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Good morning. My name is Regina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Comerica Second Quarter 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions].
I'd now like to turn the conference over to Darlene Persons, Director of Investor Relations. Ma'am, you may begin.
Thank you, Regina. Good morning and welcome to Comerica’s second quarter 2018 earnings conference call. Participating on this call will be our Chairman, Ralph Babb; President, Curt Farmer; Chief Financial Officer, Muneera Carr; Chief Credit Officer, Pete Guilfoile.
During this presentation, we will be referring to slides that -- which provide additional detail. The presentation slides and our press release are available on the SEC’s Web site, as well as in the Investor Relations section of our Web site, comerica.com.
This conference call contains forward-looking statements. And in that regard, you should be mindful of the risks and uncertainties that can cause actual results to vary materially from expectations. Forward-looking statements speak only as of the date of this presentation and we undertake no obligation to update any forward-looking statements. I refer you to the Safe Harbor statement in today’s release on Slide 2, which I incorporate into this call as well as our SEC filings for factors that could cause actual results to differ.
I also discuss in this call the referenced non-GAAP measures and, in that regard, I would direct you to the reconciliation of these measures within this presentation.
Now I’ll turn the call over to Ralph, who will begin on Slide 3.
Good morning and thank you for joining our call. Last month the Federal Reserve announced that bank holding companies of our size are no longer subject to supervisory stress testing, including both the Dodd-Frank Act stress tests and CCAR. Our solid financial performance and strong capital levels position us well to meaningfully increase the capital return to our shareholders.
We will continue to properly manage our capital base while supporting growth and investments in our business. Our Board will now be able to more efficiently and effectively take capital actions quarterly. Its next meeting is on July 24 and we expect to issue a press release announcing our planned capital actions at that time.
In addition, the fed recently announced that we are no longer subject to certain regulations and reporting requirements such as the liquidity coverage ratio and liquidity related reporting and disclosures. We are still in the process of evaluating the positive effects of these changes.
Our focus remains on achieving the most efficient views of our resources for the benefit of all of our constituencies including our customers and the communities we serve, while managing our business prudently.
Turning to our financial results, we reported second quarter earnings of $326 million or $1.87 per share. Our earnings per share increased 18% over the first quarter. Relative to the second quarter of last year, our earnings per share increased 65% and pre-tax income is up 39%. This is primarily due to our management of loan and deposit pricing as interest rates have moved higher, improved credit quality as well as continued successful execution of our GEAR Up initiatives.
On Slide 4, we are outlining adjustments related to certain items including restructuring, impacts from the new tax law and the tax benefit relating to employee stock transactions. The adjusted return on assets was 1.89% and adjusted return on equity was 16.7%. Please note, in the first quarter we adopted a new accounting standard for revenue recognition which match certain expenses against the related fee income. The adjusted noninterest income and expense figures for the second quarter 2017 can be found in the appendix.
Turning to Slide 5 and an overview of our second quarter results, average loans for the second quarter were up $804 million or 2% compared to the first quarter. Seasonality helped drive increases in Mortgage Banker and National Dealer Services. Technology and Life Sciences, specifically the equity fund services component grew over $300 million. Also we’ve posted growth in middle market as well as several of our specialty and national businesses.
As far as deposits, average balances declined primarily due to seasonality in non-interest bearing deposits. Starting mid quarter, we began seeing a rebound in deposit balances which is consistent with trends in prior years. Net interest income increased $41 million or 7.5% and our net interest margin increased 21 basis points to 3.62%. The net benefit from increased interest rates was $21 million. With the faster rise in LIBOR, we increased deposit rates to benefit our customers. In addition, nonaccrual interest recoveries were particularly strong.
We had a broad-based decline in problem loans as well as net recoveries with charged-off loans. This led to a reduction in our allowance for loan losses and a negative provision of $29 million. Noninterest income was up $4 million with a $5 million increase in customer driven income, including commercial lending fees and customer derivative income.
Noninterest expenses were relatively stable. A seasonal decrease in salaries and benefits expense was offset by increases in outside processing and advertising. Also lower restructuring expense was offset by a business tax refund we received in the first quarter which was not repeated. We increased our capital return to shareholders. Equity repurchase increased to a $169 million or 1.8 million shares and our dividend was increased 13%.
And now, I'll turn the call over to Muneera, who will go over the quarter in more detail.
Thanks, Ralph. Good morning, everyone. Turning to Slide 6. Second quarter average loans increased $804 million compared to the first quarter. Mortgage banker loans grew nearly $350 million with a normal pick up in spring home sales. Our portfolio continues to be heavily weighted to home purchases with approximately 87% purchased versus refi-ed compared to the industry average of 74%. We had solid growth in technology and life sciences, specifically equity fund services and general middle market increased nearly $115 million with growth in all three of our markets.
Our auto dealer [indiscernible] portfolio also increased over $100 million due to seasonal buildup in auto inventory. In addition, we saw growth across a number of our key specialty and national business lines including commercial real estate, environmental services and entertainment. Partly offsetting this growth with a decrease in private banking as a result of the few large loan payoffs.
Also, we remain selective in the large corporate base maintaining our pricing and underwriting standards in a highly competitive environment. As anticipated, the pace of decrease in energy loans have slowed, but continues due to capital markets activity and asset sales resulting from firmer commodity prices.
Total period-end loans increased $552 million with the largest contributions from mortgage banker and technology and life sciences. Also, commitments were up $1.6 billion driven by increases in nearly all business lines. Overall, the sentiment is positive, reflective of the improving economy, yet customers continue to be cautious given uncertainty regarding evolving trade discussions.
Our loan yield increased 37 basis points. Higher rates, including a 32 basis point increase in average 30 day LIBOR added 27 basis points to our yield. Nonaccrual interest recoveries which are difficult to predict increased $9 million and added 8 basis points. Finally, portfolio dynamics such as a mix shift in the portfolio and loan fees in the margin added 2 basis points.
Importantly, we are focused on a relationship strategy to appropriately manage loan pricing. As you can see on Slide 7, average deposits declined $260 million in the second quarter primarily as a result of seasonality. Municipal deposits decreased as they typically do following tax collection in the first quarter. Also, middle market was impacted by seasonality as customers utilizing their cash in their businesses. Midway through the quarter we began to see positive trends.
Average deposits in June grew $749 million over May. This included the highest growth in interest-bearing deposits for June we’ve seen in many years. We expect deposit growth to continue in the back half of the year in line with the historical pattern. In conjunction with the faster rise in LIBOR, we increased deposit rates. We rely on our relationship model to stay close to our customers and help ensure we’re offering competitive and appropriately priced products.
Our primary objective is to retain and attract deposits, while managing our costs. We believe we are well positioned and at the present time don’t expect similar incremental standard pricing actions. Our securities book remains at about $12 billion as shown in Slide 8. The portfolios unrealized loss position of $328 million had a minor impact on the carrying value. The yield and the portfolio continues to trend up. Recent securities purchases have been in the low 340s which was above the average base of two in a quarter on the $450 million in pay downs we received in the quarter.
Turning to Slide 9, net interest income increased $41 million and net interest margin was up 21 basis points. Our loan portfolio added $59 million and 29 basis points to the margin. Increased interest rates provided the largest benefit along with higher loan balances and unusually high level of nonaccrual interest recoveries and one additional day in the quarter.
As far as our deposit at the fed, the benefit from the higher fed funds rate was mostly offset by a decrease in average balances. This resulted in a net benefit of 3 basis points to the margin. On the funding side, deposit costs were up $12 million primarily due to increased pay rates as I previously discussed. This had a 7 basis points impact. Also, wholesale funding costs increased $5 million as a result of the increase in six month LIBOR and $2 million as a result of some FHLB funding that was added in the first quarter at attractive rates.
In summary, the net impact from increased rates contributed $21 million or 11 basis points to the margin. Credit quality remains strong as shown in Slide 10. Gross charge-offs of only $20 million were more than offset by unusually high recoveries of $23 million. Total criticized loans declined $355 million or 17% and now represents 3.5% of total loans at quarter end. This included a decrease in nonaccrual loans which comprised only 51 basis points of our total loans.
Energy criticized and nonaccrual loans continued to decrease. The positive credit migration resulted in a reserve release and a reserve ratio of 1.36%. We remain vigilant and continue to look for signs of stress. At this point, we are not in any concerning credit.
Turning to Slide 11. Noninterest income grew $4 million. This included a $5 million increase in commercial loan fees, primarily related to syndications as well as customer derivative income. This was partly offset by a decline in investment banking fees. In addition, we increased the reserve for a derivative contract related to Visa Class B shares by $2 million. We remain on track to achieve our GEAR Up revenue target.
To highlight our progress, you can see the growth we have achieved on a year-over-year basis in card, fiduciary, and brokerage. Expenses remain well controlled and our efficiency ratio fell to 53% as shown on Slide 12.
Salaries and benefits decreased $5 million following annual shared based comp and higher payroll taxes in the first quarter. This was partly offset by annual merit raises, higher incentives related to our financial performance and one additional day. We continue to execute our GEAR Up initiatives, as evidenced by our total workforce reduction of 1% from the first quarter and nearly 2% over the past year.
We had increases in outside processing, which was mostly tied to revenue generating activity as well as advertising expense, which was seasonally low in the first quarter. You may recall that we had a business tax refund of $5 million in the first quarter and it was not repeated. Restructuring charges were $11 million, a decrease of $5 million from the first quarter.
In the second quarter, we repurchased $169 million or 1.8 million shares under our equity repurchase program as you can see on Slide 13. In addition, we increased our dividend 13% to $0.34 per share. Together with dividends, we returned $227 million to shareholders. Employee stock activity added about 200,000 shares during the quarter. This activity resulted in credits to our income tax provision of $3 million or $0.02 per share.
As Ralph indicated, we expect to provide an update on our planned capital actions after our Board meets next week.
Turning to Slide 14, our balance sheet continues to be well positioned to benefit from increase in rates. Our asset sensitivity is illustrated by our betas so far this cycle with a cumulative loan beta of 94% while our cumulative deposit beta is 18%. Our asset betas have outperformed our expectations, allowing us some flexibility to manage deposit costs while significantly adding to our bottom line.
We expect the net benefit from 2018 from the first quarter rate increase to be $70 million and $35 million to $40 million in additional net interest income for the second quarter rate increase. Out of our $35 million to $40 million, $6 million is already in the second quarter run rate. In total, we estimate $270 million in additional net interest income in 2018, resulting from the full-year impact of the three rate increases last year and the March and June highs this year.
For the remainder of the year, we are assuming that short-term rates remain at the current level and average deposit rates increased 8 to 10 basis points from here. We remain focused on our relationship approach to manage loan and deposit pricing to attract and retaining customers. Of course, the ultimate outcome depends on a variety of factors such as the pace at which LIBOR move, loan and deposit competition and balance sheet movement.
It is likely that the fed could be raising rates once or two more times this year and we stand to further benefit with our well positioned balance sheet. We have not added hedges to change our asset sensitivity. Our Asset Liability Committee continues to assess our position to determine the appropriate path given balance sheet movement and our outlook for rates.
Now, I will turn the call back to Ralph to provide an update on our outlook for the remainder of 2018.
Thank you, Muneera. As usual, our outlook assumes a continuation of the current economic and interest rate environment. As I mentioned at the beginning of the call, recent regulatory developments such as elimination of CCAR and LCR are certainly positive, but it's too early to provide guidance on the effects of these changes.
As far as loans, following a seasonally strong second quarter we expect to drive moderate growth in the back half of the year. This includes increases in most businesses led by mortgage banker, primarily due to seasonality as well as Technology and Life Sciences, tempered somewhat by a seasonal decline in Dealer and a slight reduction in the pace of middle market growth due to the typical summer slowdown.
Regarding net interest income, as Muneera indicated, we expect to continue to see the net benefits of the recent rise in short-term rates. Also we expect contributions from loan growth and additional days. Recall in the second quarter we had nonaccrual interest recoveries of $11 million. This elevated level is not expected to repeat as we typically collect $1 million to $2 million per quarter. And while not included in this outlook, we are well positioned to benefit from any further rate increases.
We expect the provision to be between $10 million and $20 million per quarter as credit quality remains strong. Our fee income growth trend is expected to continue with the execution of our GEAR Up initiatives, helping drive growth in card fee, treasury management and fiduciary income. Excluding restructuring costs, expenses are expected to increase modestly from here, primarily a result of additional days in the back half of the year. We continue to be on track to fully realize our GEAR Up savings.
We expect rising technology project costs as well as typical seasonal and inflationary pressures on occupancy and advertising. Restructuring expenses for the second half of the year should be about $20 million to $25 million. We expect to continue to achieve positive operating leverage and drive our efficiency ratio lower.
Finally, we are maintaining our expectation for our effective tax rate to be approximately 23%, excluding any impact from employee stock transactions which are difficult to predict. Altogether, we expect our pre-tax pre-provision net revenue to continue to grow.
In closing, our second quarter results were solid as we’ve continued to manage loan and deposit pricing in a rising rate environment. Loan growth and favorable credit metrics combined with higher fee income and well-controlled expenses helped to drive a 16% increase in our bottom line relative to the first quarter. As I mentioned at the start of the call and as a result of recently announced changes in regulation, our Board will review our capital plan next week.
We are well positioned to meaningfully increase our capital return to our shareholders. Furthermore, we expect to benefit from additional rate increases in economic growth. We remain focused on maintaining momentum and driving shareholder returns.
And now, we will be happy to take any of your questions.
[Operator Instructions] Our first question will come from the line of Steven Alexopoulos with JPMorgan. Please go ahead.
Good morning, Steven.
Hey, good morning everybody. Ralph, I wanted to start on capital. What are your updated thoughts and how much CET1 you guys need to run the business long-term?
We really haven't put a view out there as to what our point will be at this time. That will come in the future I think as we look -- as we see how things develop.
Okay. And as we think about this upcoming Board meeting, Ralph, could you help us think about what’s on the table for this meeting? I mean, could payouts move to 150% plus where you were historically, like what range of options are you now looking at?
Well, I wouldn’t put ranges on it, but I would tell you that it is -- it will be looked at from the standpoint of what is appropriate based on what we see with the business and what we feel comfortable with moving forward. And I think that puts the ability to manage capital back in our hands along with the Board. And I think you'll see that.
Okay. Thank you. And then on the commercial business, if we look at general middle market, it's still pretty flat year-over-year. What are most of your middle market customers doing at this point with the benefit of lower taxes?
Curt, you want to give an update on that?
Yes, Steve, we did see growth in all three of our middle market regions and we had good momentum in the first half of the year. Having said that, as Muneera alluded to, I think middle market customers remain cautious, probably the greatest source of caution right now relates to the what may or may not have happened on the tariff side of the house. You know short-term the tax reform probably works against this a little bit in terms of loan growth, in terms of the fact that our customers have more cash less expenses to plow back into their business line. But we are not yet seeing what I would call a lot of like traditional CapEx spending occurring. Most of the borrowing that we have participated in has been either M&A type transactions or customers borrowing for traditional working capital needs.
Okay. Got you. And then just final one on deposit strategy. With the loan to deposit ratio at around 87% and you are now out of LCR, do you expect to be active trying to grow deposits or going forward do you think it's more likely you will fund loan growth from cash and securities, not necessarily need to grow the size of the balance sheet? Thanks.
This is Muneera.
Muneera, [indiscernible].
Yes, sure. I mean, our objective always is to grow both loans as well as deposits. We will be focused on that. You can see that we are doing what we need to do on the deposit cost side to be able to retain an attractive deposit.
Okay.
But I will also add to that, though from a security standpoint, I mean clearly that is an option that is available to us. Going forward, our securities book is a reservoir of liquidity for us, not being subject to LCR. It certainly frees up that source of funding.
Yes, got you. Okay. Thanks for all the color.
Thank you.
Your next question will come from the line of Ken Usdin with Jefferies. Please go ahead.
Good morning, Ken.
Thanks. Good morning. Good morning, Ralph. Good morning, Muneera. Muneera, can you expand a little bit on your comment about deposit costs in the second half, so the 17 basis point increase regard in interest-bearing deposits to 42 basis points. You said 8 to 10 for the rest of the year, so can you tell us what that means in terms of how you're thinking about the trajectory both in the third and the fourth? I know it's one of the hot topics out there.
Good morning, Ken. So I will tell you thus far we’ve done a great job of managing our deposit costs with the cumulative beta of 18%. We have been talking about the fact that Q2 was different. We saw LIBOR increasing 32 basis points in the first two quarters. We have earned a position to make some changes to our deposit cost that we believe positioned us well competitively. We don't expect to see another jump of 17 basis point something in that magnitude again. We have signaled that, generally deposit costs will continue to increase with every passing rate rise. For June, you heard my comments, I said the increase would be 8 to 10 basis points that translates to a beta of 30% to 40%. And then if you are asking me about trajectory and where things will go, for now I will refer you to our standard model which includes a 50% beta and have some fairly conservative assumptions both as for deposit runoffs. We will continue to update folks as the rate rises get closer as we can see the moment on our own balance sheet as well as what's happening in the competitive environment. What I will tell you is even with the 17 basis point increase, our total deposit costs of 42 basis points will still be one off the lowest deposit costs in our peer group. So I clearly expect that we will be able to hold on to the benefit that we are seeing from lower deposit costs so far in the cycle, which I don't expect that we will give it up, but you will see some variabilities in betas going up and down depending on what stress firing out there.
Very good. And as a follow-up to that, so you mentioned that you’ve done that standardized increase and you don't expect to do one at least right now. What would change your view about having to go back to the entire rate sheet and put through a broad standardized increase again. It seems like your bias is to not do that, to your point?
Yes. So, a lot depends on what’s happening in the competitive environment. It depends on what's happening with loan to deposit ratio. I would say that so far, overall, the industry continues to be well-behaved. There is still a fair amount of liquidity in the system. We see corporate treasurers having a bias to maintaining higher levels of liquidity, that's what's shows up in our own non-interest bearing deposits. And so to the extent all of that continues, I think that we won't necessarily be looking to make another broad-based price change. But having said that, you know that the fed is unwinding its balance sheet. How -- where that goes and well how that affect the system, all that remains to be seen.
Okay. And then last final thing is just the 8 to 10 basis points you said is that expected to be each quarter from here, or is that your aggregate view of what happens in the second half?
That is our view specific to the June rate rise. I will tell you beyond that, I said look at the model which is at 50% and for any given singe rate drive it's -- there will be some variability. It will go up, it will go down, but like I said, I expect to close on to the benefit that we’ve thus far to date.
Okay. Thank you very much.
You’re welcome.
Thank you.
Your next question will come from the line of John Pancari with Evercore. Please go ahead.
Good morning.
Good morning, John.
On the expense side, specifically on comp, it came in higher than what we had expected and overall expenses appeared to be have come in for the quarter higher than what you guided to. I believe you guided to down modestly off of the first quarter core base of $430 million. So what drove the somewhat higher level than you had expected for the quarter? If you could give us some specific color around comp as well? Thanks.
Muneera, you want to take that?
Sure. Our view on overall expenses from the outlook that we provided earlier this year hasn’t really changed. What has changed is our outlook was based on a continuation of the economic and rate environment. And as time has progressed, we received two more rate rises. We’ve done a good job of managing loan and deposit pricing. The credit situation has improved. And if you look at the company's performance metrics, you can see that we are doing really well across the board. All that means that we have to look at incentive comp inside financial performance, that’s one of the movers that you would see that has come through salaries and benefits expense. I mean, I pointed out workforce numbers. We continue to watch our overall expenses, but that’s the main reason for the shift.
So there is a formal change in your incentive comp structure?
No, there isn't. The comp structure is exactly the same and it depends solely on performance and moves with good years and bad years. We are having a good year and then, hence, the increase.
Okay. All right. And then separately on the loan growth side, when you look at the update you gave us that accounted for April and May, it appears that there might have been some moderation of that pace in June. Is that what you saw and what you cited on the midmarket side, some of that cautiousness getting dialed in?
Curt you want to take that?
Yes. John, I think that’s the case. When you look at sort of a go forward for us the main thing, the important thing to remember for our company, given the seasonality of Mortgage Banker Finance and Dealer, second quarter tends to be a strong quarter for us, specifically around Mortgage Banker Finance. Dealer tends to be a strong quarter in the fourth quarter. So when we’re using language like moderate growth to the remainder of the year, what we’re taking into consideration is that remain seasonality for the year and Mortgage Banker Finance and Dealer and probably you can see seasonality as well in the third quarter that we normally see in middle market with sort of the summer slowdown for many of our middle market clients. But we’re expecting growth in most of our other businesses, and specifically I might point out continued growth in technology and life sciences, commercial real estate and a few of our other select specialty lines of business.
Okay, got it. All right. Thanks, Curt.
Your next question will come from the line of Ken Zerbe with Morgan Stanley. Please go ahead.
Great. Thanks. Good morning.
Good morning.
Good morning.
Just want to, I guess, start off just in terms of the asset beta, I was hoping you can kind of go over that a little bit more. I think I calculated your total asset beta like a 120% of fed funds. I know you’re tied off of LIBOR, which went up more than fed funds in the core, but can you just talk about like the timing of resets, like was there something besides LIBOR that drove a higher in terms of how the loans reset? Just would love to get more detail? Thanks.
Muneera?
Good morning, Ken. I know that asset beta have been really well, 37 basis points up this quarter. You saw the effect of nonaccrual interest recoveries which were unabated. But really this is us pulling through and having normal resets that we typically do, I would expect that as LIBOR increases our actual flow through rate is about 80% to 85%. So as LIBOR goes up, on average, 20 basis points we see an improvement of either about 16, 17 basis points in our yield. That should be what you should expect going forward on the asset side.
Got you. Okay. So this quarter is just particularly unusual. Okay. And then, I guess -- go ahead.
No, the only thing I was going to point out, I mean, LIBOR did go up 32 basis points on average.
Yes.
So and they’re just pulling through the benefits of that.
Understood. And I guess just to be super clear on the margin for third quarter, if we use just I know it's a generic example if LIBOR goes up 20 basis points, whatever, but am I thinking about right that your loan yields will go up, say, 16, 17 basis points in your example and then you’re also saying deposit costs, the interest bearing deposit costs go up, I think it was 8 to 10 basis points. So, I mean, we can run the math on non-interest bearing etcetera, but that’s the kind of magnitude of NIM expansion we should be looking up for third quarter. Am I thinking that conceptually correct?
You’re thinking about it conceptually correct. I just used 20 as an example. I don’t know where average LIBOR is going to go, so I would say adjust accordingly.
Understood. Okay. Thank you very much.
Thank you.
Our next question will come from the line of Erika Najarian with Bank of America. Please go ahead.
Hi. Good morning.
Good morning.
So as we’re thinking about some of the flexibility afforded to you by some of the regulatory change, how much do you have in HQLA currently today? And how much of that HQLA pool can we think as flexible to potentially fund loan growth?
It's a meaningful number just in broad strokes. But clearly we have ample of funding available today. So it's not something -- this is with something we can tap as the balance sheet changes.
Got it. Okay. Just following up one last follow-up question at least for me on all the deposit questions that you’ve answered so far and thank you so much for your answers. As we think about the dynamics just following up to Ken's last question, as we think of the interest rate environment continuing to normalize and of course you mentioned Muneera the fed reducing its balance sheet what -- how should we think about a normal level of noninterest bearing deposits for Comerica? And outside of the seasonality that you saw with municipal deposits this quarter, what are you observing broadly about mix shift trends?
A couple of points on that. When we look at the changes in our portfolio, you’re right, year-over-year municipal deposits have been a headwind for us. But beyond that, when we look at our customer balances, when we look at Comerica's historical trends, the portfolio is behaving in line with what we’ve seen in times past. So it's very typical for Comerica to have a decline in deposits in the first half of the year. It's very typical for us to go up in the back half of the year as this trend holds true for several years in the past. And so that’s what we based our view on as to where things are going for us at least in the near-term. We do see some of our customers putting their money to work. It's what we said, we would be seeing people are reducing leverage, they’re using their money for M&A, for working capital needs. And so that certainly continues. Beyond that, we will just have to wait and see how things evolve and it's really difficult for us to predict what happens with deposit balances.
Got it. And just one final question for me. Just comparing the guidance slide in terms of your outlook for noninterest expenses, and just looking at what you had put forth last quarter, last quarter you mentioned that you’re expecting a 1% increase over an adjusted 2017 number, which I think at the time implied a 1.713 billion base for '18. And I just wanted to clarify that the different language that you put on this quarter slide did not indicate a change in expense guidance.
Muneera?
We are indicating that expenses will be slightly higher than what we originally estimated, because our original estimates were based on a continuation of the interest rate and economic environment. And of course, as things have improved, it means that certain costs like incentive comp has to be adjusted. And when we go get interest recoveries of $11 million, there is compensation that goes along with that and so that’s what it reflects. Also I wanted to point out that our FDIC expense we were hoping that the surcharge would go away in the back half and clearly there has been some [indiscernible] that this isn't quite reaching the percentage it needs to, and so that’s another reason for us to make a slight change.
Got it. But at the end of the day, the efficiency will continue to up improve meaningfully, okay.
Yes.
Thank you so much.
Yes, thank you for reminding me. Yes, the efficiency will increase, we expect fully to have positive operating leverage.
Thank you.
Thank you.
Your next question will come from the line of Bill Carcache with Nomura. Please go ahead.
Good morning, Bill.
Thank you. Good morning. Good morning. I had a follow-up question on capital specifically the pace of capital return. So under CCAR there had been this view that you had to take payouts up gradually over time through the process in light of the regulatory changes that we’ve seen. Do you now feel like you guys have greater freedom to simply keep what you need and return the rest? And then implicit in that question is, can you just clarify for us the degree to which you feel bound by the submission that you made that ultimately you guys didn’t have to go through the process, but nevertheless you made the submission. If you could give a little bit of color around that, that would be great?
Well as we discussed the earlier when you look at what we will be doing basically on a quarterly basis, we will be reviewing where we are from a capital standpoint and where we believe we need to be and what effects -- or the normal effects out there as to growth in the economy and so forth. And we then have the ability to manage our capital. Going forward, we haven't put out as was asked earlier a point of where we want to be from a capital standpoint. We may do that in the future, but I think we want to move down the road a while first and our CET right now is well over 11%. And I think we all understand that it is pretty high.
Right. And so in essence, there is a recognition that you are -- that the rules have changed and that in evaluating on a quarterly basis your capital levels, you are able to take that into consideration and, therefore, arrive potentially at a different outcome and you would have arrived at under the previous rules?
We could be more focused on what is happening today versus having to look out and consider what's happening over a year purposes or more. And that makes us much more agile in managing our capital going forward.
That's great. Thank you. If I may follow-up on a related M&A question. Now that you have been released from CCAR, some investors have expressed concern with the potential that some of your excess capital could be consumed in an M&A deal that could significantly dilute tangible book value similar to some of the recent deals that we have seen from others. Could you speak a little bit to your appetite for M&A whether that has or has not changed after your release from CCAR?
I would say it has not changed. And as we have always said when things became available we will take a look at them, but we feel very comfortable with our footprint today, and especially in the states where we are doing business and the growth potential there and adding internally to grow that is top of the chart at the moment where our focus is for expansion.
Thank you very much. I appreciate you taking my questions.
Thank you.
Your next question comes from the line of Scott Siefers with Sandler O'Neill & Partners. Please go ahead.
Good morning, Scott.
Good morning. Hey, Ralph, quick question just on sort of behavioral changes post-DFAST and CCAR, not as it relates to what you will do with the excess capital, but just practically what being released from this stuff means for how you will go through sort of measuring your own levels of risk etcetera, any -- under CCAR for example you spend a year and you have a dozen -- or excuse me, dozens of people getting to the same place that you can get with a few assumptions and much more rapidly. So presumably there is some opportunity to flex expenses. And even if you don’t want to get into the savings, just what will you be doing differently internally now that you’ve got some of this flexibility or relief?
As I had mentioned in the remarks earlier what we will be doing now is going through and looking at all the things that we’ve done and put together for the previous process. And what in some of those are strengths going forward and deciding exactly what we want to do going forward and there will be some savings there as well. But it will be building the process we are going to use going forward I guess is the right way to say that. But we will save expenses.
I was going to highlight the same thing. I was going to say it's going to be a lot more efficient.
Yes. Okay. And, I guess, that’s probably an iterative process, but it's not something you've come to definitive conclusions on now right? You are just sort of seeing [multiple speakers] …
That’s right.
… appropriate is continue to spend money versus get some savings out etcetera? That’s the best way to look at it?
That's the best way to look at it, but we want to go through it fairly quickly and make a determination of where we feel we are and where do we need to be today. And we will be doing that, it will take a little while to do it, but …
Okay. All right. That sounds good. Thank you very much.
Thank you.
Our next question will come from the line of Geoffrey Elliot with Autonomous Research. Please go ahead.
Good morning.
Good morning. Thanks. Good morning. Thanks for taking the question. In terms of capital and the split between dividend and buyback, does the regulatory change shift the way your thinking about the emphasis there?
I don't think the change causes an issue there. We will be looking at that based on what day we foresee in the future and taking the appropriate position obviously, because we know there are ups and downs in the economy that we have to be prepared for. And I think we have done that in the past very well and that will be something we'll look at as we go.
And can you explain the role of the regulators now? Are there still sort of certain guardrails, if you like, in terms of what you can and can't do on capital return from a regulatory perspective, what do you need to get approval to do from the regulator and where do you just kind of have flexibility to have the Board meeting and go ahead and take your own decisions?
I think there are things that are still developing there. So I really don't have a feel for exactly how it may settle in the future. But I would say that even before CCAR and all of the tests, we routinely reviewed what our thoughts where and our planning was for the future with our local regulators to make sure that they were comfortable with it as much as we are.
Great. Thank you.
Our next question will come from the line of Brett Rabatin with Piper Jaffray. Please go ahead.
Good morning, Brett.
Hi. Good morning, everyone. I wanted to ask first, Ralph, is there any explicit reason why you can't be a little less opaque about the capital return process and you're obviously being able to manage capital more in a real-time basis? I guess I just want to make sure there was not something I'm missing about why you can't be a little more effusive about what you plan?
Well, I think the reason for that is that it just happened and we are getting used to it. And I think the regulatory environment is looking at it as well and it takes a little bit of time for that to develop.
Okay. Fair enough. And then I wanted to ask on the deposit side in terms of what you're expecting on deposit betas from here, what kind of assumptions does that entail from just a seasonality perspective and municipal deposits and kind of what happens from here with some of the various categories in terms of growth, especially on a core basis?
Muneera, do you want to take that?
Yes. So as I mentioned earlier, I do expect that there will be variability in there. Deposit betas go from one rate rise to the next, but overall I would say, for now, our standard model with the 50% beta is the best thing I can point you to, a lot remains to be same on how balance sheet evolves. I think the industry as a whole has a fair amount of liquidity and lot of deposit ratios are healthy. So at least in the near-term the best I can tell, I would expect that this kind of model assumption should hold true.
Okay. And then just lastly, the credits obviously really good. Right now just from a recovery perspective is there a pool of loans whether from energy or otherwise that could still result in net charge-offs being negative going forward or can you give us any color around maybe that pool?
Pete, you want to take that?
Yes. It is [indiscernible] we’ve been in a net recovery position like this and it didn’t happen very often. We didn’t expect going forward to see those kinds of recovers.
Okay. Fair enough. Thanks for all the color.
Thank you.
Your next question will come from the line of Peter Winter with Wedbush Securities. Please go ahead.
Good morning, Peter.
Good morning. Good morning. When you guys talk about modest loan growth in the second half, can you just define modest loan growth? And then, secondly, it sounded like customers are more cautious than they were in the first quarter. Is that solely just related to the trade wars or is there something else going on?
Curt, do you want to take that?
Yes, I might start, Peter, with the second half of your question. I don’t think there is anything else going on. I do think that tariffs and trade related issues especially given the markets that we are in, Michigan, California, Texas, all who have some economic reliance on trade and some of the industry verticals that we operate in kind of given that I would say that is probably the primary concern that we are hearing from customers right now. So that's I think -- that should be in to somewhat of our moderate view on a go forward basis. But I do want to emphasize that part of that moderate view as well is just a seasonality that we see especially in the third quarter and middle market and that seasonality in both Dealer and Mortgage Banker Finance.
And when you say modest, is that more like 1% to 3% type range?
I wouldn’t quote a specific number, but just would guide you towards the language that we’ve used.
Okay. And then just separately now that you are no longer a SIFI bank, is there some type of informal stress test exams that you have to participate in?
No. But there will be, and it was said in some of the announcements that there will be a development of how we looked at over a longer term. So I think they will be adjusting what they’re looking at and how they’re looking at as well as we going through the process for us too.
Got it. Thank you.
Your next question will come from the line of Jennifer Demba with SunTrust. Please go ahead.
Thank you. My question is for Pete. Just wondering how the problem loan levels stand in the energy portfolio now when that portfolio should stabilize or grow?
Pete?
We like to see it keep from running off. It's been coming down quicker than we’ve been adding new deals. We like the energy space. We are highly selective there, but we like a lot. We still have 19% criticized. We would expect that 19% would continue to come down not just through payoffs, which will reduce loan balances, there are also upgrades as well. And so we’re hopeful that the energy portfolio will stabilize on the balance standpoint from where it is today.
Thanks a lot.
Thank you.
Your next question comes from the line of Steve Moss with B. Riley FBR. Please go ahead.
Good morning, Steve.
Good morning. I just wanted to start off, I guess, just with -- on the credit topic and more actually CECL, just wondering what your preliminary thought could be with regard to the provision and the capital impact come 2020?
Pete?
We are not prepared to release anything with regards to CECL yet. We are working towards a 2020 date when we will be implementing. The only thing that I’m comfortable saying is that you look at our portfolio relative to our peers, the duration of our portfolio, which is a big driver of CECL is substantially less than a lot of our peers. And so we would expect whatever it impacts there are -- from a level standpoint and then from a quarterly provision standpoint should impact us less because of that shorter duration.
Okay. And then, on deposits here, your noninterest-bearing deposit mix remains really strong here, over 50%. Just wondering -- the balances are down a bit year-over-year, just wondering where do you think that goes if we see another 50 to 100 basis points in rate hikes?
So when you look at our deposit base and you mentioned noninterest bearing, 90% of that is commercial. And in the past we have mentioned that of those commercial deposits vast majority of them are tied to our treasury management products. We have a lot of connectivity that these depositors. And as I mentioned earlier in my comment, that is a desire by corporate treasurers to maintain higher levels of liquidity. So all that plays in. For all those reasons, at least as far as they're concerned, we expect things to be stable when we go along with CECL, relationship propositions, deposits come along with that. So all of that kind of goes into our thinking about the fact that generally things should be fairly stable.
All right. Thank you very much.
Thank you.
Your next question comes from the line of Dave Rochester with Deutsche Bank. Please go ahead.
Good morning, Dave.
Hey, good morning, guys. On expenses, I know 2019 is still a bit further out, but I was just curious how you're thinking about expense growth next year is to GEAR Up efforts wind down. Why you should still get the benefit of the roll off of the FDIC surcharge that you were talking about. Any preliminary thoughts there?
Muneera?
Okay. Looking forward, I’m going to say you’re right, FDIC surcharge will go away. We intend to continue the expense discipline that we have used in the last couple of years. We intend to continue leveraging technology to simplify our processes and be efficient. There will be your typical inflationary pressures, but overall, I mean that’s sort of what I see looking out.
Are you thinking that the -- oh sorry, go ahead.
No, I was going to add I do respect that the efficiency ratio will keep moving in the right directions and that will maintain positive operating leverage.
Are you thinking that we could perhaps see a little bit of a pickup in expense growth because of the efforts you are talking about, the fact that the tailwinds from GEAR Up are done or do you think you can remain in this low single-digit range of growth?
I believe we will remain in the low single-digit level of that.
Okay, great. And just switching to the NIM real quick. In the absence of rate hikes, so if we don’t get a rate hike in September for example, I was just curious what your thoughts are on how the NIM would trend without the benefit of the bump up in the loan yield? Are you thinking we could see some stability in that kind of scenario or do you expect to see some kind of an upwards movement in deposit cost kind of leading into the NIM a little bit? Just any thoughts there would be great.
Yes, I mean, given our asset sensitivity, clearly NIM benefits most to the drive rates, but I would still expect that without rate, we'd have stability in our NIM. I don’t expect that deposit costs will rise in a more stable rate environment.
Okay, great. Thank you very much.
Thank you.
Your next question comes from the line of Brock Vandervliet with UBS. Please go ahead.
Good morning.
Great. Good morning. I think most of the metrics on deposit costs have been covered. I was just curious operationally when a look to make the increase that was manifest in the second quarter, was that -- how is that kind of pushed down to clients? Was that broad brush across the board increases or more of a pull through in granting exceptions that kind of thing?
Curt, you want to take that?
Yes. Brock, I think first and foremost for us whether it's loan pricing or pricing on any of our fee income products where deposit pricing is to make sure that we are taking relationship approach. And so we really think that in a consideration we are looking at both competitive landscape and also our customer relationships. And so when we look at pricing increases, we really try to make sure we’re passing that on to the majority of our clients as appropriate and I think we’ve done that effectively thus far.
Okay. And separately within equity fund services, I know that's been called out several times as an area of strength. Could you quantify that at all in terms of the annualized growth we should expect there? And secondly, has there been any change in resource allocation to that area?
Curt?
First of all, I would say that it has been an area of accelerating growth in the last several years and that’s really in response to what’s been happening in the private equity venture capital arena there has been a lot of new fund formation. There has been a lot of both corporate or institutional and private money flowing into private equity, for example, which has created a lot of the demand there. In terms of resource allocation we look across all of our businesses to make sure that we are appropriately resourced allocated and we can shift resources as needed and move relationship managers and credit support staff, analysts, etcetera, to various business lines. Part of what we’ve been doing through GEAR Up, we talked before about the Indian credit initiative which really for us is rethinking some of our processes around loan origination approval servicing going forward and that is creating through and changing some processes, additional capacity for us and Equity Fund Services would be one of the businesses that’s benefiting from that.
Great. Thank you.
Thank you.
Our final question will come from the line of Brian Klock with Keefe Bruyette Woods. Please go ahead.
Good morning, Brian.
Good morning, everybody. So I just want to follow-up and I apologize if you guys answered this already, but maybe it's a question for Pete on the interest recoveries. Can you give us a size of the loans that paid off with the net interest recovery?
Pete?
Most of the unusually large interest recovery is driven by, I want to say two or three credits. They were good sized credits. It wasn’t so much the size of the credit, though. It was how well we were accumulating the interest and not [indiscernible] through the P&L. And so, some of these were [indiscernible] not accruals for some time and that’s why recovery was still large.
Got you. So, I guess, what I’m trying to figure out is, when you look at the criticized, that dropped so meaningfully in the nonaccrual, that dropped, so should we look at that drop and say that your core growth outside of those sort of paydowns -- you had some solid growth this quarter, I could be wrong, but just thinking about it spot quarter-to-quarter, end of period basis, it's a lot stronger core loan growth than the 4.5% linked quarter annualized growth that you just look at there from spot, so …
Yes. That’s correct. I mean, that did impact our loan growth is the fact that we were successful in getting paid off on some nonaccrual loans this quarter.
Got it. Got it. And just a follow-up for Muneera. I think you mentioned something about the FDIC surcharge, when you talked about the expense going through the second half of the year. It looks like the diff is about 1.30 and it still looks like it's on its way to getting to the 1.35 by the second half of the year. So are you including any expectation of getting that $6 million to $7 million surcharge eliminated in the fourth quarter or that’s not in your guidance at all you had for the second half of the year.
It's not in our guidance.
Got it. Okay. All right. Thanks for your time. I appreciate it.
Thank you.
I will now turn the call back over to Ralph Babb, Chairman and Chief Executive Officer for any closing remarks.
We appreciate very much your interest in Comerica, and thanks for being on the call today. And we hope everybody has a great day. Thanks very much.
Ladies and gentlemen, this concludes today’s conference. Thank you all for joining and you may now disconnect.