Earnings Call Transcript - BPOP Q4 2022

Operator, Operator

Hello and welcome to today's Popular Fourth Quarter 2022 Earnings Call. My name is Bailey, and I will be the moderator for today’s call. I would now like to pass the conference over to our host, Paul Cardillo, Investor Relations Officer at Popular. Please go ahead.

Paul Cardillo, Investor Relations Officer

Good morning, and thank you for joining us. With us on the call today is our CEO, Ignacio Alvarez; our COO, Javier Ferrer; our CFO, Carlos Vazquez; and our CRO, Lidio Soriano. They will review our results for the full year and fourth quarter and then answer your questions. Other members of our management team will also be available during the Q&A session. Before we begin, I would like to remind you that on today's call, we may make forward-looking statements that are based on management's current expectations and are subject to risks and uncertainties. Factors that could cause actual results to differ materially from these forward-looking statements are set forth within today's earnings press release and are detailed in our SEC filings. You may find today's press release and our SEC filings on our web page at popular.com. I will now turn the call over to our CEO, Ignacio Alvarez.

Ignacio Alvarez, CEO

Good morning, and thank you for joining the call. Our results for the quarter in the full year were solid and reflect the strength of our franchise. Our record annual net income of $1.1 billion reflects an increase of $168 million above our 2021 annual net income of $935 million. The increase was largely driven by the benefit of the Evertec Transactions, and the partial reversal of the DTA valuation allowance. The results also reflect higher net interest income, partially offset by higher provision expense and higher operating expenses. The 2021 results included a provision benefit of $193 million. During the summer, we've completed the acquisition of key customer-facing channels from Evertec and made important changes to our contractual relationship with them. Leveraging these transactions, we have embarked on a broad-based multiyear technological and business process transformation. The needs and expectations of our clients as well as the competitive landscape has evolved, requiring us to make important investments in our technological infrastructure and adopt more agile practices. Our technology and business transformation will be a significant priority for the company over the next three years and beyond. We believe that there continues to be opportunity for growth in our primary market as well as within our existing customer base, and these efforts will help capitalize upon that opportunity. We are confident that these investments will make us a stronger, more efficient, and profitable company. Throughout 2022, we continued to return capital to our shareholders. During the year, we repurchased 8.25 million shares of common stock for $631 million, which surpassed our original expectation of $500 million. We also increased our quarterly common stock dividend to $0.55 per share, representing nearly $164 million in dividends paid in 2022. Credit quality remains strong throughout 2022. We are pleased with how our portfolios have continued to perform, particularly with net charge-offs well below historical levels and a lower level of nonperforming loans. Our capital levels are strong with a year-end common equity Tier 1 ratio of 16.4%. Our tangible book value ended 2022 at $44.97, a 31% decrease year-over-year, primarily due to unrealized losses on investment securities. However, during the fourth quarter, tangible value increased by 16%. Our quarterly net income excluding the partial reversal of the DTA valuation allowance was $189 million, or $7 million lower than the adjusted third quarter net income of $196 million. Fourth quarter results were impacted by lower net interest income, which reflected higher loan income that was more than offset by the higher cost of public deposits, as well as a higher provision for credit losses. Loan growth was strong and broad-based during the quarter, both geographically and across most loan segments. Total loan balances held in portfolio grew by $560 million. Commercial loan growth was particularly healthy at most banks in the fourth quarter. Our net interest margin decreased by 4 basis points to 3.28% in the quarter. Higher deposit costs, particularly in our Puerto Rico public deposit portfolio and at Popular Bank impacted the margin. This was offset in part by an improvement in asset mix to loan growth and a reduction in the investment portfolio. Credit quality trends remain favorable during the period. Nonperforming loans decreased in the quarter and net charge-offs have remained well below pre-pandemic levels. Our customer base in Puerto Rico grew by approximately 28,000 during the year, reaching 1.98 million unique customers. Adoption of digital channels among our retail customers continues to be strong. Active users on our Mi Banco platform exceeded 1.1 million or 56% of our customer base. Additionally, we continue to capture 60% of our deposits through digital channels. This trend remains significantly higher than pre-pandemic levels and well above our Island peers. Commercial loan growth was strong. Commercial loan balances at BPPR and Popular Bank increased by $118 million and $255 million, respectively. Credit card and auto loan balances at BPPR increased by $53 million and $31 million, respectively. In the fourth quarter, the dollar value of credit and debit card sales of our customers increased by 11% sequentially and were 6% above the fourth quarter of 2021. As on the Mainland, mortgage originations in Puerto Rico have been impacted by rising rates and limited inventory of available properties. The dollar value of mortgage originations at BPPR decreased by 29% compared to the fourth quarter of last year, driven by lower repayment activity due to the interest rate environment. However, loans to finance the purchase of homes decreased only 11% during the same period. The local economy continues to perform well during the fourth quarter, and business activity has remained strong. We remain encouraged by solid employment levels. In December, total non-farm employment in Puerto Rico increased slightly from its level in September and was 4% higher than in December of 2021. New auto sales increased by 3% in the fourth quarter compared to the same period in 2021. While auto sales declined by 4% in the year, 2022 was the second highest year of sales since 2006, easily surpassing pre-pandemic levels, evidencing continued robust demand for cars. The industry is forecasting new car sales of 118,000 in 2023, well above pre-pandemic levels. The tourism and hospitality sector continues to be a source of strength for the local economy, as Puerto Rico is a popular destination for Mainland residents. Airport traffic has remained robust. Year-to-date through December, total passenger traffic increased by 7% compared to 2021. Hotel demand has also remained strong. Occupancy rates were up more than 500 basis points in 2022 and the average daily room rate continues to compare favorably to historical results. In short, we are pleased with the results for the year, particularly our robust loan growth and continued strength in credit quality. We are mindful of the global economic uncertainty and market volatility, but remain optimistic about the future of Puerto Rico, our primary market and our ability to manage any potential challenges that may lie ahead. I now turn the call over to Carlos for more detail on our financial results.

Carlos Vazquez, CFO

Thank you, Ignacio. Good morning. Before we turn to fourth quarter results, let me expand on Popular's 2022 full year performance, which is included in the appendix to this presentation and today's press release. In 2022, we reported a record annual net income of $1.1 billion, $168 million above our 2021 annual net income. The increase was largely driven by the benefit of the Evertec Transactions and the partial reversal of the DTA valuation allowance, somewhat offset by provision expense. Our net interest income increased by 11% year-over-year to $2.17 billion due to higher rates, loan growth, and the change in the mix of earning assets. For the year, we reported an $83 million provision for credit losses, which compares to a provision benefit of $193 million in 2021. Non-interest income increased by $254 million year-over-year, primarily driven by the impact of the Evertec Transactions. Operating expenses increased 13% in 2022 to $1.75 billion with higher personnel, technology, professional fees, and regulatory costs. Net income for the fourth quarter was $257 million. This compares to $422 million in Q3. Excluding the impact of the Evertec Transactions in Q3 and the DTA reversal in Q4, net income decreased $7 million to $189 million in Q4. Net interest income for the fourth quarter was $560 million, a decrease of $20 million from Q3. Interest income grew by $62 million from loan growth of both banks as well as higher yields on loans and investment securities. This was more than offset by higher interest expense on deposits, resulting from increased deposit rates, mainly from Puerto Rico public deposits and, to a lesser extent, Popular Bank. Non-interest income was $158 million, a decrease of $268 million from Q3. The results of the third quarter included a $258 million pre-tax gain on the Evertec Transactions and a favorable fair value purchase price adjustment of $92 million related to the U.S. equipment finance business we acquired in 2021. Excluding these items, remaining various non-interest income resulted mainly from lower deposit service fees. The fourth quarter non-interest income results fully embed the changes in our operational policies and the reduction in equity pickup for the sale of our Evertec shares. The results also include an $8.2 million gain on the sale of previously written-off investments. Excluding this gain, the non-interest income for the quarter would have been approximately $150 million. For 2023, we expect non-interest income to continue around this $150 million per quarter run rate or approximately $600 million for the year. The provision for credit losses in the fourth quarter was $50 million compared to $40 million in the third quarter. Total operating expenses were $462 million in the quarter, a decrease of $14 million from the prior quarter. Q3 included $17 million in expenses related to the Evertec Transactions and a $9 million goodwill impairment on our U.S. equipment finance business. Excluding these items, expenses increased by $12 million, mostly resulting from a $10 million increase in technology expenses, seasonally higher business promotional expenses by $4 million, higher other processing and transactional services by $4 million, mainly due to higher network incentives received during the prior quarter and higher professional fees. For 2023, we expect annual expenses of approximately $1.87 billion, compared to our expenses of $1.75 billion during 2022. The drivers of the $120 million increase will be: first, continued increases in personnel expenses, driven primarily by the previously announced increase in our minimum hourly wage from $13 to $15, which took effect on January 1. This will add approximately $15 million to expenses in 2023. Additionally, the market salary adjustments that were made effective on July 1 of last year will be in effect for the full year 2023. There will also be a 2023 merit increase that traditionally is granted in the summer. These two items will add approximately $24 million to expenses in 2023. These actions are necessary to keep our compensation competitive. Second, we expect that the FDA sees a 2 basis points increase in assessment rates to all depository institutions will add $14 million to expenses. Pension and retirement healthcare expenses will also increase by $19 million. Finally, as Ignacio described in his opening remarks, we’ve undertaken a significant multiyear corporate transformation initiative. As part of this transformation, we need to expand our digital capabilities, modernize our technology platform, and implement agile and efficient business processes across the entire company. Since completing the Evertec Transactions on July 1, through the end of last year, we invested $24 million towards this effort primarily in professional fees and technology expenses. In 2023, we anticipate transformation-related expenses of $50 million. These technological ways of working and operational investments will result in an enhanced data experience from our clients as well as better technology and more efficient processes for our employees. We expect these efforts to contribute to higher earnings and a better efficiency, resulting in a sustainable 14% ROTCE target by the end of 2025. To facilitate the transparency of our progress in some of these efforts, we have now separated technology, professional fees, and transaction activities as standalone items in our income statement. Our effective tax rate for the quarter was a benefit of 24% compared to an expense of 14% in the third quarter. The income tax benefit in Q4 was mainly due to the $68 million partial reversal of the DTA valuation allowance of the U.S. operation. Excluding this impact, the effective tax rate for the fourth quarter was 12% compared to 14% in the third quarter. This partial reversal was based on our evaluation of the sustained profitability of the U.S. operation over the last two years as well as evidence of stable credit metrics while considering the remaining life of the net operating losses. As of December 31, 2022, the DTA related to the U.S. operations was $278 million, net of our valuation allowance of $423 million. For the full year 2023, we expect the effective tax rate to be in a range of 18% to 22%.

Lidio Soriano, CRO

Thank you, Carlos, and good morning. Overall, Popular continues to reflect stable credit quality trends with low levels of net charge-offs and decreasing nonperforming loans. We remain encouraged by the performance of our loan book post-pandemic, specifically, early delinquency, net charge-offs, and nonperforming loan formation continue to trend significantly below pre-pandemic levels. We also believe that the improvement in the risk profile of the corporation's loan portfolio positions Popular to operate successfully in more difficult economic conditions. We remain vigilant and continue to closely monitor changes in borrower performance and the macroeconomic environment, given potential economic headwinds, rising interest rates, and geopolitical uncertainties. Nonperforming assets decreased by $18 million to $520 million this quarter, driven by a nonperforming loan decrease of $40 million, coupled with an order decrease of $4 million. In Puerto Rico, nonperforming loans decreased by $8 million driven by lower mortgage NPLs of $10 million and lower commercial NPLs by $5 million, in part offset by higher order NPLs by $7 million. In the U.S., NPLs decreased by $6 million, mainly due to a $9 million charge-off on a previously reserved commercial borrower in the healthcare industry. Compared to the third quarter, NPL inflows, excluding consumer loans, decreased by $3 million, driven by the U.S. healthcare relationship mentioned previously that was placed in nonaccrual in the prior quarter, offset in part by higher mortgage inflows in Puerto Rico. At the end of the quarter, the ratio of nonperforming loans to total loans held in portfolio remained flat at 1.4% compared to the previous quarter. Net charge-offs amounted to $31 million or an annualized 39 basis points of average loans held in portfolio compared to $18 million or 24 basis points in the prior quarter. The results for the quarter were impacted by the $9 million charge-off on the previously reserved healthcare relationship in the U.S. Excluding this item, the net charge-off ratio was comparable to last quarter at 28 basis points. In Puerto Rico, net charge-offs remained stable, increasing by 1.5% quarter-over-quarter, mainly driven by higher consumer charge-offs by $5.5 million, mostly due to the order portfolio, in part offset by lower mortgage net charge-offs by $4 million. The corporation allowance for credit losses increased by $17 million or 2.5% to $720 million, driven by changes in macroeconomic scenarios, higher loan volumes, and changes in credit quality. The ratio of allowance for credit losses to loans held in portfolio remained stable at 2.25% compared to 2.23% in the previous quarter. The allowance for credit losses to nonperforming loans held in portfolio was 164% compared to 155% in the prior quarter. The provision for credit losses was an expense of $48 million compared to $40 million in the previous quarter, reflecting the changes in allowance for credit losses and the net charge-off activity. In Puerto Rico, the provision for credit losses was $44 million compared to $29 million in the prior quarter, and in the U.S., the provision was $44 million compared to $11 million in the prior quarter. As discussed in prior webcast, we leverage Moody's analytics for the U.S. and Puerto Rico economic forecast. Notwithstanding general economic uncertainty, Moody's baseline outlook remains for the U.S. economy to continue recession-free. Moody's fourth quarter forecast, however, reflects a slowdown in the economy with lower 2023 GDP growth for both Puerto Rico and the U.S. The baseline scenarios assume a 2023 annualized GDP growth for Puerto Rico and the U.S. of 1.3% and 0.7%, respectively, compared to 2.2% and 1.5% in the previous quarter. The reduction is due to the expected slowdown in the economy as a result of tight monetary policy. The 2023 average unemployment rate remained consistent quarter-over-quarter.

Ignacio Alvarez, CEO

Thank you, Lidio and Carlos, for your updates. 2022 was an outstanding year for Popular. In addition to record earnings, we achieved strong credit quality, continued customer growth, closed the Evertec Transactions, launched our transformation, and successfully executed on our capital actions. Our franchise provides a powerful platform to go beyond serving our customers. It also affords us the opportunity to impact the lives of our colleagues and communities and create value for our shareholders. In 2022, we reached key milestones including participating in the Bloomberg Gender Equality Index and issuing our ninth Corporate Sustainability Report. Also, following Hurricane Fiona, we provided immediate relief to affected communities and clients and assisted impacted employees. Looking ahead, I am optimistic about the economic outlook in Puerto Rico, our primary market. While we are aware of the macroeconomic headwinds related to inflation and geopolitical risk, we are confident that given the amount of stimulus support from federal funds, Puerto Rico will continue its growth path, albeit perhaps at a slower pace. 2023 marked Popular's 130th anniversary. Since 1893, we have successfully adopted and led through changing conditions, and we are proud of our history and the legacy that made Popular what it is today, a strong vibrant organization with enduring values. Leveraging these strengths, we will continue to transform our organization to ensure success for many years to come. This entails meeting the rapidly changing needs of our customers, providing our colleagues with a positive workplace, promoting progress in the communities we serve, and generating sustainable value for our shareholders. The team is energized and looking forward to another strong year. We are now ready to answer your questions.

Operator, Operator

Thank you. Our first question today comes from the line of Timur Braziler from Wells Fargo. Please go ahead. Your line is now open.

Timur Braziler, Analyst

Hi, good morning. Thanks for the questions.

Ignacio Alvarez, CEO

Good morning.

Timur Braziler, Analyst

Maybe starting on expenses and the technology and business process transformation that has been laid out, I guess on the back end of that, how should we think about Popular? Is this investment in kind of standing up Evertec and getting that investment kind of up to where you expect it to be? Or is this getting Popular more broadly on pace with the broader group? Or do you expect the back end of '25 for Popular to be an industry leader when it comes to tech and innovation?

Ignacio Alvarez, CEO

Yes, this is Ignacio. Thank you for the question. Evertec was the initial phase, and it represents more than just that. It has positioned us to begin transforming our technological foundation. Our goal extends beyond merely taking over the services Evertec provided; it is essential for competing with the new entities entering the market, particularly in offering digital options to our clients. We aspire to be best-in-class and among the top quartile in terms of the services and products we offer. Popular has traditionally been a leader in technology in Puerto Rico, and given the current developments, it is crucial that we pursue this initiative.

Timur Braziler, Analyst

Okay. And then in terms of investing into this initiative, is the expectation kind of $50 million per year through '25? Or does that ramp higher as you get closer to completion?

Carlos Vazquez, CFO

I'm not sure we can determine that at this point, Timur. What we anticipate is that expenses will transition from the current focus on professional services and consultants who are assisting us in setting up our objectives, to a focus on execution. We have not finalized a specific number for the future, and the nature of the expenses will shift towards implementation and establishing the systems and technology we are currently designing and selecting.

Timur Braziler, Analyst

Okay, great. And then maybe moving to NII and NIM. It looks like the inflection point happened here in the fourth quarter, just maybe an outlook for the magnitude of the remaining inflection as those public funds continue to lag already happened in interest rate hikes. And then more importantly, kind of once that lag is complete, what's the outlook for NII and NIM growth from there?

Carlos Vazquez, CFO

Yes. The factors that led to our margin decline this quarter will also impact us in the first quarter. As you noted, the most significant factor is the rise in the cost of public deposits. As we mentioned last quarter, we anticipate that net interest margin will trend upward in 2023. The timing of this shift will depend on the interplay of key factors, which include the rate of loan growth, changes in interest rates, and deposit balances. The interaction among these three elements will determine what unfolds during the year, but we do expect net interest margin to show an upward trend in 2023.

Timur Braziler, Analyst

Okay. Then maybe one last one for me, if I can. Just circling back on fee income, the guide for around 150 a quarter, I'm just wondering when does that inflect? And when do we start seeing some of the positive attributes from the combination with Evertec and getting those assets back in-house?

Carlos Vazquez, CFO

Well, the biggest driver of the move down from our prior guidance to this '23 guidance is the change in the fact that we don't own the shares of Evertec anymore, number one; and number two, the change in overdraft policies and number three, the change on our practice of setting mortgages that we are not setting anymore. So those are the biggest drivers of the shift down to 150 per quarter roughly. Obviously, remember, there's always some seasonality in that number. So it goes up and down for different things during the year, but that is the right range. We continue initiatives on our business initiatives to try to continue to move rates up in different fronts. So hopefully, as those initiatives succeed, we can start moving rates up from the 150. And some of those are already being designed and implemented; if everything works well, we may start seeing some of that in '23, but our best guess right now is 150 per quarter.

Timur Braziler, Analyst

Got it. Thank you.

Operator, Operator

Thank you. Our next question today comes from the line of Alex Twerdahl from Piper Sandler. Please go ahead. Your line is now open.

Alex Twerdahl, Analyst

Hey, good morning, guys.

Ignacio Alvarez, CEO

Good morning.

Carlos Vazquez, CFO

Good morning.

Alex Twerdahl, Analyst

I would like to rephrase some questions I just asked the team. I'm curious, why did you choose 2025 as a target year? Does this indicate a turning point or a conclusion for some of these initiatives? How did you arrive at that specific date?

Ignacio Alvarez, CEO

This is Ignacio. We believe that the transformation initiative will be an ongoing effort that will change the way we work. To measure our success, we wanted to establish an initial three-year period to evaluate where we expect to be by that time. That's why we chose 2025. While it may seem somewhat arbitrary, we think three years is sufficient to implement our initiatives and allow them to yield results. We expect all these efforts to be sustainable, meaning we won't just reach our goals and stop; instead, we aim to continue growing incrementally over time.

Alex Twerdahl, Analyst

Right. Will Popular be a more streamlined institution at that point? What changes should we expect? Every bank is making significant investments in technology, but will this enable you to operate with fewer branches, or what tangible differences will we see?

Ignacio Alvarez, CEO

I'm not sure that the number of branches is the main aspect you should focus on. That will depend on the traffic we see. We can discuss branches in more detail, but clearly, our goal is to enhance our digital capabilities and increase self-service options. For instance, we are working on automating our underwriting process to reduce manual intervention, which will be relevant across all our businesses. This initiative should also support our compliance efforts. We are investing in technology that is currently very manual and reliant on people. While I can't provide a specific timeline, over time we expect to significantly reduce manual intervention in many areas including underwriting and compliance. Our objective is to become more digital and offer more self-service options for our clients, and we anticipate that this will have a positive impact on our operations in the future.

Alex Twerdahl, Analyst

Are there specific phases of the initiative that might occur at certain times? You mentioned that many of the fees are currently allocated to the planning phase, and then there will be an implementation phase, which may be more relevant to 2024. However, are there segments we can observe in the near term to help us track progress?

Ignacio Alvarez, CEO

I'm not certain about the near-term specifics, but we aim to report the percentage of our loan applications that will be digitally enhanced. We will provide updates on that and track the numbers, which should reflect improvements in efficiency. We've already taken steps that focus on process improvement, in addition to technology. It's important that our pricing strategy for products and services, including cash management, is consistent throughout the organization, and we expect to see immediate benefits from that. This should significantly impact our outcomes right away, and we will monitor the revenue coming from cash management while planning significant investments in that area. Changing our cash management system will take a few years, but we are optimistic about the long-term benefits. We will continue to track our progress in relation to digitally enhanced applications and self-service options.

Carlos Vazquez, CFO

Yes. One of our strong beliefs is that there is still significant growth potential in Puerto Rico by strengthening our relationships with existing clients. A major part of our transformation efforts is aimed at realizing that belief, which means we will be positioned to provide clients with quicker and better service, offering them products that better meet their needs more efficiently. This will enhance client satisfaction, resulting in happier clients and empowered employees who can deliver excellent client service. All of these factors contribute positively to the overall contributions of our clients to the bank. As Ignacio mentioned, these are incremental efforts. Some small changes will begin to take effect in a few months, while others are scheduled for next year. The larger technology-dependent initiatives will likely come later, as we need to maintain investments and implement the necessary systems to achieve our goals. However, we anticipate some quick wins starting soon.

Ignacio Alvarez, CEO

Yes. To build on what Carlos mentioned, one of our major initiatives focuses on personalization and segmentation. This will require significant investment in our data capabilities. The goal is to provide our clients with the products they need more quickly. As you know, we have the largest client base in Puerto Rico, both in retail and commercial sectors. By penetrating this market, our acquisition costs will be considerably lower than our competitors. We are committed to investing heavily in personalization and segmentation.

Carlos Vazquez, CFO

And the last comment for you to get a sense of what we are talking about, we believe, we think we have to build the best digital banking offering in Puerto Rico already. But what we are seeking is to be able to provide more products and services to our clients through that offering and to allow us to roll out new offerings a lot faster than we can do it now. So we are changing the architecture of what is a market-leading digital offering so that we can be a lot more effective in providing more and new services quicker to our clients than we are today. So the client will never see the change in impact and architecture, but they will see the more efficient and bigger offering once we've done that.

Alex Twerdahl, Analyst

Okay. And then with the 14% ROTCE, obviously, there's a lot of pieces to that, and it could mean a lot of different things. So can you give us some of the assumptions on capital levels, or like anything else to kind of help us really figure out what it actually means for profitability?

Carlos Vazquez, CFO

No. At this point in time, we've chosen that one because it encompasses the result of everything, Alex. And you are correct, there's a lot of pieces that compose that. We are not in a position to talk about the pieces specifically yet. But again, we think this is the most comprehensive nature of everything that we do. So we've chosen to hang our head on that one for the moment. But at this point in time, we haven't disclosed the components that we will get us there. There's a lot of things that probably can change and underweight as well.

Alex Twerdahl, Analyst

Okay. And then just one final one for me before I get back in the queue. You gave us the increase in the government deposits in the first quarter of 120, assuming we get two more hikes, where do those peak out? I mean can you just spell it out for us?

Carlos Vazquez, CFO

I'm not sure where they'll peak out; you'll need to ask the Fed. If they indeed drop two more 25 basis points and then hold steady, we could see an increase of 50 basis points in expenses the following quarter. However, it really depends on the market and the actions of the Fed. Our best estimate of the Fed's increases suggests we will see an increase of 120 basis points. If it remains at two more 25 basis points, that would lead to an additional 50 basis points increase in the subsequent quarter. If rates start to decline, we would likely begin to see benefits the quarter after that. I wish I could provide a more definitive answer, but I can't predict what the Fed will do.

Alex Twerdahl, Analyst

But they do peak out below, I mean, last time they peaked at 125 basis points, but below where the Fed peaked out. Is that a reasonable assumption for this tightening cycle?

Ignacio Alvarez, CEO

It is about timing. Ultimately, the question you're asking is what the spread is that we make on the deposit. We've never answered that question on purpose, and we aren't going to start today. However, we do make a positive spread on these deposits.

Alex Twerdahl, Analyst

Okay. Thanks for taking my questions.

Operator, Operator

Thank you. Our next question today comes from the line of Kelly Motta from KBW. Please go ahead. Your line is now open.

Kelly Motta, Analyst

Hi, good morning. Thanks for the question. I may be approaching the government deposits topic a bit differently. I appreciate the information about margin and how you expect it to begin improving at some point this year. Does your commentary suggest that a certain amount of government deposits needs to decrease, or is it independent of those levels? I'm trying to understand how significant of a factor that might be in the increasing NIM you mentioned.

Carlos Vazquez, CFO

No. That commentary incorporates the outlook we expressed on the balance of the current deposits that they will remain between $13 million and $15 million for the year. Again, it's not a constant 13 to 15. They're probably going to be slightly higher than that in the first half of the year and then maybe slightly lower than that in the second half of the year. But that is what is incorporated in the components of that commentary.

Kelly Motta, Analyst

Thank you. Appreciate it. And just a point of clarification on your expense guidance that $1.87 billion that you gave, I just want to confirm that includes the innovation stuff that you're doing and that $50 million is on top of that 1.87.

Carlos Vazquez, CFO

That number includes the $50 million.

Ignacio Alvarez, CEO

Yes, definitely incorporated within it.

Kelly Motta, Analyst

Thank you very much. I have one last question regarding capital. I understand you mentioned that you will reevaluate your capital plans in the latter half of this year. Is there a specific level of TCE that would make you comfortable revisiting those plans? Are there any parameters you can share regarding that? Additionally, regarding the second half of the year, do you anticipate that this might occur around July, especially considering the recovery of AOCI?

Carlos Vazquez, CFO

Yes, I can address both questions. There is no specific TCE target that would determine our actions. What will be more significant is gaining a clearer understanding of the economic situation and the future of interest rates. These two factors are likely more important. There isn't a specific TCE number that will guide us. As Ignacio mentioned last quarter, we anticipate gaining the clarity we need in the summer, which is where our comment about the second half of the year originates. If clarity arrives in May, that puts us ahead by a couple of months, while if it arrives in September, we may be a few months behind. However, there is no specific target; instead, it is the consensus outlook on the economy and interest rates that will be the two main factors influencing the timing of our revisit to the capital plan. Our overall perspective on capital remains unchanged; we are only slightly adjusting the timing of when we execute our plans, not our intentions.

Kelly Motta, Analyst

Great. I appreciate. That’s all the color.

Carlos Vazquez, CFO

Thank you.

Gerard Cassidy, Analyst

Hey Ignacio, hey Carlos.

Carlos Vazquez, CFO

Good morning.

Ignacio Alvarez, CEO

Good morning. Happy New Year.

Gerard Cassidy, Analyst

Happy New Year to you, too. Carlos, on the OCI or AOCI, I should say, when you look at it, you had in the available-for-sale portfolio about $1.8 billion of unrealized losses. Can you share with us what kind of interest rate environment would we need to see for that number to fall materially from here?

Carlos Vazquez, CFO

I agree with that. The portfolio has a duration of about 2.8 years, which indicates some sensitivity across the portfolio. You can calculate based on the duration and the portfolio size to get an idea of when unrealized gains or losses might change. The portfolio is more sensitive at the shorter end, meaning you'll likely see the most significant impact from movements in short-term rates. AOCI would only change if the 30-year rate decreases, but this rate does not significantly influence our AOCI compared to shorter and intermediate terms. Additionally, a substantial amount of bonds mature every quarter, and the portfolio is structured to spread out maturities over six years, with about $1 billion maturing each quarter, which also reflects the duration as time progresses.

Gerard Cassidy, Analyst

Got it. And even though I’m sorry, go ahead.

Carlos Vazquez, CFO

Right, right. The reason I asked is that I noticed that the agency portion of the portfolio, which has the largest unrealized loss because the majority are 7.5 years, and even though I know the total AFS is under three, I didn’t know that piece of the portfolio, the longer into the curve, is something we are going to watch.

Ignacio Alvarez, CEO

Yes, that part of the portfolio primarily consists of agency pass-throughs. We have calculated the weighted average life of these instruments, which include a mix of 15-year and 30-year mortgage-backed securities. This part has a slightly different basis compared to treasury securities. Therefore, it will depend on the movement of intermediate rates as well as the changes in the mortgage-to-treasury basis. We experienced some relief in this area during the fourth quarter. If those trends persist, it would be good news for us. However, it ultimately depends on how the market perceives the risks.

Gerard Cassidy, Analyst

It's interesting that Popular, which has always been a technology leader in Puerto Rico, is undergoing this significant change. Are you observing any competition gaining traction with your core customer base, leading to a loss of some of these customers? Is that a key factor driving the upcoming investments?

Ignacio Alvarez, CEO

No, I believe that while we have traditionally been a leader in technology, the world is evolving much more rapidly. We may be slightly behind where we usually are on this trajectory. Although we haven't lost any customers yet, we are not going to wait for that to happen. There are specific areas, such as credit cards, where we see an increase in U.S. issuers introducing new features, and we want to stay ahead of this trend. We don't want to risk digital newcomers attracting our clients. We believe that by providing an exceptional digital experience alongside our branch network and the diverse services we offer, we have a winning combination. If we falter in any of these aspects, we risk becoming vulnerable, and we are determined to prevent that from occurring. We understand that technology is a challenging field, and we may not be able to match the investments of some larger banks. However, we need to ensure we meet our clients' expectations in today's environment. Our clients in Puerto Rico have expectations similar to those everywhere else; they seek a better and more personalized digital experience, and we are committed to delivering that.

Lidio Soriano, CRO

To elaborate on Ignacio's comment, Gerard, when I mentioned our data offerings to clients, I indicated they are market-leading, which is true. I also discussed the back end and our architecture, which needs to improve to allow for quicker rollouts of new features. We are making significant enhancements in the back end. Clients may not be aware of these changes, but they will benefit from the increased speed at which we can introduce new and additional offerings. Essentially, we are enhancing the core of our technology. While clients may not notice this in their phone app, they will experience it through our ability to provide more personalized offerings and new services at a faster pace than we currently can.

Gerard Cassidy, Analyst

Very good. And then, Lidio, you mentioned you gave us some insights into credit and credit, obviously, has been strong for you folks and your peers. Two questions. One, you gave us some of the assumptions, I think, in the Moody's outlook on real GDP growth. What kind of unemployment rates are you factoring in? I think you said they're constant, but what are those numbers? And two, are there any sectors within the portfolio that you're currently spending more time really focusing on just to make sure nothing gets tripped up if we go into some sort of shallow recession.

Carlos Vazquez, CFO

We have on a yearly basis, you have on Page 13 of the deck, the assumptions for unemployment rates, both Puerto Rico and the U.S. under the baseline, stronger growth, and recession scenarios. So I will leave you to look at those as to what's the second part of the question? I'm sorry, Gerard?

Gerard Cassidy, Analyst

That's okay. And just what parts of the portfolio are you guys really focused on to make sure that if we do go into a shallow recession, you're prepared to handle it.

Lidio Soriano, CRO

I would say small business lending is an area of focus. I mean we continue to be pleased how Popular has continued to behave post-pandemic or is an area where increasing interest rate inflationary pressures, increases in energy prices could have a potential higher impact than other sectors. I think it's important to highlight that one area where we see a lot of press in the U.S. in terms of office space, we don't have any significant exposure to the office space in Puerto Rico to the U.S.

Gerard Cassidy, Analyst

Very good. Thank you.

Operator, Operator

Thank you. The next question today is a follow-up from Alex Twerdahl from Piper Sandler. Please go ahead. Your line is now open.

Alex Twerdahl, Analyst

I just wanted to ask for the loan growth that you guys are seeing, what kind of yields new production is coming on in the various categories?

Carlos Vazquez, CFO

Yes. I don't have that number right now, Alex. We can try to dig it out, but I don't have that off the top of my head or in my notes, my apologies. You can see that the overall yield of loans, the overall loan yield of our book did go up 31 basis points on average in the quarter. So obviously, we are originating our new loans at a higher rate, but I don't have the answer to your question. We will get back.

Alex Twerdahl, Analyst

Okay. Are you able to give us a little bit more color, like if you look at the commercial growth sort of the percentage or just a rough breakdown of what might be the larger corporate customer that's based off of loans and we saw some press releases this quarter on sort of pricing that maybe we could apply to that in Puerto Rico versus what might be more tied to prime?

Carlos Vazquez, CFO

Yes, and Lidio, please correct me if I'm wrong. The adoption of sulfur in Puerto Rico has been rather limited and slow. So, looking at the bigger picture right now, Alex, I believe that any part of our portfolio that is floating is still connected to the old floating rates. Once again, the adoption of sulfur has been slow thus far.

Alex Twerdahl, Analyst

Okay. And then I just wanted to clarify your comments on the timing for capital return. It sounded like you guys go through this process every year where you engage the Fed and then a quarter later or four months later, you wind up actually telling us what you guys have all decided for the capital return. Is it the second half of this year that you gave the Fed? Or do you intend to have an announcement in the second half of the year.

Ignacio Alvarez, CEO

Yes. I think our plan would be to do both; we would engage the Fed at some point, but the announcement, I think when we talk about the second half of the year would be an announcement.

Carlos Vazquez, CFO

We will decide our next steps once we have a clearer understanding of the outlook for interest rates and the economy. We anticipate that clarity will come in the summer, which will influence our discussions for the second half of the year. From that point, we will model our options and consult with our regulator on how to proceed. We want to reconsider our previous practice of making structured announcements every January and may opt for a different approach moving forward. Our goal remains to align more closely with our Mainland peers as a buffer, but how we achieve that will be reassessed. Don’t assume we will return to a January announcement as the only update for the year. We might manage our capital return differently in the future. When we do decide to make a change, we will communicate that to the market.

Alex Twerdahl, Analyst

Okay. Thank you for taking my follow-ups.

Carlos Vazquez, CFO

You’re welcome.

Gerard Cassidy, Analyst

Thank you, Actually, I didn't pull myself out of the queue. I didn't understand the instructions. I'm also, thank you Carlos.

Carlos Vazquez, CFO

Thank you, Gerard.

Operator, Operator

That concludes today's question-and-answer session. So I'd like to pass the conference over to Ignacio Alvarez for any closing remarks. Please go ahead.

Ignacio Alvarez, CEO

Okay. Thank you for joining us today and for your questions. We look forward to updating you on our progress in April. Thank you.

Operator, Operator

This concludes today’s conference call. Thank you all for your participation. You may now disconnect your lines.