Earnings Call Transcript - MCB Q3 2022

Operator, Operator

Welcome to the Metropolitan Commercial Bank's Third Quarter 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 made 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, Katy. And good morning, and welcome to MCB's third quarter earnings call. I am pleased with MCB's strong and sustained performance, as evidenced by a 17.1% return on average tangible common equity this quarter, powered by the strength of our sustained loan growth and NIM expansion. Amid a backdrop of rising interest rates and increasing economic uncertainty, the MCB team has remained engaged with our clients, and that commitment shows in our financial performance. When we set out over 23 years ago to build a branch-like commercial bank, managing the funding side of our balance sheet by adding optionality has been the cornerstone of successful net interest margin management. Fast forward, MCB remains focused on the management and the development of our diversified lower-cost funding base while looking out two years or more to expand our funding strategies to support the balance sheet growth we have seen over the past 20 years. The third quarter was no exception. We saw total deposit growth apart from expected crypto-related deposit outflows as we were able to source lower-cost deposits that more than offset the outflows from the positive seeking treasury rates looking to substantially reprice existing arrangements. This highlights the pricing discipline that underpins our margin management. Margin management is reflected in our ability to drive top-line growth in net interest income, with high-quality loan growth, funded by lower-cost and scalable deposit verticals. We have had success moving our new loan production yields up during this unprecedented rate environment, along with raising floor rates that will provide net interest margin and net interest income protection when rates reverse. I would like to spend a moment on our global payments business. As a reminder, we provide basic retail banking services to our digital currency clients, which we often refer to as crypto-related businesses. For sake of absolute clarity, the services we provide do not include custody or lending against any digital assets, nor are we involved in any stable coin issuances. Further, as many of you have heard me say, we have not onboarded a new digital currency client since 2019. Revenues from this sector currently represent roughly 2% of MCB's total revenues or 13% of our total deposits. We remain strategically focused on expanding our banking-as-a-service offerings to FinTechs as we are well-positioned to continue taking retail market share from banks of all sizes. I am pleased to report that banking-as-a-service revenues of $2.5 million in the third quarter are up 21% over the prior year quarter. Our ability to scale banking-as-a-service related deposits over time is clearly a differentiator for us as well. Now turning to a few third quarter highlights as compared to the prior year. Total loans were up $1 billion or 28%, total deposits were up $274 million or 5%, including DBAs, which were up $254 million or 9%. Net interest income of $63.3 million was up 55%. Return on average assets was 1.51% as compared to 1.09 a year ago. As mentioned, the return on average tangible common equity was 17.1% in the quarter, and our efficiency ratio improved to 45.1% from 47.1%. I will now turn it over to Greg for more comments.

Greg Sigrist, Executive Vice President and CFO

Thank you, Mark. And good morning, everyone. We reported strong third quarter net income of $25 million, or $2.23 of fully diluted earnings per share. Loan growth and NIM expansion led net interest income higher in the third quarter, with NII increasing 15% to $63.3 million as compared to the prior quarter. Let me take you through a few of the key drivers this quarter. Commercial bank performance remains strong, with net loan growth of $242.1 million or 5.5%, bringing year-to-date net loan growth of 23.7%. While down from the record second quarter, loan originations remain strong at $424 million, bringing total originations for the first nine months of 2022 to $1.4 billion. Credit quality remains pristine, with no charge-offs to date and non-performing loans effectively at zero. The provision in the quarter was in line with loan growth. As expected, crypto-related deposits were down $486 million, led by the effort to promptly return funds to Voyager customers once approved by the bankruptcy court. This was our second consecutive quarter of measurable inflows of retail deposits, including those with loan customers, with an increase of $151 million in the third quarter. Credit goes to our retail and commercial lending teams for the sustained client engagement. We also saw strong inflows of $162 million related to our FinTech banking-as-a-service clients. Loan yields more than offset the expected outflows from deposit categories seeking higher yields, which is consistent with our disciplined approach to deposit pricing and margin management. Non-interest-bearing deposits remain robust at 53% of total deposits. Net interest margin was up 50 basis points in the quarter to 3.85%. Asset yields benefited from rising rates as well as the deployment of liquidity, with interest-earning asset yields increasing 76 basis points to 4.26%. Importantly, the total cost of funds increased a modest 20 basis points, while remaining low at 45 basis points, given our patience and ability to hold the profit betas low to this point in the cycle. We do expect to see NIM expansion into next year on the strength of our pricing discipline on both sides of the balance sheet and given the funding options available to us. We are being mindful of the current interest rate forecast. We are looking further down the field to position for an eventual decline in rates. We have increased asset duration gradually over the past several quarters. For securities, duration has naturally extended with rising rates. For loans, we have taken out a bit more duration, which is evidenced by a modest decline in the floating rate portion of the portfolio to 41% at September 30, as compared to 44% to begin the quarter. This also shows in our net interest income sensitivity modeling, which has come in a bit this quarter, particularly in the rates down scenarios highlighted in our IR deck. We have continued success in moving floors up on new origination floating rate loans, with a majority of loans subject to floors. The structural benefits are important elements of our margin management, which provides stability, as rates continue to move up and will provide a significant level of NIM protection when rates inevitably begin to back down. GPG revenues were down $1.1 million quarter-over-quarter, given the expected decline in crypto-related GPR card volumes, partially offsetting this decline with FinTech banking-as-a-service revenues, which were up $312,000 or 14% in the quarter on an 11% increase in related transaction volumes. Overall, expenses continue to be well managed as we are building per scale with a focus on generating near-term returns on the investments we make. This has been clearly evident in human capital, where compensation and benefits have continued to scale along with MCB's growth and profitability, reflecting the continued investments being made, particularly in control and infrastructure functions. Apart from our total run-rate, professional fees did increase in the quarter. The primary driver was legal fees, which were elevated by approximately $4 million, with outside counsel engagement focused on Voyager's bankruptcy proceedings as well as other matters. We do expect legal fees to moderate back to historic levels as we move through the fourth quarter, with our expected first quarter run-rate for legal fees in line with historic trends. Touching on taxes briefly, we would expect the effective tax rate for the balance of the year to be in the range of 31% to 32%, excluding discrete items recognized in the first quarter. Our capital levels remain strong, with all capital ratios significantly above well-capitalized levels. And I will now turn the call back to our operator for Q&A.

Operator, Operator

Thank you, the floor is now open for questions. Thank you, our first question will come from Chris O’Connell with KBW. Your line is now open.

Chris O’Connell, Analyst

Good morning.

Mark DeFazio, President and CEO

Hey, good morning, Chris.

Greg Sigrist, Executive Vice President and CFO

Good morning, Chris.

Chris O’Connell, Analyst

So just wanted to start out with the legal or professional fees being elevated. And see if you guys give any additional color around the issue or how you think the trajectory will be between now and 1Q'23?

Mark DeFazio, President and CEO

As Greg mentioned, this is Mark DeFazio. As Greg mentioned, we think as the legal fees will start to normalize through the fourth quarter and we should hopefully be behind it starting in the first quarter of '23. Voyager, as everyone knows, was a bankruptcy, so we had to represent ourselves there. And we also have one other matter that is a 2020 matter, which we're working through as well. So we expect these two matters, hopefully will be behind us by the end of this year. And we'll be back to normal trends as it relates to professional fees.

Chris O’Connell, Analyst

Okay, got it. And then just on the residue expenses. There's a disclosure around locking some gains that will help offset licensing fees going forward. Just any idea, given that offset, where those licensing fees trends in the fourth quarter given the recent rate hikes?

Mark DeFazio, President and CEO

Yeah, but there's only a portion of that line, which is licensing fees, that's subject to any sort of rate variability. And we'd substantially hedge that rate risk out with the interest rate capital that we disclose, Chris. So, I think what you're really going to see in the fourth quarter should largely be in line with third quarter. That rate cap, the $12.7 million net we referenced in the earnings release, that will come into P&L on that line over the remaining balance. The hedge period, which I think was in that 28 to 30 months period, it's probably down to closer to 25 months at this point in time. So we will see some continued protection from that as it comes in the income.

Chris O’Connell, Analyst

Okay, great. And then on the loan growth side, the balance sheet. Obviously strong quarter growth. Is there any update on what you're hearing from your customers as far as demand? And then any areas that you're more aggressive on or pulling back on at this point in the cycle?

Mark DeFazio, President and CEO

No, we're very fortunate, as a commercial bank, and as you see the level of diversification we have in our loan portfolio. Our clients are very active in this market looking for opportunities. And we're not pulling back on any asset class at the moment. We are just a bit more careful in certain decisions we make regarding certain asset classes. But no, we see very little headwinds ahead of us and looking forward to continuing to support our commercial clients.

Chris O’Connell, Analyst

Okay, great. And then any pushback on the substantial change in origination rates over the past couple of quarters given the upward moving rates and any pushback on that or the raising of the floors?

Mark DeFazio, President and CEO

I wouldn't call it pushback. And then obviously, there's a conversation. But one of the things, I think we benefit from being a commercial bank and having significant optionality for diversification on the commercial loan side. Our clients are very high net worth individuals, and we're assisting them in generating significant internal rates of return on their investments. So they acknowledge that funding costs are going up, and therefore, loan yields have to rise. And someone told me once it's not a cost of money, it's a cost of not having it. So they still see our funding as very strategic in their ability to generate generational wealth. So yes, it was a discussion about it, but I wouldn't suggest in any way it's a headwind.

Chris O’Connell, Analyst

Great. And then I may have missed it, but I know in the past, you guys have assumed roughly a 70% beta in interest rate sensitivity tables. And any changes you've seen in the magnitude and pace of rate hikes? And what you guys are seeing in 3Q and in conversations so far in 4Q as to when you get to that beta over the course of the cycle. And I guess, like what you're seeing in the near term in terms of betas on the deposit side?

Mark DeFazio, President and CEO

We are the first to confirm that for interest-bearing deposits, we evaluate our net interest income sensitivities with our 70% beta. Early in this cycle, we noted that this might be somewhat conservative. So far, our betas have remained low. Determining when we will reach that 70% is certainly a challenge. We currently have various funding options available and a solid pipeline of deposit opportunities we are exploring. I believe we will continue to operate within what I consider a relatively cautious 70% beta. This is an important aspect this quarter, reflecting the flexibility we have as we manage our balance sheet and margins.

Chris O’Connell, Analyst

Got it. Based on your commentary, it's safe to assume that for at least the next couple of quarters, we will see fairly positive NIM trends going forward.

Mark DeFazio, President and CEO

Yeah. And to play back in another way, I mean, even if that deposit beta on interest-bearing deposits does trend into the 50 to 60 year slightly higher range, I still think we're going to continue to see some opposites on them, just again, given our disciplines and what we're able to do on the asset side of the sheet as well combined with just overall deposit pricing initiatives.

Chris O’Connell, Analyst

Great. And last one for me, just any update you could give on where you think the $1.6 million of GPG fees, relative to digital currency business and the $762 million remaining of the digital currency-related deposits? Trends that we've seen so far in 4Q are kind of the outlook that you see on that in the near term?

Mark DeFazio, President and CEO

As it relates to the crypto deposits, I think a bit stable at this point. We're seeing a bit pickup in crypto-related transactions, but we play such a small role in that space, in any event, so the transaction volumes, therefore the revenue generated from it won't be significant either way, up or down. And on the deposit side, I think that stable. Our volatility last quarter came from Voyager, which is obviously a bankruptcy, that speaks for itself, but GPG excluding crypto, we continue to see expansion there. We see our banking-as-a-service business continuing to grow. Remember that business is a retail business. It's a retail digital bank within a commercial bank. So it's in a marathon; it takes a lot of time. Client acquisition takes a bit of time. But once you have those clients, they're here for a while. So we expect to see a continued steady increase in our banking-as-a-service business for the foreseeable future.

Chris O’Connell, Analyst

Great. I appreciate the time.

Mark DeFazio, President and CEO

Thank you.

Operator, Operator

Thank you. Our next question will come from Alex Lau with JPMorgan. Your line is now open.

Alex Lau, Analyst

Hi. Good morning, Mark and Greg.

Mark DeFazio, President and CEO

Hey, Alex. Good morning.

Greg Sigrist, Executive Vice President and CFO

Good morning, Alex.

Alex Lau, Analyst

In the past, you've talked about growing loans in that mid-teens range. Are you feeling confident continuing in this historical loan growth range, given a more challenging deposit environment?

Mark DeFazio, President and CEO

I believe the answer is yes. We manage our capital efficiently and take it very seriously. Capital is valuable to us, so we won't grow just for the sake of growth. If market conditions lead to NIM compression, it might not yield the top-line revenue we aim for, and we may reduce lending. So far, we haven't faced that challenge. Our clients are very active in the current market, and we have various options on the lending side. We will maintain control over that while being mindful of preserving our capital and ensuring we achieve the right operating leverage for returns. We will have to wait and see. We also prioritize credit discipline, and if market conditions shift and raise concerns about asset quality, we can adjust accordingly. We're taking an opportunistic approach and are not focused on achieving a specific growth rate; our primary goal is on earnings.

Alex Lau, Analyst

That's helpful. On the deposit side, outside of the crypto-related balances, there's some good growth in the FinTech deposits. Can you talk about what drove this growth in the quarter? What's the cost of these types of deposits? And in terms of just what you're seeing in the pipeline, how confident are you in growing these deposits in the near term?

Mark DeFazio, President and CEO

We're confident. We see a direct correlation between onboarding and integrating with new FinTech companies. They're executing on their business strategy in the form of the client acquisition strategy, so we're seeing the benefit of their growth while we're sharing in that. So we expect the positive to continue to grow steadily. We expect to onboard new FinTech companies at a pace that we can manage the risk, because that's the cornerstone of this business: managing the operational risk. And we expect it to continue. The consumers are continuing to move more and more to a digital platform. And the traditional banks are just not filling that void, and FinTech companies are. And they need a banking-as-a-service provider like MCB to do that.

Alex Lau, Analyst

Thank you. And on the property manager and bankruptcy trustee deposits, they continued to decline another quarter. Can you walk through what is driving this? And do you expect these balances to continue declining, or have we hit a floor?

Mark DeFazio, President and CEO

It's hard to say that we've hit a floor. And again, fortunately, we have optionality, so we were able to more than outpace those outflows. In those two cases, you had clients that are competing with much higher yields. And I think in a couple of cases, the clients were really looking to achieve more of a treasury rate return. And we're just not going to pay up for the deposits. Unfortunately, we have the optionality to manage our margin, and we're still very engaged with these clients. We expect to do more business with those clients. But they have goals that they set out for themselves, and we have discipline around managing our cost of funds. So fortunately, we have the optionality around our balance sheet that provides us the ability to say no.

Alex Lau, Analyst

Thank you. And then on to crypto deposits, just to clarify on the $486 million outflow. How much of that was from Voyager and what was the rest from?

Greg Sigrist, Executive Vice President and CFO

It was around 70% was Voyager, to be candid, and the rest just I would characterize as normal flows in the crypto space.

Alex Lau, Analyst

Thank you. And just a side question. At what point would you be comfortable using a portion of those crypto-related deposits to fund loans or securities?

Mark DeFazio, President and CEO

We have a 50% beta against those deposits already. And the ones that we do have on our balance sheet are fairly stable. So to the extent that they become useful and less costly than other options, we would consider it. But right now, there is volatility still in the crypto space. And we've been able to drive lower costs, low-cost funds elsewhere. So it's just another tool in our quiver to the extent we feel comfortable enough with relying on those deposits to be around the same longer-term earning assets.

Greg Sigrist, Executive Vice President and CFO

I agree with Mark. I think those deposits are getting closer to being interchangeable with the rest of the deposits, although there is still some hesitation. We have flexibility with the other deposit areas and additional strategies we're pursuing. Furthermore, we continue to focus on overall client funding to expand our options, and you may have noticed an increase in our FHLB capacity as well. In summary, we're becoming more comfortable and are equipped with options, which I believe is crucial.

Alex Lau, Analyst

Thanks. And on the depositor environment, can you just comment on what you're seeing on the deposit competition front? How much pressure are you seeing on the money market and savings deposits costs? And what are the spot rates on those deposits? Thanks.

Mark DeFazio, President and CEO

As we navigate the current interest rate landscape, it’s clear that competition is prevalent, as noted by various banks. Many are beginning to realize who is interested in indexed options, and there are sensitivities regarding deposit pricing among different banks. In the money market sector, it's important to remember that we maintain many long-term relationships that also involve lending. Therefore, in many instances, we are looking at pricing from both perspectives. I commend our retail and commercial banking teams for their consistent engagement with clients. Regarding spot rates, we’ve observed figures around 150 for new funds, which reflects what we see in competitive rates. Nevertheless, our focus remains on maintaining ongoing discussions with our clients and effectively managing our margins.

Alex Lau, Analyst

Thanks. And then on GPG fee income, you touched on this a little bit. But just to clarify, the GPG revenue was down a million. Do you expect more crypto-related headwinds from here, or is the FinTech income side enough to grow this overall line from here?

Greg Sigrist, Executive Vice President and CFO

I think it's challenging to forecast what will happen with the GPG, particularly regarding the crypto aspect. The crypto winter is still ongoing, and we won't be entirely insulated from developments in the wider crypto market. As Mark mentioned earlier, we are still a relatively small player in that arena, so we may see some connections to broader trends. However, our banking-as-a-service and retail FinTech partners are truly beginning to thrive, which is the segment of our business that we are focusing on. We are starting to experience the growth we anticipated. While I can't say whether it will fully compensate for the crypto side in the short term, we are very optimistic about the ongoing positive trends we are observing.

Alex Lau, Analyst

Thank you. And last question from me on credit. Credit metrics are strong again this quarter. Can you just talk about where you're keeping an eye on the closes in terms of asset class and markets as we head into a potential recession?

Mark DeFazio, President and CEO

Alex, we are concerned about various asset classes, even before the pandemic. Retail was under pressure, and hospitality was already under pressure. Coming through the pandemic, hospitality is recovering very nicely. We see weaknesses still in retail, in some segments of retail. We're just not careful when we are conservative, and we're fairly diversified. And we understand the industries and the markets that we're in very well. I think we have the best lending teams and credit analysts anywhere in New York today. I put them up against anybody of any size bank. After 23 years of having virtually no losses and having the kind of balance sheet growth we continue to have, I think being more careful than conservative has played well for us. And we're dealing with very sophisticated clients who are in the long game. We're not looking for quick profits; they're looking to build generational wealth. So they approach deals fairly carefully, as well. Some asset classes that we do like quite a bit, obviously, are healthcare that continues to serve us well. But of course, the portfolio performance speaks for itself. So we're very fortunate, again, to have that kind of optionality.

Alex Lau, Analyst

Thank you. That's it for me.

Operator, Operator

Thank you. Seeing no further questions, this concludes the allotted time for questions. I will now turn the call back over to Mark DeFazio for any additional or closing remarks.

Mark DeFazio, President and CEO

I just would like to end by saying thank you again to the shareholders who are hanging in there with us. I know it's a very difficult time out there in the market. And we're working really hard for you and we appreciate your support. Thank you very much.

Operator, Operator

Thank you. This does conclude today's conference call and webcast. A web cast archive of this call can be found at www.mcbankny.com. Please disconnect your lines at this time. And have a wonderful day.