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

Okay. So we're delighted to introduce our next presenter, who is CEO and Chairman of PNC, Bill Demchak. He is joined by Rob Reilly, who's CFO, who's sitting just in front of us. So Bill, I think this actually [ your first ] time to be here as CEO. That's great. Although Bill, I think the only question I had of you is [indiscernible]. So you've got a few [indiscernible]. But thank you very, very much for joining us.

Look, we're starting with the same question for everyone that's probably [indiscernible] question, which is what's your view of the economic outlook? So if you could just talk through what you're expecting in terms of rates from here? What you're expecting in terms of inflation? What you're the most focused on from a macro perspective? And maybe talk a little bit about the risks that you're focused on outside of just credit normalization.

So our economic forecast -- and my own economic forecast isn't widely different from the common headlines of mild recession, Fed rates going 5% or maybe a little north of 5%. And then our economists would tell you the Fed would start cutting end of '23. My personal view -- and this is an ongoing discussion and has been since the start of this, I think the Fed's going to have a harder time getting inflation below 3 handle. And so I think that front rates are going to stay elevated for a longer period of time than the market is even close to assuming yet. My new normal is 3% core inflation for a period of time, extending out, not unlike what we saw in the '90s. Therefore, and you've seen this in the way we run our asset sensitivity, I think the current bond market is uninvestable. I think that the idea to go in longer than we are -- we're asset sensitive here. We reinvested securities that roll off. We're rolling off securities that yield 1.5% and buying things that brought yield 4.5%. That's all great, but we're not going to see more because today you do it, you'll eat 150 basis points of negative carry or will shortly. A lot of banks are doing it through forward-starting swaps, which doesn't cause pain today, but causes an awful lot of pain next year. And we don't want to give up an upside. In our -- it's worth just mentioning, in our -- everybody is worried about -- credit is the big fear in banks. Where we're reserved today, we are reserved today to basically a 5% average unemployment rate next year and a GDP growth year-on-year that's basically flat assuming a recession and a little bit of growth. We run 4 scenarios. We're weighted somewhere between scenario 2 and 3. The fourth scenario, the downside case is negative GDP growth of 2.5%, unemployment of 7.3%. Unemployment of 7.3% on average, which means you basically have to get there by the middle of next year, which I think my math is like 400,000 jobs a month starting today. If we did that, our forward PE for next year's earnings is 13. Like it's -- like this just is not an issue unless you think you're going to go beyond when it's a pretty draconian scenario 4. We're already reserved today, 1.7x against charge-offs of 30 basis points. We got 5 years normalized through the last 20 years, Rob? This 50 basis points? We basically have the book covered. So I -- we think things are going to get soft, but we actually tend to do pretty well when things get a little soft.

So I mean let me ask you. I mean the market is pricing in some sort of recession, you could argue, after the last 2 days of a fairly severe recession for bank stocks. What do you think the market [ looks like ]?

Look, I don't know exactly what's going on in other banks. I would tell you that our ability to grow fees and NII into this environment is pretty strong. I think it -- would we -- if things get a little worse, would we weight our reserve scenarios, so 1, 2, 3 and 4, a little heavier to the 4? Sure. Does that dent us in any way long term? No. I think a part of what the market is missing here is that CECL, in theory, at least for the larger banks, has brought all of the known losses forward. And historically, at least when banks would have credit problems, they would upset the way they run the company. They would fire people. They would stop expanding. They wouldn't invest in technology. They stop what they were doing, which would cause their trend growth coming out of the recession to be slower than it would otherwise be. That's not the case for banking today. The banking hasn't been through a real recession post the new capital regime. Forget about PNC. I mean we can take what comes our way. But I think the whole industry, people are underestimating, if it's bad, is that actually going to cause everybody to sidestep and miss 3 years? I don't think so.

So let's talk a little bit about loan growth. I think your loan book since the start of the year is up about 10% in that tight region. It's obviously been a very strong year in terms of loan growth. And we've heard from one of your [ competitors ] at least today that on the corporate side, corporate loan demand has started to soften, utilization rates have fallen. What are you seeing in terms of loan demand falling, both corporate and consumer in the fourth quarter? And what are you expecting for next year?

Like I'm befuddled by that competitor, whoever that's suppose to comment. So our growth will exceed our -- the guidance we gave you in the third quarter -- fourth quarter, led by C&I. If anything, we're throttling C&I growth coming out of the new markets. They demand higher pricing because the pricing on it has been slower to expand than the pricing we've seen in the capital markets. New client activity is really strong. Loan growth is strong. We expect that to continue into next year. We tell you our pipeline is slightly smaller than it was earlier in the year, but that's largely a function of self-selection as we look to cut spreads and/or make sure we get cross-sell upfront as opposed to cut out on the comp. I mean I don't know where that's coming from because we're not seeing -- consumer for us is flattish, but that's a function of our book, right?

I mean are disruptions in financing markets leading to a greater opportunity perhaps for you in corporate lending specifically? I mean how is that playing out in terms of just reintermediation of lending back into the banking?

Well, that obviously was a big part of the growth, particularly in the third quarter, and it continues a little bit. But here's the thing, we're in hot markets and we're a new entrant with a good resume that people want to do business with. I think you're seeing a squeeze on both ends of banking. So the large banks right now are struggling at the market with capital and how to deploy that, given constraints that were already put on them and the noise out of regulators on how hard CCAR is going to be. Smaller banks are struggling with liquidity squeeze as deposits have really left the system. We're in a good spot with respect to both of those.

Right. So let's talk about credit conditions. I mean you touched on this briefly. Delinquency has obviously been very, very low, not just for you, but for the industry. But where are you the most focused? And have you tightened underwriting standards in a meaningful way in any part of the book? And look, commercial real estate is something that has been coming up more and more. You obviously have got the Midland Servicing business. That gives you a unique insight into what's happening in commercial real estate. So maybe you can talk a little bit about the dynamics in that market as well.

Yes. So I'll remind you that we'll always say this, we don't really change our credit lines, right? When everybody is really easy work, the same as we are when we're tighter, and we'll change spreads and it will be harder for certain clients to fit within the box that needs to fit in it. That makes sense to you? Having said that, at the margin where we're backing off a bit was in pricing structure on the consumer side, in auto, a little bit in housing at the margin. In the C&I space, we're obviously worried and we've been vocal about this. [ OpEx is not known ] for everybody. So we're heavily reserved against that, and we watch it. Is it big enough to give me heartburn? No. It really isn't -- and we have a pretty diversified book by geography and by type. There isn't any particular thing that's causing us stress at the margin. There's parts of consumer that will start to show cracks, but that's kind of it.

And in the Midlands servicing book in particular, anything that surprised you?

Well, there's still -- one of the things that surprised us at Midland the whole way through the pandemic was the amount of capital on the sidelines to cause special savings and assets to never actually grow. So something will get in trouble in the amount of new equity that was available to go in to bail out the project surprised us in our servicing book there.

Maybe you can talk about lending spreads and how those have tracked because you said you keep the box quite high, but spreads obviously low. I mean when you look at where spreads have got to broadly across both the corporate and the consumer businesses, do you think they're appropriate and do you think...

No, I think they should be wider. I mean the one of the disconnects, and this is the reason why we've throttled at the margin our C&I growth, which is still going to be beyond our forecast is -- and by the way, they're wider than they were. But relative to spread increases that you've seen in capital markets, there's still an arbitrage to be able to borrow from the banks. So that would be a little [ harder ]. In consumer, there's still -- and particularly in auto, in my view, just the rational yield on that product relative -- almost relative to anything, but certainly relative to the terms that are still off.

A number of your larger banks have been capital constrained for most of the year. I mean has that changed the dynamic at all either in terms of the competitive environment for lending or in terms of how they are underwriting from a spread perspective?

It's kind of interesting. They're -- there were 2 very visible examples of people who just told clients they're out. They were just out. [ And let's say it was ] core clients. So when you bid on that deal, we had a lot of care because of that. We're still syndicating deals to the extent they're larger, and we're winning them. That's kind of where the price pressure is. You try to lean into that. You get as much as you can. It hasn't -- and like I said, spreads are wider, but they should be wider than where they are today. And I think they'll go there.

Okay. So let's talk about the other popular topic, which is deposits. So maybe you can just give us an update in terms of deposit flows so far this quarter, again, across consumer corporate categories to the extent that it's relevant. But then talk about what your expectations are as we get into 2023, Fed funds goes presumably higher and we get in to really kind of the belly, if you like, of QT?

Yes. So basically on our forecast, we said kind of slightly down, able to dial on deposits is basically we are surrounding our -- for the fourth quarter. Having said that, one of the things is QT -- so far, the Fed's balance sheet hasn't really -- it's down whatever a couple of month's worth. There's been loan growth, which creates deposits, yet we've seen this massive runoff in deposits largely because of the growth in money funds largely as a function of the reverse repo facility. So QT, the effective QT through the reverse repo facility, in my view, has drained a couple of trillion bucks out of the banking system, and that's what you're seeing in the broader HA as deposits leave the system. We've been able to combat that -- first of all, we got ahead of it in terms of total liquidity early on by taking out a fairly big slug from the home loans that basically was a carry. Elsewhere, probably, no negative carry. We've seen betas largely follow, I think we've talked about 30%. We probably end the year there. The challenge we have is, of course, if the Fed keeps going and making an extreme example. Eventually, banks cook in a good margin, the Fed keeps going, betas become one. Or you kind of lock that and they just keep going up. So you ask them to -- from a 30 to some high number if rates went on forever. No, that's not going to happen. But over time, cumulative betas grind higher, particularly through consumer, and I'll talk about how we're combating that. But also through corporate, where betas today, particularly for the hot money that the non-TM-based deposit money are really high today, always have been. In consumer, we're using some of our technology build, frankly, to get really smart about popping bespoke first to clients when we see moving money before they move money. So I can reprice a consumer without repricing my whole back book. I mean we've had some success in that. I think this continues through next year. So I think the liquidity drain is exactly what the Fed wants to have happened. It's how they're tightening. They're going to raise loan spreads. It's going to cause, as we've already seen at the lower end of the banks, a lot of problems in liquidity. And eventually, the Fed will react to it first by dropping a reverse repo rate and ultimately causing that flow of corporate money in particular to watch backup on the bank balance sheet.

So how would you characterize composite environment deposits? When would you say it's rational? Are you seeing some of the smaller banks that you referenced who are having some funding problems at the margin?

We'll go all the way down. If you drop below 5%, tangibly, you can't borrow from the home loan bank. That's why you're seeing the discount with [indiscernible]. In between there, nobody really wants to reprice their [ backup ]. So you see growth in brokered CDs. You see their online offerings, particularly in non-linked geographies much higher. The marginal cost of funds for everybody approaches, right, the wholesale cost of funds. And that's where we are, and that's what we'd otherwise assume as we grow our bank in the next year.

So talk a little about the business as well. You referenced this, you've also increased your FHLB borrowing. So maybe you can just talk a little bit about that because I think different banks are actually accessing the FHLB for different reasons. But maybe you can talk about why you increased your advances through the FHLB. Was it through the competitive environment in terms of deposits? And then just maybe just talk more broadly about your approach to funding overall as -- if interest rates remain at higher levels for a contracted period of time.

Yes. So I mean the FHLB -- by the way, we have -- I don't know what we have today, [ we have $30 billion ]? But we have capacity for more than double that. It was free money. So anything more than an easy trade where you could borrow the money and then put it at the -- and we'll make money on it. So -- and then lock out any risk factor down the road. You heard us tell you, I don't really care what our NIM is. I don't care whether we're growing net interest income and total operating income -- operating leverage. So that was -- it's the smart thing to do. As we go forward, you're going to see us and every bank, if you go back and look at '18 and '19 in terms of the typical bank's way that they funded themselves, we all had a higher reliance on wholesale funds. We had money falling from the sky, which grew deposits that's going to reverse. We're going to have a higher reliance on wholesale where cost of funds are going to go up. That's what will happen.

Yes. So I think you said back in October that the asset sensitivity that PNC has increased over the course of the year, would you consider measures to reduce asset sensitivity if you think the rates are actually going to start to fall? Or are you just really -- or if the asset set is going to be an outcome of what happens in terms of the loan book and the security following deposit funding?

No, look, if I thought rates were going to fall relative to the growth curve, remember, we're reinvesting. We have $130 billion that yields 1.5% that we're reinvesting at [ 4.5 ], that will keep happening, right, as we roll down our existing investment book. So what I'm talking -- and we're asset-sensitive with that amount of investment, including our swaps. I say, okay, I want to invest into this market. To invest into this market necessarily means you believe the forward curve that you're going to invest in. I think that's insane. We're certainly not going to chase it after the recent rally. But if you make some base case assumption, I think what people are missing in this environment is they assume, okay, we're going to go into a recession and then the Fed is going to cut. Well, maybe. But that presumes, one, that they believe inflation is under control or at least now at a lower level of stable there. They're going to hold that thought for a long period of time. But even if they get to that place, you're in anywhere near my camp where I think inflation is going to be stickier towards the 3 handle than a 2 handle. They make up, but they're going to cut the 4. They're not going to cut 1.5% or something. Right at 4, they're basically a neutral if inflation's 3. So if the front end is 4, the back end is going to be 6, particularly if inflation is 3 for a period of time. The back end is not going to be 3.5. I just think that's just bad science. I don't know what people are thinking, that the bond market is going to be there and the equity markets, it keeps rallying. The bond market is supposed to be at 3.5%. Then our scenario 4 is going to be a lot worse in terms of our credit losses. I just don't see that as a potential outcome.

So given that, how do you manage the securities portfolio? I mean how should we expect [indiscernible]...

I think you -- look, I mean, everybody says what's the swap book? What's the securities book? We invest duration dollars. So it's how -- what's my value change for change in rates, right? And you can do that with more or less notional. But basically, what we're doing is we're reinvesting the duration dollars that we roll it in today's market which is a lot better than the market we were in when we started, right? So we're rolling off 1.5%. And the 4.5% we're going to need a lot more yield on what we're rolling on. We're just choosing not to take the next $100 billion of -- or whatever risk. The other thing that we're not doing, which a lot of people are doing, is I'm locked in and I'm hedged against lower rates. But what they're doing is they're doing a lot of forward starting swaps. As you put on a forward-starting swap, you don't have negative carry today, you have negative carry the day of the swap. There's no way to lock in rates without negative carry. You can artificially hide it through a non-mark-to-market for restarting swap, which is why probably why people say they -- there's just worry about net interest income next year. We're going to have great net interest income growth next year. If somebody piled on and locked in forward starting swaps and they start saying, well, I may not be able to grow. That's why.

So maybe we can just talk about the current quarter. I know you obviously gave guidance a few months ago. How are you tracking towards the guidance that you gave? Has anything changed? Is there anything that we should be aware of? Everything's in line?

Yes. But I think charge-offs are lower.

Okay. That's pretty good. Okay. So with that out of the way then, let's talk about operating leverage. So how should we think about inflation impacting your ability to control expenses? How should we think about the continuous improvement program, which has obviously been a source of net savings over a long period of time. I mean does it get incrementally harder for you to generate those dollars savings? And how are you thinking about the balance of investing versus driving operating leverage over the next 12 to 24 months?

We focus on -- well, we've been in a great place, and we're going to continue. We drive towards positive operating leverage. We've actually been able to do that over the last bunch of years, while at the same time, heavily investing in our future, right? We would expect more of the same as we go into next year. On the expense side, we will have the roll rate effect and the people we've added into our new markets, plus whatever you think would happen in compensation or customers now given inflation. The offset to that is the revenue growth that we fully expect to see against the growth in clients that we're seeing and the continual growth in fees. Remember, we went off of this kind of euphoric second quarterly fees and then we trend down. Well, now we have kind of a new baseline to grow from. And the core -- those core fee businesses, whether they be TM or loan syndications or even the advisory side having fallen off the cliff, it's pretty easy to see growth under those businesses.

Can you just talk a little bit about fees. I mean your expectation from here? Are you expecting a recovery in some of those businesses? Or does it take market stabilization before we walk through those recover?

Most of the -- I don't want to give specific guidance, but in our planning, we assume normalization across the market sensitive things through time. No revokes. Certainly not back to where they were. But our core fee engines are what we see on a card or what we see out of TM, which is our largest -- and those are really solid and growing almost at an accelerated pace because it comes with all the new clients were winning less the back sell of the BBVA clients that were undersold in the markets we acquired.

So I guess linked to that, I think it's 15 months since you integrated the BBVA franchise, something around that. So maybe you can take a few minutes and just talk about what [indiscernible] in that process 15 months on, both positively and negatively to the extent there's anything that was negative. And then maybe talk about how you're thinking about revenue synergies associated with that client base, how it's tracked because I know it's something that you talked about at the kind of the deal you said was a big opportunity, but how is it actually tracked relative to your expectations?

Larger and faster is what we assumed. I think the biggest surprise was how easy the fight is in a market that's growing 10% a year versus the competition that we saw in some of our legacy high market share markets. So new client growth, the ability to cross-sell, the welcoming of a new bank to the party, the competitiveness of the product set. And that's true in C&I certainly. But even in consumer, our month-on-month, I want to get this right -- or sorry, quarter-on-quarter growth in branch sales is up 30% or something. Isn't that right, Rob? Yes, 30%. So just things we're doing out of there, the old branch network with our product offerings, we never expected that.

And as an opportunity from here, how would you characterize that, given that you kind of did more earlier, does that mean that, that was a pull forward and you just did [indiscernible]...

I think there's -- I think just for a decade, we'll be growing the way we're growing. It's is just massive target sets in these new markets. You follow our ability going back to kind of RBC where we enter a new market. We're patient, persistent and consistent in what we do. We get very good people. We have good products delivered locally, you win share. And we just entered a whole bunch of markets where nobody has dominant share and we have a great competitive offering.

And conceptually, what is your appetite to do another transaction of that type? I mean is it something you think makes sense given the success of that transaction so far? And does this mean regulators would be open to that?

I don't think regulators should be open to us to get to the end first. I mean, I think, we have proven to ourselves and hopefully to all of you, that our ability to close and convert given our tech stack is unprecedented. We did that in 4 months, I think we could do it over and over again. I think our cost savings estimates were we to be able to do something that had more overlap as opposed to -- remember, we didn't have any overlap in that deal. We took out 30 plus of that. I think there's a bunch of financially attractive deal that everybody would love. I just don't think they'll ever get approved. And then to go through the effort for a smaller deal and just be hung up with 1 year, years plus approvals with no rules, I think we have to wait until this priority...

And the concern from regulators, is that systemic risk? Because it's hard to believe that your systemic relative to some of your peers. Or is it just more about what it does for the competitive landscape? Or is it more to do with the banking communities in certain areas? I mean what is the primary regulatory concern?

I think it varies by regulator, and I think it's basically in cost. It is what it is today, right? The -- we have 5,000-plus depository -- FDIC depository institutions. You know the number better than I do today. I think left to if they don't change what's happening here and they basically say, we want no more mergers, I mean, you're going to have 2 or 3 banks control the entire deposit base in this country. And that can't be the desired outcome of our government or our regulators. But I think the -- in the end game, that's what's going to happen, short of them opening up the ability to do M&A.

Okay. So let's talk a little bit about capital in that case because you do obviously have excess capital. But a few questions. The first is there's obviously a lot of uncertainty around where capital requirements are going to go. There's been a lot of focus on each from Vice Chair Michael Barr last week. So how do you think about the path for capital requirements from here? And just given the uncertainty, does that impact the way that you manage the buffer that you currently have? Should we, as investors, look at the TCE ratio when we think about capital returns, is that something that you care about? And then maybe you can talk about dividends versus buybacks.

All right. So we're in an excess position today relative to our targets or certainly to their thresholds. Could they raise them through? I mean Barr's speech was interesting. And he kind of talked about looking at the whole framework vis-a-vis Basel IV, but he also talked about this huge stress test as a way to just force fit higher capital. Hard to tell where he's going to aim that forward, if they do it in the stress test. But we kind of have our own, independent of whatever it is they might do. I'd remind you last year, part of our SCB was a function of -- we think, the fact that we have BBVA's balance sheet on their end, we had not yet taken the expenses of the BBVA. So we kind of get hit with a double whammy. My best guess is they make it a little tougher. I think we did fine inside of that through time as we grow and they look at capital standards because we need to hold more possibly, but that's kind of a long run view. I think in the near term, we've been doing $750 million, plus or minus the share buyback. We have capacity that we're kind of opportunistic, but we have the ability to do that same amount. We obviously focus on dividend. We talk about a dividend payout ratio of 40% to 50%. We think that's supportable. And we're kind of in a good place. We're going to watch and see what they put out in the CCAR instructions that will inform how aggressive we can be or not be next year in capital return. But I don't expect there to be a lot of surprises for us.

Okay. And then TLAC, that was obviously another one which I think took people by surprise. I mean how likely do you think it is? The ramifications, how should we kind of think about the impact? And presumably, if it does get implemented, it's going to be done over a period of time. So the only impact will get [indiscernible]...

Yes, it's not a big deal. I mean I don't -- if they were to do that, they've got to get 3 agencies to agree. They got -- it takes a period of time for that happen. But even if they did it, I'd remind everybody that 99% of our assets are actually in the bank, not the holding company. So -- which is very different than the large institutions. So a single point of entry is unnecessary for us. It was almost the same way we've been putting plans and they get approved for the last 10 years. We've been issuing TLAC-eligible debt for a long period of time. If you actually go back and look at capital structures for banks pre the deposit run-up and just roll that forward for us, we would otherwise be TLAC-compliant in a bunch of years anyway just because of how we're going to grow, particularly if they -- as I would expect them to do, throttle that or tailor it by size. But at the end of the day, I don't think it matters. I think it's completely wrong. We're a simple institution. As large as we become, you can -- particularly with our tech, you can literally draw circles around our map and sell 20 circle drop to people if you want to, and we can handle the data file tomorrow. So it's actually not all that hard, but we'll see.

Okay. I think you've got 1 or 2 minutes left. Let me see. We've got a question at the front. Please go ahead. I'll just repeat the question. Okay. Actually, you got to bring a microphone.

Bill, I just wanted to clarify something. You mentioned -- I just want to make sure, because I think we had set CECL into effect, which was like [ 11 20 ] in we really haven't had a proper credit cycle. I mean pandemic account, the losses went down.

Sorry, I mean we've had the pandemic.

Right. No, but you had reserves go up, but you didn't have a loss that's go up. So my question is, the way you characterize it is that you're already reserved to a pretty meaningful increase in the unemployment rate. And if we go through, say, 2023 or 2024, the unemployment rate just went to 5.5% or 5%. When losses go up, are they going to fully net against the existing reserves? Or will there be a period where you have an increase in net charge-offs flowing to the provision line and you'll have elevated reserves. That's the way you store, but the way that you characterized it sort of sounded like [ you're pulling that off ].

So now, think about it this way. If we just wrap the circle around that book and stuck us somewhere we're reserved to that economic scenario on the book we have. If we grow loans, we'll be reserving against the new loan book at whatever appropriate reserve rate is correct for the new loan book, right? So you could be in a period of time where you have provision in excess and you'd otherwise see this of charge-offs as you grow your loan book while we fully expect charge-offs from the super low level to increase. But inside of all that, I mean, even at my point in sort of taking that extreme of where we are today to take the example of the 7.3% unemployment, if you could take that couple of billion dollars and throw it down on the income statement right out of the gate, it still be a 13x earnings from the resulting [ ALCO ].

I'm just contemplating that there could be a period of time where the reserve would stay elevated, [ interest ] also going up at the same time. So it might be a little worse than that.

CECL doesn't really work that way, right? Like if we see, and we'll probably see this, right, we're going to wait these scenarios slightly worse. They're getting closer, they get a little more certain, you say, okay, now instead of being weighted 10% to this downside, I want to be weighted at 20%. I'd take a provision. If I got all the way to the downside, I'd take it all day 1, right? And then I'd have to let those charge-off grind through for a period of time. Conceivably, as I grew loans, if that were happening I'd been growing along [indiscernible], I guess, with really high spreads on the new loans. But that's -- CECL is just a different animal against where we were before.

I think with that, we're out of time. So thank you very, very much for joining.

Thank you.