State Street Corp (XLF) Q3 2020 Earnings Call Transcript

Good morning and welcome to State Street Corporation’s Third Quarter 2020 Earnings Conference Call and Webcast. Today’s discussion is being broadcast live on State Street’s website at investors.statestreet.com. This conference call is also being recorded for replay. State Street’s conference call is copyrighted and all rights are reserved. This call may not be recorded for rebroadcast or distribution in whole or in any part without the expressed written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. Now, I would like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street.

Good morning and thank you all for joining us. On our call today, our CEO, Ron O’Hanley, will speak first. Then Eric Aboaf, our CFO will take you through our third quarter 2020 earnings slide presentation, which is available for download in the Investor Relations section of our website, investors.statestreet.com. Afterwards, we will be happy to take questions. During the Q&A, please limit yourself to two questions and then re-queue. Before we get started, I would like to remind you that today’s presentation will include results presented on a basis that excludes or adjusts one or more items from GAAP. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measure are available in the appendix to our slide presentation. In addition, today’s presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors such as those factors referenced in our discussion today and in our SEC filings, including the risk factors in our Form 10-K. Our forward-looking statements speak only as of today and we disclaim any obligation to update them even if our views change. Now, let me turn it over to Ron.

Thank you, Ilene, and good morning everyone. Earlier today, we released our third quarter and year-to-date financial results. Let me start by saying how proud I am of our team members worldwide who continue to put our clients first and deliver strong results for our shareholders in these extraordinary times. Turning to Page 3, our vision is clear and remains that of becoming the leading services and data insight provider to the owners and managers of the world's capital. Despite the challenges of the current operating environment, we continue our strategic pivot in investment services from being primarily a fund servicer to being an enterprise outsource provider, further enabled by our differentiated State Street Alpha platform. We are forging ahead with the implementation of our strategy, developing new business opportunities, and continuing to drive productivity improvements. As we successfully navigate the COVID-19 environment, we are operating against four priorities; one, delivering growth through deeper client engagement; two, improving our product performance and innovating; three, driving efficiencies through improved productivity and optimization; and four, supporting the financial system and planning ahead for our team members. I will provide you a short update on each of these areas before moving on to our results. First, our clients are at the center of everything we do. This year we have proven that as a result of our strong operational capabilities we are able to effectively and efficiently onboard new clients and install new assets in even the most volatile of market environments and we continue to see proof points of our operational excellence. For example, this quarter we successfully installed approximately 800 billion of investment servicing assets. This was accomplished while also driving sales and expanding the pipeline as demonstrated by the strong level of new investment servicing wins this quarter, which amounted to 249 billion. Our front-to-back Alpha platform drove approximately one third of these wins. Of note, included in these wins was a front-to-back CRD middle office and core custody mandate with a large European asset manager that was not a pre-existing client relationship. Also, despite the challenges, we continued to expand in critical growth markets with the opening of a new office in Saudi Arabia to support our growing opportunities in the Middle East. Lastly, we continue to win new business and maintain a strong pipeline at CRD. For this quarter we more than doubled new bookings both year-over-year and quarter-over-quarter. The institutional investor market is experiencing significant disruption. Our clients are facing increased pressures to effectively employ data to achieve better investment outcomes and drive efficiencies within their operating models. We are positioning ourselves strategically to meet our clients' needs and help them with their own strategic pivot. Second, product differentiation and innovation are critical elements of how we are driving revenue growth across the franchise. Clients continue to turn to State Street for our comprehensive and differentiated servicing capabilities. For example, we recently launched our new NAV Insights product for our hedge fund clients. Elsewhere, the open architecture and interoperability of our platform will enable us to expand our capabilities and attract new clients by partnering with other service providers such as our recently announced partnership with SimCorp for the insurance segment in EMEA. At Global Advisors, where assets under management reached a record level of 3.1 trillion this quarter, we continued to expand our product offerings including expanding our range of fixed income ETFs. Third, we remain highly focused on driving productivity improvements and automation benefits as we strengthen our operating model and cost efficiencies even during this challenging period. Companywide productivity and efficiency efforts in just the first nine months of 2020 have so far achieved growth savings of 5% of our 2019 year-to-date total expense base, excluding notable items as we continue to gain efficiencies through IT optimization as well as other measures. The efficiencies we gain from the optimization of our business model to date are enabling both margin expansion and further investments to support our operations, client needs, and technology innovation, including our ongoing investments in CRD and our Alpha platform. Last, throughout this crisis, State Street has supported the financial markets and our employees. Our human capital is critically important to our success. We have safely reopened most of our office locations across the world and have brought back critical functions that operate more effectively, fuller part-time in office but most of our workforce remains working from home. At the same time, we are planning for the post-pandemic workplace of the future. We believe that enabling better productivity, innovation, and fostering cultural attributes that set us apart are critical to our success. As many of you know, Global Advisors has long been a leader in its stewardship efforts and its focus on diversity and good governance with portfolio companies. We are also addressing racial and social injustice by improving diversity and inclusion within our own organization and advocating for the same in our industry. This is critically important to our leadership team and we are taking a number of concrete actions aimed at reducing these injustices, including 10 specific actions we have committed to executing, which I encourage you to review on our website. Turning to Slide 4, we present our third quarter and year-to-date financial performance highlights. You will see that as we continue to implement our strategy and improve our productivity, these actions are bearing fruit. First, looking at our third quarter results relative to the prior year period, total revenue decreased 4%, largely driven by the impact of interest rate headwinds on our NII results. However, fee revenue increased 2%, demonstrating the progress we are making as we work to reignite fee revenue growth as well as the year-over-year contribution from CRD. Turning to expenses here again I am pleased to report that as a result of our continued productivity improvements, we have reduced both third quarter and year-to-date expenses by 2% excluding notable items. Productivity management is now a way of life for us and we will continue to build on this strong culture of expense management we have successfully established. On a year-to-date basis and excluding notable items, we have driven 3 percentage points of positive operating leverage, improved our pretax margin by 1.3 percentage points, and generated 19% of EPS growth relative to the year-ago period. We have achieved these improved results in a very challenging operating environment, particularly the low interest rate environment that I just mentioned. Lastly, reflective of our business model, our balance sheet and capital position are strong and we continued to operate with capital levels well in excess of our regulatory requirements. As we await the outcomes of the latest Federal Reserve stress test in the fourth quarter, given our strong capital levels and unique business model, we are considering a full range of capital return actions in line with Federal Reserve instructions and market conditions. To conclude, despite the challenges of the current operating environment, we are navigating it well. We are implementing our differentiated front-to-back alpha strategy, developing new business opportunities, and continuing to improve our operating model, thereby driving productivity improvements. I am pleased that our third quarter and year-to-date performance demonstrate this and how we are making measurable progress in improving State Street's financial performance. And with that, let me turn it over to Eric to take you through the quarter in more detail.

Thank you, Ron and good morning everyone. To begin my review of our 3Q 2020 results I'll start on Slide 5. As you can see on the top left panel, during the third quarter we recorded good growth in both servicing and management fees. Our expense discipline continues to bear fruit too with total expenses down 4% year-on-year and 2% ex-notables. On the right-hand side of the slide, you can see two notable items, including a small legal release this quarter. Separately and for comparison purposes only, we have also called out some of the noteworthy impacts within NII which I will discuss more in more detail shortly. Turning to Slide 6, period end AUC/A increased to 11% year-on-year and 9% quarter-on-quarter to a record $36.6 trillion. The year-on-year change was driven by higher period end market levels, client inflows, and net new business. Quarter-on-quarter AUC/A also increased as a result of higher equity market levels and net new business installations. AUM increased 7% year-on-year and 3% quarter-on-quarter to 3.1 trillion, also a record. Relative to the year-ago period, the increase was primarily driven by higher period end market levels, coupled with net ETF inflows offset by some institutional net outflows. Our SPDR Gold ETF continued to perform strongly, generating 6 billion in net inflows this quarter and taking in a record 23 billion year-to-date. Quarter-on-quarter, AUM increased mainly due to higher period end market levels, partially offset by cash net outflows as very strong inflows during the first half of the year reversed with a recent risk-on sentiment. Turning to Slide 7, third quarter servicing fees increased 2% year-on-year including FX reflecting higher average market levels, increased amounts of client activity, and net new business only partially offset by pricing headwinds which continue to moderate. Servicing fees were also up 2% relative to the second quarter, including the effects of FX driven by higher average market levels partially offset by the sequential normalization of previously elevated client activity. As a result of our commitment to clients and our strong operational capabilities, we have continued to close deals and successfully onboard new client business throughout this pandemic. On the bottom left of the slide, we summarize the statistics. On the bottom right panel, we summarize the actions we're taking to further ignite growth. In 2019 you may recall that we saw servicing fees declined 6% year-over-year probably as a result of elevated pricing pressure which is now moderating. We quickly intervened by rolling out a client coverage model to our top 50 clients, instilling pricing governance, launching the new Alpha front-to-back offering, and working more closely with our clients. The result was to not only stabilize servicing fees, but also begin to drive growth in servicing fee revenues, which are now up 2% year-on-year and year-to-date. The next phase is to extend our enhanced sales coverage model to another 150 clients, leveraging both country and regionally focused segment teams to further develop our pipeline. We think this is worth another couple of percentage points of servicing fee growth over time as we saw across our top 50 clients. Turning to Slide 8 let me discuss the other important fee revenue lines in more detail. Beginning with Global Advisors third quarter management fees increased 2% year-on-year and 7% quarter-on-quarter, with a year-on-year performance largely driven by higher average market levels as well as net ETF and cash inflows partially offset by institutional outflows. For a complete view of our investment management segment revenues we've included a page in the addendum, which also includes fees we earn as a marketing agent as we do for our SPDR Gold ETF, which are booked in other GAAP lines. All in total investment management segment fee revenues increased 5% year-on-year and 7% quarter-on-quarter and the business segment margin reached 29% this quarter. With the third quarter complete, we anticipate that the likely impact of money market fee waivers net of distribution expense will be within the previously announced $10 million to $15 million range for full year 2020. Turning to FX trading services, third quarter results were up 4% year-on-year, but were down 15% quarter-on-quarter as we saw the second quarter bump proceed. Securities finance revenue decreased 28% year-on-year, primarily driven by lower client balances and lower agency reinvestment yields affecting the industry. Securities finance revenue was down 9% quarter-on-quarter, mainly as a result of those lower yields. Finally, third quarter software and processing fees increased 21% year-on-year, but were 30% lower quarter-on-quarter, largely driven by CRD, which I'll turn to next as well as market related adjustments. Moving to Slide 9, we show a view of CRD’s business performance and revenue growth. As you can see, we have separated CRD revenues into three categories; on-premise, professional services, and software-enabled revenues. The slide illustrates the lumpy revenue pattern inherent in the 606 revenue recognition accounting standards for on-premise and more importantly, it demonstrates the consistent growth in the more predictable streams of software as a service and professional services revenues. As a reminder, second quarter CRD standalone revenue of 145 million was primarily driven by a large wealth on-premise implementation and several large asset manager renewals. This quarter CRD standalone revenue was a more normalized 99 million. Looking over a broader time horizon, you can see that total revenue, as well as the SaaS and professional fee revenue growth are strong, up 16% and 20% respectively. As we continue to invest in and expand the CRD platform, we are seeing good momentum in the business and we now expect full-year CRD standalone revenue growth to be in the low double-digits. Turning to Slide 10, third quarter NII declined 26% year-on-year and 14% quarter-on-quarter. Excluding the impact of episodic and true-ups, NII was down 20% year-on-year and 11% quarter-on-quarter. As a reminder, the year-ago period included approximately 20 million of episodic market related benefits related to the FX swap mark-to-market and hedge effectiveness. This quarter’s NII included a negative true-up as we recognized approximately 20 million from OCI to net interest expense related to the prior period transfers of securities from AFS to HTM. Year-on-year the change in NII was primarily driven by the impact of lower market rates, the impact of these two items partially offset by larger investment portfolio and loan balances. Relative to the second quarter the decline in NII was primarily driven by the impact of lower market rates, the roll-off of MMLF balances, and this quarter's true-up partially offset by a $5 billion expansion of the core investment portfolio, which was worth about $10 million of additional revenues. On the right-hand side of the slide, we show our end of period and average balance sheet trends. We currently expect to operate at around 190 billion of average deposits so that may actually increase given the Fed's continued expansion of the money supply. As a result, this puts us in a position to continue to consciously expand the investment portfolio in the coming quarters to mitigate the effect of the low rate environment. On Slide 11 we've again provided a view of the expense base this quarter ex-notable so that the underlying trends are readily visible. 3Q 2020 expenses were down 2% year-on-year, but up 1% quarter-on-quarter, excluding notable items but including the impact of FX. As we continue to concentrate on driving productivity improvements and cost management in a challenging environment, we reduce expenses across four of five GAAP lines, compensation and benefits, transaction processing, occupancy and other relative to the year-ago period. Information system costs remain lumpy but we continue to focus on technology optimization and are making good progress. On a year-to-date basis total expenses are down 2% ex-notables relative to the year-ago period, demonstrating the solid progress we are making in improving our operating model as we reduce gross expenses by about 5 percentage points, which is partially offset by natural growth and reinvestment of approximately three points. Moving to Slide 12, in the left panel we show the growth and evolution of our investment portfolio. The investment portfolio increased to 112 billion as we thoughtfully put more client deposits to work, even as MMLF Securities continued to run off as anticipated. You will see that we continued to maintain a high percentage of HQLA assets, and as the short-dated MMLF securities matured, the average duration of portfolio extended to almost three years at period end. In the right panel, we show the evolution of our CET1 and Tier 1 leverage ratios. As you can see we continue to navigate this challenging operating environment with strong and elevated capital levels. As of quarter end our standardized CET1 ratio increased by 10 basis points quarter-on-quarter to 12.4%, driven by solid retained earnings only partially offset by modestly higher risk-weighted assets. The Tier 1 leverage ratio was improved by 50 basis points to 6.6% as a result of our higher retained earnings and lower average assets. Consistent with the restrictions imposed on large banks by the Federal Reserve, we made no common share repurchases in the third quarter and cannot do any in the fourth. As Ron noted, we are confident in our strong and elevated capital position and we will consider a full range of capital actions, including the resumption of share repurchases in upcoming quarters on regulatory and market conditions allowed. Turning to Slide 13, we've again provided a summary of our 3Q 2020 and year-to-date performance. Our third quarter results reflect our focus on not only stabilizing but also reigniting fee growth, as well as the obvious headwinds from the low interest rate environment. Both our third quarter and our year-to-date results show clear evidence of how we are successfully executing on our strategy to improve State Street's financial performance and create shareholder value all the while temporarily holding elevated capital well above our regulatory requirements. Turning to the rest of the year outlook, throughout the pandemic I've discussed our outlook under a certain set of assumptions. Now with three quarters of the year behind us let me share with you our current thinking, but with the caveat that the macroeconomic environment could continue to change. We expect global central banks will keep short rates at current levels and long end rates will stay at current spot rates through year end. We also assume that average global equity market levels for the remainder of 2020 will be flat to current levels. With that backdrop, we now expect that full-year 2020 fee revenue will be up approximately 2.5% to 3% with servicing fees expected to be up approximately 2% for full year, both of which are up from our previous guide. Regarding NII given the impact of continued lower long end rates we still expect full-year NII to be down approximately 15% in line with our previous guidance. Turning to expenses, we have successfully transformed the expense base and remain laser focused on driving sustainable productivity improvements and operational efficiencies. We therefore still expect that full-year expenses will be down 2% year-on-year, excluding notable items as we continue to find ways to reduce expenses. In regards to our provision for credit losses, we continue to see a range of outcomes based on evolving economic conditions and any credit quality changes. On taxes we continue to expect our tax rate for the full year to be at the low end of our 11% to 19% range. And with that, let me hand the call back to Ron.

Thank you, Eric. Operator, let's open it up to questions.

Thank you. Your first question comes from Glenn Schorr from Evercore ISI. Your line is open.

Hi Glenn.

Hi, thank you. It's encouraging to see consistent and strong new business growth. While we typically assess this on a gross basis, the positive outlook on a net basis is also notable. I would appreciate any insights you might share on this. Additionally, it's reassuring to observe the moderation in pricing over the past few quarters. My question is about the sustainability of this trend—specifically, how much of the book has been affected, the confidence in the pricing committee's decisions, what's expected from the next 150 clients, and whether clients might also increase their commitments next year. I would love to hear your overall sense of confidence in maintaining this positive direction. Thanks.

Thanks Glenn, it is Eric. Let me start on pricing and then we can cover the broader topics of pipeline and momentum. I think on pricing, we continue to feel that the actions we took right, literally centralizing and turning pricing into a very senior conversation internally here and management process for one have made a real difference in a practical way. And so while you turn back the clock and you see that historically this industry has always had some pricing compression, literally, because there's always appreciation in our fees due to markets, right, so there's always a natural balance that we play out with our clients. You know that history was in the range of 2% per year. We saw that expand to 3% and 4% headwind last year, which obviously was not something that we want to or expect to repeat. This year we thought it would be down to 3% and we updated our view that it'll be down at around 2.5% for the year. And I think the perspective that we have is that that is largely due to a more heightened set of actions, governance, education to be honest, both of our team and clients. I think what happens next will, you know, time will tell. But I think there is not only the continuation of our intensity and actions here, but I think the other feature is that as our value proposition offering that kind of front-to-back offering, which connects the Charles River, the middle office, the accounting becomes a bigger part of what we offer. Those contracts tend to be longer, they tend to be more integrated, they tend to be stickier and we think that's going to continue to provide some support to the pricing benefits that we've accrued and at least keep us at this level. If we can do better let me tell you, we will lean hard into that. But I think we're confident where we have gotten to and operating in this area.

Okay, so I couldn't get you on the net new business that's cool. Maybe Ron last one for me is you mentioned considering the full range of capital return options which is cool, you got a lot of capital to consider options on. You particularly have had a good long history in consolidation on the asset management side. I'm just curious your take of or observation on what's going on in the industry and if there's room for State Street to participate, not that you're not already a huge player? Thanks.

Yeah, I mean, your observation is accurate. There's a heightened amount of consolidation going on. We think about it from two dimensions, not just as an asset manager, but also as a servicer to asset managers. So it's something that we're looking at carefully. We're always looking at our two businesses, investment services and investment management and trying to determine how we best optimize them and we like what we have. But to the extent to which we could add to it through some kind of a tuck-in we will consider that also.

Your next question comes from the line of Alex Blostein from Goldman Sachs. Your line is open.

Great, thanks for the question. Good morning, everybody. So Ron, just maybe building on the last point around a pickup in asset management industry M&A obviously with Eaton Vance and Morgan Stanley and there's been speculations that there could be others. How do you think about that from a service provider perspective? Obviously, on the one hand, I could see how that could be a net positive, given you guys are kind of in a sweet spot with sort of large global kind of giants, as you described them in the past. So perhaps maybe more volume, but pricing could come under pressure, given kind of the benefits of a larger platform. So help me think about that, is it a net positive or net negative for State Street that we see more consolidation in the asset management space and then specifically with respect to Eaton Vance and Morgan Stanley, any risk or opportunities from a revenue side you guys see for yourself, I don't know to what extent you provide services to either?

I'm not going to comment on any specific client situations, but it's known that we serve both of them. Regarding the impact on us, there are some negatives as well as a number of positives. The negatives could include losing a client or moving to a different position on the aggregate fee schedule after consolidation. However, the positives are that we are usually involved from the beginning due to our knowledge of asset managers and our capability to assist with operating models. We now have our front-to-back Alpha platform, which often allows us to be part of the discussions or brought in quickly afterward. Additionally, when going through integration, it’s a good opportunity to upgrade the platform. We believe this will actually spur activity since the anticipated synergies often relate to the back office and operations. We can achieve even greater synergies by overhauling operations and executing a comprehensive front-to-back implementation. So, while there are positives and negatives, we think there are likely more positives for us in the long run.

Great, thanks. And the follow-up question for Eric around NII. So just to clarify that down 15% NII for the full year to get in line with prior, does that include the $20 million true-up in the quarter and sort of you're talking about this on a reported basis, which I think implies about $480 million for NII for Q4 so just double-checking that? And then more importantly, how do you guys think about that runway developing into 2021?

Alex, it's Eric. Yeah, we did do it on a reported basis that the 15%. So I think your estimate of what we're looking at for fourth quarter is in the right area. I think the way I describe this is first to describe this year and then maybe talk a little bit about next year. We've clearly been in this interesting environment that fell sharply and what we're finding is that at this point we're starting to really slow the decline or the pace of decline of NII quarter-on-quarter. And so, you saw in our results this quarter, adjusted for the true-up will come back there if necessary down 11% sequentially. If you actually just open up the lens and say, how much was NII down first quarter to second quarter, it was down 16%. So we started at 16% 1Q to 2Q. This quarter we are at down 11% on a kind of underlying basis from 2Q to 3Q. And to your point if you take our full year guidance and you've done the math like many others, we're looking down at around 4 maybe 5 percentage points from 3Q to 4Q. So you can see that pattern consistently slowing and that's really the effect of the kind of grind through the portfolio coming through, which slows over time offset by our actions to expand the asset side, whether it's loans, the investment portfolio, which I said was up 5 billion on average for the quarter. It's actually up 9 billion on an end-of-period basis. And then some expansion of what we're doing in that sponsored repo program. So, those are the puts and the takes. As we look at next year it's a little early. But, our view is that that pace of reduction continues to slow and so we're probably looking at a couple percentage points from 4Q into 1Q or 2Q and then we see some stabilization at that level. And so I think you've seen us now really intervene and slow the decline. We'll see stabilization in 1Q or 2Q and then I think at that point, we can offset the grind down from the portfolio.

Very well, thanks very much.

Your next question comes from the line of Brennan Hawken from UBS. Your line is open.

Good morning, and thank you for taking my questions. I wanted to follow up on that, Eric. Regarding the few percentage points from the fourth quarter, do those figures rely on the same underlying assumptions you initially presented, essentially keeping spot rates stable? Additionally, considering the significance of mortgage-backed securities in your portfolio, what assumptions are you making for prepayment rates? Are you maintaining them as is, or do you anticipate some fluctuations? I would appreciate your insights so we can adjust our expectations moving forward.

Thank you for the question, Brennan. Each of those assumptions is very important. We're focused on driving towards an inflection point. Regarding current short rates, they have become more normalized, especially after the inversion between repo and treasuries has resolved, which is slightly beneficial. We hope this trend continues. Long-end rates have been fluctuating in the 70 to 80 basis point range over the past week. In terms of MBS prepayment speeds, we expect elevated levels of prepayments in the third and fourth quarters, with some expected burnout into the first and second quarters going forward. This is a reasonable assumption based on our models and those from three to four providers. Ultimately, our performance will depend on factors we can control. Our loan book, which is very high quality, has increased about 10% year-on-year, as has our investment portfolio. We believe we can put more of our deposits to work, whether through the loan book or the investment portfolio over the next couple of quarters. Even in this quarter, the difference it makes is significant and allows us to focus on stabilizing our position.

Thank you for the insights, Eric. Shifting to servicing revenue, you mentioned new business installations. We’ve also observed a repeat of the equity market rally. In the past, this has sometimes caused the way the Street calculates your servicing fee rate to compress, as not all of your servicing mandates and contracts are solely reliant on asset levels. Could you help clarify how much of the lag in servicing fees not increasing as much as AUC/A is due to new business installations where the revenue hasn’t fully materialized, and how much is attributable to the market rally, which is only partially reflected due to those contract dynamics?

Sure, let me break this down from a few perspectives. The equity markets are clearly benefiting our business, although timing can vary. What’s crucial is the overall performance of the equity markets globally. If we take a step back, the S&P is up roughly 12% to 13% year-over-year, while emerging markets and international EMEA markets have seen slight decreases. The combination of these factors is what we need to focus on. Also, while the end-of-period numbers are important, the average equity market performance is significant too. Year-to-date, we've seen equity markets increase by about 6%, which is advantageous. Historically, we've indicated that when equity markets rise by 10%, fees increase by 3%, and with fixed income markets also up around 10% and fees up by 2%. So, we are experiencing a slight advantage of about 1 to 1.5 points in fees on a quarterly or year-to-date basis, which we welcome. Additionally, we're securing new business, answering earlier questions about our business wins exceeding the minor fluctuations we see in our portfolio. We’re also able to charge more due to increased client activities and positive flows this year, which helps us mitigate some fee pressures. Overall, if equity markets maintain their current levels, it will aid our year-over-year comparisons. However, remember that from the third to the fourth quarter of 2019, equity markets were also on the rise, which will assist us sequentially from Q3 to Q4 but will pose tougher year-over-year comparisons for Q4 as well. That’s why I provided the overall guidance for servicing fees to increase by 2% this year, as it reflects a positive trend driven by global equity markets and our efforts in new business growth, pricing management, and managing the flows and activities we are witnessing.

I appreciate that, Eric. However, is there a delay in new business billing compared to the AUC/A? Sometimes there is, and I just wanted to confirm. Thank you for the insights on the market dynamics and the beta.

There is a bit of a lag but I think the EOP and the averages were relatively consistent for the quarter. And so we're not expecting a large lag adjustment into the fourth quarter at this point. There will be a little bit but because of the end-of-period and the quarter, the average was pretty consistent. I think it'll just play through more naturally.

Your next question comes from line of Ken Usdin from Jefferies. Your line is open.

Hi, good morning guys. Eric, I want to just come back to the capital return question, you have an 8% CET1 minimum. Just wondering if you can just level set us again now that SUB is totally done, we have the stress test ahead of us and the limitation through 4Q, what do you guys see as your limiting capital ratio and when you are able to get back into buybacks, do you go back to 100% capital return and how do you think about like what the actual excesses over just getting back to a more normal buyback plan?

Yeah, Ken it's obviously an important topic we've been working through. In a way we've gotten to been forced to defer any of those decisions. But I tell you, it's one that we're anticipating and eager to act upon given how strongly capitalized we are. I use the word elevated capital purposely in my prepared remarks just because that's what we're running at, right. We've got significant headroom. I think there's a couple of parts to the question. So, I think first in terms of our capital ratios, binding constraint, it is now CET1. So, core risk-weighted assets divided by common equity, Tier 1 capital. At this point, the leverage ratio is not really any more of a binding constraint. And you've seen us take advantage of that as we've reduced some of the stack of preferred on our book. And then as you think about CET1 ratio, we'd like to get that down. I mean there's very little reason that we should run above 12%. There's little reason we should run above 11%. And so there's at least 0.5 if not more. We're working through what's appropriate because we've got a lot of data over the last couple of quarters. So we want to factor in but there's a solid billion and a half of capital there that needs to go back to shareholders over and above what would go back to shareholders just from the earnings that we create each quarter. And so, we obviously want to see the results I think as the Fed and market participants do of the new CCAR test. We went through all the assumptions, as I think you guys did too. And we think we'll show well. We're very comfortable with our SEB and I think what we'll do is kind of market dependent and also based on any Fed guidance for the industry we'd like to restart capital return and if we can do that in the first quarter the pace of that needs to be a little bit paced. It got to be careful in this environment. And we're careful bankers, after all. But our view is that we need to start and then we need to accelerate that pace of return so that we return more than what we earn each quarter and start putting that back into our shareholders' hands.

Great, great color, thanks. And just to follow up on the expense question, you've been talking for a good while now that you think that the company should be able to take expenses down annually. And I know we'll hear more about this when you get to your formal outlook for the year. You did a very good job this year, still being at about down 2%. With the NII still being a headwind but fees looking better, how do you start to just think about that calibration and where are you in terms of just the ability to continue to net down the expense base? Thanks.

Yeah Ken and I appreciate your letting us answer that now and then as you say in January we'll give our annual guidance. I think I've been clear, I think we've all been clear here from the management team that down in expenses is the right direction of travel. And the direction and the volatility we've seen in market interest rates just reaffirmed that down is the new up and that's the kind of way we should operate in this environment. And I think what you've seen is us being able to do that now for effectively two years in a row. We did that last year if you adjust for the acquisition costs of CRD, we're doing that again this year. And I tell you, we have a lot of confidence in that momentum partly because that frame of mind, I think, has really kind of organically expanded through not only our management team, but our one downs and two downs. So we've got hundreds of people, hundreds of senior folks working on productivity and expenses all the while driving revenue growth and fees and so forth as you noted. But we're finding ways to do that across the line items, right. You saw four out of five of our expense line items down year-over-year and many of them were down quarter-on-quarter as well. And I tell you in our four operations area we continue to find ways to automate and reduce manual touches. And we think that has years of opportunity for us in technology we are driving a transformation and we've been clear there. And I think more broadly across our corporate functions or businesses, the notion of productivity kind of more outcomes per person is something we're actually adding measurement tools on so that we can in a more incisive way find opportunities. And I think that's why you've seen even with the pandemic, our comp and benefit costs are down 2% year-on-year. Even more if you adjust for the currency swing, our occupancy costs are down. And every one of those is a result of those pretty broad based and deep actions.

What I would add is that we've made it clear this is not a one-time initiative. While there are some quick wins to pursue, we are engaged in a long-term effort to transform our business. A significant part of this is focused on improving productivity, which is largely driven by the continuous automation of processes and reducing manual tasks. Therefore, you should anticipate that we will be consistently considering and implementing these changes.

Hi, I guess one kind of easy question, one tougher question. But first, so end of period loans were up, is that right, why is that, what seems to be a little different?

Mike, end of period loans were up but they were up slightly, we like lending to be up in this environment given that we're there for our clients. We had two offsetting factors, we had number one the continued growth in our client lending capital co-financing in particular continues to be a real important part of our growth to the managers. And that was just offset by some amount of reduction in the overdraft balances on an end of period basis. But the net was up slightly and I think more indicative is total loans were up about 9% or 10% year-on-year.

Okay, and have you said anything about cutting costs in 2021, how should we think about costs next year?

I guess you continue to ask the easy question. So we've not given outright guidance for next year, Mike, we'll do that in January. But we've been clear that we reduce costs this year, 2% last year, adjusted for the acquisition we were down 2%. And we continue to like the approach given the economic environment to drive costs down. And we think that's appropriate. So those are in our plans and what we're working through is what's the magnitude of that next year. Because what we do need to do is continue to drive for gross cost savings. But we also need to reinvest in our business and especially as we add new business and you saw some of the wins this year, we're going to have to implement that. Some of that takes some funding. And then we want to continue to invest and expand into product, features, and so forth of the platform. And that front-to-back platform in particular, which is going to take some resources. But net-net, we expect costs to continue to be down not only this year, but also next year.

What I would add to that is we've been very clear that this is not a one-time event. I mean, sure, there are some tactical opportunities that we need to take advantage of, but we are committed to a sustained program to transform our business.

Okay, that's a good segue to my harder question, which is maybe I will phrase it like a Jeopardy question. So the answer, I think, and correct me if I'm wrong, is what you're doing is you're improving efficiency, productivity, automation. You're expanding your revenue streams, as you said at the start Ron and now you're extending the total addressable market with more focus, not just in the top 50 but the next 150. And I guess the question is why and is part of the why because assets under custody were up 11% year-over-year and the servicing fees were only up 2%, in other words, I don't see the revenues keeping up with the business volume and therefore you have to go to these alternative streams and I guess really the question is, what are you seeing on pricing pressure? You said it was easing. You said some business has been coming on at a higher margin, but, we're not seeing it in the final results that are released to us? Thanks.

Mike, I'd like to start by mentioning a fourth aspect of our strategy, which involves expanding our addressable market. This means transitioning from the typical role of a custodian serving as a fund servicer to also acting as an enterprise outsourcer. We're looking to collaborate with management companies or plan sponsors on their operational models. This approach offers an incremental revenue stream that wasn't previously accessible to us. The reason behind this shift is well-known: the traditional fund services business faces several challenges, not only due to price compression, which we've been managing effectively. If you reflect on the past 10 to 15 years, the focus was primarily on creating new funds, with firms branching into new asset classes and regions. Currently, however, we observe a decline in the number of funds, as distribution platforms prefer fewer funds and prioritize estimates. These trends guide our strategic pivot. As we've mentioned, it takes time to realize this new revenue, which is evident in our discussion about our expanded pipeline since early 2019. We are now focusing on front-to-back Alpha wins. You can expect to see elements we've discussed in 2019 and early 2020 reflected in upcoming quarters as Alpha wins. It's a lengthy process because we are working closely with management companies to transform how they operate, invest, utilize data, and choose their tools. I hope that clarifies the reasoning behind our current initiatives.

Regarding the transition from a custodian to an enterprise outsourcer, at what point do you anticipate that the enterprise outsourcing will comprise a certain percentage of the firm's revenues? Where was this a few years ago, where do you see it going, and when should I shift my coverage to our firm's FinTech Analyst?

I mean, it's a little early to talk about that and we will talk about our strategy more, some of the upcoming conferences and maybe we'll get into that. We haven't really thought about that. But I think your point I would agree with your points that you should expect to see it be a higher and higher percentage of what we do. And you're also accurate about the technology content in here. And this is very much a technology and a software driven strategy.

Thank you. Good morning Ron, good morning, Eric. Eric, can you share with us you mentioned about the CET1 ratio, you are badly constrained in it. You said that it's obviously too high at 12.4%, even too high above 11, how low do you think you could comfortably bring that down to and then simultaneously, what's your thoughts about redeeming more preferred stock in 2021 or 2022?

It's Eric. To address your questions in reverse order, it’s too early to determine an appropriate level for preferred stock because we want to see the results of the upcoming CCAR tasks and whether there are any changes. We are monitoring the situation and are pleased that we have already enacted a couple of actions. We would be open to doing more if possible. Capital ratios are a significant focus for us. We recognize that we have excess capital given the constraints, which we will return to shareholders as soon as feasible. The goal is to maintain our capital above the 8% SCB requirement, which we are confident will remain stable, influenced by the Fed's guidance. We are currently analyzing the volatility in CET1 capital related to OCI and how we might adjust our positions regarding maturity versus available for sale assets. We want to address the variability in our risk-weighted assets as there is some fluctuation due to the FX book. A volatility cushion of 100 to 200 basis points is necessary because we aim to manage conservatively. I've indicated that an 11% capital level feels excessive, and we should consider dropping below 10% cautiously due to the inherent volatility in our operations. We should find a comfortable position between 10% and 11%, and we’re working to clarify that. This process indicates that there is a significant amount of capital available for release since we are operating at 12.5%, and lowering that to the 10% to 11% range would provide a considerable return for our shareholders.

Absolutely, that would be very positive. Moving little bit back into investment securities portfolio. Clearly, we're all focused on the rate environment and I think everybody's on one side of the boat, so to speak, in that rate environment is going to stay low for an extended period of time. But it also brings out the interest rate risk for a securities portfolio should rates go up, surprisingly for 2021 or 2022. What indicators do you guys keep an eye on, you can name two or three that really would make you change the way you look at your investment securities situation or where there could be a risk of a mark-to-market situation if they got out of line and rates started to go up, which, nobody's really planning for, the forward curve certainly doesn't call for that at the long end, so I was just curious how do you guys manage and keep an eye on this so that you don't get caught offside should something change unexpectedly 6 to 12 months from now?

Gerard I think there are a number of indicators but part of what we do is we manage for the concerning outcomes, the downsides, right. So what we are careful in the portfolio is, you don't want to barbell between one-month paper and 30-year paper because you get a big move in rates. The 30 year hurts. Same thing with three-month paper and 10-year paper. So we're quite careful about where we operate on the curve. And it's not just an average duration that we run at, but we have a series of limits across the curve and we'll position to your point to be quite careful and circumspect. So that's one, there's kind of an outright management process and sort of places that we will operate. I think in terms of indications, there's clearly a set of Fed indications and then market indications. The Fed's been quite clear about their policy around lifting rates. They've been quite clear about how long, they've been quite clear about inflation targets and kind of general monetary policy planning, and I think that's actually you've got to ascribe a fair amount of reliability to that. And then they're all the market indicators, whether it's the front end of the curve, the steepening, the volatility inherent in some of the curve structure is another indicator that we're very conscious of. And then I've got to say, there's no substitute for doing a running a battery of tests, a battery of stress tests, because you're always worried about what you don't know and what you're not seeing in the marketplaces. And, the good thing about rates markets is we've got 50 years plus of solid history. And we'll do all those tests and then we'll do the theoretical ones. So anyway, it's something we're very careful on, I think is the bottom line.

Thank you, appreciate the time.

Your next question comes from the line of Brian Kleinhanzl from KBW. Your line is open.

Great, thanks. Mine is just a real quick question, a clarification question, so Eric, when you were talking about the NII on kind of the go-forward past the fourth quarter, I think you said a couple of percentage points down in the first quarter, second quarter. But did you mean a couple of percentage points down in the first quarter and then another couple of percentage points down in the second quarter and then stabilized from there? Thanks.

Good question, Brian. I mentioned a couple of percentage points down, either in the first quarter or second quarter. We believe there's a small decrease from the fourth quarter to one of those quarters. It's challenging to determine the exact timing of the trough due to various headwinds and tailwinds at this inflection point. However, we think it will occur sometime in the first half, based on our current knowledge, market indicators, and shared assumptions.

Well, thanks to you all on the call for joining us.