're willing to pay for.

So you could expect those to most likely move off the balance sheet first. When you get to the middle which is at 40% to 60% beta, those are accounts that had stimulus or small business accounts with a disproportionate amount of cash in their accounts that we think will normalize over time. I think you'll see a little bit of both. You'll see some of that move off the balance sheet. You'll see some of that where we'll pay a higher price.

But at the end of the day, we're going to have to monitor that. We have a deposit rate committee. This is what they do every month. They meet to try to figure out what we should pay. As you know, our deposit beta was among the lowest of the peer group, we expect that to be true going forward because of our granular, high-promising deposit base.

So that one has that middle $13 billion is something we're going to have to watch closely to see whether it stays on. And if it does, what will it cost us? There is going to be an avenue for both of these, that is in the middle column and the right for off-balance sheet opportunities where we'll move those out of the bank, but we'll be able to have a fee associated with that. It will help compensate us a little bit. It won't cover what we're earning today or likely earning as rates move up. But nonetheless, it will be a bit of a carry for us going forward.

[Betsy Graseck, Morgan Stanley]

Okay. And then since we're looking for 100 bps up in 2Q, right, in May and June, 50 bps each, we should start to see some of this surge deposit exit in 2Q, shouldn't we? Or do I have that wrong?

[David Turner, CFO]

Yes. No, I think you're exactly right. I think, again, when it's 25 basis points, that may have been different. 50, pure large corporation that has non-operational deposits. You're going to be moving pretty quickly. So again, we expected the $5 billion to $10 billion that we talked about to move off in the first quarter, it did not. Now our corporate deposits were about flat on an average basis. We do expect that after this 50 basis points for that to start happening. So yes, you would expect deposits to be down in the second quarter as a result of that.

[Betsy Graseck, Morgan Stanley]

Okay. And then just 2 other things. One is, what factors will drive you to shift your excess cash to securities? Are you going to be waiting to get through like 80% of the Fed funds rate hike to assess and then redeploy? Or are you going to be redeploying along the way?

[David Turner, CFO]

Well, I think we've redeployed some. So we put $1.5 billion to work this last quarter. As spreads continue to actually gap out a bit, things like CMBS -- Agency CMBS was a good place for us. I guess we put at, what, 2.80 was $1.5 billion. If you were to do that today, it would be closer to 3.5. So it's kind of a little bit of a game we need to just watch and see what the rate environment will give us. We do have some cash we can put to work if our beta assumptions are better, then we'll have that much more cash to deploy over time. And our guidance we're giving you doesn't have that -- does not have that baked into the guidance. But using the spot securities and the forward starting swaps, all that's baked into our hedging strategy that we're trying to put in place so that we can protect a really nice margin that we think we can get to over time, and we've given you that guidance on one of our slides, on Slide 8. And I think in our pre-recorded message, we think we can push up to 3.75 with a 2.50 Fed funds. So that would be quite nice for us.

[Betsy Graseck, Morgan Stanley]

Okay. And last question is just on -- you had the AOCI hit. I know Gerard spoke about that with you earlier on the call. The long end of the curve, obviously, is up since March 31. So should we expect like for the DV01 hit in this quarter would be similar to last quarter for a like DV01 move? Or are some of these hedging strategies that you indicated earlier changing that? And I'm really asking what we need to take into consideration as we think through to 2Q with this rate back up what the AOCI hit could be.

[David Turner, CFO]

So my first point would be to ignore it, and you don't have to do the math and you go on to something else. But if you want to track it for whatever reason that you have, I would expect it to probably negatively impact us, but not to the tune of what it did this past quarter, partially because of what we're lagging into right now. And frankly, the change in the long end isn't going to be as -- we don't think be as severe as it was this quarter. So good luck with your math.

[Betsy Graseck, Morgan Stanley]

Those hedging strategies you talked about earlier help you on that front, is that accurate statement or not?

[David Turner, CFO]

Yes. That's right.

[Operator]

Your final question will come from the line of Bill Carcache with Wolfe Research.

[Bill Carcache, Wolfe Research]

Following up on your response to Both Gerard and Betsy, I appreciate your comments around how it doesn't make any fundamental economic sense to mark securities to fair value on the left-hand side of your balance sheet without also marking the deposits to fair value on the right side. And so fundamentally, available for sale OCI hits are nothing more than accounting noise. But how would you respond to the idea that in the recession bank stocks are going to trade down to tangible book value. And so while it may not matter fundamentally, from a practical perspective, it's something that investors trying to care about

[David Turner, CFO]

Yes. So this whole concept of tangible book value came about in the recession. To the extent we have a recession, the rate environment is actually going to go the other way and securities are going to be worth that much more. And so again, I think you -- if you want to mark the entire balance sheet to fair value, that would be reasonable, especially in trying times where you're trying to figure out what the true fair value of net assets are for a given company. But the total concept of tangible book value, in my opinion, is really not a going concern issue. It's a failure notion. It's, I'm going out of business, what I get as a shareholder if we liquidate everything?

And the biggest issue I have with OCI is you're marking one element of the entire balance sheet. Securities, you're not market loans, you're not marketing deposits or anything else. So you're not getting a very good understanding of what true tangible book value is in any rate scenario. But I realize I'm in the minority and people just do -- are going to do what they want. But in a recession, and it actually goes the other way because the rates will be down.

[Bill Carcache, Wolfe Research]

Understood. Yes, that makes sense. You guys have exhibited prowess in protecting your margins through the hedge program. I guess is there anything that could be ever considered wanting to protect that tangible book? Or maybe since it is a focus of investors may be introducing the concept of tangible book value ex available for sale might be something that people focus on because, I guess, with the passage of time, those open marks would not be realized if you held the securities to maturity?

[David Turner, CFO]

Yes. I don't -- again, we don't use this to manage our bank at all. We don't use it for capital. We don't use it for rating agencies. So to put it in held to maturity where we don't have to have a mark, all that does is restrict our ability to manage the portfolio the way we want. And so, we don't see any need for that. We do realize there are some people for whatever reason that this is important. And all I'm saying is go calculate the fair value of our deposits, which will be in our 10-Q coming up and just add that in as you're thinking about tangible book value, then we at least have a better idea of what it is.

[John Turner, President & CEO]

Thank you very much. I think that's all the questions we had. So thank you all for your time today. Thanks for your interest in Regions. Have a great weekend.

[Operator]

This concludes today's conference call. You may now disconnect.