Good morning, everyone, welcome to the Citizens Financial Group second quarter 2018 earnings conference call. My name is Paul, I'll be your operator today. Currently, all participants are in a listen-only mode. Following the presentation, we'll conduct a brief question and answer session. As a reminder, this event is being recorded. Now I'll turn the call over to Ellen Taylor, Head of Investor Relations. Ellen, you may begin.
Thanks so much, Paul, good morning, everyone. We really appreciate you joining us on another busy day. Our Chairman and CEO, Bruce Van Saun, and CFO, John Woods, will start the call by reviewing our second quarter results, then we're going to open things up for questions. Also with us in the room today are Brad Conner, Head of Consumer Banking, and Don McCree, Head of Commercial Banking. I need to remind you that in addition to today's press release, we've also provided a presentation and financial supplement that you can find on our website at investor.citizensbank.com. Of course, our comments today will include forward-looking statements, which are subject to risks and uncertainties, and we provide information about the factors that may cause our results to differ materially from expectations in our SEC filings, including the Form 8-K we filed today.
We also utilize non-GAAP financial measures and provide information and reconciliation of those measures to GAAP in our SEC filings and earnings release. With that, I'm going to hand it over to Bruce.
Okay. Thanks, Ellen. Good morning, everyone, thanks for joining our call today. We're pleased to report another very strong quarter, paced by strong top-line growth of 8% and good expense management, which combined for positive operating leverage of 4.3% year-on-year. We achieved good balance sheet growth with 2% sequential average loan and deposit growth led by strong performance in commercial. Year-on-year, our loan growth was 3% and deposit growth was 4%. We continue to feel good about our capital management strategy as we've been able to fund strong organic loan growth, deliver attractive levels of capital return to shareholders, and target modest size fee-based acquisitions to expand our product and our service offerings. Today, we announced a 23% increase in our dividend to $0.27 per common share. We also remain on track to close our Franklin American Mortgage acquisition in early August.
This strong execution so far in 2018 continues to deliver impressive improvement in key metrics. In the second quarter, our EPS grew by 40% year-on-year. Our ROTCE improved to 12.9%, which is up 3.4% year-on-year, and our efficiency ratio improved to 58%. We remain confident in our outlook for the second half with strong performance expected to continue. Today, we announced our Top Five Program, which is not a surprise since we've had one every year, but certainly not something that should be overlooked. Our management team operates with a mindset of continuous improvement. We are constantly seeking ways to run the bank better and to do more for our customers. The program announced today builds on the work of previous programs, delivering approximately $100 million in run rate benefit by the end of 2019, with two-thirds of that coming on the expense side.
These programs have been key to both our consistent delivery of positive operating leverage, plus our rising customer satisfaction scores. We continue to achieve good external recognition for our progress with customers and on innovation. You can see that laid out in our slide deck. Suffice it to say, we feel we've shifted from playing defense and catch up to now playing offense and leaning forward to utilize new technologies, embrace the digital operating model, and leverage data. More work to do, but we're heading in the right direction. With that, let me turn it over to our CFO, John Woods, who will take you through the numbers in more detail and provide you with some color. John?
Thanks, Bruce, and good morning, everyone. I'll run through the highlights of our second quarter results, which start on slide three. We generated net income of $425 million and diluted EPS of $0.88 per share, which was up 13% linked quarter and up 40% year-over-year. Once again, we delivered solid positive operating leverage of 7% year-over-year or 4% on an underlying basis, adjusting for some notable items we had in the prior year. Net interest income of $1.1 billion was up 3% linked quarter, driven by 2% average loan growth. Our net interest margin increased two basis points linked quarter and 21 basis points year-over-year. I'll cover the margin in more detail in a few minutes.
We delivered nice growth in fees which came in at $388 million, up 5% linked quarter and year-over-year, and up 2% on an underlying basis from the second quarter of 2017, which included near record capital market fees. We continue to make progress on our efficiency ratio, which came in at 58%, roughly a two and a half percentage point improvement linked quarter and year-over-year on an underlying basis. This strong performance drove a nice improvement in ROTCE, which came in at 12.9%, compared with 11.7% in the first quarter and 9.6% in the second quarter of last year. These excellent results reflect our commitment to delivering strong revenue growth while maintaining operating expense discipline, resulting in consistent and robust operating leverage. As you know, we are always looking to find ways to run the bank better and improve our returns.
In a few minutes, I'll walk you through the next phase of our top programs, which will contribute further efficiencies and revenue opportunities for us while funding investments to drive future growth. Let's go to slide five to cover our NII and NIM results. Despite a very competitive environment, we continue to deliver attractive balance sheet growth with average loans up 2% linked quarter and 3% year-over-year, which helped us drive a 3% linked quarter increase in NII. Our net interest margin improved in line with our expectations of two basis points linked quarter and 21 basis points year-over-year, reflecting a nice improvement in loan yield given the pickup in short-term rates and improvements driven by our balance sheet optimization efforts where we were able to shift the mix of our loan portfolio towards higher return categories.
Loan yields were up 19 basis points this quarter, more than offsetting higher funding costs of 15 basis points, which reflects the full quarter effect of the $750 million in senior debt we issued in late March and the impact of rising short-term rates on our deposit costs. Note that we grew period-end deposits by over 1% in the second quarter and the spot LDR ended the quarter at 97.5%. Taking a look at fees on slide six. Non-interest income was up 5% linked quarter and 2% year-over-year on an underlying basis. The improvement in linked quarter fees was driven by a strong quarter in capital markets, where we continue to leverage the investments we've made in talent and broaden our capabilities.
Market conditions in the second quarter helped drive robust activity in loan syndications, where we closed a record number of transactions and nearly doubled loan syndication fees from first quarter levels. FX and interest rate product revenue was a record for us this quarter, up over 20% on a linked quarter basis and over 30% year-over-year, reflecting the increase in loan demand and a favorable interest rate and currency environment which drove increased hedging activity. Linked-quarter service charges and fees were up from the seasonally lower first quarter levels, while trust and investment fees increased, reflecting higher sales volumes. The remaining fee categories were relatively stable linked quarter. On a year-over-year basis, non-interest income also benefited from strong contributions from FX and interest rate products and from higher trust and investment fees. Capital markets was down modestly compared with near record levels in 2Q17.
The outlook for Q3 is strong as our pipeline and activity levels continue to be robust. Turning to slide seven. Our expenses remain well controlled. Linked-quarter expenses were down $8 million given the seasonal decrease in salaries and benefits. Outside services were $7 million higher, reflecting costs tied to our strategic growth initiatives and work we are doing to run the bank more efficiently. Other expense was also $7 million higher, driven by an increase in advertising and charitable contributions. Our expenses also included about $3 million of transaction costs related to the Franklin American Mortgage acquisition, which we expect to close in early August. Year-over-year expenses were up 3% on an underlying basis, including higher salaries and benefits and outside services expense driven by continued investments to drive growth.
We remain focused on finding ways to self-fund our growth initiatives and are doing a good job of finding efficiencies and staying disciplined. Let's move on and discuss the balance sheet on slide eight. You can see we continue to grow our balance sheet and expand our NIM. Overall, we grew average core loans 2% linked quarter and 4% year-over-year, driven by strength across most of our commercial business lines and in education, mortgage and unsecured retail on the consumer side. The growth in commercial loans was somewhat impacted by the sale of $353 million of lower return commercial loans and leases near the end of the quarter associated with our balance sheet optimization initiative. For the quarter, our period end loan growth was 1.8%, or 2.1% excluding the impact of this sale.
Our loan yields continued to improve given our balance sheet optimization efforts, along with continued discipline on pricing. We also benefited from higher LIBOR rates during the quarter. We remain well positioned to benefit from the rising rate environment with asset sensitivity to a gradual rise in rates at 4.6% versus 5% last quarter. Our asset sensitivity has naturally moderated given the rising rate environment. Let's take a look at our funding costs on slide nine. Total funding costs were up 15 basis points, which reflects 11 basis points tied to deposit costs and four basis points associated with borrowed funds. This included the impact of the $750 million senior debt issuance late in the first quarter. Year-over-year, our total cost of funds was up 33 basis points, reflecting a continued shift to greater long-term funding along with the impact of higher rates.
This compares with asset yield expansion of 51 basis points. The industry overall has seen some increased deposit competition, but for the most part, deposit costs have been relatively well behaved and I'm very pleased that we continue to grow DDA. Our cumulative beta on interest-bearing deposits is now 28% and remains in line with our overall expectations given where we are in the rate cycle. We continue to invest in analytics to improve our targeting through digital and direct mail offerings on the consumer side, and in commercial, we are making investments to build out additional product capabilities and to roll out our new cash management platform early next year. Earlier this month, we launched Citizens Access, which will contribute to our funding diversification and optimization of deposit levels and costs.
We expect to raise about $2 billion of deposits through this nationwide direct-to-consumer digital channel by the end of the year. This is a relatively small part of our overall deposit strategy, but we think it will be an excellent complement to our highly accretive retail lending initiatives such as education finance, merchant finance and home equity. We're very excited about this platform giving us access to a whole new set of deposit customers with a minimal effect on our existing deposit base. Next, let's move to slide 10 and cover credit. Overall credit quality continues to be strong, reflecting the continued mix shift towards higher quality, lower risk retail loans, paired with a stable risk profile in our commercial book. The non-performing loan ratio improved to 75 basis points of loans this quarter, down from 94 basis points a year ago.
The net charge-off rate of 27 basis points for the second quarter was relatively stable, both linked quarter and compared with the prior year. Retail net charge-offs improved from the first quarter, mostly reflecting a seasonal improvement in auto. Commercial net charge-offs for the second quarter were up $15 million versus last quarter, which benefited from a modest net recovery. Provision for credit losses of $85 million included a $9 million reserve build primarily tied to loan growth. As we increase the mix of higher quality retail portfolios in our overall loan book, our allowance to total loans and leases ratio has decreased modestly to 1.1%. The NPL coverage ratio improved to 148% from 144% in the first quarter and 119% in the second quarter of 2017, given continued reductions in NPLs and run-off in the non-core portfolio. On slide 11, let's cover capital.
We ended the quarter with a strong CET1 ratio of 11.2%, which was stable compared to the first quarter and the prior year. This quarter, as part of our 2017 CCAR plan, we repurchased 3.6 million shares and returned $257 million to shareholders, including dividends. It's also worth noting the total amount returned to shareholders in the 2017 CCAR window was $1.3 billion, including dividends. As you know, we received a non-objection to our 2018 CCAR capital plan, which includes up to $1.02 billion in share repurchases. We announced an increase in our dividend today by 23% to $0.27 a share, and we also have the ability to increase the quarterly dividend again to $0.32 per share in the first quarter of 2019. Overall return of capital to shareholders in the plan is up $300 million or 23% versus 2017 CCAR.
Our planned glide path to reduce our CET1 ratio by at least 40 basis points over this cycle remains on track, and we remain confident in our ability to continue to drive improving financial performance and attractive returns to shareholders. Let's move on to slide 12. Our top programs have successfully delivered efficiencies that allow us to self-fund investments and continue to drive future growth. We have executed very well on the top four initiatives, which are now expected to deliver $100 million-$110 million pre-tax by the end of 2018. We are also very excited to share the details of our new top five program today, which highlights our focus on continuous improvement and delivering value to our shareholders. This program targets a pre-tax benefit of $90 million-$100 million by the end of 2018, with approximately two-thirds tied to efficiency initiatives.
On the efficiency side, we are constantly challenging ourselves to do even better, and we continue to see further opportunities. We will continue to focus on transforming our branch footprint in support of our shift to an advisory service model. We are also working to simplify more of our organization by leveraging lean process improvement and agile ways of working across the bank. Our customer journeys work will drive end-to-end process efficiencies with simple and excellent customer experiences. On the revenue side, we are embarking on the next phase of our data analytics efforts to enhance the targeting of our product offerings and improve the customer experience. We will continue building out our fee income capabilities through new work on customer journeys and the build-out of full service bond underwriting capabilities.
We are planning to continue our successful commercial banking expansion into attractive MSAs such as Dallas and Houston, where we already have a presence tied to industry verticals. In short, our management team remains fully committed to strong execution of these programs, which allows us to serve our customers better, make the company stronger, and deliver long-term value to our shareholders. On page 13, we have provided color on how we are progressing against our strategic initiatives. This slide highlights some of the progress we are making against our efforts to optimize the balance sheet and the investments in our fee-generating capabilities. We also wanted to highlight some of the interesting things that are going on in our businesses as we remain focused on becoming a top-performing bank. On slide 14, you can see the steady and impressive progress we are making against our financial targets.
Since 3Q13, our ROTCE has improved from 4.3%-12.9% as we approach the lower end of the range of our 13%-15% medium-term ROTCE target this quarter. Our efficiency ratio has improved by 10 percentage points over that same time frame from 68%-58%. EPS continues on a very strong trajectory as well, up to $0.88 from $0.26. Let's turn to our third quarter outlook on slide 15. I should point out that this outlook is before the impact of Franklin American Mortgage, which we expect to close in early August. On the following slide, I'll talk a little about the impact we are expecting for the third quarter from the transaction. On a standalone basis, we expect to produce linked-quarter average loan growth of around 1.25%. We also expect net interest margin to continue to expand modestly linked quarter.
In non-interest income, we are expecting to see a modest increase with continued strength in capital markets given the strength of our pipeline heading into the third quarter. We expect non-interest expense to be up modestly in the third quarter with positive operating leverage and further efficiency ratio improvements. Additionally, we expect provision expense to be in a likely range of $85 million-$95 million. Finally, we expect the manager CET1 ratio to end the third quarter around 10.9%, including the impact of Franklin American Mortgage, and expect the average LDR to be around 99%. Moving to slide 16, we expect the Franklin American Mortgage transaction to close in early August. It should contribute about $550 million of loans held for sale and about $650 million of deposits.
We also expect it to deliver about $25 million-$30 million of servicing and origination fees for the third quarter, with an MSR of about $600 million at the end of the quarter. We expect expenses to be in the same range as fees, excluding integration costs of about $10 million in the quarter. As we told you when we announced the deal, we expect our CET1 ratio to be impacted by about 18 basis points. To sum up on slide 17, our strong results this quarter demonstrate our ability to execute against our strategic initiatives and continue to improve how we run the bank to drive underlying revenue growth and carefully manage our expense base. Our outlook remains positive as we work to become a top-performing regional bank. Let me turn it back to Bruce.
Okay. Thanks, John. Paul, why don't we open it up for some questions?
Thank you, Bruce Van Saun. We are now ready for the Q&A portion of the call. If you wish to ask a question, please press star and then one on your telephone keypad. You'll hear a tone indicating you've been placed in queue, and you may remove yourself from queue at any time by pressing the pound key. Once again, to ask your question, please press star and then one at this time. Your first question comes from the line of Scott Siefers with Sandler O'Neill & Partners. Your line is now open.
Thank you. Morning, guys.
Hi.
First, just sort of a tick-tock question on the guidance. The 1.25% average loan growth expectation for the third quarter. Granted, a very subtle change, but just a little lower than the 2Q. John, I guess I'm wondering if there's been any change in demand, customer appetite, et cetera, or is that just a function of the late 2Q portfolio sale? In other words, are we sort of at a steady state 6% annualized on kind of an apples-to-apples basis, or has there been any change in your mind?
I'll start off, Scott, and then John and maybe Don can offer commentary. I'd say we feel very good about our ability to originate loans, particularly on the commercial side. We had a very strong pipeline coming into Q2. We were a little sluggish in Q1 as the whole industry was. Ultimately, we're going to trend in line with the industry. Because of the hiring that we're doing and the geographic expansion and buildup of some of our verticals, I think we should be kind of at the north end of where peers are, which we've been able to sustain. I think the outlook for Q3 continues to be very positive on the commercial side. We've got good pipelines heading into Q3. The sale that we did late in the quarter is just part of our balance sheet optimization efforts.
Probably that impacts the outlook by 25 to 30 basis points. You'd probably be looking at an annualized rate of 6% or so in the third quarter, absent the impact of that sale. Consumer has been kind of impacted somewhat by market conditions being a little sluggish in the first half. There's usually a seasonal pickup in Q3 tied to our education finance business. We would expect to see a bit of a pickup there. As you know, we're running down auto and we've had HELOC as a phenomenon in the market that's been prepaying and paying off. We've had that as a little bit of a headwind on the consumer side. Overall, feel very good about the outlook for growth.
I think if we're kind of on a year-to-date basis, a little bit behind, a tad behind on the loan growth, we've made up for it with running ahead on NIM, where we have had another rate hike than we assumed going into the year. I think the NII outlook continues to track really well for the full year. Maybe a little less on loan growth, a little more on NIM, but certainly moving towards the high end of the goalpost for the full-year outlook. I've said a lot. John, you want to pick up the ball from there?
Sure. Yeah. Just a real high-level point maybe on consumer and commercial. Some headwinds, as you mentioned, with auto running down and a pickup in some attrition that we've seen in home equity. Things will look to be balanced out a little bit into 3Q looking forward with refi, some strength in mortgage and in the unsecured space overall. That looks good. In commercial lending, as you mentioned, lending pipelines are holding strong after a very solid 2Q. We still see the pipelines holding steady in both the C&I and CRE space. From that perspective, we're feeling good about it. If you look at how we're comparing, Bruce gave you the overview, but when you think about how we're looking versus H1, pretty much across the board, we're either in line or better. I think we're executing well on that front.
Those would be the only comments I would add.
Don, you have anything?
No, I'd just confirm the pipelines look good. I feel very good about the back half of the year. You'll see us continue to manage the balance sheet for assets that just aren't working for us on a total return or a yield basis. The good news about the assets we sold is we sold them at par or better, which is a reflection of where the market is. It was a very attractive sale for us.
Yeah. I would just add one last point, Scott, is that we're constantly calibrating. We have loan growth opportunities. Do we pursue all of that or do we either look at the back book or throttle back on the front book, depending on where we think the funding costs that are going to go where we need deposits to fund the loan growth. That constant calibration is, what's it going to cost us to fund the loan growth? Is it going to be NIM accretive? Is it going to be ROTCE accretive? I think what you're seeing is that we've been able to sustain loan growth at the high end of peers, still have our NIM expand, still have our ROTCE expand because of some of the attractive lending pockets that we've identified.
Okay. That's perfect color. Thank you. If I can ask just one really quick separate one on the mortgage company acquisition. Granted, it's small, but on the financial information you detail on slide 16 for the impact, does the accretion grow at all after the third quarter, or once we pop in the NII fee and expense impact for the third quarter, is that a just sort of steady state from there on out?
Yeah. Thanks, Scott. Good question. Yeah, what that reflects excludes the synergies that once we close on the deal, we'll start executing against the various expense synergies that we talked about on the funding side, on the operational side, and in servicing categories. I think we mentioned that we would expect that things would be modestly accretive in 2H. That's our outlook there. We talked about the 2% in 2019 and 3% in 2020. What you're seeing on that page excludes synergies.
Okay. Terrific. All right. Thank you guys very much.
Thanks.
Your next question comes from the line of John Pancari with Evercore ISI. Your line is now open.
Morning.
Hi.
Back to the commercial loan growth. Just want to see if you can give us just a little bit more color on what is really driving that in terms of loan types. Is it more larger corporate? If also you can give us a bit idea of where the new money yields are for the commercial loans that are coming on the books right now. Thanks.
It's really across the board. It's concentrated in some of our industry verticals, which tend to be slightly larger accounts in our expansion markets, which also tend to be slightly larger credits, more mid-corp than middle market. The reason for that, particularly in the expansion markets, is we're being careful on credit quality. As we're in new markets, we want to be dealing with bigger companies with slightly more financial flexibility. We're also seeing a little bit better utilization of working capital, which I think is indicative of some of the tax effect coming through with particularly our mid-sized companies. We're seeing a decent amount of M&A activity in terms of fundings of M&A-oriented activities in the client base. I'd say yields have held up pretty well. Our front book originations aren't too far off our existing portfolio. We're being selective.
If we're seeing overly competitive situations where yields are unattractive from a return basis and we don't have cross-sell, we're passing. We've actually seen a fair amount of aggressiveness in the market, which we don't like, but we're being highly selective in terms of where we play. The way we look at it is not just loan yields, but it's overall return on credit extension. It includes cross-sell capability into our cash management business as well as our capital markets and markets businesses.
Okay.
Yeah. Just to add a little bit to that. The new loan yields coming in are in the middle market space or in the mid 4.50s or so. You can see that as yields continue to go up driven by the Fed, we're able to capture most of that into the coupons on the front book. That plus cross-sell drives very attractive funding opportunities as we look at that space.
Got it. Okay, thanks. Separately, in terms of the loan loss reserve, I know you bled it a little bit more down to about 110 basis points overall. How are you thinking about that level here, particularly given the pace of growth you've seen in certain loan portfolios, like in the commercial and everything, and where we are in the credit cycle? Where do you see that going from here?
I'll start and then maybe John, you can chime in. That's just been modestly declining. I think if you go back a couple of years ago, it might've been in the 116, 117, and it's down around 110. I think there's a number of things at play. Obviously, the credit back book is very clean. So that's a factor. As we remix loans and run off some of our legacy dodgier loans, if you will, and really expand in areas where on the consumer side, we're pristine in terms of our credit risk appetite. I think that remixing also requires lower overall reserve levels. So I think it's really a reflection of where we are in terms of our credit risk appetite, where we are in the credit cycle, and we feel good about those levels at this point.
Yeah, I just would add, I think, Bruce, you nailed it there. In terms of where we are in the cycle, when you look at charge-off rates being where they are in the upper 20s, we all imagine that that's on the lower end of where things.
We'll likely be through the cycle. Just how the accounting works, and that's what we're tied to, how the accounting works, we're looking at an incurred loss model, which really wouldn't allow us to really put up much more than what we're doing.
We are building reserves.
Yeah.
Two quarters in a row. This quarter, we had a $9 million build of provision over charge-offs. I think we're keeping up with some of that loan growth, but we have such good results on the credit back book that it's netting to not much of an increase in the overall allowance.
Yeah. That mix shift that Bruce mentioned is a big driver. We're seeing better quality stuff come in the front book that's going out the back.
Okay, got it. Thank you.
Your next question comes from the line of Saul Martinez with UBS. Your line is now open.
Hi, good morning, everybody. Couple questions. First, can you talk a little bit about your expectations for deposit costs up 11 basis points? If I just look at interest bearing, it's up about 15 sequentially. Can you just give us a sense of how you think about the glide path there? Because you mentioned the cumulative beta still being relatively low. As the rate cycle progresses, where do you think that can go to in terms of both the cumulative beta but also the incremental beta on the later hikes?
I'll go ahead and take that. We had deposit costs up 15 basis points on interest bearing. I think it's important to add that when you include our very solid DDA growth, really the all-in growth in deposit costs was 11 basis points. That's been really emblematic of the investments we've been making in that space to really drive DDA. We're really proud to be able to continue to grow DDA in this environment, which is better than many have been able to do. That's the position we're in. We continue to see some opportunities to grow DDA going forward, which will offset the interest-bearing costs, as you indicated. Cumulative beta is around 28. I think you could see us getting into the low 30s in the second half of the year in terms of cumulative betas.
Even ending the year still in the low 30s. Sequential betas, by the time you get to the end of the year, depends on how many hikes we get, right?
Yeah.
If you look out the window and say, listen, there's a sense that we'll get one more at least, but maybe not the second one. You could see sequential betas getting into the 50% or 60% level by the time you get to the end of the year. Being driven by that at least one more hike that we think we'll get either in September or November.
Obviously, you have the asset sensitivity and the mix shift, the balance sheet optimization helping you. Is there a point at which the beta, in terms of rates or betas that an incremental hike becomes NIM neutral?
Just something to think about on the loan side. Our loan betas are around 60% and continue to hold in at that level. When you think about deposit betas, you got to remember about all of the non-interest-bearing funding, including equity, that really needs to adjust that level. Even at a deposit beta of 60%, the effective beta is really 45%. It continues to be useful and accretive to grow into that kind of environment. We're constantly looking at that on a quarter to quarter, month to month basis. We monitor the incremental loan growth against the incremental deposit cost, and we make financial decisions that are quite prudent in that regard. I don't think we should be scared away from 60% deposit betas because of that other effect that I mentioned.
I would just add to that if you look at the overall asset sensitivity that we publish in response to 200 basis point gradual hikes, we've held in pretty much around a 5% level. I think we're a tad under 5%, that speaks to John's point that the dynamic right now still is for NIM accretion as the Fed continues to hike. I'd say, when you look at our deposit costs, if you kind of align the peer group, the super regional peer group about who's growing deposits and who's actually flat on deposits and who's actually shrinking their deposits and allowing their LDR to float up. I think we're doing a darn good job in terms of, you could draw a regression equation on that.
We're going to have slightly higher growth in our interest-bearing deposit costs because we're actually growing deposits because we have the loan growth. That's all to the good because we have NIM expanding. We have our ROTCE expanding. We've got that calibration really under focus, and we're managing it very well in my view.
Okay. No, that's helpful. If I could just follow up on the asset side. Loan yields were up a lot this quarter, 33 basis points, and I think 40+ for commercial. How much did the LIBOR blowing out relative to the Fed Funds help, and how should we think about asset yields and commercial loan yields, I guess, specifically with incremental hikes?
Yeah, that helps, right? When you get 30 some basis points That's a bit ahead.
That was there last quarter though, too.
Yeah. Sure.
That's been kind of on
Absolutely
sequential quarter basis. You've had the LIBOR anticipating the moves, it's relatively neutral, I think, from Q2 to Q3 because they both had that phenomena.
They do, yeah. First quarter, that phenomena was a little stronger than second quarter.
Yeah.
You saw three-month LIBOR and one-month LIBOR kind of tightening in a little bit. Bruce is exactly right. Quarter-over-quarter, 1Q to 2Q, same similar phenomenon. As you head into 3Q, we're going to continue to get asset yield growth, but it'll be more balanced with the consumer side of the house. In 2Q, you saw C&I really driving it. In Q3, it'll be more balanced between consumer and commercial. The other thing is top of the house. We still are in about an even post swap-adjusted basis where 52% of our assets are floating. The other 48% continues to drive improvement when you don't have a rate rise. You still get benefits from that, from the lag effect on the fixed side of the book.
Yeah. Just one final quickie. On the guidance for Franklin American, the 25 to 30, I guess we should think of that as a two-month impact, and then as opposed to
Yeah.
Yeah. Roughly, yes. Yep.
It's a two-month impact. Yes.
Thank you.
Your next question is the line of Ken Usdin with Jefferies. Your line is now open.
Hi. Good morning, guys.
Ken.
Hey. Bruce or John, I was just wondering, around the CCAR outcome, you guys had written in your own press release about your discontent about the outcome. I was just wondering if you can just help us understand what your perception is about the disconnect and what you're trying to do in terms of the dialogues about the models, hopefully that can get into a better direction for you guys because obviously you have a ton of capital and still have the ability to continue to return plenty of it. Just in terms of the outcome and the outlook, I think that'd be helpful to understand. Thanks.
Sure, Ken. This is a private conversation that we're having with the Fed. I'll tell you kind of the headline of it so you get a sense as to where we think the problem lies. The Fed changed their PPNR model in the 2017 CCAR cycle to move away from more of an average industry approach to a firm-specific approach. I think when they built that model, they pick up data from right after the Great Recession, which we think has flawed data elements in it. When you think about the super regional peers, most of the super regional peers had the benefit of TARP funding and were able to grow their balance sheets and do, in some cases, acquisitions that were quite accretive.
Citizens uniquely was owned by a foreign government, if you will, 80% owned by the U.K. government, not eligible for TARP, and needed to shrink its balance sheet because it didn't get the TARP funding, but also because its parent needed to raise capital levels, and I was there, so I saw that firsthand. From peak to trough, the Citizens balance sheet shrunk by 30%, and peers actually went the other direction. I think the average peer was $125-$160. We were $160 down to $125 over a five-year period. When you shrink, as you know, in banking, you end up with an impact on your fixed expense base. Your overall expense ratio goes up, which really depletes your PPNR.
If you're picking up that data, you're going to get one set of results for most banks, and you're going to get a unique set of results for us, who has a unique history. When you look at how does the Fed run the CCAR model, they actually assume that your balance sheet's going to grow. They don't assume that it's going to shrink when they do their forecast through stress. You have a total inconsistency between the assumption on what's going to happen to the balance sheet and then the data that they're picking up for their PPNR model. That's the short version of it. We've had continuing dialogue, and we're actually hopeful because we think this is a very clear, logical argument that we're putting forth.
When those have been presented to the Fed in the past, they've been willing to consider them and make adjustments. We're hopeful that that will resonate.
Understood. Okay. Thanks for that. Appreciate that. John, one question for you. There's a lot of focus, obviously, on the right side of the balance sheet. Can you help us understand how much more efficiency improvement do you have on the left side? You've talked about a lot of the things that you're working on in terms of the mix and the changes. Any tangible examples of where you still see an asset yield improvement that we may not be getting yet in the current results?
Yeah, absolutely. On the asset side, when you think about it, we think about it as reallocating capital from lower return categories. There's still a fair bit of that out there. We've got a relatively large auto book and an asset finance book and a non-core book that all tend to come in a bit lower on the risk-return profile than maybe some of the other opportunities that we have out there in the student space and in merchant finance and all in within C&I. There's still a fair bit of that to go, you can't really fix that kind of stuff in one or two quarters. It takes years to be able to fully transform a balance sheet.
We've embarked upon this with a level of formality. You'll continue to see benefits coming out of that behavior over the next year or two. I'd also mention, we not only see opportunities across loan categories, but within loan categories themselves and where we want to rotate lower return, basically bottom quartile investments that we may have made and maybe increasing the velocity of exiting those relationships and rotating them into and reallocating the capital into better relationships is also an opportunity. That's emblematic of what we did with the $350 million that you saw in 2Q. I think there's still a fair bit left to go on that front.
Got it. Okay. Thanks a lot, John.
Your next question comes from the line of Ken Zerbe with Morgan Stanley. Your line is now open.
Great. Thanks. Good morning. I guess first question, just in terms of the broader guidance. I certainly appreciate the third quarter guidance. It is very helpful. When we think about the full-year guidance that you had given a couple quarters ago, specifically loan growth, I think it was 4.5%-5.5% and fee growth of over 4.5%. Are those targets sort of superseded by the third quarter? Meaning, should we no longer rely on the full-year targets you gave a few quarters ago? Thanks.
We say, Ken, that we'll give you annual guidance at the beginning of the year as the policy, then we'll give you quarterly updates and we'll comment in the round about the annual guidance as we go. We're not in the business of updating that full-year guidance every quarter. You've got two quarters in the bank. You've got detailed guidance on 3Q, so really all that's left is to piece the puzzle, is to come up with a fourth quarter for all you analysts on the line. If you just look at the trends of how we're performing, as I mentioned to an earlier question, that I think on NII we're very strong and you can do the projections based on what's in the tank in 3Q and you'd come out, I think, towards the top end of the goalposts on NII.
I think the roadmap to get there, as I indicated, is maybe a little less loan growth than initially assumed. Better NIM expansion than we had initially assumed. On fees, I think you can project that out and we're going to be a little light, I think, of the range. It depends if you want to include Franklin American, that would put us back in the range, but ex that, we'd probably be a little light of the range. On expenses we're tracking to kind of certainly the range, if not the left goalpost of the range. When you stir that together, you're going to find, I think, a strong PPNR that's consistent with the guidance that we gave at the beginning of the year. Then where we've had, I think, a solid improvement is going to be on our credit costs.
We feel good about our ability to deliver against the guidance at the beginning of the year, both on a PPNR basis and on credit costs.
Okay, great. That's helpful. Just in terms of Citizens Access, when we think about the growth there, and presumably they're coming at somewhat higher cost than your normal deposits or your branch-driven deposits, how does Citizens Access change how you feel about your asset sensitivity going forward?
Yeah, I'll go ahead and take that one. As you know, we just launched this thing and just for context, this is a nice diversification of our funding sources. When you think about what we're trying to drive here, approximately $2 billion by the end of the year, that's less than 2% of our deposit base. We want to keep it in context. We're excited about it. We think it's a great platform to test and learn innovative approaches to customer experience. Nevertheless, it's less than 2% of our deposit base. With respect to costs, the launch rates, as you know, when you think it launched, are typically a little higher to drive awareness and consideration. It's still lower than the marginal large commercial consumer promo and wholesale borrowings that are on our balance sheet.
From that perspective, it's very important qualitatively, but even financially at the margin, these are desirable deposits to be on the balance sheet. Just to give you a couple of numbers here and then I think from even at our launch rate, which we have the unique ability to be able to do so that we can lag pricing later on, we're around 2% on savings, and that's the majority of what we have going on here. You look at large commercial depositors would be in excess of that and really the promotional rates when you consider the cannibalization that typically occurs in a branch-based promotional activity, those rates would be higher than what we're driving out of Citizens Access as well.
We're really excited about it on both fronts, both the strategic aspects of it and the financial aspects of it in the box that we're keeping it in on the balance sheet.
I would just add, John, I think it gives us access to a whole new customer set and a customer base that we haven't had access to before. We're 11 days into the launch. We're optimistic about the progress we've made, and we've already taken deposits in all 50 states. It's a good sign that we're reaching new customers.
All right, great. Thank you.
Next question comes from Kevin Barker with Piper Jaffray. Your line is now open.
Good morning. Could you talk about your growth projections over 2019, 2020, and maybe over the next three or four years for Citizens Access given the structure of that and how much you expect it to grow? Or at least be a portion of your overall deposit base?
Yeah. I'd say this. It's hard to see where this goes, right? We'll remain nimble as it relates to where we want this to head. You wouldn't imagine that this thing would get out of the single-digit percentages of total deposits going forward. Maybe it gets into the five to, at the very highest, 10. I would say a good expectation would be maybe high single digits. Like I said, we're going to test and learn. This is new for us and we're excited about how things have launched here out of the gate, but it won't be a huge part of our deposit base over the next couple of years as we look out into the future.
Okay. Do you view this as an alternative to funding the typical branch deposit base in order to gain new customers and potentially grow assets through those new customers? Do you view this as like an alternative funding source to replace wholesale funding?
Well, let me take that. I would say that it is an alternative funding source that can be compared and contrasted with some of our higher cost marginal dollars of funding. What would those be? Certainly on the commercial side, we have pockets like borrowings from financial institutions or pooled government funds that you could look at the marginal cost of that versus using this channel. Certainly on the consumer side, the kind of promo CD pricing to coax new money from our existing customers into the bank. You could compare and contrast that versus this offering, which is much more diffuse and going to attract money on a much broader basis. That's principally how we would view it.
Having said that, what Brad just said, I think is quite important, the kind of test and learn and enhancing our digital capabilities, and then can we offer additional products and services digitally to these customers. We have some very attractive lending products, for example, that maybe those customers would be interested in. We'll see where it goes.
Okay. Thank you very much.
Your next question is the line of Matt O'Connor with Deutsche Bank. Your line is now open.
Good morning. I was hoping you could just elaborate on the appetite for some of the fill-in fee revenue deals. Specifically in mortgage, do you feel like you've got the scale and the servicing side that you want there, or is that an area of opportunity still?
I would start here. I think the areas where we haven't had the scale, the biggest holes really have been on the consumer side of fee activities. The first was mortgage. I think this really addressed what we feel we needed. I don't think there's really more we need to do in mortgage. The second area has been wealth. We've been building that organically, getting the business model right in terms of how we distribute through our branches and become trusted advisor to a much broader swath of our client base. We're missing some opportunities, I would say, at the highest end of the pyramid and the cross-sell over into commercial where we offer great banking services to some middle-market companies and very wealthy families. We really don't have that high-end capability that competes well in the marketplace with some others.
That might be an area, for example, where we look to do an acquisition or other things in the footprint that can potentially get us more breadth and get us a bigger financial consultant force faster than doing it organically. Those would be the areas on the consumer side. I'd say on the commercial side, we did the M&A boutique. We still have opportunity, I think, based on the size of our customer base to expand that, we might build off that platform and hire organically. If we can find some other boutiques that maybe cover certain industry verticals, we could seek to bolt on that way to that platform. I think there's opportunities potentially around the payment space and some of the innovation that's taking place there. Some of those things could be through fintech.
Some of those things potentially could open opportunities for acquisitions. I think we're now feeling good about our capability to source deals, do the diligence, execute them well. That was kind of muscle that we didn't have, we didn't need. We hadn't done a deal prior to the one last year in, I guess it was 13 years, I think. 2004 was the Charter One deal. Now we've got the capability inside the bank. We feel good about our opportunity to source these things. Again, I think they're going to be straight down the fairway, modest in size, fit a strategic need, and have good financials associated with them.
Okay. That's helpful. Thank you.
Next question is from the line of Erika Najarian with Bank of America. Your line is now open.
Yes. Good morning. I just had a few follow-up questions. Bruce, it's been really impressive to see the ROTCE improvement. What's really stunning is you've been able to do that with the CET1 ratio just essentially flatlining at 11.2%. I'm wondering, given the 290 basis point difference between the co-run model and the Fed model like Ken was mentioning in his line of questioning, if there's not a significant amount of improvement in terms of the difference in modeling, what kind of flexibility do you have over the near term to take that down on an organic basis in terms of your CET1 ratio?
Well, I think we still have a fair amount of flexibility. We're targeting to bring that down 40 to 50 basis points this year when you think about the Franklin American deal. Then I think if you look at rolling to next year, the SCB is likely to go into effect, which even if we don't resolve this issue, I think we still have plenty of flexibility to keep moving down on our glide path. I don't really see much impact at this point. We just feel better. I think it's a negative to the perception of how we're going to perform in stress to have these results published and see ourselves in a group with Goldman Sachs and Morgan Stanley in terms of huge stress losses, which doesn't make any sense to anybody.
I think from a reputational standpoint, it's good to have that adjusted and have us back into the pack. After all, that ROTCE now is converging with the pack, and there shouldn't be the same kind of PPNR impacts that the Fed is modeling. It's quite apparent when you look at it. I think the first thing is I'd just like to get it fixed because it's wrong, and it doesn't help our reputation to have those results published. I think down the road it could create some flexibility that if we need it would be a little more room to work with. We feel comfortable with the glide path that we're on and that will continue. We'll execute that through the next CCAR cycle, and then we'll see where we are the year after that.
Got it. A follow-up question for you, John. I think what Saul was asking is in other conference calls that we've heard throughout this earning season, the CFOs have indicated that each subsequent 25 basis point of rate hike will be less impact to the NIM as the previous. I just wanted to make sure that we're hearing you right, that because of the DDA growth and continued optimization on the asset side, that you believe that Citizens is going to buck that trend.
I wouldn't say it that way, Erika. I guess I would say it, and just to make sure I was clear earlier, we agree that each 25 basis point increase in Fed does drive all else equal, an increase in the sequential beta that one would experience. That's clear that we agree with that. We just also would offer up that we happen to be growing DDA in an environment where most are not. On a net basis, that's helping us and it's having somewhat of an offsetting impact, but not fully reversing the impact of the fact that sequential betas will grow and we will experience growth in sequential betas like others, but not to the extent that would otherwise be the case if we weren't growing DDA.
Got it. Thank you.
Your next question comes to the line of Peter Winter with Wedbush Securities. Your line is now open.
Good morning.
Hi.
I was curious about the commercial real estate lending environment. You guys are still having very good growth, and we've heard from a number of banks this earnings that they're probably getting more cautious on commercial real estate, just given pricing and loosening of underwriting. I'm just wondering what you're seeing.
Yeah. We definitely are also getting at the margin more cautious and being more selective where we see terms and conditions being stretched. We haven't seen that much movement in price in terms of price deterioration, but we have seen a little bit of move in leverage and structure, and we are staying disciplined. The other thing that you're seeing in some of our real estate growth is we have a large construction book which is funding. It's transactions that we have put in place from an unfunded construction standpoint several years ago, which are funding up onto the balance sheet right now. I would say our growth on the origination side we think will moderate a little bit. It won't necessarily mean that our growth on the asset side will moderate due to the funding effect.
Thanks. Just a follow-up question. Could you just talk a little bit about the impact of the flattening yield curve on your margin and are there steps you could take to offset some of that pressure?
Yeah, I'll go ahead and take that one. I think the way to think about our exposure there is that we're about 75% sensitive to the short end of the curve. When we have a flattening yield curve that can give you a sense for what opportunity cost there is that would otherwise be the case had that not occurred. That 4.6% asset sensitivity number that we spoke about earlier, that assumes a parallel shift increase in rates. You can knock 25% off of that when we don't get that increase on the long end. It's hard to fight gravity on the long end of the yield curve. We are sensitive to the short end and maintain a majority exposure to the short end and a lot of our C&I lending really drives that exposure.
That's really the best defense, I guess I would say, to continue to drive net interest margin in an environment where the Fed continues to move, the long end remains stubbornly low.
Thanks.
Your next question comes from Gerard Cassidy with RBC Capital Markets. Your line is now open.
Thank you. Good morning. Bruce, you talked about the CCAR and the discussions you've had with the Fed. Obviously, with the reform to Dodd-Frank, you guys will be falling out of CCAR possibly as soon as next year, if not the following year. Aside from the obvious headline that it's not going to be in the news anymore, what do you think, or how are you guys thinking you will maybe behave differently not having to go through the formal process? Will you be able to give back more capital quicker? What's your thinking on that?
Well, I'd say, let me just emphasize that I think stress testing is a very valuable exercise, and it's embedded in our bank and every other super-regional. We have it basically built into our risk appetite framework, and it's tied to our strategy. When we make decisions in terms of where we're allocating our capital, we run it through our stress test to ensure that we're making wise decisions. Just want to make that point first off, Gerard, is that if you fall out of the public exercise, you're still going to be doing stress testing because they're quite valuable in terms of how you're running the bank.
Correct.
I think if we're not in that public exercise, I think you just gain back time and maybe some effort in terms of how you have to package things up and present them. We'll still have examiners on our local teams who are going to want to see how we're doing those exercises. There might be a little bit of time and effort savings. I think the big thing that you gain probably is just a little more flexibility, where the management team regains control over making those capital decisions, and it's not a once-a-year exercise. It would sure be great, for example, if you forecast that you're going to have 5% loan growth. If the loan growth comes in at 4%, you don't have to go through a whole resubmission. You'd simply be able to say, "Okay, my capital's building up a little bit.
I can go back and buy some more stock, and I can neutralize the impact of not having the loan growth that I assumed." I think that's the thing that we look forward to, is to kind of start to operate the way normal companies do in normal industries, not having to go through the full mother-may-I exercise that we have to today.
Just to add to that, Gerard, as Bruce mentioned earlier, even if we don't get out of the stress test regime, the SCB has some really intriguing and desirable attributes from a flexibility perspective. You could get some, maybe even most, but not all of the flexibility you would get if you get out entirely. You would still have the uncertainty factor of the annual SCB that you would be assigned, but you would get back a lot of the flexibility, maybe even in the near term, even before we get out of the test itself.
Yeah.
Very good. I'm encouraged with Vice Chairman Quarles' speech this week that hopefully all you guys will benefit from the changes that are coming. As a follow-up, obviously it's brand new. You guys just rolled it out, your national and digital strategy, Citizens Access. In your thinking, do you think this business will be more competitive versus I know you're in a day-to-day blocking and tackling business that's very competitive in your footprint, your physical footprint. Do you guys have a view on which one's more competitive, or are they just really just very both competitive?
I'll start off on pricing, maybe Brad can add. I think on a pricing standpoint, they both seem to be very competitive. When you look at the branch footprint activities, I was talking earlier about when you think about top online and direct bank offers being around, they'll call it the 175 to 200 basis points range for savings. Even in branch businesses, which have all of those physical costs associated with it, we're seeing in our footprint, competitors going out of 175, which is at the low end of an online bank with no legacy physical plans that you have to recover as well. The competition is pretty stiff in both places.
We just have to pick our spots, I think we've done that well in terms of differentiating on customer experience, we've got one of the best customer experiences, we believe, that's out there, Brad can elaborate, but being clear about how we target the level of growth and where we invest those funds. Maybe I'll turn it over to Brad.
Yeah. John, I think you're absolutely right. They're just different, right? They're both very competitive. They're just different. I can't stress enough that it is a completely different customer segment. You really have to understand the customer that's using the direct bank. It's a different customer. It is highly competitive. You win on customer experience, which we think ours is exceptional. You win with data and analytics capability and having sophisticated ways of reaching the customers. We think we're very good at that as well. We think we can win in both places. In terms of which is more competitive, I think they're equally competitive. You got to be good at both.
Yeah. On the direct bank, Brad, that you just mentioned, when you guys did your analysis and your work before you launched it, what was your conclusion on what % of customers, if they choose to purchase one of your products, is it rate driven? What % of that customer is driven to your product just because of the rate?
Yeah. Let me answer that a little bit differently because I'm not sure I can tell you what % of them are rate driven. What our research did tell us is that the customers who use the direct banks, they're digitally savvy, and they shop online. There is certainly a rate element of that. They expect an extremely simple experience, and they expect low fees. Of course, the cost of the direct bank is much lower to operate. We've launched a direct bank that really has no fees with a very simple experience.
You can open an account in under five minutes.
Yeah, you can open and fund an account in less than five minutes. Again, it's a different customer. They are rate sensitive, I think what they really are looking for is a simple experience.
Gerard, I think you're in our footprint, you might want to try it out.
Love to have you open an account.
Absolutely. I will, I'll report back. Thank you so much, guys.
There are no further questions in the queue. With that, I'll turn it over to Mr. Van Saun for closing remarks.
Okay, great. Thanks again, everyone, for dialing in today. We certainly appreciate your interest and your support. We continue to execute well, and we maintain a positive outlook for the balance of 2018. Thanks again, and have a great day.
That concludes today's conference call. Thank you for your participation, and you may now disconnect.