Good morning, and welcome to KeyCorp's Second Quarter 2023 Earnings Conference Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to the Chairman and CEO, Chris Gorman. Please go ahead.

Thank you for joining us for KeyCorp's Second Quarter 2023 Earnings Conference Call. Joining me on the call today are Clark Khayat, our Chief Financial Officer; and Mark Midkiff, our Chief Risk Officer. On Slide 2, you will find our statement on forward-looking disclosure and certain financial measures, including non-GAAP measures. These statements cover our presentation materials and comments as well as the question-and-answer segment of our call. I am now moving to Slide 3. Before Clark covers our quarterly earnings results, I want to discuss our strategic priorities and cover the fundamental strengths of our businesses, which continue to perform well despite the challenging operating environment. In our Consumer Bank, we're growing relationship households at an annualized rate of 5%, consistent with our Investor Day target. Our strongest growth continues to be in the West, driven by younger clients. We have also experienced strong growth in wealth management with double-digit year-over-year growth in asset management sales. In our Commercial business, we continue to add and expand relationships through our integrated commercial and investment bank. Our ability to distribute risk serves us well and importantly, serves our clients well through all market conditions. This quarter, we raised $25 billion of capital for our clients, placing 18% of the capital raised on our balance sheet. This is down significantly from the 30% we placed on our balance sheet last quarter. Although capital markets remain challenged, our pipelines are solid. On a year-to-date basis, our M&A revenue is up from the first half of 2022. We expect investment banking fees to be up in the second half of the year. One common theme across our franchises is our long-standing strategic commitment to Primacy, having our clients' primary operating account, whether it's an individual or a business. Our focus on primacy is reflected in the quality and diversity of our deposit base. Nearly 60% of our deposits are from retail, small business, wealth, and escrow accounts. 80% of our commercial balances are core operating accounts. Further, 97% of our total commercial deposits are from our relationship clients. Importantly, these are long-standing relationships. On average, our retail clients have been clients of Key for over 20 years and on average, our commercial clients for over 15 years. This quarter, our period-end deposits increased by $1 billion. Additionally, we've seen continued growth in the month of July. In the appendix of our presentation, you can find additional detail regarding the quality and diversity of our deposit base. We continue to proactively manage through volatility associated with the macroeconomic environment, the interest rate cycle, and potential regulatory changes impacting our industry. Going forward, Key will benefit from a well-defined net interest income opportunity over the next 18 months. As our short-term swaps and treasuries reprice, we will see a net interest income benefit that will reach approximately $900 million on an annual basis by the first quarter of 2025. We also continue to be proactive from both a balance sheet optimization and capital allocation perspective. We are well positioned to build capital and reduce risk-weighted assets. We will continue to prioritize full relationships and exit non-relationship business and non-strategic assets. In the second quarter, our period-end loan balances declined by $1 billion. We will continue to benefit from our strong fee-based businesses, which make up over 40% of our revenue. As capital markets normalize, we will utilize our differentiated platform, driving fee income and naturally reducing our balance sheet. On the capital front, we will benefit as over 44% of our AOCI will roll down over the next 18 months. The next area I would like to discuss is our exposure to credit in the current environment. Credit losses remained relatively low across the industry. But as we move through the business cycle, asset quality will matter. Today, more than half of our C&I loans are investment grade and over 70% of our consumer originations have a FICO score of 760 or greater. These measures reflect the de-risking of our portfolio over the past decade in concert with our underwrite to distribute model. We have limited exposure to leveraged lending, office loans, and other high-risk categories. B and C class office exposure in Central Business Districts totaled $121 million, two-thirds of our commercial real estate exposure is in multifamily, including affordable housing, which continues to be a significant unmet need in this country. We also continue to benefit from insights gained from our third-party commercial real estate servicing business, as we service over $630 billion of off us real estate exposure. Finally, we will continue to focus on improving productivity and efficiency. Our results this quarter reflect the successful completion earlier this year of a company-wide effort to improve efficiency. Actions completed in the first quarter represented over 4% of our expense base and $200 million in annualized benefit. These efforts remain ongoing as we will identify new opportunities to improve both productivity and efficiency. Before turning the call over to Clark, I want to take a step back. This quarter, we strategically built capital, managed the size of our balance sheet, and for the third consecutive quarter, built our allowance for credit losses. As I covered earlier, we will continue to take steps to manage our level of risk-weighted assets in consideration of anticipated regulatory changes. I will close by affirming my confidence in our long-term outlook for our business. We have a durable relationship-based business model that will continue to serve our clients, our prospects, and deliver value to our shareholders. With that, I'll turn it over to Clark to provide more details on the results for the quarter.

Thanks, Chris. I'm now on Slide 5. For the second quarter, net income from continuing operations was $0.27 per common share, down $0.03 from the prior quarter, and down $0.27 from last year, driven in part by two notable items. Our results included $87 million of additional post-tax provision expense in excess of net charge-offs or $0.09 per share as we continue to build our reserves. We also incurred $21 million of notable post-tax expenses or $0.02 per share. This includes severance costs, refunds on fees and related claims, and a Visa, Class B fair value adjustment. Turning to Slide 6. Average loans for the quarter were $120.7 billion, up 11% from the year-ago period and up less than 1% from the prior quarter as we continue to support relationship clients. Commercial loans increased 12% from the year-ago quarter. Relative to the same period, consumer loans increased 7%. Compared with the first quarter of 2023, commercial loans grew 1%, while consumer loans remained relatively stable. Total loans ended the period at $119 billion, down $1 billion from the prior quarter. Continuing on to Slide 7. Key's long-standing commitment to privacy continues to support a stable, diverse base of core deposits for funding. Our total cost of deposits was 149 basis points in Q2 and our cumulative deposit beta was 39% since the Fed began raising interest rates in March 2022. We remain focused on balance sheet management with an eye toward minimizing the total cost of funds. Average deposits totaled $142.9 billion for the second quarter of 2023, down 3% from the year-ago period and were relatively stable across the quarter, down approximately $500 million on average. Year-over-year, we saw declines in retail deposits, driven by elevated spending due to inflation, normalization from elevated pandemic levels, and changing client behavior due to higher rates. The decrease in average deposit balances from the prior quarter reflects a continuation of the same trends. Regular seasonal outflows that we saw in April were more than offset in May and June. Deposits ended the period at $145.1 billion, up $1 billion from the prior quarter. Turning to Slide 8. Taxable equivalent net interest income was $986 million for the second quarter compared with $1.1 billion in the year-ago and prior quarters, down approximately 11% against both periods. Our net interest margin was 2.12% for the second quarter compared to 2.61% for the same period last year and 2.47% for the prior quarter. Year-over-year, net interest income and the net interest margin were impacted by higher interest-bearing deposit costs, a shift in funding mix to higher cost deposits, and growth in wholesale borrowings, which in part supported elevated cash levels. The decline in net interest income was partially offset by higher yield on loans and investments. Relative to the first quarter, our net interest margin was negatively impacted by 28 basis points related to higher interest-bearing deposit costs and 17 basis points from a change in funding mix and liquidity, partly offset by 10 basis points related to higher earning asset yields and earning asset growth. Our swap portfolio and short-dated treasuries reduced net interest income by $340 million and lowered our net interest margin by 73 basis points this quarter. Turning to Slide 9. As previously mentioned, Key has begun to benefit from the maturity of our short-dated swap book, and expects to begin to benefit more significantly from increasing swap and treasury maturities as we move forward. Based on the forward curve, we continue to expect a meaningful benefit, currently estimated at $900 million annualized in the first quarter of 2025. We have continued to take a measured but opportunistic approach to locking in this potential benefit, and this analysis includes the addition of hedging activity undertaken beginning in the fourth quarter of 2022 and since. We have not and do not plan to replace the swaps rolling off in 2023, instead allowing natural asset sensitivity of the loan book to come through and benefit from higher short-term rates. Moving to Slide 10. Non-interest income was $609 million for the second quarter of 2023, compared to $688 million for the year-ago period and $608 million in the first quarter. The decline in non-interest income from the year-ago period reflects a $29 million decline in investment banking and debt placement fees, reflecting lower advisory and syndication fees. Additionally, service charges on deposit accounts declined by $27 million, reflecting previously announced and implemented changes in our NSF/OD fee structure and lower account analysis fees related to higher interest rates. The decline in non-interest income from the first quarter reflects a $25 million decline in investment banking and debt placement driven by lower advisory and syndication fees, partially offset by a $10 million increase in corporate services income, reflecting an increase in customer derivative activity. I'm now on Slide 11. Total non-interest expense for the quarter was $1.076 billion, down $2 million from the year-ago period and down $100 million from the last quarter. Compared with the year-ago quarter, net occupancy expense decreased $13 million, reflecting a downsizing of corporate facilities, and business service and professional fees decreased $11 million. These decreases were partially offset by a $17 million increase in technology expense and a $15 million increase in personnel expense, reflecting merit increases and higher benefit costs. Compared to the prior quarter, personnel expense decreased $79 million, reflecting lower incentive, stock-based compensation, and severance. Additionally, other expenses decreased $24 million in the second quarter as the first quarter included restructuring charges related to expense actions. Moving now to Slide 12. Overall credit quality remains solid. For the second quarter, net charge-offs were $52 million, or 17 basis points of average loans. Delinquencies across the portfolio have remained relatively stable. Our provision for credit losses was $167 million for the second quarter, which, as we have pointed out, exceeded net charge-offs by $115 million, or $87 million after tax. The excess provision increases our allowance for credit losses to 1.49% of period-end loans. Despite the increase in the allowance, our outlook for net charge-offs remains well below our through-the-cycle targeted level of 40 basis points to 60 basis points. Now on to Slide 13. We ended the second quarter with a Common Equity Tier 1 ratio of 9.2%, up from the prior quarter and within our targeted range of 9% to 9.5%. This provides us with sufficient capacity to continue to support our relationship customers and their needs. We did not complete any open market share repurchases in the second quarter, being unmotivated to employee compensation, nor do we expect to engage in material share repurchases in the near term. We will continue to focus our capital on supporting relationship client activity and paying dividends. On the right side of the slide is the expected reduction in our AOCI mark. The AOCI mark declines by approximately 44% by the end of 2024, and 55% by the end of 2025. In alignment with recent public remarks from regulators, we expect that any changes will be implemented with an appropriate comments and phase-in period. Given that, our view is that for any new requirements or reduction in AOCI marks, and more significantly, our future earnings and balance sheet management would allow us to organically accrete capital to the required levels over the necessary period. Slide 14 provides an outlook for the third and fourth quarter of 2023. Third and fourth quarter guidance is given relative to each prior quarter respectively. Similar to our approach in the third quarter of last year, we have shifted our guidance to focus on quarterly results. This provides a clear view of trends heading into year-end using the forward curve as of July 1. Balance sheet trends are tracking mostly as anticipated. We expect average loans to be down 1% to 3% in both the third and fourth quarter versus the prior quarter as we continue to actively manage our balance sheet and recycle capital to support relationship clients. We expect average deposits to be relatively stable in both the third and fourth quarter versus prior periods. Our outlook assumes a cumulative deposit beta approaching 50 by year-end. On a linked-quarter basis, net interest income is expected to decline 4% to 6% in the third quarter and be flat to down 2% in the fourth quarter. As we drive more benefit from the repricing of our swaps and treasuries in 2024, we expect growth in both our net interest income and net interest margin. Our guidance assumes a Fed funds rate reaching 5.5% in the third quarter, remaining flat through year-end. These interest rate assumptions, along with our expectations for customer behavior and the competitive pricing environment, are very fluid and will continue to impact our outlook prospectively. Non-interest income is estimated to be up 2% to 4% in the third quarter and up 4% to 6% in the fourth quarter versus prior periods, reflecting a gradual improvement in capital markets. Non-interest expense is expected to remain relatively stable in both the third and fourth quarters. We assume credit quality remains solid, and net charge-offs to average loans to be in the range of 20 to 25 basis points in the third quarter and 25 to 35 basis points in the fourth quarter, both below our expected over-the-cycle targeted range of 40 to 60 basis points. Our guidance for the third and fourth quarter GAAP tax rate is 18% to 19%. Using our quarterly guidance, our full year outlook for 2023 versus the prior year would be the following: net interest income down 12% to 14%, fees down 7% to 9%, expenses relatively stable, net charge-offs of 25 to 30 basis points for the year, and a GAAP tax rate of 18% to 19%. We feel confident in the foundation of our business, in our diverse high-quality deposit base, the durability of our balanced franchise, and our improved risk profile. Despite near-term headwinds, we continue to be focused on execution in 2023 and positioning the company to benefit from the strong long-term core earnings power of our businesses. With that, I will now turn the call back to the operator for instructions for the Q&A portion of our call.

Thank you. One moment, at least for the first question. That will come from the line of Scott Siefers with Piper Sandler.

Good morning, guys. Thank you.

Good morning, Scott.

Hey, Clark I wanted to talk about the NII outlook. So the pace of NII degradation looks like it should slow considerably in the second half, the fourth quarter, especially. Maybe a little more color on the main factors you see that would allow that to happen. I know you sort of rationalize the beta expectation, and of course, you've got the treasuries and swaps, but just curious to hear from your view, the sort of main factors in that outlook?

Thank you, Scott. This is definitely an important topic to discuss. First, it's worth noting that our net interest margin would have been significantly higher without the impact of swaps and treasuries, which amounted to about $340 million this quarter. Looking back at our recent guidance, we had anticipated that the second quarter would be close to the bottom. So, to your point, there’s been a slight continuing decline. However, the fundamentals of our business support that assessment. What has changed is our expectations for interest rates in the latter half of the year. Initially, we expected two rate cuts in the fourth quarter, but now we anticipate one rate hike and stable rates through the end of the year. This suggests that betas may increase slightly during the second half, and the impact of swaps and treasuries could be a greater drag than we initially expected. That said, we believe these factors are beginning to moderate. We’re observing stable deposit balances and a flattening in the rate of beta increase. Additionally, swaps and the treasury portfolio will start to mature in the third quarter, presenting us with opportunities as those assets roll off. Consequently, we expect to see a flattening in the trajectory of net interest income and net interest margin as we approach the fourth quarter, which is why we are providing guidance for each quarter. Looking ahead to 2024, we anticipate an uptick. In slide 9, we highlight the swap and treasury portfolio, similar to what we presented last quarter. As I mentioned earlier, we experienced a $340 million drag in the second quarter, or 73 basis points. Simplistically, we expect $9 million in US treasuries to mature this quarter, with an average yield of around 45 basis points, along with $10.3 billion in swaps maturing between now and the end of 2024, yielding fixed rates of 40 to 50 basis points. Altogether, this amounts to nearly $20 billion with a yield increase approaching 5% by the end of 2024, which leads us to the projected $90 million or around $230 million per quarter by Q1 2025. We aim to provide clear visibility on the treasuries and swaps, isolating them from other factors. It’s important to note that this does not include relative betas or related funding costs. However, I want to emphasize that the $720 million, equivalent to the $900 million we reported this quarter, reflects a different interest rate environment. Previously, we had lower rates toward the end of the year, resulting in a muted impact on net interest income. As I mentioned, we expect rates to be higher now, leading to higher betas. However, the pickup from swaps and treasuries has increased from $720 million to $900 million. These figures will likely move in tandem. Slide 9 is designed to focus solely on treasuries and swaps to ensure we provide maximum clarity regarding these specific challenges.

Okay. That's extraordinarily helpful color. So I appreciate that. And I don't want to put words in your mouth, but in the aggregate, would your expectation be that NII ends up sort of bottoming around end of this year, maybe early next year, but then does see a more visible inflection back up as sort of the pricing dynamics weighing on funding costs, but you then start to get a more material and visible benefit from the swap and treasury maturities. Is that the best way to think about it?

Yeah, I think that was very well stated.

We'll go next to the line of Ebrahim Poonawala with Bank of America.

Just wanted to follow-up, I think, on the same line of questioning that Scott around NII. So appreciate the lift from swaps and treasuries. I think the concern when you talk to investors has been the valley before we get to that point has kept getting deeper throughout the year. When we look at this guidance for the back half, I think, Clark, you mentioned implies negative 12% year-over-year. Give us a sense of just a level of confidence in that guidance, that this is it, absent any big change in the interest rate backdrop, how good do you feel and the level of visibility that you have? And I appreciate it's been tough for the entire industry to handicap this, but any color you can provide would be helpful.

Sure. So look, I think the biggest change as we've gone through the year has been the rate level. So given your commentary on sort of relatively stable rates, I think we feel very good about the trajectory we're sharing here. And I would say, overall, our deposit betas, I feel like, are very much in line with the peer group. We did some catching up because we outperformed last year, but I feel like that's very consistent with what's happening in the industry, and we just happen to have these specific headwinds right now on swaps and treasuries. But again, as those come off, we think we're prepared to get the benefit of that. So I would say that in the expected rate environment, our confidence would be good.

Got it. And second question, I think Chris talked about two things. One is focus on expenses. I see the guidance for flat expenses for the back half. Give us a sense, if there's a bigger opportunity around flexing expense leverage as we move into back half, and as the Street thinks about 2024 EPS and also around any proactive RWA actions. I think you mentioned getting rid of or exiting non-strategic relationships. How impactful could that be for capital?

That's a great question. These topics are closely related. Looking ahead as regulations evolve, our focus will remain on maintaining our relationship model and targeted growth. However, we anticipate significant scrutiny regarding the duration, granularity, and makeup of our deposit base, which is why we have worked to safeguard our deposits, particularly as we previously avoided having high beta. Regarding your question about loan-to-deposit ratios, we foresee a notable decrease for Category 4 banks. Currently, if those ratios are in the mid-80s, they are likely to drop considerably. We are very mindful of this. Last year, we saw a substantial loan growth of around 19%, and aimed for a 6% to 9% increase, achieving that mostly in the first quarter before March's events. We not only ceased that growth but actually reduced it by $1 billion by the end of this quarter, which is crucial. Right now, we are meticulously reviewing all our portfolios. Historically, most individual loans do not return their cost of capital, and given the need for more capital and the rise in capital costs, we will be limiting credit-only relationships that are non-strategic to us, preserving capital for more valuable relationships. Moreover, we will continue to reduce our assets. According to the guidance Clark provided, we're expecting average loans to decline by 1% to 3% in both the third and fourth quarters, and we are committed to achieving that. Regarding your second question, as we reduce our balance sheet, we also need to ensure our expense base aligns with the future size of our asset base. We are actively evaluating that as well.

And Chris, if I may squeeze one in. Just give us a sense of the dividend. There's been a lot of focus, the 7% dividend yield. As the Chairman of the Board, I know it's evaluated every quarter, but how confident are you in terms of dividend sustainability as we kind of plug through the back half into 2024?

I want to express my confidence regarding our strategy and dividend policy, which we approach with a long-term view. Our capital priorities remain consistent, focusing on supporting our clients and paying dividends. Last week, our Board approved a third-quarter dividend of $0.205. Historically, we have often paid out around 80%, primarily through buybacks and cash dividends, and we are attentive to this trend. In terms of capital, despite some challenges mentioned earlier, we grew capital this quarter, paid the dividend, and built reserves. Taking a long-term perspective, our normalized earnings potential is strong, especially with the NII reversal and projections for investment banking fees. Clark noted the anticipated AOCI reduction by 44% by the end of 2024 and 55% by the end of 2025, and our strategy regarding risk-weighted assets is crucial. Additionally, maintaining a well-positioned credit book is vital, as credit losses can quickly erode capital. Overall, we take a long-term approach to dividends and feel optimistic about our position.

Very helpful color. Thank you so much.

Sure. Thank you. Ebrahim.

We'll go next to the line of Ken Usdin with Jefferies.

Hey, everyone. I have a couple of follow-up questions regarding loans. You mentioned that you're maintaining a bit of your investment banking originations in the upper teens range. Does this impact your ability to generate business in the investment bank? Also, regarding your expectations for improvement in the investment bank in the second half of the year, is this based on your ability to start moving things out the door instead of keeping them on the balance sheet like you have over the past couple of years?

Thank you for your question, Ken. It's a complex situation because the mix plays a significant role. We did distribute a considerable amount of debt in the second quarter, much of which was investment grade. Consequently, our investment banking fees weren't as strong. However, maintaining the velocity of our balance sheet is crucial. As we aim to reduce our balance sheet, being able to distribute paper to various locations will be essential, making it an important aspect of our strategy. Regarding what I'm observing, our M&A backlog has increased year-over-year. While our total backlog has decreased, it's only by a modest amount, which isn't a major concern. What encourages me the most is witnessing activity coming out of our pipeline, particularly in the equity market. I've recently spoken with clients, including a large one who is moving forward with a transaction that has been in the works for some time as they navigate through price discovery. This perspective comes from my long experience in this business.

Got it. And just one more thing. There are some cost factors related to Laurel Road, especially with the debt moratorium and its implications. Can you discuss Laurel Road specifically and how you are considering it alongside the other consumer portfolios?

Sure, I'll begin and then pass it over to Clark. It's a great question and as we've gone through our reset, we've focused a lot on the capabilities we need to ensure we have. Before acquiring Laurel Road, they were involved in securitizing and distributing all their loans. Moving forward, we will also be securitizing and distributing those loans. We have the necessary personnel and the capability to do this. While discussing Laurel Road, we have made two significant changes in light of the federal student loan payment holiday. First, we've transitioned to a fully digital platform that encompasses loans, deposits, checking accounts, cards, mortgages, and more. Second, after acquiring GradFin, which specializes in advising on public service loan forgiveness and income-driven repayment plans—areas where the government is expanding options—we are still in the early stages of this initiative. It can be quite complex, and having guidance through this process is beneficial. Now, getting back to your question regarding our asset-light model, Clark, could you elaborate on that, especially in relation to mortgages?

Yes. So I think largely, we're going to look to continue to distribute. I mean we do have capabilities now, where we distribute a lot of debt. We're going to expand that more consistently, I think, to the consumer side. The point I think on Laurel Road that Chris made that I just want to reiterate is we never acquired it to be a student loan-only generator, that was kind of the headline. It was intended to be a full-service banking platform, and we continue to build toward that, and we think it's got some really unique and differentiated capability around this income-driven repayment and public service loan forgiveness. You may have seen some commentary out of the government in the past week around the IDR specifically and some of the complexities of that, which I think will accrue to our benefit over time.

So to summarize, is it accurate to say that by accepting lower net interest income and reduced loan growth over time to decrease the loan-to-deposit ratio, we will be sacrificing some net interest income on the capital side and shifting towards a model that generates more fees?

Yeah. I think that's the right idea. I think we're also demonstrating more deposit growing capability there. And again, we're still relatively new in having those capabilities. But I think that's the right way to think about it. So, more of a fee advice and core banking generator than a loan shot.

We'll go next to the line of John Pancari with Evercore. Please go ahead.

Good morning.

Good morning, John.

Just going back to the $900 million on slide 9 of the NII pickup from treasury and swap maturities. So let me just ask it this way, aside from a change in the rate backdrop and your interest rate outlook, what could prevent you from realizing that? I know there's a fair amount of investor skepticism around the ability of that $900 million to find its way into the numbers. From your perspective, how do you size up the risks? What are the risks that you do not realize in that? What gets in the way? Is it more on the deposit side or is it an asset side of the picture that could prevent that from being realized?

The maturity rates for treasuries and swaps are the primary factor influencing the change from $720 million to $900 million. This reflects the income aspect specifically. There are a few variables to consider regarding the treasuries, such as whether we will reinvest them in the market, use them for replacement funding, or keep them in cash. Currently, these options are fairly neutral. If there is a discrepancy among these choices in the future, we might see a slight increase or decrease based on our decision. For now, they are essentially balanced. You also correctly pointed out the funding side. I noted that in my comments about lower beta expectations at the end of Q1, which indicated a $720 million opportunity, and now we have higher beta expectations that have increased that opportunity as well. While I do not want to suggest these are directly linked, I believe they are at least somewhat correlated.

Thank you. As you continue to review the non-strategic businesses and other optimization efforts, can you confirm if any progress in that area would be in addition to the guidance of a 1% to 3% decline in loans? Is there any incremental optimization that could potentially lead to further downside to those figures?

I think if there was something more significant than what Chris referred to, which is maybe a very active management of the business, that would be incremental. But I think what we've built into this guidance is how we're running the business right now.

We'll go next to the line of Matt O'Connor with Deutsche Bank.

Good morning. I want to follow-up on the kind of capital line of questions. I guess the first thing is a lot of your peers seem to be targeting 10% plus on the CET1. And obviously, there's capital proposals coming out. But I guess first question is what are your thoughts in terms of that 9% to 9.5% target moving closer to 10% to 10.5% like some of your peers?

So, Matt, we believe that 9% to 9.5% is the appropriate target for us based on our business composition. Considering that 50% of our commercial and industrial portfolio is investment grade, and the fact that we have minimal credit card business, along with our consumer business having FICO scores around 760, we feel this is the right range. Currently, at 9.2%, having increased from 9.1% this quarter, we are within that target. That said, we, like everyone else, will wait for any forthcoming information and reassess our position then. But for now, we are confident that this is the right number for our business.

Okay. And then in terms of the RWA optimization, is it possible to size that or give a range and the timing of when you'll get the benefit of that?

We're looking at a lot of different things. But right now, I'm most comfortable just directing you to the guidance that we gave around loans. But as I mentioned, we're looking at other things as well. I'll leave it at that.

We'll go next to the line of Manan Gosalia with Morgan Stanley.

Hi, good morning. I wanted to clarify your comments earlier on the call that you believe that the LDRs for the industry and Category 4 banks, in particular, will have to move lower. Does that mean that you have some room to optimize some of your non-deposit funding like longer-term debt, or is that unlikely given the potential for TLAC rules to also apply for Category 4 banks?

Yes. So, I think that we do have that, and you would have seen us do a little bit of that even here in the second quarter. So, I think your follow-on question around TLAC or long-term debt is the right one as well. And we'll wait, as Chris just mentioned, for the proposed and final rules. But we do think that reduction in loan to deposit over time gives us an opportunity to reduce reliance on wholesale funding.

Got it. Okay. On the credit side, since the ACL increased this quarter, was that solely driven by the model? Is there still more buildup needed? What kind of environment is reflected in the current reserve ratio?

From a CECL perspective, it is clearly forward-looking. You can assume that the percentage driven by models and the percentage driven by the portfolio are roughly equal. I believe the Fed will likely achieve a soft landing, probably in 2024. However, I don’t think the market has fully accounted for the effects of banks tightening credit, and both of these factors will impact the economy. Therefore, we maintain a conservative outlook. We always begin by examining anything that is leveraged or where cash flows might be affected by an economic slowdown. We've reviewed our portfolios thoroughly and there isn't anything specific or concerning at this time.

So if we move towards a soft landing, would that suggest that you don't need to increase the ACL ratios significantly?

Yes. Right now, I feel like we have reserved what we need to reserve, for sure.

Thank you. We'll go next to the line of Mike Mayo with Wells Fargo Securities.

Hi. Can you hear me?

Yes, Mike, we can. Good morning.

Okay. Good morning. So you're guiding NII down 4% to 6% in the third quarter and another 0% to 2% in the fourth quarter. What does that mean for your NIM? Even in broad terms, it was 2.12% in the second quarter?

Yes, we would expect it to be relatively flat in the third quarter and then start to trend up.

My question is about the core margin, which seems to be at a historically low level, at least since the global financial crisis. It’s a very slim margin, so I would like to know why it is so low. After the recent increase, I estimate the net interest income to be around $1.15 billion per quarter, similar to the second quarter of 2022, before the Fed rate hikes. If I look at your midpoint for net interest income of $986 million, it declines to $937 million next quarter and $927 million in the fourth quarter. Then you mention it could increase by about one-fourth by the end of the year. Therefore, from $927 million plus a quarter of $900 million annualized, we reach approximately $1.15 billion in net interest income. I know I’m presenting many figures, but ultimately, the net interest margin and net interest income fall back to levels prior to the Fed rate hikes. Even if there is some improvement next year, which would be a positive development, it seems like you’re not reflecting any benefits from the Fed rate hikes that occurred. What caused the balance sheet’s structural positioning to result in such a low net interest margin and net interest income?

To start, Mike, I'd point out that the overall composition of our loan book reflects higher credit quality, which typically results in lower yields. More than 50% of our Commercial and Industrial loans are investment grade, and we have a super-prime consumer loan portfolio. These loans generally do not yield the same rates as credit cards, where we have minimal exposure, or personal consumer loans, which we also have limited exposure to. Consequently, we may begin with a somewhat lower net interest income, but we believe this correlates with a higher quality loan book. I will review the specific calculations you mentioned and would be happy to discuss them further. Overall, we believe that having a net interest margin starting with a 3 is a feasible target for us in the long term.

Next year, you're indicating that from the fourth quarter level where it stabilizes, the net interest income should increase by about one-fourth by the end of the year. In other words, you're projecting around $900 million for the fourth quarter or slightly above that. You're also suggesting that an annualized gain of $900 million will be achieved by the end of next year, which means the net interest income would rise by one-fourth from that fourth-quarter level, assuming all else remains equal. Is that correct?

Not exactly. So the $900 million is annualized as of the first quarter of 2025.

Okay. So just a little bit later. Got it. But eventually, NII goes up by one-fourth.

Correct.

And I mentioned the phrase "all else equal," but what factors could disrupt that? What might contribute to the NII or help the NIM increase from 2% to 3%? What aspect of the logic is missing?

I believe the key factor here is the 73 basis points derived from swaps and treasuries. This is central to our discussion. Additionally, we're seeing rates and betas aligning more with historical averages, impacting overall funding costs. As we've mentioned, there is potential to reduce some costly wholesale funding, and we have yet to see improvements in loan spreads. Various factors could enhance this situation, many of which we are currently not noticing or that haven't been observed broadly across the industry.

Mike, I mentioned earlier in the conversation that based on my long experience in this business, people tend to delay transactions for a while, but eventually, the logjam begins to break. I think we're starting to see some movement in the new issue equity business. I've been out speaking with clients, and it appears that those who have postponed deals for the past 12 months will either begin to proceed with them or find alternative options. This conclusion is drawn from closely examining the backlog and from my instinctive observations while engaging with people.

So fish or cut bait time?

Yes, for sure.

We'll go next to the line of Erika Najarian with UBS.

Hi. First question from…

Hi, Erika.

Hey. What was your adjusted CET1 in the quarter, including AOCI? And I presume at 9%, 9.5% CET1 target would be like your fully loaded target even after we get an NPR that would be inclusive of AOCI and CET1?

Yes. So, whatever that ultimate target is, Erika, will reflect the appropriate rules. So if the AOCI of that is eliminated, then yes, I think you stated that correctly. So, the 630 that level for AOCI AFS is about 630.

Got it. My second question is for you, Chris. I apologize if this sounds challenging, but this is a significant topic I'm discussing with long-term shareholders. Clearly, the stock price performance today is addressing some of the dividend concerns that were present in the market given your yield. The main conversation I'm having with your investors is regarding the 80% payout you mentioned for this quarter. It feels reminiscent of three years ago during the pandemic when similar questions about the sustainability of your dividend were raised. It seems that the underlying issue has been the denominator. Whether it was past expenses or the balance sheet needing to support fixed rates that imply a zero rate environment indefinitely, your efficiency ratio doesn't seem quite right and doesn’t reflect the true potential of the business. As you consider the next three years, what discussions will you have with your Board to ensure that the potential of your franchise is accurately reflected in your earnings power? I mean, the NIM is the NIM, and I understand the swaps. However, it seems like that ties into the dividend discussion all the time, not necessarily because the dividend is a burden, but it appears that your earnings power is vulnerable to the fluctuations of the macro environment.

Thank you for the question. I agree with your point. Our business is performing well, but we're not earning to our full potential due to our balance sheet position. I discussed this extensively with my Board last week. The challenge we face is that while we are currently under-earning, I have confidence that once we realize the normalized earnings power of the company, we will see improvement. Although investment banking fees are influenced by various factors, our current liability-sensitive position is not ideal for this environment and we need that to change over time. Unfortunately, this resolution will take time. However, the anticipated decline by December 31, 2024, and 55% reduction in AOCI by December 31, 2025, illustrates the issue at hand. In essence, we are under-earning now, but as our position stabilizes and diminishes, we can expect to see increased earnings.

Got it. Okay. Thank you.

Thank you.

And we'll go next to the line of Gerard Cassidy with RBC.

Hey, Chris and Clark.

Good morning.

Chris, you touched on in your opening remarks about the commercial mortgage servicing portfolio, I think you said $630 billion. Can you share with us the special servicing segment within that business? Obviously, with the challenges in the commercial real estate market, particularly in the CMBS market, I suspect your special servicing business has picked up, and maybe some color there?

Thank you for the question. This is a strong business because it generates a significant amount of deposits through escrows, which are more important now than ever in my career. It's also critical because it tends to perform well in downturns. For those who may not be familiar, we are the designated special servicer for large, complex debt financings. When we serve in this capacity, we receive a steady fee. If a financing goes into default, which pertains to real estate, we act as the workout agent. As Gerard mentioned, we have set records for special servicing fees for the second consecutive quarter, and I believe that trend will continue. Additionally, it's worth noting that over two-thirds of our active special servicing involves office properties. While this may not pose a challenge for Key, as it is not an asset class we focus on, office properties are likely to remain a significant challenge in the market.

And Chris, based on your experience with this, these fees stay with you for a while since the workout phase takes quite a bit of time?

Yes, these are very large advisory fees that require a considerable number of people. The capital structures are quite complex. It’s common for these fees on a single deal to reach $5 million, $6 million, or $7 million.

Great. Can you share with us what you are doing to proactively address any potential challenges with commercial loans, not specifically commercial real estate? I understand you are anticipating a soft landing, but if the economy leads to increased delinquencies and defaults, what are your current strategies to mitigate that?

Yes, we focus a lot on this area. Regarding the Commercial and Industrial book, we concentrate on assets with floating rate debt that are leveraged. Our leverage book remains consistent, representing under 2% of our loans and centered on our industry verticals. Mark Midkiff, our Chief Risk Officer, and I, along with others, are closely monitoring the situation. We are confident about the state of our portfolio. However, in an environment with declining EBITDA and businesses that are highly leveraged alongside rising capital costs, we need to remain vigilant. While we are pleased with all of our portfolios, this area demands my attention as it is the most at risk.

Thank you.

Thank you, Gerard.

And we'll go next to Steven Alexopoulos with JPMorgan.

Hi. Good morning, everyone.

Good morning, Steve Alexopoulos.

I wanted to first follow up on your answer, Chris, to Ebrahim's question. Are you signaling that the door is not open at all in terms of potentially rightsizing the dividend?

I wouldn't say it's not open at all. The reason I would put that caveat is I've yet to see the new capital rules. But what I'm saying is I'm very comfortable with our dividend payout and the trajectory of our business under the current construct.

Got it. Okay. That's helpful. Regarding the fee income guidance, I heard the comments about growth in capital markets. But are those really necessary to meet this range, the increase of 2% to 4% and then 4% to 6%? Are there other factors that could provide some cushion if the IDD fees don't recover, so that you could still achieve the fee income guidance?

There's other areas where we have cushion, but I mean, investment banking fees are a big component of that. And we need to have more trajectory in the back half of the year on investment banking fees than we did in the front half of the year in order to hit these numbers.

Got it. Okay. And then finally, just a big picture view. Obviously, a lot of questions about NIM, I'm just as surprised as Mike seeing 2/12. For Clark, how do you think about managing the balance sheet and interest rate risk differently so you don't get in this situation again where the NIM is this low, dividend payout ratio that's high, you're missing on the NII guidance, which is really all tied to what we're seeing on the swaps? But how do you think about big picture? So once you do get into a 3% NIM range that you sort of hang around there? Thanks.

It's a great question that likely requires a longer response. In short, Steve, we need to consider a variety of additional scenarios and be more dynamic in how we approach the direction and pace of rate movements. If rates had changed more smoothly, this issue would be much less significant. However, as you know, they did not, and we need to adjust our thinking regarding how to position ourselves.

Got it. Okay. Thanks for taking my questions.

Thank you. And there are no further questions in queue at the time. I'll turn it back to Mr. Gorman.

Well, thank you so much, operator. Thank you for participating in our call today. If you have any follow-up questions, you can direct them to our Investor Relations team, 216-689-4221. This concludes our remarks. Thank you, everybody. Have a good afternoon or good morning.

Thank you. And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing. You may now disconnect.