Bank OZK Q2 2026 Earnings Call | High Asset Quality and Loan Originations Underpin NII Growth

Hey, thank you for the question, Stephen. We appreciate it. I'm going to turn this straight over to Jake M. This is his area. I'll preface Jake's remarks by saying that CIB is a very important and rapidly growing and developing part of our franchise. We're investing a lot in it and hiring really talented, experienced people to lead it. We are looking forward and enjoying the diversification now of our loan portfolio with CIB's addition, and the CRA concentration coming down significantly from RSG, and we wanted to make sure we're not trading one concentration for another. So the diversification within CIB's portfolio, which has a lot of different business lines to a lot of different types of customers, is a very important long-term franchise value enhancement we believe for Bank OZK. So Jake, I'm going to let you take some of the other points there that need addressing in response to Stephen's question.

Yes, thank you, Matt. Appreciate the question. I'll take that, and then Brandon can add any color he wants to add to that. Obviously, the quarter just ended was a big quarter of repayments with that number approaching $3 billion. If you look across the last four quarters, trailing four quarters, we've averaged about $2.5 billion a quarter. So all of that is consistent with our guidance that repayments will vary somewhat from quarter to quarter and that they're going to be elevated as we work through that big origination year of 2022, a record origination year. Those are all cycling through. We do expect continued repayments this year and into next year. Our sense is that will taper off a bit next year but still be at an elevated level based on our current projections, elevated but slightly less elevated than 2026. So I think that's the guidance we can give you on that. Obviously, this is a natural phenomenon given the cadence of originations and the typical life of these loans on our RSG book. Brandon may want to add something to that.

I think the guidance we gave at the beginning of the year and we've reiterated it in the management comments of mid-single digits is a good number. When the quarter just ended, we got a wave of repayments early, which had us significantly down on loan volume early in the quarter, and we were chasing volume all quarter trying to catch up with that early wave of repayments. So I think that is some useful perspective on the color. Notwithstanding that, we were able to improve our margin four basis points in the quarter and still put up higher net interest income in Q2 than Q1. But we were battling that prepayment wave really hard early on in Q2. Hopefully those prepayments will be a little more levelized in Q3 and Q4. As Brandon mentioned, these repayments move around, but when you get a big slug of them right off the bat early in the quarter, it's hard to catch up on the average earning assets.

Yes, Manan. I think that's the principal reason. It's average earning assets and not so much the volume of paydowns as the sequence and timing of those. When we started the year, we had expected a little bit more linear growth and not the pullback in growth in Q2. We were up 2% roughly after Q1 and then had negative growth in Q2. So we went backwards. We had expected that to be a little more linear through the year, and that's tamped down our average earning assets. So as Brandon mentioned, it's a very valid comment. A lot of these loans are chunkier loans, so a loan pulling forward two months ahead of schedule or something moves the projections there. So the cautious guidance on being able to equal or beat last year's net interest income number is simply a product of average earning assets.

Yeah, let me comment on special mention and then we'll let Tim talk about the reserve. We did have an increase in our volume of special mention loans, but I wouldn't read too much into that. Loans come into special mention. Some of them, as we saw a couple of examples in the quarter just ended, become more severely graded and move into classified asset category. But a lot of loans come into special mention, extensions, recapitalizations get accomplished in the ordinary course of business, and they move back to pass rated credit. We put a sentence in the management comments this time commenting that several of those loans were in special mention. We're in really good discussions and good activities that would result in those loans back to a pass status. So they're in there because those discussions are going on and we've got to get to a final conclusion on those discussions. But I think there are several of them that look like they're going to work out favorably and be candidates for upgrade over the next couple of quarters, if not the next month or two. So Tim, you want to comment on the ACL?

Good morning.

We have a pretty healthy ACL for that portfolio reflecting the general challenges on that sector. We've got several of these life science assets that do have good leasing. They're no issues at all with those. They're well-leased. We got one of our really nice paydowns in the quarter just ended, a big paydown on a well-leased life science project that we extended the term on. That was a nice win. The life science loan that we took a charge-off on this quarter, previously special mentioned, we took a short payoff on to exit. That was probably our least desirable single asset in the portfolio in my view. Other folks might disagree, but we're focused on an asset-by-asset basis looking at these, and I thought that was a more challenging asset from a long-term value and future perspective than some of the others. So we got a chance to exit that at a discounted payoff. We thought that was a nice improvement to the portfolio to move that out. There is a fair amount of leasing activity ongoing on several of the life science projects. A lot of it is not for life science; it's for technology, AI, office purposes, but there is some activity there. So Brandon, I'll let you share any additional thoughts you want to share about life science.

Yeah. We are probably 10 basis points higher than our low point on our CD specials across the board. So we have increased that really in the last probably about four to six weeks ago. I don't remember the exact timing, but that is a reflection of the fact that we expect to need to grow more deposits in Q3 and Q4 based on a moderately increased volume of outstanding loans. So we're ramping up a little bit for that. We said in the management comments, Katherine, that we thought the Q2 cost of interest-bearing deposits was probably an inflection point and we go higher from there. I don't think we're expecting to run off the rails going higher. I think it's just somewhat of a slight increase higher from where we were on COIBD in Q2. So modest increases in that cost as we go forward, and part of that is driven by the need to generate more deposit volume simply because we expect more loan growth in Q3 and Q4. We commented in management comments that we were really pleased with the good work that our funding team, deposit generating teams did in Q2, getting that five basis point reduction in our cost of COIBD, which combined with the work our investment team did on the investment portfolio let us actually improve net interest margin by four basis points during the quarter. I don't think many people expected that improvement. It was a nice result for the quarter particularly given the high level of paydowns early in the quarter that beat our average earning assets down for the quarter. So that was a nice offset. We'll benefit less from that ability in Q3 and Q4 as we grow loans more. We'll have to be a little more aggressive on deposit generation. When we were getting a lot of loan payoffs early in the quarter, our deposit guys were able to adjust their deposit gathering strategy and squeeze a little bit of margin benefit out as a result of the higher level of loan payoff. So there's a give and take there. We would rather have the volume, but if you don't get the volume, you like the way our team responded to that and they were able to grind some margin improvement out in a lower volume environment.

Yeah. The RSG origination volume, as we've reported in management comments, has been pretty muted. We're working hard to find volume, but a lot of these cities where we've originated a lot of volume in the past are raising taxes and adopting policies that are not specifically pro-business and are really anti-business, and that is affecting the need for new product in those markets. That, plus the fact that there's a lot of capital out there chasing debt in the CRE space that's very competitive on new deals, is keeping that volume muted and probably is going to do so for some number of quarters further. My crystal ball doesn't go too far out on that. But it's a challenging environment to originate volume. And of course because of the high level of originations in 2022 and to a lesser extent 2023, we're in the heart of a big payoff wave. So RSG is going to continue to drop. We don't talk about it a lot, but we're now at our second quarter where we're under 300% of total capital for CRE concentration. So we're below the regulatory concentration guidelines for total CRE, and probably by the end of the year or early next year we'll be under the 100% guideline for construction and development. So that portfolio is going to continue to shrink for the remainder of this year and into next year. We commented in the management comments that we expect CIB and RSG portfolios will be equal in size next year, and that gives you a real indication because CIB is $7 billion plus now and RSG is $15 billion plus, and we're expecting those are going to equalize and cross at some point in 2027. That means we're going to continue to see strong growth in CIB and strong paydowns in RSG. I think what we don't talk about a lot that is important is that over the next six quarters through 2027, you're going to see more positive momentum out of our community banking group and continued positive momentum out of our indirect and RV group. That group was in the 12% range, it's now 13.7% of our portfolio in the indirect. Our community banking portfolio has pretty much languished around its current balance for a couple of years now. We have reorganized some of the reporting structures there, took a little more straight-line and clean-cut set of reporting structures we've implemented. I think the team is really excited about that, and I think we're going to get some positive growth out of that. So if you look at the portfolio as really being three parts — the community banking indirect being one part, RSG being one part, CIB being one part — I think you get to more or less equal-sized, very diversified portfolio in 2027. Being below the regulatory CRE concentrations and having that portfolio very diversified is really accretive to our long-term shareholder comfort and franchise value. So that's part of this multi-year design and strategy we've been pursuing of getting more diversified. I do think you will see RSG be an important contributor to our growth and portfolio long term. I think you will see it grow again. It may get into the 20% of portfolio range before it hits that inflection point where origination fundings exceed payoffs and it turns back to a more positive contributor to growth. So I don't think we're going to see a lot of change in the paydown volume for a number of quarters.

Brian, what I would say on that is that the RSG portfolio is recycling in a constructive, healthy, and normal way. We mentioned we've had $9.95 billion, almost $10 billion, of that portfolio pay off over the last four quarters. If you think about that in the context of the entire funded balance and the entire commitments in the portfolio, that's a massive recycling of those assets. So it has been a very long and very tough CRE cycle for a lot of our customers. The quality of our sponsors and customers has shown up really well because we went through several years of that challenging environment with no problems to speak of, and we've had a handful of problems. We'll have a few more assets that will emerge as problems over the next year, year and a half as we work through the final stages of that cycle. But the portfolio is recycling really quickly with $2 to $3 billion a quarter in payoffs. The vast majority of our sponsors, as we have said all the way through, are continuing to support their transactions in a very positive way. You saw that in the quarter just ended: we had $91.5 million of unscheduled paydowns in the RSG portfolio, $19.5 million of additional reserve deposits posted in connection with extensions of loans, $37.5 million of unfunded balances curtailed in connection with modification extension of loans, and collected $5.4 million in modification fees. So the vast majority of our sponsors continue to support their loans. There have been, obviously, we've got 10 to 12 assets that we've identified that are either in foreclosed assets or classified assets where we didn't get the support we needed. There'll be a few more of those as we go forward. But we also have one of those OREO assets and three of the substandard loans that I feel pretty optimistic about our ability to work those out over the next few months. So we're far along with resolution and liquidation plans on those assets. We're working through the problems. The problems have been fairly isolated in number, and I think we're doing an excellent job working through them as they come up. Lastly, we built a big reserve in our ACL to deal with potential loss exposure on that, and we feel very good about the adequacy of the ACL to deal with that exposure across the entire portfolio.

Thank you. Thank you, Brian. Buyback, Tim.

I'm going to resist the temptation to use a baseball analogy. I'm not a huge baseball fan, even though our Arkansas Razorbacks baseball team is a great college team. But what I will point you to is the language that we've had for several quarters now in our management comments document. That is, we think we're in the late stages of a long cycle that has been a challenging cycle for our customers for a number of years. As that cycle has worn on, the resilience of some of our customers to continue to withstand that cycle and support their assets has diminished. That's why you're seeing the handful of special mention, foreclosed assets, and classified assets that you're seeing. So as I said in response to Brian's question, the RSG portfolio is recycling quickly. The $10 billion in round numbers of payoffs over the last four quarters is a strong indication that that portfolio is recycling and recycling quickly to current generation assets that are underwritten in a different environment. So we feel like we are adequately provisioned for that. As I told Brian, I think there'll be a few more bumps in the road and we'll have a few more problem assets, but we're also resolving assets at a pretty diligent rate as well. So late stages that probably continues this year and into next year, but I think we're feeling pretty good about where we are in the cycle. Now as for the net charge-off number, we are a little above the industry's Q1 number through six months. We have a long history of outperforming the industry, a multi-decade history of outperforming the industry. I think we've got a good shot of getting back under the industry's number for the year. We'll see how that plays out. It's a chunky mix of charge-offs. The vast majority of our charge-offs in the quarter just ended were on four credits. So it tends to be a little chunky in the way those are recognized. It's not like we have 100,000 loans where there's an averaging effect. But we're cautiously optimistic about our ability to get back under the industry number for the year. We'll see how that plays out.

What I can tell you on payment in kind or PIK interest, we don't PIK interest on any loans. So the interest on that credit, as on all of our credits, is being paid from reserves that were established for that purpose. You'll recall that early last year and then previously in 2024, there were two very large contributions to the reserve that we were holding on those loans from the sponsorship group on that asset specifically, that have been paying operating costs and interest and other costs related to those projects. So we do not PIK interest on loans. That's not relevant to that project or any other project. What I could tell you is this is a pass rated credit, and that's because of the very constructive dialogue that we've had with the sponsor and the mezz lender, both of whom, as Brandon alluded to, are working in what appears to be a very constructive and positive negotiation to work out a multi-year extension of that asset. That really is a negotiation with us, but it's also a negotiation between those two parties. So it'll take a little while to negotiate that. But we're cautiously optimistic about the outcome of that and have every expectation that that will be a successful outcome and that will remain a pass rated credit. Obviously if our thoughts in that regard change, we'll make appropriate adjustments to the classification of that asset.

Good morning.

I think a lot of that is already in our net interest margin. Our RSG originations over the last couple of years have had, because of the competitive environment for those assets and the fact that a larger and larger part of our RSG loans are multifamily loans where the spreads on those loans look very much like the CIB loans, the remixing of the RSG portfolio to be predominantly multifamily and really industrial is a big part of it. Those spreads look like CIB-related spreads. If you went back three, four, or five years, we certainly were getting higher spreads on RSG loans when we were doing more large complex mixed-use projects, more office, life science sort of projects than we are getting on that portfolio today. So that differential has tended to diminish, and the yields on those portfolios have tended to get closer and closer together. There's still a delta, but it's a much smaller delta than it would have been in past years. The second thing you correctly surmised is that we get a lot more deposits with our CIB loans and a lot more contribution to non-interest fee income from CIB. Jake's talked about that in his comments, the partnership with Treasury Management and the focus on those various service parts of their business that generate fees, whether it's on interest hedges or commodity hedges or syndication of debt or equity transactions, or just other kind of loan-related but non-interest fees that they generate. So we think CIB is going to be as profitable for us as RSG long term, and the yield differential we expected is really no longer there. Jake mentioned the way he is managing that CIB book and the different types of loans we make there. Sometimes various categories of loans get very aggressive because you have a few people really trying to put a lot of money into that space. Jake mentioned one category where we've seen yields compressed, and we're finding we get better yields in other categories with the same or better risk profiles. So he's done an excellent job, he and his very capable, very veteran team, of decelerating growth in areas where spreads are getting compressed by competition and accelerating where we can get real good value on a risk-adjusted basis. So super proud of the job they're doing on managing that.

Jan, I still expect it to step up each quarter in Q3 and Q4 from where we are in Q2.

Thank you guys for being on the call today. We appreciate it. We look forward to talking to you again in about 92 days. Have a great day. Thank you.