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Edited Transcript of MTB earnings conference call or presentation 18-Jul-19 2:00pm GMT

Q2 2019 M&T Bank Corp Earnings Call

BUFFALO Jul 22, 2019 (Thomson StreetEvents) -- Edited Transcript of M&T Bank Corp earnings conference call or presentation Thursday, July 18, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Darren J. King

M&T Bank Corporation - Executive VP & CFO

* Donald J. MacLeod

M&T Bank Corporation - Administrative VP, Assistant Secretary & Director of IR

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Conference Call Participants

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* Brian Paul Klock

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* Erika Najarian

BofA Merrill Lynch, Research Division - MD and Head of US Banks Equity Research

* Frank Joseph Schiraldi

Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research

* Gerard S. Cassidy

RBC Capital Markets, LLC, Research Division - Analyst

* John G. Pancari

Evercore ISI Institutional Equities, Research Division - Senior MD & Senior Equity Research Analyst

* Kenneth Michael Usdin

Jefferies LLC, Research Division - MD and Senior Equity Research Analyst

* Kevin J. St. Pierre

KSP Research - Founder

* Saul Martinez

UBS Investment Bank, Research Division - MD & Analyst

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Presentation

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Operator [1]

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Good morning. My name is Samantha and I will be your conference operator today. At this time, I would like to welcome everyone to the M&T Bank Q2 2019 Earnings Call. (Operator Instructions)

I would now like to turn the call over to Don MacLeod, Director of Investor Relations. Please go ahead.

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Donald J. MacLeod, M&T Bank Corporation - Administrative VP, Assistant Secretary & Director of IR [2]

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Thank you, Samantha, and good morning, everyone. I'd like to thank you all for participating in M&T's Second Quarter 2019 Earnings Conference Call, both by telephone and through the webcast. If you have not read today's earnings release we issued this morning, you may access it along with the financial tables and schedules from our website, www.mtb.com, and by clicking on the Investor Relations link and then on the Events & Presentations link.

Also before we start, I'd like to mention that comments made during this call might contain forward-looking statements relating to the banking industry and to M&T Bank Corporation. M&T encourages participants to refer to our SEC filings, including those found on Forms 8-K, 10-K and 10-Q, for a complete discussion of forward-looking statements.

Now I'd like to introduce our Chief Financial Officer, Darren King.

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [3]

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Thanks, Don, and good morning, everyone. As noted in this morning's press release, M&T's results for the second quarter includes the continuation of several favorable trends. Loan growth continues to be in line with our expectations for low single digit aggregate growth in 2019. We saw healthy growth in fees, particularly mortgage banking and trust income compared with both prior quarter and the year-ago quarter.

Credit quality remains solid with net charge-offs just over half of our long-term average, notwithstanding an increase from the unusually low level we saw in the first quarter.

We continued to return excess capital beyond what is needed to support growth of the balance sheet, including $402 million of common share repurchases and paying $135 million of common stock dividends.

During the quarter, we successfully completed the onboarding of $13 billion of owned mortgage servicing as well as $17 billion of subservicing. These portfolios added to mortgage fee revenue, noninterest expenses, servicing-related purchases of mortgage loans, and non-maturity interest-bearing deposits.

At the same time, the interest rate environment has become more volatile than at any point in recent memory, impacting our outlook for net interest margin and spread revenues, which we will discuss in more detail in a few moments.

Now let's take a look at the specific numbers. Diluted GAAP earnings per common share were $3.34 for the second quarter of 2019 compared with $3.35 in the first quarter of 2019 and $3.26 in the second quarter of 2018.

Net income for the quarter was $473 million compared with $483 million in the linked quarter and $493 million in the year-ago quarter.

On a GAAP basis, M&T's second quarter results produced an annualized rate of return on average assets of 1.60% and an annualized return on average common equity of 12.68%. This compares with rates of 1.68% and 13.14%, respectively, in the previous quarter. Included in GAAP results, in the recent quarter, were the after-tax expenses from the amortization of intangible assets amounting to $4 million or $0.03 per common share, little change from the prior quarter.

Consistent with our long-term practice, M&T provides supplemental reporting of its results on a net operating or tangible basis, from which we have only ever excluded the after-tax effect of amortization of intangible assets as well as any gains or expenses associated with mergers and acquisitions when they occur.

M&T's net operating income for the second quarter, which includes intangible amortization, was $477 million compared with $486 million in the linked quarter and $498 million in last year's second quarter. Diluted net operating earnings per common share were $3.37 for the recent quarter compared with $3.38 in 2019's first quarter and $3.29 in the second quarter of 2018.

Net operating income yielded annualized rates of return on average tangible assets and average tangible common shareholders equity of 1.68% and 18.83% in the recent quarter.

The comparable returns were 1.76% and 19.56% in the first quarter of 2019.

In accordance with the SEC's guidelines, this morning's press release contains a tabular reconciliation of GAAP and non-GAAP results, including tangible assets and equity. Both GAAP and net operating earnings for the first and second quarters of 2019 were impacted by certain noteworthy items.

Our results for the first quarter of 2019 included a $37 million cash distribution from Bayview Lending Group reflected in other revenues from operations. This amounted to $28 million after-tax effect or $0.20 per diluted common share. Also affecting results for the first quarter was an addition to our legal reserves of $50 million relating to a subsidiaries role as trustee for customers employee stock ownership plans. This amounted to $37 million after-tax effect or $0.27 per diluted common share.

Reflected in the second quarter of 2019's results was a $48 million write-down of M&T's investment in an asset manager, which is accounted for using the equity method of accounting. That amounted to $36 million after-tax effect or $0.27 per common share. In July 2019, M&T agreed to sell its investment in the asset manager, which had been obtained in the 2011 acquisition of the Wilmington Trust Corporation.

Turning to the balance sheet and the income statement. Taxable equivalent net interest income was $1.05 billion in the second quarter of 2019, down by $9 million or 1% from the linked quarter. This reflects a narrow net interest margin, partially offset by growth in both loans and total earning assets.

The margin for the quarter was 3.91%, down 13 basis points from 4.04% in the linked quarter. Factors contributing to that decline include, a higher level of cash on deposit at the Fed, which accounted for an estimated 3 basis points of the decline in margin; a higher day count in the quarter compared to the first quarter, which accounted for 1 basis point of that decline. We estimate that market rates, primarily from LIBOR moving lower in advance of an anticipated cut in short-term rates by the Federal Reserve accounted for some 2 basis points of the decline, which this -- has been consistent with our recent experience where LIBOR moves in advance of Fed funds, only now it is in the opposite direction. A higher cost of interest-bearing deposits accounted for approximately 7 basis points of the decline, sharply higher mortgage escrow deposits in conjunction with our growth in mortgage servicing, much of which are indexed to a mix of Fed funds and LIBOR are the primary driver of that increase.

We expected continued migration of deposits into higher yielding categories, notably commercial deposits into interest checking and on balance sheet sweep as well as the higher cost of time deposits, as new certificates that are issued at higher rates, the maturing ones, were also factors.

Average loans grew by 1% compared with the previous quarter. Originations remained solid, while payoffs and paydowns picked up a little compared with the first quarter, but remained below our experience in the second half of 2018.

Looking at the loans by category, on an average basis compared with the linked quarter, commercial and industrial loans increased 1% compared with the linked quarter. Commercial real estate loans also grew 1% compared with the first quarter with a slightly lower proportion of construction loans compared with permanent financing.

Residential real estate loans declined by about 1% compared with the linked quarter. The continued comparatively steady pace of planned paydowns of mortgage loans acquired in the Hudson City transaction was partially offset by the purchase of government guaranteed mortgage loans out of the recently acquired servicing tools.

While that practice will continue, it was somewhat elevated this quarter in connection with the onboarding of the mortgage servicing we acquired. We expect the aggregate portfolio to resume its low double digit rate of principal amortization in future quarters.

Consumer loans were up about 2%. Growth in recreation finance loans continued to outpace declines in home equity lines and loans.

Regionally, loan growth was somewhat stronger in our Metro region, which includes New York and Philadelphia as well as in the mid-Atlantic. New Jersey continues to show solid growth of a low base.

Average core customer deposits, which exclude deposits received at M&T's Cayman Islands office and certificates of deposit over $250,000, grew an estimated 2% compared with the first quarter.

This primarily reflects the escrow deposits we referenced earlier. Deposits received at the Cayman Islands office increased by $275 million. As noted last quarter, commercial customers continued to seek a higher yield on excess funds in demand accounts and often achieved that by sweeping them into short term interest-bearing deposits.

Turning to noninterest income. Noninterest income totaled $512 million in the second quarter compared with $501 million in the prior quarter. Mortgage banking revenues were $107 million in the recent quarter compared with $95 million in the linked quarter. Residential mortgage loans originated for sale were $723 million in the quarter, up substantially from $422 million in the first quarter, reflecting the lower long-term interest rate environment as well as seasonal strength. Total residential mortgage banking revenues, including originations and servicing activities, were $72 million in the second quarter, improved from $66 million in the prior quarter.

The increase is primarily the result of the additional residential loan servicing and subservicing that we acquired, combined with higher gain on sale revenues. Commercial mortgage banking revenues were $35 million in the second quarter compared with $29 million in the linked quarter, reflecting seasonally stronger origination activity.

Trust income was $144 million in the recent quarter, improved from $133 million in the previous quarter. This quarter's results include $4 million of seasonal fees earned in assisting clients with their tax filings. The rebound in the equity markets from the sell-off in the fourth quarter of 2018 also contributed to the linked quarter growth.

Service charges on deposit accounts were $108 million, up from $103 million in the first quarter, reflecting higher levels of activity from what is usually a seasonally slower first quarter. The recent quarter also included $9 million in security gains -- securities gains, representing the valuation gains on equity securities, while the first quarter of 2019 include $12 million of similar valuation gains.

Turning to expenses. Operating expenses for the second quarter, which exclude the amortization of intangible assets were $868 million. As previously noted, the recent quarter's results include a $48 million write-down of our investment in an asset manager acquired in the Wilmington Trust merger. Also included in the quarter's results was a $9 million valuation reserve on our mortgage servicing rates, reflecting the recent decline in long-term interest rates.

Salaries and benefits were $456 million in the quarter, down $44 million from the seasonally high level in the prior quarter. The year-over-year increase reflects annual merit and increases, the salary adjustments we made in connection with the Tax Cuts & Jobs Act as well as further adds to staff as we expand our pool of IT talent. We continue to expect to offset this hiring over time by reducing our use of consultants and contractors.

The efficiency ratio, which excludes intangible amortization from the numerator and securities gains or losses from the denominator was 56% in the recent quarter compared with 57.6% in 2019's first quarter.

Both ratios reflect legal related accrual and write-down we noted earlier.

Next let's turn to credit. Overall, credit quality remains in line with our expectations. Annualized net charge-offs as a percentage of total loans were 20 basis points for the second quarter compared with 10 basis points in the first quarter. That reflects higher net charge-offs in our commercial loan portfolios. And provision for credit losses was $55 million in the recent quarter exceeding net charge-offs by $11 million.

The excess provision primarily reflects loan growth. The allowance for credit losses increased to $1.03 billion at the end of June compared with $1.02 billion at the end of the previous quarter. The ratio of the allowance to total loans was unchanged at 1.15%.

Nonaccrual loans declined by $16 million at June 30 compared with the end of March. The ratio of nonaccrual loans to total loans improved by 3 basis points and in the quarter at 0.96%. Loans 90 days past due, on which we continue to accrue interest, excluding acquired loans that had been marked to a fair value discounted acquisition were $349 million at the end of the recent quarter. Of those loans, $320 million or 92% were guaranteed by government-related entities.

Turning to capital. M&T's common equity Tier 1 ratio was an estimated 9.84% at June 30 compared with 10.03% at the end of the first quarter. The 19 basis point decline reflects the impact of higher loan balances, earnings retention and capital distributions.

During the second quarter, M&T repurchased 2.5 million shares of common stock at an aggregate cost of $402 million. The 2019 capital plan announced late last month contemplates net capital distributions of $1.9 billion over the 4-quarter period beginning this month. Our reference to net distributions reflects our intention to examine the current non-common equity components of our regulatory capital structure in the coming months.

Now turning to the outlook. As we noted at the beginning of the call, the interest rate outlook has changed materially over the past 90 days impacting the outlook for M&T as well. We continue to expect growth in total loans in 2019 to be at a low single digit pace with continued runoff in residential mortgages more than offset by aggregate growth in other loan categories.

The forward curve is implying reductions in short-term interest rates possibly starting as early as the end of this month and continuing over the next few quarters.

Recall that, following the Fed's December action to raise rates, we took further steps to hedge our asset-liability position by layering on additional receive-fixed, pay-floating interest rate swaps. While our balance sheet is much less asset sensitive than it was previously, we expect lower rates to result in less growth in net interest income than we previously thought.

At this point, we estimate that all else being equal and holding aside volatility in certain deposit categories, each hypothetical reduction of 25 basis points in the fed funds target should result in 5 to 8 basis points of margin pressure over the ensuing 12 months. With these changes in mind, we still expect year-over-year growth in net interest income for 2019.

The previously announced servicing and subservicing acquisitions have increased our mortgage banking revenues above the outlook we shared on the January call. Lower long-term interest rates have led to a pickup in residential mortgage loan originations, but not enough to further change that outlook beyond the impact of the servicing additions.

Our outlook for the remaining fee categories remains unchanged with growth in the low single-digit range, except for trust income, which should be in the mid-single-digit range, but remains vulnerable to market volatility.

The write-down of the investment in the asset manager is obviously not contemplated in our earlier expense guidance. As we noted earlier, the acquisition of on-payroll IT talent, reflected in salaries and benefits over the first half, should be offset by lower contractor and consulting expenses over the coming quarters. Beyond that, with the revenue outlook being more subdued than we previously thought we are examining our spending as we look forward.

Our outlook for credit remains little changed. Credit cost moved from an unsustainably low level in the first quarter to a level still well below long-term averages during the second quarter. We're watching criticized loans, which look like they'll be down this quarter from the end of March. M&T's capital allocation philosophy and policies remain consistent with our previous thoughts.

To summarize, we believe that our current capital levels are higher than what is necessary to operate in a safe and sound manner, given our history of solid credit underwriting and low earnings volatility.

As such, our intention remains to manage our capital to a more appropriate level over time. The 2019 capital plan is lower than the plan for 2018, basically reflecting the fact that the Fed's template used year-end 2018 capital levels as the start point, which were some 86 basis points lower than year-end 2017, combined with stress test losses calculated by the Fed for the 2018 CCAR exercise. As noted earlier, the 2019 plan contemplates net capital distributions of some $1.9 billion, with growth descriptions potentially higher as we examine the noncommon components of a regulatory capital and monitor growth in loans and risk-weighted assets.

Lastly, we'll continue to watch the Fed's rule-making on stress testing capital levels, including the stressed capital buffer and the liquidity coverage ratio as we develop our capital plans beyond 2019.

Of course, as you're aware, our projections are subject to a number of uncertainties and various assumptions regarding national, regional, economic growth, changes in interest rates, political events and other macroeconomic factors, which may differ materially from what actually unfolds in the future.

Now let's open up the call to questions, before which Samantha will briefly review the instructions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from the line of John Pancari with Evercore.

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John G. Pancari, Evercore ISI Institutional Equities, Research Division - Senior MD & Senior Equity Research Analyst [2]

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Just for little bit of -- to get a little bit of color around the other expense line. I know you indicated that had originally included the $48 million Bayview. And then, was the legal charge also, that $50 million, is that also in that line item?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [3]

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Yes. In the first quarter, other expense included the addition to the litigation reserve. And in the second quarter, it included the write-down of the asset manager as well as there was $9 million of the mortgage servicing reserve as well.

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John G. Pancari, Evercore ISI Institutional Equities, Research Division - Senior MD & Senior Equity Research Analyst [4]

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Right. Okay. So excluding that, how should we think about a good basis to grow off of as we go into the second half on that line?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [5]

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I guess, if you look at the other expense line and you look at it over the last 5 quarters, excluding kind of what I would describe as the specials, so the litigation addition and the write-down of the equity investment, you'll see that, that line is relatively consistent around 165, 170, it moves up and down a little bit, and that's the place where over time, we will expect to see some decrease in the professional services related to our IT spend. And that will start to come into play over the last half of 2019 and into 2020. But it will take a little bit of time for those expenses to ramp down as we bring on new staff, train them and deploy them on to projects. There's a bit of a tail effect where it takes a while for the outside IT professionals to finish the work that they are doing. It doesn't make sense to replace them midstream. And so that's where you'll see some of that. And also while we added to the litigation reserve in the first quarter, there's still some ongoing expense for that case and some of that will show up in the professional services or in that other cost of operations line as well. So should be -- that -- if you exclude those things, look at kind of where the average has been for the last few quarters and use that as the start point and start to decline it, probably more in 2020 than in 2019, that's the way I think about it.

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John G. Pancari, Evercore ISI Institutional Equities, Research Division - Senior MD & Senior Equity Research Analyst [6]

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Okay. All right. That's helpful. And then also on the expense front, as we look out into 2020 and given the backdrop that you acknowledged around the rate environment, can you -- how you think about operating leverage for 2020? Is that still a higher expectation that you will be able to achieve that? Or is there a risk to that, given the rate backdrop?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [7]

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It's a great question, John. We're in the process of going through forecasting 2020 and starting to look at where we think revenue will be and what that might mean for expense growth. Probably little early to handicap where 2020 looks, but obviously given a slower net interest income growth picture that makes positive operating leverage a little tougher to achieve, and we're -- obviously, we're also not going to shortchange the investments we need to make in the business for the sake of a couple of quarters of positive operating leverage. I don't think it will be wildly negative if it is, but we got work to do before we comment on what 2020 will be, and we'll give you guys an update obviously in January on that.

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Operator [8]

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

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Kenneth Michael Usdin, Jefferies LLC, Research Division - MD and Senior Equity Research Analyst [9]

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Darren, just a follow-up on your comments on the rate. Thanks for the commentary about what each 25 basis point means. If I'm doing the math right, I guess, 5 to 8 basis points on a 25 cut, that's what like $50 million to $80 million depending on annually?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [10]

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Yes.

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Kenneth Michael Usdin, Jefferies LLC, Research Division - MD and Senior Equity Research Analyst [11]

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So I guess the question is, what's baked into your forecast and in terms of that new expectation that NII will grow a little bit this year relative to your prior expectations. Have you build, formed forecast into that -- cuts into that forecast formally? And if so, how many?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [12]

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Yes. We usually run our ALCO models in off of the forward curves. And so we looked at the forward curves at the end of June and used that as the basis for forecasting our NII for the rest of the year. You could kind of see in where LIBORs move. But some of that's already started to happen. So I guess, the question is, how much incremental movement there is in LIBOR when and if the Fed actually moves. So I think a little bit of it's already kind of happened. And then we'll see where things end up. But the direct answer to your question is based off the forward curves and run at the end of June.

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Kenneth Michael Usdin, Jefferies LLC, Research Division - MD and Senior Equity Research Analyst [13]

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Okay. Understood. That's what I was getting at. And then on the ability to control deposit costs and anticipate the mix shift, what are you seeing in terms of customers and what are you deciding in ALCO about how your pricing deposits relative to that view of the curve?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [14]

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Yes. So when we -- when you look underneath the second quarter activity on deposit pricing, there's really 2 things: So one is the addition of the escrow balances that came with the servicing that we did, and actually those grew through the quarter and we actually expect them to growth into the third quarter as well.

When you hold that to the side, what we saw in the second quarter was a continuation of the trends that we saw in the first, where we still see some commercial excess balances moving into interest checking and into on-balance sheet sweep. And we continue to see some consumer migration into time, although that slowed down a little bit and really the time increases in the second quarter were driven by renewals of CDs that were actually coming off at a lower rate than where rates were in still in the 1- to 2-year and greater than 2-year space. If we look at the increase in time deposits in the second quarter, it was less than it was in the first and looked a lot more like what it did in the fourth quarter. And so most of the reactivity in deposit pricing that happened early on was in the commercial space and in the institutional space and in the wealth space. And many of those accounts are tied to an index, and so as the index comes down, those will move down faster. On the consumer side, they'll probably be a little bit slower, just because the cycle -- the repricing cycle never fully matured and the way it tends to work is people move money into CDs first, and then once those rates stabilize, they tend to look for liquidity and they move back into money market, that second step didn't happen. And so a lot of the consumer money that sits in certificates or deposits will be there for a while that will take renewals for that -- for those rates to come down. I guess, the good news is that they shouldn't probably go up much from here either, with the exception certainly of rules.

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Operator [15]

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Your next question comes from the line of Erika Najarian with Bank of America.

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Erika Najarian, BofA Merrill Lynch, Research Division - MD and Head of US Banks Equity Research [16]

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If I could follow-up on Ken's question. As we -- thank you for giving us some of the assumptions that you have for the 5 to 8 basis points of compression. I'm wondering for each 25 basis points, what is the reverse beta that you're assuming specifically on the deposit side? And does it -- is it naturally wider for the, let's say, the third cut versus the first cut?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [17]

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Sure. So when we disclose in the Q our ALCO runs, they're obviously in 100 basis point increments. When we do our work, we do it in 25. And what we expect to see is the continued lag effect of deposit repricing continue into the third quarter. It usually takes 2 or 3 quarters for that to slowdown after the Fed stops. So even if they decrease rates at the end of July, we're likely still to see a little bit of movement in deposit rates. And then, as we go from there, we'll start to see them come down. The rate of decrease in the deposits will be kind of consistent with what I mentioned before with Ken. And that for the indexed deposits, obviously, there will be 100% reactive. And then for our other customer deposits, movement out of suite back into DDA, I think, will be a function of customers' businesses and cash flow, not sure how quickly that will change, but we'll obviously be paying attention to the pricing there. And then on the consumer side, I think, we'll continue to see a slowdown of the remixing, but the pressure will be, as older CDs mature and come on to the books, it is slightly higher rate, which is why we will see a little bit of repricing there. I think as it relates to the third quarter and deposit cost specifically, I'll just remind you again that we're expecting continued increase in escrow balances, and those are linked to an index, either to LIBOR to Fed fund, there's little bit of different pricing depending on which portfolio it is. And so those will have an impact on deposit pricing, specifically, or deposit cost in the third quarter.

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Erika Najarian, BofA Merrill Lynch, Research Division - MD and Head of US Banks Equity Research [18]

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Got it. And just as a follow-up, could you give us a sense of how much of your interest-bearing deposits are indexed and would reprice immediately? And could you please remind us on the size of your swap book and the average life, please? The total new notional since you added some swaps on in the quarter?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [19]

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Sure. So the swap book -- the swaps that are currently in effect is about $13.5 billion, $14 billion of notional. And if you look at the remainder that's out there, which I think will show around $39 billion in the Q, is all forward starting. And so that should give you a sense of where the swaps are. And those should go out approximately 2 to 2.25 years based on where we are right now. I should have wrote down your first question. Remind me again your first question?

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Erika Najarian, BofA Merrill Lynch, Research Division - MD and Head of US Banks Equity Research [20]

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Apologies. What percent of your interest-bearing deposits are tied to an index and therefore would reprice immediately when Fed fund goes down?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [21]

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It's approximately 12% of total deposits. Obviously, it plays a bigger percent of interest checking.

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Operator [22]

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Our next question comes from the line of Frank Schiraldi with Sandler O'Neill.

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Frank Joseph Schiraldi, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research [23]

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Just wondering, Darren, on the -- just one more on the margin, on the 5 to 8 basis points. It seems like that's baking in the expectation that this drag in deposit pricing is going to be -- is going to continue here for a little bit. If we don't get a rate hike -- or a rate cut rather, I'm just wondering what the margin would look like -- your expectation of sort of margin outlook without those baked in rate hikes going -- rate cuts going forward?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [24]

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Sure. So within the margin in the go forward, there's a couple of things that are important to keep in mind. So when we talk about the 5 to 8, we were specific about saying holding some other deposit categories constant that can -- that creates volatility in the market. So obviously cash balances we've talked about a lot, they were over 5 basis points of expansion, the decrease in cash balances in the first quarter, expanded the margin by 5 basis points, they contracted the margin by 3 basis points this past quarter. And so those we kind of hold aside and because they can move around and they affect the margin, but not so much as the net interest income.

The other thing that's moving around right now is just the mortgage escrow balances. And as those roll on and we get to what we think is a more stable balance, we'll be able to give a little bit better guidance on our expectations on the impact of escrow. So if nothing changed in the second quarter or third quarter, there's probably some margin compression because of those escrow balances.

And so any movement would be on top of that excluding what's already been priced in. If we didn't have the escrow balances and we held cash balances constant, and you didn't see a change in rates from the Fed, I think, we'd see pretty stable margin, like the plus or minus 2 to 3 basis points, some because of the natural extension of deposit pricing and then some just because of roll-on, roll-off margins in the loan book.

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Frank Joseph Schiraldi, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research [25]

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Got you. Okay. And then there's been some recent reports out in the media talking about some branch reduction in the Philadelphia area, some consolidation and reinvesting into tech and I guess modernizing the remaining branches. Just kind of curious if you could talk maybe a little bit about that, but more generally just your brand strategy here more broadly?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [26]

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Sure. So -- no, I'll talk specifically about Philadelphia. So if you look at our market position in Philadelphia, I think, we have about 1% deposit share and a fairly similar branch share, which even as things move electronic, we find that customers still value branches as a place that they can go and get and advice and solve problems as well as it provides a sense of security that you're there for a long period of time. And our focus in Philadelphia by shrinking isn't to ignore those things, but more to recognize that our strength there has really been in the commercial space and in particular with small business customers. And we're aggregating -- or concentrating our efforts in Philadelphia in the markets where there's a concentration of small business customers and where we've had some success there and we'll really orient the branch and the activities there to support the activities of our small business and commercial customers.

Our experience has been that small business customers tend to use only 1 branch and that one tends to be close to their business, so we think that that's a better way for us to compete there. And as we reduce the footprint, we'll take some of the savings and invest it in the remaining branches. When you look more broadly, we have markets where we have really high share, both in terms of deposits and branches and markets where we have a little bit less. We're going to be looking at what we do in Philadelphia and how that works in combination with the investments we're making in digital to learn from that and see how that works. And we'll -- depending on how that goes, we'll adjust our strategy there. If we like it, we'll probably see it rollout into a few other geographies. And then when you look at the markets where we're a little bit more dense, I would describe our branch thoughts as consistent with our prior practices whereby we look at the total network each year. We look at which locations, both branches and ATMs are favored by our customers and then we make adjustments to the network each year given that information. We're always trying to make sure that we provide convenience and access to our customers and -- while managing our cost structure so that we can be competitive. The nice part is, in banking, customers vote with their feet every day, and we get to use the results of that vote to help us shape the network and that's the way we've always thought about distribution and we'll continue to.

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Frank Joseph Schiraldi, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research [27]

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Got you. But there's more thought of it as a reinvestment opportunity as opposed to cost-cutting initiative, is that fair or maybe both?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [28]

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Yes. I think it's really both. We will clearly over time have some saves, but for all of our colleagues in that geography, they will be placed in one of the branches that remains open. Usually, there is turnover in those offices and over time whether that is replaced or not will be a function of how busy the locations are. But we will be saving some of the occupancy expense. We'll reinvest a little bit of that into the existing locations and some of that we'll save.

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Operator [29]

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Your next question comes from the line of Saul Martinez with UBS.

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Saul Martinez, UBS Investment Bank, Research Division - MD & Analyst [30]

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Couple questions, more clarifications than anything. First, on the net interest income guide, I forget the exact terms you used, but you said you'll -- you expect to see some growth in 2019 full year versus 2018. By my calculations, that -- you're basically baking in, I think, something in the neighborhood of $1 billion and change in net interest income run rate in the second half of the year quarterly. Is that -- in my -- obviously, it implies some reduction in the run rate, but is that more or less correct that math?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [31]

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Yes, that's correct. It's probably based on the current forward curve. It probably comes down a little bit each quarter, but will be a little bit over $1 billion, yes.

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Saul Martinez, UBS Investment Bank, Research Division - MD & Analyst [32]

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Okay. And then, again, a clarification, great color on all the moving parts on deposit costs and why you think it can be stickier even as the Fed cuts. I guess, putting all of that together, would you expect deposit cost to actually rise in the third quarter versus the second quarter if I'm looking at your overall cost of interest-bearing deposits, that wasn't clear if that's what -- to me at least is that -- if that's what you're basically saying?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [33]

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Sure. So the short answer is yes. And I'll give you color on that. It's yes because of the growth in mortgage escrow balances that we anticipate. If those weren't there, we would expect a little bit of increase in our deposit costs just because of the last little bit of remixing that tends to happen for 2 to 3 quarters after the Fed stops. When you look at -- when you look at just that effect, it was lower in the second quarter than in the first quarter and we anticipate that the third quarter would be lower still, and that it would kind of be done by the time we get to the fourth quarter. Will it slow more quickly to 0 in the third quarter if the Fed reduces, hard to handicap, just given some of the repricing of CDs and the fact that the rolling off at a lower rate than they will roll on to. There's probably still a little bit of push there. But that's -- those are the 2 elements. And I want to make sure I'm explicit about what's driving it because one of the things is kind of in the 5 to 8 and the other one is kind of 0.

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Saul Martinez, UBS Investment Bank, Research Division - MD & Analyst [34]

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Okay. So if we were to see 2 cuts, say one in July and out in September, October, when would you think you would actually start to see deposit costs start to come down? Is it sort of late year or early part of next year? And how do you think about that lag in this cycle?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [35]

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Yes. I guess -- so again, with the new onset of the escrow balances, I think, again, holding onto the side, you would see a modest increase in deposit costs in the third quarter, and I think you'd start to see them either flatten out or decrease in the fourth quarter just because of the fact that there are several categories that are indexed, those would give you a benefit right away with the cuts and as those other categories like the time deposits as well as just people shifting still from interest -- noninterest-bearing into interest-bearing or sweep may put a modest upward pressure on it. But I would expect that you see a little bit in the third quarter and by the time you get to the fourth quarter, you'd probably start to see it level out or decrease.

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Operator [36]

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Your next question comes from the line of Kevin St. Pierre with KSP Research.

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Kevin J. St. Pierre, KSP Research - Founder [37]

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Just circling back to expenses in conjunction with overall strategy. Darren, you and -- both you and René have characterized M&T as being somewhat behind from a tech perspective and needing to catch up. Maybe you could characterize for us where you think you are from that perspective along the time line in catching up to competitors from a mobile and digital perspective?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [38]

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Sure. So I think over the last 18 months, we've made some really great strides in our technical environment. Our mobile app continues to get updated on a regular basis with new feature functionality coming basically every 6 months if not sooner. And it's in a pretty good spot. When we look at the feature functionality that is most used by customers, we feel pretty good about what we have. I think the next focus is -- in there is on security features and more subservice on security features. When we look at the commercial part of the bank, we've just gone into production with our loan origination system, and so we're getting that up and running and the team up to speed. We continue to make investments in our treasury management platform, which will make things easier both for our employees and for our customers, and should bring us a lot closer to parity with our peer group, if not towards some of the larger players, and we're making investments in our merchant capabilities.

Within the bank, we continue to invest in infrastructure. We invest in securities, things like cybersecurity and how we protect the bank and our customers as well as in data. So we're investing along all of those categories and we continue to make progress. But I think as you know and we all know that it's a bit of a moving target too. So each time you catch up, someone does something to get a little bit ahead and I think that's the nature of René's comments and my comments about you're never really there because the bar is always moving and you're continually investing. And we just kind of think about our tech spend as we've got to spend to keep in the game to stay competitive and to react to the changes that are happening in all of our businesses, whether it's in the commercial business, the consumer business, the wealth and private banking business or the institutional business. And that's just going to be a way of life. And because of that -- that's why we're making the investments we are in the tech hub and in adding IT professionals to our on-staff team because as technology continues to become a bigger part of banking then you want to control that resource and not have it walking up the door into someone else's operations the next day because they're an outside contractor. The outside contractor can help you get there quickly and maybe bring a skill set that you don't have in the short term, but over the long term, we -- such a strategic asset that we would rather control it, and that's why you see us making those investments.

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Kevin J. St. Pierre, KSP Research - Founder [39]

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Great. And so -- as we think about the impact on the income statement, we can expect that the salaries and benefits is going to have this natural upward drift as you continue to invest in people?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [40]

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Yes. You will see that happen. We'll see some from the first half to the second half just because of that as well as the full effect of mortgage servicing that we brought on and the people that help with that. The offset over time will be in that other cost of operations line that we talked about. The trick is, and the thing to keep in mind is, just the timing of that, all right? And we have to add the new facility and build it out and get people there before we can consolidate other states. So we have some double counting if you will in that time period, as you bring on new folks to the team and train them up with -- sometimes they're experienced professionals and they come up to speed faster or they could be new recruits and they take a little bit longer that you've got that overlap in time period where you get the new ones up to speed before you can reduce the expense on the other side. We don't expect that this is hundreds of millions of dollars by any stretch because we'll take it increments. We think that's also a better way to manage the change as well as the cost, but it's going to be something that will be consistent over the next several quarters.

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Operator [41]

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Your next question comes from the line of Gerard Cassidy with RBC.

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Gerard S. Cassidy, RBC Capital Markets, LLC, Research Division - Analyst [42]

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Couple of questions. As we see some of the smaller banks report numbers this quarter, the trend of these one-off credit events seem to be popping up again. Are you guys seeing now that the margin pressure is picking up for everyone, is there any evidence yet of more aggressive loan underwriting by banks to grow their balance sheets to offset this margin pressure?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [43]

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It's an interesting question. And when we look at payoffs and paydowns and we talk about that, we track it by what the source of the payoff and paydown was. And kind of to your point, what's been interesting this year so far is other banks have been a bigger source of payoffs and paydowns for us than it has been private equity or funds or insurance. So there might be a little bit to that. I guess, when we compete in the market from our perspective, we always feel like others are looser on structure and lower on price than we would want to be. So it's hard for me to say that there's a specific change. But it was notable when we were going through the numbers that we did see a little bit higher proportion of other banks as the source of payoff and paydown in the first half of this year.

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Gerard S. Cassidy, RBC Capital Markets, LLC, Research Division - Analyst [44]

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Very good. And then based on your experience, you pointed out that you guys have used the forward curves to forecast out your margins. This is not something new, of course. How accurate in your opinion are the forward curves in predicting where rates actually go at this -- in this kind of new rate environment we're in, when you have to forecast out 12 months. I would think they're very accurate over the very short period, 30 days or so, but how about if you go out into 6 and 12 months in your experience, are they very accurate?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [45]

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I don't know, Gerard. That sounds like a loaded question to me. I think we've all seen the charts that have been put together that always show the forward curves at the moment in time against the actuals. And I guess, what -- my experience has been that the forward curves are not very good predictors of the actuals, but they're good predictors of the direction.

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Gerard S. Cassidy, RBC Capital Markets, LLC, Research Division - Analyst [46]

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Yes, I agree. Yes. No, and...

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [47]

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And so we obviously, we use that in the absence of a better way to forecast, But also that's why we use the hedges, right, is that we look at where the margin is and how that compares to long-term average and we take into account some of the deposit reactivity and just the shape of the balance sheet, and that's why we use the hedging to try and take that volatility out of our earnings. And that's what gives us the wherewithal when things get a little volatile, like they've been lately, to not have to be overly draconian on expenses and allows us to make sure that we can maintain the investments, back to the question that Kevin was asking, in particular, about our ability to invest in technology.

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Operator [48]

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Your next question comes from the line of Brian Klock with Keefe, Bruyette, & Woods.

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Brian Paul Klock, Keefe, Bruyette, & Woods, Inc., Research Division - MD [49]

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One real quick question. I know there is a lot of conversation around the expenses. So I was just trying to keep up with everything. But I mean, directionally, if you want to take that operating expense base from the second quarter, it sounds like that's going to be higher in the third quarter and fourth quarter before you start to see like you said some of the double spend that you have come out in 2020. Is that the right way to think about it?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [50]

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Yes, I guess. So the way that I would look at the second half is, if you look at our expenses in the first half and you take out the big things, the write-down in the asset manager and the litigation reserve, that's probably a good guide for where the second half will show up. It should be pretty similar to that, that takes into account the investments that we're making in the tech hub, the full year cost of the mortgage servicing colleagues that we added and some of the other expenses that we foresee in the second half.

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Brian Paul Klock, Keefe, Bruyette, & Woods, Inc., Research Division - MD [51]

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Okay. Great. That's helpful. And then just another follow up on the capital discussion, it does sound like when you look at the $1.9 billion net that you talked about having in the capital plan, and now yesterday, the Board approved up to, what, $1.645 billion in a buyback. So does that imply that your -- as you mentioned something in the neighborhood of about $300 million or $350 million of a preferred issuance possible in the future. Is that what you're thinking?

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Darren J. King, M&T Bank Corporation - Executive VP & CFO [52]

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Yes. That was -- that's in the ballpark of where our thought process was. I think the logic there is when you look over the last several years of CCAR, Tier 1 capital has become our binding constraint as much as CET1. And so as we contemplated the plan this year, we are looking at the mix and the ratios of Tier 1 to CET1 and think there's an opportunity for us to just restack the capital a little bit to make sure that we're in good shape going into CCAR 2020.

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Operator [53]

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There are no further questions at this time.

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Donald J. MacLeod, M&T Bank Corporation - Administrative VP, Assistant Secretary & Director of IR [54]

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Again, thank you all for participating today. And as always, if any clarification on any of the items on the call or news release is necessary, please reach out to our Investor Relations department at (716) 842-5138.

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Operator [55]

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This does conclude today's conference call. You may now disconnect your lines.