Bank of N.T. Butterfield & Son Limited (The)

Good morning. My name is Sarah, and I will be your conference operator today. At this time, I would like to welcome everyone to the first quarter 2021 earnings call for the Bank of N.T. Butterfield & Sons Limited. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then 1 on your touchtone phone. If you would like to withdraw from the question queue, please press star then 2. Please note this event is being recorded. I would now like to turn the call over to Noah Fields, Butterfield's Head of Investor Relations.

Thank you. Good morning, everyone, and thank you for joining us. Today, we will be reviewing Butterfield's first quarter 2021 financial results. On the call, I'm joined by Butterfield's chairman and chief executive officer, Michael Collins, and chief financial officer, Michael Scrum. Following their prepared remarks, we will open the call up for a question and answer session. Yesterday afternoon, we issued a press release announcing our first quarter results. The press release and financial statements, along with a slide presentation that we will refer to during our remarks on this call, are available on the investor relations section of our website at www.butterfieldgroup.com. Before I turn the call over to Michael Collins, I would like to remind everyone that today's discussions will refer to certain non-GAAP measures, which we believe are important in evaluating the company's performance. Please note that in the first quarter of 2021, we did not record any non-core items. As a result, any references to prior period core results are comparable to US GAAP results in the first quarter of 2021. For reconciliation of any non-GAAP measures to US GAAP, please refer to the earnings press release and slide presentation. Today's call and associated materials may also contain certain forward-looking statements which are subject to risks, uncertainties, and other factors that may cause actual results to differ materially from those contemplated by these statements. On slide 25 of the presentation, we've also included a list of potential factors relevant to the implications of COVID-19 for the bank. Additional information regarding these risks can be found in our SEC filings. I will now turn the call over to Michael Collins.

Thank you, Noah, and thanks to everyone joining the call today. During the first quarter of 2021, Butterfield continued to achieve strong operating results and delivered high returns with an actively managed low-risk profile. We provide market-leading financial products and services to clients seeking banking, wealth management, trust, and custody services in our primary markets of Bermuda, Cayman, and the Channel Islands. where we have longstanding, significant, and stable market shares. We also deliver trust and wealth management services through our offices in Singapore, Switzerland, and the Bahamas. In the United Kingdom, we offer mortgages to high net worth clients with properties in prime central London. As you will see on slide four, Butterfield continues to report strong results with net income and core net income of $41.6 million, or 83 cents per share, and a return on tangible common equity of 19.3%. We had stable net interest income and fees with improving expense trends. Based on an improved economic forecast and steady loan performance, we had a credit reserve release of $1.5 million in the first quarter of 2021 compared to a recovery of $2.4 million in the prior quarter and a provision of $5.2 million in the first quarter of last year. We are encouraged by the improving economic and interest rate outlook across our operating jurisdictions as we emerge from the COVID-19 pandemic. We will continue to work with a small number of borrowing customers to help them find solutions to any challenges they may face. So far, our credit portfolios have shown a high degree of resilience during a difficult operating environment. The Board of Directors again declared the $0.44 per share dividend which is consistent with our capital management philosophy of supporting a sustainable quarterly cash dividend with consideration for both organic and inorganic growth, as well as share repurchases. We continue to target a through cycle dividend payout ratio of approximately 50% with flexibility around share buybacks, depending on market conditions and potential M&A opportunities. I will now turn the call over to Michael Scrum to provide more details on the first quarter.

Thank you, Michael. I'll start on slide six with a summary of net interest income and NIM. In the first quarter, we reported NIM of 2.09 percent, which was 16 basis points lower than the prior quarter due to three primary contributing factors. Firstly, continued low yields on the short end of the curve. Secondly, elevated prepayment speeds and reinvestment yields that are below running book yields in the investment portfolio. And thirdly, the most important significant contributor was the level of customer deposits and cash balances, which remained at historic high levels throughout the first quarter. Loan yields were down five basis points due to a jurisdictional mixed shift in the first quarter. During the quarter, Bermuda had a modest increase in commercial loans, while Cayman saw some residential loan growth. although growth was mostly offset by an early repayment of a sizable commercial facility in the Channel Islands. During the quarter, the net average balance in the investment portfolio increased approximately $500 million, or 10%, as we put new money to work in the U.S. agency MBS Securities portfolio. New money yields averaged 1.62% in the first quarter of 2021, or 16 basis points higher than the 1.46% in the prior quarter. During the first quarter, the blended rate for loan originations improved to 4.15% for $212 million of new loans from 3.66% for $201 million of originations in the fourth quarter of 2020. Turning to slide seven. Non-interest income was stable at just over $47.5 million. Transaction volumes in foreign exchange increased, which lifted foreign exchange commissions by $1.9 million in the quarter, and asset management also benefited from increased valuation-based fees. These offset the seasonal decline in debit and credit card fees due to the fourth quarter holiday shopping spending volumes. The bank continued to benefit from diverse and capital efficient fee business with a fee to income ratio of 38.4% in the first quarter of 2021. Slide eight provides a summary of core non-interest expense, which improved by 1.8% to $80.9 million in the first quarter of 2021 compared to the prior quarter. The phase restructuring during the second half of last year has continued to improve run rates with salaries and benefit costs reduced 4.3% over the prior quarter. This was moderated by an increase in high indirect taxes, but the overall restructuring program savings run rate has now been achieved. The cost to income ratio improved sequentially by 80 basis points to 64.8%, which is approximately where we expect to be at this point in the business and rate cycle. Slide 9 summarizes regulatory and leverage capital levels. Butterfield continues to maintain capital levels conservatively above regulatory requirements. During the quarter, higher U.S. dollar long-term interest rates lowered OCI gains on the AFS investment portfolio by $67.2 million, and this resulted in a TCE to TA ratio temporarily below our targeted range of 6% to 6.5%. We expect this to build back with normalized deposit levels supported by a normal organic capital build over the coming quarters. Turning now to slide 10. Butterfield's balance sheet continues to be strong and conservatively managed with very high degree of liquidity. As discussed, we continue to see historically high deposit balances due to government stimulus, one-time pension withdrawals, and varied commercial customer activity. We still expect that a portion of these deposits will be temporary in nature. On slide 11, we show that Butterfield's asset quality remains exceptionally high with low credit risk in the investment portfolio, which continues to be 99% comprised of AAA rated U.S. government guaranteed agency securities. We remain comfortable with our lending book profile with two-thirds of loans comprised of manually underwritten full recourse residential mortgages in Bermuda, Cayman, and the UK. In the Channel Islands, we are continuing the marketing of the residential mortgage products that will be similar in structure and underwriting to our Bermuda and Cayman loans and will allow us to activate our sterling deposits. The overall residential loan to value profile remains conservative at approximately 53% in Bermuda and Cayman. Our credit book continues to perform well with non-accrual loans holding steady at 1.4% of gross loans. Following an increase in the fourth quarter of 2020 related to one commercial loan, the net charge-off ratio has settled back down to negligible levels. We continue to actively monitor credit with outbound calling programs and are working with any customers who may be experiencing difficulty. On slide 12, we discussed the average cash and securities balance sheet with a summary interest rate sensitivity analysis. Butterfield's weighted average life in the AFS investment portfolio increased to 6.1 years from 4.2 years last quarter due to the expectation of slower MBS prepayment speeds as long-term rates continue to rise. As mentioned, we also added approximately net $500 million of new money to lock in some of the benefit from higher rates during the quarter. Consistent with prior quarters, Butterfields continues to expect a potential increase in net interest income in both the up and down rate scenarios. I will now turn the call back to Michael Collins.

Thank you, Michael. I remain confident in Butterfield's strong operating position and the potential for continued organic growth, as well as any possible acquisitions. We continue to examine potential acquisition targets and have seen an increase in the opportunity set that could be a good fit for Butterfield. Of particular interest are private trust companies within our geographic footprint. Pricing and due diligence will be key factors in progress on any possible deals, with particular emphasis on customer documentation and evidence of robust compliance risk management. Butterfield remains committed to the successful strategy that we initially listed with on the New York Stock Exchange in 2016. We continue to generate ROEs in the mid to high teens with recurring fee income, low-cost deposits, a manually underwritten loan book with low LTVs, a capital-efficient investment portfolio with limited credit risk, strong risk management, and a disciplined expense and capital management approach. We believe these attributes will continue to generate value for the bank and all of our stakeholders as we emerge into a post-pandemic 2021 and for the long term. Thank you, and with that, we'd be happy to take your questions. Operator?

Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from Alex Tordahl with Piper Sandler. Please go ahead.

Hey, good morning guys. First off, just wanted to ask a little bit about the, uh, the management of the balance sheet. You guys put on a good chunk of securities this quarter. Um, where are you in the process of, um, of laddering cash into securities? I know you expect some deposit outflows, but are we going to expect, should we expect some additional securities purchases over the next couple of quarters at a measured pace? Are you pretty much done at this point?

Yeah, good morning, Alex. It's Michael Scrum. So, I mean, you can see from the cash position that it's still very elevated and it's obviously driven by, you know, partly by inflow in retail and inflow in commercial. So it's about half and half. Some of that is probably search deposits, as we've seen elsewhere in the financial system. And so we do expect some of that to be temporary in nature. We still do have some capacity from the ABN acquisition to ladder further out on a net new. So, you know, we're just continuing really with our, you know, as we discussed previously, about 150 net new a quarter. But we did take the opportunity here, you know, as we saw rates kind of backing up in the quarter to lock in a bit of the asset sensitivity.

Okay, so 150 per quarter is still a good rate to assume for the next few quarters.

Yeah, I mean, you know, we want to monitor, obviously, deposit levels. As you can see, that's had an impact, obviously, with the OCI on the TCE ratio as well. So we continue to monitor. We're not quite at the point where we can behavioralize those new deposits, but As I think we've talked about before, we expect positive growth in the GDP growth range across our home markets, and clearly what we've seen is well in excess of that, which is positive, but we also want to make sure that that's sticking around.

Perfect. And then as I look at the TCE level, which I know is a capital ratio that you guys manage to and just being below 6%, is that limit your appetite for share repurchases until that TCE ratio goes above 6%? And does it also impact your ability to do M&A in the near term?

Yeah, good question as well. I mean, capital management really has remained the same. So we support the dividend rate that we currently have and have announced again, plus organic growth in our home markets, obviously. Then we look for our creative acquisitions. You know, there's clearly been a bit more dialogue in that space. And then thirdly, obviously, buybacks subject to market conditions. But as we saw the long-term rates starting to increase and deposit levels continuing in the first quarter at the sort of elevated level, we looked at the impact on leveraged capital ratios and throttled back a bit on the repurchase activity. You know, share repurchases remain an important part of the overall capital return priorities. but it's just being a bit more conservative as the M&A dialogue is picking up as well. So I wouldn't put a hard limit on it. We're still active in the market. I think on a PE basis, we're still good value in the market. So at our price report, Clayton has seen a bit of a pickup. But we're just being a bit more conservative given the TCE and given the M&A dialogue. So it's still part of the overall capital appointment.

Great, and then this final question for me, we have some potential tax changes in the U.S. coming down the pike, maybe changing from a regional to a global tax system, I guess going back to a global tax system. Can you just remind us, is that something that would have a meaningful impact on the economies of Bermuda or Cayman or the Channel Islands?

Hi, it's Michael Collins. I mean, any U.S. tax changes actually would have some impact on Bermuda and Cayman and even the Channel Islands. I'd say going back to when we had the Neal bill, which really changed the way reinsurers were able to transfer risk from their U.S. entities to Bermuda, I think the fear was that would shut down the industry, and it really didn't. I think U.S. tax changes in terms of increasing the corporate tax, increasing – Once again, the tax that U.S. companies make on overseas earnings will have some impact, but nothing directly, I think. The biggest issue for us is we're watching very closely the discussion around a minimum global tax that Europe has talked about, Janet Yellen has talked about. We think logistically it would be very difficult to get that sort of agreement across Europe. different countries, but it's something we need to keep an eye on. But I'd say if you look at companies that did inversions like Ingersoll Rand, Google had a company in Bermuda, which looks like they may not have going forward. A lot of those big multinationals didn't really do a lot of business with the banks in Bermuda. I mean, they had potentially incorporation in the account, but not a huge impact. You know, there's been tax changes for the last 100 years, and Bermuda and Cayman have been impacted by it. But so far, we've been able to adapt. And, you know, companies are here for a lot more than tax. I mean, we've got a great regulatory environment. And, you know, we always talk about, you know, more than half of foreign capital in U.S. hedge funds is based in Cayman funds. And, you know, the Bermuda reinsurance industry reinsures about 60 percent of catastrophes in the U.S., and that's not going to go away.

Perfect. Thanks for the commentary. I appreciate you taking my questions.

Our next question comes from Timur Ziller with Wells Fargo. Please go ahead.

Hi. Good morning.

Hi, Timur.

Maybe first for Michael Scrum. How big was that loan that repaid have paid down in the Channel Islands that you mentioned?

About 30 million pounds. You can see that in the segment note. Some of that was made up by the new mortgage rollout in the Channel Islands as well, but it was sizable and profitable. Again, we're not a big loan growth story, so pretty stable as a quality and stable balances.

Okay, yeah, and then that kind of dovetails to my second question. So the launching of the retail products, I guess when can we start seeing that make more of an impact on the balance sheet? And it looks like the deposit growth out of the Channel Islands has been quite strong over the past couple of quarters, especially this quarter. Is that a corollary to what's to come on the lending side? Any comment on that would be great.

Yeah, I think we've made a good start on the mortgage lending in the Channel Islands. And as we've talked about in the past, what we're trying to do is make Channel Islands a full-service bank on both sides of the balance sheet like Bermuda and Cayman. We started off with staff lending, which actually is a big part of the Bermuda and Cayman residential mortgage book. And that's gone quite well. So we're really keeping pace. I mean, I think we've talked about $500 million worth of residential mortgages in the Channel Island over five years, and we're on pace to achieve that.

Okay, thank you. And then just the last question for me, looking at the deposit book and how healthy those balances were in the first quarter, maybe if you can just quantify what your expectations are for deposit outflows. And is that a 2Q event or is your borrowing base still or your customer base still in liquidity buildup mode at this point?

Yeah, great question. Difficult to say really. I mean, as we sat here, I think after Q4, we definitely had some visibility around outflows. you know, coming into Q1, which actually did happen, but were replaced by other commercial activities, such as premiums cycle on, as you know, the insurance market is hardening quite significantly, so premiums are going up, and we have more premium inflows for captive insurance companies at the beginning of the quarter, and that's really kind of stuck around. So the half of the Deposit increase that relates to retail is as a reminder just is sort of one-time pension withdrawals particularly in in Cayman and Bermuda And general retail flows some of which will stick around On the commercial side was still Expecting you know that that flow out over time But it could be a couple of quarters Honestly, I think we were probably not expecting those commercial deposits to be replaced by other temporary deposits in Q1, but that is what happened. Good problem to have, but obviously that means a little bit more conservative management and clearly an impact on NIM from average deposits in the quarter as well.

Okay. Thank you for taking my questions.

Thanks.

Our next question comes from Will Nance with Goldman Sachs. Please go ahead.

Hey, guys. Good morning. Maybe I could start on just some of the moving pieces of the net interest margin. So one, I think the consumer loan yields came down a decent amount in the quarter, if I'm seeing that right. I'm just wondering if you could kind of speak to some of the mixed shifts between jurisdictions that you're seeing and whether the decline in yields that we saw this quarter is a good run rate, if there's anything impacting that, and just how to think about what mixed shifts will do to the loan yields, all else equal, as we kind of look out. Thank you. Yeah.

Yeah. Great question. There's quite a lot of, there's some more detail on the balance sheet on the segment reporting as well. As you know, the Cayman mortgages, new or rigid, so the front book, both in Cayman and Bermuda, obviously lower rates than the back book. And Cayman in particular is tied to U.S. Prime. So with more Cayman, Resi, obviously that pressures the loan NIMH. loan yields overall on the total book. And then, obviously, as we talked about before, the Channel Islands sterling rates are, you know, in the gross rates, 350-ish. So, again, below Bermuda and Cayman rates on mortgage origination. So, over time, that will pressure the yield a little bit on the loan book. But, I mean, it was a handful of basis points. There's still a large back book. And so, although amortization continues, you know, both in the Bermuda and Cayman book, you know, it shouldn't – it's not too much of an impact, if that makes sense.

Got it. Appreciate that. And then just on the securities reinvestments that you're making, I heard you on the average securities yield in the quarter. I'm wondering if maybe the exit run rate, given the kind of backup and yields over the course of the quarter, if the exit run rate was a little better than that. And the follow-up would be, if that is the case, can we start to see the securities yield leveling off in the near term?

Yeah, yes, is the answer. The exit yield was probably in the 185, 190, so higher than the average for sure, and a lot closer to the running book yield in the investment portfolio. So, obviously, that's helpful. We focus a lot more on NII, obviously, given the surge deposits and the impact that it has on the NIM overall. But we should see stabilization there, and certainly we would expect prepayment speeds to start slowing down as well. We haven't seen that yet, but we're expecting that with the higher rate environment as well. And obviously the maturities really have been impacted quite significantly by the PPP program in terms of almost a third of our prepayments comes from lift outs, and that's really sort of accelerated the NIM decline in the MBS book, but we're getting a lot closer to the round book yield now.

Got it, that's helpful. And then if I could please go one more, just as you look at kind of capital management, and obviously you're buying a lot of securities today, How do you think about OCI risk going forward? Any kind of sensitivity you provide? And are you thinking about any ways that you can maybe hedge that out in case we do see some further backup in yields over the next couple of quarters?

Yeah. Yeah, so we've seen, obviously, almost an elimination of AFS OCI gains. We still have a gain in that book, and obviously we're booking about 50-50 of new money between AFS and HTM, which, you know, is not necessarily a hedge, but certainly gets different accounting treatment. You know, we still have significant gains in the overall unrealized market to market on the HTM as well. And I would say it's not, you know, obviously, OCI is not a regulatory capital impact for us, but it is a leveraged capital impact. So, we're booking longer-dated maturities, obviously, in the HTM book, as you would expect, and more of the shorter-date maturities in AFS. So, that should provide some natural flow in the books and cushion the impact on AFS in a rising rate environment. Also looks at OCI paybacks and NTC paybacks from high yields, and I'm certainly very comfortable about the payback period that we're sitting at at the moment.

Got it. Thank you for taking all of my questions.

Thanks.

Again, if you'd like to ask a question, please press star, then 1 at this time. Our next question comes from Andrew DeFranco with KBW. Please go ahead.

Hi, guys. This is Andrew Franco. I'm stepping in for Mike today. Thanks for taking my questions.

Sure. Good morning, Andrew.

Good morning. So I was just wondering, it was good to see expenses tick down after some of the action you guys took last year. Any updated thoughts on where that trends near term, or is there still some upward pressure potential as things return to normal regarding travel and maybe some other items?

Yeah, so just touching on last year, obviously, We reduced headcount by about 10% of the workforce or about 130 positions. Clearly, that's not something we can do again this year. We're very focused on operational risk and making sure we've got enough people to have the controls that make us comfortable. So that was, I wouldn't say a one-time shot, but we can't replicate it every year. What we are doing, though, is continuing to focus on our Halifax Service Center. So we're continuing to automate as much as we can in Bermuda and Cayman, and then transfer those roles and functions to Halifax. We've got about 150 people up there now, so we finally have sort of a scale and critical mass where the teams are kind of supporting each other, so we continue to see that growing. And that will have a gradual impact on expenses over time. Basically, the cost is about 50% per FTE compared to Bermuda and Cayman. But then you also have currency fluctuations as well. But it's a great quality workforce and will save us money over time. But I'll let Michael talk specifically about where we think this year will go.

Yeah, and just on the restructuring, there's a bit more to come in terms of benefit. As we talked about before, this was a phased approach where we wanted to make sure certainly during year end we had folks in place in key control roles. And as we are, you know, transferring their responsibilities either to Halifax or to replacements, you know, there's a bit more relief coming on the expense side. I do expect that to be broadly picked up by, you know, additional T&E expenses in the second half this year. I mean, you know, post-pandemic, there is a need for us to come out and see clients and and go and see our colleagues in other jurisdictions. So I think the 80-81 level is probably what we previously said we were thinking it's going to end up, and that's probably still a good number.

Has the pandemic noticeably changed the competitive landscape in the near markets? Have any banks pulled back any further or any new entrants looking to diversify away from the market?

Not noticeably changed any competition. Just to give you a quick summary, Bermuda looks like is going to open up, or the government's announced on June 26th, and looks like the Channel Islands early July, and then although the Cayman government, which they just had an election, hasn't announced it, probably September. So everyone's trying to kind of open up into their high tourist seasons. Bermuda has the four banks. That's very high barriers to entry in this market. HSBC and Butterfield have equal market shares, and we don't see that changing. Cayman's a bit more competitive with six banks and some Canadian banks, but I don't think the competitive landscape has changed dramatically. Then the Channel Islands is much more competitive with all the UK banks and European banks. No, I think everyone, and particularly we feel proud that we were able to operate so efficiently from home, and we're still doing that to some extent, but no noticeable changes. But we've been really pleased in terms of how much local activity, as you can see in our fee income in the last year, was a bit surprising in terms of how that held up, but no noticeable change in competition.

Great. Thanks for taking all my questions. Appreciate all the color.

This concludes our question and answer session. I would like to turn the conference back over to management for any closing remarks.

Thank you, Sarah, and thanks to everyone for dialing in today. We look forward to speaking with you again next quarter. Have a great day.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.