PNC Financial Services Group Inc
NYSE:PNC
Earnings Call Analysis
Q3-2023 Analysis
PNC Financial Services Group Inc
The company has reported an 11% quarter-over-quarter increase in non-performing loans (NPLs), amounting to $210 million. This uptick is primarily due to challenges within the multi-tenant office commercial real estate (CRE), with NPLs in this category rising by $373 million. Despite this, there has been a $163 million drop in non-CRE NPLs. The company has recognized the need for increased reserves for potential losses, particularly in the office real estate portfolio, where reserves are 8.5% of the total loans, with an even higher reserve rate of 12.5% for multi-tenant office loans.
As of September 30, the company maintains a Common Equity Tier 1 (CET1) ratio of 9.8%. However, under proposed Basel III Endgame rules, the CET1 ratio is expected to face a reduction by roughly 190 basis points due to the inclusion of Accumulated Other Comprehensive Income (AOCI), with another estimated 40 to 50 basis points from other components. Overall, risk-weighted assets could increase by 3% to 4%, which would leave the company with an estimated CET1 ratio of approximately 7.4%.
Heading into the fourth quarter, the company anticipates a 3% increase in average loans, which includes the recent acquisition of Signature Bank capital commitment facilities. While net interest income is expected to decrease by 1% to 2%, fee income is projected to rise by approximately 1% thanks to a likely increase in capital markets activity. Other noninterest income is forecasted to fall between $150 million to $200 million, excluding certain activities. A significant focus remains on keeping core expenses stable, even as total core non-interest expenses are estimated to increase by 3% to 4%. Noteworthy, too, is the projected range for fourth quarter net charge-offs, which is expected to be $200 million to $250 million.
The company's Continuous Improvement Program (CIP), with a goal to reinvest cost savings back into the business, will maintain its momentum into 2024 with a target similar to the $450 million set for 2023. Amid the need for stringent expense control, the company is also implementing a workforce reduction of 4%, projecting a $325 million reduction in 2024 expenses and forecasting one-time costs of $150 million during the fourth quarter of 2023. This recalibration reflects ongoing efforts to enhance efficiency and support stable core expenses throughout 2024.
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Well, good morning, and welcome to today's conference call for the PNC Financial Services Group. I am Bryan Gill, the Director of Investor Relations for PNC and participating on this call are PNC's Chairman, President and CEO, Bill Demchak; and Rob Reilly, Executive Vice President and CFO. Today's presentation contains forward-looking information. Cautionary statements about this information as well as reconciliations of non-GAAP measures are included in today's earnings release materials as well as our SEC filings and other investor materials. These are all available on our corporate website, pnc.com, under Investor Relations. These statements speak only as of October 13, 2023, and PNC undertakes no obligation to update them. Now I'd like to turn the call over to Bill.
Thank you, Bryan. And good morning, everyone. As you can see on the slide, we delivered strong results in the third quarter, generating $1.6 billion in net income or $3.60 in diluted earnings per share. Rob is going to take you through the numbers in a moment, but I'd like to touch on a few highlights. First, in the challenging operating environment, we generated 3 points of positive operating leverage through disciplined expense management.
Our credit quality remained strong during the quarter, reflecting our thoughtful approach to managing risk, customer selection and long-term relationship development, all of which have historically served us well in challenging economic cycles. Next, we strengthened our capital and liquidity positions even further during the quarter. While we continue to monitor discussions regarding regulatory changes in these areas based on our current estimates, we are well positioned to meet the proposed requirements without meaningful changes to how we operate.
We continue to execute on our key strategic priorities, including our expansion market efforts and upgrading our digital capabilities and we leveraged our strong balance sheet to take advantage of opportunities such as the signature bank loans that we recently acquired. Finally, we are focused on expense management, particularly in the current environment and have taken actions to maintain disciplined expense control. We increased our continuous improvement goal last quarter from $400 million to $450 million, and we are on track to achieve that goal in 2023. Looking ahead, we expect to have CIP savings within a similar range for 2024. And as a reminder, we used savings from this program to fund investments in key growth markets and technology.
In addition, earlier this month, we began executing on staff reductions, which will reduce our 2024 expenses by $325 million and will fall to the bottom line. All told, we are implementing more than $725 million of expense management actions that will have impact on 2024. While decisions involving personnel are never easy, we believe they will help us more effectively and efficiently deliver for our customers and our stakeholders, and we'll continue to be diligent in our expense management going forward. And with that, I'll turn it over to Rob.
Thanks, Bill. And good morning, everyone. Our balance sheet is on Slide 3 and is presented on an average basis and comparing to the second quarter. Loans were down 2% and averaged $320 billion. Investment securities declined $1 billion or 1%. Cash balances at the Federal Reserve increased $7 billion to $38 billion. Deposits of $423 billion declined $3 billion or 1%. Borrowed funds increased $2 billion primarily due to senior debt issuances near the end of the second quarter.
At quarter end, AOCI was a negative $10.3 billion compared to a negative $9.5 billion at June 30, reflecting higher interest rates. However, tangible book value increased to $78.16 per common share as retained earnings growth exceeded the negative impact of AOCI. Common dividends in the quarter totaled approximately $600 million. And we remain well capitalized with an estimated CET1 ratio of 9.8% as of September 30, 2023, which increased 30 basis points linked quarter.
Slide 4 shows our loans in more detail. Third quarter loans averaged $320 billion and increased $6.5 billion or 2% compared to the same period a year ago, reflecting growth in both commercial and consumer loans.
Compared to the second quarter, average loan balances declined 2% as growth in consumer was more than offset by a decline in commercial. Consumer loans grew approximately $500 million reflecting higher residential mortgage and credit card balances. Commercial loans averaged $218 billion, a decline of $5.5 billion, driven by lower utilization as well as paydowns outpacing new production.
Loan yields increased 18 basis points to 5.75% in the third quarter, predominantly driven by the higher rate environment.
Slide 5 covers our deposits in more detail. Average deposits decreased $3 billion or 1% due to a decline in consumer deposits that was somewhat offset by a growth in commercial deposits. In regard to mix, consolidated noninterest-bearing deposits were 26% in the third quarter, down slightly from 27% from the second quarter and consistent with our expectations. And we still expect the noninterest-bearing portion of our deposits to stabilize in the mid-20% range.
Commercial noninterest-bearing deposits represented 42% of total commercial deposits in the third quarter compared to 45% in the second quarter. And our consumer deposit noninterest-bearing mix remained stable at 10%. Our rate paid on interest-bearing deposits increased to 2.26% during the third quarter, up from 1.96% in the prior quarter. And as of September 30, our cumulative deposit beta was 41%, which was slightly better than our July expectation.
Slide 6 details our investment security and swap portfolios. Average investment securities of $140 billion decreased $1 billion or 1% and as curtailed purchase activity was more than offset by portfolio paydowns and maturities. The securities portfolio yield increased 5 basis points to 2.57%, reflecting new purchase yields of 5.5% and the runoff of lower-yielding securities. As of September 30, the duration of investment securities portfolio was 4.2 years.
Our received fixed swaps point into the commercial loan book totaled $35 billion on September 30. The weighted average received fixed rate of our swap portfolio increased 34 basis points to 2.07% and the duration of the portfolio was 2.4 years as of September 30. Accumulated other comprehensive loss increased by approximately $800 million in the third quarter as a negative impact of higher rates more than offset paydowns and maturities during the quarter.
Importantly, as lower rate securities and swaps roll off, we expect our securities yield to continue to increase, resulting in a meaningful improvement to tangible book value from AOCI accretion.
Turning to the income statement on Slide 7. For the first 9 months of 2023, revenue grew 5% compared to the same period a year ago, reflecting higher interest rates and business growth. Noninterest expense grew 2% and was well controlled despite a higher FDIC assessment rate and inflationary pressures. As a result, we generated 3% positive operating leverage and PPNR grew 9%.
For the third quarter, net income was $1.6 billion or $3.60 per share. Total revenue of $5.2 billion decreased $60 million or 1% compared to the second quarter of 2023. Net interest income declined $92 million or 3%, and our net interest margin was 2.71%, a decline of 8 basis points. Noninterest income increased $32 million or 2% as higher fee income was partially offset by lower other noninterest income. Third quarter expenses decreased $127 million or 4% linked quarter. Provision was $129 million in the third quarter and our effective tax rate was 15.5%, which included a favorable impact of certain tax matters in the third quarter. For the full year, we now expect our tax rate to be approximately 16.5%.
Turning to Slide 8. We highlight our revenue trends. Third quarter revenue was down $60 million or 1% compared with the second quarter. Net interest income of $3.4 billion decreased $92 million or 3% as higher yields on interest-earning assets were more than offset by increased funding costs. Fee income was $1.7 billion and increased $67 million or 4% linked quarter.
The primary driver of the increase in fee income was residential and commercial mortgage revenue, which was up $103 million, the majority of which were $97 million was related to an increase in the valuation of net mortgage servicing rights. Partially offsetting this, capital markets and advisory revenue decreased $45 million or 21%, driven by lower trading revenue. M&A advisory activity continued to remain softer in the third quarter despite robust pipelines.
Going forward, we do expect this activity to increase in the fourth quarter, which is included in our guidance that I will cover in a few minutes.
Other noninterest income of $94 million declined $35 million linked quarter driven by lower private equity revenue and included negative Visa fair value adjustments totaling $51 million. As a reminder, at September 30, PNC owned 3.5 million Visa Class B shares with an unrecognized gain of approximately $1.3 billion.
Turning to Slide 9. Our third quarter expenses were down $127 million or 4% linked quarter which in part reflected our increased CIP program. And we generated 3% positive operating leverage on both a year-to-date and a linked quarter basis.
Importantly, every expense category remained stable or declined compared to the second quarter of 2023. Our credit metrics are presented on Slide 10 while overall credit quality remains strong across our portfolio, the pressures we anticipated within the commercial real estate office sector have begun to materialize.
Nonperforming loans increased $210 million or 11%, linked quarter. The increase was driven by multi-tenant office, CRE, which increased $373 million, but was partially offset by a decline of $163 million in non-CRE NPLs.
In regard to the CRE office portfolio, total criticized loans remained essentially flat quarter-over-quarter at 23%. The difference this quarter is the migration of certain multi-tenant office loans to NPL status which is an expected outcome as we work to resolve the occupancy and rate challenges inherent to this portfolio.
Ultimately, we expect future losses on this portfolio, and we believe we have reserved against those potential losses accordingly. As of September 30, our reserves on the office portfolio were 8.5% of total office loans and inside of that 12.5% on the multi-tenant portfolio.
Naturally, we'll continue to monitor and review our assumptions, especially in the higher rate environment to ensure they reflect the real-time market conditions and a full update of the portfolio is included in the appendix slides. Total delinquencies of $1.3 billion increased $75 million or 6% linked quarter driven by higher consumer loan delinquencies. Net loan charge-offs of $121 million declined $73 million or 38% linked quarter. Our annualized net charge-offs to average loans ratio was 15 basis points in the third quarter.
And our allowance for credit losses totaled $5.4 billion or 1.7% of total loans on September 30, essentially stable at June 30.
Turning to Slide 11. From a capital perspective, we're well positioned with a CET1 ratio of 9.8% as of September 30. This slide illustrates the impact to our capital levels assuming the Basel III end game proposed rules were effective as of September 30. The inclusion of AOCI reduces our ratio by approximately 190 basis points. And the impact of all other proposed Basel III endgame components are estimated to have an additional negative 40 to 50 basis point impact to our CET1.
Taken together, the current Basel III end-game proposal would increase our risk-weighted assets by approximately 3% to 4%. And our estimated fully phased-in expanded risk-based CET1 ratio would be approximately 7.4%, which is above our current requirement of 7%. In light of the fluidity of the capital proposals, our share repurchase activity remains on pause. We'll continue to evaluate the potential impact of the proposed rules and may resume share repurchases activity depending on market and economic conditions as well as other factors.
In regard to the long-term debt proposal, if the rule was effective at the end of the third quarter, our binding constraint would be the long-term debt to risk-weighted assets ratio at both the holding company and the bank level. We estimate our current shortfall at the holding company [indiscernible] bank to be approximately $1 billion and $8 billion, respectively. And we expect to reach compliance at both the consolidated and bank level through our current funding plan as well as the restructuring of existing intercompany debt.
We acknowledge and want to emphasize that proposals are still in their comment period and the final rules are subject to change. That being said, we're well positioned to comply with the proposals as drafted.
Slide 12 provides more detail on the $16 billion portfolio of capital commitment facilities we acquired from Signature Bridge Bank earlier this month. PNC has been active in the capital commitment business for many years. We believe the acquisition will enhance our broader efforts in the private equity sponsor industry. Signature's origination strategy was similar to PNC's, which is focused on building relationships with large and established fund managers. As such, we expect to retain 75% of the portfolio.
This acquisition is financially attractive, given the purchase price of 99% of par and the high credit quality of the portfolio. Importantly, the transaction does not have a material impact to our capital ratios or tangible book value per share.
Slide 13 details our focus on controlling expenses. As Bill mentioned, we remain diligent in our expense management efforts, particularly when considering the current revenue environment. Our continuous improvement program has been in place for over a decade. And through this program, we've utilized expense savings to fund our ongoing business growth and technology investments.
Over the past 10 years, through CIP, we've identified and completed actions to reinvest $3.7 billion in our company. As you know, we have a 2023 CIP target of $450 million, and we're on track to meet that target. Looking to 2024, even though we've just begun our budgeting process, we do expect a 2024 annual CIP goal of similar magnitude to the 2023 program. Our CIP efforts over the years have allowed us to substantially invest in our company while still delivering low single-digit annual expense growth.
However, the current environment poses meaningful pressures necessitating expense control measures beyond our annual CIP program. As a result, we took a hard look at our organizational structure and identified opportunities to operate more efficiently through staff reductions, which we began implementing earlier this month. This initiative will decrease the workforce by 4% and is expected to reduce 2024 expenses by approximately $325 million.
Onetime costs associated with this plan are expected to be approximately $150 million and will be incurred during the fourth quarter of 2023. We believe these actions will position PNC for stronger efficiency going forward. As a result, even though our budgeting cycle isn't complete, we have an objective to keep core expenses stable in 2024, which, by definition, would exclude the fourth quarter onetime charges.
In summary, PNC reported a solid third quarter 2023. In regard to our view of the overall economy, we're expecting a mild recession starting in the first half of 2024, with a contraction in real GDP of less than 1%.
We expect the federal funds rate to remain unchanged in the near term between 5.25% and 5.5% through mid-2024 when we expect the Fed to begin cutting rates. Looking ahead, our outlook for the fourth quarter of 2023 compared to the third quarter of 2023 is as follows: we expect average loans to be up approximately 3%, including the acquisition of the Signature Bank capital commitment facilities; net interest income to be down 1% to 2%; fee income to be up approximately 1% as increased capital markets activity is expected to more than offset the impact of the elevated MSR hedge gains during the third quarter.
Other noninterest income to be in the range of $150 million and $200 million, excluding net securities and Visa activity. We expect total core noninterest expense to be up 3% to 4%, which excludes charges related to the workforce reduction. Additionally, this guidance does not contemplate the pending FDIC special assessment, which could occur during the fourth quarter. And we expect fourth quarter net charge-offs to be between $200 million and $250 million. And with that, Bill and I are ready to take your questions.
[Operator Instructions] Our first question is from the line of John Pancari with Evercore.
Just regarding the office increase in nonperformers that you discussed a bit, could you just give us a little bit more detail? Is that more indicative of -- did you see an acceleration in the deterioration of these credits that were noteworthy in the quarter and that necessitated to move to nonaccrual? Or was this more of a function of an ongoing scrub of your portfolio as your as you're reevaluating collateral values or whatnot behind properties?
And as you do that as well, can you maybe talk about some of the value depreciation you're beginning to see on some properties that are traded?
I guess what I would say is what you're seeing is kind of our expected cycle through deteriorating credit. So our criticized list didn't really move. We moved inside of that loans to nonperforming. By the way, I think they're actually all still accruing. We just kind of get there because we don't think they're refinanceable in the current market. The move to nonperforming from already being criticized comes about as you just watch cap rates creeping higher and adjust the underlying value of the properties accordingly.
So I don't -- I mean, none of this is a surprise. We have heavy reserves against it. We kind of saw it coming. It's the big bulk of these properties moving through the snake, as it were.
Just the migration of the path. We do expect losses, as I said in my comments, but we believe that we're appropriately reserved.
There's no -- there's -- it's not like there's some new scrubbing, John. I mean, we've been -- we're live on every one of these properties every day. So it's not like we opened a drawer and found something. We know exactly what [indiscernible] these are and we are monitoring and updating [indiscernible].
Got it. Okay. And then separately on the expense side, can you maybe help us think about how the how the $325 million that you expect to fall out of the bottom line from the headcount rationalization? How that would impact the growth rate that you expect overall for expenses in 2024 versus 2023. How should we think about that growth?
Yes. So I mentioned in my opening comments, when we walk down both the CIP that we anticipate implementing in '24 along with this workforce reduction that our objective is to keep '24 expenses stable year-over-year. We haven't completed our budget process. In fact, we're at the beginning of our budget process. So we don't have a lot of '24 guidance for you other than that is our objective, and that will be our expectation.
John, the other thing -- the reason we kind of put the continuous improvement in there is it's a number that we typically reinvest into our growth businesses in the future of the company. So that's sort of what's been driving our investment game for the last bunch of years, and that continues. What's new is basically dropping the run rate related to personnel and just tightening the ship in what is a tougher revenue environment.
Got it. Got it. And I'm sorry, if I could ask just one more. On the Signature acquisition, of the Signature loans, that is, the $0.10 of accretion that you mentioned on that. Can you maybe just walk us through the components of that, how you arrive at that amount?
Sure. That's basically the yield in terms of the portfolio that we purchased. They are short term, about a year. So we do expect that $0.10 a share that we talked about in the fourth quarter and then going into '24. But when we get to 24, of course, we'll include that in our full year guidance.
Our next question is from the line of Matt O'Cornor with Deutsche Bank.
This is [indiscernible] on behalf of Matt O'Connor. Just one quick follow-up on the expense program. You talked about the $725 million total cost actions. So outside of the workplace reduction, can you just talk about the -- just the other areas of efficiencies you're investing in?
I mean the workforce reduction is the specific number we mentioned of the $325 million inside of continuous improvement, which we do every year. We're focused on contract renewals, on management of the [indiscernible], building...
Segments.
Occupancy, efficiencies, all the things you'd expect us to be focused on in the ordinary course of running the business.
And that's a program that we've had in place, as I mentioned, for several years and allows us to -- it has allowed us to grow annual expenses in the low single-digit range, even with all those investments. And in point of fact, this year, we're pointing to 1% growth year-over-year -- '23 over '22 and a large part of that is because of our continuous improvement program.
And then if I could just ask a follow-up question on the capital markets fees. So they came in weaker than expected this quarter. You talked about, I think, stable versus the last quarter. One of your larger peers reported stronger capital markets this morning. Can you just talk about the driver of this? Was it mostly mix related? And then maybe touch on the outlook near term given the macro outlook is better than a few months ago?
I didn't -- I'm not sure what anybody else reported. My guess was that the trading line item was better than peer fees. But -- in our case, the bulk of our capital markets income come from various advisory fees from Harris Williams or Solebury or syndications and so forth. And while the pipelines remain robust, if not at record levels, the activity level, while there's been some green shoots just hasn't been strong. Eventually, it flows through, but we're getting a little tired of predicting when it will be.
But I would add to that, our capital markets is weighted towards our M&A advisory, Harris Williams. We had a soft second quarter. At the end of the second quarter, our pipelines were higher than the first quarter. So we thought naturally that the third quarter would be higher, but it wasn't. So we find ourselves at the end of the third quarter with even higher pipelines than we had at the beginning of the quarter.
But inside of that, a subset of the pipeline are signed deals, which that part is higher than it was at this point last quarter. So we do expect to see the lift, and our expectations are that we get back to first quarter levels.
Our next question is from the line of Scott Siefers with Piper Sandler.
I wanted to ask sort of a broad question on NII. Are we getting to a point where that will start to trough. So maybe, Rob, just sort of some of the puts and takes. It seems like your deposit betas are coming in as expected or better. I know there should be some asset repricing as we look into next year. But some of the larger banks have been sort of vocal about the degree to which there's still overearning on NII, which I think is kind of kept these fears of still bleeding out NII sort of industry-wide. Maybe just some thoughts on how you see things playing out for PNC, in particular.
I'll start. All of it ends up being dependent on what you think the Fed is going to do. Personally, I think the Fed is higher for longer, even higher for longer than the market expects on our official forecast. I guess we have 2 cuts towards the back half of next year. As short rates stay higher, you will continue to see betas creep up, both because we're going to reprice the back book and secondly, because you'll just not on betas, but just on the shift from noninterest-bearing to interest-bearing.
So when that inflection point is -- has in some ways to do the most with what's going on with the yield curve and the Fed. As the curve continues to flatten by the long end selling off, all else equal, that helps not withstanding the markets on our existing bonds, it helps with the price we get on the roll down and reinvestment. So there's too many variables in there. But the basic notion that were at the inflection point, I think, is entirely dependent on what happens with the Fed in the coming year. And we haven't done our budget yet, so we're not going to call it.
I would just add to that, just observations. Deposits continue to decline. We expected that, but that decline is slowing. Betas have gone up but the increase has slowed. In fact, in the third quarter, they came -- actuals came in lower than what we expected for the first time since rates have been increasing rapidly. So things have slowed as far as that trajectory is. And then obviously, the inflection point issues that Bill just covered are valid.
Okay. Perfect. And then maybe a question on credit as well. I guess there -- just in the last few weeks, there have been a couple of commercial hiccups in the industry in the shared national credit space. Just was hoping you might be able to remind us about PNC's exposure in this next phase and then just generalization, sort of how that portfolio quality compares to the rest of the book, how much you lead, et cetera?
Yes, pretty good there, Scott in terms of credit. So all the noise, so to speak, is in the commercial real estate office space that we spoke about. As far as the shared national credit results went, they're complete. They're represented in our numbers, and it was pretty benign in terms of total deals, upgrades were more than downgrades, but they were a handful of each.
Our next question is from the line of Gerard Cassidy with RBC.
You guys gave us good color on the burn off of the securities portfolio. A question I had is, it looked like this quarter, you put more up a descend. So what are you guys doing with the cash flows from the portfolio now in terms of where you're putting it in other securities? And then second, once the Basel III end game is finalized, how do you think you guys will approach in carrying your securities? Will you carry less on available for sale or more? Can you share with us your thoughts there as well?
Just with the existing book, it's running down. We've run down the DV01 in our securities and swaps through the course of the entire year. We've had some purchases but not to the extent we've had maturities and we've been buying, I don't know what average yield is, but stuff that roughly carries flat versus leaving it into Fed.
Going forward, the switch from available for sale to held to maturity doesn't really affect anything. It's an accounting entry. So we'll keep some amount in available for sale to the extent we trade around that book. But we don't trade around that book all that much, and the rest will just buy and down to maturity, which is, by the way, what we've been doing thus far since rates have gone up.
There's a couple of things to add. One of the uses of cash, Gerard, was the purchase of the signature loans. So that was our biggest -- that was our biggest outlay. Yes, that was our biggest outlay. And then on the split, Bill has it right. Where we are now is probably about where we are, plus or minus to your views in terms of -- but where we got to holding it all to 100% of AFS was the tailoring, which has passed us. So we're back to sort of the normal split.
Very good. And then as a follow-up, you just mentioned about the purchase of the signature loans. You guys are in a good position that not being impacted by Basel III end-game, RWA inflation like some of the big money centers, of course. Do you think there's going to be opportunities for you guys to buy other portfolios, not from the FDIC per se, but from some of your peers or banks that do mitigation strategies to get to these RWA targets they need to get to?
I suppose there could be. I don't know that we've actually seen any. We get pitched by everybody to execute one, which we don't need for. But the purchase side of that is actually pretty attractive. They're giving away a lot of economics. So actually a good thought. I'll go look around.
No, we have the capital flexibility to do it, and people know our telephone number.
Yes. And then specifically, it would be more in the C&I space or consumer? Or do you guys have a preference should they call that phone number, Rob?
It's -- look, we're intelligent -- hopefully, intelligent takers of risk at the right price. We can evaluate what's out there.
[Operator Instructions] Our next question is from the line of Bill Carcache with Wolfe Research.
Bill and Rob, I wanted to follow up on your office CRE comments. How much of an impact to debt service coverage are PNC customers experiencing from swaps that are rolling off, saying cases where they issued floating rate debt on reserve 2 to 3 years ago and put on swaps to lock in low fixed rates at the time but are now facing a significant reset as those swaps mature. I'm just curious if how significant that maturing swap dynamic is inside of the portfolio and whether you feel like you have a good handle on that dynamic?
I don't know the answer to that. I would tell you though the bulk of our stuff, and you see it in our maturity schedules, we are kind of stabilization loans, project loans. And so in that instance, the hedge dynamics of somebody would put on that loan. My experience would be less than what they would have done on a term, 10-year CMBS alternative.
So my guess is it's not -- I think they're just in trouble floating rate loans, from lease rates going down, from vacancies going up and from the rehab costs of redoing floors.
Capital improvements.
Yes. Just dropping the value of the buildings.
Understood. That's helpful. And if I could follow up on that. If refinancing loans at current market rates would cause debt service coverage ratios to fall below one, can you discuss how much leeway there is inside of PNC to refinance loans under potentially more favorable terms to allow debt service coverage ratios to remain satisfactory.
And then maybe just more broadly across the industry, do you think so-called extended pretend dynamics could become pervasive, particularly since banks have made it clear they don't own office buildings. And we've seen some commentary from regulators sort of urging banks to work with their customers.
Well, I think the extend part is possible. I think the pretend part, that doesn't work. We work with borrowers to figure out how to maximize the value of the property because that's ultimately going to maximize the value of our loan. In some instances, that means taking the building and selling it. In some instances, that means getting more equity capital, extending a loan at a debt service coverage ratio, we normally wouldn't under the theory that they can lease it up itself.
But each and every one of those decisions is a decision tree based on what's the net present value of what we PNC can get against our loan. In any event, if we do something that is uneconomic relative to the original loan, that shows up in our reserves or charge-offs or so on and so forth. There's no pretend involved.
Understood. That's very helpful, Bill. And if I could squeeze in one last one on the point about whether we're at an inflection point on deposit betas sort of depending on the Fed. Does it correlate? That suggests that we could see terminal beta expectations potentially drift higher relative to prior guidance, again, depending on how much higher for longer persists?
Yes, I think -- and by the way, this isn't a forecast. I think it's just common sense, right? To the extent that we still have a back book of business as does everybody that hasn't necessarily repriced. And if rates are pinned at 5% forever in time, that beta will continue to go up. It's a function of how high does the Fed go and how long do they stay there, and everybody has been wrong so far. So yes, it's a possibility.
Understood. I wanted to ask you another one about the CFPB sort of open banking proposal, Bill, but I'll queue back up for that one.
Our next question is from the line of Peter Troisi with Barclays.
Thanks very much for the disclosure on the long-term debt shortfall in the slides. You talked about $10 billion of debt issuance annually. But do you anticipate needing to issue more than $10 billion to close the shortfall that you disclosed in the slides? Or can the $8 billion shortfall at the bank be met just by restructuring existing internal debt. And I guess the question really is, do you expect to issue debt at the holding company specifically to invest in the internal debt of the bank?
Yes. This is Rob. So good question. So in regard to the long-term debt, our message is independent of the rules. As we resume a more conventional funding structure in terms of our debt to our deposits, that was precoded, we would be compliant. So that's the takeaway. In regard to how we get there, it's a combination of everything that you outlined. There will be issuances at the holding company as part of our ongoing plan that will then ultimately be papered down to the bank.
But there's a lot of moving parts there. The message is we'll get there, and we would have gotten there independent of these rules.
Our next question is a follow-up question from the line of Bill Carcache with Wolfe Research.
Yes. So Bill, I was hoping you could just share your thoughts on the CFPB's plans to propose an open banking rule. There's a view that open banking essentially forces the industry to hand over the keys to the customer relationship. You've talked in the past about sort of the dynamic of like passwords and all that kind of stuff. But I was just hoping you could speak broadly to that point, through that topic?
Yes. I think what I've seen thus far out of CFPB commentary is they're largely focused on some of the right things: make it easier for customers, agree with that; secure data, agree with that; don't allow data to be sold and commercialized without customer permission, I agree with that; make customers agree to specific data items want they want to share in a secure environment.
So all of that stuff versus where we are today, where it's a free for all, and there's a lot of fraud. Actually, I'm in favor of. The notion of kind of open banking where somehow I can just lift and shift my account from one bank to another because now there's technology to do it, I'm not that afraid of that. It's more in the technology to allow it in a secure manner, dependent of what rule is written, doesn't exist today.
And I kind of look at what they're doing and hope it's a step in the right direction on security and the safety and soundness of customer information leading to a reduction in fraud across the industry. The sound bites are, that's where they're going.
Okay. That's helpful. I had heard something along the lines of some of the actions we're taking are intended to make it easier for customers "to break up with their banks." And so I was wondering if there was anything in the language. You mentioned now you're not worried about the ability to shift the relationship. So...
Look, at the end of the day -- by the way, if that happened, terrific. We compete every day, and we have good customer service and great products, we'll be a net beneficiary. Practically, the technology to allow that to happen. So just think about the notion of, okay, now you have connected APIs that allow somebody to gather information and move information. Now you need to build a program that keeps track of the back book while you open a new book on a checking account, transfers, balances on cards.
So eventually, somebody come up with a cool business model that might be able to do that on the back of a pause that allow it on the back of APIs that haven't been written yet on the back of technology that links all the banks and question together. But that hasn't happened yet.
Our next question is from the line of Mike Mayo with Wells Fargo Securities.
Sorry about that earlier. So in terms of the decline in commercial loans, is how much of that decline is due to softer demand? And how much of that is deliberate as you look to shore up capital more than you previously would have intended?
Well, none of it is deliberate per se. We've seen some drop in utilization. We've seen a drop in kind of refinance rate as people are -- you think about a corporate loan revolver, where it's a 3-year and every 2 years, you renew it for the next 3 years. Everybody is kind of extending that under the hope that things are going to get better on spreads. So there's just been less activity.
At the margin, we are extending less credit into credit-only new relationships on the hope that we're going to get fees versus protecting our wallet where we already have a lot of fees and get cross-sell. But that's kind of a met the margin.
That's small. It's on the demand side.
Okay. And you're very clear about the expense guidance and the tough actions you're taking with personnel. Did you give an outlook for operating leverage over next year? Do you think the pace of expense decline will be faster than any decline in revenues?
And specifically to the fourth quarter, the SBNY loan acquisition looks like it adds a couple of percent to your fourth quarter NII, but you're guiding down 1% to 2%. So that decline might be a little bit more than some had expected. Is it more than you had expected?
The quarter decline looks like 2% to 4% in the fourth quarter. Is that math correct? Why is it down, maybe more than you thought? And the big question, though, is revenues versus expenses over the next year?
Do you want me to? Well, on the expense issue, we did say that we expect '24 expenses to be stable. And we haven't finished our budgeting cycle. So we can't really answer in terms of anything beyond that in '24. In regard to the NII in the fourth quarter guide, it does include the Signature acquisition, which we said was about $0.10 a share. Recall in the third quarter, we had expected 3% to 5% decline. We ended up down 3%. So when we look to the fourth quarter, roll all that together, that's how we get down 1% to 2%.
Our next question is from the line of Ken Usdin with Jefferies.
One follow-up on the Signature acquisition as well. So just wondering if you can provide a little more context on the portfolio, seeing the line that you're expecting to hold on to -- or expecting to hold on to 75% of the relationships over time. Are you bringing on new team members? Is there expenses along with that? And just anything you can help us in terms of like the duration of the loans? And is there just kind of a natural runoff that happens given I think that they're generally a pretty short duration type of loan?
Yes. It's de minimis adds of people that we're bringing on. We're already in the business. We have the technology to be in the business. We know the clients. The rundown, we're kind of saying 75% probably survive. Most of that is simply a function of where we have overlap with clients and the size hold that we want to have for a particular client. We'd syndicate more of it as we kind of rightsize our hold.
There may be inside of that book of business, a handful of people that we would choose not to renew. But the credit quality is pristine. We know we underwrote every fund that is in that. And through time, you would expect that as they mature, we'll renew. In some period of time out a couple of years, we'll end up with 75% of the notional that we started with, and you'll have no clue between now and then. How much it was.
But that's right. De minimis expense is involved with it, and we're excited about it.
Yes. That's a fair point on we won't know. That's what I was trying to ask. The second question is...
But to be clear, it will be lost inside of our book of business. It becomes part of our C&I balance.
Completely understood. The second question I had, Bill, is you mentioned in a higher long-form environment, we got to see what the Fed does in terms of where deposit betas and mix goes. On the asset side, however, though, can you help us understand what happens in terms of fixed rate loan repricing versus -- and how much you might still have left in that versus obviously when we get to a peak in Fed funds, we'll know that the variable rates will have gotten there.
Yes. So we have I mean, beyond our securities book and swaps, which obviously we will reprice over the next several years, we have -- I don't know the percentage off the top of my head, percentage of our loan book, either fixed rate to begin with, think of an auto loan or with swaps on top of it, floating rate loan, we swapped to fixed. And those fixed rate loans and swaps are shorter duration typically than what we have in the securities book.
And there's a lot of dry powder there that will reprice. We are back to this notion that, "Hey, we're out there competing and growing this company." We will be originating those loans as they reprice. We're not dumping assets and getting out of things. It's going to shrink the total volume that's on our book.
Yes. No. Totally understand. I would think it would be a net positive as an offset to whatever has happened.
A little bit. You have the competing parts, right? We're going to have repricing of fixed rate assets, fighting reprices of our liabilities. At some point, that's going to cross and banks are going to grow NII at high percentages. I just can't tell you when that is yet, and we haven't done our budget next year.
Yes, that's fair.
And there are no further questions on the phone lines at this time.
Okay. Well, thank you. Thanks for participating. If you have any follow-up questions, please feel free to reach out to the IR team. Thanks.
That does conclude the conference call for today, and we do thank you for your participation.