The PNC Financial Services Group, Inc. (PNC) Earnings Call Transcript & Summary

Okay. Thanks, everybody, for joining us. We are pleased to have with us today Bill Demchak, Chairman, President and CEO of PNC; and Rob Reilly, CFO. Thanks so much for joining us.

Happy to be here.

Good morning.

So I do have a quick disclosure statement. Please see Morgan Stanley research disclosure website for important disclosures at morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales rep.

Okay. Bill, the question of the -- at least this year, let's discuss the BlackRock sale. And investors have been asking if you could talk through the decision to monetize the investment? And if you could talk through why now, typically people are recognizing this kind of stuff when they really need it, but clearly, you don't. So give us a sense as to what you were thinking?

Sure. First off, it wasn't -- and you've heard me say this. It wasn't a statement in particular about BlackRock, and it certainly wasn't a statement about the health of our balance sheet. Instead, it was simply the realization that our ability to see into the future as it relates to what's coming in the economy, which still holds true, by the way, was in a place that was very uncertain. And therefore, we expected and still expect there to be some fairly substantial disruption across the financial landscape, and we wanted to be able to take advantage of that from an offensive standpoint as opposed to be playing defense and hoarding capital and answering questions about dividend and all of the above. And an issue, of course, is with a great asset like BlackRock, which has a beta of more than one, if we, in fact, got into that scenario, then the ability to monetize BlackRock in the moment, which in a perfect world, you'd sell it at the absolute high when everything else was at the absolute low and life would be wonderful, but life doesn't work that way. And so we kind of recognize that we need to do, in effect, exercise that option while it was exercisable to be ready to come what may. And it wasn't -- the basic notion that it was getting harder and harder to hold BlackRock is -- was nothing new to us. We were through the years forever fighting sin bucket issues and, most recently, single counterparty credit limit issues and in all likelihood, a higher tax rate as we go forward to pay for all the stimulus that's out there. So it was coming. And when you kind of run those probability lines and potential outcomes, it was better to be a seller when we wanted to be a seller as opposed to being a seller when we were a forced seller, either because of the economy or because of changing regulation and tax. So that's how we got to where we are. Of course, had I known the market was going to rip another 15%, you would -- we would have gotten more dollars for it. But hindsight is always 20-20, and that is what it is.

Yes. No, I get that. So maybe thinking forward, looking forward here, can we talk a little bit about how you're thinking about using the proceeds. Obviously, you've suggested, hey, in a tough economy, we can go in there and pick up some like assets for a decent price, but I'm wondering about timing of this reinvestment? I mean how long are you willing to sit on this excess capital for?

We will be patient. I know everybody is worried in some way that we'll race out to do something. This hasn't begun to play out in our economy in terms of what the impacts are and what the opportunity set will be that comes out of it. And we'll be patient to watch. In a perfect world, we would use the capital to both in an organic sense, but inorganically through acquisition to expand what we've been trying -- or accelerate what we've been trying to do on a national basis with our franchise, both in retail and C&I. And we'll let that play out.

So I mean, obviously, you've been in the seat for a while and in banking for your whole career. The economic data looks better than expected and the stock market saying everything is fine. I mean what's your sense of when these problems that you're concerned about are likely to become visible?

Yes. So I think there's a bit of confusion in the market between liquidity and capital. So there's massive, massive liquidity in the capital. You see it show up in bank's balance sheets in the form of deposits. You're seeing it in the stock market. The stock market is effectively pricing in, as you said, that everything works here. What -- behind the scenes, what hasn't played out and will take some period of time to play out is the deterioration we've seen in small business in commercial and real estate and ultimately consumer that once the stimulus payment kind of runs out in the deferral of tax payments and the PPP and so on and so forth. And importantly, all the deferrals we and the rest of the industry have done just by saying, don't pay us, I think the pain shows up. And we -- all of that's been hidden today. Right? None of that is showing up today because if you just deferred somebody, you don't have to create a TDR, and it doesn't show up anywhere. But I'll give you a sense of kind of what's going on. We are the largest master servicer in CMBS in the country. We had just in the first week of June $1.5 billion of loans show up in special servicing. We've been running about $2 billion a month starting in April. And just in the first week of June, it's jumped to $2 billion. They figure it's going to hit at least by the end of the year, which is about 15% of our balance. We have as a company 30%, I think, of the notional of our small business loans and deferral, which is by disclosure, apparently less than most of our peers. All of that stuff has to kind of play out. And we'll see how it plays out. Maybe we all go work -- back to work and life is perfect, and there isn't a second wave and so on and so forth. But even in that instance, I think B Class retail hotels, unemployed coming out of government, municipalities, health care, I mean there's big sectors that are in trouble here that are going to show up and play out through time. The other thing, just real quickly, I'd remind you of, is the balance sheets of very large banks versus very small banks are really different, right? So the smaller you go as an institution, the more you bank small business and commercial and real estate and real estate related. And it's in the smaller end of our economy that's really getting crushed here. So in some of those banks, I call them smaller, but some of those banks are $100 billion banks. So this entire balance sheet is basically small business, commercial and real estate related.

So this brings up the question on when you're thinking about deploying the capital, maybe you can give us a sense as to what kind of banking acquisitions would be most attractive. I know you've mentioned, hey, your bread and butter is more C&I than consumer, obviously, you do all, but is that what you'd be more interested in, given the fact that balance sheets, like you mentioned, are a little bit more at risk in the -- in certain parts, in the smaller business part? But maybe, again, just stepping up, could you give us a sense of the type of banking acquisitions that you would most want to do?

Yes. I mean in an ideal world, something that would expand the geography somewhat and be concentrated in the C&I and real estate space. Again, at the right price. We are very good at working out those assets. We did it with National City. We did it again with RBC. We actually did it with Mercantile after the act, and that's a space we know well. We know how to value, and we'd be comfortable doing it. When I talk about consumer, we don't have an inherent bias against consumer, except for the fact that most of the consumer institutions who show up for sale end up having had a weak franchise to begin with. And therefore, would rely on us to have a capacity to fix it. And that I'm hesitant on, right, because we are not the expert fixer of a subprime lender and consumer. That is more [ BlackRock ]. So when you guys hear me talk about ideally going after the space, we know it's kind of a -- it's a logical statement. It lowers the risk boundaries because we know we can execute on it. We've done it before. We still have the same team. We know how to do it.

What about size here? I mean are you willing to cross the $700 billion in assets? Or you're looking to stay below that?

That's a function of the, in the moment, returns that you get. You'd obviously have to factor in, to the extent we did that or even came close to it, the incremental cost of carrying the extra capital.

And then -- yes. Okay. Because when...

The answer could be, sure, we can cross it, but we have to see what the returns are and obviously, the price.

Because when -- the fact that you have this extra cash enables you to make accretive deals pretty easily. So I guess people are -- some investors are concerned about how you would be assessing the return on the deal? Would you be doing it on a cash basis or on a stock basis?

You've known us long enough. That's almost offensive, right? We're not going to spend -- we're not going to spend cash and compare it to the cost of cash. We're fully cognizant and when we went through this whole assumption, we looked at it as a function of, in effect, the ability to replace the earnings from BlackRock with the capital generated from BlackRock. So we'd measured it against whether we did it on a stock basis. In the end, we probably do cash and stock. And it would -- and our return hurdles and our discipline on doing deals isn't going to be -- I don't know, you've known me -- you've known us long enough.

We're altered, altered by that, right?

Yes, we're not going to throw our basic financial margin.

Remember, you're not just speaking to me, you're speaking to a whole host of people who might not know you as well as I do.

Fair enough. But no, we'd run all the financial metrics and have the hurdles you would expect us to have. And I think we'll have the opportunity to do that.

And then just digging a little bit on the expense ratio. I mean, obviously, without BlackRock, the expense ratio is a little higher. Could you give us a sense as to how important it is for you to get that down? And how much does an acquisition help in your outlook here?

Well, an acquisition would help in any event because we've built the capacity to scale what we do and off our technology base to almost any size. But our efficiency ratio in and of itself doesn't drive me or drive us as much as the efficiency with which we spend money does. So what I mean by that is our efficiency ratio is driven by the impacts of our business mix, whether it's what we do in tax credits, whether it's the fact that we run a risk -- a less risky balance sheet than others, many different things give rise to quote that ratio. The way we spend money and how much we spend is more important. And we are focused because of this environment pretty intently on finding ways to drive costs out of the organization. You heard us talk about the ability to effectively drop expenses this year, largely in line with what we would see on a revenue drop, and we're working towards that. But that's not to give rise to what an efficiency ratio would be that would -- that simply say that in this environment, the way you spend money needs to be rethought.

Yes. Maybe we could just finish up this conversation on 2 points. One is given the fact that the banks seem to be pretty well capitalized and positioned to weather the stress more than they did in '08, do you think any -- do you think you're going to see some willing sellers come up here? It's a question I've gotten from a bunch of people.

Yes. The answer, I guess, is yes. Whether there are sellers who want to sell or have to sell in the middle of what would be the crisis remains to be seen. I think you'll have some that particularly on the very small side that I don't know we'd be interested in that will be forced sellers. But I do think, Betsy, as we look forward and you think about the environment that we're going to be going into here, right, we have a basically a 0 rate boundary that I don't know is going away anytime soon. The cost of technology, if anything, has just accelerated as consumers have moved increasingly digital during this crisis. Credit costs are going to be elevated for some period of time. It's not going to be a lot of fun to be a bank. And so the logic of a sale or a strategic partner that takes advantage of scale, I think, is going to make sense to some people. And I would tell you, and this probably isn't a surprise, the day we announced this thing, it's fascinating how many phone calls I get. Just to say, "Hey, Bill, how are you doing?" I mean it has to be on everybody's mind. What do you do if you're a bank in this coming environment?

Okay. No, that's helpful. And then just lastly, while you do have the cash on hand, there is a revenue hole, at least until you deploy the capital more strategically. Can you tell us what you're doing with that cash and how you're investing it right now?

Yes. So most of it at the moment sits at the Fed. We have paid down wholesale funding everywhere we can. We obviously had not just the cash from the sale, but massive inflows effectively off of the Fed's balance sheet as consumer deposits are higher off the back of stimulus payments, the delay in tax payments or just lowered consumer spending. And corporates are really flushed with cash given, in particular, the wave of issuance we've seen into the capital markets. So in effect, where long, massive amounts of cash, most of it's sitting at the Fed. We're obviously on an organic basis doing a lot in the market to put capital to work. So behind the scenes, you're seeing a lot of acceleration of bankruptcies and restructurings out of private equity companies. So deals that used to be cash flow now are going asset-based. We're seeing distressed borrowers who need a highly structured solution. So we have -- we're using capital to the best of our ability to put it to work in what is still a fractured market once you get outside of kind of the public markets.

Got it. Okay. You touched on a little bit earlier. Maybe we can dig into that for the P&C side of the book here. I think on the first quarter earnings call, you mentioned that you could see a material reserve build in the second quarter given the fact the economy deteriorated. Could you just give us a little more color as to how you're thinking about that at this stage in the quarter?

Sure. I mean when we ended the first quarter, I'm actually trying to find the percentages here in front of me. But when we ended the first quarter, we had a kind of a baseline assumption on GDP for the second quarter that I think was down 12% or something. We had unemployment on our baseline going to 6% or 7%. Notwithstanding the improvement we've seen, it's still a hell of a lot worse than that. So the baseline we think about now is GDP down 30% in the second quarter, recovering up either on an annualized basis, 13% in the third and maybe 10% in the fourth. Ultimately leading to a kind of 4.5% annualized peak to trough. But even -- I think it ends up being a 12% peak to trough with the second quarter dip compared to a 4.7% in the financial crisis. Unemployment, we still have holding a bit over 8% as we go into the fourth quarter. And that's in our baseline. So we would expect to see a reserve build in the second quarter. We'll run all the numbers and figure out exactly what that will be. But certainly, versus what we expected in the first quarter where we just kind of assumed, think everybody did, we do a quick time out and come ripping back. Notwithstanding some of the good news, we're not seeing that at all.

Okay. And I guess the other question we've been getting is on your C&I and your CRE books, you've got collateral, right? And so when people are assessing what kind of risk to expect in that, does it make sense to be comparing that to the great financial crisis or it's a little worse because this is much more of a C&I, CRE heavy event like you mentioned at the opening? And how should we be thinking about how much protection you have in collateral or guarantees or things like that?

I don't know that there's an easy way to answer that. I mean most of the stuff we do inside of the riskier spaces is secured- or asset-based. But we're in this weird situation in the sense that there's parts of real estate that just won't come back, right? We're going to see a mall operator likely enter bankruptcy. We have exposure to them, but we're senior secured and we'll probably get out of that fine. So I don't -- the other weird thing that's happening here in conversation with our CMBS master servicing guys, there's still a lot of capital on the sidelines. So you're seeing like B-piece buyers who are just getting toasted where their holdings and their existing B pieces are getting wiped out, yet they're actively investing in new ones, which suggests, unlike the financial crisis, there is capital to put a floor on the value of assets. Where that sort of fails, Betsy, is if those assets are no longer useful assets, right? So [ market ] economies changed such that B class retail is just never coming back, hotel usage is never coming back, office space and so forth. And then again, my primary worry is, as you get into smaller business in commercial, there's no inherent franchise value to those entities, right? They're worth the output of the individuals who work there. If you follow me in a corporate [indiscernible], there's enterprise value to that enterprise, and there isn't as you get into smaller entities. And that's where these losses are going to show up. As it relates to our book, I continue to believe that we have one of the best underwritten and diversified C&I and real estate books across the industry. One of your competitors actually put out a chart on percentage of our loans, industry's loans to COVID exposures, and they have us, which is largely accurate, at kind of 9%, which is well below the average of most of the banks out there. So I think we'll do fine. But it's kind of hard to predict exactly what's going to happen. We have capital on the sidelines, which ought to floor prices. We have assets that will never come back because the way the world works is going to change. And we have real small entity capital crisis that isn't solved by liquidity. I think it's so large, even fiscal PPP and so forth doesn't make it, right? 2.5 months of payroll doesn't bail out a small business that's going to come back at 80% of its previous volume when its profit margin before it was 10%.

Yes. What kind of loss content do you think that -- is that going to be like a 20% loss content? I mean we hear things like small business that can make it like 80%, people who need loans like 20%. So is that the right kind of framework to be thinking about?

Say that again?

Like, there's a lot of surveys of small businesses out there where roughly 20% of the small businesses say they need loans for the next 12 months to make it through, which some investors are saying, that's a good kind of rate to then -- that's what the loss content could be. I don't know how you feel about that statement?

It's probably not wildly off. I mean the issue with small business is recovery rates vary all over the place as do default rates. So for example, we have a lot of deferrals on our medical and dental practice. I fully expect those to come back. But deferrals we have into small service shops or restaurants and so on and so forth. I don't know that they ever come back, and I think the loss content is really high. I don't know if that's -- I don't know if that's 20% of the total or what shows up in the survey. But I think it ends up being a pretty large number. When you simply think through the profit margin that most of these places were operating under before and then the lack of franchise value to lend against, it becomes pretty tough.

So when I'm thinking about the reserve ratio that you've got, we're looking at, say, your 2019 stress test and your current reserve is about 40% of projected losses there, I mean could this scenario be as tough as what you had been stressing for last year in the stress test that like 100% of those? Is that -- or is that like wildly, that's a crazy statement?

It's not one that we would run as our baseline, but it's one that -- it's a different scenario, but the losses aren't wildly different that we run as kind of a downside case in COVID. I mean so everything we think about -- everything we're talking about right now kind of assumes that, in fact, the economy can reopen without a second wave and a second shutdown, right? That's what's in fact in our base case numbers. So to the extent, you put whatever probability you want on to it, that we end up with kind of second wave and second set of issues here, then it gets worse.

Yes. Okay. And anyway, your capital base seems like it's sufficient to absorb even a worst-case scenario coming through, but...

The loss content we can come up with almost no matter what we run, we're well in excess of required minimums and have an ability to support the dividend and talking about [indiscernible] show which was, obviously, part of the strategy.

Part of the BlackRock [indiscernible] -- that's just 3 of the highest level of capital on an absolute and relative basis that we've ever had in history of the company.

Yes. And so the question is, given the high capital position you've got, how do we think about buybacks resuming? Does -- is that something that you would consider? Or what are the factors that would drive that decision?

So at some point in the next couple of weeks, the CCAR results are going to come out. And along with them will be, in effect, guidance explicit or implicit from the Fed as it relates to capital returns. I think without question, the Fed is going to put their thumb on the scale versus the severe scenario they originally sent out with the instructions. And then my belief is they'll just run the ordinary process with -- to the extent you can get over that hurdle, then you can do returns as you choose. We'll see. There's obviously the Fed's intention and then there's political discourse around issue of buybacks and dividends as well. Absent the regulatory or political or publicity-based issues associated with this, we clearly have the capital to buy back shares should we choose to do so. And it's something at the margin we would think about. It certainly isn't a -- the thought process certainly isn't that, that would be a predominant use of the excess capital we have. But at the margin, we could do it. We'll have to see what comes out of the Fed in the next couple of weeks.

Okay. And people are asking about the dividend as well. But given the amount of capital you have, I can't imagine that, that would be something that you spend a lot of time thinking about whether or not to change?

We don't. If somehow the Fed set the bar so high that we failed the ability to pay the dividend, then the industry...

By definition.

[ Problem's ] in us. Yes.

Well, maybe you would shake out some potential acquisition targets.

We have to see what happens, but we'll see where they go. But I think versus the required buffers and the drawdown on CCAR, we're the best capitalized bank probably in the world. It is what it is. So if that doesn't do it, I don't know what does.

That sounds like a very strong place to end the conversation. So appreciate, Bill and Rob, your time this morning, and look forward to catching up at earnings.

All right. Happy to do it. Take care.

Thank you, Betsy.

Thank you. All right. Take care. Bye.