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Cullen/Frost Bankers, Inc. (NYSE:CFR)

Q2 2012 Earnings Conference Call

July 25, 2012 11:00 a.m. ET

Executives

Dick Evans – Chairman and CEO

Phil Green – EVP and CFO

Analysts

Brett Rabatin – Sterne Agee

Brady Gailey – KBW

Steven Alexopoulos – JPMorgan

John Pancari – Evercore Partners

Dave Rochester – Deutsche Bank

Kevin Reynolds – Wunderlich Security

Emlen Harmon – Jefferies

Scott Valentin – FBR Capital Markets

Matt Olney – Stephens

Jon Arfstrom – RBC

Operator

Good morning. My name is Fiya, and I’ll be the conference operator today. At this time, I’d like to welcome everyone to the Cullen/Frost Bankers Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions). Thank you. I will now turn the conference over to Mr. Greg Parker. Sir, you may begin.

Greg Parker

Thank you. This morning’s conference call will be led by Dick Evans, Chairman and CEO and Phil Green, Group Executive Vice President and CFO. Before I turn the call over to Dick and Phil, I need to take a moment to address the Safe Harbor provisions.

Some of the remarks made today will constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 as amended. We intend such statements to be covered by the Safe Harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act 1995 as amended. Please see the last page of the text in this morning’s earnings release for additional information about the risk factors associated with these forward-looking statements. If needed, a copy of the release is available on our website or by calling the Investor Relations department at 210-220-5632.

At this time, I’ll turn the call over to Dick.

Dick Evans

Thank you, Greg. Good morning and thanks for joining us. It’s my pleasure today to review Cullen/Frost 2012 second quarter results. Our Chief Financial Officer Phil Green will then provide some additional comments and after that we both would be happy to answer your questions.

I am pleased to report another good quarter for Cullen/Frost. Highlights include 5.2% increase in period-end loans over 2011 and the best quarter for new loan commitments in four years. New customer relationships drove 13.7% increase in deposits and improvement in all credit quality indicators.

The quarterly earnings reflect our ability to operate effectively despite a sluggish economy, regulatory challenges and historically low interest rates. While we remain cautious about the economy and the anemic recovery, we’re grateful to our dedicated employees and our loyal customers for another solid quarter.

Our net income was $58.1 million or 4.3% over the $55.7 million reported in the second quarter of 2011. On a per share basis, we recorded $0.94 a share versus $0.91 during the second quarter of last year. Second quarter returns on average assets and equity were 1.14% and 9.95% respectively. Deposits continue to grow significantly. For the quarter ending June 30th, 2012, average total deposits were $16.9 billion, up 13.7% over the $14.8 billion reported in the second quarter last year. Throughout the recession, we have focused on building new relationships. Those new relationships account for a significant amount of the $2 billion and average deposit growth since the second quarter of last year. New relationships are the foundation for future growth, especially when the economy recovers.

As an example of our commitment to continue building customer relationships in Texas, we’re happy to say that today we have signed an agreement with Cardtronics , which allows Frost customers to access ATMs at all Texas Valero Corner Stores throughout the state.

Non-interest income for the second quarter of 2012 was $164 million compared to $159.5 million for the second quarter last year. This is primarily related to an increase in the average volume of interest, earning assets and was partly offset by a decrease in the net interest margin to 3.61%.

Non-interest income for the second quarter 2012 declined only 1% from last year despite a significant negative impact from the Durbin Amendment to Dodd-Frank. The Durbin Amendment negatively affected interchange and debit card transaction fee income by some $4.4 million from the second quarter of last year. Even so, we were able to make up much of the shortfall thanks to continued good performance in other areas. For example, trust and investment management fees increased 4.8% from the second quarter of 2011.

Insurance commissions and fees were up 16% from a year ago to $9.2 million. Non-interest expenses for the second quarter of 2012 were $142.5 million, up 4.2% from the second quarter of last year. Salaries and benefits increased 2.5% over the same quarter a year earlier as a result of normal annual merit and market increases.

Turning to loan demand. We had the best quarter for new loan commitments in nearly 4 years as the positive loan growth trend continues. Average total loans for the second quarter were $8.3 billion compared to $8.1 billion a year ago. On a period-end basis loans were up 5.2% to $8.5 billion. Year-to-date we have generated double-digit increases in the number of new relationships and new commitments over last year. Loan request are broad-based across all regions and across all categories.

Our current loan pipeline is higher than it’s been in 18 months. In addition to increased activity, the advance rate on our revolving lines has increased this year. So customers are using their lines more now than they were last year. While persistent economic uncertainty still clouds the lending environment, large and medium-sized company attitudes are moving to the positive side. This is natural because large companies are the first to borrow when conditions improve and they are the first to cut back when the economy heads south. Our focus on better teaming preparation and collaboration is paying off significantly along with our disciplined calling effort.

Our team alignment with banking, insurance and wealth advisory is a big deal, because once a customer experiences the positive and unique culture at Frost, the customers more likely than not to expand the product relationship to other products.

As long as the lingering economic uncertainty and poor policy decisions in Washington don’t drag the economy down too much more, our positive loan growth trend should continue in the third quarter.

Our credit quality also continues a positive trend that began two years ago. This is a fifth consecutive quarter for past due loans to represent less than 1% of total loans.

Delinquency is end of the second quarter at 0.51% of total loans and are at the lowest level since December of 2004. Non-performing assets decreased during the second quarter an $8.5 million improvement over the first quarter of 2012. Second quarter 2012 net charge-offs also declined compared to the previous quarter. Adequately reserving for write downs in prior periods along with better credit quality trends resulted in releasing of reserves.

Absent any significant changes in the global and national economy, we expect that our positive credit quality trends will continue. Capital levels remain very strong. Tier 1 and total risk based capital ratios for Cullen/Frost are 14.07% and 15.61% respectively at the end of the second quarter 2012. The ratio of tangible common equity to tangible assets remain strong at 8.94% at the end of the second quarter 2012. It was another good quarter for Cullen/Frost despite challenging economic headwinds.

We expanded customer relationships, increased loans, improved credit quality and managed expenses well. In June after more than a century, this is a National Bank. Our banking subsidiary finalize its moved to become a Texas State Bank. Our primary regulators are now in Texas rather than Washington, D.C. We anticipate better communication with our examiners and believe it is the right decision for our company. Even though our legal name is changed to Frost Bank. Our customers can still count on both FDIC protection on deposits and our commitment to operate, one of the strongest banks in the nation.

Before I turn the call over to Phil. I’ll close with a few comments about the economy and my continued optimism for Cullen/Frost. We mentioned previously, that 2012 would be a volatile and privileged year. Due to the presidential elections in November, and other factors that create uncertainty for businesses and the economy, nothing has changed in that regard.

The U.S. Supreme Court, surprising decision on the healthcare law, merely prolong the uncertainty surrounding the legislation until and after the November elections. The upcoming 2012 general election will provide important clarity of future decisions. And on the role and scope of government in our society. Much uncertainty exist in Europe which will continue to cause unpredictable gyrations on the stock market, with 3 consecutive disappointing monthly job reports.

The U.S. economy is limping along and a very weak recovery. Fortunately for Cullen/Frost, the Texas economy continues to outpace the national averages. Job growth in Texas is now projected to be 2.5% to 3% about twice that of the U.S. Unemployment in Texas is also lower than the national average. Texas is one of only nine states that have recovered all the jobs it lost during the recession. And Texas has added far more jobs than any other state since May of 2007. CNBC named Texas, the number one state for business while five of the top 20 cities and Forbes recent list of the best places for business and careers were in Texas.

Cullen/Frost is blessed to operate in a business friendly state like Texas. Although the banking industry continues to face regulatory challenges with hundreds of rules related to Dodd-Frank still to be interpreted. We moved forward with confidence, and our value proposition and unique culture.

We continue to focus our marketing efforts on increasing brand awareness to help more Texans understand the cost difference. Our decision to publicly turn down (inaudible) resonates well with customers and prospects, along with 21 granted associate awards Frost Bank won this year for excellence and business banking and treasury management.

For the third consecutive year, Frost Bank ranks highest in Texas and JD Power and Associates, US Retail Banking Satisfaction Study and we were one of only 50 US companies across all industries to be recognized as a JD Power 2012 customer service champion. I’m grateful for our dedicated employees who treat our customers the right way and hence make our success possible.

In summary, there was another good year for going for Cullen/Frost. We grew loans in all regions, across all segments, we increased our customer base and deposits significantly. Our capital levels are very strong and we have money to lend. Our credit quality is the best it’s been in US and continues to show a positive trend for the future. We’re grateful to be in Texas, where the economy is stronger than the national averages due to the business-friendly policies.

Our new state charter allows us to have better communications with our primary regulator, our outstanding customer service is recognized and validated by multiple third party agencies. We have increased our dividend annually for the past 18 years and we continue to deliver consistent steady superior financial performance for our shareholders.

And with that, I’ll turn the call to Phil Green, our CFO.

Phil Green

Thanks, Dick. I make just a few comments regarding our net interest margin, deposit growth, our capitalization versus the Fed’s new Basel III proposal in our earnings outlook and then I’ll turn it back over to Dick for questions.

Firs regarding NIM, it was down 12 basis points from the first quarter and that change included a number of factors. As usual, strong deposit growth was a major factor on the margin in terms of impact, it reduced by 9 basis points and so our core margin was down by more or like 3 basis points.

And looking at the core components declines in both our investment portfolio and our loan portfolio, yields each reduced margin by about 4 basis points. Partially offsetting this was growth in our average loan balances during the quarter, which improved margin by about 5 basis points. At a core level given the current interest rate environment, I think this is the margin interplay that we are going to continue to see pressure on yields with the offsets coming from well we can in pour excess liquidity into the loan portfolio. So in that regard, it was really good to see the traction that we generated in the second quarter with regard to loan growth.

Turning to deposits. As Dick mentioned, average deposit growth was very strong and continue to trend for us. Overall deposit growth was up by almost 14% from last year. Well, on a linked quarter basis, we were up annualized 12%. However, demand deposits were up by 25% from both last year and on a linked quarter annualized basis.

Now looking at the composition of our total deposit growth for the last two quarters, we have reported that about half of our annual growth had come from new deposit customers and half from net balance augmentation from current customers. And this quarter, it was more 60:40 in favor of the current customer growth, not so much because of a change in new customer growth as it was a spike in our current customer balance augmentation. So at least in this quarter it appears and we’re seeing our customers build their liquidity at a higher rate.

Dick mentioned earlier, how our deposit growth from new customers is reflective of our success that we’re having building new relationship, and I believe, that’s true. And as evidence of that, I’d point out that new deposit customers over the last 12 months currently have over $0.5 billion in loans outstanding with the bank in diverse segments of our portfolio.

Now, I would like to talk about the company’s capital position in relation to the (inaudible) recently proposed rule for implementing Basel III.

In summary, if the proposal were fully phased in today as though we were in 2012, Cullen/Frost would be significantly in excess of the record ratios. This includes both the Basel III changes to watch included in capital, as well as the standardized approach proposal, which changes the computation of risk-weighted assets.

Finally, relative to our outlook for the rest of the year, we currently feel like a range of earning somewhere at or a little below the current average of analyst estimates is reasonable.

And with that, I’ll turn it back over to Dick for questions.

Dick Evans

Thank you, Phil. Well, now I’ll be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question will come from Brett Rabatin with Sterne Agee.

Brett Rabatin -- Sterne Agee

Hi, guys, good morning.

Dick Evans

Good morning.

Brett Rabatin -- Sterne Agee

I wanted to ask on the loan portfolio growth. Can you give us a little more color around -- it sounds like that was mostly in some larger corporate relationships. Can you give us some color around that, maybe, give us a sense of what kind of yields you’re adding to the portfolio, and then the Q is not out yet, so I don’t know if you have handy the yield on the loan portfolio as well as the MBS and the muni books as well?

Dick Evans

Let me tell you a couple of things and we can talk a little bit about yield. Yeah really there is no doubt we had some good, large increases in our growth, but the -- I would point out to you that I’m extremely pleased with the diversification, it’s mainly C&I loans is where the growth came, we did make some new commitments in commercial real estate that will see part of the growth come from that.

But if you will look at our new commitments, the first quarter versus the second quarter, it’s interesting that quite frankly, while the first quarter was very strong in 10 million and over, quite frankly they were pretty flat in the second quarter, but less than $10 million were up 20% the first to second. If you look at -- it’s much more balanced, if you look at year-to-date new loan commitments of over $10 million are up 35% and under $10 million are up 24%.

So both -- to your point, both are growing and certainly the bigger dollars, energy is a big part of it, certainly the energy loans have grown and the other thing that’s really important is the increased usage in lines of credit that I mentioned in my statements, but it represents about 50% of our growth and that’s really important to see our customers and the new base of customers as well as the ones we’ve had for years starting to borrow, as Phil pointed out to you how in the last 12 months the deposit growth and $0.5 billion coming from those.

So we talk to you a lot about how building these long-term relationships are important to the foundation and we’re already seeing that growing. So we’re -- I’m pleased with the diversification, there is no doubt there’s challenges in pricing. It’s a crazy market. As you know, we’re at zero interest rates and it’s hard to find any place to go, whether you’re an individual or you’re a good strong company like ourselves. So I’d let Phil comment on this.

Phil Green

Yeah, I might just make a couple of additional comments in response to your -- other parts of your questions. As Dick said, pricing has been very competitive. I think, if you just look at new and renewed loans, I think, probably last quarter we’ve, probably, ran a little over 100 basis points or so in terms of spread to prime on new and renewed loans, our estimate is somewhere around 85 basis points in the current quarter. So you can see things are tightening up somewhat.

If you just look at the overall portfolio yields, the loan yield was down about 9 basis points for the quarter, it was at 4.94 in the first quarter and it’s a 4.85 in the second quarter. You asked about the investment portfolio, it was down somewhat as well, it’s down 10 basis points. It went overall from a 3.37 in the first to a 3.27 in the second.

And we didn’t really have any change in the municipal portfolio party, it was fixed at 6.94 for both quarters, a little over $2.2 billion in both quarters. And there was pretty consistent in terms of $6.7 billion in the taxable portfolio for both quarters, but it did go down from the 2.23 to 2.11 in the second quarter. So that’s what I mean what I did with regard to the loan and securities portfolio and continue to see some contraction to those yields, which we’re going to in this interest rate environment.

Brett Rabatin -- Sterne Agee

Okay. And then just quickly, just wanted to ask, if I understood your guidance correctly, it sounds like those factors you just mentioned would probably result in the margin going down a little bit despite you deploying, maybe, some liquidity into the loan portfolio?

Phil Green

Well, let say, surely the lower portfolios put pressure on margin, it just depends on how much we grow loans to whether or not we’re going to see growth in net interest income. I mean, I think, we’ve got the opportunity to grow net interest income [sum] [ph]. So I’m not going to sit here and tell you that it is going to go down, because I don’t know that. I think we have the opportunity to grow –again it depends on how good a job we do on increasing our volumes here.

But like I said in my comments, I mean, that’s the interplay, I mean, we’ve got the -- we can’t replace the yields that are coming off of these portfolios. And but we can’t do better than 25 basis points in the fed account to the extent we put out any good high quality loans and that’s what we’re trying to do.

Brett Rabatin -- Sterne Agee

Sure.

Dick Evans

I just want to remind you, it’s important to remember that we’re not a transaction organization of just making loans. We don’t -- we make loans to people that we have relationships with and it’s really important, we’re growing deposits at the same time we’re growing loans.

Brett Rabatin -- Sterne Agee

Okay. Great. Thanks for the color.

Dick Evans

Thank you.

Operator

The next question will come from Brady Gailey with KBW.

Brady Gailey – KBW

Hey. Good morning, guys. I was just, I had a quick question to start off. Were there any loan participations that were purchased in the second quarter that might push that and the period loan growth up?

Dick Evans

Not really. Our shared national credits overall are up from the third quarter, pretty significantly and we’re still running 65% shared national credits in energy.

Brady Gailey – KBW

But nothing really to speak of?

Dick Evans

I think there is only one that we’ve got, that I would say if that’s your question.

Brady Gailey – KBW

When you look at the reserve, it’s come down, if you look over the last probably year and a half you’ve taken it from 1.55 as a percentage of loans, down to about 1.25 now. How low do you feel comfortable taking that reserve ratio or do you think at 1.25 the loan loss reserve release is pretty much done?

Dick Evans

Well, how low are classifieds going to go and how long are delinquencies going to be because it’s not - certainly, you got to remember it’s all formula driven. I think when we focused just on the percentage, that’s not the answer. The answer is the reason it’s come down is because classifieds have come down, all the indicators have improved. Now, sure, things can flatten out somewhat, but we really don’t, we just watch the formula and what’s happening to the classifieds.

Brady Gailey – KBW

Okay. And then lastly for Phil. Phil, do you have any upcoming plans for the bond book, are you going to deploy any more cash, or can you give us any color on kind of what you’re thinking over the next quarter or two for the bond book if there is any changes on top?

Phil Green

I think we’re, we’ll be employing some just because liquidity continues to be up. But I think it’s going to probably be more limited in terms of dollar amounts, that probably see us taking advantage of the municipal market more than anything else, but it, but they would not be huge amounts. We did, we did what was it 2, 2.5 billion in the fourth quarter, we did another 1 billion in the first and that was just the 2 years more defensive move. So you’re not going to see those kind of moves, but I think you’ll be seeing an opportunistic movements kind of things, that we see value and such as new news for example. So that’s the kind of thing we’re doing.

Brady Gailey – KBW

Okay. Thanks, guys.

Operator

The next question will come from Steven Alexopoulos with JPMorgan.

Steven Alexopoulos – JPMorgan

Hi. Good morning everyone.

Dick Evans

Good morning.

Steven Alexopoulos – JPMorgan

Given the strong pickup in loans outstanding and even the commitments from smaller borrowers. Can you give us a sense of what’s really changed from the past few quarters’ right to pretty notable pickup. Dick you give in your comments that customers continue to build liquidity.

Dick Evans

Well, one of the banks. Don’t forget how hard our staff has been working for years. I mean every since we went end of those great recession, we’ve been working extremely hard. And as I mentioned, may not see much to year. But this teaming and collaboration and how the alignment of the banking and insurance and wealth advisory is really working. And, I think it’s just a lot of hard work. It’s also, there’s no doubt we’re in a good market.

Yeah, just to give you an idea. I was looking at some statistics from the play, the Eagle Ford impacts, they launch some lease payments just to release plans are estimated over the past several years to be $7.5 billion. And in the Eagle Ford and about $1.6 billion in royalty payments in 2011 and there is I watch that rig, the rig count and that runs around 270 rigs that might grow up to 271 and down. So you’ve got -- there is something to be on business friendly. In addition to all our business, we’ve got good diversification and across all industries and the customers are starting to come back in and start buying. And they realize, that the quality of our company.

The other thing that I think we’re seeing, we’re poling some business which we’re being doing because we’re hustle and heart, there is no doubt the larger credits are more optimistic than the smaller ones. This is a Congress and all of the things that are being done over the last year, we’re regulating this company. I was talking to an air conditioning guy and his biggest cost was regulation.

You pick any part of it so we’re squeezing the middle market guy out, but we’re trying to help him, we’re trying to work with them and we’re aggressive in that, and I think the trends continue to look in order if you look at the trend in revolving credit lines, the growth in commitments is up 11% and the growth in balances up 15%.

These are year-to-date numbers and so the advance rate is starting to catch up with these commitments and we work hard to put on our books. If you look at construction loans, quite frankly the commitments are up 56% year-to-date and the annualized outstanding growth is up 54. So I think we still have -- now we have some momentum of the advanced rate on construction loans continue. Now the -- the advance rate on with revolvers was real high in May, came down some, but it’s still very low, we’ve been -- we had a low 40.19% advance rate in May, we had a higher 42.75%, down to 41%, but all those numbers are low, you would normally run in a normal world, which we don’t have one right now, you’d run about 50%. So if -- people want to grow, if we get the government out of business, we could really show you something.

Steven Alexopoulos – JPMorgan

Maybe to follow-up on that, banks in other markets are starting to talk about maybe a slowdown on loan demand tied to some of the issues you talked about, fiscal cliff etcetera. I’m curious, you know as you’re talking to your customers, are you sensing any shift in tone, are they just insulated from this because Texas is so much better off?

Dick Evans

Well, there’s no doubt when you got a better economy, you’re going to yeah, it is not, it’s not just about attitude, its more business in Texas. And there’s more businesses moving to taxes. We grew -- I think it since ‘07 Texas grew 4,1000 jobs and number two was New York State at 88,000. So there is a big gap and so there is activity going in that regard. So -- but also you heard me say, we’re still cautious, I mean it’s a crazy world and we’re not a separate country and not that we might not like to be, but it’s -- we are affected by all the craziness going on in Washington.

Steven Alexopoulos – JPMorgan

Okay. May be just one final question on a smaller issue, Phil, the other non-interest income is running in a little over $6 million, which is the second quarter in a row it’s off pretty sizably from the prior-year level. Is this a new run rate or is there anything in there pushing that down. Thanks.

Dick Evans

Well, I think we, I know we did break out the interchange fees, you’re not adjusting for that, are you?

Steven Alexopoulos – JPMorgan

No, I’m just looking at quarter-over-quarter, the other line, the $6 million.

Dick Evans

Well, I think the biggest thing that affect us on other income first and second was, we had 1.3 million in mineral interest income from some one-time non-recurring bonuses on some properties that we own in the holding company. So that move that moved down. So that was the biggest item that affected us there, that’s the nature of others, it’s going to move around, there are cats and dogs in there. And so I don’t think there’s anything to be said about the trend other than the numbers are what they are, it’s not like we looking at interchange or insurance commissions, I’m sorry for not having better insight.

Steven Alexopoulos – JPMorgan

Okay. I appreciate, I appreciate it.

Phil Green

Let me just give you one other comment. There’s nothing magic behind here, there’s a lot of hard work. We’re fortunate to be in Texas. If you look at the last five years, California lost 900 jobs, while Texas added more than 400,000. So there is just more going on here. So you’re going to have our customers a little better, sure a lot of them are doing whatever by across the nation, a lot of loan growth is coming from just replacing technology and doing the necessary things and equipment, machinery, those kind of things. But if you look at the statistics of the growth of the state, the state as a whole has been working hard to attract businesses and make it attractive and we had Cullen/Frost. Our staff work really hard to build customer relationships and we’re continuing to.

Steven Alexopoulos – JPMorgan

Okay. Thanks.

Operator

The next question will come from John Pancari with Evercore Partners.

John Pancari -- Evercore Partners

Phil, could you talk about the similarly I guess, can you talk about the cats and dogs in the other expense line, it looks like that popped back up to about $36 million this quarter, down from or up from $33 million last quarter. So if you can just give us some detail, looks a good run rate there?

Phil Green

You’re talking about on a linked quarter basis or the year-over-year?

John Pancari -- Evercore Partners

Linked quarter.

Phil Green

Linked quarter basis. Weather a couple things, one is there are just some various write-downs that we had whether they are OREO or bank assets, but it was the biggest factor, we had a -- we had an increase of 1.7 million and just write-downs of that type from the previous quarter and then the second thing is our advertising and promotions were up about $1 million from the previous quarter, they’re a little bit light in the first quarter from what the run rate was going to be for the entire year. So we saw really that was the lion share of the two increases.

John Pancari -- Evercore Partners

Okay, all right. Go ahead.

Gregory Parker

I was just going to say, so in terms of looking at what the growth rate would be in those two, I don’t think you’re going to see a similar growth rate on advertising dollars. I think we’re at a fairly good run rate now moving forward and I think the write-downs that you’ll see you’re sort of one -- more one-off things and so you’re not going to see that as well.

John Pancari -- Evercore Partners

Okay, that’s helpful. And then in terms of the margin, I know you’re -- seems like you’re implying some internal compression based on what you’re saying. But the -- can you talk about the magnitude that we could expect in terms of -- at least in terms of the impact on -- from the core drivers that you mentioned, I mean, could we see another eight basis point here next quarter just from this core components?

Phil Green

Eight basis points from the core component next quarter, well, I mean, I think we’ll probably see some compression. Do I think we’ll see the same level of core -- I hope it’s not nine basis points to core, I mean likely this time it was what, three, I mean we had core (inaudible) to drop, so we have some good loan growth, so we sort of offset those two and again, we’re not talking about the deposit growth factor because there is going to be some of that. Hopefully it will be nine basis points, but it could be something because again you’ve got those factors that are working against each other.

John Pancari -- Evercore Partners

Okay, all right. And then lastly, can you just help us maybe with the magnitude of the expected impact from the Basel III NPR, I know you mentioned that you remain well above minimums, but I want to get an idea of the magnitude you would expect on regulatory ratios.

Phil Green

Well, just to give you a feel, without -- I’d say just in general, these are not -- I’m not going to give you exact numbers, but it’s going to be at least this, okay, John? So (inaudible) Tier 1 leverage, I think will be around 5% over what that number requirement is for 19 -- for 2019. On the -- you look at total capital, will be, say around 300, excuse me on -- total capital risk-based assets will be something like 450 basis points over what the requirement is there, Tier 1 to risk-weighted assets, again, probably around 450 basis points or so, and about 500 basis points or so, our Tier 1 common to risk-weighted assets mean. So we’re solidly in the teens on those risk-weighted assets. Is that giving you any help?

John Pancari -- Evercore Partners

Yeah. That’s helpful. All right. Thank you, Phil.

Operator

The next question will come from Dave Rochester with Deutsche Bank.

Dave Rochester -- Deutsche Bank

Hey, guys. Thanks for taking my questions.

Dick Evans

Sure.

Dave Rochester -- Deutsche Bank

You talked about potentially be a little more interested in growing the muni book, maybe not much, but I just wonder what the yields are in that arena? And then, if you could talk about as you sustain the size of the taxable book, what you’re buying there and where you’re seeing the yields today?

Dick Evans

We’re not really buying, I think, the taxable side. I mean, the yields are -- you can see like I do, they’re terrible. That’s not really an area that we’re looking to see value right now. If you look at muni it depends on who are you buying on the curve et cetera. I think tax equivalent rates you’re looking at something around in the flourish range, it’s kind of what you buy moving to -- stick to very high quality at Texas PSF insured. And -- but we’re going to look to make sure we get value there, I mean, the muni market has been extremely strong like all the others, particularly as Phil talks about continuing with QE whatever. And so anyway that’s what I’m seeing.

But, I mean, you can look at screen just like I can and that is probably different today, right.

Dave Rochester -- Deutsche Bank

Yep. And then just a revisit a question on the reserve ratio from earlier, perhaps, from a different angle. And looking back, it looks like the reserve bottomed around 114 free cycle, around 124 now, is there any reason that could go below that prior bottom, is it the reserve methodology changed at all or this makes anything like that.

Dick Evans

You can go below it. It depends on what -- what assets do. Again, it’s not about the numbers, but -- the quality is just improving, thank God.

Dave Rochester -- Deutsche Bank

Yep.

Dick Evans

We continue to grow loans, we’re going to needle a reserve for that, just in the unallocated. So that pulls the other direction. And so...

Dave Rochester -- Deutsche Bank

Okay.

Dick Evans

I mean, you’ve got a formula that we’ve got to be consistent with and the things continue to improve. I know, it’s going to just require less. I mean, we don’t have any interest in making the reserve low, I mean, I’ll say that. I mean, we’d like to keep a strong reserve, I don’t think always (inaudible) strong reserve, but we just got a lot of the rules that we have in place and so we don’t -- we’ll make predictions about what it might do, where it might go, I mean, we’re going to have a strong reserve and it’s going to be in accordance with our formula and so and that’s our orientation.

Dick Evans

Yeah, you know -- the world changed, I mean, if you don’t follow the formula and the disciplines and be consistent with it, you go to jail. This -- this is a tough business as it is, but I don’t know.

Dave Rochester -- Deutsche Bank

Yeah, I hear you. Just one last one. I remember you’re saying there might be a little bit of a cost benefit to switching regulators, have we already seen that in 2Q or is that coming in 3Q and how much would that be?

Dick Evans

Well, yeah, there would be, as it turns out there is a cost benefit. But as I said before -- well, first of all, let me answer your question. That would be a third quarter eventually we began -- I think the way it ended up was somewhere between, I think 1.3 million to 1.5 million. But honestly, as we said before, what we plan on doing is really plan on those benefits back into our business to improve what it is that we’re doing, proving our value proposition, proving our relative market position at this time because competitively we just feel we just start out -- it’s a great opportunity for us given where we stand in the State and everything that we’re in.

Phil Green

Don’t forget the real cost benefit is not having to sit and answer a bunch of stupid questions, like what we’ve been going through. That was a lot of times.

Dave Rochester -- Deutsche Bank

Got it. Sounds good. Thanks guys.

Operator

The next question will come from Kevin Reynolds with Wunderlich Security.

Kevin Reynolds -- Wunderlich Security

Good morning, that was great, Dick, good quarter. I have a question for you, couple of one, you probably already addressed this, I got on the call a little bit late, competitive environment, in the past you’ve talked about other banks kind of lose or getting back to sort of the crazy terms and structures out there a little bit sooner than you would of thought coming out of the -- given the magnitude of recession. Did you address earlier on the call and if you did, I apologize, could you just kind of go through that again what you’re -- what you’re seeing out there competitively?

Dick Evans

Well, they’re still crazy. They are -- we’ve seen the ratio come down to a 50:50, it was right about 60:40, 60% of the benefits we’re losing to price and 40% to structure. It’s changed back to 50:50 so that means their lower-end credit standards and doing those kinds of -- it’s a real competitive environment and that’s the reason the culture and the value proposition, people are starting to pay attention, and that’s the reason for a lot of our growth of the quality of service, I get at this company. And the value, they get more value. And so you got to be competitive, we know that, we are -- we’re growing loans. We’re totally committed to not do drop the structure down or you just put in bad loans on the books. And I think there is a little bit of that going on. I don’t think it’s going on with us. So it’s big time competitive.

Kevin Reynolds -- Wunderlich Security

Okay. And I wanted to ask a bigger picture question, as well. You guys haven’t changed. You’re still Frost and you’ve been Frost forever and I’d be shocked if you want Frost in the future. On other side of the table, we tend to focus way too much on extremely short term oriented things out there. But if you look back sort of 5 years ago, you guys in a different environment. I know where, you’re on sort of 160 or away 460, 470 net interest margin, very high ROE. If you look outside of the years and the rate environment changed. Is there any reason do you think that you guys couldn’t be have numbers that would approach that again down the law and along with some pretty strong commercial loan growth out there.

Dick Evans

And certainly our goal, and I think the key word you said is approach. Phil I’ll let you join.

Phil Green

As we’ve said many times and it’s still the case today. I mean first importance look, I mean we had really good loan growth that we’re beginning to see. But with that we’re still 49% on the deposit ratio and what you talked about earlier on the returns you are referring to we had a loan deposit ratio of 80%, 3 years ago. So I think once we get back to you, a repair in the relationship between loans and deposits to what it is on a more normal basis yields. You’ll see the kind of profitability that we think, we should be reporting. I mean, but we go correlated support 115 or whatever that is way, that is way below the earnings capacity this company.

And whether it happens to be a 165, like it was 3 or 4 years ago whatever it was or something just a lot higher than it is today. I mean the point is that it’s, there is tremendous operating leverage that exists within this company. Our job is to take advantage of it, do what Dick has been talking about this is the hard work of growing relationships, whether it’s the sloughing money back into our business at a time that is it’s tougher for a lot of people, but we have the advantage.

Given our profitability and our reputation in our value proposition to state in another week -- can do things like expand or advertising budget like we’ve done, so significantly in this period of time. Dick mentioned the ATM arrangement we have with Cardtronics and Valero, we’re going to the number three largest ATM network for free for our customers in the State of Texas. So we’re going to have over a thousand ATMs that our customers can use for free at Valero Corner stores, which is a great brand that we’re going to leverage along with the great brand Frost has.

So one of those barriers to entry that’s always sort of been there that that sort of, well, you don’t have I love this, I don’t love the big banks, but I kind of need to be there because they get so much ATM care, I don’t want to lose that and that’s off the table, now we’re taking that off. So those are the kinds of things we’re doing to continue to move this Company forward and as long as we, as long as we get to where that normalized balance sheet is with relations of loans deposits over time with good loans and we’ll be able to do all the stuff and significantly improve our profitability.

Dick Evans

I’d just add to the same, those are all the things we’re doing, we’re just running the business, the best we can. We’ve got great people, wonderful culture and that makes a difference. It’s hard to go against the insanity of Dodd-Frank and the cost of this regulation and the fear that Washington has put into the business man to the extent that he didn’t want to borrow money. Those are the headwinds and we’re just going to keep riding our bicycle into those headwinds and take good care our customers despite that insanity.

Kevin Reynolds -- Wunderlich Security

Okay. And so, so that environment will sort of wax and wean overtime, but I mean if to the extent that their folks out there in the media or whatever they suggest that the banking sector can no longer earn adequate returns and therefore they’re all over value would strongly disagree with that.

Dick Evans

Well, I don’t

Kevin Reynolds -- Wunderlich Security

As it relates to the --

Dick Evans

I don’t speak for the market. But I’ll tell you the profitability this company is not what it will be and we have tremendous operating leverage to employ over the next several years, as things normalize and improve.

Kevin Reynolds -- Wunderlich Security

Okay. Thanks a lot. Good quarter.

Operator

The next question will come from Emlen Harmon with Jefferies.

Emlen Harmon – Jefferies

Hey, good morning. Just, just one kind of small question left. On the, you talked about the securities yield already being a bit of pressure on the margin. Could you give us a sense in that yield number whether it’s just kind of any MBS prepays or amortization of premiums on the, on the MBS that were a bit of an added weight there, if there is any potential for that pressure to kind of lift over time?

Dick Evans

Well, I mean, yeah. We do have a fairly sizable MBS book, I think, it’s about third of the portfolio. So if you look in the second quarter, I think, we amortized premium of about $3.5 million and that was pretty much in line with what the first quarter was, I think, we had $3.3 million in the first quarter, and that’s up. I mean, if you go back to, say, second quarter of ‘11, premium amortization was $1.3 million. So yeah, I mean, it’s up.

I don’t know, if we would see a lot more, I mean, speeds are pretty high today. But -- and that’s kind of what you’re looking at on the premium side. Is that healthy?

Kevin Reynolds -- Wunderlich Security

That does. Thank you very much. I appreciate it.

Operator

The next question will come from Scott Valentin with FBR Capital Markets.

Scott Valentin -- FBR Capital Markets

Hi, good morning. And thanks for taking my questions. It’s just two questions. One, you mentioned competition is intensifying. I’m just wondering, you called out kind of greater than $10 million, less than $10 million in terms of, I guess, loan origination. Just wondering, if you’re seeing more competition on the larger loans versus small loans?

Dick Evans

It’s everywhere. I mean, you’d be slicing the (inaudible) to try to get some distinction. I think the real difference you got to recognize is the fear in the smaller person is greater than the fear in the larger relationships. But -- and competition, you alert the impression, it’s getting worse, it’s getting worse in structure. But it’s fears and has been -- there is not anything real new in that regard. Texas is a good market, so everybody wants to get a piece of it.

Scott Valentin -- FBR Capital Markets

Okay. And then just follow-back question. In terms of outer state versus in-state players, is it the big banks causing most of the pressure or kind of local community banks?

Dick Evans

Well, the two big to fail are -- we have 55% of the deposit market in the state and they cause most of the insanity. Community banks have little more sense than some others who is too big to fail the done deal rationally were doing the right thing.

Scott Valentin -- FBR Capital Markets

Okay. One final question is, M&A. You mentioned plenty of issues facing industry. And I’m just wondering as if it starting to hit the community banks more and more that in the case as same as you do, if not in the worst position if you’re seeing more kind of reverse inquiries on M&A?

Dick Evans

I think you just got to standoff between banks who might say all are still looking back five years and banks who might buy or looking at reality today and there is a big gap.

Scott Valentin -- FBR Capital Markets

Okay, thank you very much.

Operator

The next question will come from Matt Olney with Stephens.

Matt Olney – Stephens

Hey, good morning. Dick or Phil, some of your peer banks are trying to buy their own revenue headwinds with various efficiency initiatives, whether it’s saving on branches, cutting FTE, just finding some way to manage expenses. How should we think about your expenses in 2013?

Dick Evans

I think you are -- thinking about our expenses the way that we’ve always run our business, not to be jerking, but as Phil talked about and I talked about, we’re investing in the future prudently, we always watch our expenses, I think our company does a good job. As you know, any expense, new expense over $10,000 has to -- proved by Phil and I, that’s not a government bureaucracy method, it is a method of letting the managers decide whether it’s a smart thing to spend money on. We let people spend $1 if they’ll bring us $2 worth of revenue and we’ll continue to do that. I don’t think you can get there by cutting enough expenses, you’ve got to grow the business. This -- you can cut, cut, cut and you will be out of business, but you’ve got to every day run it very prudently and watch every dime you spend. Phil, you want to add anything?

Phil Green

I would just say that Dick’s exactly right, I mean -- and on other calls, we talked about some of the initiatives that we have that has really resulted in significant cost savings. And in terms of processing, we’ve about, for example, deposit back office operations last 24 months. I think we’ve reduced our cost to back office operations just below 40%, there was about 60% reduction in personnel cost as we implemented new imaging technology and we had -- that was a big savings, we didn’t have a lot of hoopla on it because it was -- it just running the business.

I mean, I think someone told me that we have two people on our night shift now, you will think about what we used to have there. I mean, just examples about how technology is changing the business and we’re employing that. I mean, someone mentioned earlier that it’s not why we did it, but you end up with 1 million, 3 million flat and regulatory costs on the Charter deal, but I would say that, well, what our people do a good job is just doing the right thing.

When they see an opportunity to save money, they do and we see a technology, we can implement, we can do. And at the same time like Dick has been saying, we are pouring money into our franchise. I mean, frankly it’s more important that we look together the kind of company, distribution and value proposition in this market that’s going to resonate for years to come and then is for us to report another $0.01 or $0.02 should come on market share, I mean on EPS because we’re going to put an expense touch the bottom line, I mean we will put some of those to the bottom line, but we’re just, it’s a balance, it’s a balance to save in money and spend the money on the right things.

Dick Evans

Let me just give you another example, 73% of our consumer checking accounts are online. 36% of our business checking accounts are online and 60, 16% of our law grants are for mobile channels. And so, we embrace technology and the efficiencies of it and I’ll put those numbers up against anybody.

Matt Olney – Stephens

Very helpful. Thank you.

Operator

The next question is a follow-up question from Brady Gailey with KBW.

Brady Gailey – KBW

Quick clarification question. Phil, the $1.3 million to $1.5 million of costs savings from switching regulators that’s annually right or is that per quarter.

Phil Green

It’s annually.

Brady Gailey – KBW

Annually. Okay. That’s what I thought. Thank you.

Operator

(Operator Instructions) And the next question will come from Jon Arfstrom with RBC Capital Markets.

Jon Arfstrom – RBC

Good morning, guys.

Dick Evans

Good morning.

Phil Green

Good morning.

Jon Arfstrom – RBC

Sort of -- the call. I have just one question. Dick, you touched on this resettling in the last quarterly call, but can you give us an update on some of the opportunities you might be seeing in construction lending. I know you’ve been selective there, but give us an update on that and maybe an update on the Texas housing market and maybe tie the two together if you could.

Dick Evans

The -- its a still weak part of the segment, but the really strong is multifamily and it is, it’s just growing all over the country and certainly in Texas and we’re certainly participating in that, in a careful way to watch the different, to share the quality is there. There is a lot of going on, one of the things that’s driving so much of the multi-family is you can’t get a mortgage loan for first time buyers. And even though (inaudible) is good, going up significantly, the multi-family is taken care of, this can’t get a mortgage loan despite what you read about.

As far as home prices and mortgages in Texas, we’ve had less default, we never did have the big boom in prices, we continue to see Texas as far as home price declines are pretty steady. We’re starting to hear from our customers that they need to develop some lots and when you get into a lot financing, you’re always going to have a lot of lots, the point is, do you have a lot good lots and there’s a limited amount of good lots. Inventories relative to sales are below the national average, Texas inventories related to the – to the sales are 5.8 and the U.S. is 6.3. So we’re starting to – I don’t want to over-dramatize construction of houses because it’s still away, but when you got that many people move into the State and you didn’t have the price of houses get out of hand and you didn’t have the foreclosures (inaudible) we’re starting to see some needs of putting some new lots on the ground and building a few new houses and so it’s gradually improving. Does that help you?

Jon Arfstrom – RBC

That helps. And then this is may be somewhat tied to it, but – and I don’t know if you’ll answer this, but will you formally comment on the proposed Basel III rules, I mean, obviously some of the banks are upset with some of the risk weightings on particularly mortgages and may be that ties into a housing recovery, but curious if you’ll formally comment and if you’re willing to share that what are kind of the key things that you don’t like about the new capital rules.

Dick Evans

Well, you don’t have enough time to hear, I will formally comment, I think it’s insane, I thought Basel II was a bad thing, just look at the basic concept of setting a standard for every bank in the world to have the same standards. I mean, it just doesn’t work. Certainly we think that one of the worse things is the mark-to-market of the investment portfolio and if you go back to (inaudible) writes one up, 625 basis points, you’re going to destroy the capital, a lot of banks in this country and it won’t change the income (inaudible) and a year later you’ll be okay, I think so it’s -- in my opinion, it’s a terrible thing that will not accomplish anything. When the world economy is weak and it’s all about theory not about substance improving to the industry.

Jon Arfstrom – RBC

Okay. All right, thank you.

Operator

The final question will come from (inaudible) with Morgan Stanley.

Unidentified Analyst

Hey, it’s (inaudible) service team. I just want real quick to the current quarter and I was wondering if you could give a little more detail on sort of how the expenses came together. And where you see that going forward compare to sort of where you’ve been over the few quarters.

Dick Evans

I’m not sure I’ll note at it, when you say you have expense came together.

Unidentified Analyst

So as everything outside of the compensation, sort of everything else on the other expense side?

Dick Evans

Okay.

Unidentified Analyst

Do you see then -- like trends in marketing costs going up significantly, is there -- with the initiatives that you’re putting in place.

Dick Evans

Okay. Well, let me give it a shot. You know, I think that first of all, let us look at -- I don’t think you see a lot about volatility in new compensation line, okay, in terms of your salaries. On your benefits, remember seasonally, we have a really high number in the first quarter because of payroll taxes and 401k contributions related to the bonus payments that happened in that quarter. And so, you see a real decline in benefits cost in the second quarter. You’re not going to see that similar kind of decline in previous, I mean in subsequent quarters. Okay.

So what you’re going to have is, I guess I’d say this, the second quarter looks a whole lot more normal than the first quarter, if you’re doing that kind of arithmetic. I don’t think there is really any in FF&E category that’s going to dramatically change, I mean, that’s a pretty strong growth area of expenses because it include software. And we’re always doing stuff with software upgrades and maintenance upgrades and that’s just one that really have expense levels for the company. If you look at -- I don’t think, the occupancy is going to see a major impact one way or the other that -- it comes to mind right now.

As you look at other expenses, I mean that’s -- I don’t think we’re going to see same level as I’ve said earlier. I don’t think we’re going to see the same level of write-downs on OREO and that type of thing, as we saw in the first quarter. So you may get a little relief there, but, I mean, it’s another category, right. So there is always something in there that you could see come up. You mentioned advertising and promotion, as I said earlier, we had $1 million increase from the first quarter in advertising and promotion. And we will see that same kind of increase as we go up like in the second and third, and third and fourth, because we’re at that sort of the run rate today.

We talked about how you get a little relief on the regulatory side on the charter thing. There are going to be some things, we’re going to increase the expenses on back into our business, any number of things. I mean, the ATM arrangements going to cost us some money. So you will use some of it up there. I guess, I would say, it wasn’t a tremendously unusual expense quarter, but you’re going to continue to see some growth as we continue to expand the business. I know that’s not a (inaudible) expenses, because that’s I’m doing right now.

Unidentified Analyst

Okay. Great. Thanks. This is very helpful.

Operator

There are no further questions at this time. Ladies and gentlemen, thank you for participating in today’s conference call. You may now disconnect.

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