M&T Bank Corporation (NYSE:MTB) Q2 2022 Earnings Conference Call July 20, 2022 10:00 AM ET

Company Participants

Brian Klock - Head, Markets and Investor Relations
Rene Jones - Chief Executive Officer
Darren King - Chief Financial Officer

Conference Call Participants

John Pancari - Evercore ISI
Ebrahim Poonawala - Bank of America
Matt O???Connor - Deutsche Bank
Gerard Cassidy - RBC Capital Markets
Erika Najarian - UBS
Frank Schiraldi - Piper Sandler

Operator

Welcome to the M&T Bank Second Quarter 2022 Earnings Conference Call. [Operator Instructions] Please be advised that today???s conference is being recorded. I would now like to hand the conference over to Brian Klock, Head of Markets and Investor Relations. Please go ahead.

Brian Klock

Thank you, Gretchen, and good morning. I???d like to thank everyone for participating in M&T???s second quarter 2022 earnings conference call, both by telephone and through the webcast. If you have not read the earnings release we issued this morning, you may access it along with the financial tables and schedules from our website, www.mtb.com and by clicking on the Investor Relations link and then on the Events and Presentations link.

Also, before we start, I???d like to mention that today???s presentation may contain forward-looking information. Cautionary statements about this information as well as reconciliations of non-GAAP financial measures are included in today???s earnings release materials as well as our SEC filings and other investor materials. These materials are all available on our Investor Relations webpage and we encourage participants to refer to them for a complete discussion of forward-looking statements and risk factors. These statements speak only as of the date made and M&T undertakes no obligation to update them.

Now, I???d like to turn the call over to our Chief Financial Officer, Darren King.

Darren King

Thank you, Brian, and good morning, everyone. As we reflect on the past quarter and the first half of the year, we are very pleased with our progress. The second quarter results include the impact of the People???s United Financial acquisition, which closed on April 1. We are excited about the momentum we have as a combined organization, especially the progress both franchises are making in preparation for the planned systems conversion later this quarter.

With strong NII growth and effective expense management, M&T generated positive operating leverage, as pre-tax pre-provision net revenue increased by more than $300 million versus last quarter. We repurchased $600 million of our common stock in the second quarter. And yesterday, the Board of Directors authorized a new program to repurchase up to $3 billion in M&T common stock.

Our balance sheet management enabled us to benefit from the changing interest rate environment, boosting the net interest margin and allowing us to deploy excess cash into investment securities with higher yields. With more Fed hikes projected this year, we continue to add more fixed rate assets to our balance sheet and to continue expanding our interest rate hedging program.

While we are just beginning to see the positive net interest income benefit from rising rates, those same higher rates have prompted headwinds in our mortgage banking business, both for origination volumes and for gain-on-sale margins. We expect these headwinds to persist. Despite the macro challenges, the unemployment rate remains low and credit quality remains strong. We are well positioned for the future and excited to continue the integration of the People???s United franchise and to deploying our excess cash and excess capital.

Now, let???s review the results for the quarter. Diluted GAAP earnings per common share were $1.08 for the second quarter of 2022 compared with $2.62 in the first quarter of 2022. Net income for the quarter was $218 million compared with $362 million in the linked quarter. On a GAAP basis, M&T???s second quarter results produced an annualized rate of return on average assets of 0.42% and an annualized return on average common equity of 3.21%. This compares with rates of 0.97% and 8.55% respectively in the previous quarter.

Included in GAAP results in the recent quarter were after-tax expenses from the amortization of intangible assets amounting to $14 million or $0.08 per common share. That compares to $1 million or $0.01 per common share in the prior quarter. Pre-tax merger-related expenses of $465 million related to the People???s United acquisition were also included in these GAAP results. These merger-related expenses are comprised of the so-called CECL Day 2 double count of $242 million plus additional pre-tax merger-related expenses of $223 million.

The total merger-related charges translate to $346 million after-tax or $1.94 per common share. Consistent with our long-term practice, M&T provides supplemental reporting of its results on a net operating or tangible basis, from which we only ever exclude the after-tax effect of amortization of intangible assets as well as any gains or expenses associated with mergers and acquisitions.

M&T???s net operating income for the second quarter, which excludes intangible amortization and the merger-related expenses, was $578 million compared with $376 million in the linked quarter. Diluted net operating earnings per common share were $3.10 for the recent quarter compared with $2.73 in 2022???s first quarter. Net operating income yielded annualized rates of return on average tangible assets and average tangible common shareholders??? equity of 1.16% and 14.41% for the recent quarter. The comparable returns were 1.04% and 12.44% in the first quarter of 2022.

In accordance with the SEC???s guidelines, this morning???s press release contains a reconciliation of GAAP and non-GAAP results, including tangible assets and equity. As a reminder included in the first quarter???s GAAP and net operating results was a $30 million distribution from our investment in Bayview Lending Group. This amounted to $23 million after-tax effect and $0.17 per common share. We did not receive any distributions in this year???s second quarter.

Next, let???s take a little deeper dive into the underlying trends that generated these results. Taxable equivalent net interest income was $1.42 billion in the second quarter of 2022, an increase of $515 million or 57% from the linked quarter. The linked quarter increase was due largely to the $420 million net interest income contribution from People???s United. This amount included $35 million for purchase accounting accretion. The legacy M&T Bank net interest income increased $95 million sequentially, inclusive of the $138 million impact from higher rates on interest-earning assets, an $8 million increase from 1 additional day in the quarter, partially offset by a $22 million decline and the benefit from cash flow swaps and a $16 million decrease in interest received on non-accrual loans and a $9 million decline in interest income and fees related to PPP loans.

Net interest margin for the past quarter was 3.01%, up 36 basis points from 2.65% in the linked quarter. The primary driver of the increase to the margin was from higher interest rates, which we estimate boosted the margin by 26 basis points. The People???s United Earning asset yields added 8 basis points to the net interest margin. And in addition, margin benefited from a reduced level of cash held on deposit with the Federal Reserve, which we estimate added 7 basis points. These items were partially offset by a 6 basis point decline resulting from the lower interest income recovered on non-accrual loans. All other factors, including the day count, had a negligible impact on the margin.

Before we discuss the average loan balance trends for the quarter, we note there were reclassifications within the People???s United commercial loan portfolios. In order to be more consistent with M&T???s reporting methodology, just over $2 billion in loans that People???s United had classified as C&I were reclassified into CRE loans. Compared with the first quarter of 2022, average loans outstanding increased by $35.4 billion or 38% due primarily to the $35.5 billion average impact of the People???s United loans.

Looking at loans by category, on an average basis compared with the linked quarter, commercial and industrial loans increased by $14.5 billion or about 62%. The average impact from the acquired People???s United loans was $13.8 billion. Legacy M&T C&I average loans increased by about $1.2 billion, with strong growth in middle-market C&I loans and average dealer floor plan balance growth of $209 million. This growth was partially offset by a decrease of approximately $466 million in PPP loans.

On an end-of-period basis, for the combined bank, PPP loans amounted to $351 million. Average commercial real estate loans increased by $12.3 billion or 35% compared with the first quarter. The average impact from the acquired People???s United loans, was $13.1 billion. Legacy M&T CRE average balances declined $830 million during the second quarter due to almost equal reductions in construction and permanent loans.

We continue to reduce our construction exposure as there is a lack of new activity to offset the conversion of construction loans into permanent mortgages. There was an uptick in permanent mortgage financing in the quarter. However, it was outpaced by an elevated level of pay-downs. Residential real estate loans increased by $6.9 billion or 43% due almost entirely to the average impact of the People???s United loans. The legacy M&T average loan balances were essentially flat as the retention of new originations retained for investment, were offset by normal runoff, combined with the sale of Ginnie Mae buyouts that became eligible for re-pooling into new RMBS.

Average consumer loans were up $1.8 billion or 10%, again due in large part to the $1.6 billion average impact from the People???s United loans. For legacy M&T, recreational finance loan growth continues to be a key driver of growth. Average investment securities increased by $14.7 billion due to the $11.2 billion average impact from the acquired People???s United securities and a $3.5 billion increase in legacy M&T investment securities. Average earning assets, excluding money market placements, which is inclusive of cash on deposit at the Federal Reserve increased $50 billion or 50% due largely to the $46.7 billion average impact of People???s United and growth in legacy M&T average investment securities.

After closing the acquisition, we implemented various balance sheet restructuring actions to optimize the funding base of the combined bank. These actions utilize some of the cash available and resulted in a decrease in deposits. Many of these actions occurred during the quarter, so we thought it will be more informative to look at the change in end-of-period cash balances.

Cash balances decreased by $11.8 billion to $33.4 billion at the end of June, down from just over $45.2 billion on April 1. The decline was the result of several factors. These include a $2 billion increase in investment securities, a $1.5 billion restructuring of some People???s United high cost deposits, notably broker deposits, a $3 billion decline in escrow and mortgage warehouse related deposits, reflecting lower levels of activity associated with the rising rate environment, a $500 million reduction in trust demand deposits resulting from lower levels of capital market activity compared with the first quarter, and a $2 billion drop in municipal deposits. We continue to actively manage higher cost deposits and in many cases, retaining the customer and are able to move their balances to an off-balance sheet alternative that provides the interest rate they desire. With that background, average core customer deposits, which excludes CDs over $250,000 increased by $45 billion or 36% compared with the first quarter. The average impact from the People???s United deposits, was about $49 billion.

Turning to non-interest income, non-interest income totaled $571 million in the second quarter compared with $541 million in the linked quarter. The People???s United non-interest income contributed $79 million, while legacy M&T declined by $49 million. As noted, M&T received a $30 million distribution from Bayview Lending Group in the first quarter and did not receive any distribution in the second quarter of this year.

Mortgage banking revenues were $83 million in the recent quarter compared with $109 million in the linked quarter. Revenues from our residential mortgage business were $50 million in the second quarter compared with $76 million in the prior quarter. Residential loans originated for sale were $77 million in the recent quarter compared with $161 million in the first quarter. Both figures reflect our decision to retain a substantial majority of our mortgage originations for investment on our balance sheet.

The primary driver of the linked quarter decline in revenue is the higher interest rate environment, which has pressured gain-on-sale margins for loans previously purchased from Ginnie Mae servicing pools and which became eligible for resale or repooling. With the rapid increase in yields for new mortgage originations over the past few months, these Ginnie Mae repooled loans have fallen below new origination yields, which has driven the negative gain on sale margin. During the quarter, residential mortgage loans were sold at a loss of $17 million compared to a $14 million gain on sale in the prior quarter. Commercial mortgage banking revenues were $33 million in the second quarter, essentially unchanged from the linked quarter, that figure was $35 million in the year ago quarter.

Trust income was $190 million in the recent quarter and included about $14 million in income from People???s United. Legacy M&T trust income increased about 4% due largely to about $10 million from the recapture of money market fee waivers and $4 million in seasonal tax preparation fees, partially offset by the impact of lower market valuations on assets under management and administration.

Service fees on deposit accounts were $124 million compared with $102 million in the first quarter. People???s United contributed $33 million to this fee income line during the quarter. The decline in legacy M&T service charges primarily reflects the previously announced repricing of our consumer checking products. We expect foregone revenues from the program to reach a run-rate of $15 million per quarter during the second half of the year.

Operating expenses for the second quarter, which exclude the amortization of intangible assets and merger-related expenses, were $1.16 billion and included about $259 million in expenses from the operations of People???s United. Legacy M&T operating expenses were about $903 million compared to $941 million in the linked quarter and $859 million in the year ago quarter.

Recall, operating expenses for the first quarter include approximately $74 million of seasonally higher compensation costs. Aside from those seasonal factors that flows through salaries and benefits, legacy M&T operating expenses increased by $36 million from the first quarter. This increase was due almost entirely to higher salaries and benefits costs resulting from 1 additional business day, a full quarter impact of merit increases and increased incentive accruals tied to improved bank performance. The efficiency ratio, which excludes intangible amortization and merger-related expenses from the numerator and securities gains or losses from the denominator, was 58.3% in the recent quarter compared with 64.9% in 2022???s first quarter and 58.4% in the second quarter of last year.

Next, let???s turn to credit. Despite the lingering challenges of the pandemic and its variance, supply chain disruption, labor shortages and persistent inflation, credit is stable to improving. The allowance for credit losses amounted to $1.82 billion at the end of the second quarter, up $352 million from the end of the linked quarter. The increase was due largely to the impact of the allowance related to the acquired People???s United loan portfolio. We ran the acquired loan book through our allowance methodology and essentially confirmed their allowance at closing.

Applying the provisions from the CECL accounting principle, we assigned $99 million of the People???s United allowance to purchase credit deteriorated, or PCD loans and $242 million to non-PCD loans. In addition, we recorded a $60 million provision in the second quarter. Partially offsetting these increases were net charge-offs of $50 million in the second quarter compared to just $7 million in this year???s first quarter.

Economic indicators continue to show improvement from the prior period, but inflation remains at a historically high levels. Aside from movements in forward interest rate curves, the second quarter???s baseline macroeconomic forecast was relatively unchanged from the prior quarter for those indicators that have a significant impact on our CECL modeling results, including the unemployment rate, GDP growth and residential and commercial real estate values.

Non-accrual loans increased to $2.6 billion compared to $2.1 billion sequentially. The increase was entirely the result of the acquired People???s United loan portfolio as non-accrual loans at legacy M&T decreased sequentially. At the end of the second quarter, non-accrual loans represented 2.1% of loans, down from 2.3% at the end of the linked quarter. When we file our second quarter 10-Q in a few weeks, we expect to report an increase in criticized loans. However, the percentage of loans recognized as criticized will decrease. Similar to the trends in the non-accrual portfolio, the increase in the dollar amount of criticized loans is due entirely to the acquired People???s United portfolio. We expect a modest decline in criticized legacy M&T loans.

As noted, charge-offs for the recent quarter amounted to $50 million. Annualized net charge-offs as a percentage of total loans were 16 basis points for the quarter compared to 3 basis points in the first quarter. Loans 90 days past due on which we continue to accrue interest were $524 million at the end of the quarter, down from $777 million sequentially. In total, 89% of these 90 days past due loans were guaranteed by government-related entities.

Turning to capital, M&T???s common equity Tier 1 ratio was an estimated 10.9% compared with 11.7% at the end of the first quarter. The decrease was largely due to the impact of the People???s United acquisition and the repurchase of $600 million in common shares, which represented 2% of our outstanding common stock. Tangible common equity totaled $15.3 billion, increased 33% from the end of the prior quarter due largely to the impact of the People???s United merger. Tangible common equity per share amounted to $85.78 per share, down $3.55 or 4% from the end of the first quarter. As previously noted, the Board of Directors authorized a new repurchase program for up to $3 billion of common stock, which replaces the previous $800 million repurchase program, under which $600 million of M&T shares were purchased in the second quarter.

Now let???s turn to the outlook. Interest rate expectations continue to be volatile and can have a material impact on our outlook for full year 2022. Similar to last quarter, the outlook that follows reflects the combined balance sheet with three quarters of operations from People???s United as well as a more recent forward curve and is on a full year basis.

First, let???s talk about our outlook for the balance sheet. We continue to expect to grow the investment securities portfolio by $2 billion per quarter for the remainder of the year. However, that cadence could accelerate or slow depending on market conditions as well as customer loan demand.

Now turning to the outlook for average loans, when compared to standalone M&T full year 2021 average loan balances of $97 billion, we continue to expect average loan growth for our combined franchise to be in the 24% to 26% range. However, growth may come in near the lower end of that range. Note that the updated average growth rates for C&I and CRE loans reflect the reclassification of C&I loans into CRE loans in the former People???s United loan book that we mentioned earlier.

On a combined and full year average basis, we expect average C&I growth in the 37% to 39% range. We expect average CRE growth in the 17% to 19% range, average residential mortgage growth in the 28% to 30% range and average consumer loan growth in the 10% to 12% range. As we look at the combined income statement compared to stand-alone M&T operations from 2021, we believe we???re well positioned to benefit from higher rates and to manage through the macro challenges we noted earlier on this call.

Our outlook for net interest income for the combined franchise is for 56% full year growth compared with the $3.8 billion in 2021. This reflects the forward yield curve from the beginning of the month. Given the speed of interest rate hikes by the Fed, the reactivity of deposit pricing and the deployment of excess liquidity and loan growth, the full year net interest income could be plus or minus 2%.

Turning to the fee businesses. We still expect strong trust income growth driven by new business and the recapture of money market fee waivers but albeit lower than previous expectations as a result of the lower equity valuations from second quarter. In addition, higher interest rates are expected to continue to pressure mortgage originations and gain on sale margins. We have completed the sales of Ginnie Mae repooled mortgages, and we will continue with the retention of almost all originations for the rest of the year. With this in mind, we expect the gain on sale from residential mortgages to be minimal in the second half of the year. We, therefore, now expect non-interest income to grow in the 5% to 7% range for the full year compared to $2.2 billion in 2021.

Next, our outlook for full year 2022 operating non-interest expense is impacted by the timing of the People???s United systems conversion and subsequent realization of expense synergies. We continue to anticipate 24% to 26% growth in combined operating non-interest expenses when compared to the $3.6 billion in 2021. However, expenses are likely to be near the higher end of the range, reflecting inflationary pressures on wages and improved bank performance. As a reminder, these operating non-interest expenses do not include pretax merger-related charges. We do not expect these charges to be materially different than our initial estimates.

Turning to credit. We continue to expect credit losses to remain well below M&T???s long-term average of 33 basis points. For 2022, we conservatively estimate that net charge-offs for the combined company will be in the 20 basis point range.

Finally, turning to capital. We believe the current level of core capital is higher than what is needed to safely run the combined organization and to support lending in our communities. We plan to return excess capital to shareholders at a measured pace. Late in June, the Federal Reserve released the results of its stress test, also known as the DFAST. Based on these DFAST results, M&T???s preliminary stress capital buffer, or SCB, is estimated at 4.7%. As a result, we will be subject to a 9.2% common equity Tier 1 ratio threshold under the SCB regulation, which is in effect from October 1, 2022, through September 30, 2023.

M&T???s common equity Tier 1 ratio of 10.9% at June 30, comfortably exceeds the threshold, although which capital distributions could be limited by that regulation. We continue to anticipate ending 2022 with a CET1 ratio in the 10.5% range. With a solid capital ??? starting capital position and the potential to generate significant additional amounts of capital over the next few years, we don???t anticipate a material change to our capital distribution plans. Our objective, as always, is to bring our CET1 ratio down gradually to a level that is near the high end of the lower quartile of our peer group. We anticipate continuing to repurchase common shares under the new $3 billion repurchase program.

Now let???s open up the call to questions before which Gretchen will briefly review the instructions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question we will take is Betsy Graseck from Morgan Stanley.

Unidentified Analyst

Hi, good morning. This is Brian on for Betsy. I was wondering if you could give us an update on your rate sensitivity today now that we???re a little bit further into the rate hike cycle. And assuming that the current forward curve plays out, where do you expect that to trend over time? Thanks.

Darren King

Sure, Brian. As obviously, the Fed is hiking at a lot faster pace than one any of us anticipated when we started the quarter and started the year. When we look at the mix of deposits on our balance sheet and some of the actions that we???ve taken this quarter to move out of some high-cost funding, when we look at the next several hikes and think about what the impact of a 25 basis point increase might be, where we look more towards 7 to 10 basis points increase in net interest margin for each 25, that???s on an annualized basis. And net interest income growth in the $140 million to $190 million range. And looking at that, the kind of range of reactivities that we???ve sensitized is 15% to 35%. It???s kind of how we???re thinking about it and what we???re seeing, again, based on the mix of deposits on our portfolio.

Unidentified Analyst

That???s really helpful though and thank you. And in light of the changes you made some of your high-cost funding sources, I was wondering if you could just talk about your overall deposit growth expectations through year-end?

Darren King

Well, when you look at M&T and our funding, we have one of the higher, what I would call, core funding portfolios amongst our peers and amongst the banks. And so a significant portion is noninterest-bearing DDA as well as interest checking, which tend to be operational accounts. And so when we look at those accounts, whether it???s consumer, small business or commercial customers, we do expect that there will be some decline as people continue to spend given the rate of inflation.

But so far, the decline we???ve been watching has been fairly gradual. We have seen some commercial customers use some of the excess cash to pay down loans. That???s part of when you see some of the loan declines. We???re seeing that offset by payoffs or by them using the cash. And really the place where you start to see the most price sensitivity in the short-term, tends to be, as we mentioned earlier, in the municipal deposit space as well as in the wealth customer space. And so we will expect to see some movement there.

And typically, what happens, Brian, is there are some instances where the actual pricing goes up on interest checking or savings and money market, but generally, what happens first, particularly in the consumer space, is you start to see balances migrate towards time deposits. And so part of what we will see for us and we would expect for the industry is the migration towards time deposits, and that will be what kind of drives the overall beta for deposit costs. more so than any one particular category of deposits moving up in a rapid pace. And so just given the nature of our deposit base, we expect some decline, but we don???t expect it to be excessive from here, be ??? maybe in the 1% to 2% range, but really not that much.

Unidentified Analyst

Thank you.

Operator

Our next question comes from John Pancari, Evercore ISI.

John Pancari

Good morning.

Darren King

Hi, John.

John Pancari

On the ??? just on the loan growth front, I appreciate the guide for the 24% to 26% on average total balances. Just want to see if you could maybe give a little color in terms of the trajectory of the commercial real estate portfolio. Is it fair to assume that declines are going to continue I know you kind of alluded to that. And would it be outright declines in the balances or just a shrinking in the overall mix, but you could actually see growth there? Thanks.

Darren King

So looking at commercial in aggregate, I think it???s important to look at the two in aggregate. We think they will be relatively close to flat. The growth in C&I ex PPP, will offset what???s likely to be a decline in CRE. And when we look at the CRE balances and what???s happening there, there is really two things going on. The first, which we???ve been talking about for a while is construction loans are on the decline. And so we had back in 2018 and 2019, some real growth in construction lines that over the course of 2020 and 2021 and 2022 have been drawn down as projects have been underway. You did see a little delay in the pandemic, but projects got back on track. And as those come to completion, they will follow their normal course where they will get converted into permanent mortgages and that often happens off of our balance sheet. And so we continue to expect some decline in construction balances.

On the permanent side, as I mentioned, we have seen some payoffs from customers using cash. We haven???t been using their cash ??? their excess cash and declining their balances. The level of activity that you typically see in the CRE space continues to be low. With rates moving, it???s affecting cap rates and asset values. And so you???re starting ??? you???re not seeing the turnover in properties like you might have under normal circumstances. And that will affect the pace of decline and our growth in permanent CRE.

And so what we saw this quarter, if I look at loan originations in the quarter across C&I and CRE, it was actually our best post-pandemic non-fourth quarter, lots of qualifiers there, increase in originations, which I thought was a very positive sign. And it was a little bit weighted towards the back end of the quarter. And so I guess, think about permanent mortgages, down slightly, construction mortgages down a little bit more over the course of the year, which probably takes in dollars maybe $1 billion down, call it, 1%, 1% to 2%, offset by growth in C&I.

John Pancari

Got it. Okay, thanks, Darren. And then separately, just on the buyback front, it was good to see the new $3 billion authorization. How should we think about the piece of buybacks here? Is it fair to assume a similar pace as what you saw in the second quarter of the $600 million? Or could you actually get some acceleration in the pace of repurchases in coming quarters?

Darren King

Yes, sure. Yes. The best way to think about it, John, is to think about that $600 million is a good pace. It could accelerate depending on how fast rates move and what???s happening with net interest income growth and capital generation. We???ve got one quarter to go through with some of the merger expenses coming through, which will affect capital. So we could move it up a little bit or down a little bit off that $600 million. But I think for purposes of looking forward, that???s a good pace to think about.

John Pancari

Great. All right, thanks, Darren.

Operator

We will take our next question from Ebrahim Poonawala from Bank of America.

Ebrahim Poonawala

Good morning.

Darren King

Good morning.

Ebrahim Poonawala

I guess, one, I wanted to follow-up on the NII guide for up 56%. Just wanted to make sure, given all the moving pieces around the balance sheet, we have this right? It implies exit fourth quarter run rate north of $1.9 billion. Just want to make sure, that sounds reasonable in terms of how we think about what the jumping off point is for 2023. And if you don???t mind reminding us how much of purchase accounting accretion do you expect in the back half and maybe if you have an updated number for next year as well?

Darren King

Sure. So to answer your first question, the $1.9 billion run rate at the end of the year is a good number to use. ??? obviously, I???ll caveat that and keep in mind that that???s based on the forward curve and lots of assumptions on ??? as we mentioned, about deposit betas, but I think that???s a reasonable number. And then the second question remind me again what that was. I???m sorry, I???m losing my mind already.

Ebrahim Poonawala

Just in terms of how much of purchase accounting accretion is there in the numbers for...

Darren King

Yes, purchase accounting. And the number that you saw in the second quarter that we talked about the $35 million is a good start point, I mean, obviously, over time that blends its way down. And so, as you think about 2023, think about four quarters of purchase accounting accretion versus three this year, but kind of the $30 million to $35 million a quarter run-rate is a good place to be there.

Ebrahim Poonawala

Good. And I guess, just a separate follow-up on the CRE side as we think about obviously you have talked about in the past in terms of just thinking about how much to balance sheet versus not ??? and I think you had an announcement of some appointments within the CRE business a couple of days ago? I would love to hear your updated thoughts. One, coming out of the stress test, any surprises, anything that you think you would tweak as a function of the stress test? And then just where are we in terms of the evolution of the new strategy around CRE as you think about that business?

Darren King

Yes. I think the short answer is the path that we are on and our thought process around CRE hasn???t changed that we ??? when we look at I guess a couple of comments on the stress test. We were pleased to see the decline in loss rates from the pandemic stress test in CRE down to 11% from 16%. However, if you look at it even earlier stress test, they kind of averaged around 6% or 7% for CRE. So it???s still pretty elevated from that. And when we look at our own performance over time, in the CRE space, we can???t get anywhere near that number. And what???s really interesting is when you look over the last 2 years at the pandemic, that was pretty much a real live stress test on CRE without much support from the government and the losses there were pretty minimal. And so when we think about our underwriting, we???re really comfortable with the underwriting and we think about our experience in the space. We think we???ve got a really talented group of individuals that operate there and that we can use those skill sets to continue to support our customers and maybe use others balance sheets who are actually looking for the kind of skill sets that we have in underwriting.

And so, there is a great match there where we can take advantage of our skill set. We can provide funding and capital for our customers and be there for them and maybe even offer them a broader range of alternatives and make it more capital efficient over time, where we can convert some of those loan balances and dollars into fee income, which will free up capital. And so the path that we???ve been on, we feel really good about it. As you noted, we???ve added some folks. We added some folks in what we call our innovation office. We???ve also added a couple of players in our CRE capital markets area of the bank. We probably hear a little bit more about that in the coming weeks. And we slowly start to build out the team and slowly increase the mix or the percentage that ends up on balance sheet and off. It???s still not quite at a point where you can see it in the noninterest income numbers, but that will build as we go through the rest of this year and into 2023. And so I guess, a long-winded way of saying no change in the strategy, but hopefully, some of that color helps give context to why we???re on the path that we???re on.

Ebrahim Poonawala

That???s helpful. Thank you for taking my questions.

Operator

Our next question comes from Matt O???Connor from Deutsche Bank.

Matt O???Connor

Good morning. Sorry about that.

Darren King

Hi, Matt.

Matt O???Connor

Pretty explicit expense guidance this year and obviously, cost saves coming in over the next several quarters. As we think about next year and kind of just underlying expense growth, given some of the puts and takes with inflation and there is always some kind of expense component tied to credit, which might normalize a little bit. But just the bottom line is how do you think about kind of more medium-term underlying expense growth?

Darren King

Well, Matt, you???re way ahead of me. We???re still getting geared up to do our 2023 planning here. But once we get through ??? let???s start with 2022 and the path that we???re on. The guide that we gave was on a net operating basis, so it excludes the merger expenses and should start to give you an idea of what the run rate might look like as we exit 2022. What I would suggest to you is as we go through the system conversion this third quarter, that???s a key moment in some of the expense ??? the final pieces of expense reduction. And so there will be systems, contracts and decommissioning expenses that will go on, and those don???t happen immediately. Sometimes that takes a month or two months. There will be folks that we will retain from the acquired institution that, that can be systems conversion plus 30 days, plus 60 days, plus 90 days. And so some of the expense saves will bleed a little bit into the fourth quarter and maybe slightly into the first, but we should be getting towards the real run rate by the end of the first quarter should be pretty solid and it shouldn???t be much different from where we exit the fourth. Outside of that, when you get to our philosophy about expenses and the investments that we are making, our history has always been to pay close attention to the efficiency ratio and the expenses to make sure that the technology investments that we are making improved productivity, which provide an expense save. And historically, we have been in the kind of 2% to 3% growth rate in expenses on a normalized basis. It might be at the higher end of that because of inflation. Sometimes you can end up at the lower end of that if inflation is zero, but it???s not something where we expect to see mid-single digits numbers like we have seen over the last couple of years. I think there are some extenuating circumstances that led us there. But over the long run, that???s kind of how we expect to run the bank and we do it to achieve positive operating leverage over the long run. That???s our goal.

Matt O???Connor

That???s helpful. And then just following up on some of the capital questions, kind of longer term, how much buffer do you want over the regulatory minimum. I mean it???s pretty clear you are hoping to drive down the regulatory minimum over time. Obviously, ending this year at 10.5 is a big buffer. But what???s the thought on how much you would want to hold over the regulatory minimum? Thank you.

Rene Jones

Yes. Sure, Matt. I mean when we look at our capital targets, we take into account our own internal stress test analysis and losses under stress as well as the insight we get from the CCAR and the stress test. And the thing to keep in mind with the SCB is every 2 years that number can change. And so we have got to be careful about setting the place we want our capital ratio to be based on any 1 year???s test. The other part that I think is important to keep in mind, especially with the test of the last couple of years is how the Fed models take into account balance sheet size and what that does for expense growth in PPNR and operational risk. And so within that stress capital buffer, there is credit losses, and then there is these other factors that drive that up. And so those will also change as we go through time. And so you think about the work that we are doing to deploy the cash into securities, which will help in the next CCAR, the work we are doing on construction, lending balances and the impact that can have on loss rates in CRE as well as just the reduction in CRE. Many of the factors and things that we are focused on will ??? are intended to help reduce losses and PPNR negative impact in the stress test which should help bring that capital buffer down over time. And so the 10.5 that we talked about for this year is really as we enter into January of 2023 when we will go through the stress test, again, which normally that???s an off year for a Category 4 bank, but it will be the first year we go through on a combined basis. Now, we actually think the People???s portfolio is helpful to our losses under stress because their CRE portfolio is a little more skewed towards permanent mortgages, which tend to have a higher ??? or sorry, excuse me, a lower loss under stress ??? and so that we also think will be helpful for the SCB next year. And so we have always talked about operating at the low end of the peer range in the bottom quartile, the top end of the bottom quartile in terms of CET1 ratio. Given our underwriting history and our loss history, we expect to move in that direction. But we want to get through the end of this year and through that first test on a combined basis with some buffer and then continue to bring things down into the range that we talked about.

Matt O???Connor

Okay. Thank you.

Operator

The next question comes from Gerard Cassidy from RBC Capital Markets.

Gerard Cassidy

Hi Darren.

Darren King

Good morning Gerard.

Gerard Cassidy

Sticking with capital for a minute, obviously, your stress capital buffer this year was extraordinarily high. It didn???t seem to be the right number compared to your risk in your organization. I hope it???s not any retribution to one of Bob???s letters back in 2016 in the annual report about the regulators. But anyway, aside from that, can you share with us what strategies you may try to implement to show the regulators next year when you go through the stress exam, as you just pointed out, how to bring that number down to a more reasonable level?

Darren King

Yes, sure, Gerard. I guess just starting with the test. Another thing to keep in mind is, I think the stress tests were put in place by the Fed at a very unique time in the history of the country and some challenges that the banks were having and was put in place to give people confidence in the system and it???s a good process. It???s never going to be perfect. And each year, the Fed stresses certain parts of the asset base based on what???s going on in the country. And the last couple of years, it???s been focused on commercial real estate. And so as an organization that has historically had a concentration in commercial real estate, when that???s the focus, the pain is felt a little disproportionately at banks like M&T. As I mentioned earlier, if we look at our history of underwriting and actual losses, we are very comfortable with the asset class, but it???s clear that we are going to ??? we can???t operate with the size of portfolio relative to the peers that we have in the past. And so that???s why we talk about the work we are doing to continue to support our customers, which is the most important thing that we are going to be there for them, but that we are going to think about different ways to do that. And so construction loans, our construction portfolio probably got a little big, and that will come down naturally as we have talked about. And then as we go forward, we will look to move towards a slightly better balance of C&I and consumer loans in addition to commercial real estate. And so that should help overall in the test, just because construction loans are one of the higher loss categories. The ??? what part of the portfolio could be stressed next year, it could be something else. It could be C&I or it could be mortgage and that will lead to a different outcome. The other thing, though, that I think is important to keep in mind is as quantitative tightening happens and deposits come out of the system, that???s going to reduce balance sheets, reduced balance sheets will reduce that expense growth that I mentioned earlier in the test and will reduce operational losses and those will also have the effect of reducing the size of the SCB. And for M&T in particular, keep in mind that when we went through the test this year, we had the highest level of cash on our balance sheet of anyone in the system and in the test, the cash value at the Fed when ??? because the test always drops Fed funds to zero, produces zero net interest income. And so you have the benefit of the earning assets driving the expense, but not the benefit of any income that comes with them. And so as we see those balances shrink and we start to invest a little bit more in securities and those fixed rate securities that will help generate a little bit more PPNR over the ??? through the test. And so all of these things are pieces of the puzzle and actions that we are taking to help improve that capital buffer and bring it down closer to where we all might expect it to be. And it will take time, but that???s ??? we are on a path. We have talked about the path we are on to bring down the capital ratios while maintaining an appropriate cushion to where the SCB suggests we need to be and we will continue to work on the balance sheet to help drive that SCB number down, which will continue to give us the opportunity to generate capital invested in growth in the franchise and if not, distribute it to shareholders in a friendly way.

Gerard Cassidy

Very good. Thank you for thorough answer. As a follow-up question, on credit, obviously, your credit metrics on net charge-offs are through the cycle amongst the best, if not the best of the regionals, the equity markets seem to have discounted the bank stocks in anticipation of rising credit losses and problems coming from the tightening policies of the Fed. Can you share with us, are you guys seeing any evidence yet of early-stage delinquency starting to creep up in certain parts of your franchise or certain product types that there is some weakness they are developing, or is it no, it???s still clear ??? all clear and maybe it???s something next year that we have to anticipate?

Darren King

When we look at credit, if I look at the various portfolios, I start with the consumer portfolios. Consumer delinquency, whether it???s in mortgage, indirect auto, refi, credit card, home equity, Delinquency rates still are below pre-pandemic levels. And when I look at the M&T portfolio in particular, we have never been a place that does subprime and the percentage of near prime customers is also very low. And the last thing we see across all of those portfolios is LTVs are also at lows. With the increase in value of automobiles as well as home price inflation over the last couple of years, LTVs are very low. And so, so far not a lot of delinquency and good collateral coverage. And so nothing that we are seeing as signs in that ??? in those portfolios. Within the C&I and CRE space, it???s nuanced, and it???s a function of ??? in C&I what???s happening with input costs for C&I customers and how strong is their ability to pass on price increases to their end customer. And so we have seen some instances where we have moved some credits on to our watch list where input costs have risen faster than pricing. And that???s led to some decreases in debt service coverage. And so we have moved some people on to our watch list. Within the real estate portfolio, what???s interesting is it???s a bit of a remixing. And so we have seen a real strong improvement in hotel NOI. We are seeing people travel again. In fact and one of the things in our expenses, I could see our travel and entertainment expense was up as an organization. I think that???s a true statement for many organizations across the country, which is a positive sign for our urban hotel portfolio and we are seeing that in the numbers. And so as those get better, we are seeing some ??? still continue to see some challenges in the healthcare sector, which is I think about assisted living, acute care and elective surgery, there are still some lower occupancy levels. They are up off of the pandemic lows, but they are better. And office continues to be a watch for us. As people come back to the office. Again, when we look at our own staff, we are seeing more people in the office, but it???s not back to pre-pandemic levels. And I think that???s also true across the country. So, we are seeing no improved performance in retail and hotel within the real estate space and still some challenges in the healthcare and office space. And so not really a change in aggregate, but a shift in where our focus is. So, I wouldn???t give the all clear signal. That would be very unmet like. We are always worried and looking for where the next issue could be. But there is nothing that???s flashing red right now that says that there is a big crisis coming in the next several quarters.

Gerard Cassidy

And Darren, in the C&I portfolio, do you ??? is there much leverage finance? Obviously, spreads have widened in that category in particular?

Darren King

We have leveraged financing there, but it???s a small percentage of the portfolio. I think on a combined basis, it???s call it in the $2 billion of outstandings, maybe $3 billion of commitments, maybe $2.5 billion to $3.5 million in that space which given the size of the bank now, is a pretty small percentage of our total assets. And when we look at what the grading on those is still pretty strong even with rates where they are.

Gerard Cassidy

Great. Thank you.

Operator

[Operator Instructions] We will take our next question from Erika Najarian from UBS.

Erika Najarian

Hi. Just one follow-up for me. Your ??? is actually a follow-up to the first question, you are expecting some declines. It sounds like in your four accounts given inflationary pressures. And what???s interesting is pretty much all of your peers have talked about growing deposits from second quarter levels. I guess a two-part question. Number one, how much more in surge deposits do you have left? I guess I am trying to figure out how conservative the underlying deposit growth assumptions are underneath that 56% dive for NII?

Darren King

Yes. I guess as you look through the deposit portfolio, I go back to the comments from before, the bulk of our deposit base are what we refer to as operational accounts. And so it???s where our business banking customers, our commercial customers and our consumers are running their daily lives from those accounts. There are surge balances in there. We are not seeing them run out really at a dramatic pace. The reason we kind of went through the painstaking task of explaining all the deposit changes was to get to this point that we are not seeing dramatic runoff in our core accounts. There is a challenge that we see for many of our consumers, where the pace of inflation is running faster than the pace of wage growth, but they still have lots of deposits from the various stimulus programs and things that happened during the crisis. And so we believe that those balances will come down, and ??? but they will come down gradually. And really, the question on deposit decline is for customers who have excess balances beyond what they can use, some will get deployed to pay down debt, like we talked about with some of our commercial customers using some cash to pay down loans. And then the other thing will be how many folks will look for a rate for excess balances and given our excess liquidity position relative to the peers, how much do we want to pay out and for what types of customers. And so what we tend to do is we look at the depth of the relationship. And then if you have a broader relationship with the bank, we would be willing to do more 40 on your loan pricing or on your deposit pricing. And if you are a single service time account looking for a rate given the excess liquidity, we probably won???t match some of the rates that are out there and similar thing will be true on the commercial side. And so ??? it???s really a function, I think Erika, of the difference between the level of our cash position and the percentage of our balance sheet that sits in cash versus the peers that might cause that difference. But we are not anticipating by any stretch, any rapid depletion of those core accounts.

Erika Najarian

I understand. So, just to interpret that, Darren, just making sure I am thinking about it correctly, you have so much cash that your sensitivity is greater for those that are seeking higher yield? Is that a good way to think about it?

Darren King

Yes. I guess I would say we will be relationship-oriented and total relationship focused on the places where we will give rate for people that are seeking it, and that will keep those balances on our balance sheet. And for folks that are just kind of what I would describe as renting our balance sheet. We will be a little bit less sensitive and those balances could well run off. And we are in the fortunate position of being able to have that selectivity because of the excess cash that we have.

Erika Najarian

Got it. Thank you.

Operator

Our next question comes from Frank Schiraldi from Piper Sandler.

Frank Schiraldi

Good morning Darren. Just wondering, I hate to beat a dead horse on the capital and the stress test side. But even if you set aside the relatively larger pre balances, it looks like M&T has assumed loan losses in the severely adverse scenario is basically higher than the media almost across categories despite what you pointed to and what is obviously a stronger credit history overall. Just wondering if you have been able to gather any more color on is it a regional thing? What the Fed is sort of thinking that makes their loss assumptions so much more punitive than you guys would assume?

Darren King

Yes. Frank, when you look under the hood, the most important thing to remember is there is no loss rate applied to any M&T portfolio by the Fed that???s different from what they apply to anyone else with a similar portfolio, right. And so all of this is a function of mix. And what I think the Fed found, if I remember this correctly, over the course of the last couple of years and the difference between the pandemic test where the results came out in December 2020 versus this most recent one, was that the loss rates that were being assumed in some categories, notably hotel and retail was nuanced. And in the first test, it was a little bit more blunt that there was more trauma in that whole sector and that would lead to much lower asset values. And so you couldn???t rely on the collateral. In this last test, what I think the Fed did was they were more nuanced and they could see that suburban hotels, ones that you could drive to resort-oriented hotel properties had seen increases in occupancy as people started to travel again. And that led to better asset values and collateral values under stress. And where they tended to apply more was in the urban areas, where it was still ??? we still haven???t seen the recovery in business travel and conventions and winnings in those large properties. And so the loss rates were applied there. And when you look at M&T and some of our real estate portfolio, particularly in the hotel, we obviously have New York City. We had some in Boston. We have some in Philadelphia and Washington. And so, those properties at M&T would have faced a little bit more stress and that would help lead to that higher loss rate. And that seem to be the place. I think there was still a little bit of stress on retail and some beginning on office. I think they were looking a little bit more ??? with a little bit more scrutiny at what we consider B and C grade office buildings and applied a little bit tougher test to the asset values in those categories. It???s ??? it gives us more insight into how the Fed thinks about things, gives us more questions for us to think about in how we consider those property types. But again, to me, the positive is when you look at ??? even with those loss rates, and our capital levels, we were still about 300 basis points above the minimum under that stress and with the other comments I made about impact of PPNR. And so when we look at the capital ratios of the bank and where we sit, we feel really good and the Fed just helped us confirm that we can withstand a pretty severe downturn in some of these asset classes and still be in great shape. And so we continue to learn through the process and make the adjustments that we talked about before to the balance sheet to be as capital efficient as we can be.

Frank Schiraldi

Great. Thanks for all the color. That???s all I have.

Operator

[Operator Instructions] And it appears we have no further questions at this time. I will now turn the program back over to our speakers.

Brian Klock

Great. Thank you. And again, thank you all for participating today. And as always, if any clarification of any items on the call or news release is necessary, please contact our Investor Relations department at area code 716-842-5138. Yes. Good day.

Operator

This does conclude today???s program. Thank you for your participation. You may now disconnect. Have a great day.