Bank of N.T. Butterfield & Son Ltd Q1 FY2021 Earnings Call

Good morning. My name is Sarah, and I will be your conference operator today. At this time, I would like to welcome everyone to the First Quarter 2021 Earnings Call for the Bank of N.T. Butterfield & Son Limited. Please note, this event is being recorded. I would now like to turn the call over to Noah Fields, Butterfield's Head of Investor Relations.

Thank you. Good morning, everyone, and thank you for joining us. Today, we will be reviewing Butterfield's first quarter 2021 financial results. On the call, I'm joined by Butterfield's Chairman and Chief Executive Officer, Michael Collins; and Chief Financial Officer, Michael Schrum. Following their prepared remarks, we will open the call up for a question-and-answer session.

Thank you, Noah, and thanks to everyone joining the call today. During the first quarter of 2021, Butterfield continued to achieve strong operating results and delivered high returns with an actively managed low-risk profile. We provide market-leading financial products and services to clients seeking banking, wealth management, trust and custody services in our primary markets of Bermuda, Cayman and the Channel Islands, where we have long-standing, significant and stable market shares. We also delivered trust and wealth management services through our offices in Singapore, Switzerland and the Bahamas. In the United Kingdom, we offer mortgages to high net worth clients with properties in prime Central London. As you will see on Slide 4, Butterfield continues to report strong results with net income and core net income of $41.6 million or $0.83 per share and a return on tangible common equity of 19.3%. We had stable net interest income and fees with improving expense trends. Based on an improved economic forecast and steady loan performance, we had a credit reserve release of $1.5 million in the first quarter of 2021 compared to a recovery of $2.4 million in the prior quarter and a provision of $5.2 million in the first quarter of last year.

Thank you, Michael. I'll start on Slide 6 with a summary of net interest income and NIM. In the first quarter, we reported NIM of 2.09%, which was 16 basis points lower than the prior quarter due to three primary contributing factors. Firstly, continued loan yields on the short end of the curve. Secondly, elevated prepayment speeds and reinvestment yields that are below running book yields in the investment portfolio. And thirdly, the most significant contributor was the level of customer deposits and cash balances, which remained at historic high levels throughout the first quarter. Loan yields were down 5 basis points due to a jurisdictional mix shift in the first quarter. During the quarter, Bermuda had a modest increase in commercial loans while Cayman saw some residential loan growth, although growth was mostly offset by an early repayment of a sizable commercial facility in the Channel Islands. During the quarter, the net average balance in the investment portfolio increased approximately $500 million or 10% as we put new money to work in the U.S. agency, MBS securities portfolio. New money yields averaged 1.62% in the first quarter of 2021 or 16 basis points higher than the 1.46% in the prior quarter. During the first quarter, the blended rate for loan originations improved to 4.15% for $212 million of new loans from 3.66% for $201 million of originations in the fourth quarter of 2020. Turning to Slide 7, noninterest income was stable at just over $47.5 million. Transaction volumes and foreign exchange increased, which lifted foreign exchange commissions by $1.9 million in the quarter, and asset management also benefited from increased valuation-based fees. These offset the seasonal decline in debit and credit card fees due to the fourth quarter holiday shopping spending volumes. The bank continued to benefit from diverse and capital-efficient fee business with a fee-to-income ratio of 38.4% in the first quarter of 2021.

Thank you, Michael. I remain confident in Butterfield's strong operating position and the potential for continued organic growth as well as any possible acquisitions. We continue to examine potential acquisition targets and have seen an increase in the opportunity set that could be a good fit for Butterfield. Of particular interest are private trust companies within our geographic footprint. Pricing and due diligence will be key factors in progress on any possible deals with particular emphasis on customer documentation and evidence of robust compliance risk management. Butterfield remains committed to the successful strategy that we initially laid out with the New York Stock Exchange in 2016. We continue to generate ROEs in the mid- to high-teens with recurring fee income, low-cost deposits, a manually underwritten loan book with low LTVs, a capital-efficient investment portfolio with limited credit risk, strong risk management, and a disciplined expense and capital management approach. We believe these attributes will continue to generate value for the bank and all of our stakeholders as we emerge into a post-pandemic 2021 and for the long term.

First off, I just wanted to ask a little bit about the management of the balance sheet. You guys put on a good chunk of securities this quarter. Where are you in the process of laddering cash into securities? I know you expect some deposit outflows. But are we going to expect some additional securities purchases over the next couple of quarters at a measured pace? Or are you pretty much done at this point?

It's Michael Schrum. We can see that our cash position remains quite high, driven by inflows from both retail and commercial segments, roughly evenly split. Some of this may be attributed to search deposits, similar to trends in the wider financial system, and we anticipate that some of these inflows may be temporary. We still have some room from the ABN acquisition to extend our net new investments further. We are continuing with our plan of approximately $150 million in net new investments each quarter. Additionally, as interest rates have been rising this quarter, we took the opportunity to secure some of our asset sensitivity.

Okay. So $150 million per quarter is still a good rate to assume for the next few quarters?

Yes. I mean, we want to monitor, obviously, deposit levels. As you can see, that's had an impact on the OCI on the TCE ratio as well. So we continue to monitor. We're not quite at the point we can behavioralize those new deposits. As I think we've talked about before, we expect positive growth in the GDP growth range across our home markets. And clearly, what we've seen is well in excess of that, which is positive, but we also want to make sure that that's kicking around.

Perfect. And then, as I look at the TCE level, which I know is the capital ratio that you guys manage to and just being below 6%, does that limit your appetite for share repurchases until that TCE ratio goes above 6%? And does it also impact your ability to do M&A in the near term?

Yes, capital management has remained consistent. We continue to support our current dividend rate and focus on organic growth in our home markets. We are also looking for opportunities in accretive acquisitions, and there has been more discussion in that area recently. Additionally, share buybacks will depend on market conditions. As long-term rates have started to rise and deposit levels remained high in the first quarter, we have reassessed the impact on leverage capital ratios and have slowed down our repurchase activity a bit. Share repurchases are still a key part of our capital return strategy, but we are being more cautious as M&A discussions increase. We are still active in the market and believe we are providing good value based on price-to-earnings ratios. Although our price support has improved somewhat, we are being more conservative considering our TCE and the ongoing M&A dialogue. This approach is still part of our overall capital deployment strategy.

Great. And then just a final question from me. We have some potential tax changes in the U.S. coming up, possibly shifting from a regional to a global tax system. Can you remind us if that would significantly impact the economies of Bermuda, Cayman, or the Channel Islands?

It's Michael Collins. I mean, any U.S. tax changes actually would have some impact on Bermuda, Cayman and even the Channel Islands. I'd say, going back to when we had the new bill, which really changed the way reinsurers were able to transfer risk from their U.S. entities to Bermuda, I think the fear was that would shut down the industry, and it really didn't.

Maybe first for Michael Schrum. How big was that loan that was repaid in the Channel Islands that you mentioned?

About £30 million.

Okay. And then, looking...

You can see that in the segment note. Some of that was made up by the new mortgage rollout in the Channel Islands as well, but it was sizable and profitable. Again, we're not a big loan growth story. So pretty stable asset quality and stable balances.

Okay. Yes. And then that dovetails into my second question. So the launching of the retail products. I guess, when can we start seeing that make more of an impact on the balance sheet? And it looks like the deposit growth out of the Channel Islands has been quite strong over the past couple of quarters, especially this quarter. Is that a corollary to what's to come on the lending side? Any color on that would be great.

Yes. I think we've made a good start on the mortgage lending in the Channel Islands. And as we've talked about in the past, what we're trying to do is make the Channel Islands a full-service bank on both sides of the balance sheet like Bermuda and Cayman. We started off with staff lending, which actually is a big part of the Bermuda and Cayman residential mortgage book. And that's gone quite well. So we're really keeping pace. I mean, I think we've talked about $500 million worth of residential mortgages in the Channel Islands over 5 years, and we're on pace to achieve that.

Okay. And then just the last question for me. Looking at the deposit book and how healthy those balances were in the first quarter, could you quantify your expectations for deposit outflows? Is that expected to occur in the second quarter, or is your customer base still focused on building liquidity at this point?

Yes, that's a great question. It's difficult to provide a clear answer. After Q4, we had some visibility regarding outflows in Q1, which did occur but were offset by other commercial activities. The insurance market is hardening significantly, leading to increased premiums. We saw more premium inflows for captive insurance companies at the start of the quarter, and that trend has continued. The increase in retail deposits is mainly due to one-time pension withdrawals, especially in Cayman and Bermuda, along with general retail flows, some of which will persist. On the commercial side, we expect outflows over time, but it may take a couple of quarters. Honestly, we didn't anticipate those commercial deposits being substituted by temporary deposits in Q1, but that's what happened. While it's a positive development, it does require more conservative management and will impact our net interest margin due to average deposits during the quarter.

I would like to begin by discussing some factors affecting the net interest margin. Firstly, it seems that consumer loan yields decreased significantly during the quarter. Could you elaborate on the changes in mix across different jurisdictions and whether the decline in yields we observed this quarter is sustainable? Additionally, I would like to understand how the mix shift might influence loan yields going forward, assuming everything else remains constant.

Yes, that's a great question. There's quite a lot to discuss regarding the balance sheet and segment reporting. As you know, the new mortgages in Cayman, so the front book in both Cayman and Bermuda, are at lower rates compared to the back book. Specifically, Cayman is linked to U.S. prime rates. So with increased resales in Cayman, there is still pressure on the net interest margin, although yields overall on the total book are affected. Additionally, as we have discussed before, the Channel Islands have sterling rates around 350, which are again lower than Bermuda and Cayman mortgage originations. Over time, this will slightly pressure the yield on the loan book, but it will only be by a handful of basis points. There is still a substantial back book, so despite ongoing amortization in both the Bermuda and Cayman portfolios, the impact shouldn't be significant.

Got it. Appreciate that. And then just on the securities reinvestments that you're making. I heard you on the average security yield in the quarter. Wondering if maybe like the exit run rate, given the kind of backup in yields over the course of the quarter, if the exit run rate was a little better than that. And the follow-up would be, if that is the case, can we start to see the securities yield leveling off in the near term?

Yes. Yes is the answer. The exit yield was probably in the 1.85 or 1.90, so higher than the average, for sure, and a lot closer to the running book yield in the investment portfolio. So obviously, that's helpful. We focus a lot more on NII, obviously, given the search deposits and the impact that it has on the NIM overall, but we should see stabilization there. And certainly, we would expect prepayment speeds to start slowing down as well. We haven't seen that yet, but we're expecting that with a higher rate environment as well. And obviously, the maturities really have been impacted quite significantly by the PPP program in terms of almost one-third of our prepayments come from lift outs, and that's really sort of accelerated the NIM decline in the MBS book. But we're getting a lot closer to the running book deal now.

Got it. That's helpful. And then if I could squeeze in one more. Just as you look at kind of capital management and obviously, you're buying a lot of securities today, how do you think about OCI risk going forward? Any kind of sensitivity you provide? And are you thinking about any ways that you can maybe hedge that out in case we do see some further backup in yields over the next couple of quarters?

We've noticed a significant reduction in AFS OCI gains, though we still have some gains recorded. Currently, we're allocating about half of our new money into AFS and HTM, which is primarily an accounting strategy rather than a hedge. Additionally, we still have considerable gains in the overall unrealized mark-to-market for HTM. I should mention that while OCI does not affect our regulatory capital, it does influence our leverage capital. We're focusing on longer-dated maturities in the HTM book, as we tend to have more shorter-dated maturities in AFS. This approach should create a natural flow between the two books and help cushion the effects of rising rates on AFS. We're also considering OCI paybacks and TCE paybacks from high yields, and we feel quite confident about the current payback period we are experiencing.

This is Andrew DeFranco. I'm stepping in for Mike today. So I was just wondering, it was good to see expenses tick down after some of the actions you guys took last year. Any updated thoughts on where that trends near term? Or is there still some upward pressure potential as things return to normal regarding travel and maybe some other items?

Yes. So just touching on last year, obviously, we reduced headcount by about 10% of the workforce or about 130 positions. Clearly, that's not something we can do again this year. We're very focused on operational risk and making sure we've got enough people to have the controls that make us comfortable. So that was, I would say, a onetime shot, but we can't replicate it every year. What we are doing though is continuing to focus on our Halifax service center. So we're continuing to automate as much as we can in Bermuda and Cayman and then transfer those roles and functions to Halifax. We've got about 150 people up there now. So we finally have sort of a scale and critical mass where the teams are kind of supporting each other. So we continue to see that growing. And that will have a gradual impact on expenses over time. Basically, the cost is about 50% per se compared to Bermuda and Cayman. But then you also have currency fluctuations as well. But it's a great quality workforce and will save us money over time. But I'll let Michael talk specifically about where we think this year will go.

Yes. Regarding the restructuring, there are still more benefits to come. As we've mentioned before, this is a phased approach and we wanted to ensure we had staff in key control roles during the year-end. As we transition their responsibilities to Halifax or to replacements, we expect to see further expense relief. I anticipate that this will be reflected in increased travel and entertainment expenses in the second half of the year. Post-pandemic, it’s essential for us to meet with clients and colleagues in various locations. I believe the levels we previously estimated are still accurate.

Has the pandemic noticeably changed the competitive landscape in any of your markets? Have any banks pulled back any further? Or any new entrants looking to diversify away from?

The competitive landscape has not changed significantly. To summarize, Bermuda is set to reopen as announced by the government on June 26, with the Channel Islands opening in early July. Although the gaming government, which recently had an election, hasn't made an announcement, it is expected in September. Everyone is trying to reopen in time for their peak tourist seasons. Bermuda currently has four banks, making it a highly regulated market, with HSBC and Butterfield having nearly equal market shares, and we don't anticipate that changing. The Cayman Islands is slightly more competitive with six banks, including some Canadian institutions, but I don't believe there has been a dramatic shift in competition. The Channel Islands are more competitive, incorporating various U.K. and European banks. Overall, we are proud of our ability to operate efficiently from home, and while we continue to do so to some extent, we have not observed any notable changes in the competitive environment. We have been pleasantly surprised by the strong local activity reflected in our fee income over the past year, but again, there has been no significant change in competition.

This concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

Thank you, Sarah, and thanks to everyone for dialing in today. We look forward to speaking with you again next quarter. Have a great day.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.