Earnings Call Transcript - WAL Q4 2022

Miles Pondelik, Director of IR and Corporate Development

Welcome to Western Alliance Bancorporation's Fourth Quarter 2020 Conference Call. Our speakers today are Ken Vecchione, President and Chief Executive Officer; and Dale Gibbons, Chief Financial 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, including 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.

Ken Vecchione, President and CEO

Thanks, Miles. Good morning, everyone. I'd like to provide an overview of our 2022 performance and then preface our approach to 2023 before Dale reviews the bank's financial performance. I should also mention that Tim Bruckner, our Chief Credit Officer, is also in the room with us today. Western Alliance had a strong year in 2022. Our diversified national commercial bank grew loans 28%, deposits by nearly 13%, and posted record net revenue and net income growth of 30% and 17.6%, respectively. We accomplished all this while maintaining strong and stable asset quality as net charge-offs to average loans were approximately 0% for the year, while non-performing assets to total assets improved to 14 basis points. The balance sheet is well positioned to weather an evolving environment as 27% of the loan portfolio is credit protected and 53% of the loans can be classified as insured or economically resistant. Our goal is to emerge from this slowing or recessionary environment as the top-performing asset quality bank in our peer group, a position we currently occupy. For 2023, the higher interest rate environment and slowing economy will generate headwinds for the banking industry. As I mentioned on our Q3 earnings call, WAL is focused on bolstering CET1 levels, restraining loan originations with deposit growth that outpaces loan growth while maintaining leading asset quality and growing year-over-year earnings. We are pleased with the substantial progress made towards this goal. Our CET1 ratio ended the year at 9.32%, which was over 60 basis points higher than the previous quarter. The rise in capital was driven by a purposeful facility, reducing approximately $1.8 billion in certain low-margin, low deposit categories such as capital call and subscription lines and corporate finance indications. Without these actions, quarterly held for investment loans would have grown $1.5 billion and generated incremental interest income. Our ongoing investments in diversified deposit businesses should provide liquidity in excess of loan growth. Q4 ending deposits declined $1.9 billion from last quarter, while average deposits declined by only $295 million quarter-over-quarter. This decline was primarily driven by short-term seasonal tax and insurance escrow deposit outflows in the mortgage warehouse group, which has since recovered, with Q1 quarter-to-date average deposit balances up more than $2.4 billion from year-end. Previous investments in our settlement services, business escrow, and HOA deposit businesses, as well as the soon-to-be-launched corporate trust platform, combined with several other initiatives we look to roll out, provide meaningful opportunities to gather incremental deposits this year. We look for predictable balance sheet growth to improve NIM and grow net interest income in 2023. After Dale's comments, I will discuss our 2023 outlook in more detail.

Dale Gibbons, CFO

Thanks, Ken. For the year, Western Alliance generated record net revenues of $2.5 billion, net income exceeding $1 billion, and earnings per share of $9.70, marking the 14th straight year of increasing earnings. We achieved strong performance, with return on average assets and return on average tangible common equity at 162% and 25%, respectively. Tangible book value per share grew to $40.25, reflecting a 6.4% year-over-year increase. As Ken pointed out, we identified a near-term priority to strengthen our key capital ratios. We are pleased with the significant progress toward this objective, with our CET1 ratio rising over 60 basis points to 9.3% in the fourth quarter. This approach enabled us to proactively limit balance sheet growth while still achieving record net interest income and earnings. For the year, net interest income rose 43% to $2.2 billion. Our diversified deposit franchises aim to generate attractive core funding, which helps drive net interest income and earnings per share higher, rather than simply reducing deposit betas to maximize interest margin. Non-interest income fell by $80 million to $325 million due to ongoing challenges in the mortgage industry. However, we saw improvements in mortgage-related revenue in Q4, and the anticipated exit of a large money center bank from the correspondent mortgage sector could indicate stabilization in gain on sale margins and core servicing income. Asset quality remains robust and stable, with classified and non-performing assets as a percentage of total assets still lower than pre-pandemic levels. Over the past decade, WAL has significantly transformed into a national commercial bank with a focus on deep segment expertise, specialized underwriting, and increased business diversification. For the year, Western Alliance reported net charge-offs of only $1.5 million, or less than 1 basis point of average loans. In the fourth quarter, Western Alliance produced net income of $293 million, with an earnings per share of $2.67 and pre-provision net revenue of $368 million. Operating earnings per share was $2.74, or $9.95 for the entirety of 2022. Total net revenue reached $701 million, growing by $37 million or 25% year-over-year during the quarter. Net interest income rose by 6% from Q3 to $640 million, mainly driven by net interest margin expansion, alongside higher average earning asset balances. The company completed a credit-linked note transaction during the quarter, bringing total issuances for 2022 to $579 million. By year-end, we were safeguarded from adverse credit losses on reference pools of loans valued at $12 billion. Overall, non-interest income was roughly flat from the prior quarter at $61.5 million, with mortgage banking-related revenue rising by $9 million to around $47 million. This was partially offset by a $9.2 million mark-to-market charge included in other income. Non-interest expenses increased by 9% or $27 million, leading to an efficiency ratio of around 47%, mainly due to rising deposit costs related to earnings credits. The efficiency ratio was adjusted to classify deposit costs as interest expenses, while 40% of remaining operating expenses remained stable. Moving to net interest drivers, our asset-sensitive balance sheet benefited from the rising rate environment. Risk investment yields increased by 79 basis points from the previous quarter to 4.45% due to higher repricing of variable rate securities. On a linked-quarter basis, loan yields rose by 86 basis points to 570 with an end-of-quarter spot rate of 6.26. Loans held for sale benefitted from increasing mortgage rates, which rose by 76 basis points to 5.63%. Regardless of the Federal Reserve's rate path, our net interest income is expected to benefit from an average of $2.5 billion in loans maturing or repricing higher each quarter throughout 2023. Fixed rate loans are being replaced by new loans yielding over 2% more, while variable rate loans are repricing on spreads 50 basis points wider on average. Total funding costs, which include borrowings and deposits, rose by 69 basis points to 1.57% as the reliance on CDs and short-term borrowings increased. Net interest income growth of $38 million or 6% on a linked-quarter basis was driven by a 20 basis point net interest margin expansion and a slight increase in average interest-earning assets. The growth in total interest income continues to outpace changes in total funding costs, including ECR expenses, confirming our ongoing asset sensitivity. The rate shock analysis indicates that under a +100 basis point shock on a static balance sheet, net interest income is projected to increase by over 3%. In a growth balance sheet scenario, we would expect net interest income to rise by over 20%. Even if Federal rates decline, as some anticipate may occur later this year, we expect net interest income to continue increasing, despite a decreasing asset sensitivity profile. Our efficiency ratio climbed by 140 basis points to approximately 47% after the reclassification of deposit costs as interest expenses. Adjusted efficiency was nearly flat at 40%, demonstrating the high operating leverage of the company. Deposit costs increased by $26 million from the prior quarter due to rising earnings credit rates on deposits, but at a slower pace compared to Q3, as the demand deposits paying earnings credit rates fell. Pre-provision net revenue rose by 3% to a record $368 million, representing a 14% increase year-over-year, leading to a return on average tangible common equity, excluding all other comprehensive income, of 23% for the quarter, or 80 basis points higher than last quarter. Western Alliance's exceptional organic capital generation and strong performance offer substantial flexibility to fund balance sheet expansion, enhance capital ratios, and meet credit demands. Loans held for investment decreased by $339 million to $51.2 billion, while deposits fell by $1.9 million to $53.6 million at year-end, mainly due to short-term seasonal factors affecting the mortgage warehouse. Total borrowings dropped by $16 million compared to the previous quarter, largely due to a decline in short-term borrowings, counterbalanced by the issuance of $95 million in credit-linked notes on a reference pool of residential loans. Tangible book value per share rose by $3.09 or 8% from the prior quarter and 6% year-over-year to $40.25, driven by strong organic earnings and reduced drag from available-for-sale securities marks included in AOCI. This quarter, net loan growth was affected by our intentional choice to temper certain C&I loan categories, such as equity fund resources and, to a lesser extent, corporate finance, by about $1.8 billion total. Without these reductions, C&I loans would have increased by $220 million, while total loans held for investment would have grown by $1.5 billion on a linked quarter basis. C&I growth stemmed from $651 million in sponsor-backed commercial real estate, $390 million in construction, and $250 million in residential loans. Moreover, the diversity of our business lines has generated robust loan demand in regional banking, which was $696 million higher than in Q3. Hotel Franchise Finance increased by $315 million, and the tech and innovation sector rose by $140 million. We are well-positioned to sustain prudent growth amid a more uncertain economic landscape due to our diverse loan mix across national business lines, residential real estate, and regional banking. Over the past three years, 68% of our strong loan growth has come from low to no loss categories, which now constitute 53% of our entire portfolio. Additionally, we have implemented further loss prevention strategies, with 27% of loans being credit protected to enhance our industry-leading asset quality. Fluctuations in deposits, along with heightened competition for funding during the quarter, combined with larger-than-anticipated seasonal factors, temporarily reduced deposit balances. Early deposits fell by $1.9 billion, mainly due to short-term seasonal outflows in escrow deposits within our mortgage warehouse group, which are classified as non-interest-bearing but subject to earnings credit rates. As Ken highlighted, these seasonal elements have reversed since year-end, with average balances in mortgage warehouses for Q1 to date already up more than $2 billion from year-end, signifying a 15% increase year-over-year. Furthermore, average balances for total deposits are up over $2.4 billion since December 31, and approximately $660 million more than the Q4 average balance. Western Alliance's warehouse accounted for 65% of the reduction in non-interest-bearing checking accounts. The end-of-year seasonal effect is evident with the average linked-quarter decline in deposits being only $295 million, compared to the more pronounced drop on a period-end basis. Increased competition for liquidity in a higher rate environment led to an 11% increase in total interest-bearing deposits, including a $1.9 billion rise in CDs. Interest-bearing demand deposits grew by $1.2 billion compared to the previous quarter, partly due to a shift from non-interest-bearing demand deposits. The diversified deposit franchise continues to present significant opportunities to attract and generate appealing funding to facilitate loan growth. Among our scalable national business lines, we are encouraged by the ongoing momentum in settlement services and homeowners’ associations. We experienced linked quarter growth of $680 million and nearly $300 million, respectively. Looking ahead, we anticipate sustained growth from our deposit business lines, including business escrow services, which will continue to yield attractive deposits to support ongoing balance sheet growth and mitigate the impact of elevated rates on overall funding costs. Our asset quality remains robust and steady, with classified assets and non-performing assets as a percentage of total assets still lower than pre-pandemic levels. Total assets increased; classified assets rose by $8 million in Q4 to 58 basis points of total assets, only 2 basis points higher than Q3. The ratio of total non-performing assets to total assets decreased by 1 basis point from last quarter to 14. As economic volatility continues to evolve, we believe our disciplined underwriting, guided by our national business line strategies, has equipped us well for potential credit stress that may accompany macroeconomic challenges. Nonetheless, we have not observed any initial signs of a significant increase in credit migration trends, and we expect to reduce our exposure to more sensitive loan categories this year. Sound asset quality decisions will shape our intentional loan growth trajectory and enable us to maintain profitability amidst increased economic uncertainty. Quarterly net charge-offs were $1.8 million for the quarter, translating to 1 basis point of average loans, while total net charge-offs for the full year 2022 were $1.5 million. Those quarterly charge-offs have remained stable at roughly $2 million per quarter over the past year, with variances resulting from volatility and recoveries. Provision expenses for credit losses amounted to $3.1 million, mainly due to uncertainty regarding a potential recession, but were counterbalanced by efforts to optimize risk-weighted assets, the sale of corporate finance indications, and a reduction in capital call and subscription line exposure. Our base case for a mild recession reflects credit loss assumptions weighted towards the consensus forecast, which has shifted towards anticipating an increasing recessionary scenario. The total loan allowance for credit losses to funded loans was 69 basis points, while our allowance for credit losses on non-accrual loans was a noteworthy 420% at year-end. Testing the $12 million of loans covered by credit-linked notes, where substantial first loss coverage is provided by a third party, shows that the allowance for credit losses coverage rises to 89 basis points. We are confident that these favorable asset quality trends can be sustained throughout economic cycles due to Western Alliance's deliberate strategic transformation following the financial crisis. During that period, nearly 70% of the losses incurred by Western Alliance stemmed from loan categories representing 44% of the loan portfolio. Currently, those categories account for less than 6% of total loans. In contrast, 87% of our existing portfolio consists of insured and resilient categories, which include credit-protected, government-guaranteed, and cash-secured loans. Resistant loans are comprised of categories that have historically seen negligible or low losses. These categories have maintained de minimis losses since 2014. They are supported by strong collateral and counterparties, as well as our underwriting proficiency. While this category may experience some grade migration, realized losses remain minimal due to limited uncovered collateral risk, with an average loss of only 2 basis points and a maximum quarterly annualized loss of just 16 basis points. The remaining 13% of the portfolio is more sensitive to economic growth. Lending in this category has targeted unique sub-segments that yield the highest risk-adjusted returns, with a harnessing of our sector knowledge and underwriting skills to uphold superior relative asset quality. Since 2014, these loans have recorded a maximum quarterly annualized loss rate of merely 71 basis points, with average losses at five basis points. Exceptional asset quality post-financial crisis has been underscored by minimal net charge-offs of only $29 million since early 2014. When comparing ARP performance to 32 publicly traded banks with assets valued between $25 billion and $150 billion in the United States, we observe the lowest average net charge-offs and the lowest maximum quarterly annualized charge-offs as a percentage of total loans over the same timeframe. While the previous decade has generally seen low credit stress, our leading performance, characterized by low average losses and, more critically, the lowest loss volatility among peers, signals that Western Alliance is poised to surpass peers when credit stress intensifies. During our last earnings call, we highlighted our renewed focus on rebuilding capital and have made significant strides thus far. Our tangible common equity to total assets ratio of 6.5% and common equity Tier 1 of 9.3% have both improved substantially quarter-over-quarter. Our industry-leading return on equity and assets allows us to generate considerable capital to support organic growth and enhance our well-capitalized regulatory ratios. This robust capital generation this quarter is equivalent to the issuance of approximately 5.5 million shares. As mentioned earlier, tangible book value per share rose by $3 to $40.25, and since 2013 has grown 4.3 times faster than the peer group. We are confident that our business diversification, outstanding asset quality, and ability to produce solid operating leverage will persist in a softer economy, further affirming our franchise as a high-performing growth bank. Back to Ken.

Ken Vecchione, President and CEO

Thanks, Dale. I was pleased with the management team's ability to adapt to the changing interest rate economic environment to produce record operating results in 2022. A thoughtful balance sheet growth, in conjunction with executional focus, positioned the bank to capitalize on matters of income sensitivity while simultaneously growing both sides of the balance sheet with industry-leading performance as the quality remains solid and stable with few signs of elevated stress. Looking forward for the full year 2023, we expect continued careful balance sheet growth driven by our diversified business model with a flexible origination mix designed to maximize net interest income. We expect loans held for investment to grow between 10% and 15% and deposits to grow between 13% and 17%. Our specialized deposit franchises generate funds for more economically agnostic and secularly strong sectors, which offer significant deposit growth opportunities in excess of loan growth. We also expect improved interest expense on the marginal deposits raised as we had fewer term deposits and favorable interest-bearing deposits. Net interest margin is expected to expand between 4% and 4.10% as it moves in concert with Fed fund actions. Favorable earning asset repricing dynamics per quarter will support NIM even if the Fed pauses hikes this year. Net interest income is expected to grow between 20% and 25% for the year in a rising rate environment and to exceed growth in ECR-related deposit costs. Growth and efficiency ratio for the year should remain in the low 40s as we will continue to invest in risk management, technology, and new business lines to take advantage of the attractive growth opportunities we see in front of us. In aggregate, we expect pre-provision net revenue growth of 11% to 15%. Excellent asset quality should remain intact, but we could return to more normalized losses if the economy enters into a recession. Our goal remains to prudently bolster key capital ratios in line with the macro environment with a CET1 ratio of between 9.75% and 10%. Our bank's industry-leading return on average tangible common equity produces significant organic capital of approximately 45 basis points of CET1 net of dividends per quarter, which provides us with significant flexibility to achieve our strategic objectives, grow capital ratios, on balance sheet growth, or to take other capital actions. At this time, Dale, Tim, and I are happy to take your questions.

Operator, Operator

The first question comes from Casey Haire with Jefferies. Please proceed.

Casey Haire, Analyst

Thank you. Good morning, everyone. I didn't cut all that guidance, Ken. However, I did hear the NIM guidance, which I believe is 4% to 4.1%. I'm assuming that applies for the year. Can you describe how you see it progressing throughout the year and how it will end? Also, what Fed forecast are you using? Thank you.

Ken Vecchione, President and CEO

So, on the Fed forecast, we actually have only one rate increase at the beginning of the year. That's about a week from now for 25 basis points on the upside. We also have two rate decreases, both 25 basis points placed into our Q4 forecast. We're probably less confident about those rate declines, but we think it’s a good, prudent thing to do in order to manage our efficiency ratio and not have expenses run ahead of potential revenue increases. So that's the rate forecast. On NIM, we expect it to grow slowly through the year between 4% and 4.10% is pretty tight for us. So probably crosses over 4%, a little more towards the end of Q1 into Q2 and then just grows generally from there.

Casey Haire, Analyst

Okay. Regarding the deposit growth guidance of 13% to 17%, do you have any insight into the negative mix shift that might be included? Also, where do you think DDA as a percentage of total deposits could settle, considering we are currently in the low 40s?

Ken Vecchione, President and CEO

I'll start and then let Dale address the second part of the question. Deposit growth is expected to be between 13% and 17%, amounting to $7 billion to $9 billion. We aim to grow deposits at a rate that surpasses loan growth, as mentioned in Q3. Our HOA business saw a growth of $1.3 billion in 2022, and we anticipate it to continue at that rate. Additionally, we expect growth from our settlement services and business escrow services, which we invested in during 2018 and 2019 and began rolling out more robustly in 2020. These sectors performed well, especially settlement services in 2022, and the remaining deposit growth will come from various regions.

Dale Gibbons, CFO

It's quite challenging to establish new non-interest bearing deposit relationships in the current environment. However, we have observed a recovery of about half of the decline in DDA from the fourth quarter, mainly linked to mortgage banking operations, with the seasonal low point occurring in the fourth quarter. I believe we can maintain around half of the decrease seen in that period. Moving forward, our focus will be on continuing our deposit growth and securing loans with a spread of 300 basis points or more, which would help drive net interest income irrespective of the Federal Reserve's actions.

Casey Haire, Analyst

Okay, great. Tying this all together, you mentioned the 9.80% figure for this year. The analysts expected you to reach 10.75% for 2023. Do you believe that achieving 10.75% is feasible with this guidance?

Ken Vecchione, President and CEO

So Casey, what I'd say is our PPNR guide is between 11% and 15%. And from there, you have to take a viewpoint on what you think is going to happen in the economy in terms of determining the provision. So the provision will naturally grow because of balance sheet growth. We're not seeing any cracks in asset quality. It looks pretty good. But listening to a number of the talking heads, many people think towards the back half of 2023, we'll see some weakening in asset quality. Again, we haven't seen any of that, so you're going to need to make your own assumptions regarding charge-offs on top of provisioning. But the PPNR guide is between 11% and 15% for next year.

Casey Haire, Analyst

Understood. And last one for me, just the loan deposit growth, is that average or period end?

Dale Gibbons, CFO

So we talked about kind of both of those numbers. But from here, I expect this to recover about half of the DDA decline in the fourth quarter by period end.

Operator, Operator

The next question comes from the line of Brad Milsaps with Piper Sandler. Please proceed.

Brad Milsaps, Analyst

Good afternoon. Thank you for taking my questions. I appreciate the detailed insights on guidance. I wanted to explore the credit aspect further. Dale, you provided a lot of information, but with all the current uncertainties, could you elaborate on the reasons behind the $3 million provision this quarter? I realize there has been significant movement in risk-weighted assets and limited loan growth, but given the overall outlook seems to have worsened, the $3 million provision might appear somewhat low relative to the current environment. I would like to hear more about it, especially in relation to 2023.

Ken Vecchione, President and CEO

Let's begin by looking at the $3 million figure. If we consider the sale of the corporate finance applications and the fact that we didn't see growth this quarter and reduced our EFR balances, it seems that if we analyze it more closely, we would have been in line with the results from previous quarters. Therefore, the $3 million really reflects the net impact of those decisions. Dale, do you want to discuss the CECL details?

Dale Gibbons, CFO

Yes. We follow the performance indicators set by Moody's, which, as we noted, have gradually declined. However, we aren't experiencing that trend ourselves. The most important factor for us is the condition of the commercial real estate market. For many banks, this likely relates to unemployment rates. When we examine their declining consensus and factor in S-4, those figures remain significantly higher than our advance rates regarding real estate transactions. Therefore, while there may be a slight increase in losses, it isn't as pronounced as it is for some other institutions.

Brad Milsaps, Analyst

Great. And as you think about areas that you want to grow in, in 2023 in terms of the loan portfolio, would those be areas in your mind? I mean you mentioned wanting to grow in less risky areas, maybe areas that more risk would have, maybe more variable rate loans. Just kind of curious how to think about the areas that you want to grow in vis-a-vis kind of how that might impact provisioning.

Ken Vecchione, President and CEO

So I'll say our loan pipeline still remains active. I would see us growing a little more in note financing, build-to-rent. Multifamily looks strong, as well as industrial. You'll see some pickup from construction loans that we did in previous quarters that are beginning to fund up, and hotel financing will be active as we look going forward.

Dale Gibbons, CFO

Specific residential could be interesting. What we don't want to do is get in front of Fed action and kind of decrease asset sensitivity until there's more clarity in terms of where rates are headed, but I do believe that mortgage rates that begin with the 7 is probably going to work out over time.

Brad Milsaps, Analyst

Great. Thanks guys. I’ll hop back in queue.

Operator, Operator

Thank you. The next question comes from the line of Steven Alexopoulos with JPMorgan. Please proceed.

Steven Alexopoulos, Analyst

Hi, everybody. I wanted to start on the deposit side. In terms of the deposit growth, the 13% to 17%, could you talk more about how you see the mix evolving through the year? And particularly, I'm curious how much of the growth do you plan on getting from ECR deposits, time deposits. It’s obviously a fairly aggressive deposit growth guide?

Dale Gibbons, CFO

Yes. As we mentioned, if we can keep our core non-interest-bearing DDA stable, that would be a positive outcome. The main focus will likely be on interest-bearing money market accounts, which come with various spreads based on our relationships and any associated credit. I believe the contingent value side will increase a bit more than before, but at a slower rate compared to recent growth. Interest-bearing checking is expected to be a strong growth area as well, especially since many of our HOA deposits currently fall into that category. Ultimately, I anticipate that DDA will likely decrease as a proportion of our total. The growth will primarily come from ECR-related accounts, with significant contributions from money market accounts and a bit more from CDs.

Steven Alexopoulos, Analyst

Got it. So Dale, if we follow that through and interest-bearing deposit costs were $197 this quarter, where do you see that moving to by 4Q '23 in terms of what you need to get in terms of this NIM being stable to up a bit? What are you assuming deposit costs rise to interest-bearing?

Dale Gibbons, CFO

It really depends on your rate forecast. However, what we're observing is that interest-bearing deposit costs have increased. During the fourth quarter, our net interest income rose by approximately $39 million. After accounting for the interest expense and ECR charges, around 3.25 of that amount was utilized. I believe that this range is likely to remain relatively stable. Consequently, we expect a gradual improvement in net interest income, even when including ECR debits, but at a slower pace than what we experienced in the previous quarters.

Steven Alexopoulos, Analyst

Okay. When I observe the deposit rates of some regional banks this quarter, I notice that many of them have hardly changed in certain categories. I'm interested in the discussions you have with potential clients. Is this a significant opportunity for you to attract new households and businesses? Do you view this primarily as a consumer or business opportunity? Thanks.

Ken Vecchione, President and CEO

Well, we're a commercial bank, so we don't have much in the way of consumer deposits, and so our deposits are going to be floating at the marginal higher end of interest expense. But we focus on net interest income, and we have the ability to take those deposits and put them in 100% beta loans, and hence, make the spread on it. And so that's been the conversation. We're seeing larger clients move some of their money to us and having conversations about moving money to us. We like that. And what's really a little bit different for us in terms of how we approach business, thought it to change somewhere in the middle of Q3 of last year is we used to lead with loans, and now we lead with the deposit conversation. And we're very clear that there will be no credit extended unless there's a very strong deposit relationship, and that conversation has been well received by our client base.

Steven Alexopoulos, Analyst

Thanks for taking my questions.

Operator, Operator

The next question is from the line of Ebrahim Poonawala with Bank of America. Please proceed.

Ebrahim Poonawala, Analyst

Good morning. Yes, a few follow-up questions. Maybe one, I'm not sure if you already mentioned this, apologies. Just around the expense outlook as we think about core expenses. Just remind us in terms of the growth rate you are thinking about as part of your PPNR guidance. And also the one key seasonality that we should be thinking about.

Ken Vecchione, President and CEO

So I think about last point. What is the one thing we should be thinking about? Do you hear that point?

Ebrahim Poonawala, Analyst

The first quarter seasonality, like I'm assuming like first quarter historically is marked the high watermark for efficiency. I'm just wondering if there should be a seasonal lift in expenses that we should be baking in.

Ken Vecchione, President and CEO

Yes, I'll address the second part of that first. The answer is yes. Our expenses tend to be slightly higher in the first quarter. However, our target for the efficiency ratio remains in the low 40s, which has always been our goal, and we consistently maintain one of the best efficiency ratios in the industry. We believe this is the right level as it enables us to make proper investments in both risk management and technology as we continue to grow, while also allowing us to invest in new products and businesses. Over the past several years, we have been investing in settlement services and business escrow services. We recently launched a new initiative in deposits, which we are not yet ready to disclose, but it has started off strong. Maintaining the efficiency ratio in the low 40s helps us generate the operating leverage we seek and enables us to invest in opportunities today for future performance.

Ebrahim Poonawala, Analyst

Got it. And what does that imply just in terms of how you're thinking about just the expense growth for the year? Is it high single digits?

Dale Gibbons, CFO

It will likely be in the high single digits, possibly reaching low double digits. Considering the PPNR element of 11% to 15% and maintaining the efficiency ratio roughly where it is, there may be some additional flexibility. However, we will monitor this closely. As we authorize full-time employees and continue to showcase our balance sheet growth performance, our revenue will support our expense growth.

Ken Vecchione, President and CEO

I want to make sure we're not talking across each other. So my commentary was on the adjusted efficiency ratio without deposit costs because Dale just talked about that, putting it towards net interest income. So on the adjusted efficiency ratio without the rise in deposit costs, that's what we think we'll be in the low 40s. Okay?

Ebrahim Poonawala, Analyst

Noted. Go ahead. Yes. I have a separate question. Looking back at credit, I understand the macro uncertainty. However, considering your PPNR guidance, even with provisions around mid-2020, it suggests earnings of approximately $10.50. I'm curious if there are any aspects of the loan book that create hesitation regarding the EPS outlook for this year in relation to your guidance. You have shown confidence in the asset quality, so I'm wondering what scenario might prevent achieving that $10.50 EPS, give or take.

Ken Vecchione, President and CEO

So as you know, CECL works, it really comes down to the end of the year and then the outlook into 2024. So if Moody should turn more bearish as we put on loans, you're increasing your provision for the life of that loan, not for the risk that's in the book. And so that's why we've been a little bit more reticent on quoting where we think EPS numbers are and then stay more on the PPNR side. Those are the things that we can control. On asset quality, again, we're not seeing any issues at this moment. I would point you to a little bit the last two slides in the presentation, where we think we've been able to grow in loan growth in a very prudent way and keep our charge-offs down. And I would remind you that 54% of the book is either in short or resilient or resistant categories.

Ebrahim Poonawala, Analyst

Got it. I have a follow-up question. Considering the loan growth expectation of 10% to 15% for this year amid significant macro uncertainty, should we be concerned about the quality of loans being added to the balance sheet at this stage in the cycle? From a client selection perspective, is there a risk of adverse selection?

Ken Vecchione, President and CEO

No. So we're not going to grow for growth's sake. So the asset quality is incredibly important. In my opening comments, I wanted to get rid of any connection to the GFC 2007 and '08, '09. I want no connection to that, and we are a completely different company. So we want to grow above trend. Yet at the same time, we want to have above-trend asset quality or best-in-class asset quality. We're working on doing both. So we're not going to sacrifice the asset quality for higher loan growth. Having said that, after going through our reviews, we think the range that we gave of 10% to 15% allows us to grow the loan book without growing into a recession and also protect or remain with stable and strong asset quality.

Dale Gibbons, CFO

We will pivot as necessary as new facts and situations emerge. I mean we did this during the pandemic, one of the few banks that sustained a growth trajectory during that point in time and where we go. We weren't sure how it was two years or four years to a vaccine. So it went into a capital call and a low LTV residential, and never lost a dime on either of those. And so we're going to be nimble about using the flexibility of our business model to sustain earnings performance improvement over time.

Ebrahim Poonawala, Analyst

Got it. Thank you for taking my questions.

Operator, Operator

The next question comes from Brandon King with Truist. Please proceed.

Brandon King, Analyst

I wanted to touch on loan yields. I know, Ken, you mentioned last quarter, seeing a loan committee turn down 31 loans initially getting better pricing. So I wanted to get a sense of what the outlook was for loan spreads going into this year and if you're still getting the same reception from clients?

Ken Vecchione, President and CEO

I'll give you another story to that, too. So our loan yields are holding in from that last conversation we had when we did our Q3 earnings. Dale mentioned, spreads are up about, on average, 50 basis points. And we're not getting a lot of pushback on pricing. I don't have any numbers for you, but I can tell you when we say no to a loan that has good asset quality and good pricing, we usually are saying no because it's not generating the deposits that we want to accompany that loan. And what we're seeing is that when we turn down those loans, those loans have been returning to the senior loan committee now with greater deposits. So what we're encouraged about is that the pricing is holding and our determination to see more deposits to accompany the loans has been following through from our credit committee.

Brandon King, Analyst

Okay. That's helpful. And then as far as the risk-weighted asset optimization, is that process complete? Or is there still some work to do going into this year?

Ken Vecchione, President and CEO

Tim, love to take a shot at that one. You've been running the process.

Tim Bruckner, Chief Credit Officer

Yes. Thanks, Ken. That is ongoing, and it's definitely a part of our culture. So something that we'll continue to do. There's definitely remaining benefit to be achieved through optimization. Some of that's in the targeted growth portfolio mix, and some of it is just structural with our clients. But ongoing improvements are still expected. Thanks.

Brandon King, Analyst

Got it. Got it. And then just lastly, on the mortgage warehouse deposits, I understand the seasonality in the fourth quarter came back in this quarter to date. But should we expect a similar kind of magnitude as far as seasonality in the fourth quarter of this year and going forward?

Dale Gibbons, CFO

It was more noticeable in the fourth quarter of 2022 than we've ever experienced before, and some reasons for that include our accounts related to taxes, insurance, and others that are principal-related. We anticipated a decline in insurance access primarily because California property taxes are due in the fourth quarter. Principal and interest payments usually have more variations within the month rather than seasonal patterns, but that shifted this time. From our perspective, there were very few refinances and almost no sales of residential real estate in December. Consequently, when someone pays off a loan or a REIT refinances on the 5th of December, we would receive a deposit that includes the principal of that loan, which is then remitted to one of the government-sponsored enterprises two weeks later. However, that didn't occur, and I believe you can make your own estimates about what December 2023 will look like. The lack of activity in December was more pronounced than normal, contributing to this situation, and it appears to be shifting now, possibly indicating an early start to the spring buying and selling season, though I'm uncertain.

Brandon King, Analyst

Okay. Thanks for taking my question.

Operator, Operator

The next question comes from the line of Andrew Terrell with Stephens. Please proceed.

Andrew Terrell, Analyst

Good morning. Looking at the capital call loans down around $1.2 billion this quarter. Is that the pace of runoff we should expect out of the book over the next couple of quarters? And I know there are some associated CLNs against the portfolio. I guess, do those securities remain in place as the capital call portfolio comes down? Or would the CLNs fall commensurate with the reference pool?

Tim Bruckner, Chief Credit Officer

Tim Bruckner again. I'll take the first part of your question on the portfolio runoff. The answer is no. It's not to be expected. That was driven by a handful of large transactions. We elected to exit for return reasons. As we move into the coming quarters, we won't see similar dollar amounts of runoff at all.

Dale Gibbons, CFO

We do have a capital loss note related to the capital call and subscription lines. This note is different from the residential ones, which are already closed. It's a specific pool of loans, and as those loans are paid off, the note decreases in value. This particular note has the ability for substitutions, allowing it to last for three years. If something comes up, we can swap something else into it. This note represents only a small portion of our total capital call and subscription lines, so it doesn't significantly impact them. It was primarily established for return purposes rather than capital management, as we've already reduced a portion of those to 20% through this process.

Andrew Terrell, Analyst

Okay. Got it. And then, Dale, do you have what the MSR valuation change was this quarter? And then any thoughts on just run rate for mortgage servicing and then gain on sale income?

Dale Gibbons, CFO

Yes. There was no change in the valuation of the MSR in Q4, which means that the hedging effectively offset movements in market rates. Therefore, there wasn't any valuation adjustment. Looking ahead, there may be some MSR dispositions, but that shouldn't impact the market. At the same time, I believe there is greater stability in expectations around refinancing behavior, which could extend the lifespan and increase confidence in the value of those servicing rights.

Ken Vecchione, President and CEO

I would add that, as you look quarter-to-quarter, I would think about the total mortgage income being relatively flat to Q4. I think that was your specific question. And while too early to call a trend, I would say that the first 20 or so days into January, we are encouraged by margins rising in the business as that large money center bank exits the correspondent lending market. We’ve got our fingers crossed that, that continues to move forward. But at this point, that's a positive. That's an emerging opportunity, we think. But right now, I would keep Q1's mortgage income relatively flat to Q4.

Andrew Terrell, Analyst

Okay. Got it. And then if I could just sneak one in on the last point, just the competitive dynamics in the correspondent business, perhaps that does create some tailwind to the gain on sale margin. But does the exit of a large competitor give you greater opportunities to grow the balance sheet at all?

Ken Vecchione, President and CEO

We’re going to still have the balance sheet relative to our capital CET1 goals of getting towards 9.75% to 10%. As you know, MSRs, if they grow in an outsized way versus our internal capital generation, become punitive. So we will be sellers of MSRs throughout the year. And with that, we also hope if we sell to non-banks that we keep deposits that are accompanied with these MSRs as well as possibly even providing MSR financing to the buyers, and that was always our premise when we bought AmeriHome.

Andrew Terrell, Analyst

Understood. Okay, thanks for the questions.

Operator, Operator

The next question comes from the line of Chris McGratty with KBW. Please proceed.

Chris McGratty, Analyst

Great. Thanks. Dale, the capital build in the quarter, I think the way I'm thinking about it, many thought you would build capital, some thought you would build reserves. I'm interested kind of in your dynamic on how you're thinking about building one versus the other. And could you just remind us 10% of the target, I think prior commentary is to get there by midyear. But with recent efforts and maybe some more, like any change in timeline there?

Dale Gibbons, CFO

Yes. It really starts with the reserves. We assess our loans and exposures, aligning them with Moody's assessments and our understanding of market and economic sentiment. We manage GAAP compliance, and I acknowledge that our ratio is lower compared to some others in the industry. Our asset quality, particularly regarding charge-off trends, is a clear indicator of this. In our slide deck, we outline our credit segmentation into protected, resistant, resilient, and more sensitive categories. The sensitive segment comprises just a small portion—one-eighth—of our loan portfolio, which we believe may experience some volatility. Another metric we consider is the allowance for credit losses in relation to annual charge-offs. We had zero charge-offs this year, but even if we factor in a few basis points against a measure of 60 basis points, that would imply a 30-year charge-off history. While this is indeed better than average, our loan book's average duration remains just under 4%. We utilize various methods in our analysis and believe our reserve levels are adequate. Moving forward, we will focus on how this impacts our tangible common equity. I wouldn't adjust our timeline; I recognize that a 60 basis point shift is a considerable change for just one quarter. However, we plan to simultaneously grow our capital and balance sheet while maintaining an upward trend in net interest income and ensuring our returns improve as our capital approaches the high 9s later this year.

Ken Vecchione, President and CEO

Chris, to be very specific, I think you can look for us to be in that capital range of 9.75% to 10% towards the back end of the year. We got a real jump on Q4 by opportunistically selling some loans and then being able to move quickly in the EFR space. That's our capital call and subscription line. So quite frankly, we're pretty proud that we were able to move the capital 60 bps in one quarter, but I think you can look towards the back end of the year for those numbers. The outlook for quarterly capital call loans shows 9% growth for the full year. All of this is reflected in the ECR as we have had to consider that net income, which affects the allocation between retained earnings.

Operator, Operator

The next question comes from the line of David Smith with Autonomous. You may proceed.

David Smith, Analyst

You share the run rate for the ECR and the deposit costs as of 12/31, what that would be on kind of a full quarter basis?

Dale Gibbons, CFO

Yes, I wouldn't say that materially changed from where we were from for the quarterly number. It didn't grow quite as much as maybe something anticipated because the dollars came down in terms of ECR deposits. But I think that we can track from the fourth quarter number, overlay what you think is going to happen in terms of equals actions and what you think is going to happen on the balance sheet in those particular categories. That should work. We have dollars we have in there with consequent those big.

David Smith, Analyst

Okay. And in terms of the mortgage warehouse deposit book, can you share the breakdown between non-interest bearing and interest-bearing there? Is it notably different from what the mix was for the bank as a whole as of the fourth quarter?

Dale Gibbons, CFO

So most of the mortgage warehouse deposits are in DDA with an ECR, and that is the preponderance of all the ECR dollars that we have.

David Smith, Analyst

Got it. Okay. And lastly, in terms of the RWA benefit that you got from the reduction in equity fund resources. Could you expand on that a little bit? I imagine that it must not be zero risk weighting. But given the kind of the risk that those loans tend to have, it must be a pretty low risk weighting, I would have thought.

Dale Gibbons, CFO

The general construct of providing a credit-linked note is to provide protection, i.e., first loss taken by a third party. So we get funds in. We sell the bond to a third party, and they get that interest on that bond less any losses that arise from this reference school. So on the EFR loans, these subscription lines, they're normally 100% risk-weighted. But because we've sold a note to a third party, and they assume first loss, the first 12.5% of losses in that portfolio, they pay. And actually, we already have their money, so we control how much they get back as we only pay them back, less any losses incurred. And because of that architecture, whereby you have moved the now kind of the structured product to a AA or better category, it's basically treated as a 20% risk-weighted asset. So no matter what type of asset you come from, you end up at 20. So residential, you started at 50, end to 20. Capital call and warehouse, you started 100 and you still at 20.

David Smith, Analyst

Okay. Got it. So without the CLN though, the risk weighting is 100. Got it. It's good to know. Thank you.

Operator, Operator

The next question comes from the line of Timur Braziler with Wells Fargo. Please proceed.

Tim Braziler, Analyst

Hi, good afternoon. Just a couple of follow-ups. With deposit growth expecting to exceed loan growth in '23, what's the excess funding going to be used for? Is the primary focus initially to down some of this near-term borrowing? Or is that excess funding going to be layered into the securities book?

Ken Vecchione, President and CEO

Could either or, but our first goal would probably be to lower our borrowings and take down that cost.

Tim Braziler, Analyst

Okay. Great. And then, again, following up on the large bank exiting the correspondent space, and thank you for not mentioning the bank by name, but pretty large player in the space. What happens to that market share? Is that market share kind of split amongst the rest of the constituents? And are you expecting AmeriHome's portion to grow? Or are you more or less kind of ring-fencing that and keeping the existing business as is? Was there kind of competitors maybe getting more of that market share that's up for grabs?

Ken Vecchione, President and CEO

So I think like some of the other competitors, they balance market share with gain on sale margin, and that's what we do. So if we can hold our existing market share and grow the gain on sale margin, that works for us, and that's sort of where we've been. And I think that's what the industry is trying to do, and there seems to be a little discipline going on here. But without mentioning that bank that left, it's early days, and we'll wait and see, and we'll clearly have more color on it as we get through the end of the first quarter.

Dale Gibbons, CFO

During the third quarter, which is when margins dropped, we did a little experiment whereby we pulled back in terms of activity and purchase volume, and we saw margins move up a little bit in that scenario. And I'm not sure that's the reason why, but they basically stayed at a somewhat elevated place from how far they've fallen to in the fourth quarter. So I don't know if we're encouraged by that, and we'll see what happens.

Tim Braziler, Analyst

Got it. Thank you.

Operator, Operator

The next question comes from the line of Jon Arfstrom with RBC. Please proceed.

Jon Arfstrom, Analyst

Thanks to everyone. Ken, a question for you on the chart you have on Slide 18, the economically resilient portfolio positioning. That's a mouthful, sorry. What do you expect that mix to look like in one to two years from now? I guess another way is, where is the emphasis in terms of your growth drivers from where we're starting today?

Tim Bruckner, Chief Credit Officer

Tim Bruckner again. We will concentrate on growth, especially during any potential or actual recession, in areas that are resistant to economic downturns. Simultaneously, we will lessen our involvement in more vulnerable sectors. Our approach will be more precise rather than general, focusing on reducing exposure and exiting industries that are particularly sensitive, while concentrating on sectors that can withstand challenges. When we discuss growth, we refer to the development of our relationships with sponsors that we know well, not just at the lending level but also at the executive level. Our growth is specifically in low loan-to-value scenarios with significant sponsor investment in the deals. Additionally, we can now be more selective about the submarkets we enter if they relate to real estate, and that is where we are expanding.

Jon Arfstrom, Analyst

Okay, okay. Got it. Dale, a question for you. The PPNR growth of 11% to 15%, maybe obvious. But what do you see as the key risks, meaning what brings you closer to 11% or below 11%? And what could put you at the higher end?

Dale Gibbons, CFO

First and foremost, our main focus is on sustaining deposit growth. With increased deposits, we leverage our balance sheet effectively. We see potential on the asset side to invest at significant spreads, which will enhance our net interest income and, in turn, improve our pre-provision net revenue while keeping provision costs relatively manageable, apart from the higher balances. Therefore, sustaining our deposit growth is our top priority. We have several initiatives underway, and many are starting to show results, and we believe we are on track.

Jon Arfstrom, Analyst

Qualitative reserve size, any help you can give us on that? How big is the qualitative piece of your reserve?

Tim Bruckner, Chief Credit Officer

Yes, I can. You're asking about the qualitative adjustments on the ACL upgrade, which are about 5%.

Jon Arfstrom, Analyst

Okay. And then, Ken, just one for you. How are you judged? How are you guys judged? Is it tangible book value growth? Is it EPS? Is it credit? Where are you guys most focused in terms of the financial metrics that we look at for the coming year? Thanks.

Ken Vecchione, President and CEO

So as it relates to performance, it's sort of up and down both the income statement and the balance sheet as determined by our short-term or STI compensation, EPS, loan growth, deposit growth, asset quality, operational quality and the growth in our capital base. In terms of the LTI, of course, it's the share price, and the share price is motivated by the growth in EPS. And so those are the things that we focus on.

Jon Arfstrom, Analyst

Okay, alright. Thank you.

Operator, Operator

Thank you. There are no additional questions at this time. I will now hand the call over to Ken Vecchione for closing remarks.

Ken Vecchione, President and CEO

Thank you all for joining us today, and we look forward to talking to you about the Q1 results in the next couple of months. Thanks.

Operator, Operator

That concludes today's conference call. Thank you. You may now disconnect your lines.