Citizens Financial Group's (CFG) CEO Bruce Van Saun on Q2 2016 Results - Earnings Call Transcript

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Citizens Financial Group, Inc. (NYSE:CFG)

Q2 2016 Earnings Conference Call

July 21, 2016, 08:30 ET

Executives

Ellen Taylor - Head, IR

Bruce Van Saun - Chairman & CEO

Eric Aboaf - CFO

Brad Conner - Head, Consumer Banking

Don McCree - Head, Commercial Banking

Analysts

Matt O'Connor - Deutsche Bank

Erika Najarian - Bank of America Merrill Lynch

Scott Siefers - Sandler O'Neill Partners

Ken Zerbe - Morgan Stanley

Jason Harbes - Wells Fargo Securities

John Pancari - Evercore Partners

Vivek Juneja - JPMorgan

David Eads - UBS

Kevin Barker - Piper Jaffray

Gerard Cassidy - RBC Capital Markets

Jesus Bueno - Compass Point Research

Operator

Welcome to the Citizens Financial Group Second Quarter 2016 Earnings Conference Call. My name is Kerry and I will be your operator today. [Operator Instructions]. Now I will turn the call over to Ellen Taylor, Head of Investor Relations. Ellen, you may begin.

Ellen Taylor

Thanks, Kerry. Good morning to you all. Thanks so much for joining us on our second quarter earnings call. I know it's a really busy day, so just briefly our Chairman and CEO Bruce Van Saun and our CFO Eric Aboaf are going to provide some opening remarks and then we will open the call up for questions. Of course, also in the room with us today are Brad Conner, our Head of Consumer Banking; and Don McCree, who is our Head of our Commercial Banking segment. I would like to remind you that in addition to today's press release, we've also provided a presentation and financial supplement and those materials are available at investor.citizensbank.com.

Of course, our comments today will include forward-looking statements which are subject to risks and uncertainties and we provide information about the factors that may cause our results to differ materially from expectations in our SEC filings, including the Form 8-K which was filed this morning. We also utilize non-GAAP financial measures and provide information and reconciliation of those measures to GAAP in our SEC filings and earnings release material.

And with that, I will hand it over to Bruce.

Bruce Van Saun

Thanks, Ellen and good morning, everyone. Thanks for dialing in today. We feel very good about the results that we announced today. We're executing our plan well and the financial results continue to show steady and notable progress, particularly given the environment. We delivered a completely clean $0.46 quarter with 15% year-on-year EPS growth, positive operating leverage of over 3% and a 70-basis-point improvement in ROTCE versus adjusted 2015. Our revenue growth of 7% was paced by loan growth of 7%.

Our NIM was relatively stable as are our credit costs. We continue to be very disciplined on expenses. We're delivering on efficiency initiatives that allow us to self-fund growth investments, particularly in our fee-based businesses. I call out the outline of our TOP III program in today's materials. Recall that our TOP programs. TOP means tapping our TOP programs derive from our mindset of continuous improvement. This program should deliver approximately $100 million in benefits next year which is similar to TOP II's impact on 2016. It is also worth commenting on the successful execution of our TDR sale which was announced earlier this week.

We expect a gain of approximately $70 million, a portion of which will be utilized to cover restructuring costs associated with TOP III. We were pleased that we came through the CCAR process well this year and we will pursue both strong loan growth and shareholder return of capital as we continue to normalize our CET1 and total capital ratios. Our colleagues are putting customers first and are doing a great job in executing our plans. I would like to recognize them for their excellent effort that continues to propel us forward.

With that, let me turn it over to Eric to take you through the details of the quarter.

Eric Aboaf

Thanks, Bruce and good morning, everyone. In the second quarter, we continued to deliver on our growth, efficiency and balance sheet initiatives. We delivered strong operating leverage, controlling costs through our expense initiatives and improving efficiency. Earnings were up nicely, both linked quarter and year-over-year along with our returns. Let's take a closer look at the details in our second quarter earnings presentation. On page 4, we provide our GAAP results which include net income of $243 million and EPS of $0.46 per share. Up 5% sequentially and $0.11 year-over-year, those second quarter 2015 results included $40 million of restructuring charges and special expense items.

On page 5, you will find the highlights of our adjusted results. Our net income came in at $243 million, up 9% linked quarter on revenue growth of 4%, with increases in both NII and non-interest income. We grew fees 8% percent on a linked quarter basis driven by strong growth in capital markets and good volumes in mortgage banking and higher service charges. Expenses were up 2% reflecting higher operating expenses, as well as higher salaries and employee benefits. Provision for credit losses remained relatively stable as lower net charge-offs were more than offset by reserve build tied to loan growth. So on a linked quarter basis, EPS increased $0.05 or 12%.

Compared to adjusted second quarter 2015 results, net income increased $28 million or 13% and earnings per share was up 15%. We grew revenue by $78 million or 7% with a 10% increase in net interest income as we grew loans 7%, improved loan yields and mix and held deposit costs stable. Non-interest income decreased $5 million from the second quarter of 2015 which did not include the impact of a reclass of $7 million of card reward costs now reflected as a contra-revenue item. Excluding this impact, non-interest income was up $2 million or 1% year-over-year.

Non-interest expense was up $26 million or 3% driven by salaries and employee benefits expense and a change in timing of our merit and bonus payments. On the credit side, our provision was up $13 million on a modest reserve build tied to loan growth. In second quarter 2016, we continued to make demonstrable progress against our goals enhancing our efficiencies while reinvesting in the franchise.

Our adjusted efficiency ratio of 65% improved 1% on a linked quarter basis and improved 2% relative to a year ago, as we saw the continuing benefits of TOP II. Additionally, we reduced our share count by 2%, positively impacting EPS. And finally, as of June 30, 2016, our tangible book value per share totaled $25.72, a 2% improvement on a linked quarter basis.

Let's move on to net interest income on page 6. We grew NII $19 million or 2% linked quarter as we continued to generate loan growth with improving yields and portfolio mix while holding deposit costs flat. This underlying momentum was offset by pressure from the long end of the curve that played out in higher premium amortization and continued lower reinvestment opportunities in the securities portfolio. On a year-over-year basis, net interest income increased $83 million or 10% and the NIM expanded 12 basis points.

Now on page 7, our net interest margin which was down 2 basis points linked quarter, reflects higher loan yields and a better mix which were more than offset by the impact on our securities portfolio of a reduction in long term interest rates and higher borrowing costs associated with the issuance of senior debt. We continued to exercise good discipline with deposit costs which were flat for the quarter. Year-over-year, our NIM expanded 12 basis points reflecting improving retail and commercial loan yields and portfolio mix, along with the impact of the December Fed rate rise. We're pleased with the positive results of our loan pricing and mix initiatives and our taxable actions to hold deposit costs flat. Our asset sensitivity ended the quarter at 6.8% in a gradual rise scenario, relatively unchanged from the first quarter of 2016.

Next up let's take a closer look at our non-interest income. We grew non-interest income $25 million or 8% from the first quarter with strength in nearly every category. We saw volume growth in service charges and fees [indiscernible] seasonally lower levels in the first quarter and also benefited from improved pricing. Card fees and investment services fees were up slightly, while mortgage banking fees increased $7 million as we improved our origination volume 42% with higher loan sale volumes and spread.

Capital market fees improved $13 million reflecting the continued broadening of our capabilities in cross-sell, as well as a strong increase in deal volume from lower first quarter 2016 levels. Securities gains were modest and down $5 million. On a year-over-year basis, non-interest income declined $5 million or 1% from the second quarter of 2015 levels which did not include the impact of a reclass of $7 million of card reward costs as a contra revenue item. Excluding this item, underlying non-interest income was up $2 million or 1%. We drove improved pricing and volumes in service charges and fees which increased $11 million with improvement in both consumer and commercial. In wealth, we continued to add to our advisor head count which will propel higher revenues going forward, notwithstanding a shift to more fee-based product sales.

Mortgage banking fees decreased $5 million as the benefit of higher application volume and sale volume and spread was more than offset by reduction in the prior-year MSR valuation increase. Capital markets fees increased $5 million reflecting a record quarter and a continued broadening of our capabilities.

Turning to expenses on slide 9, we continue to manage our costs effectively while also redeploying cost saves prudently to invest in products, infrastructure and talent to support the long term growth of the franchise. On a linked quarter basis, non-interest expense increased $16 million or 2%. Salaries and employee benefits were up $7 million linked quarter and $27 million year-over-year largely related to a change in the timing of merit increases and incentive payments which were paid in the first quarter last year. This led to higher payroll taxes and 401(a) matching contributions this quarter than we had last year.

Other expense was up $13 million from first quarter as we experienced higher regulatory fraud in insurance costs. Otherwise, we continue to make progress in controlling costs. You can see that headcount was down by 74 linked quarter and also down year-over-year. We continue to take actions to redeploy expense dollars out of less productive uses into areas that will drive future top line and bottom line benefits. If we look at our balance sheet on page 10, year-over-year average earning assets were up $6.3 billion or 5%. We generated 10% commercial loan growth and 5% retail loan growth. Average deposits increased $5.4 billion or 6% with strength in low cost core deposits.

Let's move to page 11 where Consumer Banking continues to make good progress in growing the loan portfolio while shifting the portfolio mix with more attractive opportunities. Loan growth was 7% year-over-year driven by student lending, particularly our refinancing product and mortgage lending. Consumer loan yields increased 4 basis points reflecting continued improvement in mix.

Next on slide 12, Commercial Banking delivered another strong showing. Commercial loans increased 5% linked quarter and 11% year-over-year with continued momentum in the more attractive return areas. On a year-over-year basis, we continued to generate growth across our targeted areas, corporate and industry verticals, commercial real estate, franchise finance and corporate finance. Commercial loan yields increased 5 basis points linked quarter and 24 basis points year-over-year which reflected higher rates, pricing discipline and improved mix.

Let's take a quick look at the liability side of the balance sheet and our funding costs on slide 13. This quarter continued to see the benefit from the strategies and tactics to fund continued loan growth in a more cost effective manner. Our focus in growing low cost core deposits helped drive a $1.7 billion increase in average interest-bearing deposits, up 2% linked quarter with particular strength in checking. We held our deposit costs stable for a third consecutive quarter reflecting continued disciplined pricing strategies and tactics in Consumer Banking. We also continue to replace our wholesale funding mix to align more closely with peers and are reducing our reliance on short term borrowing and issuing senior debt.

Next let's cover credit. On slide 14, we saw broad-based improvement in our commercial and retail portfolios. Linked quarter NPLs were down $35 million, reflecting a $23 million improvement in Commercial largely tied to the oil and gas portfolio and a $12 million decrease in retail. Correspondingly, net charge-offs were down $18 million or 8 basis points to 25 basis points in loans. Provision expense in the quarter was relatively stable at $90 million as we built reserves by $25 million, largely tied to the continued loan growth. The allowance to loans ratio of 1.2% was stable with the prior quarter and our allowance NPL coverage increased to 119%. Overall, we're pleased with the continued favorable trend in our credit metrics and we expect credit costs to remain favorable this year.

On slide 15, you can see our strong capital and liquidity ratios. We had significant progress in our capital management this quarter as we received a non-objection to our capital plan which include strong loan growth, $690 million of share repurchases over the next four quarters and an ability to increase our dividend by 17% next year. We're very pleased with the results as it will enhance our returns to shareholders.

On slide 16, we have laid our key initiatives that support the balance sheet and fee growth in our turnaround plan. As you know, we have augmented the plan with incremental initiatives and assess our progress against these initiatives each quarter. We're continuing to lay strong foundations and gain momentum across most of these areas. Where we had challenges, like in mortgages, we're making good progress improving cycle times which improves the customer experience and allows us to resume growth in our sales force.

On slide 17, you can see tangible evidence that our strategic initiatives are bearing fruit. We continue to deliver positive operating leverage consistently ahead of our peers. We've been able to generate good revenue growth notwithstanding the modest economic growth and a lower for longer rate environment. Our disciplined approach to expense management reflects the importance of self-funding our growth initiatives by actively managing our expense base and driving efficiencies throughout the organization.

On slide 18, you can see that our biggest gap with peers has been revenue capture, particularly in our fee businesses which outlines the opportunity set that will allow us to enhance our returns for shareholders. We're addressing this opportunity through growth investments in our wealth management, capital markets, Treasury solution businesses, among others. Additionally, we're making progress towards improving our returns by addressing other drags on ROTCE, such as our excess capital position and a relatively high tax rate.

We have improved ROTCE by almost 3 percentage points inside of three years and we'll continue to focus on execution to drive further progress. As you look at slide 19, our top two initiatives have delivered well against our revenue and expense goals. In 2016, we were on track to realize $95 million to $100 million in total benefits from revenue initiatives and expense savings. We continue to foster a mindset of continuous improvement running the bank better every day.

On slide 20, we outline our plan to build and improve upon these efforts. Our TOP III initiative which is taking shape, places a greater emphasis on expenses. We're reducing our headcount in non-revenue areas and driving further efficiencies in the distribution network, as well as streamlining end-to-end loan processes. We're actively reaching out to customers to protect our share of wallet and conducting a thorough assessment of opportunities to improve our tax rate to align more closely with peers. We will leverage our success with previous TOP programs to help ensure that TOP III improves the bank's overall efficiency and effectiveness, while at the same time allowing us to self-fund investments and drive future growth.

Slide 21. Given our focus on efficiency in TOP III, we remain committed to continuing to deliver positive operating leverage. The rate scenario will move around based on events. Currently, the forward curve projects a low probability of a Fed rate increase during 2016 and 2017.

Additionally, the curve has flattened with the long end significantly lower. While this scenario lessens the prospect of a hoped for tailwind, we have been delivering strong operating, solid operating leverage, EPS growth and ROTCE improvement during the last two years with no net rate benefit as the one move in the Fed fund's rate has been more than offset by the impact of a flattening yield curve. In any case, it is starting to look like the rate reaction in the wake of Brexit may have been a bit overdone. But we will see. We believe the key is to focus on what we can control and to continue to execute on our plan to build a top performing bank that delivers well for all our stakeholders.

In the back half of 2016, initial TOP III savings will help to offset some costs that were unforeseen at the beginning of the year. These include higher FDIC assessment costs, higher separation costs from RBS related to new vendor contract, as well as a temporary increase in outsourcing costs. In 2017, our TOP III benefit will be deployed towards containing expense growth and generating positive operating leverage and EPS growth. This roughly $100 million impact will also help us self-fund the investments we need to drive top line growth, particularly in fees, while still showing strong discipline on expenses. In addition to the efforts we have outlined here, we're working additional efficiencies in areas like optimizing our branch network to reduce occupancy costs. Also note that we expect to utilize roughly 30% to 40% of the approximately $70 million TDR gain to fund costs associated with TOP III efficiencies and the continued optimization of the balance sheet.

Turning now to slide 22 and our recent CCAR submission DFAST outcome. We received a non-objection to the capital plan we submitted as part of the 2016 CCAR process. Our strong capital position permits strong loan growth and shareholder return of capital while maintaining a robust common equity Tier 1 ratio. We will continue to allocate our capital prudently given our need for higher earnings and ROTCE improvement. All-in, we have made great progress in improving the qualitative aspects of our framework.

On slide 23, we provide a high level outline of the TDR transaction. Earlier this week, we sold $310 million of troubled debt restructuring loans and we will look for a third quarter of 2016 gain of approximately $70 million on the sale through other income. Benefits of this transaction include an improvement in the bank's asset quality, the ability to improve risk adjusted returns, the reduction in our CCAR stress loss levels and a modest reduction in FDIC insurance expenses.

Let's turn to our third quarter outlook on slide 24. We expect to produce linked quarter loan growth of roughly 1.5%. We also expect net interest margins to be down slightly given the current curve. With the curve at these levels, this poses some challenges, but we will tightly manage our deposit costs and continue to optimize our loan portfolio mix.

We're focused on what we can control and continue to investigate additional opportunities to optimize our balance sheet. We expect to keep expenses broadly stable in the third quarter as efficiency initiatives will offset continued investment spend. We expect to continue to generate strong positive operating leverage, thereby improving our efficiency ratio, profitability and returns. We expect underlying credit metrics to remain favorable which will lead to relatively stable provision in the third quarter.

And finally, we expect to manage our CET1 ratio to 11.3% given that we have resumed buying back stock and we will manage the LDR to around 99%. Note that this guidance does not reflect a gain on the TDR Transaction of approximate $70 million or any restructuring costs.

In summary, slide 25, our strong results this quarter demonstrate our ability to continue to improve how we run the bank. We have delivered well against our strategic initiatives that help us drive underlying revenue growth and carefully manage our expense base. We remain committed to being prudent capital allocators and enhancing our returns for shareholders. In the second half of the year, we will continue to focus on execution and making progress for all our stakeholders.

With that, let me turn it back to Bruce.

Bruce Van Saun

Okay, thanks, Eric. A really strong quarter as we continue to run the bank better and better each and every day. With that, Kerry, can we open it up for questions?

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question comes from Matt O'Connor with Deutsche Bank. Your line is now open.

Matt O'Connor

Just following up on the outlook for the third quarter and I guess more broadly speaking as we think about net interest income dollars. Do you think you can still see some increase in the absolute amount of dollars as you think about the modest loan growth and the slight decline in NIM and the liquidity and securities book, when you put that all together do the revenue dollars go up from here?

Eric Aboaf

Matt, it is Eric. I think that's exactly what our outlook indicates. We're expecting solid loan growth. A little bit of potentially a slight decline in NIM, but a couple basis points, we will see. But we think the low growth will outrun that slight NIM compression in the third quarter and provide a good uptick in NII. I think we also see some tailwinds into the fourth quarter. We've got some old legacy swaps running off and so we actually see some flatness in NIM between third quarter and fourth quarter which when you add back in the loan growth, should help with a second NII uptick at the end of the year.

Matt O'Connor

Okay and then just separately on asset quality, the charge-off dollars came in a lot lower than I was looking for. It seemed like the auto book, after having some seasoning in recent quarters, you actually saw a good improvement there, but anything kind of unusual on the credit side or maybe what is just driving the drop in the charge-offs and specifically in auto it has been some negative industry headlines?

Eric Aboaf

Couple of factors there. I think you are right, auto has typically seasonally declined, but we also, I think, had a particularly strong recovery quarter in auto which was nice to see. That doesn't always repeat, but it was nice to see. I do think we saw some relatively systemic improvements in home equity generally and even a touch of mortgages as housing prices continued to float upwards. And we expect some of those improvements to stick in the coming quarters. And that will provide, I think, some real stability in the provision or maybe even a touch downwards. We will see.

Bruce Van Saun

I think the credit outlook stays very positive both on the consumer side and in commercial, away from energy. It's been pretty quiet. So we will continue to monitor the energy portfolio, but with the recent increase in energy prices, we're feeling okay about that.

Brad Conner

Bruce, just one more comment on the auto book. First of all, we did make some operational improvements that we think is having an impact, but then also we've talked a lot about the SCUSA book which has reached beyond the peak of its loss curve. So we're starting to see those SCUSA losses trimmed down at this point. Of course, our purchases are a little smaller there, so that's contributing, as well.

Operator

And our next question comes from the line of Erica Najarian with Bank of America Merrill Lynch. Please go ahead.

Erika Najarian

I just wanted to understand how we should think about the impact of the $73 million to $90 million of PP&R enhancements that you mentioned for your TOP III initiative. You touched upon 3% operating leverage growth or rather, operating leverage being achieved and I'm wondering whether or not TOP III is going to continue to accelerate this operating leverage or it will support this level of operating leverage going into 2017?

Bruce Van Saun

I think the good news here is that we've identified another roughly $100 million as we did last year. So to us we now got to go get it, but we have very well-formed plans as to how we're going to do that. And it's really money in the bank, is the way I think about it. So the first objective we have is to make sure that we're managing the expense rate of growth wisely and in line with the environment that we operate in. And underneath that, we want to make sure that we're using some of the benefits that we find to continue to invest in areas that are going to deliver medium term growth.

So building up our fee-based businesses, for example and capturing that revenue opportunity. So it's really, I think we will get some immediate benefits in the second half of the year that will cover things like higher FDIC assessment. And then we will run that out next year when we do the budget process. We will see what kind of revenue environment we're in and we will manage the overall pace of expense growth based on that revenue environment while we're protecting the things we need to invest in for the future.

Erika Najarian

And my second question is on the ROT improvement from here. Clearly, excess capital, as you mentioned, is weighing on it. And, Bruce and, Eric, I'm wondering if you could give us a little bit of insight, in as much as you can, on how Citizens has improved in the DFAST and CCAR process in 2016 versus 2015 and whether as you look out into the future that gives you confidence, as well as some of the results of some of your peers, to continue to be aggressive in terms of your ASK.

Bruce Van Saun

I'll start and, Eric, you can chime in. But, look, I think in terms of the CCAR process, we're very pleased, obviously, that we have upped our game and we're making it through the qualitative side of it well. I think when you go back to think about how we were berthed from RBS one of the good things is we were berthed with a very high capital ratio which it has allowed us a lot of flexibility in terms of improving the bank and improving returns.

So we're kind of in a rich man's position now where we can have relatively strong loan growth, so we can use that capital position to grow the balance sheet, bring new customers into the bank and also at the same time we can have very strong distributions of capital back to shareholders. And that's been bringing the capital ratio down at around 50 basis points or so for the past two years, that strategy of having aggressive loan growth and strong returns to shareholders. I think we're calling out kind of a low 11% type ending point this year, down from maybe 11.8% when we started the year.

So, say, call it 60-basis-point reduction. And I think we could do that again, clearly, we have to go through the process, but the potential exists to do that again given that our peer capital ratios the median is probably around 10%. So we could do that maybe once, maybe twice again. But, obviously, we've got to keep running the bank better and we have to get our ROTCE up. We want to get to a sustainable position where sources of capital equal uses because eventually that excess that we have will dissipate. So that's how we think about it. Eric, maybe you can chime in.

Eric Aboaf

Yes. I think on CCAR what gives us the confidence there is that the investments we've made in the qualitative factors. There are seven major qualitative factors. We have reinvested and upped our game, as we've said and I think we feel like we really understand where the bar is. We know how to make sure we stay above the bar, if the bar flows up in either credit modeling or PP&R or controls or data.

Our view is we need to stay ahead and be ahead and we know what it takes to do that. I think what's also constructive in our CCAR results is if you look at the stress tests that are done. The credit stress that we see in our book and that the Fed sees in our book tends to be a little lighter than some of the other regional banks.

And so that higher quality of underwriting of credit and of mix, I think, bodes well for us because we have less, a slightly lower CCAR draw down on capital and that gives us some confidence that the payouts that we have put forward this year and what we might recommend next year make a lot of sense.

Operator

And our next question will go to the line of Scott Siefers with Sandler O'Neill Partners. Your line is open.

Scott Siefers

Eric, I was wondering if you could speak to some of the potential additional balance sheet optimization opportunities you might see? I feel like in many ways you guys have already done such a considerable amount, so just curious, your thoughts? And then just given the presumably more likely dynamic for lower for longer, any thought to altering the Company's rate sensitivity at all?

Eric Aboaf

Yes, fair question. I think the first thing I'd share with you is I think our initiatives in the businesses, whether I describe them as pricing or mix on the loan side continue to bear fruit. I think this quarter in particular you saw 2% uptick in yields, you saw it both in Consumer and Commercial. Some of that was the mix improvement that we continue to drive and I think we continue to do that. Some of it actually just came from outright targeting and we had some improvements in yields as we really gave benchmarking tools to our bankers in Commercial to make sure that they got the yields that we deserve. And some of it came from pricing in Consumer.

We actually wanted to slow down a little lending. One of the natural ways to do that is to take price up, you've got to do that carefully. But had about 15 basis points better origin pricing in auto on an apples-to-apples basis. So we think those initiatives will continue and we think there is potential to continue to drive those forward. And I think the same thing is true in deposits. We have to do both the tactics in deposits and we're also rolling out new product programs. We've got a great new product for [indiscernible] in deposits on the Consumer side and I think those kinds of initiatives will bear fruit.

I think more broadly on the balance sheet management and investment portfolio side, we're not uncomfortable with this level of asset sensitivity, though we do want to position around the curve. Post-Brexit you saw rates that 10-year at 1.35% and I'm sure the folks are clamoring why not just close down the asset sensitive position? Well, rates are at 1.6%, right, over the last day. And you'd say, hey, good treasurers and smart managers of a Treasury portfolio will look for rates in a range and choose how to position.

I think you've also seen mortgage basis widen out over the last couple months. The provides an opportunity because we earn money in Treasury both on the duration position and on the mortgage basis and we can adjust which one we emphasize which ones we deemphasize. And then I think you will continue to see us do work around optimizing the liability side of the balance sheet, right, with an upcoming sub-debt redemption that we've planned, that we have previously announced, $500 million. And I think actions like that should help and help offset some of the lower for longer headwinds.

Bruce Van Saun

I would just add to that when you think about where we're playing, what we're trying to do is be very, very disciplined in how and where we play, particularly on the Commercial side. And so we're kind of making sure that we can get good yield, so good risk adjusted returns. But more than that, also making sure that we're playing on the basis where we can take in deposits and we can get the fee cross-sell. And so that's one of the things that we're constantly looking at trying to rotate is if there is an area, for example, the leasing business that we have is a bit light on fees and light on deposits and it had been a referral business that we were really dependent on RBS for large ticket referrals.

We're refashioning that business into something that's more focused as a cross-sell product into middle market customers so we can make it part of this whole relationship. So that is some of the continuing work that is taking place.

Operator

And next we will go to the line of Ken Zerbe with Morgan Stanley. Your line is now open.

Ken Zerbe

So I thought slide 12 was actually really interesting, that you are getting meaningfully higher loan yields on Commercial. When we look out for the net interest margin into 2017, right, I know you mentioned, Bruce, I thought you said that fourth quarter is going to possibly remain stable given the swaps running off, but how should we think about margin into 2017? Just given where rates are now, is it fair to assume that we should see a couple basis points of additional pressure per quarter or are there other offsetting factors that make keep it a little more stable?

Bruce Van Saun

I think, Ken, it's a little early to call out any guidance on 2017, but if you look at the trends that we've had, the focus on shifting the mix, being disciplined on pricing, disciplined on deposit side has served us well. So we have, I think, probably when you think about any rate benefit this year, we had some lift from the initial Fed action in December and a lot of that is given back from the flattening of the curve as you go through the year and the thing that has propelled the NIM higher has been some of these self-help actions and this discipline we have had.

So when we think about 2017, that's what the game plan is to continue with that as we go into next year. It certainly would be helpful if the Fed starts to move again. It's interesting that right after Brexit it looked like that was completely off the table for a couple of years and now that markets are saying well maybe not so fast on that one. So, anyway, we can't control that, but we want continue to influence the things that we can control.

Ken Zerbe

And then just really quick, on commercial real estate, obviously, strong growth this quarter, given some of the discussion or debate around commercial real estate, competition, pricing terms, does that sort of seri competition change the way that you view growing seri near term?

Bruce Van Saun

I'll start with this and let Don pick up. I think partly the reason we have had the good growth in commercial real estate is, I like to say that we had the shop closed line on the storefront as part of RBS's downsizing of its commercial real estate exposure globally. And we've been able, as we've gone independent, just to turn that sign around, if you will and say store is open. And so the folks that we basically put and do business with for a while that we've now welcomed back and they are happy to have us back in the rotation giving us swings at the bat.

So I think we've had a good opportunity to kind of reestablish that we're in the game and we've taken advantage of that. Having said that, we have been very disciplined in terms of T&Cs and there is hot sectors of the market, if we think they are too hot, we just pull back from. But, anyway, Don, why don't you give some more color?

Don McCree

Yes, I think that's exactly right, Bruce. We've been going quite rapidly over the last couple years in real estate and we continue to see just huge opportunities in that market. As Bruce said, we're definitely being more selective in areas like multi-family and that's allowing us to get better terms, better pricing and continue to grow the book. But I think you'll see a growth slightly slower than it has in the past couple of years, but we're seeing interesting opportunities. And with some people pulling back, we're able to do transactions which are attractive to us and we're being very disciplined on it.

Operator

And our next question will go to the line of Jason Harbes with Wells Fargo. Your line is now open.

Jason Harbes

Just wanted to drill in a little bit on the fees. It looks like you had a record quarter in capital markets, so just wondering how sustainable that is and then within the context of the low-single-digit improvement that you expect in the third quarter which areas would you expect to see that improvement coming from?

Bruce Van Saun

Don, why don't you take the first part of that and then we'll go to Eric.

Don McCree

So we did have strong and broad performance in capital markets and in interest rates on the back of the Brexit event, so we feel very good about the ability to capture the opportunity which exists in our franchise which has been the strategy for the last couple of years to position for these opportunities. It's hard to see out long term in capital markets, but we feel like the capabilities are extremely strong and our pipelines are looking quite good for the third quarter. So we think it continues at least for the next quarter.

Bruce Van Saun

I would just add that is not just market. So the market, obviously, helps and the market had for kind of leverage credits in particular and the smaller deals had dried up in Q4 and for a good part [indiscernible] opened back up and that helps. But I think the bigger point here, as Don mentioned, is we've been broadening our capabilities and adding talent and we're in the position, really, to go out and gain market share, so that's been, I think, a key aspect to this.

Eric Aboaf

And then more broadly, Jason, on fee growth into the third quarter. I think we expect it to be reasonably broad base. Usually, there is a small tick up in service charges, just as volume slowed and household growth and business activity happens. Same in cars, third quarter typically a little stronger than second quarter. I think we expect continued building in the investments area. You saw $1 of sequential growth, we expect that to continue, potentially at a slightly higher pace.

I think foreign exchange, interest rate products, we will just have to see how the markets play out and capital markets in particular, whether we can sustain this pace or those come back a little bit. I think mortgages, we're seeing a bit of a refinance boom lately. You saw our applications up almost 40% quarter-over quarter. We expect some higher level of that given rate already in, the locks are coming through and that should bode well for mortgages. I think you'll see some broad-based improvement into the third quarter here as we look forward.

Operator

And our next will go to the line of John Pancari with Evercore. Your line is now open.

John Pancari

Back to expenses, I just want to see if you can help us a little bit with how this all comes together in terms of the efficiencies that you're targeting out of the remainder of the TOP II and then the TOP III. I guess, first, how can we think about the growth rate for 2016, that 2.5% to 3% range you had previously provided? And then, secondly, how can we think about the -- what the positive operating leverage goal means for your efficiency ratio? In other words, what's a way to think about where the efficiency could come out by the end of 2017 when you dial in the TOP III, particularly given that you're reinvesting a good portion of it? Thanks.

Eric Aboaf

John, let me take that. On the expense growth, you saw we had an uptick primarily due to timing and merit increases this quarter. We expect expenses to be reasonably flat into third quarter and fourth quarter. And so, part of what will drive that is you don't have the 401(k) match and some of the payroll taxes coming through again in third quarter, offset by just the natural uptick as we hire loan officers or capital market specialists or some of our investment headcount that draws the revenue growth.

I think when it comes down to it, we had 1% up in expenses first quarter year-on-year, 3% up expenses second quarter year-on-year. We're at 2% first half growth rate and, obviously, we're trying to stick as close to that as we can, but it's hard work. I think what we want to do is make sure that we control expenses on one hand, we reinvest on the other and really balance that and that's what we've been trying to--

Bruce Van Saun

And I think the net result of all that is you can see the year-on-year numbers we're 6.5% top line growth and 3% expense growth in the quarter. That's pretty darn good. And so we're trying to make sure that we're growing the bank, growing the top line and then making those investments and keeping a big spread.

The result of that also and you mentioned efficiency ratio, is we've had year-on-year the efficiency ratio drop by 2% from 67% down to 65%. And if we can keep that up, if we can keep delivering that operating leverage and keep investing in the avenues to grow that top line, that will be terrific and that efficiency ratio should continue to move down to the low 60%'s. That's where we want to get it.

Eric Aboaf

And the pace that you get that out is you think about how you model, right. You get 3% operating leverage just on a year-over-year basis. Effectively creates 2 percentage points increase in efficiency on a year-over-year basis. So that's kind of the -- how it calibrates and so, obviously, focus on operating leverage will continue and try to match this pace as best we can.

John Pancari

And then, my follow-up is just around the solid commercial growth, I know you mentioned it's the mid-corporate as well as some of the verticals. I just want to get a little bit more specific color around what's driving it and how much it is really in the some of the sustainable areas versus anything that's transactional in nature and may not be as sustainable going into 2017? Thanks.

Don McCree

I think, obviously, we're focused on cross-sell which is partly transactional, but the franchise is growing nicely. We've targeted the verticals that we've we called out, we've targeted mid-corporate, we've targeted the franchise finance area and they're all experiencing double-digit growth in terms of loan growth. And as Bruce called out before, our process is very disciplined as we grow our client base. We're focused on growing loans but growing loans at an acceptable NIM, at acceptable terms and conditions and where we see reasonably near term cross-sell.

And there's plenty of opportunity out there as other banks adjust their books of business and particularly some of the larger banks back away from some of the clients that they been banking. And we have, I think, the more opportunity than we actually want to bank at this point and we're basically balancing our growth levels with our return levels and we're doing it pretty successfully. So I think it can continue at a healthy pace into the balance of this year and into next year.

Operator

And next we will go to the line of Vivek Juneja with JPMorgan. Your line is open.

Vivek Juneja

So, Bruce, Eric, could you remind us, ROTCE trajectory now? You had a nice quarter, you went above 7% and how should we -- what do you expect on that front?

Bruce Van Saun

I think we're continuing to make progress. It was nice to see the big jump this quarter and we want to keep propelling higher. You get, you cross over 7%, you get to the mid-7%'s and you're next goal is you want to get to 8%. But we're still focused on that 10%. We won't get there in the original timeline we thought, largely because of rates, but I think the goal is to just deliver that positive operating leverage, deliver solid EPS growth and the ROTCE will move up with that.

Vivek Juneja

Student loans, you had good growth there. The outlook on that, do you expect that to continue at this pace? Can you talk a little bit about that?

Bruce Van Saun

Brad?

Brad Conner

We feel optimistic about continued outlook for growth in student lending. Strong demand for the refi product. We will, obviously, see a little bit of a bump in student loan originations in third and fourth quarter when we hit the seasonal peak for in-school, but all signs point to continued strong demand in the refi area and we expect that momentum to continue.

Vivek Juneja

And you're still [indiscernible] with the same credit focus metrics that you're seeing on that, Brad?

Brad Conner

Yes. Very strong. All signs are very strong with the credit indicators on both sides, in-school and the refi product in student.

Eric Aboaf

And, Vivek, remember, it's a very high quality credit focus. We're talking about 750 on one of the portfolios, 780 on the other. We're talking about undergraduates to colleges that you and others and we all went to, MBA graduate degrees, doctors, lawyers, business degrees, that kind of thing. So it's a very high quality book and it is part of, I think, of the economy where we're really making a benefit for consumers.

Actually, when we get fan letters, right, because we cut their payments by $135 a month which is a real benefit to them and we provide a real service and earn good return. So it's a real nice product for us and I think for the time being, for the next couple years we see it as attractive, attractive returns, not a lot of competition and whenever someone comes in we actually feel like that actually rings [indiscernible] to the market, as Brad said and we get even more--

Bruce Van Saun

Bring attractive new customers into the mix.

Eric Aboaf

Exactly.

Operator

And our next question will go to the line of David Eads with UBS. Your line is open.

David Eads

Maybe following up on some of the loan growth, comments you guys made. I'm just curious if you guys are seeing any changes in the dynamic or maybe opportunities related to some of the transactions that are in your footprint? It seems like there's a lot going on in your area. So, just curious what you're seeing on that front?

Don McCree

On the Commercial side, the market has been dominated so far, at least for the last 18 months by refinancing. And what we're waiting to see and what we hope to see with some economic growth is some new money financings and growth in borrowings by clients in our footprint and when I talk about that, I'm talking about our middle-market client base.

So if you look at our middle-market client base, underneath our loan growth, that has been relatively flat for about a year now. So we're holding our clients, but they are just not growing their demand for credit. So most of our growth has come in our verticals and in our national businesses and upside in the future could be economically driven loan growth within our middle market. But we're not seeing that right now.

David Eads

Sorry, I guess I was meaning the opportunities to get additional clients from dislocations at other competitors due to some of the M&A transactions going on.

Eric Aboaf

Yes, it is very competitive out there. We're seeing opportunities to bid new business. We have added some new clients. I think our client count from the beginning of the year is up about 100, ballpark. So it's not a massive addition of clients, but at the margin we're adding new clients. I think it takes a while for clients to switch. So some of the M&A that's been announced, while we may be talking to some of those opportunities, they're not going to switch their business overnight. It generally revolves around a maturity of a loan facility or something else going on with their coverage. And we haven't seen that materialize in size yet. But we're hopeful. We're actually talking to those clients about joining the Citizens family.

Brad Conner

Yes and that is certainly the same on the Consumer side. There's opportunity there for new customer acquisition and we're focusing on those areas in terms of some of our marketing efforts and even opportunities to hire great colleagues in those markets, we're focusing on that, as well. So definitely opportunity we've seen.

David Eads

And then, you guys called out the, somewhere around $25 million of reinvesting of the gains in 3Q for the implementing of TOP III. Are there going to be other implementation costs that come down over the next few quarters from that?

Bruce Van Saun

No, look, I think one of the things we're pleased by is that we've been able to generate the TOP improvement programs without a lot of restructuring. So without the need to burden capital with big charges. And we're self-funding this actually by creating the gain on the TDRs, if we need to use 20% to 30% of it which is $20 million to $30 million. I think that will pretty much cover it.

There is a more heavy expense element to TOP III, but there's also revenue ideas which really just require people investment or changes in processes. So there's no big investment that goes with that. And then the tax strategies we have are largely around tax credit programs which will throw off a little bit of headwind on the non-interest income line, but certainly benefit your tax line and give a net benefit. So, in any case, I think that's the extent of it. What we said we earmarked the gain, a portion of the gain to cover.

Operator

And our next question will go to the line of Kevin Barker with Piper Jaffray. Go ahead, your line is open.

Kevin Barker

I noticed that auto loans increased by roughly $200 million this quarter despite the pullback on the SCUSA purchases. You mentioned some strength there, some of that might be seasonality and you also noted some better pricing on your auto loans. Could you just give additional color on what you're seeing there on why that's growing in particular?

Brad Conner

Yes. Actually, I want to be really clear. Went Eric talk about better pricing what he means by that is better yield and better margin for us, not more aggressive pricing. We made a conscious decision to slow our growth there and look for opportunities to improve spreads and margins and we've done that but the demand remains remained quite strong. So I would attribute most of it to demand in the marketplace. We're expecting to see that growth taper down a little bit, maybe be more flattish in the third quarter, but just very strong marketplace demand is what I would attribute it to.

Bruce Van Saun

At a portfolio level, just to refresh the thinking, is that we've basically and I like this pun, you tried to put the brakes on auto and keep it relatively flat and go for the margin. And then we're allocating more capital to areas like the ed refinance loan and student, some of our unsecured products like Apple IF program or some new pilots on unsecured lending. So we're focused on yield maximization and I think you can't always hit the nail on the head, you try to keep auto flat, but as Brad said, it's robust in the market and we're just playing in the prime and super prime spaces, we're not playing in sub-prime. But there's still good activity there and good loan demand there.

Kevin Barker

And then in regards to your -- the balance between organic growth and the loans that you're purchasing, where do you think you will stand by the end of 2016 on the percentage growth that you can see organically versus purchases?

Bruce Van Saun

We have been moving that, migrating that well over 80% now and I think the only -- we've got -- I guess the SCUSA is really net neutral or winding down on the charge level of purchases. And SoFi on the student loans is the only thing where we're really acquiring at this point. But it's a relatively modest portion of overall growth because we're seeing such good organic growth.

Brad Conner

We were 90%, on the Consumer side we were 90% organic and 10% purchase for the quarter. So it certainly coming from organic--

Bruce Van Saun

The bigger loan growth and they are 100% organic. So it's relatively modest at this point.

Eric Aboaf

And the trends are, as you would expect, it was 80% organic in first quarter, well into the 90% second quarter and we like it in that area.

Kevin Barker

And then just, housekeeping, what was the ending balance of the upgrade program with Apple?

Bruce Van Saun

It's over $350 million.

Eric Aboaf

Yes, $360 million ending, $350 million average.

Operator

And next we will go to the line of Gerard Cassidy with RBC Capital. Your line is now open.

Gerard Cassidy

You guys show up pretty low when you look at how you are addressing your expenses to average assets to a peer group. Fee revenue or non-interest income still is not as strong as some of your peers. Have you given some thought about making acquisitions in the fee revenue area, not necessarily the depository, but companies that could help you boost your fee revenue as a percentage of total revenue?

Bruce Van Saun

I think, Gerard, we have been very focused on just running the bank better and putting the right foundations in place to really capture the opportunity we see right in front of us in terms of organic growth. I think when we feel that we've got that right, we certainly have the capital capacity to go out and look at some bolt-on acquisitions that could accelerate the lift off in fee revenues, but I think that's still a bit of the ways into the future.

Gerard Cassidy

And then second, if rates don't really move much over the next 18 months, you're making progress in the consumer banking profitability, as evidenced by this quarter's return on tangible common equity breaking 7%. How long will it take you to get to that number, bringing it close to the 10%, if you don't get any rate relief in doing it for the consumer bank?

Bruce Van Saun

I guess we're not calling out the milestones beyond this year. We're just giving our -- focusing our guidance on this year. If you kind of can use almost the past as a projection for the future if you say, as Eric said in his prepared remarks, we've lifted the overall Company ROTCE over 3% or approximately 3%, in under three years. And we haven't had any rate benefit to do that and so the formula of putting our capital to work wisely, growing the balance sheet, getting the top line to move, building up the fee businesses and being very disciplined on expenses, that's the formula. We're going to keep going with that formula and hopefully it will continue to propel us higher.

Operator

And next we will go to the line of Jesus Bueno with Compass Point. Your line is now open.

Jesus Bueno

Very quickly on the share repurchase, obviously, a great result out of CCAR this year. Just in terms of the share repurchases and the pace of them throughout this cycle, last cycle you seem to front load them and, of course, here you are below tangible book. I guess, in terms of pace, do you have any guidance on that of what to expect there?

Bruce Van Saun

One thing I would say is, the reason we front loaded them last year was we were helping RBS exit their position. So we were buying their stock back and we were still issuing their stock to the market, so we had no buyback program to the market. And we got them out of the stock in October which left us basically with no buy capacity from October through June 30 of this year. The good news is, now that we have authorization to buy $690 million, we're not going to repeat that.

Obviously, we're going to try to spread that out so we have some buying capacity in the whole, each of the four quarters. But, clearly, when there's events, when the stock gets washed out, like it did, when the market goes to risk offload we will step up and buy more. That's what any prudent treasurer would be doing.

Jesus Bueno

And just going back to the loan purchases, could you break out, what were the originations on the refi product for student? And, I guess, separately, what were the SoFi purchases during the quarter?

Brad Conner

Yes I do. The refi originations were $340 million for the quarter and SoFi purchases were also about $300 million, I believe.

Jesus Bueno

I just have one more, just on the provision. I guess, based on the 3Q guidance, you are actually running even below your guidance that you had initially put up for the year, so I guess, so how do you feel about your original guidance? Do you think we could actually come in below that for the year on provision?

Bruce Van Saun

It's a little early to say. I would just say that we've been pleasantly surprised. We were pleasantly surprised last year and the credit metrics remain very solid. So we will see how it plays out. At this point, we're just guiding one quarter at a time and we're calling for provisions to be broadly stable, but the skew could be more to the positive new side than the negative at this point absent any unforeseen changes in the economy or any SCUD missiles that could always hit you at any time.

Jesus Bueno

Fair enough. Thank you very much for taking my questions.

Bruce Van Saun

Okay. I think we're at the top of the hour here. Actually, we ran over by five minutes or so. But, again, I want to thank everybody for dialing in today and listening to our presentation and asking good questions and have a great day. Thank you.

Operator

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

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