First Republic Bank's (FRC) CEO Jim Herbert on Q2 2017 Results - Earnings Call Transcript

First Republic Bank (FRC) Q2 2017 Results Earnings Conference Call July 14, 2017 10:00 AM ET

Executives

Shannon Houston - Deputy Chief Marketing and Communications Officer

Jim Herbert - Chairman and CEO

Mike Roffler - CFO

Gaye Erkan - President

Mike Selfridge - Chief Banking Officer

Bob Thornton - President of Wealth Management

Jason Bender - COO

Mollie Richardson - Chief Administrative Officer and Chief People Officer

Analysts

Chris McGratty - Keefe, Bruyette & Woods

Steven Alexopoulos - J.P. Morgan

Casey Haire - Jefferies

Aaron Deer - Sandler O’Neill & Partners

Ken Zerbe - Morgan Stanley

Matthew Clark - Piper Jaffray

David Chiaverini - Wedbush Securities

Oliver Brassard - BMO Capital Markets

Operator

Greetings and welcome to First Republic Bank’s Second Quarter 2017 Earnings Conference Call. During today’s call, the lines will be in a listen-only mode. Following the presentation, the conference will be open for questions.

I would now like to turn the call over to Shannon Houston, Deputy Chief Marketing and Communications Officer. Please go ahead.

Shannon Houston

Thank you. And welcome to First Republic Bank’s second quarter 2017 conference call. Speaking today will be Jim Herbert, the Bank’s Chairman and Chief Executive Officer; Mike Roffler, Chief Financial Officer; Gaye Erkan, President; Mike Selfridge, Chief Banking Officer; Bob Thornton, President of Wealth Management, Jason Bender, Chief Operating Officer; and Mollie Richardson, Chief Administrative Officer and Chief People Officer.

Before I hand the call over to Jim, please note that we may make forward-looking statements during today’s call that are subject to risks, uncertainties and assumptions. For a more complete discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements, please see the Bank’s FDIC filings, including the Form 8-K filed today, all available on the Bank’s website.

And now, I’d like to turn the call over to Jim Herbert.

Jim Herbert

Thank you, Shannon, and thanks to everyone for joining our call today. It was a very strong quarter. Revenues have grown 20% year-over-year and our tangible book value per share continues to grow very nicely, up 16% over the last year.

Let me share a few key highlights.

Year-over-year, our total regulatory capital has grown 27%. Our total deposits have increased by 24%. Total loans have been up 21%; in the loan volume of this last quarter was the second best quarter we’ve ever had. Net interest income has also increased 20% year-over-year and wealth management assets have grown 26% and now exceed $95 billion.

During the quarter, total loan growth was led by single family lending along with a significant increase in the utilization levels of our business lines of credit. As a result of this very strong loan growth, we’ve provided $24 million to our loan reserves in the quarter. Mike Roffler will speak about the impact of this in a moment.

Very importantly, we continue to originate the highest quality loans across our franchise. That’s demonstrated in numerous ways including our strong loan-to-value ratios which continue to be very low. Mike Selfridge will provide more details on our lending quality in a moment.

The credit quality overall remains excellent. Non-performing assets were a very low 6 basis points and net charge-offs for the quarter totaled only $600,000 or less than a single basis-point. In addition to excellent credit, we remain very-focused on being strongly capitalized at all times. I would note that even with the strong level of overall growth, our common equity tier 1 ratio was consistent or steady with the level a year ago.

During the quarter, we redeemed our 6.2% perpetual preferred stock, $150 million worth, replacing to a $200 million of 5.125% fixed rate perpetual preferred. This 5125% dividend rate matches the lowest fixed for life rate ever done by a bank preferred issuance. This rate reflects the ongoing strength and stability for First Republic and the acceptance of our capital instruments in the market.

Let me speak for a moment about the strength and depth of the management team. We are really delighted to name Gaye Erkan as President of First Republic. I was also pleased to extend my tenure as CEO through the end of 2020 and to continue working with our outstanding management team. The entire team plays a critical role in maintaining First Republic’s very unique culture, which is based on extraordinary client service, strong credit quality of all times and continuing capital strength. Overall, we’re very pleased with the quarter results and the continued consistent performance.

Now, let me turn the call over to Mike Roffler, Chief Financial Officer.

Mike Roffler

Thanks, Jim. We are particularly pleased with the ongoing development of the franchise. During the quarter, First Republic delivered strong revenue and income growth while maintaining excellent credit quality and capital strength. At the same time, we also continued to invest in the franchise for future growth.

Let me cover several key metrics for the quarter along with the loan loss provision, efficiency ratio and income taxes.

We’re pleased that revenues were up 20% from a year ago, driven by robust growth. Such revenue was a strong contributor to the Bank’s net income growth of 13% year-over-year. Our net interest margin for the second quarter improved to 31.6% as it was 3.13% last quarter. We were also pleased that our average loan yield increased 7 basis points during the quarter.

Let me take a moment to talk about the elevated provision this quarter. The provision increased to $24 million in the quarter from $9 million last quarter. I would note that this quarter’s provision is about $0.03 per share greater than the average quarterly provision for the first half of 2017. This increase was solely a function of our loan growth and not related to any deterioration in credit quality. On the contrary, as Jim mentioned, credit quality remains excellent and is even slightly stronger from last quarter. The increase in the provision is due entirely to loan growth of $3.8 billion in the second quarter along with the shift in loan mix which includes higher utilization of business lines of credit. About 25% of the loan growth in the quarter was due to higher usage of business lines of credit, in particular capital call lines.

Turning to expenses. The efficiency ratio for the quarter was 61.9%. Expenses associated with Gradifi, which we acquired at the end of 2016, were in line with what we discussed on the call last quarter, and totaled approximately $5 million. Going forward, we expect to continue investing in marketing and operations of Gradifi at a rate of about $6 million to $8 million per quarter. This continuing level of investment will impact earnings $0.03 to $0.04 per share each quarter through 2018.

Looking at our efficiency ratio through the end of 2018, we expect the annual efficiency ratio to be in a range of 60% to 63%. We would note that this metric reflects two fundamental ongoing costs associated with running an extraordinarily high touch service enterprise. First, we continue to making investments to support extremely high client service levels; and second, investments are also made that anticipate the robust future growth opportunities such as attracting the next generation of clients which Gaye will speak to in a moment. These investments in service and future opportunities are what drive our consistent revenue growth and performance.

Finally, turning to income taxes. Our effective tax rate was 15.3% in the second quarter and 16.2% overall for the first half of 2017. This quarter’s tax rate is lower as the majority of the Bank’s restricted stock awards vest in the second quarter as they do each year; this creates incremental tax benefits in the current quarter as compared with other quarters during the year. We continue to expect the full year’s effective tax rate to be in a range of 17% to 20%.

Now, I’d like to turn the call over to Gaye Erkan, our newly appointed President.

Gaye Erkan

Thank you, Mike. It was a terrific quarter characterized by growth across the board. We continue to successfully execute our simple business model which is focused on excellent credit, a strong capital position at all time and most importantly, exceptional differentiated client service.

Let me take a moment to talk about our strategic efforts and investments to develop the next generation of clients and then touch on our investment portfolio and deposit franchise.

To attract the next generation of clients in our urban coastal markets, long [ph] before their first home purchase, over the past years, we have developed our professional loan program and our All-in-One Student Loan Refinance. Our professional loan program provides credit to employees, who have an opportunity to invest in or with their first. These borrowers at the time of loan origination are 40 years old on average. Recognizing that student debt widely affects younger professionals, we created our All-in-One Student Loan Refinance product to address this need. The average age of these clients at the time of loan origination is 32.

As of June 30th, clients that have been acquired through these two channels represented fully 20% of all borrowing households at the Bank, compared to 14% one year ago, up over 40% during the last year. We apply the same high credit standards to these two products as we do to the rest of our lending activities, and the quality of these portfolios reflects that same conservative approach.

As Mike mentioned, at the end of 2016, we acquired Gradifi, an early stage fintech startup that has introduced a new HR benefit, a corporate student debt repayment benefit plan for companies nationwide. Gradifi addresses the student debt challenge at the corporate level to provide loan repayment assistance to employees through a new, meaningful benefit. Gradifi gives us the opportunity to build yet another channel to grow our next generation of clients by offering student debt refinance options, alongside this benefit. We are cautiously optimistic about the opportunity ahead. As Mike mentioned, we are making and will continue to make meaningful investments in Gradifi through this year and into the next.

Now, turning to investments. Our total securities portfolio represented 21% of total assets as of June 30. High-quality liquid assets at the end of the second quarter including eligible cash were 12.8% of average total assets.

Turning to deposits. We are very pleased with the continued growth of our deposit franchise. Total deposits increased to $63.3 billion, up 24% compared to a year ago. At June 30th, checking deposits continued to represent over 63% of our total deposits. The average rate paid on deposits during the quarter was only 18 basis points, up slightly from 15 basis points last quarter and 13 basis points a year ago. We are also very pleased that our deposit growth has fully funded our loan growth over the past year.

And now, I would like to turn the call over to Mike Selfridge, Chief Banking Officer.

Mike Selfridge

Thank you, Gaye. I’ll cover economic conditions in our markets, overall lending activity and business banking.

Turning to our geographic markets. Economic conditions remain good across our footprint and our clients are quite active. In our largest market, the San Francisco Bay Area, the diverse economy continues to perform well. Values for single family homes under $3 million have remained strong. For higher end properties, prices have softened a bit but we view this as a positive development for market stability going forward. Overall, the market in the Bay Area remains supply constrained and we continue to see strong loan demand.

In New York, values for single family homes under $3 million also remains strong. Higher end properties in this market have softened more than San Francisco, but again we view this as a positive as well.

While the San Francisco Bay Area and New York markets represent about 65% of our total loan portfolio. Our markets in Southern California, Boston, Portland and Palm Beach also continued to do well. Economic activity in our regions remained somewhat stronger than the rest of the United States as a whole and we continue to benefit from this strength.

Loan origination volume was $7.3 billion during the second quarter, which was up 12% from a year ago. Single family residential lending volume was 55% purchase and 45% refinance during the second quarter. Our credit standards remained consistent with an average loan to value ratio of 59% for single family loans originated during the quarter. Overall, loan demand is strong, though pricing remains very competitive. We have a robust pipeline going into the third quarter.

Turning to multi-family and commercial real estate lending, it was also a strong quarter. We continue to apply the same disciplined underwriting standards to multi-family and commercial real estate lending as we always have. To that point, the average loan-to-value ratios for multi-family and commercial real estate loans originated during the quarter were only 50% and 43%, respectively. We would note that as a percentage of total capital, our outstanding commercial real estate loans including multi-family and construction is well below 200% of total capital.

Business banking had another very good quarter. Year-over-year, total business line commitments were up 28%. As Jim and Mike mentioned, during the second quarter, we experienced a considerable increase in the utilization rates on our business lines of credit. The utilization rate on capital call lines of credit used primarily by private equity and venture capital clients, increased to 38% which was up from 27% at the end of the first quarter. This led to a $950 million increase in outstanding capital call lines of credit at quarter-end.

Over the last 10 quarters, the utilization rate on capital call lines of credit has ranged from 27% to 41%. This utilization rate is driven by clients fund investment opportunities rather than seasonality. Business banking also continues to be an important contributor to the deposit franchise. Business deposits now represent 57% of total deposits. The average account size is under $400,000 and the average rate paid on business deposits was just 8 basis points. We would note that business deposits were 4.5 times the amount of business loans outstanding as of June 30th.

Overall, we’re very pleased with the quarter. And now, I’d like to turn the call over to Bob Thornton, President of Private Wealth Management.

Bob Thornton

Thank you, Mike and good morning everyone. Wealth management had a terrific quarter and I want to touch on a few highlights. Wealth management fee revenues for the quarter were up 22% compared to a year ago. Wealth management assets now exceed $95 billion and are up 26% year-over-year. As a point of reference, approximately two-thirds of our investment -- management assets are equities and alternative investments with the balance in fixed income. The increase in the quarter’s assets was 54% from net client inflows including those from teams hired earlier this year and 46% from market appreciation. We’re also pleased to have hired two exceptional wealth management teams in late June, further growing our wealth management franchise.

First Republic continues to be an attractive option for successful wealth managers and their clients because of our full service, private banking and high touch business model. Finally, wealth management continues to be an important contributor to deposits franchise.

Our sweep accounts totaled $4.8 billion and represented 8% of total deposits. Importantly, banking referrals from wealth management also continue to grow and now represent more than $2 billion of total deposits. Overall, we’re very pleased with the growth in wealth management.

And with that, let me turn the call over Jason Bender, Chief Operating Officer.

Jason Bender

Thank you, Bob. Let me speak for a moment about some of the investments we’re making in the franchise. First and foremost, we continue to make ongoing investments in our risk management infrastructure, commensurate with our growth, size and complexity. At the same time, we’re pleased to have shifted more of our incremental investments toward the enhancement of the client experience and the further optimization of our simple, service-focused business model. Such ongoing investments are key to ensuring safe, consistent, long-term growth and maintaining existing high levels of client service and satisfaction.

During the second quarter, we made great progress on two key initiatives. In June, we began the rollout of our new digital banking experience for consumer clients. This initiative includes a significant redesign and improvement to our consumer desktop and mobile online banking systems. It also provides our clients with a more comprehensive view of their financial picture and streamline money movement capabilities along with other features.

Additionally, during the quarter, we introduced a new loan origination system. This allows us to originate mortgage loans more effectively with more automated controls, improved workflows and support for better client interactions.

Seeking and implementing ongoing enhancements goes beyond new systems and initiatives; it is also a part of our culture. For example, we have recently launched an internal effort, our continuous process improvement initiative through which employees in all roles at the Bank are empowered to identify and implement operational enhancements. With this new program, such employee ideas have already addressed several opportunities to create significant time savings, more streamline processes and an improved client experience.

Ongoing investments to continually enhance the client experience and optimize our business model, particularly with a focus on enabling and empowering our people are key to the successful delivery of extraordinary service over the long-term.

Now, let me turn the call to Mollie Richardson, Chief Administrative Officer and People Officer.

Mollie Richardson

Thank you, Jason. I’d like to speak to First Republic’s culture of excellence and service, our efforts toward sustaining that culture and our focus on continued leadership development.

Our culture is founded on core values that emphasize integrity and collaboration and promote employee empowerment and personal responsibility. These values reinforce the meritocracy and winning culture that has long enabled First Republic to attract a highly diverse and talented workforce.

Diversity of perspective, experience and background is reflected among other things by more than 45 languages spoken by First Republic employees in our urban coastal markets. Our unique culture and exceptionally motivated workforce are the reasons we are successful in providing outstanding service to clients. Accordingly, we invest in programs that maintain our dynamic culture and seek to continually develop leadership skills that benefit the bank and the community.

Let me take a moment to share some details about two programs in particular that advance these objectives.

In the second quarter, we held our 13th Culture Career Roundtable. Established in 2010, these culture career roundtables bring together colleagues in all roles and at all levels of the Bank. Overall a three-day session, we hold lively and very productive discussions about the strategic importance of our values and focus on client service and creating growth opportunities. Nearly 20% of our total workforce has attended one of our culture career roundtables.

Also in the second quarter, we held our third annual leadership academy, which is led by one of our independent Board directors and brings together, the Bank’s top 100 leaders. This leadership group, which is equally balanced between men and women plays a critical role in setting the strategic direction of the enterprise and is vital for the long-term success of First Republic.

Our competitive advantage starts with our culture and our people, which enable us to achieve our goal of unsurpassed client satisfaction.

And now, let me turn the call back to Jim.

Jim Herbert

Thank you, Mollie. Thank you, everyone. We’re very pleased with the quarter’s results. We remain completely focused on delivering a consistent, stable result, driven by excellent credit quality, capital strength at all times and absolutely and above all else, exceptional client service.

Our ongoing investments in innovation, talent, systems and operations not only support the current growth of the franchise but our focus on our long-term vision and the enormous future opportunities that lie ahead. Thank you for joining today’s call. We’d be delighted to open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Chris McGratty with Keefe, Bruyette & Woods.

Chris McGratty

Hey, Jim, question on the balance sheet dynamic. Obviously, very strong loan growth and deposit growth was good but it obviously couldn’t keep pace. How do you -- given the focus on deposits with rates moving up, how do you see this dynamic evolving over the next few quarters? Obviously, I can imagine, expect the same level of loan growth, but can you self fund it with deposits or you’re going to have to continue to rely on the borrowing to fund it? Thanks.

Jim Herbert

Let me turn to Gaye here in a second, but I think we can self fund it. The pattern of our deposits over the years, and I’m going to guess most banks are the same way, but I don’t know. The first couple of quarters are the most challenging always in deposit raising, because in fact taxes, particularly for our client base, if you think about it, are going out in a pretty big way in the first two quarters.

The second half of the year is usually in fact much stronger. We run an internal deposit index which we have annual version of and a five-year moving version of. And it’s actually quite consistent and we’re pretty much on the index as we go through this year so far. But the loan growth of course has been extraordinary. And so keeping up with it right now is challenging. We did technically keep up with the loan growth, but we didn’t have the margin that we would normally have to have a loan to deposit ratio of around 80%.

Gaye Erkan

And this is Gaye Erkan. Just to add to Jim’s comments, seasonality in deposits -- because of the seasonality in deposits, we prefer to look at the performance year-over-year. To give you an example, in the second quarter of 2016, the annualized growth was slightly below 2% quarter-over-quarter annualized. And when we look at our quarter in 2017, the second quarter 2017, the annualized growth was 13.7%, even when for the averages, it’s over 7% for the average growth. So, we are very pleased with the growth and the rates associated with this.

Chris McGratty

Okay, great. Thanks for the color. If I could ask a quick follow-up. Given what’s happening, Mike Roffler, with the yield curve, I’m interested in maybe some comments about kind of incremental loan pricing and that kind of a trajectory of the margin from here. Obviously loan yields reacted pretty well this quarter. Thanks.

Mike Roffler

Yes. I think Chris, your comment is a good one because the curve did flatten a bit during the quarter. Competition and pricing in the marketplace, I think as Mike Selfridge mentioned, continues to be very strong, especially for the clients we’re looking to attract, especially when you layer in the very strong credit quality that we are focused on maintaining. In terms of yields for the new business, it’s been pretty consistent with portfolio averages, low 320s which is pretty consistent with the overall portfolio, but it does remain tight. And if the curve flattens that could put a little pressure on.

Jim Herbert

Let me just make one -- let me emphasize one thing Mike just said. You do not get A quality loans at B pricing. That’s not how the world works.

Chris McGratty

Okay. So should we -- as I’m hearing your comments, we should expect a little bit of pressure on the margins given what you’re going after in your customer base?

Jim Herbert

Well, I think we can probably at it as fairly stable, maybe a little pressure but stable. If you go back and look at our deck, we’ve operated for 10 or 12 years, maybe longer, between 3% and 3.30% and we’re not right at the middle point where we’re about 314%. So, we’re extremely happy at this margin point, given the quality of the lending that we’re doing.

Mike Roffler

Yes. If you look just near-term, obviously we did some capital raising and some expansion of liabilities in the quarter. There is some impact of that that will happen sort of into the third quarter because we didn’t bear the full impact of that in the second quarter.

Operator

Your next question comes from the line of Steven Alexopoulos with J.P. Morgan.

Steven Alexopoulos

Jim, just to follow up on your comment that you think that NIM will hold relatively stable here. If we look at deposit costs, they did tick up a couple of basis points after being flat the last several quarters. Can you just talk about what you’re seeing on the deposit front? Are you finally starting to see pressure to raise rates?

Jim Herbert

Well, we’re seeing -- we’re seeing -- obviously, we’re seeing pressure from our loan growth. But, I think Gaye is -- sort of growth rates that should put forth is second quarter last year annualized versus second quarter annualized this year, pretty indicative. We’re very comfortable with our deposit raising capability. The test will be third quarter and fourth quarter, but historically unless we’re off track here, we don’t think we are by the way, they are much stronger than the first two quarters. Basically, you had a 75 basis-point move in fed funds and we’re up 5 year-over-year. So, let’s add -- we actually are pretty happy with that.

Steven Alexopoulos

But, Jim, you’re starting to see some of your larger customers come to you and demand the higher rate for your existing customers?

Jim Herbert

I would say, it’s more in the category of ask about.

Steven Alexopoulos

Okay. That’s fair. And then maybe for Mike Roffler, just following up on the provision being elevated this quarter; loan mix was obviously a big factor there with the commercial growth. Mike, can you parse out for us what the provision was for commercial loans this quarter and maybe how that compared to prior quarters?

Mike Roffler

So, what I would say is, in the first quarter, our business loans outstanding were essentially flat, which leads to a pretty much no provision on business banking in the first quarter. In the second quarter, I believe that they are up about a $1 billion. That probably leads to call it $10 million, $12 million of provision.

Steven Alexopoulos

Okay. That’s great very helpful.

Jim Herbert

Just to add to this, the issue going on here, and we don’t like it because you know how much we like predictability. But the reality is, the good news is that we have a lot of draws from our just in timelines in the event capital and private equity fund area. Those draws of course are pretty short-term in nature. They can -- most of them are paid back within 90 days. And so, one thing that people ought to pay a little attention to is that we had an extraordinary amount of draws at the end of June 30. The venture capital business and the private equity business is alive and well.

Steven Alexopoulos

Sounds good. Thank you, Jim. If I could just ask one final one. Mike, following up on the commentary around Gradifi expenses should be $6 million to $8 million moving forward, that’s up quite a bit I think, it’s the $3 million to $5 million was the run rate last quarter. Just give us some color, what’s driving the higher run rate? Are you just seeing more client wins? And is that the run rate through 2018 as well or is that just some investment for the back half for this year? Thanks.

Mike Roffler

So, you’re right. Our last call, we talked about $3 million to $5 million. And I would say at that point, we were 90 days in, and so we still were formulating plans. The modest increase is really a function of our continuing to invest and look at the marketing of Gradifi and how we move forward and investing in some of their operations.

Steven Alexopoulos

Okay. Okay. Thanks for all the color. Appreciate it.

Jim Herbert

Let me just on that last point, Steve. That’s not overhead. About 80% of that is discretionary marketing. So, it’s within our control.

Operator

Your next question comes from Jared Shaw with Wells Fargo Securities. Mr. Shaw, your line is open. Mr. Shaw, if your line is muted, please un-mute your line.

Jim Herbert

Let’s go ahead to another one.

Operator

Okay. Your next question comes from Casey Haire with Jefferies.

Casey Haire

I wanted to touch on loan growth outlook, obviously a strong quarter here, up 11% year-to-date and pipeline sounds pretty robust. You guys, I think have put out mid-teens; it’ll be probably there another quarter. Just wondering, what the updated view is on 2017?

Mike Selfridge

Casey, Mike Selfridge. I would say, we’re sticking to the mid-teens guidance. The pipeline is strong growing in third quarter. A little bit of slowdown in the third quarter; August tends to be a slower month, but we’re still comfortable with our guidance there?

Casey Haire

Okay. Is there some capital management consideration embedded there. Where you guys may choose to offload some production to preserve capital ratios?

Mike Roffler

I wouldn’t say our secondary market is tied necessarily to capital market or maintaining this capital ratio. That’s more a function of demand in the secondary market and how we look to continue to sell periodically. This quarter might have been a little bit lower than it has been in the last three or four quarters. But we’ll continue to utilize the secondary market to manage, most importantly interest rate risk and the balance sheet.

Jason Bender

This is Jason, if I can just add on secondary loan sales. We see pretty consistent demand, when you look at the long-term quarter-over-quarter for loan sales. And if you look at the first half of this year, it compares pretty consistently with the first half of last year. And I’d just say, early on in the third quarter, we’re seeing pretty normal market activity and demand for loans in the secondary marketplace.

Casey Haire

And then Mike, just following up on the efficiency ratio, the guidance that you -- the 60 to 63, what sort of revenue mix does that presume? Because obviously wealth management runs fast and that will put upward pressure on it. I’m just curious, does that presume that the Bank runs faster than wealth management or does that presume that wealth management continues to run faster than the Bank? Just trying to get a sense of how you’re thinking about it.

Mike Roffler

Yes. So, if you think about the revenue side of that equation, the wealth revenues I think are 13.5% of total revenues of the Company; it has been growing as a percentage. If that does continue to tick up slightly, that does put an upward bias on the efficiency ratio, given the sort of 85%, roughly efficiency ratio of that business. So that is part of it. The other part is, I mean honestly, low-60s to us always meant 60 to 63; we will consider that low 60s. And importantly, you heard us talk about investments in a high touch, extraordinary service delivery model, which really supports and allows us to consistently grow, is very important. And couple that with what Jim said earlier, pristine credit has led to very competitive lower pricing than you might see at other institutions. And so, we’re very comfortable in this range because it allows us to keep investing in the franchise for the future.

Casey Haire

Okay, great. And just one last one on the margin, the loan yield is up 7 basis points quarter-to-quarter. How much -- was there a lot of prepaid penalty or it was an uptick in purchase accounting, just trying to get a closer line of sight on the drivers?

Mike Roffler

Not a lot. The prepaid penalty and purchase accounting accretion combined was plus 1.5 million compared to Q2. So that’s probably 1 basis-point.

Casey Haire

Great. Thanks for the color.

Jim Herbert

Casey, if I could just reiterate, this last thing that Mike made the point. The efficiency ratio in the low 60s compares very favorably to all 50 -- the $250 billion banks. I think that average is about 67% efficiency ratio. And of course we outgrow them by 3X and our credit quality is higher and our net promoter scores are better.

Operator

Your next question comes from Aaron Deer with Sandler ‘O Neil & Partners.

Aaron Deer

Hi. Good morning, everyone. I just wanted to follow up if I could on some of the expense line items, particularly as it relates maybe to Gradifi. It seems like commodity expense increases this quarter were in the IT expenses and then in the other line. Are most of those increases in those lines particularly related to Gradifi and was there anything else in there that might have been more one time or non-recurrent?

Mike Roffler

So, maybe give me a second, I’ll run through a little bit. In IT, there is probably very, very modest amount associated with the Gradifi that’s probably tied more to some of the larger scale initiatives that Jason talked about earlier and just investing in a larger franchise. Where you see the Gradifi impact mostly, probably just on a delta is mostly in the advertising and marketing line. And then in other, it’s sort of a combination of what I call three things. One would be higher business volumes across the board leads to greater what I’ll call, ancillary costs associated with the deposit franchise, lending custody and clearing for wealth management. Mollie earlier talked about some of the initiatives we have going on from a cultural and leadership perspective. Some of that clusters in the second quarter were very busy in those initiatives. And so that leads to a little bit of a uptick there. And finally, Mike Selfridge mentioned this, while not a large provision, when loan commitments grow, we do provide for a portion of the unfunded commitments for future sort of average utilization. And so that probably is another couple of million dollars.

So, it’s a combination of those things. And again, this is an investment for the longer term future of the Bank, which is a constant effort that we go through.

Aaron Deer

Got it, and that’s helpful. I especially appreciate the breaking of the unfunded commitment provision. Okay. And then just curious, on the loan growth in the quarter, it was impressive to see the volumes that you say, particularly on the single family residential, given the concerns we’ve heard from other banks and about the level of inventory. What’s different about your model and what you guys are doing that’s allowing you to continue to gain such traction, despite the low inventories that we’ve seen out here in the West Coast?

Jason Bender

Aaron, the model really is -- if you look at our deck, as we’ve said, half our growth comes from, roughly half our growth comes from existing clients and those promoting clients bring us more over time and that happens to translate into our loan growth. And then what happens is they start referring their friends and colleagues and that contributes to about another quarter of the growth. So, that’s really what it is. It’s always hard to predict at least an income property in business banking where they might end up quarter-to-quarter, but in the long run, it looks good. I would also say, the purchase market has been a little bit better this quarter, spring season kicked in, so we saw roughly 55% of our single family volume in purchase. And as you know, we do better in a purchase market where we have great opportunities to demonstrate our extraordinary service model and execution.

Operator

Your next question comes from the Ken Zerbe with Morgan Stanley.

Ken Zerbe

Great, thanks. Good morning. I guess first question is starting with Gradifi, obviously there was that increase from the 3 to 5 up to the 6 to 8. When you think about sort of the longer term investment in the business, like, what are the chances of profitability that next quarter instead being 6 to 8, it could be 8 to 10, right or in 2018 it’s even something higher because I know you obviously need to invest in this to really make a successful. But I just wonder, are we going to see that creep up in advertising marketing expenses over time?

Jim Herbert

It’s Jim. No, Ken, you’re not. The issue really is decision on our part as to how much we want to invest to take the ground, so to speak. Remember, this is a new function for HR, and we are up to about 140 companies using us and we bought on ahead about 35 or 40. So, it’s a matter of getting HR departments to adopt the concept is accelerating relatively quickly, but only about 4% of U.S. corporations are doing this yet. So, the market is enormous. And so, we’re -- it’s our judgment call as to how rapidly to go. So, the core investment run rate in the enterprise is probably $5 million or $6 million a year; the delta above that is discretionary marketing expense on our part.

And we’ll see how it works and how -- what kind of a response we get. So far, we’re pleased with it, but we think there is such a great opportunity here that we don’t want to miss it. The thing I would add though, and this is the most important part of the discussion actually, the Gradifi is interesting by itself, but we bought it because it links in to our millennial strategy, virtually perfectly. And remember that at least one in probably six or eight member, student member clients of Gradifi is a likely qualified client for this bank. And so, our -- so, it’s a feeder mechanism for that business. And to the extent that we invest in Gradifi, we’re actually investing in the whole millennial strategy, not just the Gradifi.

Ken Zerbe

Got you. Okay. That’s helps a lot. And then, another question, just on the provision expense again. Do capital call lines require more reserve than other loans? Because I guess I am just wondering because I think I heard Mike say that utilization rates are at one point over the last 12 months or so, as high as somewhere in the low 40s. It just feels like we had a much higher provision expense this quarter. I’m trying to just connect the dots on why it was so large this quarter versus other quarters when utilization was even higher? Thanks.

Mike Roffler

I think, so, you see some what I would call periodically spike in our provisions, if you look back over time quarter-to-quarter that typically coincides with a greater utilization rate on business and primarily capital call lines of credit, especially as sort of the base continues to grow. And so, the best example I think I have is the first quarter this year where the utilization on capital calls was essentially flat from December to March and you really had no provision. And then obviously, when it jumps, quite considerably in the second quarter, you lead to the provision you see. And again, I would reiterate, this is all tied to growth in balance outstanding, nothing related to credit.

Ken Zerbe

Got you, understood. So, if next quarter we see the utilizations falls, wherever, 9 percentage points, then you could have sort of a let’s call it zeroish, [ph] I mean something like that?

Mike Roffler

That’s exactly right, Ken. If you saw it flip back to 33%, our provisions would commensurately adjust accordingly.

Operator

Your next question comes from Matthew Clark with Piper Jaffray.

Matthew Clark

First one, just on the contractual loan rates, just curious what that percentage was this quarter, what the linked quarter change was as well?

Mike Roffler

Yes. So, at the end of the quarter, the portfolio yield was 3.27, which is up 5 from March.

Matthew Clark

Great. And then, given the strength in the capital call lines this quarter, is it fair to assume, we might actually see C&I loan balances down in the upcoming quarter, just given the short-term nature of that?

Mike Selfridge

It’s hard to predict that as I think Jim mentioned; these are short-term draws, so they tend to be 60 or 90 days in outstanding. So, we could very well see a decrease in that line item. I look more at the kind of year-over-year growth in commitments and then the utilization is always tough to predict. But it’s an active market, to Jim’s point.

Matthew Clark

And last one, just how should we think about the tax rate in 2018 and 2019?

Mike Roffler

Tax rate related to 2018 and 2019, I think 17% to 20% continues to be sort of a good longer term range for the tax rate. Obviously, as you saw this quarter, there can be some variability based upon stock awards primarily and when they’re investing. We do have a more clustered vesting in the second quarter. And so that probably, as we start to get more trend on this sort of new presentation, you’ll see the second quarter tax rate probably a little bit lower and the others a little bit higher.

Jim Herbert

Matthew, Jim Herbert, just for a second, going back to the thing that Mike Selfridge mentioned. Our overall commitments on business lines are up 28%, which also relates to Ken’s question. So, the base of Mike Roffler spoke to is 28% larger. So, the likelihood -- so, even if you applied no change in swing levels on line usage, but remind yourself, the basis, call it 30% bigger.

Operator

Your next question comes from David Chiaverini with Wedbush Securities.

David Chiaverini

Hi. Thanks. Question on underwriting. Given the strength in home values, below $3, has this caused you to change your underwriting standards? Is that all in terms of lowering you LTVs at origination?

Jason Bender

We’ve been every consistent in underwriting. I think we’ve said a few times, maybe 24 months, we’ve been a little more cautious, particularly in income property. I’d say, we’ve been very consistent, strong underwriting on income property, strong debt service coverage ratios with recourse, very modest medium loan sizes and of course low loan-to-values.

David Chiaverini

And your provisioning, has that changed at all related to home originations?

Mike Roffler

Provision for loan loss, no, it’s remained consistent over time, especially when you see the continued excellent credit quality.

Operator

Your next question comes from Oliver Brassard with BMO Capital Markets.

Oliver Brassard

Hi. I just had a one brief question on securities yields. You’ve had a pretty nice tick up the last two quarters, even as the curve is kind of flattening. Kind of how should we think of that in an environment when the curves come down a bit?

Mike Roffler

So, I’ll speak to sort of the quarter-to-quarter and may be Gaye comment on the sort of purchase market. The second quarter had a little bit of a benefit from some accelerated accretion from some discounted securities and so that probably increased the yield. I think otherwise it would be about sort of consistent with last quarter overall. And Gaye, talk about maybe the purchase.

Gaye Erkan

The current market yields just on the HQLA front tend to be between 3% to 3.25%, just to give some color on the current market yields of purchases.

Oliver Brassard

And what kind of durations are those?

Gaye Erkan

They tend to be around 3.5 to 4.5 type of duration on the HQLA and on the AFS portfolio much lower than that.

Operator

There are no further questions in the queue. Mr. Herbert, do you have any closing remarks?

Jim Herbert

No. Thank you very much everyone for being on the call today. We’re very pleased with the quarter and delighted with the run rate of the business. Thank you.

Operator

This does conclude today’s conference call. You may now disconnect.