Regions Financial Corp
NYSE:RF
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Regions Financial Corp
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Good morning, and welcome to the Regions Financial Corporation's Quarterly Earnings Call. My name is Shelby, 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.
Thank you, Shelby. Welcome to Regions’ second quarter 2020 earnings conference call. John Turner will provide some high level commentary and David Turner will take you through an overview of the quarter. Earnings-related documents, including forward-looking statements, are available under the Investor Relations section of our website. These disclosures cover our presentation materials, prepared comments, as well as the Q&A segment of today's call.
And with that, I will turn the call over to John.
Thank you, Dana, and thank you all for joining our call today. Over the last four months, we've experienced tremendous disruption and uncertainty caused by both COVID-19 and overt examples of social inequality. The impact on our customers, communities, and associates has been profound, and the resulting operating environment has been challenging. As our country works through the current health crisis and take steps to address the systemic racial injustices that impact so many people in our society, we remain focused on the things that we can control.
We're committed to supporting our associates, our communities, and our customers through these difficult times by providing much needed capital, advice and guidance, and financial support. It is incumbent on us to use our resources and expertise in ways that create positive change. Providing value to all stakeholders creates the foundation to deliver sustainable long-term performance.
The disruptive and uncertain operating environment has presented both opportunities and challenges. In the second quarter, we delivered $646 million in adjusted pre-tax pre-provision income. This was Region's highest PPI in over 10 years, and a reflection of our decade long effort to optimize our balance sheet and improve risk adjusted returns while making strategic investments, all to deliver sustainable performance and reduce variability in our revenue streams.
However, while the core business performance was solid, it was more than offset by an elevated provisions caused by further deterioration in the economic outlook and the resulting impact on risk ratings and credit quality. Just a few weeks ago, while acknowledging that conditions were fragile, I said we were cautiously optimistic about the prospect for economic recovery in our footprint.
The southeast had fared better than other parts of the economy as evidenced by the fact that the unemployment rate in the majority of southeastern states had been better than the national average. And the number of small businesses it closed within the region, because of the crisis, was also below the national average. Most of the states where we operate had reopened, consumer deferral requests have begun to taper off and consumer spend continued to increase toward more normal levels.
So clearly, there were some positive signs that we felt pretty good about. However, by the end of the quarter, certain areas in our footprint began experiencing an acceleration in COVID-19 cases and some states paused or reversed their reopening plans. The potential for a second wave of COVID-19 infections, coupled with uncertainty surrounding the extension, or renewal of various aid programs included in the CARES Act has impacted our view on the potential pace of the recovery.
While we have experienced positive momentum over the latter part of the quarter, much uncertainty remains and our provisioning reflects that. As a result of this environment, we recorded a second quarter credit loss provision of $882 million. The provision reflects adverse conditions and significant uncertainty within the economic outlook, combined with downgrades in certain portfolios, particularly energy, restaurant, retail and hotel, as well as the impact of $182 million in net charge offs. This quarter’s provision also includes $64 million related to the initial allowance for non-credit deteriorated loans acquired in the purchase of Ascentium Capital, which closed on April 1.
We're committed to assisting our customers through this difficult time. However, we have not modified our rigorous credit review process and have continued to make risk rating adjustments as necessary. In addition, all business loans granted a deferral had been reviewed, and risk ratings have been adjusted in accordance with our existing policies. Based upon the work we've done and our assumptions around the economic outlook, we do not anticipate substantial reserve bills during the remainder of 2020.
We know the economy will continue to experience stress as we combat the public health crisis. However, we've spent a decade strengthening our capital position and credit risk management framework, which have positioned us well to weather the economic downturn. In the most recent round of supervisory stress tests conducted by the Federal Reserve, regions exceeded all minimum capital levels.
While we were pleased with our capital resiliency under stress, we believe our industry leading hedging program, which became effective in 2020 will provide additional support to pre-provision net revenue. With respect to our common stock dividend, the Federal Reserve has introduced an income test where the common dividend cannot exceed the average of the trailing four quarters net income. Management will recommend to the Board later next week that we maintain the dividend for the third quarter of 2020.
We are committed to effectively managing our capital and strengthen organic growth, generate sustainable long-term value for our shareholders, and continue lending activities to support customers and communities during the economic downturn. That being said, we must continue to focus on what we can control and remain committed to prudently managing expenses in the face of a challenging revenue environment.
Thank you for your time and attention this morning. With that, I'll now turn it over to David.
Thank you, John. Let's start with our quarterly highlights. Second quarter results reflected a net loss available to common shareholders of $237 million or $0.25 per share items. Items impacting our results this quarter included a significant credit loss provision, pandemic-related expenses, branch consolidation charges, expenses associated with the purchase of our equipment finance business, Ascentium Capital, and a loss on early extinguishment of debt.
Partially offsetting the negative adjustments was a favorable CVA associated with customer derivatives as credit spreads improved significantly during the quarter, as well as net interest income derived from newly originated Paycheck Protection Program loans. In total, the adjusted and additional selected items highlighted on the slide reduced our pre-tax results by approximately $692 million.
Let's take a look at our results starting with the balance sheet. Adjusted average loans increased 11%. Loan growth was driven primarily by elevated commercial draw activity, the addition of $2 billion in loans related to our equipment finance acquisition, and $3 billion average impact from newly originated Paycheck Protection Program loans during the quarter.
Looking ahead, our focus remains on client’s selectivity and full relationships with appropriate risk-adjusted returns. Commercial loan utilization levels normalized during the quarter, as liquidity concerns have eased, and corporate borrowers have accessed the capital markets. In addition, corporate borrowers were generally feeling better about the economic outlook as the economy started to reopen.
Although the recent rise in COVID-19 cases may tamper that perspective. With respect to PPP loans, it remains difficult to predict the timing of loan forgiveness. Currently, we anticipate forgiveness requests to begin in the third quarter and continue into the fourth. We will have a better idea around timing once the forgiveness process begins. Adjusted average consumer loans decreased 1% reflecting declines across all categories except mortgage, which was up 3% reflective of historically low market interest rates.
Turning to deposits, deposit balances increased to record levels this quarter. Average deposits increase 16%, while ending deposits increased 17% as many of our commercial customers have brought their excess deposits back to regions, while also keeping their excess cash from line draws, PPP loans and other government stimulus in their deposit accounts. On an ending basis, corporate segment deposits increased 30%, while wealth and consumer segment deposits increased 6% and 12% respectively. These increases were partially offset by a decrease in wholesale brokered deposits within the other segment.
Although commercial line utilization rates have normalized, corporate customers are using cash held outside of the bank to pay down line draws, which continues to support elevated deposit levels. We anticipate funds received through government stimulus, and PPP will be spent by the end of the year, and the remaining deposits will stay with us until interest rates begin to move higher. Similarly, consumer deposits have continued to increase primarily due to government stimulus programs, coupled with lower overall spend. The delay in the tax filing deadline until July is also a contributor.
We anticipate consumer balances to the decline in the second half of the year, as consumers make tax payments, increase spending commensurate with improvement in the economy and the current round of federal unemployment benefits expire at the end of July. Let's shift to net interest income and margin, which remain the strong story for regions. Net interest income increased 5% linked quarter, and as expected net interest margin decreased 25 basis points to 3.19%.
Net interest income remains a source of stability for regions despite an extremely volatile market interest rate backdrop. Linked quarter, our equipment finance acquisition elevated loan and deposit balances and our significant hedging program supported net interest income. The decline in net interest margin was mostly attributable to elevated liquidity, specifically, elevated cash levels at the Federal Reserve and higher low spread loan balances associated with PPP accounted for approximately 19 basis points of margin compression.
Efforts to reduce these elevated cash levels are ongoing. During the quarter $7.4 billion of early extinguishment of FHLB advances, and a $650 million bank debt tender directly reduced outstanding cash balances. The implications of liquidity on net interest margin are expected to abate over the remainder of the year. However, the impact remains uncertain given the amount of liquidity in the system.
Now that most of our forward starting hedges have begun, and given our ability to move deposit costs lower, our balance sheet was largely insulated from the decline in short-term rates this quarter. Loan hedges added approximately $60 million to net interest income and 19 basis points to the margin. The benefits from hedging will continue to increase as the majority of the remaining forward starting hedges begin in the third quarter.
Current estimates for the third and fourth quarters have hedging benefits approximating $95 million per quarter. Recall, our hedges have roughly five year tenors and a quarter-end pre-tax market valuation of $1.9 billion an important relative differentiator. Total deposit costs were 14 basis points for the quarter, representing a linked quarter decline of 21 basis points. Regions continues to deliver industry leading performance in this space exhibiting the strength of our deposit franchise.
Over the coming quarters we expect deposit costs to further decline to historical lows. Lower long-term interest rates negatively impacted net interest income and net interest margin during the quarter. Premium amortization increased $7 million to $33 million attributable in-part to an unusually low first quarter. Furthermore, the re-pricing of fixed rate loans and securities at lower market rates reduced net interest income and net interest margin by $8 million and 3 basis points, respectively.
Looking ahead to the third quarter, let me start by saying the uncertainty surrounding the timing of forgiveness for PPP loans may create volatility in net interest income across quarters, given the impacts from fee acceleration. We currently anticipate NII to decline between 1.5% and 2.5% linked quarter, mostly from the normalization of line activity that was elevated in the second quarter. Excluding PPP and excess cash liquidity, our core net interest margin is expected to stabilize in the mid-to-high [3.30s].
Now let’s take a look at fee revenue and expense. Despite the challenging operating environment, adjusted non-interest income increased 18% quarter-over-quarter. Capital markets experienced a record quarter, producing $95 million of income. Excluding favorable CVA, capital markets income totaled $61 million. Growth in capital markets was driven by record debt and equity underwriting, as well as record fees generated from the placement of permanent financing for real estate customers.
In light of the current environment, it is reasonable to expect capital markets to generate quarterly revenue, excluding CVA in the $40 million to $50 million range. Mortgage income increased 21% driven primarily by record production volumes associated with a favorable rate environment. Lower interest rates have contributed to a significant increase and year-over-year production.
In fact, our full-year 2020 production is expected to exceed full-year 2019 levels by 50%. Mortgage remains a core business for regions and our strategic decision to add a significant number of mortgage bankers last year is paying off. Closed mortgage loans in the month of May represent the highest single month in our company's history and we continue to experience elevated application volumes throughout the quarter.
In addition, mortgage servicing continues to be a strategic initiative. During the quarter, we initiated the new flow arrangement, allowing us to grow the servicing portfolio after experiencing several quarters of net decline. We expect mortgage to remain a strength in the consumer bank for the remainder of the year. Wealth management revenue declined 6% driven primarily by lower investment services fee income, which has been negatively impacted by reduced branch activity.
Service charges revenue and card & ATM fees decreased 26% and 4% respectively, driven by lower customer spend activity. Consumer debit card spend has improved across the second quarter in fact, in the month of June, transactions were up slightly year-over-year, while spend was up over 15% year-over-year.
Consumer credit card spend has improved as well, although June transaction levels were approximately 6% below the prior year, while spend was down 4%. The current environment has led to reduced overdrafts and credit card balances are lower quarter-over-quarter.
Looking forward, if current spend levels persist, we estimate consumer service charges and card & ATM fees will be reduced by approximately $10 million to $15 million per month from pre-March levels. So, despite elevated unemployment, consumers appear to be holding up well. They entered the pandemic in a position of strength, and while spend levels are improving; customers continue to deliver while carefully managing their finances.
Wrapping up non-interest income, market values associated with certain employee benefit assets improved during the quarter, resulting in a significant quarter-over-quarter benefit. While this increased non-interest income, it was fully offset by corresponding increase in salaries and employee benefits expense.
Let's move on to non-interest expense. Adjusted non-interest expenses increased 9%, compared to the prior quarter. Salaries and benefits increased 13% driven primarily by the liability impact associated with positive market value adjustments on employee benefit accounts.
Elevated production based incentives, temporary [COVID pay] increases, the addition of approximately 460 associates from our equipment finance acquisition, as well as our annual merit increases, also contributed to the increase. Professional fees increased 56%, driven primarily by legal fees associated with the completion of our acquisition. FDIC assessment increased 36% attributable primarily to the effects of unfavorable economic conditions, a higher assessment base and a reduction in unsecured bank debt.
In addition, expenses associated with Visa class B shares sold in a prior year increased to $9 million. The company's second quarter adjusted efficiency ratio was 57.7% and the effective tax rate was 18.3%. We continue to benefit from continuous improvement processes, as we have just completed over 50% of the current list of identified initiatives. For example, excluding our equipment finance acquisition, we have reduced total corporate space by almost 700,000 square feet, or 5% since the second quarter of last year.
Through the pandemic, we have learned how to interact and communicate with customers and each other in new ways. We have seen a dramatic increase in digital adoption and continue to have success through increased calling efforts using video conferencing. Our video conferencing accounts have increased by 128% since mid-March, and year-to-date we have already surpassed a number of video conferencing sessions conducted in all of 2019. This is clear evidence our associates and customers are embracing alternatives to in-person meetings.
In addition, year-over-year mobile deposits are up 36%. Deposit accounts opened digitally are up 29% and digital logins are up 24%. Further, almost half of our new digital users in 2020 have come from customers 40 years and older. In fact, digital played a significant role in our ability to assist our customers in obtaining PPP loans during the pandemic. Approximately 80% of applications were submitted online and 97% were closed using e-signature.
We have been actively reducing the size of our retail network for several years now. In fact, we consolidated 36 branches this quarter. Because of increased digital adoption and changing customer preferences, we expect branch consolidations to continue. Customers have an increasing desire for an omni-channel delivery model for their banking needs. So while we consolidate branches, we will continue to add new modern locations that are best suited to provide the advice and guidance our customers expect.
Similarly, we are evaluating our digital and technology spend priorities to best leverage the digital momentum we are experiencing. This shift will allow us to focus on enhancing digital banking capabilities, further advancing our digital sales capabilities in leveraging e-signature to make banking easier for our customers. We also believe there are additional opportunities where corporate space is concerned whether through increased use of [hotelling], work from home or modified scheduling; we are confident overall office square footage will continue to decline.
Our expense number this quarter has a bit of noise in it, and I want to spend a few minutes walking through. If you start with our adjusted total expenses of $898 million and back out unusual items we don't adjust for, such as the expense associated with employee benefit accounts and total COVID related expenses, you get back to the core quarterly run rate, inclusive of our equipment finance acquisition in the $860 million to $870 million range.
To be clear, we remain committed to making the investments needed to grow our business. However, our overall expense base must always be reflective of the revenue environment. So to an extent, the revenue environment is challenged, we will look for additional efficiency opportunities.
So let's move on to asset quality. The credit loss provisions for the quarter totaled $882 million. The provision reflects adverse conditions and significant uncertainty within the economic outlook combined with downgrades in certain portfolios, as well as the impact of $182 million in net charge-offs. Portfolio level downgrades were made primarily within energy, restaurant, hotel, and retail while economic outlook uncertainty is centered primarily on the impact of unemployment and the benefits of government stimulus already enacted and the potential for additional stimulus.
This quarter’s provision also includes $64 million establishing the initial allowance for the non-credit deteriorated small business loans acquired as part of our equipment finance acquisition, which closed on April 1. The resulting allowance for credit losses is 2.68% of total loans and 395% of total non-accrual loans. Importantly, excluding the fully guaranteed PPP loans, our allowance for credit losses increases to 2.82% of total loans.
Annualized net charge-offs were 80 basis points this quarter. The increase reflects charges taken within the energy and restaurant portfolios. Additionally, for the first time, our results now include charge-offs related to our recent equipment finance acquisition. These charge-offs contributed to $24 million decline in total non-performing loans. Total delinquencies and troubled debt restructuring loans increased 6% and 5%, respectively. Business services criticized loans increased 67%.
Despite our willingness to work with our customers during this difficult time, we are not relaxing our credit policies and continue to revise risk ratings as necessary. This approach as well as specific portfolio level downgrades led to a significant increase in criticized loans. We have executed a bottom up approach to review all of our stressed business portfolios and feel this gives us good insight into potential loss and underlying stress over the second half of the year.
With respect to consumers, they entered the pandemic in good shape in relation to jobs, income, loan devalues, et cetera. They have clearly benefited from the government stimulus, and recent momentum in the jobs numbers has been positive. However, resurgence of COVID-19 cases has slowed some re-openings and expectation of certain federal benefits ending in July create some downside risk.
Based on the work we have completed and what we know today, we do not anticipate substantial reserve builds during the remainder of 2020. Additionally, we anticipate net charge-off levels for the remainder of the year to be consistent with the second quarter.
In addition, we've continued to refine our view of at-risk portfolios resulting from the pandemic. Through our engagement with customers and actual market observations gained through the quarter, we have a more informed view of which sectors can withstand operations in this new normal.
As a result, the portion of our portfolio we consider to be at the highest risk of potential loss due to the pandemic declined from $12.4 billion at the end of last quarter to $8.4 billion at June 30. This amount includes loans acquired during the quarter from our equipment finance acquisition.
With respect to loan deferrals, we will have better insight in the next few weeks as the initial deferral periods expire, but we continue to see positive underlying trends. As of July 1, approximately 34% of clients have made mortgage payments, [while in forbearance] in the last 61 days.
For home equity, payments while in deferral have been 36%; credit card is at 56%; and auto is at 41%; and approximately 25% of our corporate banking clients in deferral have made a payment in the last 61 days. While we have modeled second business loan deferral request at approximately 40%, early trends indicate request or tracking at less than 10% for both commitments and relationships.
Let's take a look at capital and liquidity. Our common equity Tier 1 ratio is estimated at 8.9%. In late June, we received notice that the company exceeded all minimum capital levels under the supervisory stress test. Our preliminary stress capital buffer for the fourth quarter of 2020 through the third quarter of 2021 is currently estimated at 3%. This represents the amount of capital degradation under the supervisory severely adverse scenario and is inclusive of four quarters of planned common stock dividends.
These results allow Regions to manage capital in support of lending activities and focus on appropriate shareholder returns. Our current capital plan reflects a previously announced suspension of share repurchases through the end of 2020. With respect to the common stock dividend, management will recommend to the Board that the third quarter dividend remain at its current level.
Looking ahead, we expect to maintain the dividend. However, future payout capacity will be dependent on earnings over the second half of the year and any constraints imposed by the Federal Reserve. Also, it is important to note that we have approximately $1 billion of pre-tax security gains in OCI that are not included in our regulatory capital numbers unlike advanced approach banks. We exclude OCI from our capital calculations, but nonetheless, it is available to absorb potential losses.
As previously noted, we have an additional $1.9 billion of pre-tax gains on our cash flow hedges in OCI, which is also excluded from regulatory capital. Terminating these hedges would not provide immediate recognition in income or capital as a gain would be deferred and amortized into income therefore supporting capital over the remaining life of the derivatives.
These transactions are hedges designed to protect net income in a low rate environment. We believe there is incremental value in leaving the hedges live based on the current forward five-year LIBOR curve. However, we continue to evaluate and discuss decisioning points. This demonstrates significant additional loss absorbing capacity, which is not reflected in our regulatory capital levels.
With respect to liquidity, significant deposit growth during the quarter has contributed to historically elevated liquidity sources for the company. Deposits ended the quarter at record levels and contributed to a 10 percentage point decline in our loan-to-deposit ratio to 78%.
So in summary, our robust capital and liquidity planning processes, which are stressed internally, as well as externally by our regulators, are designed to ensure resilience and sustainability. This gives us confidence that we can continue to meet the needs of our customers and communities during this exceptional period of economic uncertainty. Despite the uncertain environment, we remain focused on helping our customers, associates and communities navigate through this difficult time. We have a solid strategic plan and are committed to its continued execution. Rest assured, during this extraordinary time, Regions stands ready to help and support all stakeholders.
With that, we are happy to take your questions. Considering the current environment, we do ask that each of you ask only one question to allow for more questions and participants. We will now open the line for your questions.
Thank you. The floor is now open for questions. [Operator Instructions] Your first question is from Betsy Graseck of Morgan Stanley.
Good morning, Betsy.
Hi, good morning. Thanks very much.
Good morning.
Hi. Okay, a couple questions, one, just on the outlook here for net charge-offs, you highlighted, you know, flat in 2H or so and I guess I'm just trying to understand how you're thinking about the trajectory from there. Is it that at this current run rate, you feel like you're anticipating the, you know, near-term impact on the portfolio? Or is it that you don't expect an uptick in net charge-offs until things like stimulus roll-off?
Hey, it’s Barb and I'll go ahead and respond to that, Betsy. It's a couple of things. One is we've done a deep dive in all of our portfolios. You know, virtually 95% of our business services portfolio, we've had conversations with the first line and credit together; we've talked to customer-by-customer, et cetera; we've had ongoing discussions of – some of them are happening weekly, some of them monthly, some of them bi-weekly, et cetera.
So, we really feel good about the information we have on which to look and say which customers may create an issue, but we also made a change in our thinking over the – you know since the last great recession, which is we don't want to let problems age. So if we see a problem out there and we think it might hit towards a charge-off, we are actually moving it towards charge-off, hoping we'll get a recovery in due course, but that recovery is going to be much further out. So, as we think about getting to – and that's part of what's in the second half thinking.
As we get to the beginning of next year, what we anticipate is that on our business services side, the commercial part of the book, that those numbers will indeed come down and consumer is a bit of the wild card because you're right, once the deferments roll-off and the stimulus rolls off, how will they behave? But so far, I'm pretty encouraged by what I see relative to people asking for things like second deferrals, et cetera, early on, but still encouraged somewhat on that front.
Okay, that's helpful color. And I noticed, yes, the NCOs are up a little bit Q-on-Q more than what we've seen out of other institutions, so that reflects your more proactive stance, I guess, with moving people into the NPLs. Can you give us …
Yes, and Betsy, you know, just to correlate that, you see a little decline in non-performing loans quarter-over-quarter, which I think is again, a reflection of the fact that we're moving those charge-offs through the system.
Yes. Yes, exactly. Okay. A follow-up question just on the outlook for NII guide down 1.5 to 2.5 in 3Q Q-on-Q, could you just give in – give us some color around the inputs to that with regard to what you're thinking about for average earning asset growth versus the NIM? And then I know with the hedges, your core NIM is mid-to-high 330s. You know, you've got some benefit from PPP at some point through the next couple of quarters as well, so you can give us some sense of the trajectory for the main pieces into 3Q. And then, as we look for PPP, how we should anticipate that flows through from here? Thanks.
Yes, there's a lot in there. So, let me see if I can bullet down. So what we don't know is what the regime is going to be on forgiveness of PPP, so we don't have anything meaningful really coming through other than the carry that we are getting, which is, you know, pretty low carry. Probably the biggest driver is reduction in the loan book that we see. There were a lot of draws that happened in the late first quarter and in the second quarter and we saw about 80% of those be repaid by the end of the second quarter, but there's still some more that are going to be coming through. And so, I think it's reflective of that continued decline in loans.
The other is – so our deposits were up some 16%. You know, big part of that, we believe is also driven by the fact that the tax payment date was moved to July 15. And so, we should expect a run-off of deposits in the quarter, and therefore, using some assets from that standpoint. So, when you kind of add all that up, we're going to have premium amortization in terms of prepayment.
So, we had talked about that being up in the $33 million range this quarter, that's probably going to be close to the upper 30s this next quarter as we see prepayments increase. And then, you know, we've talked about the reinvestment of cash flows from fixed rate loans and securities that have to go on the books at prevailing rates, that component of it cost us $8 billion this past quarter and that's harder to hedge out. So we're fully protected on the short-term moves, but we aren't – we still have some exposure to the reinvestment piece. So, you add all that up and that's where that decline in the NII is coming from.
Betsy, I should also point out that, you know, the benefit from our hedge is in the first quarter were about $10 million. What we saw this quarter was about $60 million and the benefit we'll see in the third quarter assuming rates are in the third quarter and beyond all the way for five years is about $95 million. So the hedges, we're very thankful that we have those and that's a big part of us keeping the stability of our NII and resulting core margins.
And so then, I know you don't have anything in your numbers for – you know your guidance obviously for PPP, but as those loans are forgiven, you get a temporary uptick in your NII, and so you're just going to treat that as, you know, kind of a one-off, is that how we should be thinking about it?
Well, again, it depends on what the regime is. If we end up having an unusual bump in any given quarter, we’ll point that out so that investors understand that. You know if it comes in over time and it's just kind of part of our business, maybe we wouldn't, but right now, it's just so – we don't know what the regime is going to be and when we get further guidance on that we’ll tell everybody and reforecast for you.
And David – this is, you know, Ronnie Smith, Betsy. Just to reiterate, there has been an extension from the initial eight-week period that businesses were able to count the funds that qualified for uses under PPP. So that 24 weeks has pushed that out a bit depending on which process the customers elect.
Okay. All right, thank you.
Thank you, Betsy.
Your next question is from Ken Usdin of Jefferies.
Hey, Ken.
Thanks. Hey, good morning, everyone. You know obviously, with the big reserve this quarter, the CET1 ratio slipped a little bit below the 9% zone where you talked about being comfortable. And I just wanted to ask you to kind of flush that out vis-a-vis your other comments about, you know, continuing to recommend the dividend, the back and forth between comfort on where your ratio sit, where do you think that CET1 can get back to? And then, put that in context of the – you know, the income constraint and how you think about that, too? Thanks.
Sure. So, I assume everybody's looking at the Slide 18, where we have our waterfall and you could see the positive contribution generated from our core engine, our PPNR and then the impact of the dividend. So between those two is 50 basis points to the plus. We did have provision expense that drove that down, as well as our acquisition of Ascentium in the first quarter.
So – well, I think we'd all acknowledge we're in some form of stress in the country and we've always said our mathematical calculation would lead us to desiring a common equity Tier 1 of 9% and we’re holding a little excess capital to take advantage of opportunities, which one occurred, Ascentium. And so, you should expect, as you look at that waterfall chart, and again, we don't expect to have a provision at the level we just had.
So, we can accrete that capital back pretty quickly, while we also have pretty robust reserves. If you look at our coverage, distress losses now, so you know, we couldn't pick the timing of when that particular transaction hit. We went to [8.9]. We're comfortable where we are, but dividend is not a capital adequacy issue. You can glean that from the DFAST analysis that came through.
Now, we're going through some form of a stress test in the fourth quarter and we're not sure exactly what that regime is going to look like. What we do know is that we have, for the third quarter of the dividend limitation on the past four quarters, you know, based on our math, as we mentioned in the prepared remarks, we'll be recommending to our Board to sustain the dividend in third quarter. As we think about the fourth quarter and the first quarter of next year, we don't know if that regime will continue and we have to suspect that it might. And therefore, we gave you guidance that we believe our dividend is sustainable going out into the fourth quarter and into the first quarter based on our expectations of forecasted earnings.
That being said, the two caveats are, let's see what the economy looks like when we prepare the financial statements for September 30 and we'll make, you know, whatever adjustments are necessary. And then, whatever the Federal Reserve and supervisors may do in this fourth quarter analysis, we don't know. So, those are the two caveats, but based on what we can see, we feel good about sustaining the dividend.
Thank you, Ken.
Our next question is from Stephen Scouten of Piper Sandler.
Good morning, Stephen.
Hey, good morning. Yes, I was wondering if you guys could give a little more color around the loan deferrals. I know you said your expectation for second deferrals are maybe 40%, you're tracking under [10%]. And I'm also kind of wondering how much of those may be deferred loans that are still performing were downgraded from a rating perspective because it feels like you guys are ahead of your peers in terms of changing risk ratings, but I want to see if you can frame that up for us a little bit.
Barb, you want to speak to that?
Sure. Yes, so as we – when you talk about referrals in general, to begin with, I’ll start with consumer, work my way to Business Services really quick, Stephen. And so, for consumer, what we saw is that deferral rate all in, in fact, for the company, it’s about 6%. What I was looking at, in fact, earlier this morning is that those numbers are in fact coming down and so far in consumer, we've had no requests for second deferral yet. Mind you, it's early, and some of the first deferrals are just rolling off, but it's still a good encouraging early sign.
For the Business Services portfolio, all-in, it's about 6% as well. And again, talking to our customers, that's – you know again, the benefit of these one-by-one conversations, we've heard very limited need for a second deferral, so again, very encouraging news from that front. Relative to those that are deferred and the percent, you know, that are criticized within those, we've given a chart on Page 12 that doesn't give the criticized portion of the deferrals, but you can [intuit] from it that the criticized are large portion of those criticized percentages were – do include a deferral.
Ronnie Smith, you want to talk about the wholesale book?
Yes, John. Just from a – just the numbers, if I step back into it, Stephen, we've – we have 2,000 clients in the wholesale book that have requested deferral and out of that particular universe, we are seeing, and I think David said this in his opening comments, but we're seeing a very low request for a second deferral period. And we are using that as a leading indicator to go in and provide a scrub on a name-by-name basis to appropriately assign risk ratings to those clients who had requested a deferral.
We're finding, as you can tell, in the early returns, and I want to stress its early, less than 10% of those are requesting a second deferral period. And so, that shows the strength of cash flows, liquidity that they have built up. And so, we feel good about where we are at this point, but there's a lot more deferrals that need to mature as we continue to work with each of these clients.
Okay. Very, very helpful. And if I could ask David one clarifier on the expense guidance or information you gave, you said $860 million to $870 million is kind of a better longer term run rate, maybe when do you think you can get to that level? And what level of kind of PPP-related expenses are within that number, if you have any guidance there?
Yes. So we think we can get there now. It's just – this past quarter, I acknowledge there’s a lot of noise in our numbers and that's why we actually gave you a little better guidance to what to expect going forward. We had some expenses that came through PPP. They weren't particularly material in any of those that were related to loan originations or deferred as part of the fees that we get and would be amortized over the life of the loan. So, I wouldn't expect anything material from that standpoint hit us in the third quarter and going forward.
Great. Thanks for the color. I appreciate the time.
Thank you.
Your next question is from Matt O’Connor of Deutsche Bank.
Hi.
Good morning, Matt.
I know you guys touched on this a little bit, but coming back to credit, yes, today is an interesting day because, you know, your stock is getting hit because folks think you have worst credit because you reserve for more. Another company came out today and was taking some heat for maybe under reserving. So, you know, from an outside point of view, it's a little hard to tell, like who's being aggressive, who's maybe behind and I guess from your point of view, like, you know, why do you think you are able to kind of be more aggressive than maybe some others? Is it the loan mix? Is it just the data that you have, as you’ve mentioned, has changed quite a bit in your markets, the last six weeks?
I’ll answer that?
Is that the pain that you went through in the last downturn? Is there anything else you could add on that? Thank you.
You know, it is, I think last quarter, we were criticized for potentially under reserving and this quarter there's questions about credit. And I think, you know, I can't speak to what other banks are doing. What I do know is what we're doing. Over the last 10 years, we worked really hard to improve our credit risk management processes. And as Ronnie and Barb described, on the wholesale side of our business, we've been through the large majority, if not all of our portfolios, high-risk portfolios, large exposures, and we have risk rated those credits, we think appropriately. And, as a result, our allowance for credit losses reflects those risk ratings.
We've considered companies, industries, their ability to repay, and we're actively monitoring our portfolios, and so have presented what we believe to be an appropriate allowance given the risk that's currently in our portfolio based upon the economic assumptions we're applying and expected life of loan losses. And, you know, it's our anticipation that the portfolio will, as David has described, perform consistent with in the future, at least next two quarters. Well, charge-offs will approximate [over the] current levels and we don't anticipate any significant additional provisioning if there are no changes in the economic environment and if our, you know, credit quality doesn't further deteriorate because of changes in the economic environment.
Yes, we’re trying to help everybody in our Page 19 showing the allowance waterfall and you can see the economic outlook component of $242 million that was added to the reserve and that's a reflection of – the primary driver for this is unemployment. So, when we were at the first quarter, you know, our expectation of unemployment was closer to 9%. Today, its 13%. That's a big delta. And the question is how quick is the recovery going to be? What's the impact of stimulus?
So there's a lot of work that goes into ultimately determining what the allowance needs to be. We are risk grading. And Barb, you may want to chime in on this risk grading relative to what we see in the book from the ground up process that was earlier described and that's the [$382 million] that you see in the middle of that page. And remember, on top of that is the charge-off number of about $182 million. So if you add to that, it's about [$564 million of our $882 million] provision. So Barb, you want to talk about the risk rating?
I think we've covered. The point I'd make is though that there is – it's hard to distinguish between deterioration of the credit portfolio and changes in the economic environment because one effectively [begets] the other.
Yes.
I think it visually represents what is just overall, you know, our assumptions based upon the current stress environment that we're in.
Alright, that was helpful. Thanks for coming through that again.
Your next question is from Peter Winter of Wedbush Securities.
Good morning, Peter.
Hi, good morning. Good morning. I was just wondering when I look at the DFAST results, it seemed like they won the strongest they should have been on PPNR. And is there anything that the Fed is missing or anything you can do to address that with the Fed, especially when it comes to a stressed capital buffer?
So Peter, we – you know, as we lay down our prepared comments, we have a unique benefit of our forward starting hedges that we had put in place a couple of years ago, but they didn't become effective until the first quarter of this year for a piece of them. The second quarter had another piece, and then the third quarter, there's one more step up and you can see that in a chart that we put in the slide deck. Because that benefit wasn't in our run rate, we don't believe we got full benefit of that in our PPNR estimation in that last DFAST. As a matter of fact, our PPNR, which we believe should outperform our peer group, in that test it was in the middle of the peers, it was a median [part of] the peer group.
So we're in – having discussions on how that can be reviewed by them differently. Obviously, we're going to go through some form of a stress test this fourth quarter. They'll have the knowledge [indiscernible] of our derivatives and how they come into to protect our PPNR in the stressful times, especially in the low-rate environment. So let's see what happens as they continue to evaluate both the SCB, so it’s a preliminary SCB. The final won't be out until August 31. And then, on top of that, we'll have the fourth quarter stress test of some type.
Alright, thanks.
Thank you.
Your next question is from Jennifer Demba of SunTrust.
Good morning, Jennifer.
Good morning. Just a question on deposit service charges, they were $131 million in second quarter, down from $178 million. What kind of run rate are we looking at for that line item in future quarters? And how much of the waivers are coming back in?
Yes, Jennifer, so, we tried to give a little bit of guidance. So let me roll it forward from the first quarter. If you recall, spin was down quite a bit on the consumer side and that we were concerned at that state at that level is going to cost us about $25 million a month between service charges and card and ATM fees. In our prepared comments, because of the spin coming back, in particular on debit card usage, that number is down to $10 million to $15 million per month at this current level.
Now, in the month of June, we started to see that pick up a bit, but still not to the level that we had seen pre-crisis. A big driver that is the amount of stimulus that’s still sitting in the deposit accounts of our customers. Therefore, you don't have NSF fees, for instance, coming through and you don't have credit card interchange coming through. So right now, we're guiding to $10 million to $15 million per month from the pre-March numbers that you really ought to think through as you model.
Thanks so much.
Thank you.
Your next question is from Saul Martinez of UBS.
Good morning, Saul.
Hey, good morning. Hey, I wanted to go through the dividend math a little bit – in a little bit more detail and I know you guys said just based on your best estimates and realizing there's a lot of uncertainty here, you should be able to pay your dividend. But if the Fed does, you know, extend the dividend cap in the end of the fourth quarter, by my calculation, you guys would have to do about $260 million of net income for deferreds in the third quarter to keep your dividend at $0.16 a share. And, you know, if it's extended into next year, the math gets even more difficult as 2019 rolls off because then presumably that goes up to closer to 300. So, I guess – so what I want to get a better sense for is that when you say that you're confident in meeting your dividends, are you basically saying that you're confident that you'll be able to meet that kind of net income threshold over the next couple of quarters?
Yes, that's what we're saying.
All right. That's good. I’ll be respectful of the one question rule. So thank you.
Okay. Thanks, Saul.
Your next question is from Dave Rochester of Compass Point.
Hey, good morning, guys.
Good morning.
Hey, given all the work you guys have done, but the more at-risk book and those credits under stress, which drove, you know, a lot of these downgrades and the quantitative reserve bills you guys have here, was just wondering what the reserve ratio is that you have on that at-risk book? Or what you're seeing as the, you know, overall potential loss content there?
Yes, and this is Barb, and right now, we would have a reserve ratio on that at-risk book of about a little over 7%. And then, if you look at some of the sub-sectors, you know, energy as an example, those high-risk segments that we point out, 10.5% to give you a sense, restaurants over 7%. So, we think we have a pretty healthy reserve on it.
Great. All right, thanks, guys. Appreciate it.
Thank you.
Your next question is from Christopher Marinac of Janney Montgomery.
Good morning.
Thanks, good morning. Just want to follow up on some points that Bob was making earlier. So, given the changes on the business criticized, and the results of this quarter, what has to change to see that further deteriorate? Do you feel like you're ahead of that with the changes that you made this quarter?
Yes, I would say we're certainly on top of it. And of course, the wild card, as we all know, is what's going to happen in the economy. So, you know, our best view of the economy is what's incorporated into what our thinking is. If all of a sudden we get a second wave that comes in and closes everything down, there's going to be some more pain, but based on what we know today, and back to, you know, I'm really confident on it. As I said, we've gone through; we've had the discussions. They're not a [one and done] discussion. They are an ongoing discussion.
We have these meetings set up with – I’ll use Ronnie’s team again and we have them all in there, we have credit in there; we spend hours going through it. So again, that gives back to giving me that level of confidence that there's nothing that's happening that we're not talking about or seeing, and more importantly, reflecting in our thoughts around what are we going to call a criticized loan or a classified loan, an MPL or charge-off for that matter.
Yes, I think the other caveat is we really – the level of federal government relief is unprecedented and it is very difficult for us to apply any sort of modeling to that. And so, depending upon whether the relief is extended or not, what that looks like, certainly is a factor as we look forward, but that, of course, would influence I think the economic conditions that we're currently assuming as well. So, it is an unusual time, but as Barb said, we feel like we're on top of our reserving and credit issues.
Absolutely.
Great. Thanks for the additional color. I appreciate it.
Thank you.
Your next question is from Vivek Juneja of JPMorgan.
Vivek, good morning.
Hi, good morning. Thank you. Just a couple of clarifications around credit, you mentioned – I think David mentioned, no more reserve build. David, am I to presume that you're – and at the same time you gave a guide on for net charge-offs to remain at second quarter levels? So two elements to that, where are you expecting charge offs? Where’s the – you know in your line of sight that you've given this guidance, you're obviously expecting charge-offs in some categories, which are those? And then, to your reserve point, related to that, David, are you expecting provisions will at least match charge-offs? Are you presuming reserves to loans are not going to start to come down, so you're not starting to release reserves yet, right?
Well, let me start with your back part of the question, and Barb will answer the first part. So the way CECL works is we're supposed to reserve for all losses in the portfolio at the balance sheet date based on all the factors that are – that we can observe, economic indicators and the like. You know, and so, if we do that right and portfolio – the economy doesn't change, there's no degradation in the credit metrics, loans aren't growing, then you wouldn't expect to have provision – you can't have provision necessarily equal to charge-offs. It's kind of whatever it takes to get the reserve to the level it needs to be at the balance sheet date.
So, right now, you know, we think we have it all. But as we did in the first quarter, the caveat we gave you then, we're going to give to you now. We don't know what the economy is going to look like at September 30, but based on what we do know, you know, even subsequent to closing the books, the economy hadn't degraded materially from [where we were when] we set the reserves. So, you know, we're feeling better about that going into the third quarter, which is different than going into the second. So, Barb, you want to answer the…
Yes, first part of the question, which is where are the charge-offs going to come from in our estimation based on the analysis that we've done, the conversations that we've had. Again, primarily from the two portfolios we've already talked about energy and restaurant. We have to see the rest of that play out. There's going to be some retail and some hotel that could impact as well, but that's generally what I would size it up to.
Okay, thank you.
Thank you, Vivek.
Your next question is from Gerard Cassidy of RBC.
Good morning, Gerard.
Good morning, John. How are you?
Good, thank you.
I've got some questions on the forbearance part of this portfolio. Once a technical question on, are you accruing all the interest for those loans, even though the customers that may not be paying versus the ones that are paying? And then a second part of the question is, have you had any conversations with the Fed on when they may go back to their more traditional stance on forbearance and more on how banks have to, you know, carry the higher capital levels against those loans? And the third part of the question is, once you go off forbearance, the Fed says, it ends let's say, second quarter of 2021 and you still got loans on forbearance, will they immediately start going into a non-performing status meaning, you know, being 30 days past due, or will you just immediately put them in a non-accrual because they're already in forbearance?
Georgia, this is David. I'll start with the first part. So loans go onto forbearance, we still accrue interest unless that loan was already on non-accrual status or it had – it didn't have the ability to pay all of its principal and its contractual principal and interest, which case, any payments that we were to receive, we actually write down the principal balance, that's our accounting policy. So for the most part, this type of forbearance that you're seeing, you can see the performance where people are still making their payments, but even if they're not, and they're not on nonaccrual we are in fact accruing interest on those.
You want to talk about second part.
The second part of the question is, we have not had any conversations with the Fed about when they may change their guidance about how we work with customers in respect to the coronavirus. Their initial guidance gave examples, including six month periods of forbearance as examples of how we might consider working with customers, and we really haven't had any guidance since then. The third part of your question I think was hypothetically what do we do if we get out nine months, 12 months and a customer still can't pay, Barb you want to talk about that?
Yeah, I don't see a cliff at that point in time, because what we're doing is, what the process we have in place right now is, we're taking all of that information we have in place today, the customers on deferral, that's but one input point. We're looking at their cash flows. We're looking at a lot of other things to make the determination on the risk rating, which is why you're going to see customers who are paying that we may have sitting in a non-performing loan category and moved to a criticized reclassified category. So, we are making those risk rating changes, not because of the deferral, but as I said deferral is simply a point. So, I don't see a huge Cliff on any of that.
And Barb we are using the deferral as a leading indicator to go dig deeper [drawn into] that relationship, not looking at trailing 12, but what the current information is today. And what challenges that that relationship is facing. So, we're – to Barb's point, we're calling it as we see it today.
This David, I hate to pile on this, but it is important that people understand that. We are – because you are given leeway on forbearance from a regulatory standpoint. If we believe that needs to be rich graded a certain way we're doing that. So that's why you shouldn't see a cliff effect, regardless of what the Fed says about how we can treat loans or TDRs or anything. We're calling that independent – independently.
Exactly.
Thank you.
Thank you, Gerard.
Your final question is from John Pancari of Evercore.
Good morning, John.
Hi, this is Rahul Patil on behalf of John. I just have one question on the efficiency ratio, I mean it is like 2Q 2020 the efficiency ratio was around adjusted basis of 57.7%, you know you talked about your willingness to look at expenses little bit closely if the revenue environment is a challenge. Can you talk about how you are thinking about the efficiency ratio going forward, you know what sort of level is reasonable, assuming that the current conditions kind of stayed or persist through at least year-end? Because I know in the past you’ve talked about a mid-50%, I’m not sure if there is any update on that.
Yes, so we still have that as our long-term goal to get our efficiency ratio down into the mid-50s and then when we get there we are going to be pushing it even harder. So, we have a little bit of volatility obviously in our revenue given changing rate environment, we'll have a little bit of pressure on NII as we've mentioned just a minute ago, for the next quarter, but when you have challenges on revenue, then you have to go back and work on expenses. And that's part of our program. So, while you may see that percentage change a bit, any good quarter to quarter, I think where we are right now is sustainable over time and perhaps working that way down over time as we as we continue to work on expenses and the benefits from further hedges that actually come into force and the third quarter will help us from a revenue standpoint.
Okay. [With no] further questions, we really appreciate your participation today. Thank you for your interest in our company. Have a good weekend.
This concludes today's conference call. You may now disconnect.