Western Alliance Bancorporation Q2 FY2022 Earnings Call

Good day, everyone. Welcome to Western Alliance Bancorporation's Second Quarter 2022 Earnings Call. You may also view the presentation today via webcast through the company's website at www.westernalliancebancorporation.com. I would now like to turn today's call over to Miles Pondelik, Director of Investor Relations and Corporate Development. Please go ahead, sir.

Thank you and welcome to Western Alliance Bank's second quarter 2022 conference call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; Dale Gibbons, Chief Financial Officer; and Tim Bruckner, our Chief Credit Officer. Before I hand the call over to Ken, please note that today's presentation contains forward-looking statements which are subject to risks, uncertainties, and assumptions. Except as required by law, the company does not undertake any obligation to update any forward-looking statements. For a more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements, please refer to the company's SEC filings through the Form 8-K filed yesterday which are available on the company's website. Now for opening remarks, I'd like to turn the call over to Ken Vecchione.

Thanks, Miles. We had solid performance this quarter as the company passed the $66 billion asset milestone, and the strong earnings power of our diversified asset-sensitive business model was on display even as we remain keenly focused on the economic uncertainty around us. For the second quarter, WAL generated total net revenues of $620 million, net income of $260 million, and EPS of $2.39. Record earnings were propelled by accelerating net interest income quarterly growth of $75 million, or 17%, from the prior quarter to $525 million as the rising rate environment expanded our net interest margin 22 basis points to 3.54%. Interest income rose three times faster than interest expenses, inclusive of deposit costs and ECRs. We maintain industry-leading performance with return on average assets and return on average tangible common equity of 1.62% and 25.6%, respectively, which will continue to support capital accumulation and strong capital levels in the quarters to come. Balance sheet expansion continued with quarterly organic growth of $5.3 billion, or 52% year-over-year, excluding the $1.9 billion of loans transferred from held for sale to held for investment, which was done to avoid income volatility from rising rate bonds. Dale will speak to this later. Deposits rose by $1.6 billion, or 28%, from the prior year as we continue to effectively attract and deploy liquidity. Loan growth was broadly diversified this quarter, with regional banking divisions contributing 16% of organic growth or $863 million, our specialized national business lines adding 55%, or almost $3 billion, and residential loans composing 28%, or $1.5 billion, excluding the held-for-sale transactions. Deposit growth trailed loan growth in our $2 billion guide as a few large customers were pushed to July. Mortgage banking-related income modestly declined by $5.4 million as the mortgage origination market continues to face headwinds from higher rates, affordability issues, and inventory constraints. We believe the rationalization of the mortgage sector will take time, but we have already positioned AmeriHome to profitably operate in a lower origination market and to unlock value as a bank-owned mortgage business by attracting custodial deposits and deploying liquidity into low credit risk loans. Finally, asset quality continues to remain stable as total nonperforming assets declined $6 million to 15 basis points of total assets, and net charge-offs were only $1.4 million. We are cognizant of the macro uncertainties and possibly more difficult credit environment in the future, but we have deliberately positioned the portfolio to withstand these pressures through credit-linked notes issuance, government guarantees, and cash collateral that now cover 27% of our portfolio. In addition, another 33% of our loans are in low-to-no loss loan categories. At this time, Dale will take you through our financial performance.

Thanks, Ken. For the quarter, Western Alliance generated net income of $260 million, EPS of $2.39, and PPNR of $351 million. Total net revenue was $620 million, an increase of $64 million during the quarter and $114 million, or 22%, year-over-year. Net interest income increased $75 million to $525 million during the quarter, driven by robust loan growth and the impact of higher rates on the margin. Overall, noninterest income declined $11 million to $95 million from the prior quarter, driven primarily by a $10 million loss on mark-to-market adjustments for preferred securities as credit spreads widened and lower mortgage banking-related income, which fell $5.4 million during the quarter to $72.6 million. This decline was partially offset by a $9 million gain on credit recoveries related to credit linked notes sold during the quarter, which is reported in noninterest income as really a contra expense to the provision for credit losses using the same CECL methodology. Finally, noninterest expense increased $20 million in the quarter, resulting in an efficiency ratio of 42.8%, primarily due to higher deposit costs from earnings credit rates as rates rose and processing expenses from a larger balance sheet. All in all, net revenues grew three times out of the increase in expenses. Turning on to our net interest drivers. Our growing asset-sensitive balance sheet benefited from the rising interest rate environment. Investment yields increased 17 basis points from the prior quarter to 2.94%. On a linked-quarter basis, loan yields increased 21 basis points to 4.19%. Loans held for sale also benefited from rising mortgage rates and increased 85 basis points to 3.99%. Funding costs were higher, with interest-bearing deposit costs increasing 17 basis points to 0.37%, while balances grew $1.4 billion. Total cost of funds increased 11 basis points to 0.38% as the rate and utilization of short-term borrowings increased, as loan growth exceeded deposit growth. Net interest income increased $75 million during the quarter or 17% annualized to $525 million as average interest-earning assets grew $4.5 billion and NIM expanded 22 basis points to 3.54%. To put our asset sensitivity into perspective, our total funding costs, inclusive of ECR expenses, only grew 30% of the $95 million increase in interest income for the quarter. After recent Fed actions to rapidly increase interest rates, we continue to remain materially asset-sensitive since our variable-rate loans moved above their floors. Given that the Fed has increased rates by 125 basis points since last quarter, a proportion of variable-rate loans after floors is now only 16%, down from 80% in Q1. Based on expectations of an additional 75-basis-point rate increase by the Fed next week, nearly all of our loans will be at variable rate at that point in time. In a rate shock scenario of 100 basis points over 12 months in our static balance sheet, net interest income is expected to rise 5.3%. Using the same scenario on a growth balance sheet, we expect NII to grow over 25%. Under a plus 200-basis-point rate shock scenario on a static balance sheet, net interest income is expected to decline by 10.8% in the coming year, and over 40% if that rate environment were to materialize when balance sheet growth expectations are also incorporated. Our efficiency ratio fell to 42.8% from 44.1% in Q1 due to rapidly increasing net interest income. Non-interest expenses rose $20.3 million, or 8%, during the quarter, primarily due to an $8.8 million increase in ECR-related deposit costs on noninterest-bearing deposits and higher loan servicing and data processing expense from a larger balance sheet. Total deposits subject to ECRs were $14.5 billion at quarter-end. We expect our efficiency ratio to remain in the lower 40s for 2022. Pre-provision net revenue was a record $351 million during the quarter, a 34% increase from the same period last year, an increase of $44 million, or 14%, quarter-over-quarter. This resulted in a PPNR ROA of 2.19% for the quarter, an increase of 9 basis points compared to 2.10% in Q1. Despite our strong balance sheet growth and volatile rate environment, our PPNR ROA has remained quite stable over time. Strong balance sheet momentum continued during the quarter as loans held for investment increased $5.3 billion, net of the HFS HFI loan transfer, or 13% to $48.4 billion, and deposit growth of $1.6 billion from balances back to $53.7 billion at quarter end. As Ken mentioned, during Q2, we transferred $1.9 billion of government-guaranteed early buyout residential loans from held for sale to the held for investment portfolio to eliminate the mark-to-market volatility of HFS loans. Since these loans are targeted to re-perform or roll off the balance sheet in various forms of liquidation, they have significantly lower duration than other mortgages. Mortgage servicing rights balances declined $124 million in the quarter to $826 million as we optimize capital through certain MSR portfolio sales. Total borrowings increased $4.4 billion over the prior quarter to $6.1 billion, primarily due to an increase in short-term borrowings of $3.9 billion and issuance of $494 million in credit-linked notes, providing first loss credit protection on a pool of $2.2 billion in capital call loans and $3.9 billion in residential loans. Finally, tangible book value per share decreased $0.46, or 1.2%, over the prior quarter to $36.67, primarily due to unrealized fair value losses on available-for-sale securities recorded in all other comprehensive income. Tangible book value per share increased by 11.6% year-over-year. We continue to generate attractive organic loan growth from our flexible commercial business strategy and see broad-based loan demand between our regional banking divisions and national business lines. Loans held for investment grew $5.3 billion, driven by an increase in C&I loans of $2.9 billion as demand for capital call lines and regional banking remains strong, contributing $1.1 billion and $863 million to growth, respectively. Commercial real estate loans grew $969 million, and residential grew $1.5 billion, representing 28% of loan growth, excluding the EBO transfer during the quarter. We expect residential loans to remain at this lower proportion of loan growth going forward than it has been historically. Turning to deposits. We continue to see growth across our diversified channels that will generate stable, low-cost funding in different rate environments through deep-rooted banking relationships with our clients. This quarter, our specialty deposit non-national business lines drove most of the deposit growth, while regional banking divisions were flat. In total, deposits grew $1.6 billion, or 11.9%, annualized in the second quarter, driven by increases in term CDs of $760 million, interest-bearing deposits of $592 million, and noninterest-bearing DDA of $201 million. Noninterest-bearing accounts comprised 44% of our total deposit mix. Our specialty deposit franchises continue to provide ample opportunities to generate attractive funding to support loan growth, with deposits from warehouse lending higher by $520 million, HOA up $219 million, and settlement services up $135 million. Going forward, we expect deposit growth to more closely match our loan growth as Q2 was impacted by a few deferrals of new deposit relationships to the current quarter. Our asset quality continues to remain strong, and total classified assets and special mention loans as a percentage of total assets and funded loans are lower than 2019 levels. Total classified assets declined $19 million during the quarter to $346 million, or 52 basis points of total assets as the temporary impact of the overtime bearings on hotel loans continues to wane. Special mentioned loans decreased $33 million during the quarter to 66 basis points of funded loans and are at historical lows as a percentage of assets. As the economic environment continues to evolve, we believe that our portfolio is structurally well-positioned to sustain superior asset quality through cycles based on our deliberate decade-long business transformation and diversification strategy that emphasizes underwriting discipline. Our national reach and deep segment expertise enable selective relationships with the strongest counterparties, leading to profitability and superior company risk management. Approximately 56% of our loans are in low-to-no-loss categories, and 27% of the portfolio is credit protected from government guarantees, credit-linked notes, or first loss protection or in cash security. We do not currently see signs of a notable recession or credit stress, but we're prepared for these events should they arise. Quarterly net credit losses were $1.4 billion or one basis point of average loans. Our total loan allowance for credit losses increased $26 million from the prior quarter to $327 million, as the provision exceeded losses due to strong loan growth and the adjusted economic assumptions for unexpected tail risks. In all, our total loan ACLs and funded loans declined 5 basis points to 68 basis points. Adjusting for the $11.2 billion of the loans covered by credit linked notes, where ample first loss coverage is assumed by a third party, the ACL coverage ratio rises to 0.88%. Finally, given our industry-leading return on equity and assets, we continue to generate capital to fund organic growth and maintain well-capitalized regulatory capital ratios. Our CET1 ratio was stable at 9%, as our net income and risk-weighted asset reduction from credit-linked notes offset the capital necessary to support our exceptional loan growth. However, our tangible common equity to total assets fell to 6.1% this quarter, reflecting negative fair value marks on available-for-sale securities. It's notable that the TCE ratio does not consider the increased value of low-cost deposits in this higher rate environment. Inclusive of our quarterly cash dividend payment of $0.35 per share, our tangible book value per share declined $0.46 during the quarter to $36.67, primarily reflecting the adverse available-for-sale mark at quarter end. While rates have continued to rise, the rate of increase we witnessed in the first quarter and the second should subside later this year. Given our robust capital generation, we still expect that 2022 will turn out to be a year of tangible book value growth. I'll now hand the call back to Ken.

Thanks, Dale. I was very pleased with Q2's results and the management team's ability to adapt to the changing interest rate and economic environments. Loan and deposit growth was strong. Net interest growth accelerated with expanding NIM. Credit remains solid and clean, and expenses were balanced for both near-term efficiency and long-term investments. Looking forward, we expect loans held for investment and deposits to grow in excess of $2 billion per quarter. Our loan and deposit pipelines, also by client confidence, give us reassurance that our balance sheet will continue to grow in a safe, sound, and balanced manner. Net interest margin is expected to grow throughout the year, accelerating net interest income growth and driving higher PPNR. Net interest income expansion in the third quarter is expected to exceed the increase in the second quarter. Strong net interest income growth will continue to drive total revenue higher, inclusive of mortgage banking slowdown. Mortgage banking-related income is likely to more closely track changes in overall mortgage sector volumes going forward. The bank's asset quality remains solid. We are not seeing emerging delinquencies or defaults within any segment. However, we believe we are in a technical recession and are planning for a further slowdown, and are prepared for a more difficult economy if that occurs. Regarding capital, we believe our internal capital generation can support up to $3 billion to $4 billion of loan growth depending on the mix. We expect capital ratios to remain fairly stable at current levels throughout the remainder of the year. In conclusion, we continue to see EPS of $9.80 for full year 2022 as a floor from which 2023 can ascend. At this time, Dale, Tim, and I would be happy to take your questions.

Your first question comes from Casey Haire of Jefferies.

Question on the funding strategy. The borrowings up to $5.2 billion at quarter end. I know that everyone sees short term and they think it's overnight. I'm just wondering, are those one-year borrowings, what is the spot rate at 630 versus 119? And then what is the appetite? How aggressively are you going to use this going forward?

Yes. There are two items to note. One is that we have some credit linked notes included. However, about 90% of it consists mainly of Federal Home Loan Bank borrowings on a short-term basis. I believe this represents a complete beta response to our current situation. Our loan growth is also entirely in line with this beta response. I anticipate that deposit growth and loan growth will converge in the third quarter, contrasting with the gap we experienced in the second quarter. Therefore, we are confident in continuing our growth strategy. Over time, I think our reliance on wholesale funding sources may become less significant.

Okay. So it sounds like borrowings hold this level or not and potentially decline. If you could give some of the path growth side?

Yes. I think they're going to be trending lower. We have initiatives that are underway and under development on deposits that I think are going to take hold. I'm not sure we're going to see much of a drop in the third quarter. I think you're going to see more balance in loan and deposit increases.

Casey, it's Ken. We're trying to balance loan growth and deposit growth. But that's very hard to do. And sometimes loan growth gets a little bit ahead of deposit growth, in which case, we're going to use short-term borrowings if we think the loans we're putting on the balance sheet are good loans, good asset quality. So while we try to have a balanced approach, any particular quarter, we could be slightly out of balance.

Got you. Okay. And I got your comments on the NII growth exceeding the 2Q level in 3Q. But can you just give us a flavor for where asset yields are exiting the quarter, specifically spot loan yields versus 4.19% and then the HFS loan yields at 6.30% versus the 3.99% in the quarter?

Yes, we're anticipating rates to increase by about 30 basis points. However, this will be overshadowed by our expectations for next week, where we've factored in an additional 50 basis points for the September meeting. After July, we will be nearly 100% above the loan floors, which will contribute positively to the third quarter as well.

Got it. Last question for me, Ken. You mentioned that you're preparing for a slowdown. I'm curious, understanding that you are a growth company and have made commitments regarding EPS, aiming to build on that $9.80 next year. Is there a consideration to possibly be more aggressive with the ACL build in light of the expectations around credit normalization for Western Alliance?

I want to share a few thoughts regarding the ACL build. First, keep in mind that 27% of our total loans are credit protected. The figures reflected in the ACL are balanced by the fee income we gain from that. Second, many of our loans, particularly in the commercial and industrial segment, have an average lifespan of 26 months, so we won't see a significant build in that area due to the short average life. In the real estate sector, the average life is just over 3.5 years, indicating that we lack long-duration loans that would require a larger ACL or credit loss reserve. Over the past several years, we've concentrated on low loss or no loss loan segments. Reviewing our history over the last decade to compute our CECL provision shows very low numbers. This quarter, we increased the provision from $9 million to $27.5 million, despite only incurring $1.4 million in losses. Our special mention and classified assets have both decreased, which suggests we're well-positioned right now. Moving forward, the provision is likely to stay around this level, depending on loan growth. Our reaction to the pandemic and the minimal losses we faced attests to our robust underwriting strategy, characterized by low loan-to-value ratios. A good example is the hotel sector, which was significantly impacted during the pandemic with occupancy rates plummeting to the low teens. However, we experienced no losses in that portfolio because we had low advance rates and strong backing from entities with liquidity, which is a hallmark of our underwriting practices. Over the last decade, our losses have been nearly non-existent. Looking at our current loan book duration and the losses we're incurring, the reserve ratio should only need to be a single-digit percentage. Presently, we stand at 88 basis points, excluding the provisions we already have from the insurance of credit-linked notes.

Your next question comes from Ebrahim Poonawala of Bank of America.

I just wanted to follow up. One, I think a few things that you mentioned. We want to make sure we interpret this correctly. One, you expect loan-to-deposit ratio to go from 80% to 90%. You don't see that going higher given what you said about funding loans with deposits. And secondly, can you give us a sense of just the pace of loan growth when you think about the third and the fourth quarter? The residential book is now all the way up to 30% of the total loan portfolio. So I would love to hear just in terms of the pace of loan growth and the makeup of that we are hearing from others around the slowdown in capital call line lending as well. So any color would be helpful.

Yes. First, regarding the loan-to-deposit ratio, if we successfully balance loans and deposits each quarter, around 90% seems like the appropriate level. However, there may be certain quarters where this balance could shift slightly, resulting in that number increasing or decreasing a bit. For instance, in Q1, we experienced $4 billion in deposit growth, which outpaced loan growth. Therefore, it's likely to hover around 90%, but don't be surprised if it occasionally rises a bit above that. Regarding your second question, what was that again?

Just the pace of loan growth and the makeup of loan growth now that mortgage has hit 30% target that you had?

Our loan pipeline is very strong. We're focused on credit commitments that align with our typical approach, without trying to take market share from others. The loan growth we anticipate is consistent with our historical practices, primarily coming from capital call lines and our new entertainment and media business line. National business lines are also showing solid pipeline growth across all regions. This gives us the opportunity to select high-quality credits for our balance sheet. I expect loan growth to reach at least $2 billion, with the portion of residential loans likely decreasing to around 25%.

Got it. So let's say about 25% of that growth. On a separate note, regarding the core expense outlook, you mentioned that a low 40s efficiency ratio is still favorable. However, your net interest income guidance suggests a significant increase in revenue. Can you provide insight into where investment spending is directed, such as hiring and technology?

We continue to invest in the company for both the short and long term. In the short term, we are focusing on improving technology and risk management. We are determined to reach the $100 billion asset level and are preparing for this in advance. A significant portion of our spending is directed towards technology and risk management. Furthermore, we are investing heavily in our national business lines by introducing new products and services that we expect to launch by the end of this year or early 2023. While this has an intermediate timeline, we are currently allocating funds towards these initiatives. In the near term, you may notice a slight increase in expenses due to rising deposit costs. However, this increase is accompanied by a strong rise in net interest income. Consequently, you may see the efficiency ratio increase a bit in Q3 before it decreases again in Q4.

Got it. And just one quick follow-up. The held-for-sale portfolio, is that done declining after the transfer you made? Or could we see held-for-sale balances continue to drift lower?

Yes, it will track the mortgage industry, and it should stay roughly at the number it is today.

Your next question comes from Brad Milsaps of Piper Sandler.

Dale, I was curious on deposits. Can you remind us what percentage of the DDA are subject to the earnings credit rating? And maybe kind of what spot deposit rates were as you exited the quarter?

Yes, it's approximately half. Deposit spot deposit rates were up, although slightly less than what we saw on the spot loan rates. Our focus is not on managing betas but on managing net interest income growth, PPNR, and earnings per share, which makes us less concerned about that. I believe there are two types of betas: one for maintaining a balance and another for acquiring new business. Since we are gaining more business than other institutions, we will likely see a greater proportion of our growth come in and potentially higher beta numbers in terms of the delta. So yes, the spot rates increased by about 23 basis points, and moving forward, we expect to continue driving net interest income, as Ken mentioned.

Great. And it looks like you added some more bonds in the quarter. Are you still adding variable bonds? Or I think it was about 1/3 of the mix in the second quarter or the first quarter. Just curious if that was maintained?

Those were in the early part in Q2, all 100% beta bonds basically loan obligation subject to only 20% risk-weighted asset categorization, and that is basically soft.

Got it. And then the CONs that you did, I presume those were at the end of the quarter and didn't really have a huge impact in the quarter. What were the rates there, similar to the other credit-linked notes that you did?

The rates are essentially SOFR plus $600 million. There is a slight difference between them, but it is not reflected in the total funding cost beta I mentioned earlier. However, you are correct that they were booked out in June.

Got it. And then maybe a final question for me. On the loan transfer, understand more in the mark-to-market. But as those loans fuel themselves, do they come off your books any differently than they would have otherwise? Is there something else you have to trigger, or does it just go back the same way it would have if it were in held for sale?

Yes. The reason why they're so much shorter is because they had some type of credit distress. Again, these are 100% guaranteed by Ginnie Mae, so there's no risk to us. And as a result, you're going to get faster liquidation. Most of these are going to be sold probably by the current borrower. I mean they've got a good opportunity to do that if their personal situation has changed. You're also going to see a good portion of them refinanced at now current rates to put them into probably a lower fee per month or something like that. And then, also some of them are just going to go through kind of a foreclosure process. We expect that to be about half of that total. So those are either going to get remarked to current rates or move off completely. The balance will probably be adjusted and reperform at the current note rate, and those will have a longer life to them, but half of them are going to have a shorter life. So again, it does, as we said, it kind of avoid the mark-to-market effects on them, and there's no risk of credit.

Your next question comes from Timur Braziler of Wells Fargo.

Just following up on credit linked notes. Dale, if you can give us just some color as to how you choose the credits that these are applied to? I know you gave us the balance of the capital call and the residential loan. But what's the process in deciding which credits you choose to go, the credit linked route versus traditional?

The main aspect of our strategy is to lower the risk-weighted assets. We aim to leverage reductions in these assets effectively and prefer options that initially have a low loss expectation, which allows us to manage our costs; for instance, the rate we pay on the notes is SOFR plus $600 million. If the credit risk is higher, we may need to accept a higher note rate to mitigate that. We're drawing from examples in residential real estate and warehouse lending that have been successful in the past. We haven't seen anyone do this for capital call lines domestically, but we believe it could be effective, and we are actively pursuing opportunities in that area, which seems promising. Additionally, regarding the credit linked notes, we initiated this primarily to strengthen our capital position. It’s worth noting that due to four deals we completed since last year, 27% of our business is now insured. I don't believe any bank can claim that over 25% of their portfolio has credit insurance, which significantly enhances our confidence in our asset quality. The relief we obtained from risk-weighted assets has also provided us with a $500 million capital savings.

Great. Maybe switching over to bridge just to see that the lending activity is still pretty strong. What do deposits do out of that business?

So tech and innovation loans just had a very small outflow this quarter of just over $100 million. And year-to-date, the deposits over at bridge have remained rather steady. So they're really flat to the beginning of the year.

And do you have the warehouse balances at quarter-end?

Yes, when we discuss warehouse lending, we categorize it with two other types since it is managed by the same team. We include warehouse lending, MSR lending, and loan finance lending. We have not provided detailed information on each category separately for competitive reasons, but I can tell you that on a cubic basis, those three groups—MSR, loan finance, and warehouse lending—experienced growth for the quarter.

Okay, great. Lastly, I'm pleased to see that we reached this part of the call before the first AmeriHome question. With production being relatively flat sequentially and a significant decrease in the gain on sale margin, are we approaching the bottom for gain on sale revenue? Additionally, can you break down the MSR revenue into core revenue versus the fair value adjustment for the quarter?

As we've said, I think almost from day one, we look at everything together and it's mortgage banking revenue. And I would say that based upon the industry data that we are seeing and what we are seeing in day-to-day activity, there will be a natural drifting downward from the numbers that we posted in Q2. All that was taken into account when we provided the floor of the $9.80 EPS guide.

Your next question comes from Chris McGratty of KBW.

Ken, I want to come back to the $9.80 for a minute and just to make sure I understand all the pieces. You talked about the investments that you're making. You talked about the conservatism you're making on the provision. But then you say that the NII increase in Q3 is going to be larger than Q2. To me, it feels like that number should be decently higher than $9.80. And so I'm interested in some color there. And I think on prior calls, you've talked about, like, I think, $2.75 fourth quarter run rate? Just maybe an update would be great.

Yes. I think, by the way, we started putting out the $9.80 floor number, and keyword there is floor. In the back half of 2021, we haven't moved off of that. And we'll keep directing you to the word floor. So at this point, we feel very comfortable at saying that $9.80 is a floor number. There are some upward biases that you could see in our P&L that could raise that number. And our Q4 number exiting Q4, I think, is $2.75 if not higher than that.

Is there anything you are doing in the second half of the year due to the significant momentum in net interest income to potentially ease expenses next year since you are on track to meet that number? Are you implementing strategies in the second half to simplify comparisons for next year?

No, we've been focused on long-term business operations for quite some time. The projects we've implemented have likely been in place since 2019 and 2020, and we're continuing to invest in them. We're not increasing expenses to counterbalance the revenue growth. You might notice a slight uptick in expense growth due to deposit costs and ECR credits, but that will be more than compensated by the growth in net interest income. We are also analyzing the provision, which is based on loan growth, and we're aiming for a loan growth floor of $2 billion. Therefore, the provision may remain similar to our Q2 levels as we move into Q3 and Q4.

Great. And if I could sneak one in for Dale. I know you manage NII, but one of the themes in the quarter has been peak margins for the industry when we get there. And maybe just interested in your thoughts about the cadence of the margin given the futures curve. And when you think timing and about where that would occur.

We are currently experiencing the longest period of lag in this uptrend. This might start to change in the fourth quarter or the first of next year. I believe there could be some momentum even after that as fixed-rate loans are repriced at higher levels. Our floor strategy, which was very effective during the pandemic, is not as useful right now since rates are fluctuating so quickly that the floors quickly fall away from the current variable rate. Ideally, I would like to see things stabilize for the first half of next year before declining afterward, although I might be a bit optimistic about how quickly we can move through this. However, it seems likely we are still early in 2023.

Your next question comes from Brandon King of Truist Securities.

I wanted to understand the composition of deposit growth moving forward. I noticed that most of the growth in the quarter came from CDs compared to market accounts and savings. I'm curious if this composition will remain similar in the latter half of the year.

I think it's going to be a little more balanced to our current mix. I don't think CDs are going to be as large a piece. I think it is probably going to be money market and some interest-bearing checking. I would say that garnering real DDA without an ECR in this environment with a very elevated level of awareness of what's happened with rates, it's probably challenging. So I don't think we're going to hold that mix at 44% DDA, but I don't think it's going to be skewed to CDs in what you just saw.

Got it. Got it. And then just broader picture, looking out to next year, most comments on the strong pipeline near term and for this year. But is there any sort of possibility of slowing loan growth depending on if you get a more severe downturn next year? Is that a potential? Or do you think you could continue to achieve this growth even if we get some sort of a mild-to-moderate recession next year?

This is Ken. I'm going to let Tim Bruckner, our Chief Credit Officer, that he probably gets a chance to speak take that one.

Thanks, Ken. It's a good question. We have focused the whole business on appropriate lending in every economic circumstance. So there are things naturally that we will do less as we head into what might be a recessionary economy. And there are segments that we began adjustments in the second half of last year. So we've already seen muted volume. In some segments, we will achieve appropriate balance really for any economic scenario, but we do that in a deliberate way, and we do it in advance.

Okay. So I get a sense that you could achieve the same loan growth, but just the composition would change. Is that fair to say?

Yes. That's definitely possible. We would generally be less aggressive in stressed economic circumstances. So if that presents, you'd see likely a little less, a little more deliberate and a little higher margin. We've been doing this for the last four or five years. But we break loan commitments into a couple of different categories. The first and the easiest one is insurable risk, which is what the CLMs are. That's on one end of the spectrum. On the other end of the spectrum are economic-sensitive loans tied more to the economy. And so we've been pulling back on that for a while now. And so less growth will come from that. And then, our middle two categories are what we call economic resilience and economic resistance. Sorry. And so we balance our loan growth into those categories to ensure that we can grow in a very balanced and safe manner. And as I said, we've been doing this for several years now. So entering into a downturn, there's an intellectual curiosity on our part that I think we prepared the balance sheet for the stresses that are going to come forward. Tim?

I'd like to tie back to one thing that you said when we talked about ACL. It's important that's foundational to the way that we underwrite here. We have a short-tenure portfolio very deliberately. We underwrite in the current economic circumstance. We underwrite within our line of sight. Underwriting to a short tenor permits that. It also lets us reset those assets that are on our books in an appropriate way based on the current economic circumstance. So it all really ties together.

Your next question comes from Gary Tenner of D.A. Davidson.

I wanted to ask about the opposite of the peak margin question. I'm curious if, in 2024, we might see lower rates and if you have any thoughts on how to safeguard the margin gains you expect to achieve over the next several quarters in that situation.

Sure. Timing can be challenging without hindsight. However, we actively look for opportunities. We engaged in several billion dollars of swaps when we could secure 3-year term swaps at just 8 basis points, which now makes sense in hindsight. We have various approaches to adapt our strategy, one being a potential shift back toward a stronger residential focus. We can also implement more swaps. What I find most appealing about our business model is our flexibility; we operate across different lines. Similar to how we adapted during the pandemic when interest rates fell and others reduced credit availability, we chose to focus on capital calls and residential real estate, which are relatively safe, thereby maintaining loan growth during that time. Regarding the timing you mentioned, I believe we will likely see a shift before the presidential election, and we would certainly like to be in a position to take advantage of that opportunity again.

All right. And then secondly, I wonder if you could provide any progress update regarding the integration launch and customer reception at this point?

We have some clients using it, but it is still in beta testing. The number of users is not significant, which is why we haven't discussed it much. Currently, we have only small deposit balances from that area. However, despite the ongoing volatility, we believe there is a great opportunity for stable coins in the financial services sector moving forward.

Your next question comes from Jon Arfstrom of RBC Capital Markets.

A couple of quick ones. Can you go back to the message you want us to take away on Q3 expenses, Ken? You kind of alluded to it, but I just want to make sure I understand it. It sounds like you're talking about a step-up in Q3. I'm just curious how material you want us to think through that? How material is that?

Expenses are expected to increase as deposit costs rise, with the effects of the ECR changes from the end of Q2 impacting Q3. These deposit costs will eventually contribute to our net interest income. I want to emphasize that while the efficiency ratio is likely to rise in Q3, it should return to current levels by Q4. Our focus is on the net interest income generated from interest expenses and additional deposit costs. In Q2, we saw a 3:1 ratio, but we anticipate this will compress slightly in Q3 and Q4, remaining above a 2:1 ratio, around 2 to 2.5. We are concentrated on growing net interest income and ensuring that this growth positively impacts our bottom line as we prepare for 2023.

I understand. Thank you. Lastly, I believe this question is likely for Dale. Referring to your comments on capital, TCE ratio, and AOCI impact, you mentioned not marking the low-cost deposits. I have a two-part question. Do you think the current TCE ratio limits your ability to manage the company? Furthermore, what value do you assign to your deposit base?

No, I don't think the TCE ratio limits our capacity. I'm sure you're aware; there's a number of banks, including some of the global SIFIs, that are a point below us or nearly a point below us. So we think there's kind of latitude there. Ours hasn't been primarily driven by the AOCI mark. We have had strong hope, but I think that can come down. I think the kind of the regulatory view, the one that we're focused on, is really risk-weighted assets, and that's kind of the CET1 level. So yes, we feel strongly about that.

I'd say we target at or around 9% for CET1, Jon, and that's what we're more focused on. And that drives us to making decisions about risk-weighted assets which drives us to the CLNs. It all gets combined together, which drives us to ensuring 27% of our portfolio. So when you take down the waterfall thought, that's how we think about it when you think about a 9% CET1 ratio.

Okay. And then any bigger picture thoughts on your deposit base?

So yes, I mean, we've had a number of different initiatives that had, I think, strong success with. We've got some more queued up, and we think we're going to have kind of continued growth with what we've had already. We acquired digital disbursements in the first quarter. We're still seeing that kind of come into provision in terms of accelerating that performance. And our philosophy has been having a strong stable kind of core deposit franchise; it really gives you the opportunity to underwrite good credit. And that hasn't changed. That's been going on for quite a while, a few years. And we expect that to kind of rebalance with where we've been in loans going forward. So we're looking forward to it. We think this is a good opportunity for us to shine. The volatility is something that we can make our way through, we think, better than most as we have more opportunities to pivot more appropriately.

There are no further questions at this time. I'll turn the conference back over to Ken Vecchione for closing remarks.

Yes. We're very pleased with the quarter. We like the results very much, and we look forward to talking to you on our third quarter earnings call. Thank you all, and have a great day.

Ladies and gentlemen, this does conclude your conference call for today. We would like to thank everyone for participating and ask you to please disconnect your lines.