Citizens Financial Group - Q4 2022

Transcript

Operator (participant)

Good morning, everyone, welcome to the Citizens Financial Group Fourth Quarter and Full year 2022 Earnings Conference Call. My name is Keeley and I'll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we will conduct a brief question-and-answer session. As a reminder, this event is being recorded. Now I'll turn the call over to Kristin Silberberg, Executive Vice President, Investor Relations. Kristin, you may begin.

Kristin Silberberg (EVP and Head of Investor Relations)

Thank you, Keeley. Good morning, everyone, thank you for joining us. First this morning, our Chairman and CEO Bruce Van Saun, and CFO John Woods will provide an overview of our fourth quarter and full year results. Brendan Coughlin, Head of Consumer Banking, and Don McCree, Head of Commercial Banking, are also here to provide additional color. We will be referencing our fourth quarter and full year earnings presentation located on our investor relations website. After the presentation, we will be happy to take questions. Our comments today will include forward-looking statements which are subject to risks and uncertainties that may cause our results to differ materially from expectations. These are outlined for your review on page two of the presentation. We are also referencing non-GAAP financial measures, it's important to review our GAAP results on page three of the presentation and the reconciliations in the appendix.

With that, I will hand over to you, Bruce.

Bruce Van Saun (Chairman and CEO)

Okay. Thanks, Kristin, good morning, everyone. Thanks for joining our call today. We are pleased with the financial performance we delivered for the fourth quarter and the full year, and we feel well positioned to navigate through an uncertain environment in 2023. We are playing strong defense with a robust balance sheet position and highly prudent credit risk appetite. At the same time, we continue to play disciplined offense with continuing investments in our growth initiatives. We are focused on building out a prudent, sustainable growth trajectory over the medium term. I'll comment briefly on the financial headlines and let John take you through the details. For the quarter, our underlying EPS was $1.32. Our return on tangible common equity was 19.4%, and the efficiency ratio was 54%. Sequential operating leverage was 1% and sequential PPNR growth was 2.6%.

Leading our performance was 2% sequential NII growth, reflecting NIM expansion of 5 basis points to 3.3% and relatively stable loans given the impact of a $900 million reduction in our auto portfolio. Growth was 1% ex this impact. Deposits were solid with 1% sequential growth, and our LDR remained stable at 87%. Our fee businesses showed resilience and diversity given a challenging environment, down about 1% sequentially. A number of M&A fees pushed into Q1 and mortgage results were softer than expected. We maintained stable expenses in the quarter and credit metrics remained good. We boosted our allowance for credit losses to 1.43% of loans, which compares with pro forma day one CECL levels of 1.30%.

We restarted our share repurchase activity in Q4, buying $150 million of stock, and we ended the year with a CET1 ratio of 10% at the top of our targeted range. For full year 2022, we delivered underlying EPS of $4.84 and ROTCE of 16.4% as we captured the benefit of rising rates and our strengthened deposit base. The results handily exceeded our beginning of year guide, which we included in the appendix of the presentation. With respect to our guidance for 2023, we assume a slowdown in economic growth to 1% for the year, two early Fed rate hikes and a Q4 cut, and inflation getting below 3% by Q4. We project moderate loan growth, partially offset by continued runoff in our auto book of close to $3 billion.

Overall, we see solid NII growth as NIM gradually rises to 3.4% over the year. A roughly 8% growth in fees, given a rebound in capital markets fees over the course of the year. Solid expense discipline with core expense growth, ex acquisition and FDIC impacts of 3.5%-4%. We announced today our TOP 8 program, which targets $100 million in run rate benefits, and about 80% of that is expense impact. Credit should be manageable with net charge-offs in the 30-35 basis point range, and we expect to build our ACL to 1.45%-1.5% of loans.

We expect to repurchase a meaningful amount of stock given strong profitability, modest loan growth, and limited expectation for acquisitions with our CET1 ratio forecast near the high end of our 9.5%-10% range. Capital return to shareholders should approach 100% and yield to investors of our dividends plus capital return via repurchase could top 12%. All in all, a very strong year of execution and delivery for all stakeholders by Citizens in 2022. We feel we are well-positioned in 2023 to continue our journey towards becoming a top-performing bank. We continue to make good progress in executing on our strategic initiatives across consumer, commercial, and the enterprise. We've transformed our deposit base and are reaping the benefits. We've adjusted our interest hedging to protect against lower rates through 2025.

Given the improvement in our ROTCE over time, we are raising our medium-term target to 16%-18% from 14%-16%. We've stayed focused on positive operating leverage. We've captured the benefit of moving to a more normal rate environment, and we still have plenty of upside in our fee businesses as market conditions improve. Exciting times for Citizens. I'd like to end my remarks by thanking our colleagues for rising to the occasion and delivering a great effort in 2022. We know we can count on you again in the new year. With that, I'll turn it over to John.

John Woods (CFO)

Thanks, Bruce. Good morning, everyone. Big picture, 2022 was a strong year for Citizens, with significant delivery of strategic initiatives against the backdrop of uncertainty and volatility in the macro environment. Most notably, we closed our acquisitions of HSBC and ISBC. We captured the benefit of higher rates with strong NII and NIM. Our balance sheet and interest rate position were well managed. While fee revenues were impacted by the environment, we are very well positioned across our businesses to capitalize on the upside potential when markets normalize, particularly in capital markets. Mortgage margins and buy-ins should recover over time. We are excited for the growth prospects arising from our wealth investments. We are actively managing our loan portfolio, focusing on allocating capital where we can drive deeper relationship business into 2023 and beyond.

We continue to maintain good expense discipline, delivering in excess of $115 million of pre-tax run rate benefit through TOP 7, generating 4.7% underlying positive operating leverage for the year and 16.4% full-year ROC. Let me give you the headlines for the financial results referencing slide five. For the fourth quarter, we reported underlying net income of $685 million and EPS of $1.32. Our underlying ROC for the quarter was 19.4%. Net interest income was up 2% linked quarter, with 5 basis points of margin expansion to 3.3% and relatively stable loans, given a planned reduction in our auto portfolio. Period end and average loans are broadly stable linked quarter, up 1% excluding auto runoffs.

We grew deposits of 1% linked quarter and our LDR was stable at 87%. Fees showed some resilience amid a challenging environment, down 1% linked quarter. We saw a modest improvement in capital markets fees driven by underwriting and M&A, but this was more than offset by a drop in mortgage fees and a CVA/DVA impact in our FX and IRP business. Expenses were broadly stable linked quarter. Overall, we delivered underlying positive operating leverage of 1% linked quarter, and our underlying efficiency ratio improved to 54.4%. Our credit metrics were good, with NCOs of 22 basis points, up 3 basis points linked quarter. We recorded a provision for credit losses of $132 million and a reserve build of $44 million this quarter.

Our ACL ratio stands at 1.43%, up from 1.41% at the end of the third quarter and approximately 13 basis points above our pro forma day one CECL adoption coverage ratio. Our tangible book value per share is up 5% linked quarter. I'll provide further details related to the fourth quarter results. On slide six, net interest income was up 2% given higher net interest margin. The net interest margin of 3.3% was up 5 basis points. As you can see on the NIM walk on the bottom left-hand side of the slide, a healthy increase in asset yields continues to outpace funding costs, reflecting the asset sensitivity of our balance sheet.

With Fed funds increasing 425 basis points since the end of 2021, our cumulative interest-bearing deposit beta has been well controlled at 29% through the end of the fourth quarter. Moving on to slide seven. We posted solid fee results despite headwinds from continued market volatility and higher rates. Fees were fairly stable, down 1% linked quarter with lower mortgage and FX and derivative fees, partly offset by an improvement in capital markets fees. Focusing on capital markets, market volatility continued through the quarter. However, underwriting and M&A advisory fees ticked up. We continue to see good strength in our M&A pipelines, including several deals that were pushed into Q1. Mortgage fees were softer as the higher rate environment continued to weigh on production volumes.

We are seeing pressure on volumes moderating and signs of the industry reducing capacity, which should benefit margins over time. Servicing operating fees were stable. Card and wealth fees posted solid results for the quarter. On slide eight, expenses were well controlled, broadly stable linked quarter. Our TOP 7 efficiency program delivered over $115 million of pre-tax run rate benefits by the end of the year. We are excited to announce the launch of our new TOP 8 program, and I'll cover that in a few slides. On slide nine, average and period end loans were broadly stable linked quarter, but up 1% ex auto runoff, with 1% growth in commercial reflecting demand and asset-backed financing and growth in CRE, primarily reflecting line draws and slower pay downs.

We have seen commercial utilization moderate a bit over the quarter as inflation and supply chain pressures continue easing and clients are adjusting inventories to reflect this, as well as lower CapEx in anticipation of a softer economy. Average retail loans are down slightly but up 1% ex planned runoff in auto, given growth in mortgage and home equity, which bring an opportunity for deeper relationships and better risk-adjusted returns. On slide 10, average deposits were up $1.4 billion or 1% linked quarter, with growth primarily coming from term deposits, money market accounts, and Citizens Access Savings. Overall, commercial banking deposits were up 2.4% and consumer banking deposits were broadly stable. We feel good about how we are optimizing deposit costs in this rate environment.

Our interest-bearing deposit costs were up 67 basis points, which translates to a 29% cumulative beta broadly consistent with our expectations. We began the rate cycle with a strong liquidity and funding profile, including significant improvements to our deposit mix and capabilities. We achieved overall deposit growth this quarter and we will continue to optimize our deposit base and to invest in our capabilities to attract durable customer deposits. Overall liquidity remains strong as we reduce our FLIP advances by $1.3 billion and increased our cash position at quarter end. Our period-end LDR improved slightly to 86.7%. Moving on to slide 11. We saw good credit results again this quarter across the retail and commercial portfolios. Net charge-offs were 22 basis points, up 3 basis points linked quarter, which is still low relative to historical levels.

Non-performing loans are 60 basis points of total loans, up 5 basis points from the third quarter, given an increase in commercial largely in CRE. Retail delinquencies continue to remain favorable to historical levels. We continue to closely monitor leading indicators to gauge how the consumer is faring. Although personal disposable income remains strong, debt service as a percentage of disposable income has essentially returned to pre-pandemic levels, while consumer confidence has stabilized as inflation has eased. Turning to slide 12, I'll walk through the drivers of the allowance this quarter. While our current credit metrics are good, we increased our allowance by $44 million to take into account the growing risk of an economic slowdown. Our overall coverage ratio stands at 1.43%, which is a modest increase from the third quarter.

The current reserve level contemplates a moderate recession and incorporates expectations of lower asset prices and the risk of added stress on certain portfolios, including those subject to higher risk from inflation, supply chain issues, higher interest rates, and return to office trends. Given these pressures, we are watching our loan portfolio very carefully for early signs of stress, in particular, CRE office. Back on slide 32 in the appendix, we have provided some additional information about the CRE portfolio. Our total CRE allowance coverage of 1.86% includes elevated coverage for the office portfolio, while the multifamily portfolio has a much lower reserve requirement. The $6.3 billion office portfolio includes $2.2 billion of credit tenant and life sciences properties, which are not as exposed to adverse back to office trends.

The remaining $4 billion relates to the general office segment, for which we are holding a roughly 5% allowance coverage. About 95% of the general office portfolio is income producing, and about 70% is located in suburban areas. Moving to slide 13, we maintained excellent balance sheet strength. Our CET1 ratio increased to 10%, which is at the top end of our range. Tangible book value per share was up 5% in the quarter, and the tangible common equity ratios improved to 6.3%. We returned a total of $350 million to shareholders through share repurchases and dividends. Our strong capital position, combined with our earnings outlook, puts us in a position to continue to return capital to shareholders through additional share repurchases. Shifting gears a bit.

Starting on slide 14, we'll cover some of the unique opportunities we have to drive outperformance over the next few years. We are trying to be very disciplined in prioritizing the areas that we think have big potential and where we have a right to win. In consumer, we've got four big opportunities. First is our push into New York Metro. We are investing in brand marketing, doing well in the technology conversions, and putting our best people against the market opportunity. We are encouraged by our early success with some recent client wins in commercial and the HSBC branches driving some of the highest customer acquisition and sales rates in our network.

The full ISBC conversion is just around the corner on Presidents' Day weekend. We look forward to making further strides as we leverage the full power of our product lineup and customer-focused retail and small business model across the New York market. You will see more details on slide 28 and 29 in the appendix. Importantly, we achieved about 70% in run rate of our planned $130 million of Investors net expense synergies as of the end of the year. We expect to capture the rest by the middle of the year. We also continue to expect that the integration costs will come in below our initial estimates. Moving to wealth. We've launched a number of exciting initiatives with Citizens Private Client and Citizens Plus as we orient the business towards financial planning-led advice.

These should really help us penetrate the opportunity with our existing customer base. On slide 15, our national expansion is another area where we have a great opportunity to build on our digital platform that has been focused on deposits for the last few years. We've moved that to a cloud-based platform, and we are adding our other product capabilities so that we can offer a complete digital bank experience to serve customers nationwide with a focus on the young mass affluent market segment. Where we might have only had a lending or deposit relationship before, our vision is to build a national platform that allows us to serve our customers in a comprehensive way. We have also been very innovative in creating distinctive ways to serve customers. Citizens Pay, for example, is an area where we have significant running room.

We've attracted many new partners, up about 150 vs a year ago, which should really ramp the business. We built an industry-leading home equity business powered by our innovative FastLine process, which is enabled by advanced analytics and digital innovations that have drastically reduced originations time. Moving to the commercial bank on slide 16 and 17, we filled in all the product gaps. Acquisitions brought us M&A and other advisory capabilities, and we built out debt capital markets capabilities organically. We've hired some great coverage bankers, and we are focused on high-growth regions around the country and the right industry verticals to serve larger companies. We also have a very strong sponsor coverage and we're well-positioned to support private equity capital. Bottom line, we've aligned ourselves with the attractive opportunities with a full product set to drive significant market share and fee revenues.

Moving to slide 18. We are excited to announce the launch of our latest TOP program. Even as we push forward on offense with our strategic initiatives and acquisitions, it is important to remember that a key to Citizens' success since our IPO has been our continuous effort to find new revenue pools and realize efficiencies, and then reinvest those benefits back into our businesses so we can serve customers better. We've effectively executed up our TOP 7 program, achieving a pre-tax run rate benefit of approximately $150 million-- $15 million at the end of 2022. We've launched TOP 8 with a goal of an exit run rate of about $100 million in pre-tax benefits by the end of 2023, with that split about 80/20 between efficiency and revenue-oriented initiatives. Moving to slide 19.

I'll walk through the outlook for the full year, which contemplates an economic slowdown and the end-of-December forward curve view of 225 basis point Fed hikes before an expected 25 basis point cut in the fourth quarter. We expect solid NII growth up 11%-14%. We project our NIM to gradually rise towards approximately 3.4% for the fourth quarter of 2023. Our overall hedge position is expected to provide a NIM floor of about 3.2% through the fourth quarter of 2024. A gradual 200 basis point decline across the curve commencing in Q4 2023. In the fourth quarter, we took actions to transition $3 billion of active swaps from 2023 to forward starting positions in 2024.

We've done even more so far in January to rebalance the distribution of down rate protection. You'll find a summary of our hedge position in the appendix on slide 30. We expect moderate loan growth with average loans up about 4%-5%. We are targeting about $3 billion of spot auto runoff as we shift the portfolio towards products with more attractive risk-adjusted returns. We expect total average earning assets to be up 3%-4%. On the deposit side, we see 3% average deposit growth and a 2%-3% spot deposit decline with cumulative deposit betas at year-end reaching the high 30s. Fees are expected to be up 7%-9%, with the capital markets rebound building over the course of the year.

Non-interest expense is expected to be up roughly 7% or about 3.5%-4% if you adjust for the full-year effect of the HSBC and Investors acquisitions and the FDIC premium increase. The year unfolds as we expect, we should be able to drive about 400-500 basis points of positive operating leverage. Given current macro trends and portfolio originations, we expect that our ACL ratio will rise to the 1.45%-1.5% level, depending upon how the economy fares. We expect our CET1 ratio to land at the upper end of our target range of 9.5%-10%, even with our target payout ratio approaching 100%. All of this translates into our ROCE in the high teens for 2023. On slide 20, we provide the guide for Q1.

Note that Q1 is seasonally weak for us, with a day count impact and seasonality impacting revenues and taxes on compensation payouts impacting expenses. Moving to slide 21. As Bruce mentioned, we have completely transformed the franchise since the IPO, executing well against our priorities and achieving our desired performance targets. We are ready to raise the bar, lifting our ROCE target to 16%-18%. The key to the further ROCE improvement is continuing to deliver positive operating leverage. As we look out over the medium term, we should see a recovery in loan and deposit growth. We will continue our balance sheet optimization efforts to focus on deep relationship lending to maximize risk-adjusted returns. We are well-positioned to grow fees meaningfully.

Even if rates come down a bit, we expect NII to benefit from the protection we have put on through the swap portfolio. You should expect us to stay disciplined on expenses. Credit is projected to be stable as the economy strengthens, and we continue to focus on returning a meaningful amount of capital to our shareholders through our repurchase program and targeting a dividend payout of 35%-40%. Over this time frame, we would expect our CET1 ratio to remain within our target range of 9.5%-10%. To sum up slide 22, we delivered a strong quarter against the backdrop of a dynamic environment, and we have a positive outlook for 2023. We are ready for the uncertainty of an economic slowdown in 2023 with a strong capital liquidity and funding position.

We've taken actions to protect our NIM, we are being prudent with respect to our credit risk appetite and loan growth. At the same time, we are moving forward executing against our strategy and making important investments in our business that we believe will deliver sustainable growth and outperformance over the medium term. With that, I'll hand it back over to Bruce.

Bruce Van Saun (Chairman and CEO)

Okay. Thank you, John. Operator, why don't we open it up for Q&A?

Operator (participant)

Thank you, Mr. Van Saun. We are now ready for the Q&A portion of the call. Ladies and gentlemen, if you wish to ask a question, please press 1 then 0 on your touch-tone phone. You'll hear an acknowledgment that you've been placed into queue, and you can remove yourself from queue at any time by repeating that one-zero command. If you're on a speakerphone, please pick up your handset before pressing the numbers. Once again, it's one and then zero. Your first question comes from the line of Scott Siefers of Piper Sandler. Your line is open.

Scott Siefers (Managing Director and Senior Research Analyst)

Morning, everybody. Thanks for taking the question. It sounds like you guys rebalanced some of the hedges in the fourth quarter and are continuing to do so year to date so far. Was hoping you might please just expand upon how your thinking on ALCO has changed since last quarter and sorta how you intend to position yourself.

John Woods (CFO)

Yeah, I'll go ahead and start off. I mean, big picture, we, asset sensitivity last quarter was around 3%. We're a little bit below that this quarter, just given the way the outlook for the balance sheet, you know, appears to be playing out in 2023. As you've seen over time, we've taken our asset sensitivity down. We are, you know, most of that asset sensitivity is really driven by the short end of the curve, which we expect to remain elevated throughout 2023. As a result, we're looking at some of the downside down rate protection that we had in place in 2023 and just repositioning that out of spot starting active swaps into forward starting swaps into 2024 and beyond.

We're looking to, you know, we're looking to basically push that out and basically get that down rate protection, you know, smoothed out into the 2024 and 2025 periods rather than holding on to all of that down rate protection here in 2023. That's the main objective in what we were doing in fourth quarter, and we've done a little bit more of that in early, you know, 1Q. More broadly, you know, we're looking at net interest margin, that corridor, if you will. We're trying to protect that corridor with, you know, at the low end, if rates were to fall by 200 basis points out in 2024, then you'll see a floor of around 3.20.

You see that 320-340 corridor being something that over time is more narrow than you would've seen from us maybe in past cycles. That's the main objective.

Bruce Van Saun (Chairman and CEO)

Yeah. I would just add to that, Scott. I mean, our view in the macro is that the Fed likely moves maybe once or twice. The forward curve says they'll move up 25 basis points a couple of times and then stop. Typically, they would pause for six or seven months before they would cut. If there's a cut happening, it likely happens very late in the year, and maybe it could be early next year. Guided by that view, that's kind of why we're pushing out that downside protection a bit.

Scott Siefers (Managing Director and Senior Research Analyst)

Terrific. Thank you very much. Just a separate question. Looks like fees will need to rebound fairly meaningfully following the first quarter to hit the guide. I know, Bruce, you had mentioned an expectation for improved capital markets through the year. Maybe just a thought or two on how you see the main drivers of that fee guide as the year progresses, please.

Bruce Van Saun (Chairman and CEO)

Sure. I think really you put your finger on it there, Scott, is the capital markets business. We've had really strong pipelines this year, but because of the volatility, because of the fact that the Fed is still moving higher, that's created uncertainty and just an inability to actually get the money to work from private equity or some of the deals done, because the financing hasn't been there the way it's been in the past. I think going back to that macro forecast, as the Fed is likely nearing kind of the destination in terms of peak rates, I think that starts to loosen up the markets, the financing markets.

You'll see less volatility, and a lot of the businesses, kind of clocked into our pipelines will start to print and get delivered, and we'll start to see more transactions. Just by reference, most of the quarters this year, our capital markets revenues were $90-$100. If you go back to the fourth quarter of 2021, we had $184 million of fees, so roughly double that level. We thought coming into this year that we'd have much stronger levels of revenue generation. You know, the good news is we still have a great overall focus on the right sectors in the market. We've got a great team.

I think you'll see that start to rev up, as we, as we see the market conditions improve. Beyond that, you know, I'm also quite optimistic. We've made a lot of investments in the wealth business. Again, there, if you start to see some stability, in the asset markets, we should get a kinda tailwind from that plus the investments that we've made. Feel confident about that. Then I'd say mortgage is so washed out. I keep thinking it can't go any lower, and it did in the fourth quarter. I think, you know, you're starting to see people exit the business and capacity coming out of the business.

You know, you'll start to see margins expand, and I think volumes will tick up as we go through the year. Linked back to the Fed reaching the destination and so some stability on rates. Those would be the big things. I'm happy to pass the horn here. Don, do you want to say anything else?

Don McCree (Chair of Commercial Banking)

Yeah. I think you pretty much covered it on cap markets. I said this last quarter, and I'll just remind people again, we are a middle market investment bank, so we're not dependent on these giant transactions that need, you know, $5 billion of financing. We do singles and doubles all day long, and our pipelines are reasonably strong with a very heavy content of private equity who is awash with cash. There will be transactions. If you don't get regular way transactions, you're going to get a lot of restructuring transactions. There's minority capital, there's a lot of different ways to skin the cat. We're relatively optimistic about what's ahead of us in the coming year.

Bruce Van Saun (Chairman and CEO)

Yeah. Brendan, anything on consumer?

Brendan Coughlin (Head of Consumer Banking)

No. I think you nailed it, excuse me, pretty well. I'd say, you know, wealth for the year we're projecting slow and steady continued progress, and it's a bit of a hopeful, coiled spring when the equity markets really come back. As long as they're stable, we should see some growth. I'd say the other bright spot is debit and ATM fees that continue to hit records, both through customer engagement and privacy and all the investments we made in the health of the franchise. That's also translating into our deposit quality. Also some restructure on vendor relationships and such. That's giving us a bit of a boost there too. That should be a continued area of slow and steady progress.

On the other side, there will continue to be a little bit of pressure still on overdraft income and service charges. We're sort of near the bottom there.

Bruce Van Saun (Chairman and CEO)

Most of that's in the run rate.

Brendan Coughlin (Head of Consumer Banking)

Most of that's in the run rate.

Bruce Van Saun (Chairman and CEO)

Yeah.

Brendan Coughlin (Head of Consumer Banking)

We're sort of near the bottom, which is good. That will, you know, move away from being a headwind for us, real soon.

Bruce Van Saun (Chairman and CEO)

Okay. Very good. That's great. Thank you very much.

Brendan Coughlin (Head of Consumer Banking)

Yep.

Operator (participant)

Thank you. Your next question comes from the line of Peter Winter with D.A. Davidson. Your line is now open.

Peter Winter (Managing Director and Senior Research Analyst)

Good morning. I wanted to ask on credit. John, you mentioned that most of the increase in non-performing loans was commercial real estate. I was just wondering, was that office related? If you can just give a little bit more color on what your outlook is for office.

John Woods (CFO)

Yeah, maybe I'll just talk about the coverage levels. You know, just broadly, as you may have seen in our materials that the CRE coverage from an allowance standpoint is around 186 basis points. When you, when you carve out some of the really high quality stuff in multifamily and credit tenant lease and life sciences, you get to our general office segment where we have very healthy coverage of around 5%. We are seeing some trends there that are telling us that we should be putting away some reserves to deal with the back-to-office trends that are, that are a headwind in that, in that space. You get good, healthy coverage of around 5%.

We are seeing some of that tick into the non-accrual space. I would say more broadly, you know, even though that goes into non-accrual, our overall CRE, you know, LTVs are typically around 60%. You got to distinguish from non-accruals from actual loss content. Even though, you know, we're putting some allowance away, you know, we feel like that's commensurate with the loss content that we see in the book. Maybe I'll just stop there.

Bruce Van Saun (Chairman and CEO)

Yeah. Don, do you want to add?

Don McCree (Chair of Commercial Banking)

I'll just say for the for the office portfolio, but CRE in general, you know, it's first and foremost who's the sponsor and who's the investor. We have a very high quality group of investors that we do business with, which are largely institutional. Second is what MSAs are you in and where are you? We think suburban will do better than urban. As we said in the comments, we're heavily weighted to suburban. We're going through every single property in the office portfolio. We'll restructure a lot of them with the sponsors. We restructured one already this year where the sponsor contributed equity. You know, we're comfortable around where we are with the coverage ratios right now, but we'll be active in restructuring the portfolio.

We kind of like the contours of what we've got.

Peter Winter (Managing Director and Senior Research Analyst)

Got it. Thank you. Just as a follow-up, can you just talk about what changed in the updated margin guidance of towards 3.40% vs the prior guidance of 3.50%? Is it just the higher deposit beta outlook?

John Woods (CFO)

Yeah, I'll just go. I'll go ahead and cover that. I mean, I think more broadly it's two overall comments really. The, just given the pace and speed of rate changes and the impact on the migration of the deposit mix that we expect as you get into 2023 is really, you know, most in the majority of what we're looking at. That migration manifests itself in two ways. It's really the amount of DDA migration that we see, as well as the cost of our relatively low cost deposits that we're seeing not only within our platform but across the industry.

From that perspective, just kind of marking that to market with respect to what we're seeing and the trends in the fourth quarter and the rate and curve outlook that we see going throughout the rest of 2023. I would hasten to add, what's embedded in there, nevertheless, is a transformed deposit platform that back prior to the pandemic, we would have had DDA percentages that would be in the low 20s compared with a majority of the portfolio being outside of DDA, of course. You fast-forward to where we are in the fourth quarter, and we're at 28% of our deposit franchise is sitting in DDA. That's a significant increase vs pre-pandemic.

We expect to end the year, you know, sort of the mid-to-high-20s in the DDA space, down a little bit from where we are today. Nevertheless, still, you know, very high quality. When you add in consumer, commercial and consumer savings, which is other low costs, you end up with still, you know, about 50% or more of our deposit portfolio sitting in low-cost categories. That's up from the low 40s prior to the pandemic. This has been a multi-year transformation of the deposit franchise. I think we're basically just, you know, calibrating what we expect in 2023, which is, was the majority of what we saw in terms of the decline from $350 to $340.

I think you could also add in, you know, what's going on with the curve and front book/back book as well. When you look at just how quickly rates are rising, the front book originations take a longer time to contribute. From that perspective view, we're seeing, you know, that being a driver as well. Then, you know, I guess the last point I'll make is not only the speed of rates rising, but the inversion of the yield curve is something that is also pretty has a, is a headwind to front book/back book. You know, just to end it with, nevertheless, front book/back book is a positive tailwind over time.

We're seeing 300 basis points of positive front book/back book across securities and our fixed rate lending businesses. That's still a tailwind. That's gonna be a driver into 2023 with net interest margins rising, just not by quite as much as we thought last quarter.

Ken Usdin (Managing Director of Equity Research)

Got it. Thanks very much.

Operator (participant)

Your next question comes from the line of Ken Usdin, with Jefferies. Your line is now open.

Ken Usdin (Managing Director of Equity Research)

Thanks. Hi, good morning. wondering, Bruce, heard your early comments about, you know, we're at 130 ACL day one, adjusted for the deals in the low 140s now, and your comments about 145, 150 year-end. I'm just wondering if you can help us, you know, given that you're slowing loan growth and letting the auto book run out. How do you just help us understand what you're seeing in terms of what your CECL impact might be looking ahead vs the impact of slower loan growth in terms of that, you know, endpoint that you're expecting? Thanks.

John Woods (CFO)

Yeah.

Bruce Van Saun (Chairman and CEO)

Sure. I'll start, John. You can pick up. You know, I'd say what we've done for the past several quarters is kind of keep looking forward as to what's the macro forecast and are there any particular segments of the portfolio that could come under stress given the Fed has continued to push higher and economic growth has been downgraded. I think there's, like I read today, that over 60% of the leading economists are projecting a forecast for this year. The reason that we've been building gradually is just taking that into account. I think at some point, you kind of get the cards turned up in 2023, and you'll have more information and less uncertainty, but we don't see that where we sit today.

I think it's prudent to continue to view, the course, likely courses that the ACL will go up, you know, a couple of basis points a quarter like we've done, and get into that 145-150 range. At some point, then you'll have, seen whatever the recessionary impact is, and then you'll be looking forward, and then you may get to the point where you can release some of those reserves depending on what your charge-off experience is. Clearly, Ken, the slower loan growth plays into that, to some degree, is mitigating what the, the build could have been. Anyway, those are, those are the dynamics at play. John, I don't know if you wanna add to that.

John Woods (CFO)

Yeah, I'll add that. I mean, just for the last couple of quarters, we've had a mild to moderate recession built into the ACL. You know, our peak to trough to GDP decline that we have built into our models are 1.5%. That would be a moderate recession at this point. I think the changes you may have seen in the second half of 2022 were not quite as much on the expectation that there would be, you know, a recession as much as what the collateral value outlook really impact was. When you think about house prices and used car prices, et cetera, we've been increasing the amount of decline expected.

You've got, sort of the low to mid-teens declines now built into our models for both, house prices and auto prices, over the foreseeable and, kind of, period. That's really not really driving a lot of losses. Just, we've been having a lot of recoveries in the portfolio over the last year or so. You might see some lower recoveries, and that'll have You saw our loss that's built into our loss forecast for 23. I think that's an important item that you saw in 4Q in terms of our outlook for 2023 and 2024.

Ken Usdin (Managing Director of Equity Research)

Got it. Okay, thanks. Just one quick follow-up on the capital points. You know, you're nearing 100% implies a nice incremental step-up in the buyback. I'm just wondering how you're thinking about the mix of the dividend vs the buyback going forward. You obviously moved to $0.42 in the third quarter. What should we also think about that you would be moving the dividend up in line with, increased earnings potential as well within that context?

John Woods (CFO)

Yeah, I'd say that what we do here is, every year we're on a cadence. We're post CCAR. You know, we basically take that as the opportunity to broadly, you know, update our capital return profile. Over the medium term, you know, we're looking at 35%-40%, you know, dividend, you know, payout. And you saw that in some of our medium-term outlook. We've updated that this is gonna be more of a buyback return year in 2023 because of the outlook for RWAs. But, you know, we take a look at dividend policy and earnings outlook and update whether there should be a change in the dividend after CCAR.

Bruce Van Saun (Chairman and CEO)

Yeah. I would just add to that, Ken, that clearly with the uncertainty in the environment, we are being cautious in terms of the lending of kind of risk appetite. I think that in and of itself creates some additional capital vs what we've had in prior years. I also think, we still have our plate full in integration of existing acquisitions, and we haven't seen a whole lot that's attractive at valuation that we're interested in on the acquisition front. I think the combination of operating at very high profitability levels with ROCE returns in the high teens, plus more modest loan growth than historical, more modest acquisition activity than historical, creates the opportunity.

I think it's appropriate given the uncertainty and chance for recession that returning capital to shareholders is the right course of action here. You could expect, we would like to raise the dividend during the course of the year, and we'd also like to get close to that 100% return of capital to shareholders.

Don McCree (Chair of Commercial Banking)

Got it. Great. Thank you, Bruce and John.

Operator (participant)

Your next question comes from the line of John Pancari with Evercore. Your line is now open.

John Pancari (Senior Managing Director and Senior Research Analyst)

Morning. On the overall deposit dynamics, I know you expect a 2%-3% year-over-year spot decline. Can you maybe give us a little more color on how you expect overall deposit trends to progress through 2023 to get to that 2%-3% spot decline? Maybe help us with the magnitude of declines that you think is reasonable here in the coming quarters as you look at deposit flows. Thanks.

John Woods (CFO)

Yeah, sure. I'll jump in there. I mean.

Bruce Van Saun (Chairman and CEO)

I'll let you start and then maybe pass it to Don and Brendan.

John Woods (CFO)

Sure. Yeah, that sounds good. Yeah, I mean, I think overall, as I mentioned before, you know, we're seeing deposit migration from a DDA perspective as well as from some of our low-lower cost levels. Broadly, the mix is superior and improved compared to pre-pandemic. I think we're around 28% DDA in 4Q. That's probably gonna tick down a bit, call it to maybe 27% or so by the end of the year. That's part of the story.

I'd say the, some of the higher costs, you know, deposits in money markets, and savings will be part of the runoff as well, such that you get to something along the lines of a 2%-3% decline spot to spot, end of 2022 into 2023. I'd say that you end up with, some, again, improved mix compared to pre-pandemics, but a little bit of, mix, softening as you get throughout 2023. I'll just, maybe-

Bruce Van Saun (Chairman and CEO)

I would add to that, you know, I'd say we did not take in as much surge deposit as many in our peer group. We have a consumer tilted deposit base which tends to be more stable. We've been monitoring that surge deposits quite carefully. We have seen it actually be more sticky than we initially expected. I think where you'd see a slight runoff probably is more on the commercial side where, you know, treasurers have other alternatives besides bank deposits to move some money out. Again, we're relatively protected there because we didn't take in a lot of that money in terms of surge deposits. Maybe, Don, you could comment, and then Brendan.

Don McCree (Chair of Commercial Banking)

Yeah. I think our spot is down a little less than 2%, you know, year-to-year. We actually ended this year a little higher than we thought we were going to because we had some nice inflow at the end of the year. Back to the. I think John said it in his comments. We've really transformed our deposit base really off the back of our treasury services business. Both specialty deposit offerings. You know, we've got two that we're now in the market with around ESG green deposits and carbon offsets. Just the strengthening of our DDA deposits with our treasury services business gives us more stability than we would've had in prior years. We feel pretty good about that projection.

We're, you know, in general, really managing the balance sheet from a BSO standpoint, we're avoiding most new transactions given just the shyness around the credit environment and the uncertainty. We're moving clients who aren't generating positive returns off the off the franchise and off the balance sheet. It gives us a little bit of a dynamic that we don't really need to go chase deposits because we're keeping the loan side relatively, you know, modestly in terms of how it grows.

Brendan Coughlin (Head of Consumer Banking)

Yeah. Without being too redundant to what John mentioned, I'd say, consumer's been broadly stable on deposits, which is a really good thing. All indications are quite positive.

We look at a lot of benchmarking data and, you know, we're pretty confident that we're performing in the top quartile of our peer banks in terms of retention of low-cost deposits, as well as interest-bearing deposit costs so far in the cycle. It's sort of midway through the cycle, we've got to stay disciplined and manage it well. It's been driven by a lot of health improvements, household growth, improvements in primacy, mix shift to Bruce's point. We were 45% mass affluent and above five years ago. We're now 60% of our customer base is mass affluent and above. The quality has been quite good. On the stimulus front, what we're seeing is the bottom 2 deciles of our customer base is essentially back to paycheck to paycheck.

That stimulus has already burned off and is in the rearview mirror. The stimulus that remains with us tends to be with the more fluid customers, whether that's actual stimulus checks or that's balance parking that happened during COVID from not making mortgage payments and not traveling, et cetera, et cetera. We're not actually seeing that burn off as much as we're starting to see that rotate out of low-cost deposits into interest bearing, which is natural, given the state of interest rates. We're managing that really tight. All the investments we've made in the franchise, whether it's analytics, new products, the introduction of CitizensPlus in our Private Client Group, as well as having Citizens Access to fence off interest-bearing deposits to maintain discipline in the core, have all been really big levers for us to manage well.

All indications we see so far is that we're right on track with where we want it to be and dramatically outperforming where we were last time in an uprate cycle. You know, at worst, in line with peers, but some signs that we may be doing a bit better, which is a big turnaround from where we were five, six years ago.

Bruce Van Saun (Chairman and CEO)

Great.

John Pancari (Senior Managing Director and Senior Research Analyst)

Okay, great. Thank you. That's helpful. Separately, on the commercial real estate front, I know you stated 60% LTV on overall commercial real estate. Is that at origination? Do you happen to have refreshed LTV? I know you mentioned that a lot of your deals have sponsor participation, but we're hearing that with sponsors exiting or refinancing out certain deals that's impacting the LTV. The refreshed LTVs may be a better read, particularly on the office front. Thanks.

Brendan Coughlin (Head of Consumer Banking)

The 60% was the office LTVs in terms of not the overall, the overall CRE book. We think those are still pretty good. We're refreshing them property by property. We haven't gone through and done a total refresh on the entirety of the book yet, but we're kind of working it on the maturing quarter by quarter maturities and working with the sponsors to either refinance out, inject equity or adjust the value of the portfolio. That's what drove the NPL this quarter. It was really one real estate deal.

John Pancari (Senior Managing Director and Senior Research Analyst)

Okay, sorry. That 60% is a refresh number on the office side, or is it at origination?

Brendan Coughlin (Head of Consumer Banking)

Those were at origination.

John Pancari (Senior Managing Director and Senior Research Analyst)

Okay. All right. Thank you.

Operator (participant)

Your next question comes from the line of Matt O'Connor with Deutsche Bank. Your line is now open.

Speaker 12

Hey, everyone. This is Nathan Stovall on behalf of Matt O'Connor. On capital, the 9.5%-10% medium-term CET1 target range, that's well above the regulatory minimum. You've built reserves a lot, and it seems like the conversion timeline of ISBC is going really well. I guess my question is, why hold so much capital down the road given solid reserves and successful deal integration timelines?

Bruce Van Saun (Chairman and CEO)

I would say part of it is just a philosophy of, you know, liking to have a strong balance sheet. I think 9.5-10 is a strong ratio. You've seen over time that we originally had a target of 10-10.5, and we've been kind of sliding that down as our profitability goes up. I think the stakeholders gain more confidence that we have a good strategy and we're executing well. It wouldn't surprise me at some point where we start to manage down in that range. I think the time of 2023 today, when we're looking at a potential recession to be at the top end of that range makes sense.

Once we get to the other side of that to start to move that down and maybe manage that closer to the bottom end of that range will provide more leverage. Then at that point, I think we could step back and say, "Do we still need 9.5-10, or can we skinny that down a little bit?" I think that's all in front of us. We thought at this point, given the dynamics around 2023, it wouldn't make sense to actually move that target range down.

Speaker 12

Okay, thanks. Second question is just on loans. The $3 billion auto runoff will offset growth in other areas this year. What are your expectations for other loan categories in 2023 coming off of a strong 2022? Thanks.

John Woods (CFO)

Yeah. I'll go ahead and start there, and others can chime in. I mean, I think when you look out into 2023, we still see very, very strong opportunities in the commercial space, and within C&I. I think something to always keep in mind is our utilization is well below where historical levels would imply we should be. You know, as you get into the later part of the year, you see some recovery in investment, in inventories and CapEx and possibly M&A, which actually provides financing opportunities. We see lots of opportunities across commercial. That's really one of the main drivers. When you get into consumer, you know, we're looking at home equity being a place that we like.

And card and Citizens Pay would contribute as well. All of that wraps up to a stable year-over-year on loans. Back to the point around that being taking that otherwise RWA that would have been deployed against auto and some other categories with lower risk-adjusted returns and giving that back to shareholders.

Operator (participant)

Your next question comes from the line of Manan Gosalia with Morgan Stanley. Your line is now open.

Manan Gosalia (Executive Director and Senior Equity Analyst)

Hi. Good morning.

John Woods (CFO)

Morning.

Manan Gosalia (Executive Director and Senior Equity Analyst)

I just wanted to follow up on the NIM line of questioning. I think you brought down the floor for NIM from 3.25 to 3.2%. Is that also a function of what you mentioned on the DDA migration, and the curve and, you know, also the fact that you pushed out the forward swaps? You know, is the biggest variable on that number mostly the cost of funding side, or, you know, I guess would there be any changes to that 3.2% number if the Fed cuts rates sooner?

Bruce Van Saun (Chairman and CEO)

Yeah. I'll start and flip to John. It's Bruce. You know, I think the two numbers are tethered together. If the 350 is now seen to be 340, your floor is gonna also commensurately move lower. The good news is, in a way, is that we've tightened the bottom side of that range. Previously it was 350, down to 320-

John Woods (CFO)

Right.

Bruce Van Saun (Chairman and CEO)

25. It was 25 basis points, now it's 340 to 320, so it's 20 basis points. Anyway, I think we certainly John's initial answer on the movement down has been focused more on migration, the DDA and low cost migration. Also, some of the impact from the yield curve on front book, back book has been the other dynamic. Those are the things that we're watching. John, you can pick up from there.

John Woods (CFO)

Yeah. I'd say the only thing I'd add just to remember, we constructed, we modeled that 320. There's a lot of assumptions that go into that with respect to what the mix of the balance sheet would be, et cetera. What we're assuming is a 200 basis point gradual decline in 2024 that would get you down to that 320. Given that we are still asset sensitive and we haven't closed out that position, you know, that's really, you know, what you're seeing in terms of the decline in net interest margin.

you know, if, you know, as and when we, you know, continue to look at ways to lock in, you know, protection against down rates, you could see that 320 move around based on hedging activities as well as updated views on what the mix of the balance sheet is likely to be in the context of what the Fed does.

Bruce Van Saun (Chairman and CEO)

It's a very dynamic process. We look and see where the forward curves say rates are gonna be. We have our own view of that. We see what the valuations we can get in the hedge market are. You know, you can be assured. I think we played our hand quite well so far, and we'll continue to stay really focused on this.

Manan Gosalia (Executive Director and Senior Equity Analyst)

I appreciate that. Then separately, just on the TOP 8 program. Can you unpack some of the drivers there of the $100 million in pretax benefits and maybe how quickly those can come out from the expense base over the course of the year?

John Woods (CFO)

Yeah, I'll go and cover that. I'd say the one dynamic to keep in mind is that we tend to form these programs and generate a year-end run rate benefit that will contribute, you know, for each of them. On the one hand, the $100 million will build throughout 2023 so that it gets to a run rate when you get to the fourth quarter of 2023. Keep in mind, we did the same thing with TOP 7. There's a full year effect of TOP 7 that comes in. When the programs are reasonably similarly sized, you can almost use that as an estimate of what the contribution is in any given year.

You have maybe a combined, you know, $100 million plus contribution from the full year effect of TOP 7 hitting 2023 and the in-year effect of TOP 8 hitting 2023. The big drivers of that really are in a couple of places. You've got the traditional areas that we focus on, which is third party costs and vendor cost management, which is an area that we've been that's been contributing over the years as well as continuing to optimize the branch network and just being really careful about, you know, ensuring that our organizational approach is, as, is fit for purpose with respect to what we're trying to accomplish in 2023. Those are more traditional areas.

The other places we're looking at that have been more recent include maturing our agile delivery model, you know, away from a waterfall approach to agile. You know, next gen technology initiatives continue to contribute as well. We're working towards a data center exit in 2025. We're looking to migrate to the cloud from our, you know, internal applications, and that's contributing in 2023 as well. There's a lot of very strategic, you know, sort of initiatives that are built within the TOP 8 program, and we're excited about it. It's part of who we are, and we're looking forward to deliver against that next year.

Manan Gosalia (Executive Director and Senior Equity Analyst)

Great. Thanks for taking my questions.

Operator (participant)

Our next question comes from the line of Vivek Juneja with J.P. Morgan. Your line is now open.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Thanks for taking my questions. A couple of questions for you folks. Firstly, the deposit betas that you expect to get to the high 30s, given the pace of change in the fourth quarter should be and your expectation for rate hikes, you know, early in the year, and not after that. Should we expect you get to that in Q1? Any color on that, on the pace of it, especially given our rates have been going up?

John Woods (CFO)

Yeah. I mean, I think we will not get there in Q1. That is an over the year expectation in terms of the cumulative growth. I mean, I think you'll see the growth in cumulative betas begin to moderate and flatten out. You get the big jumps early in the cycle. You know, we began, you know, you go way back to the second quarter of 2022, our cumulative beta was 6%. You get to the fourth quarter, the cumulative beta is 29. You've got 23 points just in 2022. What we're looking for in 2023 is another 9 points. It'll increase over time. You won't get to 38 in the first quarter. It will gradually rise.

Bruce Van Saun (Chairman and CEO)

Deposits tend to reprice with a lag.

John Woods (CFO)

Yeah.

Bruce Van Saun (Chairman and CEO)

Even after the Fed pauses, you still see a little bit of upward pressure on those betas.

John Woods (CFO)

That's right.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Does that mean, Bruce, the bulk of it is probably early on and just a little further increase after that, after the Fed jumps?

John Woods (CFO)

I'd say the majority in one H, and it continues to trickle in in two H. That's built in to our outlook.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Okay. different question, the second one. Fee income, your guide of about either 7%-9% growth in full year 2023 vs 2022, how much of that would you expect would come from capital markets or at least what's in your forecast that you're thinking how much comes from capital markets?

John Woods (CFO)

Yeah, I think there's a big part of it. I mean, I think, you know, back to the big drivers, you had capital markets, and you heard about card fees from Brendan and wealth from Brendan as well. Those are the three big ones. You see mortgage really-

Bruce Van Saun (Chairman and CEO)

A little bit of rebound.

John Woods (CFO)

Potentially rebounding as well. I think part of it would come from capital markets, you know, from the underwriting perspective. M&A advisory, just as we may have mentioned in the fourth quarter, we saw some deals push from four Q into one Q. That's gonna support the capital markets business, which by the way, over the years has really become a very diversified capital markets business itself. I mean, just broadening out M&A advisory, underwriting and loan syndications. Those businesses really tend to really diversify our overall fee outlook. Yeah, a good part of it and a good chunk of the growth in 23 comes from capital markets.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Okay. Thank you.

Operator (participant)

Thank you. There are no further questions in queue. With that, I'll turn it over to Mr. Van Saun for closing remarks.

Bruce Van Saun (Chairman and CEO)

Okay, great. Thanks again everyone for dialing in today. We certainly appreciate your interest and support. Have a great day.

Operator (participant)

Thank you. That does conclude today's conference. Thank you for your participation, and you may now disconnect.