Fifth Third Bancorp (NASDAQ:FITB) Q2 2023 Earnings Conference Call July 20, 2023 9:00 AM ET

Company Participants

Chris Doll - Director-Investor Relations

Timothy Spence - President and Chief Executive Officer

James Leonard - Executive Vice President and Chief Financial Officer

Bryan Preston - Treasurer

Greg Schroeck - Chief Credit Officer

Conference Call Participants

Scott Siefers - Piper Sandler

Erika Najarian - UBS

John Panc - Evercore

Ken Usdin - Jefferies

Ebrahim Poonawala - Bank of America

Michael Mayo - Wells Fargo

Gerard Cassidy - RBC

Operator

Good morning. My name is Rob and I will be your conference operator today. At this time, I would like to welcome everyone to the Fifth Third Bancorp Second Quarter 2023 Earnings Conference Call. [Operator Instructions]

Chris Doll, Head of Investor Relations. You may begin your conference.

Chris Doll

Good morning, everyone. Welcome to the Fifth Third Second Quarter 2023 Earnings Call. This morning, our President and CEO, Tim Spence; and CFO, Jamie Leonard, will provide an overview of our second quarter results and outlook. Our Treasurer, Bryan Preston and Chief Credit Officer, Greg Schroeck, have also joined the Q&A portion of the call.

Please review the cautionary statements on our materials, which can be found in our earnings release and presentation. These materials contain information regarding the use of non-GAAP measures, reconciliations to the GAAP results and forward-looking statements about Fifth Third's performance. These statements speak only as of July 20, 2023, and Fifth Third undertakes no obligation to update them. Following prepared remarks by Tim and Jamie, we will open the call for questions.

With that, let me turn it over to Tim.

Timothy Spence

Thanks, Chris, and good morning, everyone. Before we get to the quarter, I'd like to welcome our new Chief Credit Officer, Greg Schroeck to the call. Greg has been a part of Fifth Third for 35 years, and during that time, you see more than a few credit cycles.

He previously held leadership roles in both credit risk and the line of business, including serving as our Chief Commercial Credit Officer for several years and is our Head of Leasing, asset-based lending and structured finance. We're fortunate to have him as part of the Fifth Third executive team.

Despite heightened market volatility over the past four months, Fifth Third has delivered consistent top quartile financial results while investing strategically to position the bank for the long term. Our operating priorities have been and continue to be stability, profitability and growth in that order.

Earlier today, we reported second quarter earnings per share of $0.87, excluding items noted in the release, a 10% increase compared to the year ago quarter. Adjusted revenue increased 9%, reflecting our diverse fee sources and resilient balance sheet. Expenses increased 4%, excluding items noted in the release. And credit quality was strong with net charge-offs and early stage delinquencies remaining below normalized levels.

Our key return metrics improved even as we increased our capital levels and credit reserves. We generated an adjusted return on assets of over 1.2% and adjusted return on tangible common equity, excluding AOCI, of 15.4% and an efficiency ratio below 55% for the quarter. These will be important bellwether metrics for all banks as we adapt to impending regulatory changes.

Deposits continue to be in focus for the entire sector in the second quarter. Fifth Third's total period-end deposits increased 1% sequentially and increased 2% year-over-year as compared to a 5% decline for the HA [ph] over the same period. Our commercial banking and commercial banking business segments both generated period-end deposit growth.

Given the year-over-year decline in deposit system-wide, it's reasonable to ask how Fifth Third has continued to outperform. The answers are deliberate multiyear strategies to expand distribution in our Southeast markets to launch innovative operational deposit-oriented solutions like momentum banking and our treasury management offerings and our sustained focus on primary household growth.

We have added over 70 de novo branches in our Southeast footprint since 2019, more than any other bank except JPMorgan. As a portfolio, these branches are outperforming their original business cases on deposit production with several producing at a rate of 200% to 300% of plan.

In consumer, we generated year-over-year net household growth of 3% once again this quarter, continuing a strong multiyear trend and punctuated by 7% year-on-year growth in the Southeast and continued success in our Momentum banking product. In commercial, we have added a record number of new quality middle-market relationships this year, up 30% from 2022.

Our embedded payments business, Newline, has also been a strong catalyst for deposit growth. We expect the environment in the back half of the year to remain highly competitive for deposits. While we will continue to protect our house relationships and manage to a strong and stable liquidity profile, we will not match a rational pricing competition in a way that prioritizes headline growth over profitability.

Turning to pending regulation. We are taking steps to adapt our balance sheet in anticipation of higher capital and liquidity requirements across the industry. We finished the second quarter with a CET1 ratio of 9.5% having accreted around 90 basis points of capital from retained earnings over the course of the past year. We are balancing three capital priorities, continuing to build capital on an accelerated pace, supporting a dividend increase in the third quarter subject to Board approval and supporting clients to drive organic growth.

We will continue to pause share repurchases until the final capital rules are published and new capital targets are established. We are also taking several actions to boost on balance sheet liquidity and optimize returns. -- in reducing our indirect auto lending origination volumes by approximately 15% through the exit of noncore states, trimming outsized lines and closely evaluating select areas of our corporate banking business.

While we acknowledge the market's more optimistic outlook, we remain vigilant on the potential for a recession in 2024. Our commercial clients continue to perform well, but they are being cautious by slowing their growth plans. Many are closely watching the impact that regulation may have on credit availability and pricing.

Consumers have held up well in aggregate, but there has been a divergence between homeowners who were able to lock in historically low mortgage rates and renters who have had to face persistent inflation in their largest monthly expense. Compared to three years ago, homeowners in our deposit base have maintained strong deposit balances, whereas renters deposit balances are down meaningfully.

I want to thank our nearly 20,000 employees for their unwavering commitment to serving clients in our communities. Last year, you volunteered more than 117,000 hours to community organizations and you provided leadership to roughly 1,200 not-for-profit boards. Due to your hard work, we have already delivered nearly $30 billion of our 10-year $100 billion commitment to provide affordable housing, access to essential services and renewable energy.

In June, we celebrated Fifth Third's 165th anniversary. Given the current pace of technological and regulatory change and the logical questions about market structure and competitive model to follow. It was an interesting time to reflect on our history and what it could tell us about this moment.

Since Fifth Third's founding in 1858, the company has withstood a civil war, two World Wars, two global health pandemic and 33 recessions. The company adapted its business model to take advantage of technological innovations including the telephone, electric white bulbs, the automobile and the Internet.

We were an early adopter of the wire and ACH Windows, anchored the rollout of the credit card networks in the Midwest, invented the network ATM and were one of the 15 initial launch bankers. We witnessed the creation of the OCC, the Federal Reserve and the FDIC and have continued to thrive through many different regulatory regimes. I believe that companies that stand the test of time, develop a character of their own that extends beyond the people who work there.

Fifth Third's character is rooted in hard work, ingenuity and insistence on excellence and the sense of responsibility for the communities we serve. I'm as confident as in Fifth Third's positioning, our ability to outperform through the cycle and to deliver innovations that improve lives for all our stakeholders. And frankly, I'm just thankful to be part of [indiscernible] steward the bank into the future.

With that, I'll now hand it over to Jamie to provide more details on our financial results and outlook.

James Leonard

Thank you, Tim, and thank all of you for joining us today. Our second quarter results were once again strong despite the market headwinds. We achieved an adjusted efficiency ratio of just below 55%, which is a 4-point improvement compared to the prior quarter. Our second quarter adjusted PPNR grew more than 8% compared to both the prior quarter and year ago quarter, driven by the continued diversification and growth of our fee revenue streams combined with disciplined expense management throughout the bank. .

Net interest income primate $1.46 billion increased 9% year-over-year, did decline 4% sequentially. Our sequential NII performance was the result of our deliberate actions to grow on balance sheet liquidity to support a defensive balance sheet position, given the uncertain macroeconomic outlook and tightening liquidity conditions.

Interest-bearing deposit costs increased 54 basis points to 2.3%, which represents a cycle-to-date beta of 45% on interest-bearing deposits, which includes the impact of CDs. Adjusted noninterest income increased 2% compared to the year ago quarter, with increases in mortgage fee income and commercial banking revenue partially offset by a decline in deposit service charges due to the impact of earnings credits from higher market rates and the elimination of our consumer NSF fees in July of last year.

Adjusted noninterest expense increased 10% compared to the year ago quarter as elevated compensation and benefits expense was driven by nonqualified deferred compensation costs, the minimum wage increase that went into effect in July of 2022 and continued investment in dividend finance. Additionally, expenses increased from higher technology and communications expense and the impact of the increased FDIC assessment that began in January.

Excluding the impacts of nonqualified deferred compensation, which are offset by a gross up in securities gains, the FDIC assessment increase and incremental expense growth from dividend finance, Total underlying expenses increased approximately 4% compared to the year ago quarter.

Moving to the balance sheet. Total average portfolio loans and leases were stable sequentially in both commercial and consumer portfolios due to our continued discipline with respect to client selection and optimizing returns and also reflecting softening demand.

The period-end commercial revolver utilization rate of 35% decreased 2% compared to last quarter. C&I balances were flat compared to the prior quarter as strong middle market loan production and muted payoffs were offset by the lower revolver utilization. Corporate banking production was also tempered due to our focus on optimizing returns on capital in this environment and lower customer demand.

Average total consumer portfolio loan and lease balances reflected growth from dividend finance, offset by declines in indirect auto and residential mortgage. Average total deposits were flat compared to the prior quarter as increases in CDs and interest checking balances were offset by a decline in demand deposits. By segment, consumer deposits increased 1% and commercial deposits decreased 1%, while wealth and asset management deposits declined 12%, reflecting the impact of tax payments as well as clients' alternative investment options.

June activity reflected continued momentum such that period-end total deposits were up 1% compared to the prior quarter. Notably, we have grown deposits 2% since the end of last June compared to a 5% decline for the top 25 banks as shown in the Fed's H8 data.

Moving to credit. As Tim mentioned, credit trends were stable with our key credit metrics remaining below normalized levels. The net charge-off ratio of 29 basis points increased three basis points compared to the prior quarter. The NPA ratio of 54 basis points was up three basis points compared to the prior quarter. In consumer, we have focused on lending to homeowners, which represents 85% of our consumer portfolio.

We have also maintained one of the lowest overall portfolio concentrations in nonprime consumer borrowers among our peers. In commercial, we have maintained the lowest overall CRE concentration as a percent of total loans relative to peers for many years. Within CRE, we have limited office exposure with a low and improving criticized asset ratio and almost no delinquencies.

We continue to watch office closely and believe the overall impact on Fifth Third will be limited. We had deemphasized office even before the pandemic, and we are not currently pursuing new office CRE originations. From an overall credit management perspective, we have continually improved the granularity and diversification of our loan portfolios through a focus on generating and maintaining high-quality relationships. As many of you know, we have been and remain cautious in our economic outlook.

We tightened underwriting standards during COVID, including stressing credits to an up 200-basis-point scenario off the forward curve, which limited our growth but improved the stability of our balance sheet. Since we began tightening underwriting standards, roughly 90% of our commercial portfolio has been re-underwritten. Our criticized assets have been stable over the past several quarters. Across all loan categories, we continue to closely monitor exposures where inflation and higher rates may cause stress.

Moving to the ACL. Our reserves increased $87 million, reflecting the impacts of dividend finance and Moody's macroeconomic forecast, which eroded slightly. The ACL ratio increased nine basis points sequentially. As you know, we incorporate Moody's macroeconomic scenarios when evaluating our allowance.

The base economic scenario from Moody's assumes the unemployment rate reaches 4.3%, while the downside scenario incorporates a peak unemployment rate of 7.8%. We maintained our scenario weightings of 80% to the base and 10% to each of the upside and downside scenarios.

Moving to capital. Our CET1 ratio increased 25 basis points sequentially, ending the quarter at over 9.5%. Our capital position reflects our ability to build capital quickly through our strong earnings generation. Our tangible book value per share, excluding AOCI, increased 11% compared to the year ago quarter.

We continue to expect a meaningful improvement in our unrealized loss position, assuming the forward curve plays out, resulting in approximately 36% of our current loss position accreting back into equity by the end of 2024 and approximately 50% by the end of 2025.

Looking forward, we expect to build capital at an accelerated pace given our RWA optimization initiatives and by extending our share buyback pause. As Tim mentioned, we will postpone repurchases until we have more clarity on the regulatory environment in order to determine the new level of required capital dollars. Assuming we do not buy back shares through year-end, we would anticipate accreting capital such that our CET1 ratio ends this year at or above 10%.

Moving to our current outlook; we expect full year average total loan growth between 1% and 2%, which reflects our cautious outlook on the economic environment and our decision to proactively adapt our balance sheet to the new regulatory regime.

We expect total commercial loans to increase in the low single digits area compared to 2022, which implies a decline in the second half of the year relative to the first half. This outlook assumes the revolver utilization rate of 35% in the second quarter remained stable throughout the remainder of 2023.

Our commercial loan outlook also assumes that we meaningfully reduced originations in certain areas of the commercial franchise, predominantly in the corporate bank to meet our higher risk-adjusted return thresholds, while continuing to increase the generation in our core middle market business, we expect total consumer loans to be stable to down slightly from reduced originations of the lower-yielding out-of-footprint auto and specialty lending channels, combined with portfolio residential mortgages, partially offset by growth from dividend finance.

We currently expect to need approximately $4 billion in dividend loans for this year, which is a modest decrease from our previous expectations. We continue to expect to grow deposits in the back half of 2023, assuming stable or even slightly tighter market liquidity conditions Consistent with our track record over the past year of taking market share and maintaining high levels of core operating relationships in both consumer and commercial.

Within that, we continue to expect migration from DDA into interest-bearing products throughout the remainder of 2023 with the mix of demand deposits to total core deposits declining from 30% in the second quarter to 27% by year-end as we discussed last month.

For the third quarter of 2023, we expect average total loan balances to decline 1% to 2% sequentially with commercial down in the low single digits area and consumer stable to slightly down. We expect average deposits to be up 1% on a sequential basis, impacted by our strong finish to the second quarter, some seasonal uplift and the benefits of our multiyear investments in the franchise that Tim discussed earlier.

Shifting to the income statement; we estimate full year NII will increase 3% to 5%, consistent with comments from the mid-June investor conference. Our AI guidance assumes a cumulative beta of 53% by the fourth quarter, assuming an additional 25 basis point rate hike in July and no further rate movements in 2023. Our outlook translates to total interest-bearing deposit costs increasing around 40 basis points in the third quarter and another 15 basis points or so in the fourth quarter.

Our guidance assumes that our securities portfolio balances remained relatively stable between now and year-end. As a byproduct of strong deposit growth, combined with lower loan growth and stable securities balances, we expect to hold closer to $15 billion in cash and cash equivalents by year-end. We expect our loan-to-core deposit ratio to end the year in the mid-70s area. It will keep Fifth Third in a strong liquidity position in anticipation of more stringent regulatory environments. We expect third quarter NII to be down approximately 2% to 3% sequentially due to the continued impacts of the balance sheet dynamics I mentioned.

We expect adjusted noninterest income to be stable in 2023, resulting from continued success, increasing market share due to our investments in talent and capabilities. with stronger gross treasury management, capital markets, wealth and asset management and mortgage servicing revenue to be offset by higher earnings credit rates on treasury management, subdued leasing remarketing revenue and a reduction in other fees due to lower TRA and private equity income this year.

We expect our fourth quarter TRA revenue to decline from $46 million in 2022 to $22 million in 2023. We expect third quarter adjusted noninterest income to be down 3% to 4% compared to the second quarter.

We expect to continue generating strong revenue across most fee captions, which we conservatively assume will be more than offset by a slight erosion in debt capital markets and mortgage revenue. reflecting the environmental headwinds as well as lower other noninterest income. We continue to expect full year adjusted noninterest expenses to be up 4% to 5% compared to 2022. If capital markets fees improve relative to our current expectations, we will likely land at the upper end of the range.

Our expense outlook incorporates the FDIC insurance assessment rate change that went into effect on January 1, the mark-to-market impact on nonqualified deferred compensation plans which was a reductant in 2022 expenses but an increase in 2023 and full year impact of investments to grow the dividend finance and provide businesses. Excluding the FDIC assessment and NQDC impacts, we would expect our full year 2023 core expenses to be up 3%.

Our guidance reflects continued investment in our digital transformation, which should result in technology expense growth in the low double digits for the year. We also expect marketing expenses to increase in the mid- to high single digits area.

Our guidance also factors in the run rate benefits from the severance expense recognized in the first half of the year, which reflected proactive actions taken to reduce ongoing expenses given the operating environment. We expect third quarter adjusted noninterest expenses to decrease 1% to 2% compared to the second quarter. In total, our guide implies full year adjusted revenue growth of 3% to 4%. This would result in an efficiency ratio of around 56% for the full year.

We expect full year total net charge-offs to continue to be in our previously stated 25 basis point to 35 basis point range. However, as you would expect, with normalizing credit costs in this environment from record low levels, there may be a little lumpiness in C&I in the second half such that total Bancorp's third quarter losses are expected to be 35 to 45 basis points and then fourth quarter losses improving relative to the third quarter.

Given our reduced loan growth outlook, we expect a lower quarterly build to the ACL in the $25 million to $75 million range, assuming no significant changes in the underlying Moody's economic scenarios. This considers strong production from dividend finance of around $750 million in the third quarter, which, as you know, carries a higher reserve level.

In summary, with our proactive balance sheet management, disciplined credit risk management and commitment to delivering strong performance through the cycle, we believe we are well positioned to continue generating long-term sustainable value for our customers, communities, employees and shareholders.

With that, let me turn it over to Chris to open the call up for Q&A.

Chris Doll

Thanks, Jamie. Before we start Q&A, given the time we have this morning, we ask that you limit yourself to one question and a follow-up and return to the queue if you have additional questions. Operator, please open the call up for Q&A. .

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Scott Siefers from Piper Sandler.

Scott Siefers

The first question I wanted to ask is -- and I think if I've done the math correctly, the fourth quarter NII could kind of level out, even at the low end of the range, it could kind of level out or at least really slow the rate of decline. And I guess, in your view, what would allow NII to find a bottom at that point? I guess, I asked specifically in the context of you all having been bought the most conservative out there on your funding cost outlook for the second half of the year.

James Leonard

Yes, Scott, thanks for the question. It really comes down to the rate environment with the Fed in our forecast, the assumption being that the Fed reaches 5.5%, and holds. And therefore, by the end of the fourth quarter, we've gotten through all of the repricing lag that would occur. So that right now, the third quarter guide is down 2% to 3% and then the full year guide implies a little bit of a step down from third quarter into fourth quarter, and then we'll see what 2024 holds when we get there.

Implicit in the guide is an increase in our deposit costs so that the terminal beta is 53%. And I guess, coming out of listening to some of the other earned calls, the one comment we would have is that our June, like everyone else's was quite strong and could -- and I think to the point in your head could result in better NII outcomes than what it reflects.

But from our standpoint, spotting one robin doesn't make it spring. And therefore, we're going to continue to be cautious in the outlook and play defense in this environment. We've got a long way to go from the liquidity conditions tightening with at $80 billion a month, $1.5 trillion or more of trade issuance, the student loan repayments kicking back in, and then the competitive dynamics that we're seeing across the footprint. So we're going to play a good defense, and we think defense wins championships in this environment.

Scott Siefers

Perfect. Okay. And then I think I take tack one that you might have addressed towards the end of your prepared comments. But as it relates to the reserving needs, which look less in the second half in aggregate than in the first half is. No change to the reserving needs for dividend, right? I think you mentioned that's just due to the anticipated commercial growth.

James Leonard

Correct in that the dividend reserve coverage ratio, we're assuming, remains in that 9% area. The reduction in the guide for the ACL build is driven by all of the loan production changes that we are forecasting with the RWA diet and reducing the balance sheet for the new capital regimes that will be forthcoming.

Operator

And your next question comes from the line of Erika Najarian from UBS.

Erika Najarian

My first question is for Jamie. According to your first quarter Q, we're down 100 basis points parallel, I believe, your NII would be up 44 basis points over a full year. A lot of investors are now thinking about the potential for a Fed rate cut in 1Q '24. So I'm wondering, as we think about that 4Q '23 exit rate in all else equal, do you expect relative stability in NII if in the scenario as the Fed cuts?

And how does that play out in terms of deposit costs? In other words, is just -- is there an absolute level where deposit costs don't move that much. Do deposit costs continue to increase even in the first few cuts? You are the most trusted CFOs out there. So it would be interesting to hear your perspective on all of that.

James Leonard

Now you've just given the publicity then I'm going to have to live up giving you a 2024 NII guide. There's no question that Bryan and I have positioned the balance sheet to be currently neutral to benefiting for the rate cuts when the rate cuts ultimately occur. The down rate scenarios continue to be the most difficult for a bank earnings profile to manage as credit costs would ramp up and recession kicks in. So for us, I believe that the deposit cost pressures will mitigate as the Fed begins a cutting cycle.

We just don't see that happening this year, which is why the guide on NII is what it is that we continue to expect a competitive environment. But should the Fed move to the cuts, we really like how the balance sheet is positioned for that environment. Our guide the exit run rate on fourth quarter NII, if you took our guide and multiplied it by 4, it's about where consensus is for 2024. So I don't think there's necessarily a gap at this point in time, but 2024 is a very long way from July 20.

Erika Najarian

Understood. And my second question maybe is for Tim. It took a lot of years of hard work, but Fifth Third has put itself in a position where you're pretty down the middle in terms of the results you're not talking about taking expenses down next year. You're not talking about RWA mitigation. And while I'm sure there's something on LCR and long-term debt as those requirements come in that you're working on, the business seemed to be something that would change strategy.

The question really here is as you think is Fifth Third is positioned, and there seems to be now appreciable differences on how peers are positioned for this sort of new world order. How are you going to take advantage of it from a market share perspective? .

Timothy Spence

Yes. That's a good question, Erika, and I appreciate it. I will say, I think all of the things that you described, the RWA diet, a continuous focus on expenses, thinking about liquidity profile and in particular, the value of different sorts of deposits in the new world are all things we're doing here today.

But we have the benefit of having made multiyear investments in either asset classes or in particular, on the operational deposit side of the equation that are benefiting us in this environment, and they're going to continue to be very valuable going forward. I think narrowly, the hardest thing on an organization, if you're trying to deliver predictable long-term results is to have to move into a binge purge mode, right?

And whether that is outsized growth followed by shrinking or letting expenses run up, followed by deep cuts later it creates -- the two things happen. One, the first thing that people cut tends to be the last thing that came in the door. And the byproduct of that is your cuts end up being concentrated in the areas you are investing for future growth, one. Two, your people actually become more reticent to stretch and to try to give better outcomes because they don't want to get outsized and have to work backwards.

So I think what -- the advantage we're going to have next year and the year after that and the year forward is our ability to be consistent about investing in the franchise. And that will mean that we stay on the pace that we've been on the last several years in building branches.

It will mean that we continue to add to the middle market teams because I think the economics of these middle market banking relationships are going to continue to be excellent regardless of what happens to capital and liquidity. And we're going to continue to focus on having the best retail deposit franchise and best treasury management franchise in our peer group.

Operator

And your next question comes from the line of John Panc from Evercore.

John Panc

On the -- back to the loss reserve, just to clarify, the $25 million to $75 million build in -- per quarter in the back half for dividends and is that again, is for growth expected in dividend stance, but it's no change in the reserve ratio that you're assigning to that business?

James Leonard

Yes. And let me clarify one thing from what you said that just to make sure we're on the same page. Our guide for the ACL is for the total Bancorp balance sheet. However, the primary driver of that ACL build is dividend. Dividend, we expect to do $750 million a quarter of production, that reserve rate ballpark it in the 9% range.

But the rest of the balance sheet, as we discussed in the guide is actually going -- from a loan standpoint is actually going to be down a bit. And so the net of those growing dividend, shrinking other parts of the balance sheet, inclusive of auto where we exited the states west of the Mississippi, but for Texas, combined with our efforts in shrinking the corporate banking book will result in a lower ACL build than what we've been running at this year because those other businesses will essentially be reducing the ACL coverage due to lower volumes, whereas dividend call it, in that same area, but the net effect is, let's call it, a build of $25 million to $75 million a quarter going forward.

John Panc

Okay. No, that helps a lot. And then separately, on the credit front, can you just talk a little bit about your C&I portfolio and how that's performing just as we've started to see some larger bankruptcies develop. But curious how the book is performing on the C&I side. And I know you mentioned that commercial book has been re-underwritten. How does that typically work with shared national credits? I know they're about 30% of your book. So how does the reunderwriting work for that portfolio?

James Leonard

Yes. Let me start, and then I'll turn it over to Greg Schroeck to add a little bit more color. But in terms of -- as we discussed in the outlook, we continue to have a total Bancorp charge-off guide in the 25 to 35 basis point range. Within commercial over the past couple of years, it's obviously bounced around from 36 bps in 2020 down to 10 bps in '21 and 13 bps last year. And this year on commercial, we continue to be in that 20 to 30 basis point range.

And then within total commercial, C&I is expected to be at the high end of that range given some of the lumpiness that we're seeing with a few credits that resulted in a little bit of that uptick in the NPA ratio at the end of the quarter. But with that, I'll turn it over to Greg for thoughts on C&I underwriting and other views.

Greg Schroeck

Yes. I agree with Jamie. First of all, the portfolio monitoring really doesn't change, whether it's a SNC, middle C&I loan regardless. We have a robust portfolio management structure and discipline in place that keeps us out ahead of these emerging trends. We're really not seeing a significant trends in that C&I book. We're not seeing it certainly in the shared national credit book.

So I still feel really good about the middle market. As Jamie said, we're going to have some lumpiness. You've probably seen our guidance into the third quarter from a charge-off perspective. the headline there, I think, is twofold. And we're starting from a very low base. And so because of that low base, one or two loans can move the needle, and that's exactly what happened, right?

We've got two credits, one in the professional services industry and the other in the manufacturing that are going to move the needle in the third quarter. But overall, I feel really good about portfolio, and I would expect fourth quarter charge-offs to be back in line with what we saw in the first and second quarter. .

Operator

Your next question comes from the line of Ken Usdin from Jefferies.

Ken Usdin

I just wanted to ask on the securities book. I know you guys do daily LCR calcs and you got still the two third portfolio in the locked out and bulleted as you contemplate what the LCR requirements might look like, and I know we're going to learn that ton, do you think are you comfortable with the structure of the portfolio and meeting any push down requirements to category 4?

James Leonard

Yes, Ken, great question. And embedded in all of our comments and outlook today, we should have outlined the strategy that our approach here for our company is that we fully expect TLAC to get pushed down. We expect the more draconian capital rules on ops risk to get pushed down, but not any of the benefits from the credit rating risk weighting, and we expect to have to be compliant with the full LCR.

So that is the underpinning of all of our strategies for managing the balance sheet, and we want to do that expeditiously. And therefore, we are going to be holding higher levels of cash. We will be rotating more into Level 1 securities. But we love the bullet locked-out structure because that provides the shock absorber to potential low rate environment. And so the flip side to all of this will be the AOCI impacts with the capital rules.

And so we'll wait to see what those final rules look like, but it sounds like, obviously, AFS inclusion, HTM exclusion. And so we may have to pivot a bit on the HTM classifications given that we've not done anything to date. But that might be an outcome from the brave new world that will have to adapt to.

Ken Usdin

Right. And I guess in the near term, with rates high, the move to cash is actually helpful, right, because you're now earning five and change versus the average yield of the book, which seems like it's kind of just held in. So it's fair to say that, that's kind of what we expect to see as the securities book for now just continues to shrink back down. And as to your point, we just see that cash build continue.

James Leonard

Yes. What we did in the second quarter was we let the portfolio cash flows of $600 million roll off and not get reinvested. So essentially, to your point, bolster cash. For the rest of the year, we're assuming stable, give or take, $1 billion. We may let it run down, we may rotate into treasuries just depending on the day and the opportunities. But what you should expect from us is continued rotation into Level 1, whether cash or treasuries.

Ken Usdin

Okay. And if I can ask one quick one. In terms of your deposit growth outlook and the higher beta assumptions, I know you talked about 3% year-over-year household growth. I guess, can you parse out deposit growth just coming from the franchise as opposed to pricing up to get it? .

James Leonard

Yes. It's just that there is a several factors impacting that. So in terms of consumer on the household side, we do have a very strong and consistent growth of 3%, but offsetting that tailwind is the headwind from consumer spending and the declines in the average deposit balance. So when you look at the consumer, the average deposit is still 20% higher than pre-COVID levels, but it is down 10% from the COVID average balance peaks.

And so we're modeling that, that erosion does continue and therefore, it creates a little bit of a headwind. So for us, the majority of the growth is obviously coming from the Southeast de novo market and they're growing at a 7% rate. But the Midwest, whether it's same-store sales or the total Midwest networks growing households at 2%. So we like what we've been able to do, and I would say it's more about core new customer acquisition than anything else.

Operator

Your next question comes from the line of Ebrahim Poonawala from Bank of America.

Ebrahim Poonawala

I guess just first question around reserves and less to do with the mechanical finance and what you -- the ACL. But when we think about the 80% base case, Jamie, that you mentioned, I think if I heard you correctly, you said that had an unemployment rate of 4.3%.

I guess, philosophically, I guess, Tim, like in the past, you've talked about 2024 could be worse in terms of debt maybe we do get a delayed recession. So just give us a mark-to-market around your operating outlook over the next, I guess, 12 to 24 months. Are you expecting a recession? And if that's the case, shouldn't you be weighted a lot more to the downside than just the 80-10-10 split that you have? .

Timothy Spence

Yes. So let me answer the question about the outlook, Ebrahim and then I think we'll go to Jamie to talk about the dynamics around the specific ACL. So look, I think our outlook is that it's hard to know. Like I watch -- we watch the same equity market indicators that you do.

We see the trends on unemployment. We see that signal around inflation moderating. And I hear a lot from folks about the increased probability for a soft landing. We just don't get paid to manage to a Goldilocks scenario outcome here, right? Because for every positive indicator, you still have like a yield curve that's more inverted than it has been in decades.

You have data coming out of the red book that suggests that same-store sales in retail across the US has been negative since the beginning of the year, the consumer spending on a real basis, so take the impact of inflation out, like flat or down in five of the last seven periods you have a negative ISM in terms of what we're seeing their freight levels, whether it's exports and imports or the over-the-road stuff here in the U.S. continuing to be depressed, like those are not positive signs.

And if you buy the thesis that the -- what we're experiencing today is the interest rate environment we had 12 months ago, that we're seeing all of that in a world where Fed funds was 150, 175, right? So at least from our point of view, while it's very possible that we end up with a soft landing here. And I think even if we end up with a mild recession that it is not one that's characterized by unemployment levels, that we still are going to end up in a recessionary environment.

The last thing I just want to make sure that I flag because I think sometimes words matter is, we talk about an RWA diet where other people talk about balance sheet optimization. What we're really saying is tightening credit supply and higher risk spreads, right? And those things have an impact on M2 that compounds whatever gets done on M1, that are the other factor that's sort of lingering out there that I think that we need to take into account as we're looking at the outcomes.

So that's probably a long way of saying, I don't know any more than you do in terms of where we settle, but we're going to always plan around a more conservative outcome because if we're wrong, everybody does well. And if we're right, we're better positioned to deliver stable earnings for you.

James Leonard

And in terms of scenario weightings, we anchored to the 80-10-10 distribution because that is the probability assignment by Moody's for each of those scenarios occurring. So that as you saw in this quarter, the scenarios eroded, unemployment ticked up about 30 basis points or so on a peak basis in their baseline scenario. And as Tim mentioned, it's certainly possible that we have a full employment soft recession. But we believe that obviously, the reserve is adequate and at 208 basis points of coverage, we feel good how we're positioned.

Ebrahim Poonawala

Understood. Just as a follow-up to that, I guess spreads widening, tightening credit is one thing. Are you also seeing demand fall off? Like as you look through your commercial customer base, both in West and Southeast, we've heard from some other banks where things have really cooled off in the last month or 2. Are you actually seeing that from your customers where they are pulling back around investment spend and activity?

Timothy Spence

Yes. We are seeing some softening in demand. There's no question about that. I think in general, part of its conservatism on the part of the clients. I think and the lack of visibility that they have into what the economy is going to look like 18 months from now. I think the other dynamic that we hear from clients is they are saying they're a little bit nervous about credit availability.

So there's an interaction effect here that you have to take into account. But I was on the phone with two large clients, one in the medical field, one in the real estate field, in the past 1.5 weeks. And in both cases, they had gone out and surveyed their bank groups, and there were a lot of, hey, we've allocated all the capital we have available to invest in the second half of the year sort of responses that they were hearing back and/or real constraints on the way that they have to spread ancillaries.

So I think there is a dynamic that will materialize here where demand will be lower for credit because the cost of credit will be higher. And that's the interaction effect that I think as we roll forward here, we're going to continue to see in addition to just general caution.

Operator

Your next question comes from the line of Michael Mayo from Wells Fargo.

Michael Mayo

I'm not sure if Jamie was quoting Aristotle earlier. One Robin does not make a spring. But we'll stick to the Aristotle quotes. So excellence is never an accident. So in terms of operating leverage or positive operating leverage, I mean, you did guide revenues lower by 350 basis points, taking the midpoint, and you didn't change expenses, and that's consistent with the industry.

It looks like you could still have a shot at positive leverage, but doesn't look that way a whole lot or -- and for next year, and there's only so much you can do about higher rates and inverted curve. But do you think you have a shot for this year? How do you think about next year? Do you double up on your expense plans or do you preserve the infrastructure for potential additional growth?

Timothy Spence

Yes. Mike, it's Tim. I'm going to take that one. I mean we are working on expenses. The severance item that we called out as part of an exercise that we ran, just to try to rightsize the resource base here for demand, given the outlook in the environment. And as you know, the primary outcome of all of this investment we're making in the core platforms is to bring more automation and straight-through processing to the business, which we think is going to provide a lot of intermediate-term expense positive expense outcomes.

I think what we're trying to do is to manage the expense base and the focus on positive operating leverage around sort of three-year increments. So if you look back over the course of the past three years, we have the lowest expense growth. It's something like half of what our peer group average is in terms of noninterest expense, annual compound annual growth. And we were growing revenue at a little more than 2x the rate we were growing expenses during that period.

I think we have every intention to do exactly the same thing over the course of the next three years. What we want to make sure that we're doing though is that when we make an investment, we finish the play, we get the outcomes of the investment and we move on. And I try to correct at the midpoint, you run the risk of having started a lot of things. And then you don't get the excellence that you mentioned at the beginning. It's the bench bird cycle I referenced when I talked to Erika.

Michael Mayo

And I'm sorry, the start of the 3-year period now is -- was when?

Timothy Spence

The last three years, we will have grown expenses less than anybody else. The next three years, we intend to do the same thing. We intend to generate positive operating leverage over the next three years. The same way we have to last three years.

Michael Mayo

Got it. And then let's just go back to that quote One Robin does not make a spring. You said June was better, but you're not extrapolating that. Your guidance may be conservative, may not be, but Jamie, what is it that you saw in June and why.

James Leonard

Yes. there were two -- yes, two things, Mike, that happened in June that are certainly opportunities for the back half of the year to be better than what we're guiding to. But like most things, I'll give you another quote. The beauty is in of the beholder.

So some folks look at the credit spread widening and the C&I coupon expansion that occurred in the market, and we experienced that as well in June. Spreads were up a bit. We're not guiding to continued spread expansion in the back half of the year in C&I. And then on deposits, June was a very good month for the industry, whether you watched the H8 or you've heard from all the banks that have been reporting, and you see it in our numbers.

We're up 2% on deposits year-over-year. We're up 1% on an EOP basis sequentially. We had a very nice June from a deposit gathering, a new customer acquisition perspective. So what we're seeing from here is we actually are forecasting on an average basis, some deposit growth in the third quarter. But frankly, if you look at the guide on an average basis, it's about one point lower than our balances.

So maybe we do better, maybe not, maybe it gives us a little bit of pricing power to do better on the beta. But with all that being said, we just still are cautious about the liquidity environment in the back half of the year, and we want to make sure that we prioritize stability until these challenges are behind us, and we start to enter into at least a Fed pause cycle, let alone a Fed cut cycle.

Michael Mayo

And then last follow-up. Just how comfortable are you that your NII guide kind of captures it? And is that the kind of entry point for thinking about 2024?

Bryan Preston

Mike, it's Bryan. We certainly feel comfortable with our guide. As Jamie talked earlier and as we've talked consistently the Fed hiking cycle ends, we expect a quarter or two of impact as the deposit repricing lags play out. And we still feel like we're going to see stability then both from an NII and NIM perspective. and growth as earning asset growth starts to pick up from there or from an NII perspective.

And so we feel very well positioned with the actions that we've taken and the optionality that's going to give us as we manage the balance year. But certainly, a lot can change from an outlook perspective, a lot can change in terms of what happens in 2024. But with what we see right now, we feel very good about our guide and what it's going to allow us to grow in 2024.

Operator

And your final question comes from the line of Gerard Cassidy from RBC.

Gerard Cassidy

Jamie. I'd like to come back to Jamie and Greg on credit for a moment. Greg, you talked about -- and we all recognize your credit is very strong. The numbers are very low. But I'm curious, you mentioned about how you guys have a very robust management structure that allowed you to stay ahead of these emerging trends. Can you share with us what is that robust structure. And what do you mean by keeps you ahead of those trends when you say something like that?

Greg Schroeck

Yes. I think it's the ongoing review of the portfolio. As an example, in the second quarter, our team completed a complete review of our office portfolio, right? And so as we continue to stress that portfolio increasing rates using the forward curve to try to get out ahead of where those cash flows end up if rates continue to increase, but also looking at the softening rental rates in that portfolio in the real estate portfolio. That's how we stay ahead of it.

We're not waiting for a covenant to forge, we're not waiting for borrowers to come to us. We're active, proactive in again, stressing the portfolio across the board, not just in commercial real estate. So we see what's coming. I think it's one of the lessons learned and a lot of us have the battles cars from the last crisis of being much more proactive state out ahead of it and then bringing forward solutions to our clients that, again, that are more proactive as opposed to, again, waiting for the covenant defaults, waiting for something to drop off the table. So that's what I'm really referring to in terms of the merchant risk.

James Leonard

The other one, Gerard, that we've talked about in the past has been some of the proprietary systems we have from an early warning perspective, keeping an eye on real-time liquidity metrics out of the book that we've learned, whether it's through some of the ABL monitoring that was doing that we've adapted as the best practice inside Fifth Third as well as then what other banks do always with regard to covenant monitoring and other vulnerability assessment.

Greg Schroeck

Real-time liquidity metrics was kind of what Jamie is referring to.

Gerard Cassidy

Very good. And then just as a follow-up, Greg, you mentioned one to two loans, the little pop that you'll likely see in the third quarter. were those shared national credits? And second, how big were the individual loans? And are you still making shared national credit loans today? .

Greg Schroeck

So second question, yes, on a select basis, we are still making shared national credit decisions. One of the credits that I was referring to that could impact is a shared national credit. The second one is not.

Operator

And we have reached the end of our question-and-answer session. I will now turn the call back over to Chris Doll for some closing remarks.

Chris Doll

Thank you, Rob, and thanks, everyone, for your interest in Fifth Third. Please contact the IR department if you have any follow-up questions. Rob, you may now disconnect the call.

Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.