Good morning, and welcome to KeyCorp's Second Quarter 2023 Earnings Conference Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to the Chairman and CEO, Chris Gorman. Please go ahead..

Thank you for joining us for KeyCorp's Second Quarter 2023 Earnings Conference Call. Joining me on the call today are Clark Khayat, our Chief Financial Officer; and Mark Midkiff, our Chief Risk Officer. On Slide 2, you will find our statement on forward-looking disclosure and certain financial measures, including non-GAAP measures.

These statements cover our presentation materials and comments as well as the question-and-answer segment of our call. I am now moving to Slide 3.

Before Clark covers our quarterly earnings results, I want to discuss our strategic priorities and cover the fundamental strengths of our businesses, which continue to perform well despite the challenging operating environment.

In our Consumer Bank, we're growing relationship households at an annualized rate of 5%, consistent with our Investor Day target. Our strongest growth continues to be in the West, driven by younger clients. We have also experienced strong growth in wealth management with double-digit year-over-year growth in asset management sales.

In our Commercial business, we continue to add and expand relationships through our integrated commercial and investment bank. Our ability to distribute risk serves us well and importantly, serves our clients well through all market conditions.

This quarter, we raised $25 billion of capital for our clients, placing 18% of the capital raised on our balance sheet. This is down significantly from the 30% we placed on our balance sheet last quarter. Although capital markets remain challenged, our pipelines are solid. On a year-to-date basis, our M&A revenue is up from the first half of 2022.

We expect investment banking fees to be up in the second half of the year. One common theme across our franchises are long-standing strategic commitment to Primacy, having our clients' primary operating account, whether it's an individual or a business. Our focus on primacy is reflected in the quality and diversity of our deposit base.

Nearly 60% of our deposits are from retail, small business, wealth and escrow accounts. 80% of our commercial balances are core operating accounts. Further, 97% of our total commercial deposits are from our relationship clients. Importantly, these are long-standing relationships.

On average, our retail clients have been clients of key for over 20 years and on average, our commercial clients for over 15 years. This quarter, our period end deposits increased by $1 billion. Additionally, we've seen continued growth in the month of July.

In the appendix of our presentation, you can find additional detail regarding the quality and diversity of our deposit base. We continue to proactively manage through volatility as it relates to the macroeconomic environment, the interest rate cycle and potential regulatory changes impacting our industry.

Going forward, Key will benefit from a well-defined net interest income opportunity over the next 18 months. As our short-term swaps and treasuries reprice, we will see a net interest income benefit that will reach approximately $900 million on an annual basis by the first quarter of 2025.

We also continue to be proactive from both a balance sheet optimization and capital allocation perspective. We are well positioned to build capital and reduce risk-weighted assets. We will continue to prioritize full relationships and exit non-relationship business and non-strategic assets.

In the second quarter, our period-end loan balances declined by $1 billion. We will continue to benefit from our strong fee-based businesses, which make up over 40% of our revenue. As capital markets normalize, we will utilize our differentiated platform, driving fee income and naturally reducing our balance sheet.

On the capital front, we will benefit as over 44% of our AOCI will roll down over the next 18 months. The next area, I would like to discuss is our exposure to credit in the current environment. Credit losses remained relatively low across the industry. But as we move through the business cycle, asset quality will matter.

Today, more than half of our C&I loans are investment grade and over 70% of our consumer originations have a FICO score of 760 or greater. These measures reflect the derisking of our portfolio over the past decade in concert with our underwrite to distribute model.

We have limited exposure to leveraged lending, office loans and other high risk categories. B and C class office exposure in Central Business Districts totaled $121 million, two-thirds of our commercial real estate exposure is in multifamily, including affordable housing, which continues to be a significant unmet need in this country.

We also continue to benefit from insights gained from our third-party commercial real estate servicing business, as we service over $630 billion of off us real estate exposure. Finally, we will continue to focus on improving productivity and efficiency.

Our results this quarter reflect the successful completion earlier this year of a company-wide effort to improve efficiency. Actions completed in the first quarter represented over 4% of our expense base and $200 million in annualized benefit.

These efforts remain ongoing as we will identify new opportunities to improve both productivity and efficiency. Before turning the call over to Clark, I want to take a step back. This quarter, we strategically built capital, managed the size of our balance sheet and for the third consecutive quarter, built our allowance for credit losses.

As I covered earlier, we will continue to take steps to manage our level of risk-weighted assets in consideration of anticipated regulatory changes. I will close by affirming my confidence is long-term outlook for our business.

We have a durable relationship-based business model that will continue to serve our clients, our prospects and deliver value to our shareholders. With that, I'll turn it over to Clark to provide more details on the results for the quarter.

Clark?.

net interest income down 12% to 14%, fees down 7% to 9%, expenses relatively stable, net charge-offs of 25 to 30 basis points for the year and a GAAP tax rate of 18% to 19%. We feel confident in the foundation of our business, in our diverse high-quality deposit base the durability of our balanced franchise and our improved risk profile.

Despite near-term headwinds, we continue to be focused on execution in 2023 and positioning the company to benefit from the strong long-term core earnings power of our businesses. With that, I will now turn the call back to the operator for instructions for the Q&A portion of our call.

Operator?.

Thank you. [Operator Instructions] One moment, at least for the first question. That will come from the line of Scott Siefers with Piper Sandler..

Good morning, guys. Thank you..

Good morning, Scott..

Hey, Clark I wanted to talk about the NII outlook. So the pace of NII degradation looks like it should slow considerably in the second half, the fourth quarter, especially. Maybe a little more color on the main factors you see that would allow that to happen.

I know you sort of rationalize the beta expectation, and of course you've got the treasuries and swaps, but just curious to hear from your view, the sort of main factors in that outlook?.

Sure. Thanks, Scott. And I think this will be a topic worth spending a little time on. So first, let me just remind you that the 212 NIM would have been 285 without the swaps and treasuries, which were about $340 million in the quarter, just to give you kind of a level set.

If we go back to recent -- the most recent guidance, we would have guided you to the second quarter being at or near the bottom. So to your point, Scott, it's a little bit of a continued decline. What I'd say is the fundamentals of our business are very consistent with that comment. What's changed is the rate expectation in the back half of the year.

So at that time, we were expecting two cuts in the fourth quarter. As I stated in the prepared remarks, we're now going to see kind of a one hike and it flat through the end of the year.

And I think the implication of that is the betas will drift a little higher through the back half of the year, and the swaps and the treasuries will be a little bit bigger drag than we previously expected. That said, we do think that both of those factors are moderating.

So we're seeing deposit balances stabilize, and we're seeing the slope of that beta increase flatten. And we're continuing to see swaps mature and the treasury portfolio will begin to mature now in the third quarter. So we'll see opportunity as those two books come off.

So what we're seeing then is that flattening of the NII and NIM trajectory as we go into fourth quarter, and we wanted to reflect that by providing guidance for each individual quarter. As we go beyond that into 2024, I think we'll start to see a pickup. Slide 9 isolates the swap and treasury portfolio, so consistent with what we did last quarter.

As I stated a few minutes ago, $340 million drag in Q2 or 73 basis points.

And the way I'd think about it just in its simplest terms is $9 million US treasuries that start maturing in this quarter, with basically an average yield, think, of 45 basis points and $10.3 billion of swaps between now and the end of 2024, with a received fixed rate between 40 and 50 basis points.

So put those together, you're looking at close to $20 billion with an almost 5% yield pickup by the end of 2024, and that's what gets you to the $90 million or 220 per quarter -- 230, sorry, per quarter that we have on slide 9 in the deck as of Q1 2025.

So again, in that case, we're trying to isolate just the treasuries and swaps and provide as much transparency as we can there on these specific headwinds. What I would say that doesn't include is the relative betas or funding costs that go with that. But I just want to touch on that because, again, I think it's important to understand.

If you look at the $720 million, which is equivalent to the $900 million that we quote this quarter, that was consistent with a different rate environment, where rates were coming down at the end of the quarter or the end of the year and we would have had a muted -- slightly muted impact on the NII pickup.

As I just said, rates, we think, are going to be higher now. The betas will be higher. But commensurately, the pickup in those swaps and treasuries has gone from $720 million to $900 million. So those are going to move in sync.

Slide 9 is intended to be, again, isolated to the treasuries and swaps just to make sure we're giving you as much disclosure on those as we can..

Okay. That's extraordinarily helpful color. So I appreciate that.

And I don't want to put words in your mouth, but in the aggregate, would your expectation be that NII ends up sort of bottoming around end of this year, maybe early next year, but then does see a more visible inflection back up as sort of the pricing dynamics weighing on funding costs, but you then start to get a more material and visible benefit from the swap and treasury maturities.

Is that the best way to think about it?.

Yeah, I think that was very well stated..

Okay. All right. Perfect. Thank you very much. I appreciate it..

Yeah. Thanks, Scott..

We'll go next to the line of Ebrahim Poonawala with Bank of America..

Just wanted to follow-up, I think, on the same line of questioning that Scott around NII. So appreciate the lift from swaps and treasuries. I think the concern when you talk to investors has been the valley before we get to that point has kept getting deeper throughout the year.

When we look at this guidance for the back half, I think, Clark, you mentioned implies negative 12% year-over-year.

Give us a sense of just a level of confidence in that guidance, that this is it, absent any big change in the interest rate backdrop, how good do you feel and the level of visibility that you have? And I appreciate it's been tough for the entire industry to handicap this, but any color you can provide would be helpful..

Sure. So look, I think the biggest change as we've gone through the year has been the rate level. So given your commentary on sort of relatively stable rates, I think we feel very good about the trajectory we're sharing here. And I would say, overall, our deposit betas, I feel like, are very much in line with the peer group.

We did some catching up because we outperformed last year, but I feel like that's very consistent with what's happening in the industry, and we just happen to have these specific headwinds right now on swaps and treasuries. But again, as those come off, we think we're prepared to get the benefit of that.

So I would say that in the expected rate environment, our confidence would be good..

Got it. And second question, I think Chris talked about 2 things. One is focus on expenses. I see the guidance for flat expenses for the back half. Give us a sense, if there's a bigger opportunity around flexing expense leverage as we move into back half, and as at least the Street thinks about 2024 EPS and also around any proactive RWA actions.

I think you mentioned getting rid of or exiting nonstrategic relationships.

How impactful could that be for capital?.

Sure. So that's a great question. And as you put them together, they are closely related. So if you just step back here, here's how we see the future as all the regs unfold. What's not going to change for us, Ebrahim, is we're going to remain focused on our relationship model. We're going to stay focused on targeted scale.

But I think there's going to be incredible and intense scrutiny around the duration, the granularity, the composition of the deposit base, and that's one of the reasons that Clark talked about that we pivoted and made sure we protected our deposits, whereas we were kind of leading in terms of not having a lot of beta.

Next gets to -- I think there's -- and this gets directly to your question. I think there's going to be a significant change in loan-to-deposit ratios. As you kind of run all this through your models and we run it through our models, I think loan-to-deposit ratios for Category 4 banks, if they're mid-80s now, they're going to be significantly less.

And we are very focused on this. And so keep in mind, last year, we grew our loans kind of high double digits. I mean like around 19%, I should say, high teens. And then we were on a path to grow 6% to 9%, but that all happened in the first quarter before the events of March.

And we not only stopped that growth, but actually pushed it back $1 billion by the end of this quarter, which I think is really, really important. And right now, what we're doing is we are scrutinizing every portfolio we have in the bank.

I've always said that on a risk-adjusted basis, most loans -- most standalone loans don't return their cost of capital. And if you think about having to carry more capital and you think about the capital that you have being a lot more expensive, then you can rest assured there will be a lot of credit-only relationships that won't be strategic to us.

So we'll preserve our capital for those relationships. As you know, we can do a lot with them. But we will be continuing to push down our assets. And you see in the guidance that Clark gave you, we're looking at average loans being down 1% to 3% in the third quarter and down 1% to 3% in the fourth quarter, we will hit that.

So -- and then the second part of your question, which is also related, as we shrink the balance sheet, we're going to have to make sure that our expense base is rightsized for the future asset base of our company. And rest assured, we're looking at that as well..

And Chris, if I may squeeze one in. Just give us a sense of the dividend. There's been a lot of focus, the 7% dividend yield.

As the Chairman of the Board, I know it's evaluated every quarter, but how confident are you in terms of dividend sustainability as we kind of plug through the back half into 2024?.

Sure. Well, the headline there is I am confident. But as a Board member, we spend a lot of time talking about strategy and talking about dividend policy. We manage the company for the long-term. And the dividend policy is no exception.

Our capital priorities, as I just mentioned, are unchanged, is to support our clients, our prospects and to pay dividends. And to your point, last week, our Board did approve a $0.205 third quarter dividend. Keep in mind, over our history, we have paid out 80% very, very often. It's just been in the form of both buybacks and a cash dividend.

So we're obviously paying close attention to that. I feel good about it. Let me talk a little bit about capital because it's so related. This -- in spite of some of the challenges Clark mentioned, this quarter, we grew capital. We paid a $0.205 dividend, and we built reserves.

And so as we think about taking this long-term perspective, when you look at our normalized earnings power of our company, and that is the reversal of the NII headwind into a tailwind and also having a reasonable expectation around investment banking fees, the earnings power of the company is strong. We can build capital there.

Clark mentioned the AOCI burn down, 44% by 12/31 2024, 55% by 12/31 2025. And then, as I just mentioned, this game plan that we have around risk-weighted assets will be important.

And then the last thing that I think is really important -- and it's going to be important, I think, as the cycle continues to play out is we have a well-positioned credit book. And there's nothing that destroys capital faster and bigger hunks than having a bunch of credit losses.

And so I put all those things together, we take a long-term perspective on the dividend. We feel good about it..

Very helpful color. Thank you so much..

Sure. Thank you. Ebrahim..

We'll go next to the line of Ken Usdin with Jefferies..

Hey, guys. Just a couple of follow-ups on the loan side. Obviously, you said that your retaining a little bit -- you're back to kind of that upper teens point of your investment banking originations.

And I'm just wondering, does that have any throughput in terms of the ability to generate business in the investment bank? And I guess connected just then, your confidence in the second half improvement in the investment bank, is that because you start – you're starting to see things get back out the door as opposed to keep on the balance sheet like you have been doing for the last couple of years?.

Well, first of all, thank you for your question, Ken. It's complicated by the fact that, as usual, mix has a lot to do with it. So we actually distributed a lot of debt in the second quarter. The reality is a lot of it was investment grade. So in terms of investment banking fees, not so great.

In terms of keeping the velocity of our balance sheet, very, very important. But the premise of your question, as we look to shrink our balance sheet, the ability to distribute paper to a lot of different places will be -- will, in fact, be important. And so that will be an important part of the mix.

In terms of what I'm seeing, here's kind of what I'm saying. One, our M&A backlog year-over-year is up. Our total backlog is down, but down kind of mid-single digits which is really not a big deal. What I'm most encouraged by is not that I'm seeing things coming out of the pipeline. Obviously, in the equity market, we're starting to see that.

You're seeing that for sure. But what I'm really pleased with is I talk to our clients all the time -- in fact, as recently as yesterday, I talked to one of our large clients who is proceeding with a transaction that's been sort of percolating for some time as people kind of go through the price discovery.

So it's really more a gut feel on my part having been around this business just for so long..

Got it. And just one more. Laurel Road, some cost factors there, too, obviously, with the debt moratorium and what happens there.

But just as far as also being -- scrutinizing every incremental loan that you're making, just can you talk about the Laurel Road specifically, but how you're also thinking through that in terms of the other consumer portfolios..

Sure. I'll start, and then I'm going to flip it over to Clark. But it's a great question and it's one, as we sort of have gone through our reset, we've spent a lot of time talking about these capabilities that we need to make sure we have. Before we bought Laurel Road, they securitized and distributed 100% of their loans.

Going forward, we're going to be securitizing and distributing their loans. We have the people and we have the ability to do it. So it's a really good question. While I'm on the point of Laurel Road, the other thing we've done on Laurel Road is we really made two pivots in what's been going on with the federal student loan payment holiday.

One, we turned it into a complete digital platform, whereby we can have loans, deposits, importantly, checking account, card, mortgage, et cetera.

The other thing that we did is when we bought GradFin, and we're in the early days of this, Ken, but GradFin is a market leader in advising people around not only public service loan forgiveness, but the whole income-based debt repayment which the government is really opening up the aperture for.

It's falsely complex and you need someone to sort of help you through it, which is a good thing. But that's another pivot that we've made there. But getting back to your question about sort of our asset-light model. Clark, why don't you talk about -- speak to that, particularly around mortgage as well..

Yes. So I think largely, we're going to look to continue to distribute. I mean we do have capabilities now, where we distribute a lot of debt. We're going to expand that more consistently, I think, to the consumer side.

The point I think on Laurel Road that Chris made that I just want to reiterate is we never acquired it to be a student loan only generator, that was kind of the headline. It was intended to be a full-service banking platform, and we continue to build toward that, and we think it's got some really unique.

And differentiated capability around this income-driven repayment and public service loan forgiveness, and you may have seen some commentary out of the government in the past week around the IDR specifically and some of the complexities of that, which I think will accrue to our benefit over time. ..

Got it. So, if I can wrap that together, is it fair to say that the trade-off of less NII -- less loan growth over time getting the LDR down, you'll sacrifice some NII help on the capital side and then move towards more of a fee-generating model just in terms -- yeah..

Yeah. I think that's the right idea. I think we're also demonstrating more deposit growing capability there. And again, we're still relatively new in having those capabilities. But I think that's the right way to think about it. So, more of a fee advice and core banking generator than a loan shot..

Okay. Got it. Thank you..

Yep..

We'll go next to the line of John Pancari with Evercore. Please go ahead..

Good morning..

Good morning, John..

Just going back to the $900 million on slide 9 of the NII pickup from treasury and swap maturities.

So let me just ask it this way, aside from a change in the rate backdrop and your interest rate outlook, what could prevent you from realizing that? I know, there's a fair amount of investor skepticism around the ability of that $900 million to find its way into the numbers.

From your perspective, how do you size up the risks? What are the -- the risk that you do not realize in that? What gets in the way? Is it more on the deposit side, or is it an asset side of the picture that could prevent that from being realized?.

Yeah. So I think, I mean, the rate available when the treasuries and swaps mature is sort of the single biggest factor, and that would be -- would have been reflected in the $720 million moving to $900 million. So -- and again, that's isolating kind of the income portion of that. I do think there's a couple of variables.

So think about the treasuries, whether or not we reinvest them in the market, use them as replacement funding or hold them in cash. Today, those are relatively neutral. Over time, if there's a disparity between those three, you might see a little bit of pickup or drop depending on which decision we make.

But today, it's kind of a push across all three of those. And then your other point was right, which is the funding side of this.

So I tried to reflect that as well in my comments of lower beta expectations at the end of Q1, when we showed you a $720 million opportunity, higher beta expectations here today, but that opportunity has gone up kind of in a related way.

So, I don't know and I don't want to pretend those are kind of one-to-one tide, but I would think about those moving at least in a fairly correlated direction..

Got it. Okay. All right. Thank you.

And then separately, as you continue to exit the -- or as you're evaluating the non-strategic businesses and other optimization, just to confirm, any progress you make incrementally on that front that would be in addition, like to the guidance of a decline of 1% to 3% on the loan front? So, anything on the incremental optimization that would provide -- that would lead to potential incremental downside to those numbers..

I think if there was something more significant than what Chris referred to, which is maybe a very active management of the business, that would be incremental. But I think what we've built into this guidance is how we're running the business right now..

Okay. All right. Thank you..

We'll go next to the line of Matt O'Connor with Deutsche Bank..

Good morning. I want to follow-up on the kind of capital line of questions. I guess the first thing is a lot of your peers seem to be targeting 10% plus on the CET1. And obviously, there's capital proposals coming out.

But I guess first question is what are your thoughts in terms of that 9% to 9.5% target moving closer to 10% to 10.5% like some of your peers?.

So, Matt, we think 9% to 9.5% is the right number for us given our business mix.

If you think about 50% of our C&I book being investment grade, if you think about the fact that we don't have really any credit card business to speak of, if you think about the fact that a funding -- we have FICO scores in our consumer business of 760 or so, we think it's the right number.

And obviously, at 9.2% and having grown it from 9.1% this quarter, we're right in the strike zone. Having said all of that, we, like everybody else, will wait and digest anything that comes out in the not-too-distant future and reevaluate it at that point. But for our business, right now, we feel that's the right number..

Okay.

And then in terms of the RWA optimization, is it possible to size that or give a range and the timing of when you'll get the benefit of that?.

We're looking at a lot of different things. But right now, I'm most comfortable just directing you to the guidance that we gave around loans. But as I mentioned, we're looking at other things as well. I'll leave it at that..

Okay. Thank you..

Thank you, Matt..

We'll go next to the line of Manan Gosalia with Morgan Stanley..

Hi, good morning. I wanted to clarify your comments earlier on the call that you believe that the LDRs for the industry and Category 4 banks, in particular, will have to move lower.

Does that mean that you have some room to optimize some of your non-deposit funding like longer-term debt, or is that unlikely given the potential for TLAC rules to also apply for Category 4 banks?.

Yes. So, I think that we do have that, and you would have seen us do a little bit of that even here in the second quarter. So, I think your follow-on question around TLAC or long-term debt is the right one as well. And we'll wait, as Chris just mentioned, for the proposed and final rules.

But we do think that reduction in loan to deposit over time gives us an opportunity to reduced reliance on wholesale funding..

Got it. Okay. And then maybe on the credit side, given the ACL was up this quarter as well.

Was that entirely model-driven? And I guess how much of a buildup -- is there more of a buildup to do? And what sort of an environment do you have baked into that current reserve ratio?.

Sure. So, just from a CECL perspective, obviously, it's very forward-looking. In terms of what percentage is model-driven, what percent is kind of portfolio driven, I think you can assume it's kind of sort of half and half. And my assumption is that -- just to step back for a second.

My assumption is that we will have -- I think the Fed is going to successfully engineer a soft landing. I think it will probably happen in 2024. Having said that, what I don't think is yet in the market is the impact of and also the impact of banks tightening down on credit. And I think both of those will have an impact on the economy.

And as such, we're pretty conservative in terms of how we look at things. And so the first thing we always do is look at anything that is leveraged and anything where the cash flows could be in any way impacted by a slowing economy. So that's kind of the lens that we looked at it. There is nothing specific.

There's nothing that we're particularly worried about. We kind of looked across all the portfolios..

So as we -- if we do move towards a soft landing, would that imply that you don't need the ACL ratios to really move higher?.

Yes. Right now, I feel like we have reserved what we need to reserve, for sure..

Got it. Thank you..

Thank you. We'll go next to the line of Mike Mayo with Wells Fargo Securities..

Hi.

Can you hear me?.

Yes, Mike, we can. Good morning..

Okay. Good morning. So you're guiding NII down 4% to 6% in the third quarter and another 0% to 2% in the fourth quarter.

What does that mean for your NIM? Even in broad terms, it was -- I guess, it was 2.12% in the second quarter?.

Yes, we would expect it to be relatively flat in the third quarter and then start to trend up..

Okay. So my question is, look, that's the lowest core margin possibly ever, at least since the global financial crisis. I mean, that is such a slim margin here.

And then -- so I guess, why such a low margin? And even after the increase, I guess I get to around NII of about $1.15 billion per quarter, which is where you were in the second quarter 2022, which is before the Fed rate hikes.

And you can correct the math, but you're using the midpoint to your NII of $986 million, goes down to $937 million next quarter and then $927 million in the fourth quarter.

And then I guess you're saying it goes up by about one-fourth from there by the end of the year, right? So $927 million plus 1/4 of that $900 million annualized, gets you around 11 50 NII. So I'm throwing a lot of numbers around here. But in the end, you wind up with a NIM, you wind up with NII that's at a level before the Fed rate hikes.

So even with the potential improvement next year, which would be an incremental positive, you're still not getting credit for any of the Fed rate hikes that took place.

So what happened with the structural positioning of the balance sheet that leads to such a low NIM and NII?.

So I mean what I -- where I'd start there, Mike, is that if you look at the composition of our loan book in general, it is, in our view, higher credit quality, but higher credit quality comes generally with lower yields. So we have over 50% of our C&I book is investment grade, we have super-prime consumer books.

So those are not going to carry the same rates broadly is something like credit card, which we have very little exposure to or personal consumer loans, which we have very little exposure to. So in that regard, we're starting probably structurally a little bit lower NII, but the counter to that is what we think is a higher credit quality book.

So I'll have to go back through the specific math you have there, but -- and I'm happy to do that and talk about it offline. But I think that's at least a starting point. But we think, over time, NIM that starts with a 3 is not an unreasonable place for us to be..

And so is that right, so next year, you're guiding basically -- from the fourth quarter level where it stabilizes, at least the NII should go up by about one-fourth by the end of the year. In other words, you're guiding basically close to $900 million for the fourth quarter or a little above.

And then you're saying you're gaining $900 million annualized by the end of next year. So that would imply NII would go one-fourth higher from that fourth quarter level, all else equal.

Is that correct, the logic?.

Not exactly. So the $900 million is annualized as of the first quarter of 2025..

Okay. So, just a little bit later. Got it. But eventually, NII goes up by one-fourth..

Correct..

And I said the words, all else equal, but what would not be equal? What could help -- say NII, what could help that NIM go back from 2% to 3%? What is that logic missing?.

Well, I think, it's -- I mean, the obvious one right there is the 73 basis points that comes from swaps and treasuries. So that's what we're talking about. And betas, I think, getting -- or general rates and betas getting kind of more in line with historical averages, or overall funding costs.

So as we just talked about, we have some opportunity to reduce some wholesale funding, which is obviously expensive, and we're still yet to see pull-through on loan spreads. So I think there's a variety of factors that could improve that, many of which we are either not experienced at the moment or haven't seen kind of broadly in the industry..

And then last one, Chris, you started off saying you expect investment banking to be stronger in the second half of the year. There's been some drought for the industry.

What gives you confidence either for the industry for Key or for both?.

Mike, I was just -- I mentioned this earlier in the conversation. It is based on my experience being around this business as long as I have. People will defer transactions for so long, but eventually sort of the logjam starts to break. I think we're starting to see it a little bit in the new issue equity business.

And I've just been out talking to clients. And I think people that have put deals on hold now for 12 months, either these deals are going to start to happen, or they're going to move on and do something else. So, it's based on, one, just looking and scrutinizing the backlog. And then secondly, just more instinctive, as I'm out talking to people..

So fish or cut bait time?.

Yes, for sure..

Okay. Thank you..

Thank you, Mike..

We'll go next to the line of Erika Najarian with UBS..

Hi. First question from….

Hi, Erika..

Hey.

What was your adjusted CET1 in the quarter, including AOCI? And I presume at 9%, 9.5% CET1 target would be like your fully loaded target even after we get an NPR that would be inclusive of AOCI and CET1?.

Yes. So, whatever that ultimate target is, Erika, will reflect the appropriate rules. So if the AOCI of that is eliminated, then yes, I think you stated that correctly. So, 630 that level for AOCI AFS is about 630..

Got it. So, my second question is for you, Chris. And I apologize if this sounds challenging, but this is sort of the big conversation that I'm having with long-term shareholders. Clearly, the stock price performance today is trying to price out some of the dividend fears that were in the market given where your yield is.

And I think the big discussion I'm having with your investors is that, that 80% payout, right, that you mentioned and that happened for this quarter, it feels like three years ago sort of in the pandemic, you were getting the same question about the sustainability of your dividend.

And it feels like at the end of the day, it's really the denominator that has been challenged.

So, whether it's been expenses previously or steady having the balance sheet set up to have these received fixed rates that essentially imply a zero rate environment forever, it just feels like your efficiency ratio isn't just quite right and doesn't really reflect the potential of the business.

So, as you think about the next three years, how are you -- what discussion are you going to have with your Board to have that earning -- the potential of your franchise really be reflected in your earnings power? I mean the NIM is the NIM, and I get the swaps.

But like I feel like that -- gets wrapped up in the dividend conversation at the entire time, not necessarily because the dividend is an albatross, but it feels like that your earnings power is sensitive to vagaries of the macro?.

Well, first of all, I appreciate the question. I agree with the premise of it. Our business -- the challenging thing for us, and we just -- I was with my Board last week and we were talking at length about this, our challenge is our business is performing well.

We clearly are under-earning, and we're under-earning based on how we have our balance sheet position. And that's why I mentioned one of the things that gives me confidence, Erika, is when we get the normalized earnings power of the company, we just talked about investment banking fees, that's driven by something else.

But what we really need is the position that we have, which is liability sensitive at a time when you wouldn't want to be liability sensitive, we need for that to burn off. And the passage of time will do a lot on that. Unfortunately, it is the passage of time.

But as I mentioned, the burn down between now and 12/31/2024, and 55%, this is as it relates to AOCI by 12/31/2025. So, that is the issue. And I think we are -- said differently, we are under-earning right now and we will be over-earning as the position unwinds and rolls down..

Got it. Okay. Thank you..

Thank you..

And we'll go next to the line of Gerard Cassidy with RBC..

Hey, Chris and Clark..

Good morning..

Chris, you touched on in your opening remarks about the commercial mortgage servicing portfolio, I think you said $630 billion.

Can you share with us the special servicing segment within that business? Obviously, with the challenges in the commercial real estate market, particularly in the CMBS market, I suspect your special servicing business has picked up, and maybe some color there?.

Sure. Well, thanks for the question. It's a great business – it's a great business because it generates a bunch of deposits through escrows, which are more important today than they ever have been in my career. It's also important because it's countercyclical.

So for those of you that aren't as familiar with the business, we are the named special servicer when a large complex debt financing is put together. And so when you're the named special servicer, you get sort of what I would think of as sort of a ticking fee.

And then if, in fact, it goes into default, and this is all off us real estate, we are the workout agent. And to Gerard's point, we just set for the second quarter in a row a record in terms of special servicing fees. And so I think that will continue.

And this won't surprise you, Gerard, but more than two-thirds of what is in active special servicing is office. And I think that's going to continue. And I think office is going to be -- it's not going to be a challenge for Key because it's not an asset class we focus on. But I think office is going to continue to be a significant challenge..

And Chris, based on your experience with this, these fees stay with you for a while since the workout phase takes quite a bit of time?.

Yes, it's -- these are very large -- think of kind of very large advisory fees that take a lot of people. These are very complex capital structures. It's not unusual for these fees on a single deal to be $5 million, $6 million, $7 million..

Great. And then sticking with this, can you share with us -- just on the commercial loans, not commercial real estate necessarily, just what you guys are doing to get out in front of any potential challenges we could see if the economy? I know you said soft landing is what you're thinking.

But if the economy does lead to more delinquencies and defaults, what are you guys doing now in front of that?.

Yes. Well, this is an area where we spend a lot of time. We are -- as it relates to the C&I book, particularly focused on anything that has floating rate debt that's leveraged. And so for us, our leverage book literally is the same than it was a decade ago. It's under 2% of our loans and it's focused on our industry verticals.

But we are -- there's a lot of us -- Mark Midkiff is in the room with me, who is our Chief Risk Officer, he and I and others are laying eyes on this. We feel really good about where the portfolio is.

But any time you go into an environment where you have declining EBITDA and a business with a lot of leverage and the cost of capital going up, you got to pay close attention. And that's where we pay very close attention.

We feel good about -- we feel really good about all of our portfolios, but that's where I spend sort of my time because that's what's most vulnerable..

Thank you..

Thank you, Gerard..

And we'll go next to Steven Alexopoulos with JPMorgan..

Hi. Good morning, everyone..

Good morning, Steve Alexopoulos..

I wanted to first follow up on your answer, Chris, to Ebrahim's question.

Are you signaling that the door is not open at all in terms of potentially rightsizing the dividend?.

I wouldn't say, it's not open at all. The reason I would put that caveat is, I've yet to see the new capital rules. But what I'm saying is, I'm very comfortable with our dividend payout and the trajectory of our business under the current construct..

Got it. Okay. That's helpful. And then on the fee income guide, I heard the messaging around green shoots and capital markets.

But are those really needed to get us to this range, right, the up 4% to 6% and then -- sorry, up 2% to 4% and then 4% to 6%? Are there other factors, which give us some cushion, if the IDDs fees don't come back, that you could still deliver on the fee income guide?.

There's other areas where we have cushion, but I mean, investment banking fees are a big component of that. And we need to have more trajectory in the back half of the year on investment banking fees than we did in the front half of the year in order to hit these numbers..

Got it. Okay. And then finally, just a big picture view. Obviously, a lot of questions about NIM, I'm just as surprised as Mike seeing 2/12.

For Clark, how do you think about managing the balance sheet and interest rate risk differently so you don't get in this situation again where the NIM is this low dividend payout ratio that's high, you're missing on the NII guidance, which is really all tied to what we're seeing on the swaps? But how do you think about big picture? So once you do get into a 3% NIM range that you sort of hang around there? Thanks..

Yeah. It's a great question. I think -- and it probably requires a longer answer. But short story, Steve, I think you just have to be probably considering a variety of additional scenarios and being a little bit more dynamic in the direction and pace of rate movements.

So I think if rates had moved in an orderly fashion, this would be much less of an issue. They did not, as you know, and I think we just have to be more dynamic in our thinking about putting on certain positions..

Got it. Okay. Thanks for taking my questions..

Thank you. And there are no further questions in queue at the time. I'll turn it back to Mr. Gorman..

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