Q4 2017 First Republic Bank Earnings Call
Jan 16, 2018 AM EST
FRC - First Republic Bank
Q4 2017 First Republic Bank Earnings Call
Jan 16, 2018 / 03:00PM GMT
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Corporate Participants
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* Hafize Gaye Erkan
First Republic Bank - President
* James H. Herbert
First Republic Bank - Chairman and Chief Executive Officer (Founding)
* Jason C. Bender
First Republic Bank - Executive Vice President and Chief Operating Officer
* Michael D. Selfridge
First Republic Bank - Senior Executive Vice President and Chief Banking Officer
* Michael J. Roffler
First Republic Bank - Executive Vice President & Chief Financial Officer
* Mollie M. Richardson
First Republic Bank - Executive Vice President, Chief Administrative Officer & Chief People Officer
* Robert Lee Thornton
First Republic Bank - Executive Vice President and President Private Wealth Management
* Shannon Houston
First Republic Bank - SVP & Chief Marketing and Communications Officer
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Conference Call Participants
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* Aaron James Deer
Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research and Equity Research Analyst
* Brandon Berman
Bank of America Merrill Lynch, Research Division - Analyst
* Casey Haire
Jefferies LLC, Research Division - VP and Equity Analyst
* Christopher Edward McGratty
Keefe, Bruyette, & Woods, Inc., Research Division - MD
* David John Chiaverini
Wedbush Securities Inc., Research Division - Research Analyst
* David Joseph Long
Raymond James & Associates, Inc., Research Division - Senior Analyst
* David Patrick Rochester
Deutsche Bank AG, Research Division - Equity Research Analyst
* Emlen Briggs Harmon
JMP Securities LLC, Research Division - MD and Senior Research Analyst of Regional Banks
* Geoffrey Elliott
Autonomous Research LLP - Partner, Regional and Trust Banks
* Jared David Wesley Shaw
Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst
* John G. Pancari
Evercore ISI, Research Division - Senior MD, Senior Equity Research Analyst & Fundamental Research Analyst
* Kenneth Allen Zerbe
Morgan Stanley, Research Division - Executive Director
* Lana Chan
BMO Capital Markets Equity Research - MD & Senior Equity Analyst
* Matthew Timothy Clark
Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst
* Steven A. Alexopoulos
JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap and Small-Cap Banks
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Presentation
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Operator [1]
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Greetings, and welcome to First Republic Bank's Fourth Quarter and Full Year 2017 Earnings Conference Call. (Operator Instructions) I would now like to turn the call over to Shannon Houston, Senior Vice President and Chief Marketing and Communications Officer. Please go ahead.
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Shannon Houston, First Republic Bank - SVP & Chief Marketing and Communications Officer [2]
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Thank you, and welcome to First Republic Bank's Fourth 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, 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.
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [3]
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Thank you, Shannon, and thanks to everyone for joining our call today. It was a particularly good year for First Republic across our entire franchise. We continue to be successful in executing our very stable, client-centric business model, growing households very consistently.
2017 was a good number -- a good year on a number of fronts. We'll go through a few. Loans grew by $10 billion with no change in loan mix or quality. Our total deposits grew by over $10 billion, up 18%. Wealth management grew to over $107 billion in assets, up fully 28%. As always, and key, our credit quality remains very good. Our nonperforming assets were only 4 basis points. Net charge-offs for the year were only $650,000 on a portfolio of over $62 billion. Importantly, our capital levels remained quite strong. A couple of additional metrics. During the year, total revenues rose 18%, net income was up 13% and tangible book value was up over 14%.
Let me take one moment to talk about the business model and our acquisition of client households, which is the key growth metric, which we focus on. Each year we typically grow our total client households in the mid-teens percentage. In 2017, household growth was even higher than this already strong rate driven largely by our success in consumer deposit gathering and our millennial strategies. Overall, client growth of First Republic is always a direct and continuing result of exceptional client service delivery. Our high-touch model leads to uniquely strong client satisfaction levels that far exceed our competition.
The service quality is why we have net promoter score that's twice the industry average. It's also why we have a client attrition rate of only 2% compared to the industry's 8%. And it's why our home loan clients have an average of 8 products with us.
Our urban coastal well-educated professional clients tend to have an intrinsically high economic growth rate, which benefits First Republic. With their high levels of client satisfaction and their growth, over time, they do much more with us and they happily refer their friends and colleagues.
Let me turn the call over to Mike Roffler, Chief Financial Officer.
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [4]
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Thanks, Jim. I'll cover the new tax law, our net interest margin, net interest income and efficiency ratio. Let me start with the impact of the tax law in the fourth quarter results. As noted in our 2 recent 8-K filings, some of our employees chose to exercise an unusually large portion of their remaining stock options during the quarter. Also during the fourth quarter, we revalued our deferred tax assets due to the new federal corporate tax rate. The net effect of these 2 activities was a reduction to earnings of approximately $0.02 per share for the quarter. Our effective tax rate for the full year 2017 was 17%. As we look ahead to 2018, we currently expect the bank's effective tax rate to be approximately 19%.
Turning to net interest margin. Beginning in the first quarter of 2018, the bank will use the reduced federal corporate tax rate of 21% to compute the tax equivalent yields on our tax-exempt municipal securities and loans. The newly reduced rate lowers the tax equivalent yield of these holdings, which has a negative impact on our reported net interest margin. As a result of this change in tax rate calculation and assuming a continued competitive lending environment, coupled with flatter yield curve, we currently expect the bank's net interest margin to be in the range of 2.85% to 2.95% in 2018. Importantly, however, the tax rate change does not affect the contractual interest income of these investments, and it will have no impact on either our reported net interest income or our efficiency ratio. With the nature of our growing business, we look closely at net interest income as the most meaningful reflection of the growing earnings power of enterprise. Growth in net interest income was up a very strong 18% in 2017.
Turning to expenses. The efficiency ratio for the quarter was 63.7% and for the full year 2017 was 62.8%. Looking ahead, we currently expect the bank's efficiency ratio to be in the range of 63% to 64% for the full year 2018. This excludes the seasonal impact of higher payroll taxes and employee benefits that occur each year in the first quarter.
And now I'd like to turn the call over to Gaye Erkan, President.
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Hafize Gaye Erkan, First Republic Bank - President [5]
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Thank you, Mike. I would like to talk about our investment portfolio, deposit franchise and Gradifi. In terms of investments, our total portfolio grew to $18.6 billion at year-end. High-quality liquid assets, including eligible cash totaled $10.5 billion at December 31, or 12.4% of average total assets in the fourth quarter.
Turning to deposits. We are very pleased with the diversified and strong deposit growth across all channels and geographies. Total deposits were $68.9 billion, up 5% from the last quarter and up 18% for 2017, a very successful year. Growth in checking deposits remained strong and checking represented 63% of our total deposits at year-end. The average rate paid on total deposits during the fourth quarter was 28 basis points, up only 3 basis points from the third quarter.
Let me provide some perspective on our deposit franchise. Our mission every day is to fully serve our clients' personal banking, business banking and wealth management needs. Through exceptional service, our clients stayed with us over time. This leads to deep, stable relationship driven banking, not just transactional. Rate matters when selling your product, however, service matters when building broad, long-lasting relationships, and that is the reason our home loan clients use 8 products on average.
We source and service our consumer deposit relationships through a variety of diverse channels. These include private banking, our Preferred Banking Office network, relationship managers, business bankers and private wealth management. At year-end, consumer deposits represented 46% of total deposits with an average consumer checking account of approximately $80,000, which is not particularly large. We are very pleased that total consumer deposit households grew 20% during the year. It's largely our consumer relationships that drive growth in business banking. By providing extraordinary service, our individual clients introduce us to the businesses and nonprofits they lead and influence. Mike Selfridge will speak to this in a moment.
Turning to private wealth management, sweep accounts represented 6% of total deposits at year-end. Private wealth management has been an increasingly important source of deposits, not only through the sweep accounts but also the direct referral of wealth management clients to personal banking.
As seen with both business banking and private wealth management, our deposit franchise realizes great benefit from the holistic, personal, client-focused relationship model of First Republic. One channel often serves as a referral source to another, and our deposit results speak for themselves. Over the past 9 quarters, the Fed funds rate has increased 125 basis points. And over the same time period, our deposit rate has increased 14 basis points. This reflects our relationship based banking model.
Let me now discuss Gradifi for a moment. We are pleased with the continued momentum of Gradifi, which we acquired a year ago. At year-end 2017, Gradifi had over 300 companies on its platform, an eight-fold increase during the year. Increasingly, more companies are helping their employees repay their student debt by offering this innovative benefit. Employers recognize this benefit as a very effective way to attract and retain talent. Overall, it was a terrific year across the franchise.
And now I would like to turn the call over to Mike Selfridge, Chief Banking Officer.
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Michael D. Selfridge, First Republic Bank - Senior Executive Vice President and Chief Banking Officer [6]
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Thank you, Gaye. Let me start with economic conditions in our markets. We continue to operate in some of the most dynamic geographic markets in the country. The strength of our market is demonstrated in the loan origination volume in 2017, which was $28 billion. This was our best year ever. 2/3 of our loan growth in 2017 was real estate collateralized housing, both single-family and multifamily. For the full year, single-family residential lending volume was about half purchased and half refinanced. Our medium loan size was about $650,000 with an average loan-to-value of only 58%.
Multifamily and commercial real estate also grew nicely this year. The average loan-to-value ratio at origination was 50% for our multifamily originations and 47% for commercial real estate. Very importantly, credit quality remains excellent. We continue to make high-quality loans based on our consistent, conservative underwriting standards. During 2017, we added fully $60 million to our loan loss reserves. For perspective, the total loan loss reserve is now $366 million or almost 10x our year-end nonperforming assets.
Turning to business banking, it was another great year. Business deposits were up 21% compared to a year ago. At year-end, business deposits represented 54% of total deposits with an average business checking account size of approximately $299,000, not particularly large at all. Over 60% of these business deposit balances are operational or working capital in nature. These are very relationship-driven accounts and tend to be less rate sensitive. Year-over-year, business loan commitments were up 16% and business loans outstanding were up 21%. I would note that loans to nonprofits are the largest segment of business loans outstanding and represent 37% of our total business banking loan portfolio.
Over the past 5 years, we've made significant investments in our business banking franchise, which have yielded the results you see today. Total business deposits 5 years ago were $11.4 billion. Today, they are $37.4 billion, up 27% per annum. We served 20,000 business clients 5 years ago. Today, it's double that number. The investments in our business banking franchise continue to deliver meaningful results. Looking forward to 2018, our overall loan pipeline is strong, up modestly compared to a year ago.
And now I'd like to turn the call over to Bob Thornton, President of Private Wealth Management.
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Robert Lee Thornton, First Republic Bank - Executive Vice President and President Private Wealth Management [7]
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Thank you, Mike. Wealth management had a record year. We continue to be very successful in growing wealth management assets by winning a greater share of our clients' existing client assets, generating new business from word-of-mouth referrals and recruiting new advisers.
Now let me share some key results. Wealth management assets totaled $107 billion at year-end 2017, up $23 billion compared to a year ago. Client inflow represented nearly half of that growth. Wealth management revenue totaled $356 million for the year, up 22% compared to the prior year.
Let me also touch on further on how private wealth management contributes -- continues to drive deposits. As Gaye mentioned, private wealth management sweep accounts represented 6% of total assets at year-end. Sweep accounts represent a strong, stable source of consumer deposits for the bank. In addition, these deposits are highly diversified with an average account size of only $116,000. And during the year, many wealth management clients also became new deposit relationships. The growth in individual deposit relationships sourced through private wealth management highlights our highly integrated team-based approach and our ability to holistically serve our clients' financial needs.
In terms of recruiting experienced wealth professionals, 2017 was another very good year. During the year, we brought on 7 new wealth management teams and we also successfully integrated some of our most recent hires. Our reputation in the adviser community continues to grow as our client-centric service focused -- as a client-centric service focused firm that provides exceptional banking.
We're also quite pleased with the investments we've made in the wealth management franchise, which have supported our very strong growth. For example, 5 years ago, wealth management revenues were 7% of our total enterprise revenues. Today, they are 14%. Over the same period, the number of wealth management households with banking relationships at First Republic has more than doubled. We are very happy with this success and continued growth of wealth management and the opportunities that lie ahead.
And now it's my pleasure to turn the call over to Jason Bender, Chief Operating Officer.
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Jason C. Bender, First Republic Bank - Executive Vice President and Chief Operating Officer [8]
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Thank you, Bob. I'd like to comment on our business model, its scalability and some significant operational initiatives that we completed in 2017.
As Jim said, our business model begins and ends with extraordinary client satisfaction and loyalty. That's demonstrated by First Republic's Net Promoter Score, which is more than double that of the U.S. banking industry. A highly differentiated level of client satisfaction produces a more stable client base and allows us to do more with our existing clients. It also leads to strong word-of-mouth referrals.
As a result, half of our growth in any given year comes from doing more business with existing clients, with another 1/4 of our growth from their direct referrals. Our stable client base, coupled with growth largely driven by existing clients, allows us an advantage in operational scale. This further supports our efforts to provide exceptional client service.
Let me tie our operational scale to Jim's description of our business model. For context, looking at banks of a similar asset size, First Republic has far fewer the number of employees, branches and deposit accounts, just to list a few metrics. This relatively modest operational scale supports key tenets of our client service-focused business model as well as its scalability.
Fewer employees on average means fewer layers of management and faster decision-making. Fewer accounts on average means more time spent on each relationship, which in turn has further benefits. More time per loan leads to better credit. More time per transaction leads to lower execution risks. And more time per client leads to greater client knowledge and differentiated service. Maintaining that differentiated level of client satisfaction and ensuring the scalability of our client service-focused business model underscores all that we do and drives our investments in technology and operations.
To that end, we completed 3 major investments in technology and operations during 2017. We completed the rollout of our new single-family loan origination system with almost all of our new single-family mortgages now being originated on this system at year-end. Approximately 60% of all loans we originate going forward will be originated on this new system.
We completed development on our new consumer digital banking platform, the largest technology project for First Republic to date. We have successfully and smoothly converted 2/3 of our online clients to the new system, and we'll have converted nearly all remaining clients by the end of the first quarter.
Finally, we completed development of our new deposit client onboarding system and have migrated all of our bankers and offices to the new system at year-end. This new technology reduces the number of systems necessary to open a new account from 8 to 1, and enables bankers to now open new deposit accounts up to 50% faster than before.
Together, these 3 initiatives represent a big upgrade in some of our most important systems allowing for improved usability, streamlined workflows and paperless functionality. With the completion of these investments in 2017, First Republic has further scaled its capacity to continue to deliver consistent, exceptional client service well into the future.
Let me now turn the call over to Mollie Richardson, Chief People Officer and Chief Administrative Officer.
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Mollie M. Richardson, First Republic Bank - Executive Vice President, Chief Administrative Officer & Chief People Officer [9]
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Thank you, Jason. The diversity of perspective, experience and background of our people is key to our culture as is exceptional client service. We invest in our people in order to ensure that our culture and high service levels remain consistent. In 2017, we launched a new management development program, which brings together colleagues from across departments and regions to learn best practices in identifying and growing talent. We also introduced a new relationship manager development program, mostly recruiting from within First Republic, this program develops our next generation of bankers to support the growth of our new younger clients.
We would note that we have been paying a $20 per hour minimum wage for 2 years now in support of our people. Our meritocracy-based inclusive and diverse workplace environment has been fundamental to First Republic's success throughout our 32-year history. 48% of our total workforce and 52% of senior management are female, and 48% of our total workforce represents minorities. Additionally, approximately 1/3 of our Board of Directors is female and has historically been so. In fact, collectively, we speak over 50 languages at First Republic.
In addition to investing in our people and culture, we also invest to fully serve our diverse and dynamic communities. In 2016, we launched our Eagle Community Home Loan program, which provides attractive rates for home loan in underserved areas or communities. In 2017, we closed 3.5x more Eagle Community Home Loans than the prior year with a total portfolio of almost $1 billion and median loan amount of $377,000.
We also support our diverse markets through community development lending. Since 2011, First Republic has originated over 1,900 community development loans with a total portfolio of over $4.4 billion. Our community lending and engagement efforts are guided by our Community Advisory Board. This independent and diverse group of community leaders offers strategic guidance on the bank's affordable housing, small business and economic development and financial empowerment initiative. A continued focus on culture, diversity and our communities continues to be a foundation of our First Republic values and success.
And now let me turn the call back to Jim.
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [10]
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Thank you all very much. The bank remains steadfastly committed to our key pillars, highest possible credit quality, capital strength and exceptional differentiated client service. We've always focused on the longer term and remain steady in our approach to that. In this regard, we're continuing to invest in our systems, our people and our client services. 2017 was a very strong year marked by safe and solid growth, substantial systems improvements and successful capital raises. We're looking forward to 2018 very much. We expect it to be a good year.
Now we'd like to open the line for questions.
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Questions and Answers
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Operator [1]
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(Operator Instructions) Our first question comes from the line of Steven Alexopoulos with JPMorgan.
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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap and Small-Cap Banks [2]
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I wanted to start on the tax rate. I know you guys have had several moving pieces in tax rate in 2017, particularly around all the stock option exercising. Maybe for Mike Roffler, from a very high level, why is the effective tax rate not expected to move lower in 2018 given the lower federal tax rate now?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [3]
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So it's -- Steve, it actually leads into what you just said. So in the fourth quarter, we had a sort of a pull forward or an acceleration of employees exercising their options given the changes to the personal tax code also. When we had projected taxes before, you had assumed a more, what I'll call, a normal distribution or level exercise pattern. But in essence, those got exercised in the fourth quarter so you have less benefits in future periods. So it's sort of an offset where you won't see the benefit from the federal rate cut because this offsets it.
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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap and Small-Cap Banks [4]
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Okay. Okay, that makes sense. Mike, on expenses, following up on the efficiency ratio guidance you gave for 2018. Given all the puts and takes around the efficiency ratio, can you help us think about a reasonable range for expense growth in 2018 particularly as the spend for Gradifi subsides?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [5]
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Yes. So in 2017, on Gradifi, that's a good point, we spent about $17 million. And so that was a $17 million increase off of the base, and that was about $0.07 or $0.08 per share. Probably, also, impacted our efficiency ratio by a negative 70 basis points. If we think about -- we've been a consistent revenue growth of mid to high teens. And so you'd look at the expense growth, you know, probably in that same range. We've been running a bit higher because of all the investments we've made in the franchise, including Gradifi going from 0 to $17 million. But I think we look at sort of mid to high teens for, hopefully, both revenues and expenses as we look out, which keeps efficiency kind of where it is.
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Steven A. Alexopoulos, JP Morgan Chase & Co, Research Division - MD and Head of Mid-Cap and Small-Cap Banks [6]
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Maybe if I could squeeze one more. And just on the new margin guidance, you gave the 2.85% to 2.95%. What's the new money margin currently running at under the new tax rate?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [7]
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Yes. So loan yields in the quarter were around 3.25% on new business, and that it was really reflective, probably, of pricing from the third quarter as they sort of pull through into the fourth quarter. That doesn't change a lot because there's not a bunch of tax exempt lending in our current production.
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Operator [8]
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Our next question comes from the line of David Long with Raymond James.
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David Joseph Long, Raymond James & Associates, Inc., Research Division - Senior Analyst [9]
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In the past, you guys have talked about mid-teen loan growth. Is that still your expectations here going forward?
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Michael D. Selfridge, First Republic Bank - Senior Executive Vice President and Chief Banking Officer [10]
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That feels about right to us. We don't set targets, I should note that. And at the same time, we see a lot of good credit opportunities in our markets so that drove a little bit higher volume in 2017. But looking forward, we think mid-teens feels about right.
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David Joseph Long, Raymond James & Associates, Inc., Research Division - Senior Analyst [11]
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Got it. And then as a follow-up, I think, Jason, you'd mentioned the 3 platform upgrades that were completed or close to being completed. Does that have any positive impact on your operating expenses that you can talk about?
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Jason C. Bender, First Republic Bank - Executive Vice President and Chief Operating Officer [12]
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Sure. We think we continue to invest in the infrastructure of the bank. And what we think is that, that really allows us to scale our overall business model and to continue to offer differentiated levels of client service, particularly as we grow. But I think in terms of the efficiency ratio, I'd refer you back to Mike's earlier comments on our expectations for '18.
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Operator [13]
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Our next question comes from the line of John Pancari with Evercore.
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John G. Pancari, Evercore ISI, Research Division - Senior MD, Senior Equity Research Analyst & Fundamental Research Analyst [14]
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Regarding the loan yields in the quarter, I know -- I heard your margin commentary and some of the factors influencing. But the loan yields were essentially flat linked quarter, despite the upside move in rates on the short end. I know you pointed to the flatter curve as being a factor to a degree, but can you give us a little bit color. What's -- is there anything going on in terms of pricing? Are you adopting a bit more of a competitive posture that's eating into the spreads over the benchmark rates?
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [15]
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No, not really. We are always competitive on pricing as need be. We don't compete on terms, as you know, in terms of credit issues. But the market is just holding at a very competitive level on mortgages. They begun to move up a little bit recently, and so we're getting some additional pricing power, but not much. So I -- but I don't think our margins--our margins that -- as Mike indicated, reflect a pretty steady state situation.
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [16]
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The other thing I'd add is your comment about the rate hike. Obviously, it happened mid-December, and so there's a very modest benefit in December. And you'll see the HELOCs and other adjustable rate have a little bit of a move in the first quarter, but we have just a little benefit in Q4.
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John G. Pancari, Evercore ISI, Research Division - Senior MD, Senior Equity Research Analyst & Fundamental Research Analyst [17]
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Okay. Great. And then my follow-up is around expenses. I just want to get your latest take on what was the -- would you say the biggest driver of the reason why the efficiency ratio expectation was dialed higher through the year and now we're at 63% to 64%. What was the greatest driver of the upside pressure? And then, separately, are you starting to see higher-than-expected cost of hiring in your wealth management business just given some of your peer brokers are exiting the broker protocol and it's possibly making FA hiring more expensive?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [18]
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So on the first, really continued investment in the franchise around a couple of things we mentioned specifically, Gradifi and systems and sort of operational improvements we're making at a pretty rapid pace to support the household acquisition that Jim talked about during the prepared remarks. And so those investments really support the bank's overall differentiated service that are important to make. Second, on the wealth management, I don't think we've really seen a change in the sort of the way we are negotiating or the packages that come through when we hire advisers.
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [19]
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Well, just on this expense issue for a second. We passed $50 billion, officially, in terms of completion of all the programs only about 1.5 years ago. And although the math would say it was about 2.5 years ago, in fact, all the systems we needed for that were only signed off on about 1.5 years ago. That expense build up has leveled -- it's not going down, but it has leveled. We then shifted to investing in the entire systems of the enterprise, service delivery efficiency. You heard Jason go through several of them. So we've been focused on building out the improvement of our systems delivery and our client service delivery for only about 1.5 years. That has a ways to go, but the benefits are now beginning to show, particularly the online banking system, particularly the improved loan booking system as well as many other benefits throughout. We will be at that in '18 for sure. On the other hand, the growth of households and the growth of client base in the bank has never, in 33 years of history, been stronger. It is absolutely extraordinary what is happening, and that has some upfront cost. It will have enormous short, intermediate and longer term benefits.
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Operator [20]
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Our next question comes from the line of Aaron Deer with Sandler O'Neill.
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Aaron James Deer, Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research and Equity Research Analyst [21]
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I guess, sort of looking at the Gradifi investment that's been made over the past year, just curious where we should expect to see that starting to pull through on the revenue line? Is there something we can be watching for to see when that starts to really deliver?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [22]
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We're continuing to make investments in the platform and as Gaye mentioned, companies are signing up at an increasing pace. I think the revenues probably start to grow in sort of 2019 and thereafter.
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [23]
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Actually, that right -- it's very interesting to us. Right at this moment, if you think about it, you're hearing a lot of companies very appropriately so, increase the compensation of their employees as a result of the tax cut. As Mollie said, we've been a $20 minimum wage for a couple of years. But what a wonderful time for companies to take on a student loan repayment activity. And so the ramping up of Gradifi, the timing on Gradifi is virtually perfect. If companies want to help their younger employees who may be struggling a bit economically, helping them to repay their student loans as an additional HR benefit is central casting for exactly what they're trying to do right now.
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Aaron James Deer, Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research and Equity Research Analyst [24]
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Sure, that's a good point. And then on the deposit costs, Gaye mentioned that they're up 14 basis points since the Fed started raising rates. There's a little bit of catch up it seem back in the third quarter. This quarter, it seems like they were still pretty benign. What if you kind of look out and kind of what consumer and business expectations are now for deposit rates, what kind of pressure do you see on that going forward?
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Hafize Gaye Erkan, First Republic Bank - President [25]
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Sure, as you said, we are very pleased to have grown 18% year-over-year in terms of ending balances, and only 13 basis points up in rate in the entire year with 75 bps increase over the last 12 months. We are extremely pleased with the checking growth. Obviously, that doesn't have rate associated with it. It is there for service. Just going back to the business model, we tend to do a lot with the clients we have, 50% of our growth on deposit side comes from existing clients and 25% comes from referrals. And our coordinated focus on a holistic relationship has resulted great growth, if you look at the fourth quarter in consumer checking, which we're very pleased about. So it has been a great quarter from a deposit -- and year from a deposit perspective.
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Aaron James Deer, Sandler O'Neill + Partners, L.P., Research Division - MD, Equity Research and Equity Research Analyst [26]
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In terms of -- given that the loan growth that you're looking to fund this year, what would you expect in terms of deposit pricing at this point? Obviously it's hard to know where exactly that grows but just based on what expectations are now from your customers, are you seeing much more deposit pricing pressure here related in 2018?
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Hafize Gaye Erkan, First Republic Bank - President [27]
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Nothing any different than the banking sector. The betas has been in line with the banking sector and lower than the historical betas. If I could bifurcate on the consumer side, obviously those are the lowest betas given the relationship nature, and there's a lot of healthy activity on the businesses that we're banking that are led by the individuals who we have the personal banking relationship with as well. So we, --looking at 2017 as a trend, we would expect to fund the loan growth with deposits and have the loan deposit ratio in the low-90s.
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Operator [28]
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Our next question comes from the line of Ken Zerbe with Morgan Stanley.
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Kenneth Allen Zerbe, Morgan Stanley, Research Division - Executive Director [29]
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I guess the first question, just on the tax rate. I definitely appreciate the guidance for the 19% next year, but I guess, I'm trying to just get a sense of like how much more of this, I guess, in sort of stock option exercise impact is out there, right? I know it's kind of a vague question, but if you think about say 2019 or 2020, like should the tax rate only move higher from the 19% or is there still big chunks of lumpy exercises that could meaningfully reduce that?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [30]
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So, it's a good question, Ken. So the stock options, which are sort of a biggest variable on this, they will -- they have a 10-year life and so they're through to the middle of 2020. And maybe just for a little bit of perspective to give, we've put this in our filings, 8-Ks that we did. At the start of September -- October 1st, we had just over $4 million options outstanding. We're down to $2.4 million. So you had about what's that, 40% of them in 1 quarter when there were 11 quarters left. That's unusual. And so think of the $1.7 million being sort of -- or the $2.4 million that are left being done over the next 8 to 10 quarters on a pretty normal basis and so after that, you won't have this sort of volatility in the tax rate I'll call it.
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Kenneth Allen Zerbe, Morgan Stanley, Research Division - Executive Director [31]
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Got it, understand that your 19% assumes that $2.4 million is spread evenly over the quarters?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [32]
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That's correct.
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Kenneth Allen Zerbe, Morgan Stanley, Research Division - Executive Director [33]
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Got it. Okay. And then just really quickly on expenses, did I hear you right that you said 63 to 64, excluding the higher cost in first quarter? And if that's right, just give us a magnitude of what it'll be on an all-in basis?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [34]
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Sorry if I misspoke. So 63 to 64 was the annual efficiency range. The first quarter will naturally be higher than 64, but that's higher first quarter is included in the annual range guidance.
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Kenneth Allen Zerbe, Morgan Stanley, Research Division - Executive Director [35]
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Perfect, okay, my mistake.
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Operator [36]
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Our next question comes from the line of Dave Rochester with Deutsche Bank.
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David Patrick Rochester, Deutsche Bank AG, Research Division - Equity Research Analyst [37]
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Switching to the NIM guide again. Does your guide factor in today's curve with no additional rate hikes beyond the December hike at this point, is that right?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [38]
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No. We would have rate hikes in the forecast for 2018 pretty similar to market expectations. It's a function of, one, obviously we make the adjustment for the tax calculation. And second is competitive lending environment and the curve is relatively flat, obviously, it steepened a little bit lately. But competition is the biggest part of that sort of outlook.
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David Patrick Rochester, Deutsche Bank AG, Research Division - Equity Research Analyst [39]
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Got it. And then how many hikes are you assuming at this point, are you just going with the forward curves, is that basically what you said the expectation in the market right now?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [40]
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3 hikes, 3 hikes.
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David Patrick Rochester, Deutsche Bank AG, Research Division - Equity Research Analyst [41]
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3 hikes okay, great. And then just on expenses. I was curious how much would you say is discretionary spending you're doing right now that's in the run rate like marketing expense for Gradifi or other items you can choose to slow or reduce over time following the ramp up in Gradifi?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [42]
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So there are several million dollars in there, you're right, the fourth quarter had the completion of our advertising campaign that ran the television campaign. We also had some millennial strategy that we were doing, marketing wise in the fourth quarter. So there are some dollars we could pull back on From an investment infrastructure standpoint, Jason mentioned the big things that were largely completed, and will now be mostly in our run rate going forward and we do have other things that we're looking to do as we continue to build out and improve our infrastructure and operations again, in the name of client service.
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David Patrick Rochester, Deutsche Bank AG, Research Division - Equity Research Analyst [43]
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Okay, great. Just one off on the income side. It's on the investment management fee growth is pretty substantial this quarter, especially versus the AUM growth, which is also strong. Were there any performance fees or anything like that, else one-time or anything like that in there?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [44]
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Good question, David. There actually is one item, it's a legacy performance item from an acquisition that was about $7 million, that would only occur in the fourth quarter if it does occur. So the run rate, I would pull that out when you project forward. But there's also a corresponding compensation -- a relatively close compensation increase also as a result of that fee.
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David Patrick Rochester, Deutsche Bank AG, Research Division - Equity Research Analyst [45]
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So a compensation item that was roughly $7 million as well or maybe a little less?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [46]
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A little bit less, call it $5 million.
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David Patrick Rochester, Deutsche Bank AG, Research Division - Equity Research Analyst [47]
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Okay, and one last one on credits. Any uptick in LTVs or increase in competitors cutting corners on credit that you guys are seeing? Or is it just pretty much similar standards that you're seeing from last quarter?
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Michael D. Selfridge, First Republic Bank - Senior Executive Vice President and Chief Banking Officer [48]
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I would say, from our perspective, we're very consistent in our LTVs. While competitors may go higher, we as you know don't chase on credit. And we do price to win based on relationship.
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David Patrick Rochester, Deutsche Bank AG, Research Division - Equity Research Analyst [49]
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From that you're basically saying you haven't seen any uptick in competitive pressures on the credit side?
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Michael D. Selfridge, First Republic Bank - Senior Executive Vice President and Chief Banking Officer [50]
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It's about the same.
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Operator [51]
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Our next question comes from the line of Jared Shaw with Wells Fargo.
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Jared David Wesley Shaw, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [52]
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Just circling back on the taxes of that 19% guidance. What are your assumptions for that for tax credits going forward? And can you share with us what the expense -- the non-interest expense for tax credits in the fourth quarter was? And then I guess what your expectation is for 2018 to get that 19% level?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [53]
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Sure. So on the tax credit investment, obviously, with the market -- the syndicators and developers will be adjusting for the new federal tax code. We invested less last year but we do continue to make investments, it is part of our CRA activities, and we will continue to make probably more moderately amount of credits going forward. This might be a little bit different than your other banks, I'm not sure. But our expense associated with low income housing, the amortization, the investment actually goes into our tax expense under accounting that was issued probably 2 or 3 years ago. Some banks may not follow that, I'm not sure. And so that amortization included in our tax rate every quarter has been sort of $25 million to $30 million per quarter in terms of the run rate on amortization of the low income housing investments. And that's embedded in the 19% that you see in our forward projection.
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Jared David Wesley Shaw, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [54]
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Okay, and then on the muni side, any change in the expectation of sort of purchase level of munis going forward or where ultimately you would like to see munis as a percentage of securities?
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Hafize Gaye Erkan, First Republic Bank - President [55]
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Yes, on the muni side, we'll be more opportunistic. We will continue to be opportunistic in the purchases looking forward into 2018. At the current levels, from a yield to duration perspective, we would expect to slow down on the muni purchases and maintain the HQLA above 12% as previously guided.
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Operator [56]
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Our next question comes from the line of Casey Haire with Jefferies.
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Casey Haire, Jefferies LLC, Research Division - VP and Equity Analyst [57]
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One of -- big picture question, I guess, on the operating leverage dynamics. It looks like this is going to be another year of negative operating leverage. I know you guys are growing very well and investing in some of your wealth management and millennial strategies. But as we look forward to 2019, do you need the yield curve to be steeper to get to positive operating leverage? Or can you get there by maybe striking a better balance with your longer-term investment strategies and profitability -- near-term profitability?
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [58]
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Actually very good question, Casey. I think we can get there in the latter way. We don't need a steeper yield curve and our projections don't necessarily assume it. We assume kind of where we are now on the yield curve, which is obviously, a very challenging yield curve. And so we don't expect to get any benefit from the market. Obviously, we'd be delighted if we did. So our expense growth should fall more into line with our expansion. The big variables are systems investment, Gradifi and some of the flow of our millennial strategies and other fronts. But generally speaking, we're really -- we're quite pleased, we realized we get a lot of grief on the expense ratio, but the quality of what we're doing with the clients, the Net Promoter Scores and the referrals at rate at which they are operating is such that we really can't complain. We can -- we don't expect negative operating leverage next year though, I wouldn't characterize it that way at all.
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Casey Haire, Jefferies LLC, Research Division - VP and Equity Analyst [59]
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Okay, great. And just switching I guess to capital management. You guys redeemed some preferreds early on in the year. The Tier 1 leverage at 8.85%, how low are you willing to take that because you do have an opportunity to redeem more of the preferreds and get some earnings back given that Tier 1 common is the gating ratio for you?
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [60]
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Well we're actually quite happy with our capital ratios at this point. The leverage ratio is one of the ratios obviously that we can -- that can run a little tighter. But we don't -- at this point, our common equity seems to be quite adequate.
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Operator [61]
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Our next question comes from the line of Erika Najarian with Wedbush -- I am sorry with Bank of America Merrill Lynch.
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Brandon Berman, Bank of America Merrill Lynch, Research Division - Analyst [62]
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This is Brandon Berman on for Erika. We just wanted to ask a question, a clarifying question on the net interest guidance -- net interest margin guidance. The 2.85, 2.95 range, is that off of the 280 basis points in 4Q so you're implying margin expansion? I guess, another way of asking it is: what is the pro forma securities yield and assumptions for FTE going forward?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [63]
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So let me walk through this maybe briefly. So the fourth quarter was 3.08 and we have to make the tax equivalent adjustment that I talked about to the go-forward yield. That puts us at about 2.93, 2.94. And so that guidance reflects the tax adjustment being made and after that, it's reflective of sort of what we view the competitive landscape to be to stay in that 2.85 to 2.95 range.
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Operator [64]
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Our next question comes from the line of David Chiaverini with Wedbush.
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David John Chiaverini, Wedbush Securities Inc., Research Division - Research Analyst [65]
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So a follow-up on the net interest margin. So when we look at the increase in the 10-year treasury yield which has been pronounced over the last few weeks, I would think that should help loan pricing for First Republic. Could you talk about how leverage First Republic is to a rising 10-year yield as it relates to the net interest margin? Or do the benefits of that get completely competed away in on the deposit pricing front?
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [66]
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No, it's not competed away. It's really a case of -- it's obviously is positive because we are in our real estate activities at least mostly an intermediate term lender, pricing a lot of our loans price off the 5- and 10-year. And so when I commented earlier that our thinking forward for the first -- for next year is assuming the current yield curve, it did not take into account the recent tick up in 10-year rates. It remains to be seen whether it holds, whether it goes further and whether the yield continues to steepen. If the yield curve continue to steepen, we would get some benefit.
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David John Chiaverini, Wedbush Securities Inc., Research Division - Research Analyst [67]
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Great. And as a follow-up, to what extent, if any, is the student refi product pressuring the NIM?
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [68]
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It's not pressuring the NIM. The incremental margin on that product is probably right in the high 2s at this point. The size of the loans and the marketing to bring them on puts some pressure on it in the early years of the relationship, actually in the early year of the relationship. And so the fact that we have a fairly large growth rate in the number of relationships relative to what we already have, it's kind of how many new, how many old do you have kind of analysis. That business is in its early stages and as a result, the magnitude of the new, which is considerable, is weighing on the profitability of the older. As each year goes by, the base grows larger and the profitability increases actually rather rapidly.
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Operator [69]
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Our next question comes from the line of Chris McGratty with KBW.
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Christopher Edward McGratty, Keefe, Bruyette, & Woods, Inc., Research Division - MD [70]
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Maybe, Gaye, on the HQLA 12% comment, I'm interested, number one in why 12% is the right number? I thought maybe in the deregulatory world that we live in, hopefully live in, that number could potentially go a bit lower and the remix of that piece of the securities book could have an upward bias. Any color would be great.
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Hafize Gaye Erkan, First Republic Bank - President [71]
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Sure, similar to the conservatism we have in capital and credit, we apply the same conservatism on liquidity risk management as well. According to our own liquidity stress testing, we deemed 12% as a good guidance looking into 2018, and we'll continue to maintain, absent any changes, we continue to maintain that in 2018.
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Christopher Edward McGratty, Keefe, Bruyette, & Woods, Inc., Research Division - MD [72]
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Okay, great and what is the yield on that portfolio today or where new money purchases have been?
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Hafize Gaye Erkan, First Republic Bank - President [73]
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I'm glad you asked because I was going to -- I remember that I forgot to mention that. The HQLA has picked up nicely in yield. The marginal purchases -- the additional purchases that we're making is now in the low 3s, 3% to 3.3% with a 4- to 5-year duration. So compared to the rest of the bank's NIM, it's actually, while being liquid, it's still a good investment.
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Operator [74]
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Our next question comes from the line of Geoffrey Elliott with Autonomous Research.
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Geoffrey Elliott, Autonomous Research LLP - Partner, Regional and Trust Banks [75]
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When you look at originations in 4Q, do you think there was much impact from activity getting pulled forward ahead of the changes in deductibility limits on mortgage?
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Michael D. Selfridge, First Republic Bank - Senior Executive Vice President and Chief Banking Officer [76]
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I think perhaps a little bit, yes. And also when you compare it to Q4 '16, remember that was our best -- that was a record quarter for us, and it was also a little bit of pull forward, that was the second Fed rate hike, little bit rush to refi. So quarter-over-quarter, it's a little noisy but if you look at year-over-year, we're quite pleased.
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Geoffrey Elliott, Autonomous Research LLP - Partner, Regional and Trust Banks [77]
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And then it seems like prepayments have gone down a bit is that just a function of rates or is there anything else going on there?
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [78]
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Yes, that's a function of rates a little bit. It happens pretty much every time rates go up and there's a reset on refinances primarily slow down for a bit.
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Operator [79]
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Our next question comes from the line of Matthew Clark with Piper Jaffray.
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Matthew Timothy Clark, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [80]
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On the tax credit-related discussion, assuming you do maybe less of it again in 2019, I mean, is it fair to assume you can hold that 19% tax rate, or should we assume some upward creep?
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [81]
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So again, it largely is on the timing of when employees will exercise but for the next couple of years, that feels like a good place for us to be.
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Matthew Timothy Clark, Piper Jaffray Companies, Research Division - Principal & Senior Research Analyst [82]
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Okay. And then on reserve coverage, you guys were unchanged with the strong -- providing for the stronger growth keeping the reserve ratio at 58 basis points. Again, how should we think about that ratio with CECL on the horizon, should we assume some upward bias there? Or do you think you can kind of hold the same level even -- when that rule goes into effect.
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [83]
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So it is too early to say. We're 2 years away. We are actively working on the project and going through the portfolios. But given the bank's credit quality from a historical perspective when you look at our losses over 33 years, that should tell us we should be less impacted than probably others when we go to the new methodology in 2020.
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Operator [84]
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Our next question comes from the line of Emlen Harmon with JMP Securities.
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Emlen Briggs Harmon, JMP Securities LLC, Research Division - MD and Senior Research Analyst of Regional Banks [85]
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Just a quick one there for me. You guys are into the markets kind of most meaningful impacted by personal SALT provisions and mortgage deductibility, are you guys starting to see any impact of the housing market from tax reform yet. Just be interested on your views there?
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Michael D. Selfridge, First Republic Bank - Senior Executive Vice President and Chief Banking Officer [86]
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No, it's a good question and we're paying close attention to that. We're in touch with a number of brokers, our clients prospects and our bankers. And right now, to be honest, it's too soon to tell. I would also note our vibrant markets, strong economies, low unemployment and there is still a lot of activity, but again, too soon to tell.
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Operator [87]
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Our next question comes from the line of Lana Chan with BMO.
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Lana Chan, BMO Capital Markets Equity Research - MD & Senior Equity Analyst [88]
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Just one quick question about the average cash position. It seems like average balances have come down over the last couple of quarters, although period end's only down slightly from September 30. How should we think about that? I assume that that's helped your margin recently.
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Michael J. Roffler, First Republic Bank - Executive Vice President & Chief Financial Officer [89]
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If you look in the fourth quarter, it was down a bit, it has helped the margin. I think we've been running around $1 billion in the last couple of quarters, which feels about right in order to meet sort of the strong loan demand that we obviously had, coupled with the investments we've been making, we've been able to run at this level and it's a comfortable level for us to be on the average.
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Hafize Gaye Erkan, First Republic Bank - President [90]
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And just to add, it also is a function of the liquidity portfolio growing as well as the deposits -- strength of the deposit activity in those quarters. The second half tends to be much better. Deposits are seasonal, so the second half tends to have the increased activity in deposits.
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Lana Chan, BMO Capital Markets Equity Research - MD & Senior Equity Analyst [91]
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Okay and just one more. Do you have where your cost of deposits ended the year at?
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Hafize Gaye Erkan, First Republic Bank - President [92]
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So we ended at 28 basis points in total deposit rate.
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Lana Chan, BMO Capital Markets Equity Research - MD & Senior Equity Analyst [93]
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The average was 28 basis points and the end-of-period was also 28 basis points?
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Hafize Gaye Erkan, First Republic Bank - President [94]
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The ending period was around 28, 29 type of level, if I'm not mistaken.
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Operator [95]
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Mr. Herbert, we have no further questions at this time. I would now like to turn the floor back over to you for closing comments.
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James H. Herbert, First Republic Bank - Chairman and Chief Executive Officer (Founding) [96]
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Thank you all very much. Sorry about the glitch at the beginning of the call. Thanks for your attention. Bye-bye. Have a good day.
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Operator [97]
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Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for participation, and have a wonderful day.
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