Earnings Call Transcript - MCB Q4 2022

Operator, Operator

Welcome to Metropolitan Commercial Bank's Fourth Quarter and Full Year 2022 Earnings Call. Hosting the call today from Metropolitan Commercial Bank are Mark DeFazio, President and Chief Executive Officer; and Greg Sigrist, Executive Vice President and Chief Financial Officer. Today's call is being recorded. At this time, all participants have been placed in a listen-only mode, and the floor will be open for your questions following the prepared remarks. During today's presentation, reference will be made to the company's earnings release and investor presentation, copies of which are available at mcbankny.com. Today's presentation may include forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially. Please refer to the company's notices regarding forward-looking statements and non-GAAP measures that appear in the earnings release. It is now my pleasure to turn the floor over to Mark DeFazio, President and Chief Executive Officer. You may begin.

Mark DeFazio, President and CEO

Thank you, and good morning, and welcome to MCB's fourth quarter earnings call. On an operating basis, MCB had a record year with adjusted net income of $94.4 million, up from $38.4 million in 2021, and adjusted efficiency ratio of 44.5% versus 48.2% in 2021. Our fourth quarter net interest margin was 4.05% versus 2.59% in the prior year quarter. The commercial bank, along with our banking-as-a-service initiatives, saw growth across all lines of business contributing to our operating results. While 2022 was a challenging year for our industry, we worked through rising interest rates, increased cost of funds, fierce competition for deposits, and a material correction in the digital asset industry, along with increased regulatory scrutiny. Our early intuition that we should pivot away from the crypto industry has served us well. Our minimal exposure coming into 2022 allowed us to efficiently replace the deposits we have foregone to date, generating efficient liquidity to sustain loan growth. As we previously announced, we will fully exit the industry in 2023 with minimal impact on earnings and liquidity. We are very close to concluding our ongoing investigation with the Department of Financial Services and the New York Fed regarding a fintech client MCB banked in 2020. As a result of the investigation, MCB has reserved $35 million toward a joint settlement. MCB's decision to settle was a conscious effort to move forward with the business of MCB and reduce our professional fees to a more normalized run rate. There were lessons learned throughout this experience, and we have implemented improved oversight of consumer compliance for our banking-as-a-service business. This was an unfortunate situation that occurred during an unprecedented time. On balance, we successfully covered tremendous ground in 2022 and are entering 2023 in a strong position to support our clients with enhanced resilience and strong capital levels. Our operating performance in 2022 continues to demonstrate the strength and sustainability of our business, along with the dedication and execution of MCB's employees and clients. We have effectively managed through the challenging environment and are in a good position to support our clients with enhanced resilience and strong capital levels. Now, for a few financial highlights for 2022. Loans increased by $1.1 billion or 30%. Net interest income of $229.2 million was up 46%. Total revenues were up 42% to $255.8 million. Net interest margin improved to 3.49% from 2.77% in 2021. And our return on tangible common equity from operations remained very strong at 16.6%. Our efficiency ratio improved to 44.5% from 48.3%. I will now turn the call over to Greg Sigrist.

Greg Sigrist, Executive Vice President and CFO

Thank you, Mark, and good morning, everyone. MCB's core business continued to scale as it reported adjusted fourth quarter net income of $27.3 million or diluted EPS of $2.44. Reported net income inclusive of the regulatory settlement was a $7.7 million loss with a $0.71 loss per common share. Turning to key drivers in the quarter, the Commercial Bank posted a strong quarter with net loan growth of $223.2 million or 4.8% on loan originations of $411 million. We saw growth across all loan verticals. Loan yields increased to 5.98% from 5.3% in the prior linked quarter. The credit environment remains benign with no charge-offs in 2022, and non-performing loans effectively at zero. The provision in the quarter was in line with loan growth. I do want to spend a moment on deposits. We have successfully managed the transition to a leaner, more efficient balance sheet. As certain core deposit clients looking for higher yields have moved into treasuries or other money market investments, we have onboarded efficient, lower-cost deposits. This is evidenced in the fourth quarter with outflows from bankruptcy trustees and property managers offset by strong inflows from retail deposits, which increased by $178 million in the quarter, and fintech banking-as-a-service deposits, which were up $40 million in the quarter. As expected, digital asset-related deposits were down in the quarter by $268 million to $494 million at year-end. Of that remaining $494 million deposit balance, $326 million or 6% of total deposits are related to MCB's four active institutional crypto asset-related clients, which are subject to wind down in 2023. To support a more efficient balance sheet, particularly as deposits related to these active crypto clients wind down, we may, at times, utilize Federal Home Loan Bank advances for other funding sources in advance of executing on strategic core deposit initiatives. We did have $250 million of Federal Home Loan Bank advances and Federal funds purchased at year-end, which in part reflects the strategy, but it's also indicative of the timing of normal client cash flows around year-end. While deposit competition has increased, we remain thoughtful and patient both on the pricing of existing deposits and on the execution of funding alternatives. Our pricing discipline is evident in the success we have had in moving our new production loan yields up, raising loan floors, and in our net interest margin of 4.05% in the fourth quarter, which is up from 3.85% in the prior linked quarter. The interest-earning asset yield increased by 86 basis points to 5.12% in the quarter. Asset yields benefited from rising rates on floating-rate loans and overnight deposits, as well as increasing new production loan yields. Given the extent of rate increases since late September and as a result of our active management, total cost of funds has increased by 72 basis points but remains at a low 1.17%, which is particularly notable in light of our branch-light model. We have also moved toward a much more neutral stance from a net interest income perspective, which will allow stability to the extent rates continue to rise this year, but we are also well-positioned for eventual rate cuts. For our Global Payments business, revenues were up $244,000 in the quarter to $4.3 million. To give you more color, fintech banking-as-a-service revenues were up $569,000 to $3.1 million, while crypto-related revenues were down $324,000 to $1.2 million in the quarter. We're very pleased to see the continued scaling of our banking-as-a-service revenues. Turning to operating expenses, compensation and benefits were up modestly in the quarter, reflecting our continued investment in human capital, particularly into risk and infrastructure teams. Legal fees remained elevated by approximately $2.4 million in the quarter and $6.2 million for the full year, with outside counsel engagement focused on the regulatory matter as well as carry over from Voyager's bankruptcy proceedings. We do expect legal fees to moderate back to historic levels during the first quarter. Despite the elevated legal fees, our adjusted efficiency ratio remained low at 45.1%. The effective tax rate was impacted by the regulatory settlement reserve as well as discrete tax items that came through in the quarter. This includes the impact of vesting date fair values of employee stock-based compensation and refined state apportionment rates. Going forward, we would expect the effective tax rate to be in the range of 31% to 32% excluding discrete items. Our capital levels remained very strong, with all capital ratios significantly above well-capitalized levels. I will now turn the call back to our operator for Q&A.

Operator, Operator

Thank you. Our first question is from Alex Lau with J.P. Morgan.

Alex Lau, Analyst

Hi, good morning.

Mark DeFazio, President and CEO

Good morning, Alex.

Alex Lau, Analyst

I wanted to start off with the regulatory settlement reserve. Can you provide some additional color on that reserve? And can you just confirm that it was a fintech client and not a crypto-related client? And how does this change how you approach the business going forward? And as a follow-up, how do you think about the risk of needing additional regulatory reserves on top of that $35 million? Thanks.

Mark DeFazio, President and CEO

There was a lot to unpack, so if I miss anything, please follow up. To clarify, we're discussing a specific fintech client, not a crypto client, and we will announce the client's name eventually. This banking-as-a-service client hasn't been with the bank since the summer of 2020. I believe this experience has strengthened our bank. The regulators have been valuable partners, pointing out key areas where we can improve. It's important to note that the events in question took place in March 2020 during a particularly challenging period as we navigated a federal initiative related to the CARES Act aimed at unemployment benefits. The level of fraud we experienced was minor compared to the total $1 trillion disbursed for unemployment benefits, essentially a rounding error. However, it still occurred. Over the past several months, and really over the last two-and-a-half years, we've worked with regulators, who have offered important insights and recommendations for enhancing our oversight. Both the regulators and MCB recognize that banking-as-a-service is a viable and scalable model that will expand alongside digital banking. I don't see this as a challenge; rather, I perceive it positively, although it has been a difficult process.

Alex Lau, Analyst

Thanks, Mark. And moving on to the crypto business exit, can you talk about the timing of the rundown of the crypto-related deposits for the four accounts? And could that come with potential security sales? Thanks.

Mark DeFazio, President and CEO

We do not plan on any security sales at all, and there should be no reason for that. We expect that by the end of 2023, these four clients will be off our balance sheet. We are gradually winding down our relationship with them, and they are making significant progress in discussions with other banks, which could speed up the process. However, we are planning for a smooth transition over the next two to two-and-a-half quarters.

Alex Lau, Analyst

Thanks, Mark. And what about outside of those four relationships in terms of crypto-related clients? I think there's about 3% of total deposits. How do you think about those balances moving forward as those exchange clients depart?

Mark DeFazio, President and CEO

They're not exchange; they're corporate funds, they're operating accounts. We just have operating accounts for, let's say, a hedge fund that has raised some equity and is running their payroll, etc. So, these are just real operating accounts that do not touch crypto in any way.

Alex Lau, Analyst

Thanks, Mark. And one more before I step in the queue. On loan growth, when you exclude the crypto-related deposits, your loan-to-deposit ratio is approaching 100%. Can you talk about your expectations for loan growth in 2023? And if we should expect a pullback in growth relative to that historical level given a more challenging deposit environment? Thanks.

Mark DeFazio, President and CEO

I have a much clearer perspective for 2024 and beyond. I am confident that we will return to a lower loan-to-deposit ratio. We have significant flexibility on that side of the balance sheet, and we are implementing new initiatives that the market will learn about in the coming quarters. For 2023, we could be slightly above or below historical levels, but overall, I believe we will enter 2024 as a well-funded bank with core funding. I am optimistic that our loan-to-deposit ratio will decrease substantially in 2024 and beyond.

Alex Lau, Analyst

Thank you. I'll step back in the queue.

Operator, Operator

We'll take our next question from Chris O'Connell of KBW.

Chris O'Connell, Analyst

Hey, good morning.

Mark DeFazio, President and CEO

Good morning, Chris.

Chris O'Connell, Analyst

I just wanted to circle back quickly to the regulatory settlement reserve. If you could comment on how confident you are that this reserve is adequate, and how close to a final settlement you might be?

Mark DeFazio, President and CEO

Yes, I'm very, very confident that this is the high watermark of the $35 million in settling with both regulatory agencies. Both parties are working in good faith to finalize this settlement, and I believe we're very close to reaching an agreement. This isn't a contentious situation at all; we've always had great relationships with regulators, my entire career, not to mention the 23 years here at MCB. We've outlined some enhancements and changes that the regulators would like, with which we fully agree. We'll get this behind us; that's why we fully reserved for this. Is there a chance it could be slightly lower? Yes, that's possible, but we are all working in good faith, including the regulators. I felt it was prudent to fully reserve an amount that I think is absolutely the high watermark.

Chris O'Connell, Analyst

Okay, great. As far as the expenses after this falls out of the expense run rate going forward, how do you view the professional and legal lines, which are still elevated relative to the past?

Greg Sigrist, Executive Vice President and CFO

Yes, sure, Chris. As you mentioned, the professional fees will moderate back to the levels we saw late in 2021 through probably the first half of 2022. We've executed several initiatives over the last year and a half, so I do expect that line to moderate a little. We're still a growth company, so we will continue to invest in human capital. We've onboarded a substantial team over the last year or two. You're going to see continued expansion in that line. We'll remain focused on keeping our efficiency ratio down from current levels. It's about leveraging what we're investing in and ensuring we keep an eye on overall expense growth.

Chris O'Connell, Analyst

Got it. All right. And you mentioned some initiatives for deposit growth as you move into the front end of this year. How are you thinking about deposit growth if we exclude the anticipated runoff of crypto deposits over the next quarter or two?

Mark DeFazio, President and CEO

I think it will be robust. If you remove the crypto, we would be very pleased if all crypto ran off in the first quarter, so we don't have to talk about it again. Then we will need to fill that bucket, but I'm feeling really comfortable with the initiatives we have. Everyone in the company whose client-facing is working really hard. We will always be a core-funded institution. For the first time in 15 or 16 years, we dipped into the Federal Home Loan Bank, which is not something we tend to rely on long-term. It serves as good bridge funding but will not be a core strategy going forward.

Greg Sigrist, Executive Vice President and CFO

Yes. Just to add to that, Chris, around year-end, we have a very active and successful client base. There were some normal client cash flows around year-end. The important takeaway is that we've hit business as usual in terms of managing a leaner, more efficient balance sheet. We could always bring on more deposits to manage the loan-to-deposit ratio. We are focused on pricing discipline and margin management, and we have options available. We have strategic initiatives beyond our current deposit verticals that are actionable and in the queue, which Mark mentioned. We're all confident in our ability to support high-quality, prudent loan growth with low-cost deposits.

Mark DeFazio, President and CEO

And I should point out two deposit verticals that we developed internally: the property management business, which is nationwide, and the U.S. Trustee business. Only a handful of banks can hold U.S. Trustee deposits on balance sheet. We chose to let those deposits run off but have been able to replace them. We have excellent relationships with these companies, and we can dial that up anytime we want. There’s no capital investment required to bring these deposits back on. We're working diligently to expand our supply of deposit verticals. This rate cycle will pass, and those rates will stabilize. We are fortunate to be one of the few banks that can hold U.S. Trustee deposits on balance sheet. We can ease that loan-to-deposit ratio whenever we want, but we maintain our commitment to achieving mid-teens and higher return on tangible common equity.

Chris O'Connell, Analyst

Got it. Circling back to one of the earlier questions on the crypto runoff over the next couple of quarters, can you clarify if the offset of that will come from cash or securities?

Greg Sigrist, Executive Vice President and CFO

Yes, I think part of our decision comes from the opportunities we see on the deposit side. We have $7 million or $8 million a month of principal cash flows coming off the securities portfolio that will be available to us. We are generating substantial cash on an operational basis. It will be part of the mix. With banking-as-a-service deposits still increasing quarter-on-quarter, we don't feel there’s any urgency to fill that bucket immediately. We're targeting between $200 million and $250 million of on-balance sheet cash at any time, which is part of our strategy using Federal Home Loan Bank advances, for instance, to supplement our liquidity. We're confident in supporting loan growth and replacing crypto deposits with our existing verticals and outlined initiatives.

Chris O'Connell, Analyst

Understood. Thank you. Lastly, have you had internal discussions regarding a potential buyback authorization? Also, I believe your office book is around 8% of total commercial real estate. Can you discuss some characteristics of that book and where it's located?

Greg Sigrist, Executive Vice President and CFO

I'll start with the buyback, and then Mark can discuss the composition of the commercial real estate book. We evaluate all capital alternatives, including dividends and buybacks. Trading near book value requires careful consideration. Yes, we are having conversations around it. If anything becomes actionable, we'll inform you. It has certainly been on our minds.

Mark DeFazio, President and CEO

As for the office building market, as you noted, we have limited exposure, primarily in the suburban office market across various geographies. Our borrowers have strong sponsorships, healthy cash flows, and low loan-to-value ratios. We avoid Class A office building assets in New York City with low occupancies, yet occupancy levels are rising monthly, currently around 50%. The default rate remains low across the industry, and we are comfortable with the ownership and sponsorship related to our office building portfolio.

Chris O'Connell, Analyst

Great. That's all I had. Appreciate the color. Thanks, guys.

Greg Sigrist, Executive Vice President and CFO

Okay, Chris. Thank you.

Operator, Operator

This concludes the allotted time for questions. I would like to turn the call over to Mark DeFazio for any additional or closing remarks.

Mark DeFazio, President and CEO

Just really quickly, I know a lot of people were a bit taken aback by the regulatory settlement, but looking forward, I do want to stress that this is behind us. We're a better bank today, and we're positioned well to continue doing what we've done in the past. I look forward to a continued good working relationship with the regulators as we move forward and become best in practice in banking-as-a-service. Thank you very much for joining us today, and we look forward to continuing the conversation.

Operator, Operator

This does conclude today's conference and webcast. A webcast archive of this call can be found at www.mcbankny.com. Please disconnect your line at this time, and have a wonderful day.