Welcome to the M&T Bank Q2 2022 earnings conference call. At this time, all participants are in a listen-only mode. Following management's prepared remarks, the call will be open for questions. If you would like to ask a question at that time, please press star one on your telephone keypad. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Brian Klock, Head of Markets and Investor Relations. Please go ahead.
Thank you, Gretchen, and good morning. I'd like to thank everyone for participating in M&T's Q2 2022 earnings conference call, both by telephone and through the webcast. If you have not read the earnings release we issued this morning, you may access it along with the financial tables and schedules from our website, www.mtb.com, and by clicking on the Investor Relations link and then on the Events and Presentations link. Also before we start, I'd like to mention that today's presentation may contain forward-looking information. Cautionary statements about this information, as well as reconciliations of non-GAAP financial measures, are included in today's earnings release materials as well as our SEC filings and other investor materials. These materials are all available on our Investor Relations webpage, and we encourage participants to refer to them for a complete discussion of forward-looking statements and risk factors.
These statements speak only as of the date made, and M&T undertakes no obligation to update them. Now, I'd like to turn the call over to our Chief Financial Officer, Darren King.
Thank you, Brian, and good morning, everyone. As we reflect on the past quarter and the H1 of the year, we're very pleased with our progress. The Q2 results include the impact of the People's United Financial acquisition, which closed on April 1. We're excited about the momentum we have as a combined organization, especially the progress both franchises are making in preparation for the planned systems conversion later this quarter. With strong NII growth and effective expense management, M&T generated positive operating leverage as pre-tax, pre-provision net revenue increased by more than $300 million versus last quarter. We repurchased $600 million of our common stock in the Q2 , and yesterday the board of directors authorized a new program to repurchase up to $3 billion in M&T common stock.
Our balance sheet management enabled us to benefit from the changing interest rate environment, boosting the net interest margin and allowing us to deploy excess cash into investment securities with higher yields. With more Fed hikes projected this year, we continue to add more fixed rate assets to our balance sheet and to continue expanding our interest rate hedging program. While we're just beginning to see the positive net interest income benefit from rising rates, those same higher rates have prompted headwinds in our mortgage banking business, both for origination volumes and for gain on sale margins. We expect these headwinds to persist. Despite the macro challenges, the unemployment rate remains low and credit quality remains strong. We're well positioned for the future and excited to continue the integration of the People's United franchise and to deploying our excess cash and excess capital.
Now let's review the results for the quarter. Diluted GAAP earnings per common share were $1.08 for the Q2 of 2022, compared with $2.62 in the Q1 of 2022. Net income for the quarter was $218 million, compared with $362 million in the linked quarter. On a GAAP basis, M&T's Q2 results produced an annualized rate of return on average assets of 0.42% and an annualized return on average common equity of 3.21%. This compares with rates of 0.97% and 8.55% respectively in the previous quarter. Included in GAAP results in the recent quarter were after-tax expenses from the amortization of intangible assets amounting to $14 million or $0.08 per common share.
That compares to $1 million or $0.01 per common share in the prior quarter. Pre-tax merger-related expenses of $465 million related to the People's United acquisition were also included in these GAAP results. These merger-related expenses are comprised of the so-called CECL Day 2 double count of $242 million+ additional pre-tax merger-related expenses of $223 million. The total merger-related charges translate to $346 million after tax or $1.94 per common share. Consistent with our long-term practice, M&T provides supplemental reporting of its results on a net operating or tangible basis from which we only ever exclude the after-tax effect of amortization of intangible assets as well as any gains or expenses associated with mergers and acquisitions.
M&T's net operating income for the Q2 , which excludes intangible amortization and the merger-related expenses, was $578 million, compared with $376 million in the linked quarter. Diluted net operating earnings per common share were $3.10 for the recent quarter, compared with $2.73 in 2022's Q1 . Net operating income yielded annualized rates of return on average tangible assets and average tangible common shareholders equity of 1.16% and 14.41% for the recent quarter. The comparable returns were 1.04% and 12.44% in the Q1 of 2022. In accordance with the SEC's guidelines, this morning's press release contains a reconciliation of GAAP and non-GAAP results, including tangible assets and equity.
As a reminder, included in the Q1 's GAAP and net operating results was a $30 million distribution from our investment in Bayview Lending Group. This amounted to $23 million after-tax effect and $0.17 per common share. We did not receive any distributions in this year's Q2 . Next, let's take a little deeper dive into the underlying trends that generated these results. Taxable equivalent net interest income was $1.42 billion in the Q2 of 2022, an increase of $515 million or 57% from the linked quarter. The linked quarter increase was due largely to the $420 million net interest income contribution from People's United. This amount included $35 million for purchase accounting accretion.
The legacy M&T Bank net interest income increased $95 million sequentially, inclusive of the $138 million impact from higher rates on interest earning assets, an $8 million increase from 1 additional day in the quarter, partially offset by a $22 million decline in the benefit from cash flow swaps and a $16 million decrease in interest received on non-accrual loans and a $9 million decline in interest income and fees related to PPP loans. Net interest margin for the past quarter was 3.01%, up 36 basis points from 2.65% in the linked quarter. The primary driver of the increase to the margin was from higher interest rates, which we estimate boosted the margin by 26 basis points. The People's United earning asset yields added 8 basis points to the net interest margin.
In addition, margin benefited from a reduced level of cash held on deposit with the Federal Reserve, which we estimate added 7 basis points. These items were partially offset by a 6 basis point decline resulting from the lower interest income recovered on non-accrual loans. All other factors, including the day count, had a negligible impact on the margin. Before we discuss the average loan balance trends for the quarter, we note there were reclassifications within the People's United commercial loan portfolios. In order to be more consistent with M&T's reporting methodology, just over $2 billion in loans that People's United had classified as C&I were reclassified into CRE loans. Compared with the Q1 of 2022, average loans outstanding increased by $35.4 billion or 38%, due primarily to the $35.5 billion average impact of the People's United loans.
Looking at loans by category on an average basis compared with the linked quarter, commercial and industrial loans increased by $14.5 billion or about 62%. The average impact from the acquired People's United loans was $13.8 billion. Legacy M&T C&I average loans increased by about $1.2 billion with strong growth in middle market C&I loans and average dealer floor plan balance growth of $209 million. This growth was partially offset by a decrease of approximately $466 million in PPP loans. On an end of period basis for the combined bank, PPP loans amounted to $351 million. Average commercial real estate loans increased by $12.3 billion or 35% compared with the Q1 .
The average impact from the acquired People's United loans was $13.1 billion. Legacy M&T CRE average balances declined $830 million during the Q2 due to almost equal reductions in construction and permanent loans. We continue to reduce our construction exposure as there is a lack of new activity to offset the conversion of construction loans into permanent mortgages. There was an uptick in permanent mortgage financing in the quarter. However, it was outpaced by an elevated level of payouts. Residential real estate loans increased by $6.9 billion or 43%, due almost entirely to the average impact of the People's United loans.
The legacy M&T average loan balances were essentially flat as the retention of new originations retained for investment were offset by normal runoff combined with the sale of Ginnie Mae buyouts that became eligible for re-pooling into new RMBS. Average consumer loans were up $1.8 billion or 10%, again due in large part to the $1.6 billion average impact from the People's United loans. For legacy M&T, recreational finance loan growth continues to be a key driver of growth. Average investment securities increased by $14.7 billion due to the $11.2 billion average impact from the acquired People's United Securities and a $3.5 billion increase in legacy M&T investment securities.
Average earning assets, excluding money market placements, which is inclusive of cash on deposit at the Federal Reserve, increased $50 billion or 50%, due largely to the $46.7 billion average impact of People's United and growth in legacy M&T average investment securities. After closing the acquisition, we implemented various balance sheet restructuring actions to optimize the funding base of the combined bank. These actions utilized some of the cash available and resulted in a decrease in deposits. Many of these actions occurred during the quarter, so we thought it would be more informative to look at the change in end-of-period cash balances. Cash balances decreased by $11.8 billion to $33.4 billion at the end of June, down from just over $45.2 billion on April 1st. The decline was the result of several factors.
These include a $2 billion increase in investment securities, a $1.5 billion restructuring of some People's United high-cost deposits, notably broker deposits, a $3 billion decline in escrow and mortgage warehouse related deposits, reflecting lower levels of activity associated with the rising rate environment, a $500 million reduction in trust demand deposits resulting from lower levels of capital market activity compared with the Q1 , and a $2 billion drop in municipal deposits. We continue to actively manage higher cost deposits and in many cases retain the customer and are able to move their balances to an off-balance sheet alternative that provides the interest rate they desire. With that background, average core customer deposits, which exclude CDs over $250,000, increased by $45 billion or 36% compared with the Q1 .
The average impact from the People's United deposits was about $49 billion. Turning to non-interest income. Non-interest income totaled $571 million in the Q2 compared with $541 million in the linked quarter. The People's United non-interest income contributed $79 million, while legacy M&T declined by $49 million. As noted, M&T received a $30 million distribution from Bayview Lending Group in the Q1 and did not receive any distribution in the Q2 of this year. Mortgage banking revenues were $83 million in the recent quarter compared with $109 million in the linked quarter. Revenues from our residential mortgage business were $50 million in the Q2 compared with $76 million in the prior quarter.
Residential loans originated for sale were $77 million in the recent quarter compared with $161 million in the Q1 . Both figures reflect our decision to retain a substantial majority of our mortgage originations for investment on our balance sheet. The primary driver of the linked quarter decline in revenue is the higher interest rate environment, which has pressured gain on sale margins for loans previously purchased from Ginnie Mae servicing pools and which became eligible for resale or re-pooling. With the rapid increase in yields for new mortgage originations over the past few months, these Ginnie Mae re-pooled loans have fallen below new origination yields, which has driven the negative gain on sale margin. During the quarter, residential mortgage loans were sold at a loss of $17 million compared to a $14 million gain on sale in the prior quarter.
Commercial mortgage banking revenues were $33 million in the Q2 , essentially unchanged from the linked quarter. That figure was $35 million in the year ago quarter. Trust income was $190 million in the recent quarter and included about $14 million in income from People's United. Legacy M&T trust income increased about 4%, due largely to about $10 million from the recapture of money market fee waivers and $4 million in seasonal tax preparation fees, partially offset by the impact of lower market valuations on assets under management and administration. Service fees on deposit accounts were $124 million, compared with $102 million in the Q1 . People's United contributed $33 million to this fee income line during the quarter.
The decline in legacy M&T service charges primarily reflects the previously announced repricing of our consumer checking products. We expect foregone revenues from the program to reach a run rate of $15 million per quarter during the H2 of the year. Operating expenses for the Q2 , which exclude the amortization of intangible assets and merger related expenses, were $1.16 billion and included about $259 million in expenses from the operations of People's United. Legacy M&T operating expenses were about $903 million compared to $941 million in the linked quarter and $859 million in the year ago quarter. Recall, operating expenses for the Q1 include approximately $74 million of seasonally higher compensation costs.
Aside from those seasonal factors that flow through salaries and benefits, legacy M&T operating expenses increased by $36 million from the Q1 . This increase was due almost entirely to higher salaries and benefits costs resulting from 1 additional business day, a full quarter impact of merit increases, and increased incentive accruals tied to improved bank performance. The efficiency ratio, which excludes intangible amortization and merger-related expenses from the numerator and securities gains or losses from the denominator, was 58.3% in the recent quarter, compared with 64.9% in 2022's Q1 and 58.4% in the Q2 of last year. Next, let's turn to credit. Despite the lingering challenges of the pandemic and its variants, supply chain disruption, labor shortages, and persistent inflation, credit is stable to improving.
The allowance for credit losses amounted to $1.82 billion at the end of the Q2 , up $352 million from the end of the linked quarter. The increase was due largely to the impact of the allowance related to the acquired People's United loan portfolio. We ran the acquired loan book through our allowance methodology and essentially confirmed their allowance at closing. Applying the provisions from the CECL accounting principle, we assigned $99 million of the People's United allowance to purchased credit deteriorated or PCD loans and $242 million to non-PCD loans. In addition, we recorded a $60 million provision in the Q2 . Partially offsetting these increases were net charge-offs of $50 million in the Q2 compared to just $7 million in this year's Q1 .
Economic indicators continue to show improvement from the prior period, but inflation remains at a historically high levels. Aside from movements in forward interest rate curves, the Q2 's baseline macroeconomic forecast was relatively unchanged from the prior quarter for those indicators that have a significant impact on our CECL modeling results, including the unemployment rate, GDP growth, and residential and commercial real estate values. Non-accrual loans increased to $2.6 billion compared to $2.1 billion sequentially. The increase was entirely the result of the acquired People's United loan portfolio as non-accrual loans at Legacy M&T decreased sequentially. At the end of the Q2 , non-accrual loans represented 2.1% of loans down from 2.3% at the end of the linked quarter.
When we file our Q2 10-Q in a few weeks, we expect to report an increase in criticized loans. However, the percentage of loans recognized as criticized will decrease. Similar to the trends in the non-accrual portfolio, the increase in the dollar amount of criticized loans is due entirely to the acquired People's United portfolio. We expect a modest decline in criticized legacy M&T loans. As noted, charge-offs for the recent quarter amounted to $50 million. Annualized net charge-offs as a percentage of total loans were 16 basis points for the quarter compared to 3 basis points in the Q1 . Loans 90 days past due on which we continue to accrue interest were $524 million at the end of the quarter, down from $777 million sequentially.
In total, 89% of these 90 days past due loans were guaranteed by government-related entities. Turning to capital. M&T's common equity tier 1 ratio was an estimated 10.9% compared with 11.7% at the end of the Q1 . The decrease was largely due to the impact of the People's United acquisition and the repurchase of $600 million in common shares, which represented 2% of our outstanding common stock. Tangible common equity totaled $15.3 billion, increased 33% from the end of the prior quarter, due largely to the impact of the People's United merger. Tangible common equity per share amounted to $85.78 per share, down $3.55 or 4% from the end of the Q1 .
As previously noted, the board of directors authorized a new repurchase program for up to $3 billion of common stock, which replaces the previous $800 million repurchase program under which $600 million of M&T shares were purchased in the Q2 . Now let's turn to the outlook. Interest rate expectations continue to be volatile and can have a material impact on our outlook for full year 2022. Similar to last quarter, the outlook that follows reflects the combined balance sheet with 3 quarters of operations from People's United, as well as a more recent forward curve and is on a full year basis. First, let's talk about our outlook for the balance sheet. We continue to expect to grow the investment securities portfolio by $2 billion per quarter for the remainder of the year.
However, that cadence could accelerate or slow depending on market conditions as well as customer loan demand. Now to turn to the outlook for average loans. When compared to standalone M&T full year 2021 average loan balances of $97 billion, we continue to expect average loan growth for our combined franchise to be in the 24%-26% range. However, growth may come in near the lower end of that range. Note that the updated average growth rates for C&I and CRE loans reflect the reclassification of C&I loans into CRE loans from the former People's United loan book that we mentioned earlier. On a combined and full year average basis, we expect average C&I growth in the 37%-39% range.
We expect average CRE growth in the 17%-19% range, average residential mortgage growth in the 28%-30% range, and average consumer loan growth in the 10%-12% range. As we look at the combined income statement compared to stand-alone M&T operations from 2021, we believe we're well-positioned to benefit from higher rates and to manage through the macro challenges we noted earlier on this call. Our outlook for net interest income for the combined franchise is for 56% full year growth compared with the $3.8 billion in 2021. This reflects the forward yield curve from the beginning of the month.
Given the speed of interest rate hikes by the Fed, the reactivity of deposit pricing, and the deployment of excess liquidity and loan growth, the full year net interest income could be ±2%. Turning to the fee businesses. We still expect strong trust income growth driven by new business and the recapture of money market fee waivers, but albeit lower than previous expectations as a result of the lower equity valuations from Q2 . In addition, higher interest rates are expected to continue to pressure mortgage originations and gain on sale margins. We have completed the sales of Ginnie Mae repooled mortgages, and we will continue with the retention of almost all originations for the rest of the year. With this in mind, we expect the gain on sale from residential mortgages to be minimal in the H2 of the year.
We therefore now expect non-interest income to grow in the 5%-7% range for the full year compared to $2.2 billion in 2021. Next, our outlook for full year 2022 operating non-interest expense is impacted by the timing of the People's United systems conversion and subsequent realization of expense synergies. We continue to anticipate 24%-26% growth in combined operating non-interest expenses when compared to the $3.6 billion in 2021. However, expenses are likely to be near the higher end of the range, reflecting inflationary pressures on wages and improved bank performance. As a reminder, these operating non-interest expenses do not include pre-tax merger-related charges. We do not expect these charges to be materially different than our initial estimates. Turning to credit.
We continue to expect credit losses to remain well below M&T's long-term average of 33 basis points. For 2022, we conservatively estimate that net charge-offs for the combined company will be in the 20 basis point range. Finally, turning to capital. We believe the current level of core capital is higher than what is needed to safely run the combined organization and to support lending in our communities. We plan to return excess capital to shareholders at a measured pace. Late in June, the Federal Reserve released the results of its stress test, also known as the DFAST. Based on these DFAST results, M&T's preliminary stress capital buffer, or SCB, is estimated at 4.7%.
As a result, we will be subject to a 9.2% common equity Tier 1 ratio threshold under the SCB regulation, which is in effect from October 1, 2022 through September 30, 2023. M&T's common equity Tier 1 ratio of 10.9% at June 30 comfortably exceeds the threshold below which capital distributions could be limited by that regulation. We continue to anticipate ending 2022 with a CET1 ratio in the 10.5% range. With a solid starting capital position and the potential to generate significant additional amounts of capital over the next few years, we don't anticipate a material change to our capital distribution plans. Our objective, as always, is to bring our CET1 ratio down gradually to a level that is near the high end of the lower quartile of our peer group.
We anticipate continuing to repurchase common shares under the new $3 billion repurchase program. Now let's open up the call to questions, before which Gretchen will briefly review the instructions.
At this time, if you'd like to ask a question, please press the star and one on your touch tone phone. You may remove yourself from the queue at any time by pressing the pound key. We do ask that you limit yourself to 1 question and 1 follow-up in the interest of others. Thank you. The first question we'll take is Betsy Graseck from Morgan Stanley.
Hi. Good morning. This is Brian on for Betsy. Was wondering if you could give us an update on your rate sensitivity today now that we're a little bit further into the rate hike cycle. Assuming that the current forward curve plays out, where do you expect that to trend over time? Thanks.
Sure, Brian. Good morning. You know, as obviously the Fed's hiking at a lot faster pace than what any of us anticipated when we started the quarter and started the year. When we look at the mix of deposits, you know, on our balance sheet and some of the actions that we've taken this quarter to move out of some high-cost funding, you know, when we look at the next several hikes and think about what the impact of a 25 basis point increase might be, we look more towards 7 to 10 basis points increase in net interest margin for each 25. That's on an annualized basis. Net interest income growth in the $140 million-$190 million range.
Looking at that, you know, the kind of range of reactivities that we have sensitized is 15%-35%. It's kind of how we're thinking about it and what we're seeing, again based on the mix of deposits on our portfolio.
That's really helpful, though. Thank you. In light of the changes you made to some of your high-cost funding sources, I was wondering if you could just talk about your overall deposit growth expectations through year-end.
Well, when you look at M&T and our funding, you know, we have one of the higher what I would call core funding portfolios amongst our peers and amongst the banks. A significant portion is in non-interest-bearing DDA as well as interest checking, which tend to be operational accounts. You know, when we look at those accounts, whether it's consumers, small business or commercial customers, you know, we do expect that there will be some decline as people continue to spend, given the rate of inflation. So far the decline we've been watching has been fairly gradual. We have seen some commercial customers use some of the excess cash to pay down loans. That's part of when you see some of the loan declines.
We're seeing that offset by payoffs or by them using the cash. Really the place where you start to see the most price sensitivity in the short term tends to be, as we mentioned earlier, in the municipal deposit space as well as in the wealth customer space. W e'll expect to see some movement there. Typically what happens, Brian, is there's some instances where the actual pricing goes up on interest checking or savings and money market. Generally what happens first, particularly in the consumer space, is you start to see balances migrate towards time deposits. You know, part of what we'll see for us and we would expect for the industry is a migration towards time deposits.
That will be what kind of drives the overall beta for deposit costs, more so than any one particular category of deposits moving up in a rapid pace. You know, just given the nature of our deposit base, we expect some decline, but we don't expect it to be excessive from here. You know, maybe in the 1%-2% range, but really not that much.
Thank you.
Our next question comes from John Pancari at Evercore ISI.
Morning.
Hey, John.
On the loan growth front, I appreciate the guide for the 24%-26% on average total balances. Just want to see if you could maybe give a little color in terms of the trajectory of the commercial real estate portfolio. You know, is it fair to assume that declines are going to continue? I know you kind of alluded to that. Would it be outright declines in the balances or just a shrinking in the overall mix, but you could actually see growth there? Thanks.
Looking at commercial in aggregate, I think it's important to look at the 2 in aggregate. We think they'll be, you know, relatively close to flat. The growth in C&I ex PPP will offset, you know, what's likely to be a decline in CRE. When we look at the CRE balances and what's happening there's really 2 things going on. You know, the first which we've been talking about for a while is construction loans are on the decline. We had back in 2018 and 2019 some real growth in construction lines that over the course of 2020 and 2021 and 2022 have been drawn down as projects have been underway.
You know, you did see a little delay in the pandemic, but projects got back on track. As those come to completion, they'll follow their normal course where they will get converted into permanent mortgages, and that often happens off of our balance sheet. You know, I continue to expect some decline in construction balances. On the permanent side, you know, as I mentioned, we have seen some payoffs from customers using their cash, their excess cash and declining their balances. The level of activity that you typically see in the CRE space continues to be low.
You know, with rates moving, it's affecting cap rates and asset values, and so you're not seeing the turnover in properties like you might have under normal circumstances. T hat will affect the pace of decline and/or growth in permanent CRE. What we saw this quarter, you know, if I look at loan originations in the quarter across C&I and CRE, it was actually our best post-pandemic, non-Q4 lots of qualifiers there, increase in originations, which I thought was a very positive sign. It was a little bit weighted towards the back end of the quarter.
You know, I guess to think about, permanent mortgages down slightly, construction mortgages down, a little bit more over the course of the year, which probably takes in dollars maybe, $1 billion down. You know, call it 1%, 1%-2%, offset by growth in C&I.
Got it. Okay. Thanks, Darren. Separately, just on the buyback front, it was good to see the new $3 billion authorization. How should we think about the pace of buybacks here? You know, is it fair to assume a similar pace as what you saw in the Q2 of the $600 million, or could you actually get some acceleration in the pace of repurchases in coming quarters?
Yeah, sure. The best way to think about it, John, is to think about that $600 million as a good pace. You know, it could accelerate depending on how fast rates move and what's happening with net interest income growth and capital generation. You know, we've got 1 quarter to go through with some of the merger expenses coming through, which will affect capital. You know, we could move it up a little bit or down a little bit off that $600 million. I think for purposes of looking forward, that's a good pace to think about.
Great. All right. Thanks, Darren.
We'll take our next question from Ebrahim Poonawala from Bank of America.
Good morning.
Morning.
I guess I wanted to follow up on the NII guide for up 56%. Just wanted to make sure, given all the moving pieces around the balance sheet we have this right. It implies exit Q4 run rate north of $1.9 billion. Just want to make sure, Darren, that sounds reasonable in terms of how we think about what the jumping-off point is for 2023. If you don't mind reminding us how much of purchase accounting accretion do you expect in the back half and, maybe if you have an updated number for next year as well.
Sure. To answer your first question, the $1.9 billion run rate at the end of the year is a good number to use. You know, obviously, I'll caveat that and keep in mind that that's based on the forward curve and lots of assumptions on, as we mentioned, about deposit betas, but I think that's a reasonable number. Then the second question, remind me again what that was. I'm sorry. I'm losing my mind already.
Just in terms of how much of purchase accounting accretion is there in the numbers for-
Right. Sorry.
Yeah.
Yeah. Purchase accounting. The number that you saw in the Q2 that we talked about, the $35 million is a good start point. I mean, obviously over time, that winds its way down. You know, as you think about 2023, think about 4 quarters of purchase accounting accretion versus 3 this year. Y ou know, kind of the $30-$35 million a quarter run rate is a good place to be there.
Got it. I guess just a separate follow-up on the CRE side as we think about, obviously, you've talked about in the past in terms of, just thinking about how much to balance sheet versus not, and I think you had an announcement of some appointments within the CRE business a couple of days ago. I would love to hear your updated thoughts. 1, coming out of the stress test, any surprises, anything that you think you would tweak as a function of the stress test? Just where are we in terms of the evolution of the new strategy around CRE as you think about that business?
Yeah. You know, I think the short answer is the path that we're on and our thought process around CRE hasn't changed. When we look at, I guess, a couple of comments on the stress test. We were pleased to see the decline in loss rates from the pandemic stress test in CRE, you know, down to 11% from 16%. You know, however, if you look at it even earlier stress tests, they kind of average around 6 or 7% for CRE, so it's still pretty elevated from that. You know, when we look at our own performance over time in the CRE space, we can't get anywhere near that number.
What's really interesting is when you look over the last 2 years at the pandemic, that was pretty much a real live stress test on CRE without much support from the government, and the losses there were pretty minimal. When we think about our underwriting, we're really comfortable with the underwriting. When we think about our experience in the space, we think we've got a really talented group of individuals that operate there, and that we can use those skill sets to continue to support our customers, and maybe use others' balance sheets, who are actually looking for the kind of skill sets that we have in underwriting. There's a great match there where we can take advantage of our skill set.
We can provide funding and capital for our customers and be there for them and maybe even offer them a broader range of alternatives, and make it more capital efficient over time, where we can convert some of those loan balances and dollars into fee income, which will free up capital. You know, the path that we've been on, we feel really good about. As you noted, we've added some folks. We added some folks in what we call our innovation office. We've also added a couple of players in our CRE capital markets area of the bank. You'll probably hear a little bit more about that in the coming weeks.
We slowly start to build out the team and slowly increase the mix or the percentage that ends up on balance sheet and off. You know, it's still not quite at a point where you can see it in the noninterest income numbers, but that will build as we go through the rest of this year and into 2023. You know, I guess long-winded way of saying no change in the strategy. You know, hopefully, some of that color helps give context to why we're on the path that we're on.
That's helpful. Thank you for taking my call.
Our next question comes from Matt O'Connor from Deutsche Bank.
Good morning. Sorry about that.
Hey, Matt.
Pretty explicit expense guidance this year and obviously cost saves coming in over the next several quarters. You know, as we think about next year and kind of just underlying expense growth, given some of the puts and takes with inflation, and there's always some kind of expense component tied to credit, which might normalize a little bit. Just, you know, the bottom line is how do you think about kind of more medium-term underlying expense growth?
Well, Matt, you're way ahead of me. We're still getting geared up to do our 2023 planning here. You know, once we get through, let's start with 2022 and the path that we're on. You know, the guide that we gave was on a net operating basis, so it excludes the merger expenses and should start to give you an idea of what the run rate might look like as we exit 2022. What I would suggest to you is as we go through the system conversion this Q3 , that's a key moment in the final pieces of expense reduction. There will be systems, contracts, and decommissioning expenses that will go on, and those don't happen immediately.
Sometimes that takes, you know, a month or 2. There will be folks that we will retain from the acquired institution that can be systems conversion + 30 days, + 60, + 90. Some of the expense saves will bleed a little bit into the Q4 and maybe slightly into the first. We should be getting towards the, you know, the real run rate by the end of the Q1 should be pretty solid, and it shouldn't be much different from where we exit the 4th.
You know, outside of that, when you get to our philosophy about expenses and the investments that we're making, you know, our history has always been to pay close attention to the efficiency ratio and the expenses, to make sure that the technology investments that we're making improve productivity, which provide an expense save. You know, historically, we've been in the kind of 2%-3% growth rate in expenses on a normalized basis. You know, might be at the higher end of that because of inflation. Sometimes you can end up at the lower end of that if inflation's 0. You know, it's not something where we expect to see mid-single digits numbers like we've seen over the last couple of years.
I think there's some extenuating circumstances that led us there. Over the long run, that's kind of how we expect to run the bank and we do it to achieve positive operating leverage. You know, over the long run, that's our goal.
That's helpful. Just following up on some of the capital questions. Kind of longer term, how much buffer do you want over the regulatory minimum? I mean, it's pretty clear you're hoping to drive down the regulatory minimum over time. Obviously ending this year at 10.5% is a big buffer. What's the thought on how much you'd want to hold over the regulatory minimum? Thank you.
Yeah, sure, Matt. I mean, you know, when we look at our capital targets, we take into account our own internal stress test analysis and losses under stress, as well as the insight we get from the CCAR and the stress test. The thing to keep in mind with the SCB is every 2 years, that number can change. We've got to be careful about setting, you know, the place we want our capital ratio to be based on any 1 year's test. The other part that I think is important to keep in mind, especially with the test of the last couple years, is how the Fed models take into account balance sheet size and what that does for expense growth in PPNR and operational risk.
Within that stress capital buffer, there's credit losses, and then there's these other factors that drive that up. Those will also change as we go through time. You think about the work that we're doing to deploy the cash into securities, which will help in the next CCAR, the work we're doing on construction lending balances and the impact that can have on loss rates and CRE, as well as just the reduction in CRE. Many of the factors and things that we're focused on are intended to help reduce losses and PPNR negative impact in the stress test, which should help bring that capital buffer down over time.
The 10.5 that we talked about for this year is really as we enter into January of 2023, when we'll go through the stress test again, which normally that's an off year for a Category IV bank, but it'll be the 1st year we go through on a combined basis. Now, we actually think the People's portfolio is helpful to our losses under stress, because their CRE portfolio is a little more skewed towards permanent mortgages, which tend to have a lower loss under stress. That we also think will be helpful for the SCB next year.
You know, we've always talked about operating at the low end of the peer range, you know, in the bottom quartile, the top end of the bottom quartile in terms of CET1 ratio. Given our underwriting history and our loss history, you know, we expect to move in that direction. We want to get through the end of this year and through that first test on a combined basis with some buffer and then continue to bring things down, you know, into the range that we talked about.
Okay. Thank you.
Our next question comes from Gerard Cassidy from RBC Capital Markets.
Hi, Darren.
Morning, Gerard.
Sticking with capital for a minute. Obviously your stress capital buffer this year was extraordinarily high. It didn't seem to be the right number compared to. You're risking your organization. I hope it's not any retribution to, you know, 1 of Bob's letters back in 2016 in the annual report about the regulators. Anyway, aside from that, can you share with us what strategies you may try to implement to show the regulators next year when you go through the stress test exam, as you just pointed out, you know, how to bring that number down to a more reasonable level?
Yeah, sure, Gerard. You know what? I guess just starting with the test. You know, the thing to keep in mind is I think that the stress tests were put in place by the Fed at a very unique time in the history of the country and some challenges that the banks were having. It was put in place to give people confidence in the system, and it's a good process. You know, it's never going to be perfect. Each year, the Fed stresses certain parts of the asset base based on what's going on in the country. The last couple of years, it's been focused on commercial real estate.
As an organization that has historically had a concentration in commercial real estate, when that's the focus, the pain is felt a little disproportionately at banks like M&T. You know, as I mentioned earlier, if we look at our history of underwriting and actual losses, we're very comfortable with the asset class. I t's clear that we can't operate with the size of portfolio relative to the peers that we had in the past. That's why we talk about you know, the work we're doing to continue to support our customers, you know, which is the most important thing that we're going to be there for them. T hat we're going to think about different ways to do that.
You know, construction loans, our construction portfolio probably got a little big, and that will come down naturally as we've talked about. As we go forward, we'll look to move towards a slightly better balance of C&I and consumer loans in addition to commercial real estate. That should help overall in the test just because construction loans are one of the higher loss categories. You know, what part of the portfolio could be stressed next year? It could be something else. It could be C&I, or it could be mortgage, and that will lead to a different outcome.
The other thing, though, that I think is important to keep in mind is as quantitative tightening happens and deposits come out of the system, that's going to reduce balance sheets. Reduced balance sheets will reduce that expense growth that I mentioned earlier in the test and will reduce operational losses. Those will also have the effect of reducing the size of the SCB. For M&T in particular, keep in mind that when we went through the test this year, we had the highest level of cash on our balance sheet of anyone in the system. In the test, the cash value at the Fed when because the test always drops Fed funds to 0, produces 0 net interest income.
You have the benefit of the earning assets driving the expense, but not the benefit of any income that comes with them. As we see those balances shrink and we start to invest a little bit more in securities in those fixed rate securities, that will help generate a little bit more PPNR through the test. All of these things are pieces of the puzzle and actions that we're taking to help improve that capital buffer and bring it down, you know, closer to where we all might expect it to be. It'll take time, but we're on a path.
We've talked about the path we're on to bring down the capital ratios, while maintaining an appropriate cushion to where the SCB suggests we need to be. We'll continue to work on the balance sheet to help drive that SCB number down, which will continue to give us the opportunity to generate capital invested in growth in the franchise, and if not, distribute it to shareholders in a friendly way.
Very good. Thank you for the thorough answer. As a follow-up question, on credit, obviously your credit metrics on net charge-offs are through the cycle amongst the best, if not the best of the regionals. The equity markets have seemed to have discounted the bank stocks in anticipation of rising credit losses and problems, coming from the tightening policies of the Fed. Can you share with us, are you guys seeing any evidence yet of early-stage delinquencies starting to creep up in certain parts of your franchise or certain product types that there is some weakness that are developing? Or is it, no, it's still, you know, clear, all clear, and maybe it's something next year that we have to anticipate?
When we look at credit, if I look at the various portfolios, if I start with the consumer portfolios. Consumer delinquency, whether it's in mortgage, indirect auto, RecFi, credit card, home equity, delinquency rates still are below pre-pandemic levels. When I look at the M&T portfolio in particular, we've never been a place that does subprime, and the percentage of near-prime customers is also very low. The last thing we see across all of those portfolios is LTVs are also at lows. You know, with the increase in value of automobiles as well as home price inflation over the last couple of years, LTVs are very low.
So far, not a lot of delinquency and good collateral coverage. Nothing that we're seeing, you know, as signs in those portfolios. Within the C&I and CRE space, it's nuanced, and it's a function of in C&I what's happening with input costs for C&I customers and how strong is their ability to pass on price increases to their end customer. We've seen some instances where we've moved some credits onto our watch list where input costs have risen faster than pricing. That's led to some decreases in debt service coverage. We've moved some people onto our watch list. You know, within the real estate portfolio, what's interesting is it's a bit of a remixing.
We've seen a real strong improvement in hotel NOIs. You know, we're seeing people travel again, in fact. One of the things in our expenses, I could see our travel and entertainment expense was up, as an organization. I think that's a true statement for many organizations across the country, which is a positive sign for our urban hotel portfolio. We're seeing that in the numbers. As those get better, we're still continuing to see some challenges in the healthcare sector, which is, you know, you think about assisted living, acute care, and elective surgery. There's still some lower occupancy levels. They're up off of the pandemic lows, but they're better.
Office continues to be a watch for us, you know, as people come back to the office. Again, when we look at our own staff, we're seeing more people in the office, but it's not back to pre-pandemic levels, and I think that's also true across the country. We're seeing an improved performance in retail and hotel within the real estate space and, you know, still some challenges in the healthcare and office space. Not really a change in aggregate, but a shift in where our focus is. You know, I wouldn't give the all clear signal. That would be very un-M&T like. We're always worried and looking for where the next issue could be.
There's nothing that's flashing red right now that says that there's a big crisis coming in the next several quarters.
Darren, in the C&I portfolio, is there much leverage finance? Obviously, spreads have widened in that category in particular.
We have leveraged finance in there, but it's a small percentage of the portfolio. You know, I think on a combined basis, it's you know, call it $2 billion of outstandings, maybe $3 billion of commitments. You know, maybe $2.5 billion-$3.5 billion, you know, in that space. Which you know, given the size of the bank now, is a pretty small percentage of our total assets. When we look at what the grading on those is, still pretty strong, even with rates where they are.
Great. Thank you so much.
As a reminder, that's star and one to ask a question. We'll take our next question from Erika Najarian from UBS.
Yes. Hi. Just 1 follow-up for me. It's actually a follow-up to the first question. You're expecting some declines, it sounds like, in your core accounts given inflationary pressures. What's interesting is pretty much all of your peers have talked about growing deposits from Q2 levels. I guess a 2-part question. Number 1, how much more in surge deposits do you have left? I guess I'm trying to figure out how conservative the underlying deposit growth assumptions are underneath that 56% guide for NII.
Yeah. I guess as you look through the deposit portfolio, you know, go back to the comments from before. The bulk of our deposit base are what we refer to as operational accounts. You know, it's where our business banking customers, our commercial customers, and our consumers are running their daily lives from those accounts. There are surge balances in there. We're not seeing them run out really in any dramatic pace. You know, the reason we kinda went through the painstaking task of explaining all the deposit changes was to get to this point that we're not seeing dramatic runoff in our core accounts.
You know, there is a challenge that we see for many of our consumers, where the pace of inflation is running faster than the pace of wage growth. They still have lots of deposits, you know, from the various stimulus programs and things that happened during the crisis. We believe that those balances will come down, but they'll come down gradually. Really, the question on deposit decline is for customers who have excess balances beyond what they can use. Some will get deployed to pay down debt, like we talked about with some of our commercial customers using some cash to pay down loans. The other thing will be how many folks will look for a rate for excess balances.
Given our excess liquidity position, you know, relative to the peers, how much do we wanna pay up and for what types of customers? You know, what we tend to do is we look at the depth of the relationship. If you have a broader relationship with the bank, we would be willing to, you know, do more for you on your loan pricing or on your deposit pricing. If you're a single service, you know, time account looking for a rate. Given the excess liquidity, we probably won't match some of the rates that are out there. A similar thing would be true on the commercial side.
It's really a function, I think, Erika, of the difference between the level of our cash position and the percentage of our balance sheet that sits in cash versus the peers that might cause that difference. W e're not anticipating, by any stretch, any rapid depletion of those core accounts.
I understand. Just to interpret that, Darren, just making sure I'm thinking about it correctly. You have so much cash that your sensitivity is greater for those that are seeking higher yield. Is that a good way to think about it?
Yeah, I guess I would say we will be relationship oriented and total relationship focused on the places where we will give rate for people that are seeking it. That will keep those balances on our balance sheet. For folks that you know are just kind of what I would describe as renting our balance sheet, will be a little bit less sensitive and those balances could well run off. We're in the fortunate position of being able to have that selectivity because of the excess cash that we have.
Got it. Thank you.
Our next question comes from Frank Schiraldi from Piper Sandler.
Morning, Darren.
Morning, Frank.
Just wondering, you know, I hate to beat a dead horse on the capital and the stress test side, but you know, even if you set aside the relatively larger CRE balances, it looks like M&T's assumed loan losses in the severely adverse scenario is basically higher than the median, almost across categories, despite what you pointed to and what is obviously a stronger credit history overall. Just wondering if you've been able to gather any more color on, is it a regional thing? You know, what the Fed is sort of thinking that makes their loss assumptions so much more punitive than you guys would assume.
Yeah. You know, Frank, when you look under the hood, you know, the most important thing to remember is there's no loss rate applied to any M&T portfolio by the Fed that's different from what they apply to anyone else with a similar portfolio, right? So all of this is a function of mix. What I think the Fed found, if I remember this correctly, over the course of the last couple of years and the difference between the pandemic test, where the results came out in December 2020, versus this most recent one, was that the loss rates that were being assumed in some categories, notably hotel and retail, was nuanced.
In the first test it was a little bit more blunt that there was more trauma in that whole sector and that would lead to much lower asset values. You couldn't rely on the collateral. In this last test, what I think the Fed did was they were more nuanced and they could see that suburban hotels, ones that you could drive to, resort-oriented hotel properties had seen increases in occupancy, as people started to travel again. That led to better asset values and collateral values under stress. Where they tended to apply more was in the urban areas where it was still we still hadn't seen the recovery in business travel and conventions and, you know, weddings in those large properties. The loss rates were applied there.
When you look at M&T and some of our real estate portfolio, particularly in the hotel, you know, we obviously have New York City. We had some in Boston. We have some in Philadelphia and Washington. Those properties at M&T would have faced a little bit more stress and that would help lead to that higher loss rate. That seemed to be the place. I think there was still a little bit of stress on retail and some beginning on office. I think they were looking a little bit more with a little bit more scrutiny at, you know, what we consider B and C grade office buildings and applied a little bit tougher test to the asset values in those categories.
You know, it gives us more insight into how the Fed thinks about things. It gives us more questions for us to think about in how we consider those property types. You know, but again, to me, the positive is when you look at even with those loss rates and our capital levels, we were still about 300 basis points above the minimum under that stress and with the other comments I made about impact of PPNR. You know, when we look at the capital ratios of the bank and where we sit, we feel really good. The Fed just helped us confirm that we can withstand a pretty severe downturn in some of these asset classes and still be in great shape.
you know, we continue to learn through the process and make the adjustments that we talked about before, to the balance sheet to be as capital efficient as we can be.
Great. Thanks for all the color. That's all I have.
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