Webster Financial Corp Q3 FY2021 Earnings Call

Good morning, and welcome to Webster Financial Corporation Third Quarter 2021 Earnings Call. Please note this event is being recorded. I would now like to introduce Webster's Director of Investor Relations, Kristen Manginelli to introduce the call. Ms. Manginelli, please go ahead.

Thank you, Sherry. Good morning, and welcome. Earlier this morning, we issued a press release to announce Webster Financial Corporation’s third quarter 2021 earnings. On the call today, we will provide some brief comments regarding the company's third quarter earnings. Today's presentation slides have been posted on the company's Investor Relations website. Before we begin our remarks, I want to remind you that the comments made by management may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and are subject to the Safe Harbor rule. Please review the forward-looking disclaimer and Safe Harbor language in today's press release and presentation for more information about risks and uncertainties which may affect us. I'll now introduce Webster's Chairman and CEO, John Ciulla.

Thanks, Kristen. Good morning and thank you for joining Webster's third quarter earnings call. CFO, Glenn MacInnes and I are here in Waterbury, and we will review our performance for the quarter. I'll also provide an update on the status of our merger process with Sterling, and at the end of our presentation, Glenn and I will take your questions. Despite the continued impact of COVID, expectations for higher inflation, and supply chain and labor challenges, we see increased economic activity and strengthening confidence from our business and consumer clients with respect to demand for products and services. We've seen improving loan activity, which coupled with anticipated higher interest rates should benefit the banking industry and Webster. Credit quality has remained remarkably strong for Webster and for the industry as a whole. With respect to our internal transformational project, we continue to make significant progress on the strategic revenue enhancements and operational efficiencies across the organization in order to achieve our fourth quarter 2021 cost savings target. Glenn will provide more detail in his remarks. Related to our merger with Sterling, our teams have been working diligently and collaboratively to prepare for our closing and remain on schedule for all integration design, planning and execution activities. We are in a position to close the transaction shortly after we receive the final regulatory approvals on our application. In August, we received approval from our primary regulator, the OCC, and shareholders of both banks. While we have no certainty on the timing of the final approvals, we hope we will receive them during the fourth quarter. Based on our communications with regulators and the fact that there are no outstanding information requests, we remain confident that an approval is forthcoming. With respect to the strategic rationale for the merger, I can say that through integration planning our team is more excited about the deal and the opportunities that the combination will provide for our clients, colleagues, communities and shareholders than we were during due diligence and at announcement. The two organizations are very complementary, with virtually no customer or branch footprint overlap. The strong commercial banking teams at both banks will benefit from a larger balance sheet and a more diversified combined loan book. We are creating a unique commercially focused midsize bank with differentiated businesses and a diverse and growing funding profile. Interestingly, last week, both Sterling and Webster were among five banks nationally recognized by Coalition Greenwich as 2021 Greenwich CX Leaders — financial services leaders that have excelled in customer satisfaction, customer loyalty, and creating an environment that is easy for the customer to do business with. Specifically, each bank was recognized for customer experience in commercial, middle market banking. I'll begin the financial report on Slide 2. Our financial metrics remain strong. We continue to execute on our fundamental banking activities, organically adding new customers and deepening existing relationships across all business lines and geographies. Excluding PPP, linked quarter loan balances grew by an 11% annualized rate. Despite NIM compression, the strong loan growth enabled us to increase net interest income by 4% when compared to last quarter. Our adjusted earnings per share in Q3 were $1.08. Third quarter performance includes $5.8 million of net pre-tax charges related to the merger and our strategic initiatives. Tangible common equity grew by 7% and is $171 million higher than a year ago. Total revenue in Q3 was 6.5% higher than a year ago, while adjusted expenses decreased 2.7%. Our efficiency ratio improved to 55%, a decrease of more than 500 basis points from a year ago. Our third quarter adjusted return on common equity was 12%, and the adjusted return on tangible common equity was nearly 15%. Our $8 million provision was driven by strong loan growth and resulted in a reserve build of $7 million in the quarter. Credit quality remained solid with key asset quality metrics continuing to be near cycle lows. As a percentage of the portfolio, NPLs, net charge-offs and commercial classified loans were all better than a year ago. Our percentage of NPLs to total loans is at its lowest point since before the Great Recession. I'm now on Slide 3. Excluding PPP, total loans grew 3.3% from a year ago, led by commercial loan growth of $700 million, or 5%. This is a very strong quarter for commercial banking with $1.2 billion of loan originations, up solidly from a year ago, driven by growth in sponsor and specialty, commercial real estate, middle market and business banking verticals. Loan fundings of $967 million were up 62% or $372 million from a year ago. Consumer loans grew 3.8% or $252 million from second quarter, and declined less than 1% compared to prior year. The linked quarter increase reflected stronger purchase mortgage activity and lower refinance activity during the quarter. Overall residential mortgage activities drove 82% of consumer loan originations, flat to linked quarter and from a year ago. I'm now on Slide 4. Deposits grew 11.5% year-over-year driven across all business lines. Core deposits grew by $3.8 billion and represent 94% of total deposits compared to 90% a year ago, while CDs declined $686 million from a year ago. Deposit costs continue to decline and were 6 basis points in total in the quarter. Commercial banking deposits are up more than 23% from a year ago, primarily driven from municipalities and excess liquidity among clients across all lines of business and geographies. Retail banking deposits grew 7.3% year-over-year, with consumer and small business deposits growing 6.5% and 12.7%, respectively. Retail deposit costs have continued to decline as well, and totaled 5 basis points in the quarter. Turning to HSA Bank, total deposits grew 5% year-over-year or 8% on a core basis, excluding the TPA balances. Total footings grew 14% year-over-year. Slide 5 provides an overview of the transaction and integration timeline. As I discussed earlier, merger integration activities continue to be on track, with the teams from both banks working collaboratively and tirelessly to position us for success at close and beyond. We are prepared to successfully combine the two companies and begin operations shortly after we receive the necessary approvals. As shared in our merger announcement in April, Jack Kopnisky and I both recognized that a critical element of success in bringing these two companies together is cultural alignment. As such, we've established a cultural integration framework that provides a clear and aligned view on the purpose and values of the organization, and what we will expect from our colleagues in terms of guiding behaviors and performance. The new executive management team is working together to ensure that our combined culture reflects the strengths that both banks bring to the combination. With that, I'll now turn it over to Glenn for the financial review.

Thanks, John, and good morning, everyone. We reported another quarter of solid results evidenced by strong loan growth, favorable credit performance and continued execution on our merger strategic initiatives. I'll begin with our average balance sheet on Slide 6. Average securities increased $76 million linked quarter. Securities represented 27% of total assets at September 30. During the quarter we purchased approximately $1.1 billion in securities, up from $600 million in the prior quarter. Purchases had a weighted yield of 1.44% and a duration of five years. Securities called, matured or paid down totaled around $500 million, with a yield of 2.23%. Our average cash balance held at the Fed totaled $2.3 billion, an increase of $1.1 billion linked quarter, driven by growth in commercial deposits. Average loans increased $125 million or 0.6% linked quarter, primarily driven by an increase in C&I, commercial real estate and residential mortgages, partially offset by PPP loan forgiveness. During the quarter forgiveness on PPP loans totaled $448 million, and the remaining PPP loans were $398 million. In Q3, we recognized $16 million of PPP deferred fee accretion, and the remaining deferred fees totaled $15 million. Excluding PPP, average loans grew $650 million or 3.2%, average commercial loans grew $427 million or 3.1%, while residential mortgage loans increased $297 million, or 6.3%. Average deposits grew $1.1 billion or 4% linked quarter. The increase was driven by continued growth in commercial transaction deposit products, and was partially offset by a decline in higher-cost retail CDs. Average borrowings were flat to Q2, and down $1 billion from prior year as a result of excess liquidity. Borrowings represent 3.8% of total assets at September 30, compared to 7% a year ago. The loan to deposit ratio was 72% at September 30. The common equity Tier 1 ratio increased 10 basis points linked quarter to 11.77%. The tangible common equity ratio decreased 20 basis points to 7.71% as a result of balance sheet growth. Tangible book value grew 2.2% linked quarter and 6.4% from prior year. Slide 7 highlights our GAAP performance and adjustments to reported income available to common. During the quarter, we recognized a net of $4.3 million after-tax charges related to our merger and strategic initiatives. On an adjusted basis, income available to common was $98 million or $1.08 per share, resulting in a 12.2% return on average common equity and a 14.8% return on tangible common equity. On Slide 8, we provided our reported to adjusted income statement. On an adjusted basis, net interest income increased by $9 million linked quarter, driven by loan growth and PPP fee accretion, which was partially offset by a lower yield on securities. NIM of 2.8% declined 2 basis points from prior quarter, primarily due to an increase in excess deposits held at the Fed, partially offset by higher PPP fee accretion. Excluding excess liquidity and PPP fees, third quarter NIM was approximately flat linked quarter. As compared to prior year net interest income increased by $10 million. This was a result of higher PPP fee accretion, lower funding cost and loan growth, which was partially offset by lower yield in the securities portfolio. Non-interest income increased $11 million linked quarter, primarily driven by fair value adjustments of $6 million on direct investments, and $3 million on customer derivatives, as well as higher loan related fees of $3 million. This was partially offset by a decline of $2 million in HSA fee income due to lower exit fees on TPA accounts, and a seasonal decline in interchange revenue. Compared to prior year, non-interest income grew $8.7 million. This reflects an increase of $9 million related to fair value adjustments on direct investments, $6.1 million from higher loan and deposit service fees, and a $1.7 million increase in investment income. This was partially offset by declines of $5.6 million in mortgage banking revenue, and $2.5 million in HSA fee income. The reduction in mortgage banking revenue was the result of holding more loans on the balance sheet, as we deployed excess liquidity into fixed rate loans. The decline in HSA fee income was driven by $3.2 million in TPA closure fees recorded a year ago. Adjusted non-interest expense increased $5.6 million from prior quarter, reflective of a $4.3 million increase in performance-based compensation, and a $1.4 million increase in technology expense. Versus prior year, non-interest expense declined $4.8 million due to our previously announced efficiency initiatives, resulting in lower occupancy costs, compensation and other expenses. Pre-provision net revenue was $139 million in Q3. This compares to $125 million in Q2, and $115 million in prior year. Our CECL provision in the quarter reflects an expense of $7.8 million. The adjusted tax rate was 23.8%, an increase of 15 basis points linked quarter. The net result is an adjusted net income of $98 million or $1.08 per share, down from $1.21 per share in prior quarter. As you see on Slide 9, we reported a $5 million linked quarter increase in core non-interest expense. This was primarily the result of performance-related compensation, as evidenced by balance sheet and revenue growth and strong credit quality. We expect to complete the execution of our strategic initiatives by the end of the year, and remain on track to deliver core expenses in the range of $164 million in Q4. Any variability would be related to performance-based compensation. The cost savings on this slide are reflective of our standalone initiatives. Over the last six months we've made meaningful progress on our integration plans with Sterling, and remain confident in our ability to deliver 11% of incremental cost synergies on a combined basis. Turning to Slide 10, I'll review the results of our third quarter allowance for loan losses under CECL. In the quarter, we reported an $8 million provision expense and a $7 million increase in the allowance. The allowance coverage ratio excluding PPP loans remained flat at 1.49% with total reserves of $315 million. As we look at the trend from Q2 to Q3, we established $6 million in reserves related to commercial and residential loan growth, and $2 million due to credit quality and macroeconomic trends. Slide 11 highlights our key asset quality metrics, reflecting strong credit quality performance. Non-performing loans in the upper left declined $20 million from Q2. Commercial, residential mortgage and consumer each recorded linked quarter declines. NPLs as a percent of total loans are 47 basis points, down from 74 basis points a year ago. Net charge-offs in the upper right were $900,000 in the quarter, including $1.6 million in net charges for commercial and $700,000 in net recoveries for consumer. Year-to-date, we have recorded $5 million in net charge-off, which is on track for our lowest level since 2005. Commercial classified loans in the lower left increased $2 million from Q2 and represent 251 basis points of total commercial loans. Slide 12 highlights our strong capital levels. Regulatory capital ratios exceed well-capitalized levels by a substantial amount. Our common equity Tier 1 ratio of 11.77% exceeds well-capitalized by more than $1.2 billion. Likewise, Tier 1 risk-based capital is 12.39% and exceeds well-capitalized levels by $1 billion. With respect to the fourth quarter, we expect average core loan growth excluding PPP loans to be in the range of 2% to 2.5%. Net interest income will decline $3 million linked quarter, primarily due to lower PPP income. Non-interest income will decline around $4 million linked quarter, as the net result of non-recurring fair value marks on direct investment and customer derivatives. As indicated earlier, core expenses will be in the range of $164 million. Any variability would be related to performance-based compensation, and our tax rate will be similar to the Q3 level. With that, I'll turn it back over to John for closing remarks.

Thanks, Glenn. Webster's third quarter results demonstrate our continued focus on building long-term franchise value, and maximizing economic profits through a disciplined capital allocation process and strong execution in our differentiated businesses. Our colleagues remain committed to serving their clients while at the same time preparing for a successful integration. Webster continues and the new Webster will continue to deliver for its clients, communities, shareholders and colleagues. Lastly, I want to say a big thank you to all of our colleagues for their commitment to our values and dedication to our customers and to each other. With that Sherry, Glenn and I are prepared to take questions.

Thank you. Our first question is from Chris McGratty with KBW. Please proceed.

Hey, good morning.

Good morning, Chris.

Let me start with you on the deployment in the quarter on the securities book. You've seen a lot of your peers be a little more aggressive in deploying cash. What are your thoughts into the merger in terms of redeploying more cash into the investment portfolio?

Sure. Good morning, Chris. In the quarter, we had an average balance at the Fed of about $2.2 billion and we have begun to deploy some of that. So we're below $2 billion as we speak. I think you would expect with a combination of both loan growth and securities deployment that we would probably end the quarter on average before quarter end at about $1 billion.

Okay. Great. And then maybe a question on capital. Once the deal closes, you guys have a lot of capital and you're generating a lot of capital. John, can you just talk about the buyback and the potential magnitude of a buyback?

Sure. When we put out the announcement of the transaction, we showed a $400 million stock repurchase to sort of plug excess capital there. We've talked about a 10.5% target CET1 ratio. What I would say is what I always say, which is we'd like to deploy capital in areas where we think we can generate and maximize economic profits first. Clearly, this company will have a lot of excess capital pro forma for the combination and we also generate a lot of capital each year. So we'll then look at dividends and buybacks. Certainly, I think we have the capacity for significant stock repurchase. But again, if we find areas where we can accelerate loan growth, look at acquiring portfolios of commercial loans, or deploying capital into our differentiated businesses, that's our first choice. We'll be appropriate in our allocation of capital deployment.

Okay. And I think you said last quarter, you think the pro forma company can do double-digit loan growth. Sterling's results supported that last night. Any change to your view on prior comments?

Chris, I still think 8% to 10% growth is absolutely achievable. Could we outperform that? We're going to have a larger balance sheet, we'll have higher holds, but the market is still not back to normal in terms of loan demand. We've seen fewer payoffs in the last couple quarters, so I think the prudent guidance sticks with approaching that double-digit loan growth, which we think as a combined company we can achieve.

Great, thank you.

Thank you.

Our next question is from Matthew Breese with Stephens. Please proceed.

Good morning. Just on expenses, obviously, the delta was driven by performance-based comp. And it sounds like that could happen again for the fourth quarter. So could you just outline for us what performance-based comp was this quarter? And is that a good range to consider for the fourth quarter?

Yeah, so I think there was a bit of a true up, Matt, in the third quarter based on our performance. So it spiked up in the third quarter. I would expect it to be somewhere between $1 million and $1.5 million in the fourth quarter at most.

Okay.

Sorry, I wouldn't pull it forward or push it forward.

Okay. And then maybe you could just talk about the health and strength of the pipeline, obviously, you're very optimistic on long-term loan growth. But how do you feel about it over the next three to six months?

Yeah, Matt, I'm getting more bullish. I think we talked last time that before you saw back-to-normal loan demand, a lot of companies and individuals needed to deploy their excess liquidity. With some uncertainty around supply chain issues and labor issues, people were a little reticent to invest. We saw good third quarter following a pretty good second quarter for us. Our pipeline going into the fourth quarter is one of the strongest it has been in the last several years, and that's across all of our business lines. Utilization still hasn't seen a significant tick up, so that could be a tailwind if we start to see asset conversion cycles and businesses like ABL start to pick up. I'm getting more bullish; we are seeing a lot of pent-up activity. But I still think there's a lot of liquidity out there and we haven't seen utilization tick up materially. I expect we'll be cranking as we get into the second and third quarters next year.

Got it. And then just to follow up on the last question, the near double-digit loan growth on a combined basis. In niche markets from Boston and New York, these are traditionally slower growth markets and it's going to be a much bigger balance sheet. Could you just walk us through some of the areas that might need to change on a combined basis in order for you to get there? Or maybe it's nothing at all? Are you considering bringing some business lines national or adding new business lines? Could you just give us a sense for it? Historically banks that big, it’s tough for them to get that kind of loan growth. How do you intend to get there?

Sure. Our current assumptions of 8% to 10% really reflect business-as-usual. We're likely to continue all specialized national and local businesses out of the gate. We've done a lot of diligence. We like all the businesses; they give us a lot of levers. It gives us diversity across geographies and some national franchises. I don't think we will make any significant changes to the lines of businesses that we're focused on or the geographies we're in over the short term. As we move forward, we'll look at each business to assess risk-return dynamics and whether we can generate significant economic profits and maintain our competitive position. But the short answer is we expect to achieve 8% to 10% loan growth next year by executing on all the business lines that the combined bank will have. There are opportunities to go deeper in some businesses and accelerate the trajectory, but that's not included in our strategic plan right now.

Great. I'll leave it there. Thanks for taking my questions.

Thank you.

Our next question is from Brock Vandervliet with UBS. Please proceed.

Thank you. Good morning.

Hey, Brock.

Just zeroing in on a couple aspects of loan growth. I think you covered the sponsor and specialty and C&I. What are you thinking in terms of residential, especially in the Q4 timeframe with that seasonal slowdown? Also, you noted some strength in CRE; maybe you could talk about those two areas?

Our commercial real estate actually had one of its biggest origination and funding quarters in quite some time, so there's obviously activity there. We always talk about the dynamic of originations and paydowns, and we had fewer paydowns in commercial real estate in the quarter which benefited net growth. Most of our growth will continue to come in commercial categories, but we have had a couple of strong quarters in residential mortgage given the dynamics of interest rates and where people are moving. Connecticut has been the beneficiary of a lot of influx, which is where we have most of our residential loan exposure, so that's helped. We do think that'll slow a little bit due to seasonality in the fourth quarter and winter. That never really moves the needle for our overall loan growth, so anticipate our residential originations and fundings to be slightly lower than the prior quarter. We expect the commercial pipelines, which are robust, to continue to convert into funded loans in the fourth quarter.

Okay. And Glenn, you touched on this in your prepared remarks, but if you could just review and connect the chord for us between the operating expense we saw in Q3 and your goal for Q4, and how we get from here to there?

Yeah, one of the bigger drivers was performance-based compensation, and so that was the largest driver. There are other seasonal items—marketing, timing of mailing campaigns, and similar items. But when I pull it all together, we still feel comfortable we'll hit around $164 million, subject to variability on performance-based compensation. That $164 million excludes amortization and similar items; it's an efficiency-based target.

Got it. Okay, thank you.

Thanks, Brock.

Our next question is from David Chiaverini with Wedbush. Please proceed.

Hey, thanks. A couple questions for you. Starting on loans, you spoke about the growth, but I wanted to touch on the pricing, loan pricing. On Slide 3, I see the yield increased to 3.6% in the third quarter. I'm assuming PPP was a key driver of that. Can you talk about the loan pricing environment?

Sure, David. The 14 basis points quarter-over-quarter increase in yield wasn't really on pricing, it was on acceleration. The biggest drivers were acceleration of deferred fees on PPP and loan prepayments. From an origination standpoint, our yields held up pretty well relative to prior quarter, which is a good sign. We're not seeing a lot of degradation in price. Originations ranged from mid-2% yields for high-quality commercial real estate, to approaching 5% on good sponsor and specialty deals, around 4% on business banking, and middle market somewhere in the 2.5% to 3% range. Depending on mix, those are the coupons on our originations and we didn't see much degradation over the last several quarters, which in a competitive market was a plus for us.

If I can add a bit, David, third quarter versus second quarter the yield is basically flat if you adjust out for PPP. In Q2 the yield on the total book was about 3.40% and in Q3 it was about 3.38% — basically flat.

Got it. Thanks for that. And then shifting to HSA, can you talk about the pipeline there as we head into the open enrollment period?

We've had a good year in selling activity, particularly in the direct-to-employer channels. Our healthcare partners have grown a little less quickly. Our pipeline this year is good; much of what will matter for open enrollment is in process and it looks encouraging. This quarter is typically slow as we approach the enrollment period. The wildcard over the last couple years has been new customer acquisition versus account signups from larger employers. Changing employment dynamics and hiring disruption slowed that a bit last year. We typically get 75% to 80% of new accounts from existing customers, and that waned a little last year. We're hopeful that with improving employment dynamics we'll have a solid selling season, better retention and more normalized new account openings from existing customers, which should lead to a robust enrollment period. We're enthusiastic, but reticent to give precise numbers until we see the enrollment activity in the fourth quarter.

Great to hear. Thanks very much.

Our next question is from Steven Duong with RBC Capital Markets. Please proceed.

Hey, good morning, guys. Glenn, we spoke about your deposit beta. Can you share with everyone just overall on Slide 22 your rate sensitivity analysis? What goes into the deposit beta for the first say 50 basis points and the subsequent 50 basis points as well?

Thanks, Steven. If you look at Page 22, our short-end 50 basis points sensitivity shows 6.2% on the pro forma. We have lowered our deposit beta; it was as high as 32 and we lowered it to between 25 and 30. Even in a rising rate environment we're assuming a lag. For the first 25 basis points the modeled beta will be closer to 11, and the second 25 basis points around 11 as well. It's not until a third lift that the beta starts to increase materially; at that point we'd model around 20%. By a full 100 basis points we'd probably be closer to a full beta of about 29%. So there is a lag built into the model. There is a school of thought that it's closer to zero for the first two moves; anything like that would be additive to our asset sensitivity.

That's something we're all trying to wrestle with since we've never been here before. Given the amount of liquidity in the system, it doesn't seem like everyone will be chasing deposits. I appreciate that. John, do you get a sense that the Fed is just backed up, or is it something more where regulators want to slow the process down a little bit?

We think it's backed up. We don't have a clear line of sight to timing. We've had good discussions with all the regulators. We announced the deal in April; if you look at historic timelines on mergers we're still well within a comfortable zone. We don't think there's anything behind the scenes that could derail this transaction. We've answered all questions, we like our application and the merits of the transaction; we think it's just timing.

I appreciate it. Thank you.

Our next question is from Laurie Hunsicker with Compass Point. Please proceed.

Good morning. I'm just wondering if you could comment on the jumps in your leveraged sponsor and specialty (S&S) book and how we should think about that. It's almost $200 million linked quarter; where are your plans to grow that? Is that the sense of where loan growth is going to come from in your projection?

Laurie, we've demonstrated over time a disciplined approach to enterprise-reliant lending, whether it's regulatorily leveraged or not. Activities in that book remain within appropriate levels given the entire loan book. This transaction gives us more running room from a risk management and concentration framework to continue to grow sponsor and specialty. That business has high originations, is very profitable, and we believe we're strong in it. It also has a relatively low and short average life, so you often see good originations and many payoffs. I don't think you'll see disproportionate outsized growth over the long term. Once we close the merger, our concentration there will be about half of what it was, and we'll be able to accelerate growth as appropriate. We're not in a position where regulators or our risk infrastructure are concerned with the overall exposure.

So to follow up, you mentioned $1.4 billion and $3.6 billion earlier — as a percentage, would you like that leveraged piece to remain around the same or change as you think about growth going forward?

We don't look at it as a simple percentage split. We look at overall risk rating. Some leveraged deals are highly risk graded and fit regulatory definition. Our enterprise book is about $3.6 billion on a $20 billion loan portfolio. We think we have some running room; if you look forward to a $40 billion loan portfolio, we'd have significant running room. We've been prudent risk managers and will continue to be.

Okay, helpful. Thanks. Can you clarify the $4 million gain you booked on the strategic initiatives — what exactly was that?

That was a reversal of an estimate we made on severance liabilities. It was driven by two things: a higher retention rate on some employees, and the fact that initiatives tied to things like the core banking platform and loan system were paused until final decisions are made. That drove the $4 million reversal.

How should we think about that line going forward? Last quarter it was $1.1 million. Are we done with those kinds of items?

I don't think you should expect to see much after the fourth quarter. Once we achieve the $164 million target for efficiency-based compensation, you shouldn't expect to see significant amounts on that line.

That makes sense. One last question: on margin, I'm looking at margin ex-PPP which was about 2.65% in June and 2.60% in September. If we fast forward a couple of quarters, PPP will be mostly gone and Sterling is rolled in. How should we think about pro forma margin?

Let me give color from Q3 to Q4 first. PPP runs off which reduces NII benefit, but that's partially offset by deployment of excess cash. Going into Q4 you'll have about 7 basis points impact from PPP coming down. You'll have some compression in the securities portfolio, but deployment of cash and some room on deposits should lead deposit cost closer to 5 basis points in the fourth quarter. Overall, I gave guidance of net interest income down $3 million which backs into about a 3 basis point NIM compression in Q4. In Q1 you don't have PPP benefit, but deployment of excess cash should more than offset that, which bodes well for core ex-PPP net interest margin.

Do you have an accretion number yet for net interest income from the Sterling transaction?

No.

We haven't made the marks yet. We're closer to where we were when we announced the transaction in April given where rates are at 163 basis points. There was a dip in rates in the second quarter, but we're close to where we were when we made the announcement, though all that has to be trued up.

Right. Thank you.

Thanks, Laurie.

Our next question is from Jared Shaw with Wells Fargo Securities. Please proceed.

Hey, everybody, good morning.

Hey, Jared.

Sticking with loan growth, great trends there in a market that really isn't seeing overall growth yet. Are you taking market share? If so, where are you seeing the most success in terms of bringing new customers on, especially with utilization rates being flat?

Particularly in this market, there hasn't been a lot of trading of traditional middle market relationships; many banks have hugged their customers. We're taking advantage of economic growth and activity with sponsors — commercial real estate investors, private equity sponsors, family offices engaged in capital markets activities — and benefiting from that activity. This quarter, we're doing a good job in business banking, winning more than our fair share, particularly from Boston to Westchester County. Those are on-the-ground wins with good products and quick credit turnarounds. In sponsor and specialty and commercial real estate, our depth and duration of relationships mean we're often the first or second call, and we can win transactions related to new acquisitions or repositionings. We're not necessarily gaining significant market share in traditional multi-generational middle market companies, but we are gaining disproportionate share in the economic activity coming back post-pandemic through transactions.

Thanks, that's great color. Shifting to credit, credits are very strong and I was surprised the allowance ratio stayed flat. Can you give color on progression back to a more normalized level? How should we think about that, especially with the deal closing where you'll have additional supplemental credit coverage?

Almost the entire provision was related to robust loan growth and mix. We're disciplined in the CECL process and rely on our models. The outlook is still positive with no significant change in forward outlook, though labor and supply chain remain considerations. We're adding for significant balance sheet growth. Over time, as the economy grows and we maintain strong asset quality, there's opportunity for that coverage ratio to come down. We stick to the CECL process; nothing in the portfolio gives us concern. We will continue to provide for life-of-loan projected losses as the loan book grows.

Okay. And then finally for me, Glenn, can you comment on LIBOR transition progress? Some data show SOFR spreads are a bit better. Are you seeing that, or are assets still under LIBOR?

We're well positioned from a LIBOR standpoint. We actually have a transaction coming up that will be SOFR-based. The spread between SOFR and LIBOR will likely result in some spread on top of SOFR when markets price loans. We haven't seen enough in the market yet to determine how that will settle, but that's our current thinking.

Great. Thanks a lot.

Thank you.

And our final question is from Ken Zerbe with Morgan Stanley. Please proceed.

Alright. Thanks. Going back to expenses, I want to make sure we're thinking about the $164 million target correctly. I recognize the merger closes, and you may not actually see $164 million. But the $164 doesn't include amortization, correct? And are you excluding all performance-based comp from the $164 such that we should add those on top?

Ken, if you look on Slide 9, the reason we call it an efficiency-based target is that we've excluded amortization. That million has always been excluded. We feel confident in hitting the $164, but understand that if we were up say $1 million or $1.5 million, it would all be performance-based compensation. That's how we feel right now.

When we set targets, we set performance at plan. In the last couple of months and quarters we've significantly outperformed. Glenn trues up the accrual and you've seen similar true-ups across banks this quarter. To the extent we significantly outperform plan in the fourth quarter and accruals need to increase, that would be the delta.

Got it. So it would be on top of the $164 if fees and other things were above plan.

Exactly, it would be excess revenue.

Understood. And then on the reserve: you're one of the banks that built or captured reserve relatively flat this quarter. Do you feel you're at a good place where your reserve on a Webster standalone basis is appropriate for the near term? More importantly, post-Sterling, what is the right allowance target or CECL day-one level we should think about?

Look at the 1.49% coverage ratio; we feel comfortable with where we've posted it. Sterling is quite similar from a coverage standpoint. It will be driven by portfolio mix and economic outlook. Our provision for the quarter was primarily driven by loan growth, and that's what drove the increase.

Ken, as a former credit officer I view the reserve as a function of risk ratings, probabilities of default, loss given default, and macro factors. We're at the right level now. On a combined basis, as concentrations decrease with a larger portfolio and if macro factors improve, there's room for the coverage to come down. Our sponsor and specialty business by definition can have higher loss given default, so when mix shifts toward that business you can see higher provisions. We're at the right level now and continued execution and macro improvement could lower it.

I was asking what that future number could be in a better environment. Some banks call it their CECL day-one number. If you don't want to comment, I understand.

I don't want to speculate on a specific day-one number. There is logic to looking at a day-one number if you assume certain macro and portfolio size, and a combined $40 billion loan portfolio could lower correlated risks. But I won't put a specific number on it today.

Alright. Thank you very much.

Thank you.

We have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing remarks.

Terrific. I want to thank everyone for your continued interest in Webster. Have a great day.

Thank you. This does conclude today's conference. You may disconnect your lines and thank you for your participation.