KeyCorp (KEY) Earnings Call Transcript & Summary

Great. As everyone takes their seats coming back from lunch, if we could put up the first ARS question. Kicking off this afternoon slate of banks, very pleased to have KeyCorp with us. From the company, we have Chris Gorman, Chairman and CEO; and Clark Khayat, Chief Financial Officer. Chris has, I think, one slide and some comments he is going to make to kick it off, and then we're going to sit down and take some Q&A. Chris?

Well perfect. And thank you, Jason. We always look forward to participating in your conference. I'm joined today on the stage with Clark Khayat. Clark is our Chief Financial Officer. On Slide 2, you'll find our statement on forward-looking disclosures. These statements cover our presentation materials and comments as well as the question-and-answer segment of our presentation. I'm now on Slide 3. We will devote most of our time this afternoon to Q&A, but I want to begin with just a few opening comments. This continues to be the very challenging time for our industry, but with challenges also come opportunities. Key is well positioned to continue to serve our clients through all market conditions and deliver long-term value for our shareholders. It starts with having a [ set of ] foundation with a strong core funded balance sheet. Supported by our long-standing strategic commitment to primacy, namely having our primary operating account. There's been a lot of focus on our balance sheet positioning, which has clearly been a near-term headwind. However, over the next 6 quarters, Key will benefit from a well-defined net interest income opportunity as short-term swaps and treasuries reprice. As I mentioned during our second quarter earnings call, we expect our interest income benefit to reach approximately $900 million on an annual basis by the first quarter of 2025. We also benefit from a strong fee-based business with approximately 40% of our revenue coming from fees, a competitive advantage in the proposed new regulatory framework. Our fee businesses are driven by our leading positions in capital markets, payments, wealth management and commercial real estate and that's commercial real estate [ business ]. We have growth opportunities in each of these areas, including significant upside as capital markets return to more normalized levels. We are also continuing to focus on improving productivity and efficiency. Earlier this year, we successfully completed a company-wide initiative to reduce our annual expense run rate by $200 million, which in our instance, is 4% of our annual spend. We will further reduce expenses in the second half of 2023 and accelerate our plans to streamline and simplify our businesses and position Key for success in the future environment in the post positively environment. Another strength of our company is credit quality. Credit losses remain relatively low across the entire industry. But as we move through the business cycle, asset quality will matter. Today, more than half of our C&I loans are investment grade, and over 70% of our consumer originations have a FICO score of 760 or greater. These measures reflect the de-risking of our portfolio over the past decade in concert with our underwrite to distribute model. Key also has very limited exposure to leveraged lending office loans and other high-risk categories. Our exposure specifically to B and C class office space in central business districts is a total of $121 million. We continue to benefit from insights gained from our third-party commercial real estate servicing business as we service over [ $630 ] million off-us real estate debt. I also want to comment a bit on the Basel III end game. We continue to be proactive on the balance sheet optimization and capital allocation perspective. We are well positioned to build capital and reduce risk-weighted assets. We will reduce risk-weighted assets by approximately $10 billion during fiscal year 12/31, '23. We will continue to prioritize full relationships and exit nonrelationship business and nonstrategic assets. In the second quarter, our period-end loan balances declined by $1 billion. We anticipate an acceleration in the pace of reduction in the second half of this year. As I mentioned earlier, we will continue to benefit from our strong fee-based businesses, which make up a significant portion of our revenue. As capital markets normalize, we will utilize our differentiated platform, driving fee income and reducing our balance sheet exposure in the ordinary course of the business. On the capital front, we will benefit from ongoing capital generation and the roll down of our AOCI over the next 6 quarters. We expect our common equity Tier 1 ratio to be above our 9% to 9.5% targeted range by year-end. I will close by reaffirming our earnings guidance for the next 2 quarters and for the full year, consistent with that which we provided during our second quarter earnings call, which is included in the appendix of our presentation. I am confident in the long-term outlook of our business, our business flows are good, and our risk management practices are strong. Today, we are underearning due to our short-dated swaps and treasury securities, which will mature over the next 6 quarters. As these positions mature and capital markets activity normalizes, we expect to deliver results which reflect the long-term earnings potential of our company. With that, Jason, I'd like to turn it over to you, and we can jump into the Q&A.

So Chris, by those are short remarks. There was a lot in there. So I do want to follow up.

Short from a time frame perspective.

Yes. So RWAs coming down $10 billion this year, although you kind of stuck with your loan growth guidance and your NII guidance. Can you maybe just expand in terms of what, how you are reducing RWAs? And then I would think there'd be more of an earnings impact, maybe not this year, how it thinks about your thought process for next year?

Sure. Well, thank you for the question. And obviously, the premise of the question is that RWAs are dropping significantly at a greater [indiscernible] than our loans. And so it's really, there's really a few things. One is -- we've gone through our portfolio and a lot of our, a significant amount of our portfolio has unused lines, Jason. And to the extent you're exiting credits that don't make sense from an earnings perspective and you have unused lines that gives you an opportunity to do so. While I'm on that point, we have literally ripped through our portfolio in any business that's not returning to the levels, and obviously, the number of businesses that are returning at our early levels just went up given that the amount of capital has gone up and the cost of capital has gone up. We're exiting those businesses. And then to some extent, there's also, as we looked at our portfolio, there was, there were opportunities for us to reclass RWAs, both on an idiosyncratic basis and on a portfolio basis, which leads me to the second part of your question, Jason, is there a huge impact with respect to earnings as we go forward? The answer is there is some impact, but for example, if you're looking at whether it's a re-class or whether you're exiting unused line fees and there is absolutely [ thrilling ]. So in each instance, we're exiting business that we don't think gives us the return that we want, in some cases, the release of RWAs is free so to speak.

Okay. That's helpful. Any particular examples of businesses you want to talk about? I know you guys were early in terms of getting an indirect auto a few years ago. And anything else of consequence? Or is it more kind of smaller hobbies?

I think you could assume that it's mostly smaller hobbies, but when you go about the business of reducing expenses, one of the best ways to reduce expenses is to stop doing things, and like Indirect Auto, which we exited in 2024, we had about $4.4 billion of exposure. That's a nice opportunity to eliminate the expenses in the front, middle and back office. So more to come on that as we work through the balance of the year, Jason.

Right. And then you touched on the opportunity for net interest income as swaps and treasuries reprice. It seems like it's a meaningful benefit over, I guess we should start to begin to see it nearer term. Just maybe talk to, are there any kind of risk or concerns that you're not to be able to benefit that? Or is that just a function of timing?

Well, a huge function of it is timing, and I'm going to ask Clark to comment on the specific drivers that could move it up or down. But, the important thing to think about these short-durated swaps and treasuries is that really the only thing, and I said the only thing, 85% or 90% of it is all based on nothing but timing. Having said that, there are obviously variables that could impact that. Clark, do you want to comment on that?

Sure. So I mean, look, as rates go up, there's more benefit when you come out of the treasuries and the swaps. There's also likely more funding costs. So it moves a little bit in tandem, Same thing on the way down. I think if you isolate this opportunity, what happens to the swaps in the treasuries, the biggest risk is rates come down and your reinvestment rate is lower we have offsetting benefits in that case as well. So we do think there's a little bit of movement kind of in either direction to support that, but it will largely be timing as we talked about. So you get through the second half of '24 most of this is rolling and you're starting to see it really pull through heavily. We are going to see treasuries start to mature this quarter. So we've been talking about this now for 12 months. And we will see the treasuries, we'll see close to $3 billion of swaps over the last 2 quarters of the year and then all the things we've talked about [ 3 ] quarters.

And all that incremental revenue when that roll off, we should find its way to the bottom line?

Again, it depends, I think, if you look at it in a stable rate environment, yes, as rates go up, the benefit increases, the cost increase, as rates go down, the benefit decreases, cost should decrease. And again, there's some timing mismatches in terms of betas and when things like that would get deployed, but it should be sort of more contained to some degree there.

Got you. And so we talked about kind of related to the guidance, I think we had NII down 4% to 6% in Q3, getting better to kind of flat to down only 2% in Q4. As we start to think about 2024, is it safe to assume that could start to see maybe gradual NAI in growth from there? Or how should we kind of think about that backdrop given this repricing scenario?

Yes. So we'll obviously give full guidance when we give full guidance, but I think it's safe given that portfolio to expect NII and NIM to go up in '24 as we move through the year.

Got it. And then on deposits, I think the guidance was kind of relatively stable for Q3 and Q4. you reaffirm that. I guess maybe just get some more granularity around that in terms of maybe how deposit costs are moving deposit mix, deposit beta expectations I know there's catch up this year and just kind of what you're seeing today?

Yes. So we said nearing [ 50 ] as we got through the year. I think that's still pretty safe. I think we are seeing stability in the deposit base for sure. We are seeing the slope of increase in betas, plateau some. So I think generally, it's all, I think, constructive. And are stable to flat. I think this is an important point in deposits are stable to flat on balances is also working out of our brokered deposit mix. So we're really replacing a lot of brokered runoff with customer deposits.

Got it. And then with respect to loan growth, I guess one of the takes on conferences, it seems like loan growth has been a bit sluggish. Your guidance kind of incorporated that to be down a little bit in the next 2 quarters. Maybe just talk to, I guess, on the supply side, how much of that is tied to initiatives to manage RWAs more carefully versus demand side where economy slowing, borrowing costs are higher and maybe borrowers are pulling back?

I think it's some of each. Clearly, in our instance, we are aggressively managing our balance sheet. And so we are engaging in new loans because we're supporting our clients. But we're also, we ended up, we ended the second quarter down $1 billion in loans, and we've guided that we're going to continue to be down. I don't think there's robust loan demand right now. As we look at it, for example, at utilization, we've been flat at about 32% over each of the last 3 quarters. So I think it's on the supply side and on the demand side that we're seeing for tepid loan demand right now. There's also not a lot of transactions. I think that will change. One of the things that really drives demand is people making significant investments in property plant equipment and people doing strategic things. And I think as there's more clarity, higher for loan growth , I think you'll start to see more demand out there.

And then you stuck with your fee income guidance up, I think, 2% to 4%, 4% to 6% this quarter and next month, respectively. One of the themes kind of coming out of the conference is while maybe July and August was soft from a capital markets perspective, it feels like the tone coming out of Labor Day was a bit better. You guys have a very solid capital markets operation. Maybe just provide some more context in terms of what you're seeing there?

No, I think your point is well taken. I mean, in [ Granite ], these numbers are coming off a very low base. So I have to qualify what I'm going to say. But clearly, we, to this day, see pitch activity and pitch activity for the months of September and October, very significant. So people are starting to think about strategic things. In the last couple of weeks, you started to see some initial public offerings roll out. This believe it or not, was the second worst year in the last 50, 5-0 years on the IPO side. On the M&A side, starting to see the private equity community start to both be a buyer and a seller. They have really been, and in the middle market, they're a big part of the market, and they were basically on the sidelines in the first half. So I'm not talking to all our clients all the time. I think there had been a real pause in terms of people not knowing where the economy is going to go, not knowing what the cost of capital was going to be and there was sort of, and I think it's starting to sort itself out. It's not going to come roaring back. Just to frame it for everyone here, our capital markets business on an annual basis as kind of a run rate of, call it, $900 million. In the last quarter, we had $120 million of revenue. So it's clearly coming up but it's coming off an artificially low which I think is an opportunity as we look forward.

Got it. And then on your slides, you talked about aligning expenses with revenue opportunities, targeting additional expense opportunities in 2H '23. You're shedding $10 billion of RWAs. Maybe just talk about how smaller banks, a smaller expenses? What are you working on there? And you talked about a 4% expense reduction program. Just how does that position you as you kind of enter '24?

Yes. So to kind of get to sort of the headline here. I think in 2024, our expenses will be roughly flat and that will include both a lot of expense cuts and investment because I'm a believer that you can't ever put yourself into a position where you're not investing. And so we took out $200 million in the first quarter. And what we're going about the business of doing that I mentioned from my prepared remarks, is we'll take out more expenses. And what we'll focus on is not just cutting by 5%, but figuring out those businesses that we don't think makes sense in the new kind of Basel III end game. So it won't be necessarily whole businesses, but it will be activities within those businesses.

Okay. And then maybe on credit quality, just maybe any developments on the credit front? Any changes in lending standards just how you're thinking about that? .

So absolutely no changes in lending standards. And I say that because I'm a big believer, you can't have a bunch of variation and what you're willing to do from a lending perspective. It's not good for your customers, and it's not a good way to run your business. By the way, if you wait until you're at sort of the end of the cycle and you start making adjustments, it's too late anyway because you own what you own on your balance sheet. But with respect to our credit quality, I feel really good about it. We charged off 17 basis points in the second quarter. We've guided through the cycle being at 40 to 60 basis points. I looked very closely at this. I don't see any path absent something significant geopolitical or something. I don't see any path for us to get to 40 to 60. We've got 50% of our C&I loans are investment grade. Average FICO score in consumer 760. The consumer is in good shape. We will see some migration in terms of criticized and classified. When interest rates go up to the degree that they have, the trajectory that they have, we look very closely at places where there's any leverage and where and, there's any leverage in the business model can come under pressure. Having said that, while you might see some migration on criticized and classified, I don't see loss content there.

And then your allowance though was up like 18 basis points over the last 2 quarters combined, like 17 basis points of charge-offs in that span. Your office exposure, I think, is surprisingly much, much lower than anyone else I cover. I guess maybe kind of what's driving that to build and kind of how do you think your reserves position? Now that you've kind of added more to [ first half ]?

We're pretty consistent. The biggest thing that drives under CECL, that's supposed to be proactive. The biggest thing that drives it is, what's your view of the economy going forward. And in each of the last 3 quarters, unambiguously, if you look forward, it looked worse going forward and if you look backward. And so we felt the need to build reserves there. We're actually shrinking our loan book. That's another thing that would drive reserves. And then third are kind of idiosyncratic risks. And as I mentioned, as we went through the portfolio, in general, we felt good about that. So I think right now, our reserves, I think, cover 7 years at our current charge-off levels. I feel good about it, but we're pretty conservative when we take a look at things like that. I just think it's important to be proactive and build the reserve.

Yes. [indiscernible] and as now, but Laurel Road, maybe provide us an update? And just how does that fit into kind of all the stuff we talked about?

I'd be happy to. And Clark's been intimately involved in Laurel Road. Let me kind of kick it off, and then we can talk a little bit about it. So Laurel Road is a business that we bought that is in the student loan refinance business. It's a complete digital approach basically for doctors and dentists. We then, the next step is we've built it out. So it wasn't a single product company so that digitally, we have 80-some-odd partners and people like the AMA and the ADA, so that digitally, you could have a checking account, you could have a savings account, you can have a credit card. Then we built it out to include nurses. Nurses obviously expands the loop a lot, then we bought a business called GradFin. GradFin is a really interesting business because they are the leaders and we got to know them through the student loan business. They're the leader in providing advice should you refinance the student loan? And also, do you qualify for public service loan forgiveness. So everyone that works in a hospital, not everyone, most everyone that works in hospital works for not-for-profit. And now the government has really expanded the opportunity under income-based debt repayment. So that's a way that we can continue to grow that business. Now what will change going forward, if you think about the new asset-light model and we will go back to securitizing and selling student loans as opposed to putting them on our balance sheet. Because if you think about the Basel III end game, we'll have to make some changes to our business as we this asset light. Clark, would you add anything to that?

I think we always intended to build it as a full-service business, and we'll continue to do that. But to Chris' point, we'll revert to moving the loans rather than holding it.

Got it. And then Basel III proposal, you kind of touched on it upon should we put up the next ARS question. But I guess a lot of different views on the impact of the NPR, may share kind of what you think about it overall and maybe implications for the industry and for Key?

Well, I will say this. It came out about how we saw it. I mean, I think it had been in telegraphed very clearly. There are certainly some things in there that I would say are positives. There are things in there that is, that I think as an industry, I think we have some concerns about. To your specific question around RWAs, I'm going to ask Clark to answer that because we've done a ton of modeling and Clark, how would you respond to that?

There's puts and takes. Obviously, the OpRisk piece is brand new, that's going to add for everybody. I do think what is reflected in the NPR has been consistent with the way we talked about our credit profile. So 50-plus percent C&I is investment grade. That will get some RWA value in the new outlook. Our CRE portfolio similarly, it's an LTV stratification, not just 100%. Most of that is 60% or lower. So we've got some real benefit there. There's some other portfolios that sort of go in either direction. But I think net-net, the credit quality is largely offsetting the addition of the OpRisk piece.

So don't expect much RWA inflation?

We wouldn't expect a ton based on our current read.

Because the buy-side consensus has you up 10% to 15%. But it sounds like if you were answering this question, you would have put flat 5%.

That's where I would be based on our current view.

Interesting. I guess with that, so RWA is not necessarily, is quite manageable, but you are kind of facing a 300 or so basis point headwind from AOCI opt out. You talked about being above 9.5% on CET1, but you probably AOCI probably a touch below 7% fully appreciate we're talking today versus something that's not going to be a happening into the future. But just how do you kind of think about that?

Well, I mean, obviously, one of the things that came out in the NPR is the time is our friend, right? And that's really, really important. As we think about capital and what we need to do there's nothing that we need to do that is inorganic in order to hit all the capital measures that we need to hit. And, we actually feel good about where we stand with respect to the capital build between now and either July of '25 or July of '28, however you look at it.

And I guess, a, on the topic of regulation, there's also a long-term debt proposal came out a week or 2 ago for $100 billion-plus asset banks. Maybe just help us talk what that impact could be. .

Clark will cover that.

Yes. So I mean, we've, we're still sorting through some of it, which is at times overly complicated. But I think generally speaking, we're kind of looking in less than $5 billion range of additional debt. And again, sort of fine-tuning those numbers. But it's not, we saw some things that were as low as $1 billion, some as high as $10 billion just given what was [indiscernible] and what wasn't that we think we're in that range but towards the lower end of that range.

Got it. Maybe we'll put up the next ARS question. What do you think normalized ROTCE ranges for Key? And I guess I noticed you put up your outlook slide in the deck this morning kind of reaffirming Q3, Q4 guidance, full year guidance, it also kind of had long-term targets kind of unchanged with that 16% to 19% ROTCE, as you kind of think about the new environment with implicitly higher capital RWA [ dividing ], does that alter your view in terms of kind of what the long-term ROE potential is?

So the guidance that we gave, we have not updated our long-term guidance. So to your question, there's been a lot written on what everyone thinks everyone's ROTCE is going to be. I've seen a lot of numbers that range from down 200 basis points or down 400 basis points. I'd make a couple of comments, if I could, on that. One, as I go through most of the analysis, most of the analysis assumes that management teams aren't going to pull any levers and do anything differently than they have. And as you can tell by the comments that I made and the discussion that we've had so far, we and others will take a bunch of actions that are required. And the other thing that is missing, I think, in a lot of the analysis, the biggest driver of ROTCE at least in terms of degradation of the same is credit losses. And so I don't think you can think about kind of ROTCE without really thinking about what are the credit losses going to be on an actual and on a relative basis. All that -- put all that together, do I think it's going to be no change? I do not. I think by definition, if you carry more capital and it's more expensive, it's going to impact it. Do I think it's going to impact our targeted ROTCE, which is currently 16% to 19% by 400 basis points, I do not. We'll see where it shakes out. I see let's, we say here that, so if we're at for 16% to 19%, it looks like most folks are sort of in the, it looks like they're mostly 13% to 14%. I think it will be, and we're running a bunch of models it will be higher than that.

Higher than the 14%. But not the 16%?

That's right. .

Fair enough. So we'll go with mid-teens. I think that's a reasonable assumption. And you mentioned the risk, it sounds like you kind of talked about that 40 to 60 normalized loss rate, I guess, kind of given the current balance sheet maybe that number is too high as well?

When we come out with guidance, as we always do in January for next year, we're going to restate our long-term goals as well just under the Basel III end game. And my guess is that will be your instant. That will be something under review. Can we still think 40 to 60 is a good number. My guess is that it will be below that.

Fair enough. Why don't we look to the audience for questions. I guess you touched on this, but you made the comment that given your CRE servicing platform, you have unique insights into what's going on in that segment, but you didn't share those insights, so I mean, we keep on reading the Wall Street Journal? How it's like the end of the world. But maybe you could kind of talk to, I know it's not on Key's balance sheet and probably a revenue opportunity, but just maybe talk to in terms of what you're seeing?

Yes. So it is a revenue opportunity because the $630 billion that were the servicer of over $200 billion of it were the named special servicer and it goes into active. So picture, we're basically the workout agent. So that's how we have this unique insight. There's no question that it's office. In its office and central business districts and it's B and C class. It was, as you look back at first, it was lodging, as you can imagine, coming out of the pandemic. Before lodging, it was retail, no surprise there, just given sort of the macro trends. And I actually think office is going to get a lot more challenging. I can speak for us. We said we were going to take out 25% of our non-branch non-ops real estate. We had too much real estate before the pandemic. I traveled around and, many of you traveled around your other offices. There's a lot of empty offices when you travel around. We took out 25%. We're probably closer to 30% or 33%, and we're going to take out more I just think there's, I think we're over office, and I think it's going to be a challenge that goes on for some time. The good news is that, obviously, these are multi-tenant buildings. And so at least as they're staggered, but we, as I said, we only have $121 million of exposure. And just to remind some of the listeners we have about $120 billion of loans. So it's not a big number for us.

Right. No, understood. Understood. Questions from the audience.

Can you talk a little bit about your long-term debt requirement and the friction sort of between the bank and the OpCo and what or sorry, bank and [ HoldCo ] and what you need to carry for that friction? Relative to just the stated requirement.

Yes. Sort of to be determined as we're sorting through the rule, but I don't think, if you were on either extreme, you, the one bad extreme would be issued at the [ HoldCo ] push it down issue again. I don't think that's the answer. I don't think it's as simple as issue once and push it all down, right? So the balance is really how much do you still need to hold at the [ HoldCo ]. I think the other question will really have to understand, and it's too early to tell. Is how regulators think about the ability to go up and down? So historically, as long as you were in good standing, you could move dollars up and down relatively easily, but with different regulators with different requirements. I'm not sure how much friction that's going to create, and that time will tell, but that's a place where you may end up carrying more than you need because you can't move it as flexibly as we have in the past.

Maybe we'll go to the next ARS question as the audience thinks of other, but which would have the most impact on improving Key's valuation.

Going back to your comments on office CRE, what's your, what are you seeing in terms of value declines and loss rates so far? And what's your expectation based on the special view that you have with the vector?

Well, the interesting thing is there's been such a precipitous decline because, there's really nothing trading right now. So I can't really tell you what the adjustment has been. I mean if you go to people, we use a bunch of outside sources, people would say that the degradation over, from peak to present is a number that starts with a 3. I think it might be greater than that. I don't really know because it's not something that we're really dealing with. We don't have couple of loans in that area. But I think I think it's going to be really, really significant. The other thing is everyone quickly goes to the fact that we're, that we don't have enough front doors in the United States, which we don't. And everyone says, well, people will just convert offices to multifamily, it's not that easy. If you think about how, if you think about just how they're plumbed if for no other reason, it's just not that easy to do. So more to come on that, but I think I think there's, the adjustment period has just begun.

I think if you take it from the tenant standpoint, as Chris said, we're out of a lot of space, do you just write off the lease and make the payment and now the landlord has to decide what they at the space. Do you sublet it. There's a whole series of that and in multi-tenant buildings, they're all in different time frames. So I'm not sure we'll see the exact implication of this until we kind of start to move through leases turning over. .

By the way, I agree with the concept that better NIM and NII performance would be the biggest driver. And the good news for us is it's just a matter of it's just time bound. Most times in business, there's all kinds of execution risks and all kinds of variables. This is pretty clear.

Why don't we go to the next ARS question, kind of tease it up. but expectations for Keys NIM next year with [ $212 ] million in the second quarter? Clark, this is where I really would appreciate your answer. .

You'll get our answer later, Jason. .

Can we until January? Let's see what the audience comes up with. So that's interesting, so not much improvement from current levels would be the kind of buy-side consensus.

That didn't sound like a question. We're obviously not going to give guidance today. But what Clark has said is that on a normalized basis, our NIM should start with a 3, and so that is after these things burn off. And we've also said that our NIM bottoms out in this year. So those are kind of two data points that we have out there that I think would be potentially well, I'll just leave it at that. .

I would just say the other thing we've done this year, Jason, whether it's RWAs, whether it's driving down wholesale borrowings, so a bunch of movement we made building capital through the year. I think we have more flexibility today than we had 6 months ago to pursue different paths as the market changes. And I think those that flexibility will only increase as the treasuries and swaps mature.

Any last final questions. If not, please join me in thanking Chris and Clark today.

Thank you, Jason. I appreciate it.