Bank OZK Q3 FY2024 Earnings Call

Good morning. I'm Jay Staley, Managing Director of Investor Relations and Corporate Development for Bank OZK. Thank you for joining our call this morning and participating in our question-and-answer session. In today's Q&A session, we may make forward-looking statements about our expectations, estimates, and outlook for the future. Please refer to our earnings release, management comments, and other public filings for more information on the various factors and risks that may cause actual results or outcomes to vary from those projected in or implied by such forward-looking statements. Joining me on the call to take your questions are George Gleason, Chairman and CEO; Brannon Hamblen, President; Tim Hicks, Chief Financial Officer; Cindy Wolfe, Chief Operating Officer, and Jake Munn, President, Corporate and Institutional Banking. We will now open up the lines for your questions. Let me ask our operator Marvin to remind our listeners how to queue in for questions.

Thank you. It is time to connect the question-and-answer session. Our first question comes from the line of Stephen Scouten of Piper Sandler. Your line is now open.

Hi, good morning, everyone. I appreciate all the insights from the management comments, particularly regarding the potential for net interest margin and selection in late 2025, which I found interesting. Could you provide some details on the various factors at play? There’s obviously a lot happening there. Perhaps you could elaborate on the CD yields during repricing and the expectations for beta as it decreases, as well as the impact of the floors and the lag effect you mentioned regarding the transition from RESG to CIB and other verticals. Additionally, considering any debt maturities, I’d like to understand the overall picture of the factors influencing net interest margin and what gives you confidence in the potential for change in the latter half of 2025.

Tim, since Stephen's question touches everything on the balance sheet and income statement, would you like to take that?

Sure. Thanks, Stephen. How are you doing?

Great. Thank you.

Great. There are many factors at play. The pace of the Federal Reserve's actions significantly influences the timing and extent of changes in our net interest margin (NIM). We've provided a detailed timeline for when our loan yields are expected to be impacted. The speed at which we can adjust the rates on our interest-bearing deposits is also crucial. This includes a substantial amount of time deposits set to mature this quarter, which totals $5.9 billion with a weighted average rate of $5.19 billion. Additionally, there's $6.2 billion in time deposits maturing in Q1, with a weighted average rate of $5.10 billion. Our current special rates for 7-month and 13-month CDs are lower than those figures. As these adjust, we anticipate a quick reduction in deposit costs over the next two quarters. Our securities portfolio is also expected to contribute positively to cash flow in the upcoming quarters, with many loans set to reprice at higher yields. The Federal Reserve's actions and their timing will impact our NIM, particularly as we look toward potential improvements in the second half of next year. Our current assumptions anticipate a 25 basis point decline over the next six meetings. A slower pace from the Fed would benefit us, while a quicker pace could pose challenges. If the Fed continues its actions into late 2025, we will have more opportunities to adjust our CDs and loans favorable as well. Overall, we believe our guidance remains solid across various scenarios.

That is a suitable response to a detailed inquiry.

Yes. Let me elaborate on that, and Tim, please confirm if this aligns with your thoughts. Our baseline assumption is that our margin will face pressure in Q4 and Q1 due to the 25 basis point decreases in each meeting, along with the expectation that deposits will reprice while loans will reprice at a faster rate. We experienced the benefits of this during the rate increases, and we anticipate the challenges as rates decline. If the Fed were to implement 50 basis point cuts in increments, it would have a more significant negative impact in Q4, but we would reach the lower bounds more quickly, allowing us to hit an inflection point where our net interest margin starts to improve more rapidly next year. It's important to recognize that these lower bounds will begin to take effect soon with a few more Fed adjustments, as Tim highlighted in the chart. This will lead us to a point where we start to benefit significantly from those lower bounds.

Perfect. Perfect. Great. And it seems as though you guys feel a little bit more confident around the handoff strategy and the ability to grow loans nicely. I think you said mid- to high single digits in 2025, which is great. And I like that you have Jake here on the call. So can you talk a little bit about that hand off the confidence and maybe the incremental investments, if you can frame those up within CIB from a headcount perspective that gives you that level of confidence?

Yes. Why don't we start out and let Brannon Hamblen talk about the overall expectations for loan growth, and then he can introduce Jake and Jake can comment on some CIB specifics.

Yes, good morning everyone. It's great to be here. There are many factors to consider as we look at loan growth. RESG had a strong year in 2022 with $13.8 billion in originations and has been well-funded, allowing for significant growth. However, as we progress, we know that the completion of construction loans will lead to repayments, and there are still some deferred payments from COVID-related loans. We’ve made excellent progress with RESG, but we expect changes ahead. It's complex to predict the exact timing of these shifts, but our asset management team is exceptional. Each member manages around 15 loans and dedicates significant time to the projects. A crucial aspect of their work is accurately forecasting funding and repayment schedules with a detailed 36-month projection done monthly. We are confident that RESG will see a turnaround, and we are thrilled to have Jake and his team joining us. I've personally spent a considerable amount of time this year helping Jake get that team up and running. At the beginning of the year, we had about 10 to 15 people in that group, but Jake has worked diligently to triple that number, and we now have around 40 employees. We believe the timing for these changes has been very well executed. Now, I'll let Jake discuss what he's observing and the opportunities ahead as he takes over from RESG.

Thank you, Brannon. I appreciate it, and that's a great question. The Corporate and Investment Banking division was established in March of this year, with most of its initiatives launching just last quarter, including our corporate banking and sponsor finance group, as well as our loan syndications and corporate services group. Therefore, the third-quarter numbers are really just a preview of what we expect going forward. We are confident and have strong pipelines in our legacy asset-based lending group, where we have added more staff on the origination side to drive growth. Additionally, our equipment finance and capital solutions team is performing very well. We've provided enhanced portfolio management and operational support in the last quarter to help them focus on building a robust pipeline of future opportunities. Lastly, our fund finance group within the CIB is also experiencing great momentum, led by a new leader from a reputable institution who is actively contributing to our growth. We are excited about this positive outlook and feel optimistic about our future potential.

Fantastic. And if I could squeeze in one quick one on kind of an accounting question. Can you give any color on what causes the transfer of like a construction loan into maybe a more permanent CRE classification? Is that like when you reach a CO or kind of what drives that classification change? And does that change how you guys have to evaluate the loan from a rating perspective internally?

Brannon? Could you take that?

Yes. Stephen, I'll take that. It's really a very simple two criteria that make that move. First, the property is complete and has a certificate of occupancy, and second, the loan structure includes a monthly amortizing feature. Regarding the second part of your question, whether it changes how we look at or rate it, we are constantly reevaluating our risk ratings on a quarterly basis. So nothing really changes there. We consider what is going to happen after it's complete, what leasing has occurred, what we expect to occur, valuations, and other related factors. So not really a big change there.

Got it. Thanks for the color and congrats on more record earnings.

Yes, Steve, I'd like to provide some additional insight on this handoff, complementing what Brannon and Jake mentioned. First, under Jake's leadership, our corporate and institutional banking group is new, and he has significantly expanded the team this year, attracting experienced and talented individuals. However, he is also building on a foundation that has been developing over the past three to five years within our company. Our fund finance, asset-based lending, and equipment finance and structural solutions businesses have been established for several years, and all existing team members are still with us because they are doing excellent work. Adding to these great teams only strengthens our capabilities. Furthermore, this handoff isn’t limited to corporate and institutional banking. Alan Jessup, Ken Ronecker, and Dennis Poer, who oversee our commercial bank lending through our community bank structure and other lending types, are also enhancing their performance. We've spent years preparing for this transition. This is a comprehensive effort with contributions from CIB, indirect lending, commercial banking, and a renewed focus on small business banking and consumer lending through our branch network. We feel optimistic about these developments. As Brannon noted, we believe the timing is right, as RESG funded balances are likely to remain relatively stable through the end of next year, fluctuating somewhat each quarter. Despite this, we still anticipate mid- to high single-digit growth thanks to the contributions from these other business units, which, although receiving fresh attention, are not new to our company.

Thanks for all the incremental color George, appreciate it.

Thank you. One moment for our next question. Our next question comes from the line of Manan Gosalia of Morgan Stanley. Your line is now open.

Hi, good morning.

Good morning.

I was just trying to think through the relationship between paydowns and floors and the impact that might have on NIM. As capital markets open up, more loans get paid down, is it more likely that some of the older loans that were made with lower floors get paid down first? Or that some of the more recent loans that were made with higher floors get paid down sooner, right? So I recognize that there is a prepayment penalty, but at some point with the 200 basis points of Fed rate cuts, does it become NPV positive for some of the people that have higher floors to pay down the loan and pay the prepayment penalty?

That's a good question, Manan. Based on our experience, there's generally some reluctance among customers to pay off loans during construction, although it's not uncommon. Typically, early payouts occur when billing is nearly complete. Most loans will reach full completion terms, and if we don't reach our target minimum return on equity, we’ll be safeguarded by minimum interest, which would be advantageous for yield. Regarding older loans with lower floors, we anticipate a greater likelihood of those being paid off compared to newer loans with higher floors.

Got it. So as a figure 27 is a good metric to look at as rates come down, what portion of your loans will hold at their floors. And then we can use that to model out NIM going forward?

Yes.

Got it. And in that chart, I know it is based on commitments, but it should be pretty similar for loans that are actually on the balance sheet?

The loans on the balance sheet because they are the older loans probably have lower floors than the commitments on average.

Got it. Okay. Perfect. And then separately, I saw you launched a new loan syndications desk and reduced the whole limit, would you consider reducing the whole limit further in the future? Or even if you don't reduce the aggregate whole level, does this give you the opportunity to be a little bit more flexible syndicating smaller loans in the future?

We have no plans or thoughts or discussions about reducing the whole limit further and have not had any discussions about syndicating any of our RESG loans that are smaller than that. This simply reflects the fact that as we've talked about extensively for a number of quarters and actually a couple of years now. We're focused on more diversification within the portfolio. And less concentration risk. Obviously, when you've got a big credit out there, it creates an environment where people can make better target and spin a story that may have no foundation and basis in fact, it may not be completely accurate but still create a lot of drama about a single credit. And we just decided that wasn't worth the headache of having to deal with that sort of crap, honestly. And we've only had five loans in our history that were above $500 million. We only have two now. We've grandfathered those two. So it's not going to be a material impact on our business to do that and actually, probably opens up the door for us to do more loans. There are loans that we have passed on in the past that were too big for our whole limit that would now be in the strike zone for us to syndicate. So I may let our syndications desk, our capital market desk, as part of our corporate and institutional banking group, and it is a new part of that. So Jake, if you would take just a minute and give a few sentences on what that desk is and what else it does other than potentially syndicating RESG loans.

Right. I appreciate that, George. And good color and good question. The loan syndications group and the desk falls underneath loan syndications and corporate services within the CIB, which is a relatively new business line, and candidly something we're very excited about. Our loan syndications desk is fully functional. This allows the bank to now serve as admin agent and lead opportunities. And as you all know, with coming in leading opportunities, results in additional typically fee income and potentially spread skimming, on multibank deals. And so we view it as an overall benefit. It allows us to George's point, have more levers to pull, so we can chase larger deals if we want to and then sell them down in a very credit minded way and as well as pursue more syndicated opportunities across the bank as needed. Aside from the syndications desk that I mentioned, and again all this rolls up to Tim Neuhaus within our LSCS. We've also launched an interest rate hedging desk. And so the bank has historically pushed-off all of our hedging opportunities, whether those are caps or swaps or other derivative instruments to a third party. We now have the opportunity and the abilities and capabilities to handle those in-house through a desk that we've stood up. And so that, combined with our addition of permanent placement solutions where we can now assist our real estate clients in accessing other sources of capital when they decided to go permanent. So placing those with institutionals with REITs, et cetera. Those expanded capabilities under LSCS, we are very excited about. We view it to be, again, a step in the right direction for diversification for the bank. It allows us to chase additional clients, but it also allows us to keep our eye on over time, continue to improve our additional fee income for the institution. So excited about and what Tim Neuhaus and his team has brought to the bank for us.

Thanks, Jake.

Great. I appreciate it, holistic response. Thank you.

Thank you. One moment for our next question. Our next question comes from the line of Matt Olney of Stephens. Your line is now open.

Hi, thanks for taking the question. Want to ask about credit quality, and I guess specifically, the Chicago land loan that drove the higher charge-offs in the quarter. I think you've been winning on that sponsor to recap the project. So just any more color on these efforts that ultimately drove the action to charge down a portion of the loan and move the remaining portion to the non-accruals?

Thank you for the question, Matt. Our sponsor is still actively engaged, and we are currently in talks with them about increasing reserves to give them more time to address the situation. These discussions are ongoing, and I won’t elaborate further at this moment. However, our patience with the sponsor's progress is waning. While they are putting in serious effort, the progress has not been as fast as we anticipated, especially since we expected a resolution by the end of the third quarter. Because a resolution hasn’t been reached yet, we decided it was prudent to write down the asset due to its previously high appraised value. We had already set aside reserves, and the reserve we hold now, along with the charge-down we took, is approximately equal to what we had last quarter. So, it doesn't significantly alter our credit allocation; it simply reflects the slow progress by moving it to non-accrual status. Regarding asset quality, we see this quarter as positive in terms of improvement. In Los Angeles, our large OREO has had the sponsor pay an additional $1 million to extend their contract for the third consecutive quarter, totaling $3 million in earnest money. The updates indicate they are making good progress with city entitlements related to the project. Each additional fee reinforces our belief that the likelihood of closing that transaction next year is increasing. For our Arts District building, which we put on non-accrual earlier this year and wrote down by $9.3 million, the sponsor has continued to make payments, adding nearly $1 million in paydowns last quarter. While we don't anticipate further paydowns, the sponsor is still engaged and has the property under contract at a price that should fully pay off our loan and potentially recover our previous write-off. This is significant progress. It’s noteworthy that the sponsor's equity in this project is depleted, and they are continuing to work towards a successful sale, solely to fulfill their obligations. This demonstrates the integrity of many of our sponsors. All three other classified loans in the RESG portfolio have also seen payments and progress, which we believe reflects positively on our asset quality this quarter.

Thanks for the details on the RESG credit. I would like to switch topics to loan pricing. I think it was mentioned earlier, but I would like more information on how loan pricing at RESG stacks up against CIB loans. I understand there are different segments within CIB, but could you provide an average comparison? I'm interested in how these spreads measure up to those at RESG.

Well, the loan pricing in RESG, and we've talked about this a number of times, is our RESG loan spreads are going to be higher in the vast majority of cases than the pricing in our corporate and institutional banking group clients. But with that said, our CIB loans come with treasury fee opportunities, collateral inspection fee opportunities, unused fee capabilities. And there are various other fees and benefits, including deposits and other cross-sell opportunities that come with those CIB loans. So when you look at the required capital allocations for the different loans, I think your return on equity numbers are not materially different between RESG and CIB. Our RESG loans require us to hold some ambiguous amount of additional capital because of our CRE concentration. We obviously, on our CIB loans can be more capital efficient as well as taking advantage of the deposit opportunities that are more prevalent than significant with the CIB loans and the other fee and cross-sell opportunities that are more significant. So net-net, I think you are coming out to about the same return on equity on those lines of business, if you properly run both of them as we expect to do.

Thanks for taking the question.

All right. Thank you.

Thank you. One moment for our next question. The next question comes from the line of Catherine Mealor of KBW. Your line is now open.

Thanks good morning.

Good morning.

I noted in your loan outstanding chart, there was a shift out of construction and land development and into the non-farm non-residential more than we've seen in past quarters. Just curious what drove that shift? It was just a reclass or if there's any kind of change going on there?

Brannon, do you want to take that one?

Sure. Sure, Catherine. As we said earlier, there are really two criteria for moving from construction or moving out of the construction category. One is projects complete and has a certificate of occupancy and the loan structure includes a monthly amortizing feature. And so we talked about significant originations back in '22 and before and those are starting to move through the completion process.

Okay. Great. So that wasn't a reclass. That was just the natural process of those loans moving.

Correct.

And then would those be the loans that you could theoretically think would be at higher risk of paying down as rates continue to go down.

Yes. I would say that's certainly true. As I mentioned earlier in response to a previous question, it's not unprecedented for a loan payoff mix construction, but the normal mindset of sponsors is to look at bridge or refinancing opportunities when a project is completed. So I think you're thinking about that correctly as these mature and migrate from an active construction to a post construction phase and particularly as amortizing payments kick in those are things that promote sponsor to look at their opportunities to refi that.

As you consider the loans that have transitioned into the CRE category from construction, is there a greater focus on cash flow analysis compared to just loan-to-value ratios when evaluating risk ratings, or is the analysis consistent?

The analysis definitely evolves after construction is complete. While it doesn't drastically change, there’s a stronger focus on sales performance, leasing activity, and market dynamics. These aspects all contribute to our risk assessment. However, as we've discussed in past calls, just because a project isn't leasing as quickly as anticipated doesn't mean it's problematic. It might become a concern if the sponsor isn't committed to supporting the project. We've provided substantial data showing our sponsors' history of investing additional funds, covering extensions, renewals, rebalancing reserves, and making principal paydowns. Sponsor support is crucial in our decision-making process. If we’re confident that our sponsors will protect and manage their assets throughout a prolonged leasing period, we don't classify it as a credit issue. It may be costly for the sponsor, but it doesn’t pose a problem for us, and we have seen strong backing from our sponsors for their projects.

Okay, great. I have a follow-up regarding your bubble chart. You provided some disclosures on your special mention loans, and I noticed there are four in that category. Three are clearly visible in the bubble chart, but one is associated with a much larger bubble, making it difficult to discern its credit type based on size. It appears to be a substantial credit. Can you offer any insights regarding the size and type of that credit?

Catherine, I'm not going to talk about the special mention credits. They're not as you and I had a conversation, I think, about three months ago on this subject. And as I told you then, our special mention credits, we don't view as problem credits. And when we talk about credits, that's an unfair invasion of our customers' privacy and so forth. So we give extreme details on our substandard credits. And I think we are very transparent about everything going on in the portfolio and give a lot of information you've got to draw the line in some place and getting into detailed information on those substandard credits is just not fair and appropriate for our customers.

I understand. I was hoping you could provide a bit more disclosure regarding Figure 31. While we don't need specifics about its location, knowing the size and perhaps the type of credit would be beneficial since it's not very clear in the bubble chart.

Given you.

I appreciate that.

Yes. We've given you because we got some questions about it last quarter, we've given you the Appendix B information that gives you property types and the breakdown of the portfolio between the past special mention and substandard. This is data that's previously been in our 10-Q and Annual Report. So we had some questions about it. So we went ahead and put that in Appendix B that's on Page 43 of the management comments. So I think you've got the information you need on that page as to the breakdown of special mention credits.

Oh, I see that. That's helpful. I see that now. Thank you, George.

I think that addresses what you're looking for.

Yes, it definitely does. It does. On this Appendix B. Thank you for that. All right. I appreciate it.

Thank you. One moment for our next question. Our next question comes from the line of Michael Rose of Raymond James. Your line is now open.

Hi, good morning everyone. Thanks for taking my questions. Just on the CIB build out, is there any sort of deposit opportunity there? I assume that there would be? And maybe if you could quantify what you'd expect that to be kind of over time? And I know it's going to depend on the different types of loans, verticals, things like that. But any way to think about that or size it? Thanks.

The answer Michael, is yes, and I'm going to ask Jake Munn if he would provide a little color on that and how they're thinking about that and approaching that. So Jake, you up to another question?

So I'm up for it. I appreciate it, George, and good question at that. If we look across the CIB, there is obviously certain verticals that are going to be more deposit-rich than others, just given the inherent nature of what they do and the customers they provide. If we are looking at working capital intensive customers that we'd find underneath Mike Sheff's ABL team, for instance. We would anticipate smaller deposits there simply because they typically are on suites, right? And so there's paydowns, their associated debt on a reoccurring basis. If we look across the board to Equipment Finance and Capital Solutions, which Jim Lyons runs at a little rock and does a fantastic job at. We do see a healthy amount of deposits there. And Jim and his team continued to push hard to generate additional opportunities, as it relates there. As it relates to our newest vertical, their corporate banking and sponsor finance, that's where you're going to see a good amount of depository growth. These are bread-and-butter C&I clients located across. Our footprint and associated with our footprint, public companies, private companies, sponsor-backed companies, and it's a mix of both asset-based type lending as well as enterprise value lending. And so with this vertical, that's coming online, and you all are just getting a little bit of a taste of initially. We also anticipate great growth kind of in the similar footprints of ABLG and EFCS. That vertical typically has a little bit better yield to answer some of his prior question. And so we typically see spreads 50 to 100 basis points in excess of the other verticals that I mentioned, which is nice. But in addition to that, these are typically companies that are very low levered and they have a little bit more cash on their balance sheet. And OZK has a fantastic treasury management platform underneath Mr. Jessup. And as a result, we're starting to see a lift in deposits within the CIB. These verticals are not necessarily intended to ever be a 1-to-1 self-funded vertical by any means, but we're starting to see some steady lift there. And over time, for instance, within CBSF, I would foresee tracking closer to a 30% self-funded ratio with that business as they continue to come online and build out.

That's great color, very helpful. I appreciate it. Just as a follow-up, as you guys do kind of shift the loan book and I think the target is to get RESG to about 50% of total loans over the next couple of years. Can you just talk about what that could potentially mean from a credit standpoint? Obviously, other verticals are going to have and other silos are going to have higher kind of default frequency, and severity versus what we've seen with RESG, which is really just a handful of losses over a very long period of time. Is there a way to kind of think about that? Obviously, the economy is in a good spot, but I think some of those other verticals would be a little bit more economically sensitive and given the shifting mix. Could we expect to see a little bit higher, just kind of run rate just generally speaking of non-performers and charge-offs as we move forward? Thanks.

Michael, I appreciate the fact that you mentioned and acknowledge the outstanding long-term history of our RESG portfolio quality. As you look back over the years, RESG has had a lower net charge-off percentage than any of our other verticals in almost every period since we went active with RESG back in 2003. So it is a great track record, and it is certainly contributed to our consistent below industry average charge-off ratios every year. So I think you are right in that other business lines will have a somewhat higher net charge ratio, and that's true of all other business lines within OZK, not just the CIB growth. With that said, each of the guys that has come on board and Jim or Jake mentioned, Jim Lyons and Mike Sheff, who run a couple of those units and have run them for several years for us. These guys were attracted to OZK and we were attracted to them because they share that same philosophical ban on high credit quality. Credit quality is paramount, probability is secondary and growth is tertiary sort of mindset that is just at the core DNA of Bank OZK. So I think the net charge-off ratios that we'll experience from each of those units that we are building in corporate and institutional banking. And the same philosophy runs through Alan Jessup and Ken Ronecker and Dennis Poer's business units and Commercial Banking and ILD. I think that same commitment to excellence in asset quality and making that priority number one, profitability priority number two, and growth is totally a tertiary consideration. It means that you just don't do things that don't meet your credit standards. And that discipline is why over our 27 years as a public company, we beat the industry's charge-off ratio every year averaged just about one-third of the industry's charge-off ratio. And if RESG is 50% of the book as opposed to 64% of the book yes, charge-offs might be a couple of basis points higher, but that fundamental culture of asset quality is always paramount, always the focus should continue to keep us at roughly one-third of the industry's charge-off average. So that's our goal, and that's our expectation.

And real quick, echo George's sentiment there specifically to the CIB. If you look at the types of opportunities that we are pursuing. It's really relationship focused, and that's where we are getting the yield and the cross-sell I mentioned, but it's also relationship focused and a very similar like to RESG, where we understand management's visions, we understand the underlying sponsors. We've looked at these deals. We understand them. We are not chasing exotic sectors. We're being very picky and choosing our plays, if you will, of what industries we want to dive into that have better risk profiles that suit OZK's credit-first philosophy. In addition to that, if you look at our ABL lending, for instance, a lot of institutions out there, their ABL book is chock-full of distressed assets or quasi-distressed assets. That's not the case for our ABL group. We focus on high-quality, larger-scale ABL deals where they are not distressed ABL. Same can be said for our CBSF. If you were to look at the leverage points on those opportunities we are pursuing, or the LTVs or LTEVs, I should say for our enterprise value deals. We have not onboarded any leverage loans to that group, and we don't intend to do so either. And so lower leverage points, better quality sponsors and we’re picking our plays. That's very helpful. I appreciate the detailed answer. I'll step back. Thanks.

Thank you. One moment for our next question. Our next question comes from the line of Brian Martin of Janney. Your line is now open.

Hi, good morning everyone.

Good morning Brian.

Hey George, I just wanted to follow up on a previous question regarding the transition from RESG to CIB. How should we approach the topic of provisioning as we move into these different business units? You've mentioned before how well RESG has performed over the years compared to CIB. Given Jake's comments about the high-quality relationships and low leverage at CIB, it seems there might not be much difference in our perspective on provisioning based on what has been discussed.

That's a great question. We model every loan and apply our various macroeconomic models and scenario selections to determine an appropriate allowance for credit losses for the entire portfolio each quarter. We will continue this process. In the current environment, our commercial real estate customers are facing challenges due to higher interest levels, especially over the past couple of years. Consequently, we have increased our reserve allocations and allowance for credit losses for commercial real estate loans compared to historical levels, reflecting the more difficult circumstances for our sponsors. We've nearly doubled our allowance for credit losses over the past nine quarters from $300 million to almost $600 million. As interest rates decrease and the stress in commercial real estate eases, I expect we'll be able to reduce some of the reserve allocations for those loans. We will continue to set appropriate reserves for corporate investment banking loans based on a detailed analysis of their quality and market conditions. While I can’t say for certain if these reserves will be higher than our historical reserves in stable times, it will depend on the performance of those individual credits. It's possible that there may be a modest increase in the allowance for credit losses associated with those loans over the long term. In our corporate investment banking loans, we have clear collateral backing, which is easier to assess compared to more complex enterprise values or transient assets. We are structuring these loans conservatively, applying the same credit quality standards that have resulted in positive outcomes in our residential and specialty lending division. Therefore, I don't anticipate a significant difference in this regard, just a slight variation.

Got you. I appreciate the insight. I have a couple of quick questions. Regarding the scaling and development of CIB, can you share your vision for the next three to five years? Specifically, how do you see this business contributing to OZK, and what are your expectations for its future growth?

Well, I'll just say what we've said a number of times and maybe give a little additional color. It is near its peak. RESG was about 70% of our funded balances. It is at the end of the last quarter was 64%, it rounded up to 64%, it was like 63.55%, I think. And we expect RESG to continue to come down, not that we expect those balances. So as I said, we are probably going to be more or less flat on funded balances over the next year because we're going to take this hit from this payoff wave. It's going to keep RESG from growing. And during that period of time, I think we see these other lines of business. And again, it includes our commercial bank and our ILD businesses not just CIB. CIB is a big part of it, and we'll probably grow faster than the others, but these other units are going to be big parts of what we do as well. So I think we will get to a period of time, even having our RESG grow, as much as it can grow and do every deal that meets our RESG standards I think over two or three years, we'll get to a point where RESG is less than 50% of our total outstanding book. Maybe and probably will be bigger than it is today, but it will be less than 50% of our book because these other units will make big growth contributions. So our guys there understand the strict credit standards they've got to adhere to. They completely embrace and agree with those standards. But we've got high-performing teams over each of these verticals in CIB, as well as our commercial banking and indirect lending units, and those guys see lots of opportunities for us to grow out there.

Perfect. Okay. I appreciate that, George. For my last question, Tim, could you briefly revisit your discussion on the best-case and worst-case scenarios regarding rate movements and their impact on margins? Specifically, could you highlight where you see the greatest potential for a margin rebound?

Yes. Our comments and guidance provided in the document are based on the assumption that the Fed will increase rates by 25 basis points over their next six meetings. If they proceed more slowly, it would create a favorable situation for us. Conversely, if they raise rates more quickly or by 50 basis points, it presents a more challenging environment. While the initial quarter may be tough, it could improve later on. Our established thresholds will begin to be significant in these situations as shown in the chart we shared. The timing for repricing our interest-bearing deposits will also depend on the Fed's actions.

Okay. I understand. Tim, you mentioned the buyback in the slides. Could you share any updates on your outlook for M&A today or how you are currently viewing that?

No change. I mean there is not a lot of activity from the traditional M&A standpoint at this point. I wouldn't be surprised if that kind of opens up next year, we'll be active in looking at opportunities, but we've got such a great track record with our organic growth and the momentum we've got with CIB. We don't want to do anything that's disruptive to that organic growth that we've got. But we are very interested in growing our bank. And if there’s an opportunity that fits our very disciplined M&A strategy, that’s something that we would – something that we would look at.

Perfect. Thanks for taking the question guys.

Thank you. One moment for our next question. Our next question comes from the line of Samuel Varga of UBS. Your line is now open.

Hi, good morning.

Good morning.

I wanted to ask about deposits briefly. You mentioned the branch extension plans by the end of 2025. Do you have specific deposit production targets for those new branches? Also, which areas are you considering?

Thank you for the question. We do not have a specific deposit target for each new branch when we open them. We have a general understanding of the market opportunity when we choose locations. Our selection is based on various factors, such as filling gaps in the market where our customers want us to be, improving our presence in low to moderate income areas, and other considerations. While we have expectations for each branch's performance, these vary by location. Overall, as mentioned in the management comments, we anticipate roughly 10% growth over the next 18 months. The timing of this growth depends on factors like site entitlements, construction schedules, and regulatory approvals. Generally, we expect branches to generate between $20 million to $50 million in deposits, though this is highly dependent on the specific market conditions of each branch location.

The branches we're looking at adding are within our existing states of Arkansas, Texas, Tennessee, Georgia, Florida and North Carolina. So we are not looking at any branches outside of those six states at this time. And as we said in the comments, we would expect that branch network to be up plus or minus 10%, roughly 10% between now and year-end 2025. So our $230 million number would be $250 million, $255 million something in that range, would be where we would expect our branch count to be. It takes a while to get a branch to build a significant customer base, you just don't open it and get to a full capacity in a year or six months. It's a long-term process. So these branches, we're adding are primarily expected to support our deposit growth needs in '26, '27 and '28. They are not going to have a meaningful impact on deposits next year. We'll continue to achieve that growth we need through our existing network. But these will be important to our growth numbers three to six years out.

I'll add some color about the geography that the biggest concentration of the new branches is in Texas. So those branches are in higher population areas and presumably would have a much higher deposit opportunity long-term than some of the ones that we're opening and smaller areas in North Carolina and Georgia, for example.

Thank you both for the insights on that. My final question is about fee income, which hasn't been a major part of our revenue, but you've mentioned several factors like the syndication desk, the hedging desk, and treasury management events. I would like to understand your thoughts on the potential run rate or ramp for these, as they appear to be significant new opportunities.

Yes, we are not providing any forward guidance on that, but I can say that over the course of 2025, we expect a positive trend. I want to be cautious about quantifying this. Earlier this year, we launched a mortgage business that had been in the planning stages for a year or two. We are pleased with the initial results. The necessary infrastructure is in place, and they began taking applications around the end of Q1 or the beginning of Q2. We are currently incurring several hundred thousand dollars in quarterly losses due to startup infrastructure and headcount costs, which exceed revenue. However, we are starting to see a significant increase in origination volumes. We have an internal projection that we will not share, but it indicates a favorable trajectory for that business to become profitable next year and contribute to net income. Jake provided some good insights regarding their syndications desk and the interest rate swap hedging aspect of that business, along with other elements in the capital markets that may generate attractive fee income opportunities. It is still early for us to quantify or project those, but we are hopeful and cautiously optimistic that both the mortgage and capital markets desk will become valuable contributors to fee income. We have invested significant resources in enhancing our trust and wealth business. Although it’s currently a small segment for us, we anticipate steady growth leading up to year-end 2025, which will also contribute. We have several initiatives that haven’t received much attention in public discussions because they are either new or smaller, but I believe that in three to five years, we will view them as important components of our business.

Got it. Thank you George for all the color. Appreciate it.

All right. Thank you.

Thank you. One moment for our next question. Our next question comes from the line of Timur Braziler of Wells Fargo. Your line is now open.

Hi, good morning. Circling back to Catherine's question around construction loans going into permanent financing. I'm just wondering, are those going from variable to a more typical perm kind of 5/1 type structure? Are those staying on as variable? And then I guess, historically, OZK didn't seem to do much of their own permanent finance or the construction book, as those loans tended to get refied out kind of three years into the construction process. I'm just wondering this change is this more indicative of what's going on in the broader kind of secondary market for these loans? Or is this more inclined of clients waiting maybe to refi into something at a less punitive rate.

No, it is none of the above. We're not converting from variable to fixed. They're all with the same exact variable rate loan structure and minimum interest structure and so forth, they had as a construction loan. We're not re-leveraging the loans or extending additional credit to the customers. And the permanent loan opportunities or the bridge loan opportunities that are attractive to our customers, most of the time, not all the time, but most of the time are at substantially higher leverage points than our loans, sometimes as much as 200% or 225% of our loan amount. So we are certainly not a permanent loan solution for a customer that's going to come out of our loan and go into a permanent loan on the same asset at 150% to 225% of our loan amount. So that's just not our business. With that said, one of the elements of our CIB capital markets group is the ability for a fee to place permanent financing for our sponsors. This is a piece of business we have never tapped. And we would not be the lender on that. But we do have relationships with those customers and our CIB group believes that we can capitalize on the existing relationships we have with our customers and the ability of our team and experience of our team in placing credits on a bridge or permanent financing market to help our customers arrange that refinancing and generate some good fee income in the process. So that is an additional part of that capital markets desk that could become a nice contributor to profitability in the future.

Great. Thanks. And then as a follow-up, the comment about reducing the hold limit on newly originated loans to $500 million, the placement of that in the paragraph and talking about CIB, I think would imply that maybe you're seeing some larger credits coming through that portfolio or you are expecting to see some larger credits come through that portfolio. I mean that's a really competitive space. It seems like right now with private credit and everything else. I guess what's the typical deal size that we should expect to see out of CIB? And then just I know you've touched on it a little bit through the comments already, but just what's the competitive advantage that OZK is bringing to the space and maybe some of these other private players don't have or aren't willing to do?

Jake, do you want to talk about the relationship and the relatively diverse deal size we are looking at?

The average relationship size varies by business line. For our ABL G group, relationships are typically between $50 million to $150 million. In similar fund finance and our corporate banking and sponsor finance group, the loans tend to be smaller. For instance, last quarter, we averaged a hold size of about $50 million. Our CBSF group generally holds around $30 million to $75 million per transaction, but we can go higher if we are acting as an agent for a larger syndication. On the commercial and industrial side, we focus on balancing our bank's commitment with capital commitment and aiming for the best overall yield. Many of our additional yields come from strong cross-selling opportunities. We've upgraded our treasury management platform, which is beneficial for our institution, and we offer a range of services from interest rate hedging to private banking for our clients. This comprehensive approach helps us build strong relationships that many other institutions lack. As Mark Simoes often mentions, we can outperform national banks in local markets and vice versa. We have the products, services, capabilities, and credit resources to compete effectively with larger institutions while remaining agile and competitive against local and regional banks.

Thank you. One moment for our next question. Our next question comes from the line of Ben Gerlinger of Citi. Your line is now open.

Hi, good morning everyone. Just curious how you guys think about some of the more stressed pockets of commercial real estate, specifically something like life science or office? I mean Joe put a report recently that said that the life science market, if you assume no new supply could take up to five years. Is there anything that we should be looking at in terms of like your sponsors that you might be putting more ACL towards those specific loans in general? Or how you guys are approaching just the credit standards of more stressed pockets of construction?

Ben, the core of our portfolio lies in its design around high-quality assets with strong sponsors, ensuring robust support from sponsors in most instances. Despite the recent re-appraisal process in a setting where cap rates have increased and property values have decreased, our overall weighted average loan-to-value ratio for the entire RESG portfolio remains at 51%. The loan-to-value ratio is at 43%, while the loan-to-cost ratio is at 51%. These low leverage points indicate that our sponsors and their capital partners have a significant stake they need to protect. If you own a low-yield office building from several decades ago that lacks potential, you might hesitate to safeguard your investment even if you've contributed half the capital. Conversely, if you possess a high-quality, modern property built to contemporary standards, which is likely to be leased or sold, you will have a strong motivation to safeguard that asset. The low leverage of our properties, combined with the fact that most of our loans are tied to new construction, means that our sponsors are generally highly motivated to protect those assets. We've observed numerous sponsors paying down loans when appraisals indicated a higher loan-to-value ratio, putting additional reserves for extensions, and paying fees for the same. Overall, our sponsors have shown a strong commitment to protecting these assets. The quality of the assets and the caliber of the sponsors are the primary differentiators for these loans, and we are confident in both aspects across our portfolio. Consequently, even with a substantial concentration in commercial real estate, we've seen solid performance during this period of rising rates following the COVID pandemic and other challenges in the sector, thanks to our strong sponsors, quality assets, and the motivation of sponsors to engage with these assets over the long term.

Got you. And then in the prepared commentary, you guys gave some remarks towards NII for 2025. And then with the presumed paydown and payoff of your RESG portfolio, I know you guys front-load some of the early payoff fees and all those break things. So it temporarily boost net interest income that you market on that day. Is that included within your NII outlook?

Yes. Our NII outlook includes everything that would normally be under GAAP accounting calculated as part of net interest income. It is all in accordance with GAAP accounting.

Got. Okay, appreciate it. Thanks.

All right. Thank you.

Thank you. I'm showing no further questions at this time. I would now like to turn it back to George Gleason, Chairman and CEO, for closing remarks.

All right. Thanks, guys. Thanks for all the great questions. Thanks for your interest in Bank OZK. We look forward to talking with you and reporting some good fourth quarter results in about 90 days. Thanks so much. Have a good one.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.