KeyCorp

Ladies and gentlemen, good morning and welcome to Key Corp's first quarter 2023 earnings conference call. As a reminder, this conference is being recorded. I would now like to turn the conference over to the chairman and CEO, Chris Gorman. Please go ahead.

Well, good morning and thank you for joining us for Key Corp's first quarter 2023 earnings conference call. Joining me on the call today are Clark Kyatt, our Chief Financial Officer, Don Kimball, our Vice Chairman and Chief Administrative Officer, and Mark Midkiff, our Chief Risk Officer. On slide two, you will find our statement on forward-looking disclosure and non-GAAP financial measures. It covers our presentation materials and comments, as well as the question and answer segment of our call. I am now moving to slide three. Before I comment on our quarterly results, I want to touch on three areas that I know have been top of mind for investors, namely deposits, capital, and credit quality. Key has significantly strengthened each of these areas over the last decade. We have de-risked our business and built a differentiated franchise that is well positioned for all business conditions, including the current environment. Key's relationship-based business model provides us with strong, granular deposit base and with attractive lending and fee-based opportunities. Our long-term standing strategic commitment to primacy, that is, serving as our client's primary bank, continues to serve us well. Over 60% of our deposit balances are from consumers, wealth clients, small businesses, and escrow accounts. Over 80% of our commercial balances are core operating accounts. The diversity of our deposits extends across client type, account size, industry, and geography. Our deposits come from 3.5 million retail, small business, private banking, and commercial customers, with 56% covered by FDIC insurance and an additional 10 percent of balances that are collateralized. In the first quarter, our period in deposits remained stable, and balances from March 31 to present remain relatively unchanged. With respect to capital, Key's position remains strong, with a common equity Tier 1 ratio of 9.1 percent. This positions us well to execute against our capital priorities including supporting our clients. We are also aware of the heightened focus on accumulated other comprehensive income, AOCI. AOCI improved this quarter by 13%, which drove a 20 basis point improvement in our tangible common equity to tangible asset ratio. Our capital position will benefit from the expected $2 billion improvement in AOCI by 12-31-24. Credit quality remains strong, once again reflecting our proactive and intentional de-risking over the past decade. In our consumer bank, we serve a wide range of clients. Our weighted average FICO score at origination is above 770. In our commercial bank, 82 percent of our credit exposure is to relationship clients, and 56 percent of our CNI portfolio is investment grade. We have built a strong originate to distribute model that strengthens our risk management and allows us to offer our clients a wide range of on and off balance sheet financing options. In the first quarter, we raised $26 billion for our clients. Another area getting attention is commercial real estate. Our largest exposure is multifamily, including a growing affordable housing segment. There exists a significant shortage of available housing broadly and affordable housing specifically in the United States today. As such, affordable housing will continue to receive bipartisan government support. Importantly, we have limited exposure to high-risk areas such as office, lodging, and retail. We also have unique insights into commercial real estate through our third-party commercial loan servicing business. Not only is this a great business with over $630 billion of servicing assets, but the business provides us with unique insight into the markets, which vary greatly by asset type and geography. Each of these three areas that I have covered, deposits, capital, and credit quality, provide a foundation and support the long-term earnings power of our company. With that as a backdrop, let me move to slide four and touch on a few quarterly highlights before I turn it over to Clark to cover the quarter in detail. This morning, we reported earnings of $275 million, or 30 cents per common share. Our results included $126 million, or 14 cents per share, as a result of both our increase in allowance for credit losses and the expense actions we previously announced. The build in our allowance for credit losses is principally model-driven and reflective of a greater range of outcomes as we look ahead. Our strong credit quality and guidance for net charge-offs, however, remain unchanged. Our expense actions this quarter were part of a company-wide effort to improve efficiency and support reinvestment back into our business. We completed actions this quarter, which represented over 4% of our expense base, or $200 million in annualized benefits. This will allow us to hold non-interest expense relatively flat in spite of persistent inflation. Our results this quarter were driven by year-over-year growth in both our consumer and commercial businesses. In our consumer business, we grew new households at a pace, supporting our Investor Day target. Our commercial businesses also continued to add and expand relationships. Recent market disruption has provided us with further opportunity to acquire clients and opportunistically add high-quality bankers to the platform. Net interest income declined from the fourth quarter, reflecting higher interest-bearing deposit costs and a shift in funding mix. Net interest income was also negatively impacted by our received fixed rate swaps, which are used to hedge our floating rate portfolio. Swaps in treasuries reduced net interest income by $317 million this quarter, and lowered our net interest margin by 72 basis points. Given the short duration of our swaps and treasuries and the meaningful repricing opportunity, we will see significant benefit to our net interest income beginning late this year and extending into 2024 and beyond. We have continued to take actions to lock in the net interest income benefit going forward. Clark will cover our interest rate positioning in detail during his presentation. Our fee-based businesses in the first quarter showed several areas of strength, but overall reflected expected weakness in capital markets. Although the market remains challenging, we did experience a record first quarter in our M&A advisory business. While we do not anticipate a significant pickup in our capital markets business in the first half of the year, we continue to expect deal activity to pick up sometime in the second half. As I pointed out on the prior slide, credit quality remained strong this quarter, with net charge-offs as a percentage of average loans of 15 basis points. Our credit losses remain near historic lows, and we remain confident in the way we have positioned our portfolio, consistent with our moderate risk profile. Despite the market disruption, we have not lost focus on driving our targeted scale strategy and investing in points of differentiation. In our wealth business, for example, which currently has $54 billion in assets under management, we are bringing the power and capabilities of our private bank to better serve mass affluent clients through our retail channel. Our Laurel Road business is expanding to serve the distinct needs of healthcare professionals through hospital system partnerships. In our commercial businesses, we are empowering our relationship managers with a comprehensive suite of tools to enhance productivity and to better support our clients. I remain confident and key in the long-term outlook for our business. We have durable, relationship-based businesses that will continue to serve our clients, our prospects, and deliver value to our shareholders. Lastly, I would like to thank our 18,000 employees for what they do each and every day to serve our clients. With that, I'll turn it over to Clark to provide more details on the results of the quarter and our 2023 outlook. Clark?

Thanks, Chris, and good morning. I'm now on slide six. For the first quarter, net income from continuing operations was $0.30 per common share, down $0.08 from the prior quarter and down $0.15 from last year. driven in part by two notable items. We incurred $64 million of restructuring expense, or $0.06 per share, which included $36 million of severance and other related costs, and $28 million of corporate real estate-related rationalization and other contract terminations or renegotiations. Our results also included $94 million of additional provision expense and excess of charge-offs, or $0.08 per share, as we continued to build our reserves, reflecting a more cautious, economic outlook, and view on home prices. Turning to slide seven. Average loans for the quarter were $119.8 billion, up 16% from the year-ago period and up 2% from the prior quarter as we continue to support relationship clients. Commercial loans increased 15% from the year-ago quarter. Relative to the same period, consumer loans increased 16%, reflecting growth in consumer mortgage. Compared with the fourth quarter of 2022, commercial loans grew 3%. Our commercial growth continues to reflect the strength in our targeted industry verticals and support for our relationship clients. Continuing on to slide eight, average deposits totaled $143.4 billion for the first quarter of 2023, down 5% from the year-ago period and down 2.3 billion or 2% compared to the prior quarter. Year over year, we saw declines in retail deposits driven by elevated spend due to inflation, normalization from pandemic levels, and changing client behavior due to higher rates. Commercial balances, which included $6 billion of broker deposits, remained relatively flat. The decrease in deposits from the prior quarter reflects a continuation of these same trends. Interest-bearing deposit costs increased 62 basis points from the prior quarter, and our cumulative deposit beta was 29% since the Fed began raising interest rates in March 2022. Our outlook for 2023 now assumes a cumulative deposit beta peaking in the low 40s. Turning to slide 9, we wanted to provide incremental detail on the granularity and composition of our $143 billion deposit portfolio. At the end of the first quarter, approximately 54% of our deposits came from consumer, wealth, and small business clients. An incremental 6% of deposits are from low-cost, stable escrow balances. The remaining approximately 40% of our deposits comes from our large corporate and middle market commercial clients. Over 80% of commercial segment deposit balances are from core operating accounts. Of our total deposits, 56% are covered by FDI fee insurance, while an additional 10% are collateralized. We maintain access to enough liquidity to cover over 150% of uninsured and uncollateralized deposits. The quality of our deposit base derives from the strength of our relationship-based strategy, which has benefited Key both from a balance stability and cost perspective. At period end, our loan-to-deposit ratio was 84%. Now moving to slide 10. Taxable equivalent net interest income was $1.1 billion for the first quarter, compared with $1 billion in the year-ago quarter and $1.2 billion in the prior quarter. Our net interest margin was 2.47% for the first quarter compared to 2.46% for the same period last year and 2.73% for the prior quarter. Year over year, net interest income and the net interest margin benefited from higher earning asset balances and higher interest rates, partly offset by higher interest-bearing deposit costs and a shift in funding mix. Relative to Q4, our net interest margin was negatively impacted by 22 basis points related to higher interest-bearing deposit costs and 22 basis points from a change in funding mix and liquidity and loan fees, partly offset by 18 basis points related to higher interest rates and earning asset growth. As Chris noted earlier, our swap portfolio and short-dated treasuries reduced net interest margin by 72 basis points in the quarter. Additionally, the net interest income was lower, reflecting two fewer days in the quarter. Turning to slide 11, as previously mentioned, Key stands to benefit significantly from the maturity of our short-dated swap book and treasuries. This opportunity is consistent with the billion dollars of upside we've been talking about over the last few quarters. While we recently offered more detail on the swaps and treasuries by quarter and interest rate, we thought it would be valuable to include a view on the realization of that potential value in both timing and amount. The chart on slide 11 shows this with the forward curve. We do include the value should short-term rates remain at current levels in a higher for longer scenario as well. We have also gotten questions about how we plan to lock in this value. As we've shared, we've taken a measured but opportunistic approach to adding hedges to address this potential. The analysis on slide 11 reflects the additional hedging activity we've undertaken beginning in Q4 and since. The point here is to provide one more level of depth to clarify the timing and magnitude of this opportunity. As it demonstrates, we continue to see significant future value in NII as these swaps and treasuries mature. Moving to slide 12, non-interest income was $688 million in the first quarter of 2023. compared to $676 million for the year-ago period and $671 million in the fourth quarter. The decline in non-interest income from the year-ago period reflects a $24 million decline in service charges on deposit accounts due to changes in our NSF OD fee structure that we previously discussed and implemented in September and lower account analysis fees related to interest rates. Additionally, investment banking debt placement fees declined $18 million, reflecting lower syndication fees partly offset by an increase in advisory fees, while corporate services income declined $15 million, reflecting lower loan fees and market-related adjustments in the prior period. The decline in non-interest income from the fourth quarter reflects a $27 million decline in investment banking and debt placement, driven by lower advisory and syndication fees. Recall that Q1 is historically the low point for investment banking activity in the year. Other income decreased by $20 million driven by a visa litigation assessment and market-related adjustments. Additionally, corporate services income decreased by $13 million, reflecting lower derivatives volume. Moving on to slide 13. Total non-interest expense for the quarter was $1.18 billion, up $106 million from a year-ago period and up $20 million from last quarter, inclusive of $64 million of restructuring charges related to actions we completed this quarter to take out $200 million in annualized costs. As we shared on the Q4 call, we took these steps proactively to support investment in our business in the face of continued inflation. Compared with the year-ago quarter and in addition to restructuring charges, personnel expense increased, reflecting an increase in salaries and headcount, partly offset by lower incentive compensation. Compared to the prior quarter and in addition to restructuring, business services and professional fees declined $15 million and marketing expense declined $10 million. Additionally, other expense increased in the first quarter by $9 million, reflecting an increase in the base FDIC assessment rate. Moving now to slide 14, overall credit quality remains strong. For the first quarter, net charge-offs were $45 million for 15 basis points of average loans, which remain near historically low levels. Our provision for credit losses was $139 million for the first quarter, which, as we pointed out, exceeded net charge-offs by $94 million. 30 to 89 day delinquencies to period end loans were down one basis point to 14 basis points, while 90 plus day delinquencies remain stable. The excess provision increases our allowance for credit losses, reflecting a more cautious model driven assumption. Despite the increase in the allowance, our outlook for net charge offs in 2023 of 25 to 30 basis points remains unchanged and well below our through the cycle levels of 40 to 60 basis points. Moving to slide 50. With regard to commercial real estate in particular, QIES exposure is well controlled and credit quality remains strong. Over the past decade, we meaningfully repositioned our commercial real estate book by sharply reducing our exposure to construction and home builders and reducing the level of commercial real estate loans in our book. We focus on relationship lending with select owners and operators. Our improved risk profile has been demonstrated in Key's most recent stress test results, where projected losses on our commercial real estate book stand at 8.2% compared to 11.5% for peers. Now on slide 16, our liquidity position is strong. Our period in cash balances at the Federal Reserve stood at $8 billion, and we maintain flexibility with significant levels of unused borrowing capacity from additional sources. We would expect to maintain higher cash balances until the market stabilizes. Our levels of additional available liquidity have not changed materially since the end of the quarter. On to slide 17. We ended the first quarter with common equity Tier 1 ratio of 9.1% within our targeted range of 9 to 9.5%. This provides us with sufficient capacity to continue to support our relationship customers and their needs. We completed $38 million of open market share repurchases in the first quarter related to our employee compensation plan. Given market conditions, we do not expect to engage in material share repurchases in the near term. We will continue to focus our capital on supporting relationship client activity and paying dividends. Over the last six weeks, there's been significant discussion of AOCI and its potential inclusion in CET1 capital levels for Category 4 banks. We've historically chosen to put most of our portfolio purchases in available for sale, and given the recent market rise in rates, we saw significant increases in the negative markets. As time passes and if rates have come down, we've seen our AOCI mark decrease by 13% from 6.3 billion at 1231 to 5.5 billion at 331. We share on slide 16 the expected reduction in the AOC mark from 331 to the end of this year and the end of 2024. Over that timeframe, the AOC mark declines by approximately 40%. And while this analysis assumes the forward curve, it's important to note that 90% of the value is from maturities and cash flows and is not rate dependent. Although we have no unique insight into the path of potential regulatory changes, as we've seen historically when bank capital regulations have changed, they carry with them comic periods and a reasonable phase-in timeframe. Our view is that for any new requirements, our reduction in AOCI mark, and more significantly, our earnings, would allow us to organically accrete capital to required levels over the necessary period. Slide 18 updates our full year 2023 outlook. The guidance is relative to our full year 2022 results. We expect average loans to grow between 6% and 9%. Importantly, most of this growth has already occurred relative to 2022, so we don't expect material loan balance growth. We'll continue to support relationship clients by recycling capital throughout the year. We expect average deposits to be flat to down 2%. Net interest income is now expected to decline by 1% to 3%, driven by higher interest-bearing deposit costs and a continued shift in funding mix. Our guidance is based on the forward curve, assuming a Fed funds rate peaking at 5.1% in the third quarter and starting to decline in the fourth quarter. These interest rate assumptions, along with our expectations for customer behavior and the competitive pricing environment, are very fluid and will continue to impact our outlook prospectively. Not interested. Income guidance is unchanged. We continue to expect it to be down 1 to 3 percent, reflecting the implementation of our new NSF OD fee structure last year and continued challenging capital markets activity, at least in the first half. Our non-interest expense outlook is also unchanged. We expect it to be relatively stable, driven in part by the actions we took last quarter to accelerate cost savings, which includes the impact of the $64 million in restructuring charge. For the year, we continue to expect credit quality to remain strong and net charge-offs to be in the 25 to 30 basis point range, well below our over-the-cycle range of 40 to 60 basis points. Our guidance for our GAAP tax rate is now 20 to 21%. We feel confident in the foundation of our business, the relationship-driven value of our deposit book, the durability of our balance franchise, and our improved risk profile. Despite near-term headwinds, we continue to be focused on execution in 2023 and the strong long-term earnings power of our company. With that, I'll now turn the call back to the operator for instructions on the Q&A portion of the call. Operator?

Thank you. Ladies and gentlemen, if you would like to ask a question, you may press 1, then 0 on your telephone keypad. You will hear acknowledgment that your line has been placed in queue. You may remove yourself from the queue by repeating the same 1, 0 command. One moment, please, for the first question. We go to the line of Ibrahim Poonawalla with Bank of America. Please go ahead. Good morning.

Good morning, Ibrahim. How are you? Good.

So just starting on deposits, we've obviously gone from mid to high 20s beta to 30s to now low 40s. I guess, Chris Clark, give us a sense of just in terms of your comfort level that this high, if the forward curve, or at least if the Fed is done with one more hike, why the low 40s beta should be the right number in terms of your confidence level, and just the vigor of the analysis that went behind that assumption?

Sure. We'll get into that analysis in just a second, but there's no question that we early were surprised at how low the betas were, and as of late, We've been surprised at the steepness of the curve, so your question is a good one. Before I turn it over to Clark, let me just give you a little bit of context on our deposit base. Our total cost of deposits, as is in the deck there, is 99 basis points. Our cost of interest-bearing deposits are 136. As we mentioned, our cumulative beta is 29. And as you just brought up, we now expect betas to peak in the low 40s. But I just want to talk a little bit about the composition of our deposit base. We are a business that's more heavily canted to commercial than retail. And if you think about those deposits, these are people that we've helped through many cycles. Most recently, we've helped through PPP. Over 80% of these accounts are operating accounts. And so when people talk about what's insured, what's not insured, I think one thing that some people miss is if you're running a two or three or $400 million business and we have the operating account, those deposits aren't going to go anywhere because it's a living, breathing thing. And so I just, I thought I would just give you that context because when we think about deposits, we always kind of bifurcated in by category, but getting back to your question, Clark, give us the rigor behind the low 40s and our confidence in SANE.

Yeah, so I'd start, I think, with balances, Ibrahim. I think we feel very good about where our balances sit today relative to where they have been relative to the market we're in and relative to competitors. So, you know, it starts with balances and then you get to pricing. As we've talked about in the past, we've been more focused on retention of deposits than acquisition of new deposits, and I think that is reflected in the beta to date. The other point, since last sort of third quarter, fourth quarter, as we've watched the market develop, I think we, while we would not purport to have perfect information about behavior, we have a much better view on how customers are interacting. I think the commercial betas have mostly played through, so we've seen those come up. Many of those, as we've talked about before, are indexed. and, you know, others, there's been a lot of conversation and engagement with commercial clients. The consumers are always slower to move, and we believe at this point we have a better view on how they're behaving, the types of accounts they want, and how competitors are reacting. So when we look at the low 40s number up a bit from the high 30s, we have some confidence that we can deploy beta in areas across the retail franchise, but also in some targeted customer sets to not only retain, but potentially acquire some deposits going forward.

Got it. Thanks for that. And just maybe a quick one, Clark, on the slide 11, the bar chart with the NII upside from swaps and treasury roll-off. Give us a sense of sensitivity if rates are 100 basis points lower next year versus today. What does that mean for that upside that you lay out there?

Yeah, so what's embedded in the chart on the page, Ibrahim, is the forward curve, which is coming off. I don't have in front of me exactly what those rates are, but they're coming down pretty significantly over that time frame. I could follow up with a little more sensitivity, but effectively you can think about the forward curve in that 720 range as we talked about annualized. Maybe the right comparison is if rates didn't move at all and the spot rate just sort of played out, you'd get back to that billion-dollar number. So you see a little bit of a sensitivity between a, quote, higher-for-longer version where the spot rate just sort of sticks versus the forward curve, which is coming down fairly significantly over the next seven quarters.

I think in the prepared remarks you said you were taking actions to log that in. How are you doing that?

So I think we've shared before, but I'm happy to talk about it. So if you think about 2023, we had at the beginning of the year about $6.2 billion of receipt-fix swaps rolling off, $1.7 billion in the first quarter at a rate of 2.62. So that was sort of the highest of the two-year rate. The rest will roll off through the year, so another $4.5 billion. We're not replacing those, so we're going to allow on that portion the natural asset sensitivity of that loan book to come through. Next year, another $7.5 billion of swaps mature, and we've essentially replaced those with a combination of forward starters at an average rate of 3.4%. So there's some negative carry in that, but in the forward rate, they actually are a bit in the money by the end of the year. And then the other half with floor spreads that kick in at 340. And the value of that, as you can imagine, is we get all of the floating rate value above 340 until the forward curve comes down. And if we were in a higher rate environment, we would benefit from actually not hitting that floor. So we think we've managed the downside risk there quite well and preserved some of the upside there. The reason we wouldn't do or haven't done more or all floors or floor spreads at this point is just the cost of volatility is pretty high, so we're trying to balance the risk-reward on that trade.

Thanks for taking my questions. Sure. Next, we go to the line of Scott Seifers with Piper Sandler. Please go ahead.

Thank you for taking the questions. So, Clark, as we look for sort of from the margin at 247 now and then that kind of, I guess, aspirational margin near 320x treasury in some spots, I guess one of the big things has been sort of what happens between here and there. Do you have a sense for when, based on what you see now, when the margin would bottom, where that might be, and then, you know, kind of more specifically when it would start to inflect upward to, I know the treasuries start to, The treasures and swaps, that's more of an end of 2023 and into 2024. But will we get a margin inflection this year, or is that something that do we continue to bleed out a bit through the remainder of the year before it inflects back up? How do you think about that dynamic?

Good question, Scott. So we would have originally thought Q1 was the low point. We think that's now Q2. And then we'll start to see some stabilization and uptick in the back half of the year. And, again, part of that is really the swap book starts to roll off. We begin to see some treasuries, although they're fairly light, in 2023. Okay.

That's perfect. Thank you. And then, Chris, maybe just a thought on investment banking rebound in the second half. What does that kind of look like in your mind? How powerful could it be? It's been such an odd environment. You've got the VIX at a level where historically there would be a lot of activity now. But, you know, it certainly feels very uncertain. And I think we've all been sort of surprised by overall lack of activity. So when you sort of look out over the remaining several months of the year, what's sort of your best guess as to how a rebound might play out?

I think you have to go through sort of the price discovery. And I think there's a bid and an ask basically on, you know, equities is you can see there's some deals getting priced. You can see there's some high yield that's getting done. But I think, Scott, what it's going to take is for kind of buyers and sellers to readjust their expectations. And I think my experience is that process takes a while, but eventually people adapt to kind of what the new normal is. And as I said in my comments, I actually think it will come back sometime in the second half. Our pipelines are down about 10% from last year, which in the grand scheme of things, if you think about this time last year is – is not bad. So the pipelines are good. We actually had a nice quarter in terms of advisory. But a lot of our clients, frankly, are sitting on the sidelines, there are deals to be done. And frankly, we're advising many of our clients that now is not the perfect time, either to enter into the financing market, or to complete a transaction. But it will it will come back in the pipeline is building some deals will just go away. But it will come back.

Yeah. Okay. Perfect. Thank you all very much. Thank you, Scott.

Our next question is from John Pancari with Evercore. Please go ahead.

Good morning. Good morning, John. Good morning. Just a couple of questions regarding the NII outlook for the year. Can you just share with us your thought of the noninterest-bearing deposit mix shift, how you view that progressing? And then also on the On the progression for the second quarter, just regarding Scott's question on the margin, you mentioned that you see a pullback again in the second quarter and then inflection. Can you maybe help us size up that amount of margin compression incrementally in the second quarter? Thanks.

Sure. From non-interest bearing, we've seen that come down 29% to 26%, 27%. We would think that that would increase. make its way to the mid-20s, but I will say there's one caveat in there, and that is we have been using, I believe we've talked about this, but we've been using what we refer to as a hybrid account with many of our commercial clients where we're taking non-interest-bearing deposits and some of their excess balances and keeping them together in one interest-bearing account. So we've moved balances out of non-interest-bearing into those accounts. They would reflect on the balance sheet as a decline in non-interest bearing, but it allows us to maintain those balances in a technically interest bearing account, but at very attractive rates. So, again, we can break that out over time, but I would say the non-interest bearing decline probably isn't quite as stark as it would appear on its face. As it relates to net interest income, second quarter, we'd expect that to be down kind of 4% to 5% in Q2, with NIM coming down in part because we're carrying a little bit excess liquidity post the early March period. And we would see that come down, we think, maybe another six to eight basis points. And then, as I mentioned, responded to in Scott's question, kind of stabilized and started to come back up in the second half of the year.

Got it. Okay. All right. That's helpful. And do you care to venture a projection in terms of the magnitude of the inflection in the back half?

Not at the moment. We haven't provided that yet. But you would see obviously our guide for the year on them being down a little, but that's obviously going to require us to be stronger in the second half, and we expect to see that.

Gotcha. Okay, thanks. And then just separately on regulation, I want to see if you can maybe provide some comments around how you're thinking about the most likely areas of regulation where you expect some measures out of the regulators around, you know, inclusion of AOCI, potentially TLAC, FDIC, stress capital buffer, you know, risk. Maybe if you could just comment on that. Chris, I'm interested in your comments on that as well.

I'd be happy to comment on that. To the premise of your question, there's no question that we'll be experiencing we're going to have to carry more capital and there'll be more regulation. I personally think TLAC is going to be part of that or some debt security that looks like TLAC. I also think that we'll probably have to carry more capital. We, as you can imagine, have run all kinds of scenarios. We feel comfortable that based on the burndown of our AOCI, based on the earnings power of the company, and based on timing, i.e., there would be some comment period and some phase-in period, we feel like no matter, under all the scenarios that we've looked at, we feel confident that Key can be in a position to meet both the regulatory and the capital requirements going forward.

Great, thank you.

Thank you, John.

Next, we go to Erica Najarian with UBS. Please go ahead. Yes, hi, good morning.

If I could ask the... NII protection question another way. Clark, the loan data of your commercial portfolio was something like 52% in the second half of 2022 and about 65% this quarter. As we think about the protection for down short rates, and I think a lot of investors are expecting down short rates in 2023, Should we interpret your protection as a lower sensitivity to each 25 basis points of cut that we've seen to the upside?

Sorry, can you ask that one more time, Erica? I just want to make sure I'm understanding.

Yeah, so I wanted to understand slide 11 a different way, right? So the protection on your commercial portfolio and locking in the upside is So we saw the sensitivity to higher short rates, you know, in terms of the carry-through-tier yield at about the low 50s in the second half of last year and in the mid-60s this quarter, right? The way investors are interpreting, you know, protection to the downside is a lower sensitivity as the Fed cuts, right? And so should we expect the key commercial yields have a lower sensitivity to cuts on the way down than it did to increases in rates on the way up?

I mean, yes, if you think about the incorporation of the swaps, right? So the swaps are there for exactly that purpose, and they would, you know, reduce the sensitivity on the way down. That's the intent of those instruments.

Okay, and what you're showing us on slide 11 is essentially the assumption that your current swap book, as it rolls off, gets replaced with a higher received fixed rate?

Yes, so two components, right? In 23, I think our view, the forward curve, I have not seen a view yet where rates come down below where swap rates would be. So we're going to let that roll through our natural loan rates and yields flow through in 23. In 24, we've effectively replaced the swap book with forward starters at a higher rate, 340 on average, and floor spreads with a kick-in rate of 340. So if rates were to stay higher We'll get the value on the floor spreads. We'll carry the negative carry on the forward starters. If the forward curve plays out, both of those will be in the money at some point in 24.

Got it. And I'm sorry to just put this all together in the third question, but, you know, investors are thinking about whether bank stocks are truly cheap. I think they're thinking about 24 EPS as a trough. As I think about your commercial yield today, right, there are essentially sort of two, quote, headwinds, right? So the first would be the lower received rate, received fixed rate on your notional, and the second would be, you know, on the other side of that, right, the yield will be better protected as the Fed cuts. So am I thinking about, you know, sort of the message on downside NII protections the right way as it relates to your commercial block.

Yeah, I think you said that well.

Okay, thank you.

And next we move to Ken Houston with Jefferies. Please go ahead.

Hey, good morning. Just a follow-up on the swap. So maybe just ask it a different way. So in the back-end number from the 10K, of the reported impact from swaps in the fourth quarter was minus 162 million. Do you have the number of what that negative impact was in the first quarter? And can you help us understand what it'll look like when we see the new disclosure for the roll forward next four quarters? Thanks.

You're talking just swaps specifically, Ken? Yes. Yeah, 215 in the first quarter.

Okay, that's 215. And then so last quarter's next four quarters roll forward from the K was 665 after tax. Do you have an idea of what the new roll forward will be when we see that in the 10Q? Not at this point, but we can follow up and let you know that. Okay. And then the last question is you mentioned the 750 and the billion and that you're not going to be replacing now. Can you maybe just flesh that out a little bit in terms of any change to that strategy around protection and how you'll be replacing going forward to get that incremental forward benefit from the roll-off versus what you're putting on?

Yeah, so I'll keep trying. I'm worried I'm not being super clear. So the $6.2 billion of received fixed swaps in 2023 are going to mature. $1.7 billion of that matured in the first quarter. We're not planning to replace those to protect the loan book in-year from a received fixed swap standpoint. There's another $7.5 billion that roll out through 2024, and we've taken steps to effectively replace that. Not all of it exactly. We're in the $7 billion range, half of which is forward start received fixed with an average rate of $340. So just think about that as replacing the existing 24 rate and now bringing that up to 340. And then the other half with floor spreads that have an attachment point at also roughly 340, just by coincidence. So that really is the protection against rates coming down, which the forward curve would project at this point. And it would sort of lock that $7 billion or so at a 340 yield or higher as those other swaps roll off.

Got it, and I know that was asked, so I apologize for re-asking.

No, that's okay. I think I'm maybe not doing it as clearly as possible, so I appreciate the follow-up.

And next we go to a question from Mike Mayo with Wealth Fargo Securities. Please go ahead. Hi. Good morning, Mike.

So this is a tough quarter for you guys, I guess, relative to expectations. You guys missed on NII, NIM, fees, provisions, and expenses. You got NII lower, down 1% to 3% this year, when before it was up 1% to 4%. You said NIM will go down next quarter. And so that's just, you know, given all of those headwinds and pressures, and maybe I'm misstating that, and correct me if I did, are you ratcheting down expenses more? Are you becoming more cautious, or are you just kind of have to take the stomach punch of the higher funding and go on with it. And part of that, you didn't change your own guidance, so it doesn't look like you're being more cautious there. So just, I guess I'm trying to say, is this as bad as it looks, or are there some silver linings out of this? I mean, with your resiliency, maybe you can gain share, but that's not showing up in your guidance.

Yeah, so thank you for the question. Let me just kind of broadly... Talk about the quarter. Mike, there's no question it was a challenging quarter for us. But we continue to do the things that we need to do to build the franchise. So what are those things? You mentioned expenses. We put a hiring freeze in place in November, and we took out $200 million or 4% of our expense base just in the quarter we just completed. So that's one of the things we do. We've done. We've talked a lot today about kind of how we're managing our balance sheet. We have taken significant actions and we have the luxury of taking the actions because they're short duration, both on our swaps and on our investments to put us in a position where we can benefit from the rise in interest rates. So we've done that. And then the other thing we continue to do, as you know, is we continue to strategically invest in our business and focus on targeted scale. So my perspective is, yes, this is a challenging quarter. Yes, we have to get through this NII drag, but we have a clear path to do so. And, you know, that's what we as a team are in the business of focusing on.

And, Mike, I'd just add two things. On the expenses, they're up because of the charge, $64 million. If you took that out, we'd be in good shape. And I think if you annualize that number, we're, you know, right in line with our guidance, relatively stable year over year. And again, that's in the face of, you know, some inflationary headwinds. I think on the provision, you know, you heard it's our charge-offs. We didn't change our guidance, which may beg the question of why did you build your provision? And frankly, we're doing what we think CECL was intended to do, which was when macroeconomic conditions change, you build a reserve. You know, we're applying that standard, and that would be the reconciliation between two quarters of build and no change in the charge-off guidance.

Given that extra caution, you kept your loan growth the same at, what, 6% to 9%. So I'm trying to reconcile your more caution with your provisions with no change in your loan guidance, whereas others have brought down their loan guidance as they tighten things up.

Yeah, Mike, there are we have basically we are at the low end of our guidance for the year already. So what we're going to be doing for the balance of the year is we're going to be recycling capital. And to your point, there's no question that the cost of raw material has gone up significantly. We're certainly not going to change our lending standards. But in terms of pricing, we will make those adjustments. We're fortunate that we have a bunch of relationships that pay us really well, and we're in a position to serve those relationships. But as you and I have talked before, lending on a standalone business, it's hard to return your cost of capital. So you can imagine when your cost of capital goes up that the pricing and the other things that you're doing for those customers, frankly, will have to be even greater.

Yeah, so just to be super clear, the 6% to 9% year-over-year loan growth really was resident at the end of 2022. So it really just reflects the growth that occurred in 2022, just to make that abundantly clear.

And so one more follow-up. It seems like the capital markets is pricing for risk more than the lending markets. So when you have that conversation with your commercial customers and say, hey, we're going to pass on this higher cost of raw materials, are you seeing any additional pricing power in lending markets? I mean, it just seems like loan yields should be going up more than they already have done.

Yeah, and they never go up as much as they should because, frankly, there's too much excess capacity in the banking market. But, no, they haven't moved. And that's where it really pays to have a wholesome relationship like where we can drive a bunch of other revenue. But there hasn't been the adjustment yet that there should be based on the arbitrage between the capital markets and the bank market.

I guess I'll sneak one last one in. If that's the case then, I mean, if the cost of all materials are going up and you can't get the loan yields you desire, maybe just, you know, de-lever a little bit and just not as much growth but have less risk? Or, I mean, how do you do that trade-off?

Because it just doesn't seem to add up. I think over time that's what you're going to see, right? We'll be using the capital markets as they open up to actually place paper for people. But in terms of putting new debt on our balance sheet, we're not going to do it unless we have a complete relationship and we can drive a whole bunch of revenue. And that in itself will be limiting. Got it. All right. Thank you. Thanks, Mike.

And our next question is from Manan Ghazalia with Morgan Stanley. Please go ahead.

Hey, good morning. I wanted to follow up on the cost-cutting efforts that are underway to counter inflation. Just given the event of the past few weeks, How does that change what you think you need to do on the investments, right? So, you know, as I think about deposit competition accelerating, are there any investments you think you need to make on either the technology or the product side in order to retain and grow deposits? And how much of that is embedded in your expense guide?

Yeah, thanks, Manan. So, right question, the good news for us is, We undertook the expense cuts so we could make those investments, and we've got both on the consumer and commercial side a focus on deposit and customer acquisition technology, whether it's digital capabilities in consumer, things like embedded banking, which we've talked about before, or other payments capabilities on the commercial side. So that cost cutting was in part to make room for exactly those types of investments.

But is there anything additional you need to do given the events of the past few weeks?

I mean, we'll assess that as we go forward. I think we feel well prepared to handle the deposit challenges in front of the market right now, and I think our numbers have shown that. I think more than anything, we're probably likely to be more offensive on the deposit side than we've been to date, and we feel well-armed to do that.

Got it. Great. And then just on securities, I appreciate the detail on the AOCI accretion over time. I wanted to ask, how do you think about the future mix in duration of the securities book, just given what we've seen in the past few weeks, and just given the potential for higher regulation? Would you skew the mix of your securities more short-dated, more towards treasuries? Just want to get a sense of how you're thinking about that.

Yeah, it's a good question, hard to answer in a vacuum, but my sense would be you'll see higher quality portfolios, although ours is pretty high quality today, and you'll probably see shorter duration or more floaters. So it'll be interesting to see if that's the way it shakes out, the broader impacts of bank security portfolios moving in that direction and how that might impact the market more broadly.

Great, thank you.

And next we have a question from Stephen Alexopoulos with J.P. Morgan. Please go ahead.

Hey, good morning, everyone. Morning, Steve. So first, on the deposit side, so your uninsured deposits are fairly high, but it does not appear that you saw a large degree of outflows, right, that many of your peers saw in the aftermath of Silicon Valley Bank. Could you comment on that? Were there notable outflows? Or because of the operating nature of these accounts, which you called out, Chris, was that enough of a factor where... You just didn't see what many peers saw.

Yeah, well, just to be clear, you know, 66% of our deposits are either uninsured, either insured or collateralized, Steve. So that's point one. But I don't know, I can't speak to other people's book. We, like everyone, we saw some deposits move out, particularly in places like high net worth individuals. We saw some in the smaller end of kind of small business and business banking, where basically the business and the person are sort of synonymous. We saw a couple of larger excess deposits move. But in general, the reason we've enjoyed such stickiness of the deposit is kind of the comments that I made earlier. These are operating accounts for businesses, and these are businesses that have been clients of Key for a long time. you know, frankly, there wasn't, you know, even a lot of angst. I mean, we obviously did a good job of reaching out to all of our customers, as we always do. But I was very pleased with the stickiness of the deposit in the core deposit base. Okay.

That's helpful. And then, Chris, on the potential for new regulation, and you said you're in a good position to organically build capital, right, in anticipation of new regulations potentially coming. Do you assume that you need to suspend buybacks for an extended period until we see new regulation in order to build that capital?

Yes. I don't really plan on – we don't plan on executing any buybacks until there's clarity as to what the capital framework is going forward. So I don't anticipate that we'll be doing any share repurchases until there's clarity.

Got it. Okay. Thanks. And just one final one in terms of you responding to John's. I think there was an earlier question. This hybrid account for commercial customers, which is paying interest. Red's not interest-bearing, but you're paying some interest. What was the balance in that account, and how much are you paying? Thanks.

Yeah, we'll have to follow up. I don't have that specific number in front of me, but we'll follow up if you see it. Okay. Sounds good.

Thanks for taking my questions. Yep.

And next we go to the line of Gerard Cassidy with RBC. Please go ahead.

Good morning, Chris. Good morning, Clark.

Good morning, Gerard.

You touched on in your opening remarks about the third-party company that services commercial loans and gives you an insight into pipelines of what may be coming down the pike, so to speak. Can you share with us, is that company, the one that obviously you own, are they seeing an increase in activity from commercial loans? mortgages that are in, you know, commercial mortgage-backed security products, that they're the special servicer on. Has that started to pick up yet? And if not, what are they saying?

Well, thanks for your question. So basically you have, you know, you have servicing, then you have special servicing where you're the named special servicer, and then it goes into active special servicing. So think of active special servicing as being the workout agent for office loans, whether they're CMBS or whatever. we have seen a huge surge in active servicing. And what was the number one just a quarter ago, the biggest category was retail, and the fastest growing was office. And what's happened is that's flipped. Now office is both the fastest growing and it's the largest by a significant factor. So we do have a pretty good insight. We have an insight by class. And just so you know, office is first and then retail is second. And then we also, of course, have a geographic breakdown because real estate is always geographic. So it does give us great insights and it is very dynamic. And kind of the trends that we, you know, some time ago we said we thought we'd see a lot of B and C class office buildings in central business districts. And although we, for our own book, only have like 127 million of that exposure, We are seeing that play out, and now office is the number one category in active special servicing.

And can you remind us, I don't know if you have this number, in active special servicing, I know the fees are greater than your regular servicing. By what factor? Is it a two times higher fee, four times higher fee?

It's much higher than four times because you go from getting really kind of just sort of a ticking fee to you're actively working on it. So it is in multiples of what the regular fees are as you go into special servicing. And when you look at our financials, you can see the bump in that line item.

Which is in the commercial mortgage servicing fees, is that correct?

Exactly, correct.

And then as a follow-up, Clark, you identified that the provision was higher to build up reserves due to CECL accounting. Can you share with us Some of the metrics, maybe, I don't know if you want to use, you know, HPI, the housing price index, or unemployment, the unemployment rate. What were your assumptions in the fourth quarter, and how did they change in the first quarter to support the increase in the provision for loan losses?

Yeah. So let me just start with HPI, because that's where you started. The I think we may have talked about Moody's, which we use the Moody's consensus. They put out an HPI model in Q4 that was updated. They still produced their old one. We were comfortable with the old one. Now it's just the new one, which I would say is fairly draconian and sort of biased.

Yeah, their HPI, Clark, went from 4.6% in November to 8.8% as of February under the Moody's consensus.

So that would be the draconian part of draconian, yeah. So that's a big mover. And largely, you know, unemployment went from 4.5% to 5%. So those would be sort of the two big impacted areas. Thank you.

And, ladies and gentlemen, we will now be turning the conference for closing remarks back to the CEO, Chris Gorman.

Well, I want to thank everyone for joining us today. This concludes our first quarter call. If you have any questions, please, as always, reach out to Vern Patterson. Thank you so much. Have a good day. Goodbye.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.