All right. Good morning, and welcome to day three of the 14th annual Morgan Stanley U.S. Financials Conference. I'm Manan Gosalia, the mid-cap banks analyst. Before we start, our standard disclosures apply. For important disclosures, please see the Morgan Stanley Research Disclosure website at morganstanley.com/researchdisclosures. The taking of photographs and use of recording devices is not allowed. If you have any questions, please reach out to your Morgan Stanley sales representative. With that out of the way, I'm delighted to have with us today from Fifth Third, Tim Spence, President and CEO, and Jamie Leonard, CFO. Tim is going to start with some prepared remarks, and then we'll move into Q&A.
Great. Thanks, Manan. Good morning, everybody. We published a slide presentation last night on our investor relations page, which I will refer to throughout my prepared remarks, and then after that, Jamie Leonard and I are happy to take your questions. At Fifth Third, we have long believed that the best banks differentiate themselves not by how they perform when markets are constructive, but rather how well they navigate more challenging environments. Our operating priorities, stability, profitability, and growth, in that order, are the lens through which we make strategic decisions and are reflected in the discipline with which we run the business. We create stability by focusing on stable core deposit funding, a consistently strong credit profile, and diversified revenue streams. We deliver profitability through an unwavering commitment to operating efficiency and a focus on unit economics throughout the company.
Our return metrics have steadily improved over the course of the past decade and are now at the upper end of our peer group. We produce growth through establishing leading positions in the markets where we compete, delivering innovative products, and providing excellent customer service. We believe deliberate multi-year investments are the only path to sustainable competitive advantages. For us, these include our high-growth southeast markets, our differentiated Momentum Banking and treasury management products, our tech platform modernization, and our fintech platforms Dividend and Provide. This also includes the launch of our embedded payments business, Newline, which I will expand upon in a moment. Turning to slide four, our strong deposit franchise is the byproduct of our consistent multi-year investment in the company. We've discussed our branch strategies several times with you in the past. A healthy branch network remains critically important for growing primary consumer relationships.
Newer branches provide superior household growth, and legacy branches provide the connective tissue for long-standing customer relationships. We've added 80 de novo branches over the past five years, the second most in our footprint, at a time when most banks are simply closing branches. We've also frequently discussed Momentum Banking, our flagship mass-market, non-interest-bearing checking offering, launched in 2021. Momentum was the first fintech-equivalent everyday banking solution offered by traditional banks. Momentum customers benefit from ongoing product upgrades roughly every six months, like what we have come to expect from the operating systems on our mobile phones. Our winter release included the ability to get your tax refund up to 5 days early, and later this year, we will launch a simplified account switching experience and Smart Shield, a suite of services designed to help customers protect against fraud.
We've also heavily invested in decision science capabilities over the past decade to enhance internal decision-making and provide a more tailored customer experience. For instance, we leverage our award-winning geospatial models to inform our de novo strategy. Our customer recommendation engine, which shapes customer interactions across our channels, is powered by over 75 artificial narrow intelligence algorithms. These capabilities have been instrumental in producing strong deposit outcomes, particularly over the past three months. We believe our multi-year investment discipline results in a sustainable competitive advantage over peers. We've successfully grown non-interest-bearing deposit accounts in consumer, led by Momentum, and in commercial, led by our treasury management business. This gives us confidence in our ability to maintain a non-interest-bearing deposit concentration significantly higher than what we had before the great financial crisis. Turning to slide five, our deposit franchise stands out amongst peers.
Including the trillionaire banks, we are the only large cap bank to grow deposits since the middle of last year, when the Fed accelerated its interest rate increases and began reducing liquidity in the system. The result is the byproduct of a multi-year effort to grow core operating accounts in both the consumer and commercial segments. On the right side of the slide, we've provided you with a scatter plot leveraging publicly available information from Nacha, which publishes the top 50 ACH originators and receivers on an annual basis. The x-axis represents the ACH credit received transactions, which are dominated by direct deposits, divided by consumer deposit balances. This provides the best proxy for primary consumer relationships. The y-axis represents ACH debit send transactions divided by commercial deposit balances, which represents commercial operating relationships.
Combined, this provides you with a good view of how Fifth Third stands out among peers. Our strong core deposit franchise will remain a key differentiator for Fifth Third in this environment. We expect average and period-end deposits to be stable in the second quarter compared to the first quarter. Slide six highlights areas in our consumer business where we've consistently grown our deposit franchise. Our consumer strategy is focused on a strong local presence, innovative products, and excellent customer service.... We maintain a number four deposit share in markets in which we compete, with the top three being trillionaire banks. We are number two overall in our Midwest markets and number six in our Southeast markets.
We continue to gain market share, having achieved a consistent annual organic household growth rate of 3% over the past five years across the entire footprint, including 7%+ growth in the Southeast last year. From a service standpoint, our MyDay portal gives our retail employees an easy-to-follow dashboard with the top 15 actions they should take every day. These are personalized recommendations tailored to customers' needs. MyDay helped improve retail banker productivity by 25% since it was launched, and is the same analytic engine which drives customized content for customers in our digital channels. Slide seven highlights our commercial deposit franchise, led by our peer-leading treasury management business. We rank in the top 10 nationally in nearly all commercial payment types, as shown in EY's recent cash management survey. We are also among the leaders in driving adoption of real-time payments, ranking number seven nationally.
We've made investments in our treasury management business over many years to generate sustainable revenue and deposit growth. Central among these are our investments in building payment software automation around our core payment processing activities, which we refer to as managed services. The managed services ecosystem is now more than 35% of our total treasury management top-line revenue, and will continue to grow with the advent of our Big Data Healthcare acquisition. Slide eight provides more information on our embedded payments business, which we recently rebranded as Newline, a homage to the Python coding character, representing a new line of code, and to the fact that payments are a new product line for the software companies we serve. Newline's origins date back to the spin-out of Vantiv, our legacy card processing business, and represent a decade of embedded payments expertise inside the company.
We focus on serving the largest, best-established firms in their respective vertical markets and help them build, launch, and scale compliant payment products. To be clear, this is a payments business and not a rent-to-charter fintech lending business. We offer the full suite of payment types, including debit, ACH, real-time payments, and wire, and allow clients to customize more than 20 APIs with functionality for more than 70 different product features. We project our risk protocols to clients, showing the value of our first-class risk and compliance infrastructure, including AML BSA requirements. The business has grown rapidly over the past several years, and our recent Rize Money acquisition accelerates investments we've been making to continue to enhance our developer tools and tech infrastructure. We expect to continue to grow revenue and deposits at a strong pace for the next several years. Moving to slide nine.
Our conservative consumer loan portfolio continues to be highly concentrated in loans represented by super prime borrowers and homeowners. We think these two attributes will be key differentiators for us. Mounting inflationary pressures are disproportionately affecting lower FICO borrowers and those who have not been able to lock in their single largest monthly expense at low historically fixed rates. We see that corroborated in our deposit data. Depositors with a 720 plus FICO still have 25% more in deposit balances compared to three years ago, while sub 720 borrowers have 5% less today compared to where they were three years ago. Similarly, homeowners have 20% more in deposit balances, while renters have 20% less in deposit balances than they did three years ago today. Slide 10 highlights our commercial portfolio.
We continue to believe our disciplined client selection and well-diversified portfolio with strict concentration limits, including in CRE, will be a key differentiator for us going forward. As many of you know, we have maintained a cautious outlook for several years and have become increasingly cautious through the first half of 2023. We tightened underwriting standards during COVID, including stressing credits to an up 200 basis point scenario off of the forward curve, which limited our growth, but improved the stability of our balance sheet. Since we began tightening underwriting standards, roughly 90% of our commercial portfolio has been re-underwritten. Our criticized assets have been stable to down over the past several quarters. We've also provided some statistics on our office CRE portfolio.
We continue to watch it closely, but believe the overall impact for Fifth Third will be limited, given that we have maintained the lowest CRE concentration among our peers for many years and had de-emphasized office even before the pandemic. We are not concurrently pursuing any new office CRE originations. Moving to our outlook for the second quarter, we now expect average loans to be stable in the quarter, reflecting our defensive positioning. As I mentioned earlier, we expect deposits to be stable. We are not immune to the competitive landscape. We've seen a sharp increase in competitor rate offers this quarter, and we have defended our deposit book, but that comes at a cost.
As we discussed in April, we were cautious on the market dynamics and therefore provided a range of potential deposit beta outcomes of 43%-49% for the full year, based on peer commentary and our own experience. We now expect our cumulative deposit beta to increase to 46% in the second quarter and to finish the year in the low 50s. That impact, combined with additional DDA migration to interest-bearing products, will result in second quarter NII being down 4%-5% from the first quarter. We continue to expect net charge-offs to be in the 25-35 basis point range. We also continue to expect fees and expenses to be within the range of guidance we provided in April. In summary, even against a more challenging backdrop, we believe we can sustain our returns better than any other regional bank.
Our strategic and operational priorities remain consistent, with a focus of stability, profitability, and growth to generate strong returns through the full economic cycle. With that, Jamie and I are now happy to take your questions.
Perfect. Thanks so much.
Thank you.
Tim, maybe if you can set the stage in terms of, you know, what you're seeing in the environment overall, and then, if we can just take a step back before we get into the quarter and the recent trends. Can you talk about just the returns for the industry overall? You know, a lot of people are pushing back, saying that the returns are going to be a lot lower as we go into the next couple of years or the next three years, given what's happened. What's your take on that?
Yeah. It's a difficult environment at the moment, and I think it will continue to be a difficult environment, because the Fed has been clear that they want to suppress inflation, and they're either going to do that by suppressing demand with high interest rates or suppressing supply by tightening liquidity. I think those of us who have run our businesses defensively, and who have not predicated our strategies on the belief that we were going to get a lot of balance sheet growth, are going to do better than, those of us who came into the year expecting to be able to grow our way through accelerating deposit betas and are now going to have to do the wrenching work, to restructure our expense plans and to cut back on investments and otherwise. You see that, right?
I think you all see that as, you're seeing the impact of the increase in pressure on deposits making their way through, the outlook for banks of all different sizes. As it relates to the intermediate term, I think the thing I would caution everybody is if you look back over time, what you will find is we tend to overestimate the degree to which change is permanent when there's a new issue that materializes in the industry, and then underestimate our ability as a sector to restructure and to return to what is an appropriate return profile, given our cost of equity. You know, the easiest example of that would be COVID.
I mean, think about how many billions of dollars got spent on building data centers and otherwise on the belief that people would never want to shop in physical retail stores again. Then the last year and a half, we've had one large retailer after the next come out and say, "Well, we really misthought this, and we've got 10 years' worth of capacity now, and we thought we were going to absorb it into and otherwise." I think we're going to see the same thing in the sector. There's no question that there will be a regulatory policy response to what we just witnessed in Silicon Valley's case, and that we will need to adapt.
As I mentioned in our first quarter earnings call, if you pull the quarterly banking profile from the FDIC, you can get data back to the thirties. Just tax adjust the returns there, in different periods, and you'll see that, despite many changes to the regulatory regime, the industry has been remarkably resilient in terms of getting back to a, you know, ROE that is north of its cost of equity.
Got it. Jamie, maybe you want to touch on the NII guide. You know, clearly deposits is a major focus. Fifth Third was one of the better performing banks in our coverage in the first quarter, with deposit balances largely stable. You have another quarter of stable deposits here. Can you talk about the trends you're seeing on the deposit side, whether it's the mix or the deposit betas and how that feeds into NII?
Sure. As you said, you know, first quarter, we performed very well, being stable, and as Tim mentioned in his prepared remarks, one of the only banks to actually grow deposits over the past nine months. We continued to target stable deposits both second quarter, we are stable quarter to date, and stable deposit balances over the back half of the year. The challenge comes in with the environment as well as then the competitive behaviors, where deposits are getting more expensive. So when we were coming out of the April earnings season, you know, we were thinking deposit betas would be 47, maybe 48% by the end of the year. I guess as one point of clarification, when we talk about deposit betas, I know different banks calculate it differently. Some include DDA, we do not.
Some exclude CDs, we do not. I think ours is a very straightforward approach, but we were thinking, you know, 47%-48%. Given the guides we were hearing across the industry, said, Okay, choose your own adventure, 43%-49%. As we sit here today, given some of the rate offers that you're seeing, from competitors and our goal of maintaining stable balances, we've been very defensive at defending the deposit book. The most interesting thing, I think, will be how does all of this play out? I believe we have, if not the best, one of the best retail franchises in banking, and we have an incredibly strong treasury management business. When you have those two factors, we ought to perform at or better than the industry average when it comes to pricing.
Yet we're modeling a number that is higher than what we're hearing from peers at this conference. Ultimately, time will tell how this plays out. When you then transition to the NII guide, the NII guide down from up 7%-10%, to up 3%-5% on a full year basis, you know, we're still growing NII, we're still doing well. But the factors driving the revision are three factors, and I'll take them least to most. One, Tim mentioned in the lending environment, we have pulled back in certain areas as well as customer demand is lower. Line utilization is actually down a point this quarter from 37%-36%. We expect that to continue as the year progresses. That's about 10% of the change in the NII guide.
The betas that we just discussed, call it 30% change to the NII guide. The biggest factor, about 60% change, has been faster DDA migration into either the Regulation Q hybrid account, interest-bearing account, or into other interest-bearing activities, such that, you know, we started the year at a 34% DDA level. We thought we would finish the year at 30%. We're now forecasting that that DDA percentage of total deposits will end the year at about 27%. We're seeing that erosion. With that said, June's actually been a very healthy month, and that erosion has stopped. You know, we're beating our forecast a little bit thus far in June, but too early to tell how all of this plays out.
You know, we could spend the next 15 minutes talking about all the factors on what's driving that DDA change, but ultimately, we feel good about our ability to counteract that over time. It's just you can't fight the tape and the headwind in any one quarter or any two quarters. It does take time to build and sell through that from a treasury management perspective.
I know it can be a long discussion, but maybe if you just want to touch on that. You know, what gives you the confidence that, okay, you know, DDA should go down from, you know, 30% to 27%?
Mm-hmm.
27% is the right level? Can you talk a little bit more about that and the trends we're seeing?
Sure. If you look at the guardrails on the DDA % of total deposits, you have fourth quarter 2006, we were at a 20% level, and that was several quarters after the Fed had reached the five and a quarter peak rate level. You go back at fourth quarter 2016, we were at 30% DDA mix. I'd put those as the guideposts. Right now, we're saying at the end of this year, fourth quarter 2023, we'll be between the goalpost, but at 27%. Part of the reason why it's not drifting lower to 20% is that our consumer DDA proportion of our total DDAs is up significantly because of all of the investments we've made in the de novos, in Momentum Banking, which is a non-interest-bearing checking account that supports that consumer DDA balances.
Consumer DDAs represent a third of our total DDAs, and so that book is going to be stable. It'll, you know, grow slightly with new households, but we expect it to decrease a little bit as consumer spending and those excess deposits erode, but fairly stable $16 billion portfolio. That helps relative to that 2006, 20% level. What's happening, as we talk about the hybrid account we have on the commercial side, faster migration into those other products. What we've looked at is the amount, the dollar amount of our excess earnings credits sitting in our analyzed commercial DDAs, and we are modeling those excess earnings credits on a dollar basis to actually be at record low levels at the end of this year.
Which means that there's not a whole lot of flexibility for that erosion to go further, barring further increases in the velocity of money movement, which, you know, I think we've already absorbed that impact now. Given our excess earnings credits modeling and the other factors, we feel good at the 27%. You know, there's the challenging environment, and ultimately, we'll see how this plays out, but we feel good about our ability to defend the deposit book this year.
What do you think about the TGA refill? Do you think that's going to have an impact on bank deposits?
Yeah, it, our view, and it may not be the popular one, is that the back half of 2023 is going to be a very challenging six months from a liquidity perspective. There's the well-advertised $1.5 trillion of funding that the Treasury will execute on, but you also have $80 billion a month in QT, you've got deficit spending, you've got student loan repayments, perhaps kicking back in, and then you have very competitive offers from banks that are challenged because they lack the retail scale and product, and therefore, they want to compete on price. Ultimately, we are positioning the balance sheet very defensively. We're sitting on $9 billion-$10 billion of excess cash every day because we believe the next six months will be a very difficult liquidity environment.
Tim, I think you noted on the first quarter call that you were active in adding a lot of commercial deposit accounts as well during the quarter, I think you were the beneficiary of some of the stress that was going on in the system. Can you talk about the stickiness of those deposits and, you know, whether you're actually seeing some more funding going on in some of those new accounts?
Yeah. Absolutely. If you were to look at the deposits we added at the end of the first quarter, in the wake of March Madness, probably about half, a little more than half, came from existing clients, where we had, we were the beneficiary of a high level of confidence in our stability. People moved more money onto our platform. The other, call it 40%-45% of it, came from new clients. There, most of what we were doing was accelerating the existing sales pipeline. The TM implementations queue went from being a 30 to 35 day process, because clients typically, when they agree to move TM, try to time movement to quarter end, to being a, "Can we get this done over the weekend?" sort of a process.
The embedded payments business in particular, the pipeline there really surged because you have clients in our, you know, some of our focus verticals, like payroll, as an example, who had direct exposure to the banks who were either, you know, failing or perceived to be at risk and who needed to find a different home. Because these were activities we were already working on, they weren't, you know, a lifeline or let me spread my money out to the broadest possible portfolio of banks, the stickiness of deposits has actually been very good, and the funding rate was excellent.
Tim, I do want to get into regulation because that's clearly a big topic for banks of Fifth Third's size. Maybe if we can just round out the discussion on guidance. You know, is there anything more that you want to update us on in addition to the revenue, deposits, and loans?
I guess the silver lining of this, fees, credit, expenses, everything is as advertised. This just literally comes down to the cost of deposits in a challenging environment.
Yep.
All right, perfect. On, on regulation, you know, we've seen the reports on Silicon Valley Bank and Signature from the regulators. Clearly, there is, you know, some momentum to getting new regulation, whether it's on the AOCI opt-out going away, LCR, TLAC. What's, what's your view on what we could get here?
I'll let Jamie talk a little bit about the specifics here. I think from my point of view, the thing that the market is getting wrong right now is the process through which the regulators are going to make changes to policy and the speed with which they're going to be adopted. The bank group has been very active and has a very constructive dialogue with every one of the regulators in D.C. And in every case, they recognize that rash decisions here, where they don't think through the second order of consequences, will create more problems than they will solve.
I think as investors, while you should expect the rules to be rewritten in different areas, you should have confidence that the folks in D.C. are going to be deliberative about the way that they do it, that there will be an opportunity for the industry to comment and to help tailor the regulations appropriately, as we did with Dodd-Frank. If you look back on what the initial proposals were relative to where the final rulemaking came out. That they will provide a multi-year phase-in period, the same way that they did for CECL, as an example, when we had to adopt CECL and otherwise.
I just think, we're expecting right now that there's going to be, you know, a notice of proposed rule making in June, and that we're all going to be required to comply with it by the end of September. I just don't believe that's the case. Do you want to talk specifics?
Sure. Even though we lack specifics, what we would expect to happen would be the AOCI opt-out for available for sale goes away. All of us are then going to have to react to that. We've suspended our buybacks in the second quarter. If that is indeed how the rule comes out, you would expect buybacks to continue to be halted until we get to the appropriate CET1 level. I think the follow-on issue to that is how do you manage a balance sheet and investment portfolio when you have to absorb that hit, especially if on top of that, HTM gets either caps or hopefully, ultimately, HTM is put in the same AOCI bucket as AFS, because economically, it's the exact same rate risk.
I don't know why the accounting would be, you know, the accounting determination at the time of purchase would impact capital, but, you know, we'd probably lose that argument. What it does mean is then you're going to have to be holding shorter duration and either cash or T-bills, you know, a different construct for your portfolio, which ultimately has an earnings impact and has a heightened rate risk impact in a falling rate environment. We view our investment portfolio as the buffer to help protect NII in a falling rate environment, along with the swap program that we've executed on. I think the go-forward management of the balance sheet gets more challenging given that regulation, and we perhaps take a little bit more duration in the lending side in key areas.
For us, the benefit of the nice auto business, plus Provide, plus dividend, is it gives you that ability to have intermediate duration, fixed rate assets, if you're not able to accomplish that in your investment portfolio. Beyond the AOCI, TLAC for us would be a very manageable item. We're one of the lowest, if not the lowest regional banks from a TLAC shortfall perspective, call it $4 billion or so.
That would be fine. Then you have the liquidity regime, whether it's LCR or whether it's, you know, supervision and the Regulation Y buffer with your internal stress testing. And that is where we've talked about, you know, different businesses within our company will have to be put on an RWA diet to free up that liquidity. That has a business impact. When you add it all up, higher liquidity levels, higher capital levels, but you do have time in order to meet those requirements and still deliver healthy returns to your shareholders.
Just to follow up on that, did you say higher liquidity levels in both the cash and security side, but you could take a little bit more duration on the loan side? Is that how the balance-?
That's how we're viewing it now. The details will matter based on all of the rules and how they come out.
Got it. Then on TLAC, you know, I think you mentioned on the earnings call that you would probably have to issue somewhere in the range of $4 billion of long-term debt over time. Given that the fixed income markets have been, you know, fairly quiet for regional banks at this stage, you know, you're seeing some of the other banks start to come out now. You know, what are you hearing from fixed income investors? You know, how do you think about issuance as you go through this year?
Fortunately, our spreads have been one of the best performing spreads since March eighth. I think there's high demand for Fifth Third paper, but I believe the rules will give us several years to meet that. From an issuance perspective, there's no need, you know, to rush to the market in a challenging time. You know, we'll be opportunistic and, if, there's a window and, we'll execute, and we'll just keep chipping away at it.
Quick question on capital return before I check in with the audience. At earnings you mentioned, you know, like other banks, you're unlikely to do buybacks in the near term. I guess, what do you need to see change before you restart, or how are you thinking about capital return in general?
Certainty around the capital rule.
You need to see that certainty before you restart buybacks? Got it. Are there any questions in the room? All right, maybe let's move on to credit. You know, you noted that you've been increasingly cautious on CRE. You de-emphasized office even before COVID. Maybe talk about credit, you know, what you're seeing there.
Long time before I get to the doctor. That's the same way we feel about with credit and the quality of the deposit book, is you need to have done those things years ago, and that is what we have been focused on from the time that Greg took over in 2015, and then under Tim's leadership. We have been very disciplined on credit. You see that, you know, 90% plus weighted to solar. Solar credit continues to do very well. Loss rates, you know, call it 50 basis points or so right now, versus our modeled 125 basis points. That is a very high returning asset class. We like the asset.
Same name, a totally different bank than we were 15 years ago, right? Jamie used 2006 as a point of comparison. If you look at the way we ran the business in the 2000 to 2010 timeframe, the priorities were really growth, profitability, and then stability. We had a higher growth, higher volatility return profile. We've inverted that in terms of the priorities. We did a deal a year at a minimum during that decade. We did one deal in total in the last decade, which meant that the growth we were generating was what we wanted and not a portion of what we wanted, and then other stuff. We ran the bank as a federation of 20 different community banks a decade ago.
It's run as a single organization with strong national business lines and good local delivery today. We had the highest concentration of CRE to capital, I believe, in our peer group at that time. We have the lowest concentration of CRE to total capital today, and we had a deposit business, which at that time, you got the value out of by opening an account, right? We gave you a beer koozie or a cooler or a lawn chair or something like that. Today, you get the value out of the accounts by using them, the way that we've talked about over and over again on Momentum Banking and on treasury management. You have a business that, while it has the same basic outline in terms of its geographic footprint, is just a totally different business today.
The byproduct of that is, I think it surprised people that Fifth Third, among all the large cap banks, is the one that has been able to hold deposit balances stable, right? I think it surprised people because, you know, we had the issues we had during the financial crisis in commercial real estate. I think we have the lowest crit rate in terms of the commercial real estate portfolio of any of our peers today. The byproduct of that is, I think as the rate cycle peaks here and turns into a credit cycle, it's gonna surprise investors that the same sort of stable performance that we have been getting out of deposit balances should materialize in the return profile and in the credit performance in the business.
All right, perfect. On that note, Tim and Jamie, thanks so much for your time.
Thank you.
Thank you.