State Street Corp (XLF) Q1 2021 Earnings Call Transcript

Good morning, and welcome to State Street Corporation’s First Quarter 2021 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 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.

Thank you. Good morning, everyone, 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 first quarter 2021 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 measures 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 this morning, we released our first quarter financial results. Before I review our results, I would like to briefly reflect on the environment we’re operating in today as compared to this time last year and then highlight some of the data that evidences the progress we are making towards enhancing and improving our operating model and innovating across our franchise while being an essential partner for our clients. Relative to the first quarter of 2020, the first three months of 2021 could hardly be more different. Economic activity is sharply rebounding, unemployment is declining, and equity markets have recovered strongly from the crisis levels experienced in 2020. Although short end rates remain at historically low levels, long end US bond yields are rebounding. While COVID-19 infection and death rates remain stubbornly high in many parts of the world, there is clearly light at the end of this pandemic tunnel. The owners and managers of the world’s capital are also looking to the future and the next stage of growth. As the economy and financial markets continue to recover and investment inflows continue to grow, we remain focused on delivering for our clients across segments and regions. As demonstrated by our first quarter financial results, State Street continued to successfully navigate the improving operating environment. Although, as I noted, short-term interest rates, which compressed further during the first quarter, remain a critical headwind for our industry. While we cannot control interest rates, we are resolutely focused on implementing our strategy and pivoting our business to being more of an enterprise outsourced solutions provider, underpinned by the ongoing development and delivery of our State Street Alpha front-to-back platform. And we look forward with confidence for a number of reasons. First, we further built upon our reputation for reliability during the crisis, and our clients know they can depend on us to deliver the services and market solutions they need in good times and in bad. Second, throughout the crisis, we continued to invest in further strengthening and distinguishing our global operating model, client service, and operational resiliency, which has been apparent to and noted by our clients. Third, many clients are reassessing their own operating models. As a result, we have the opportunity to take on more of their operations and data activities, allowing them to focus on creating better investment outcomes for their clients. Fourth, our employees continue to perform at very high levels despite a year of largely remote work and disrupted routines. I am grateful for their extraordinary dedication and service. Finally, both our Alpha and non-Alpha institutional servicing value propositions continue to resonate and enjoy take-up, as demonstrated by some recent announcements. For example, we reported an additional three State Street Alpha clients during the first quarter, and separately this morning, we announced the full front-to-back Alpha relationship with Invesco, adding front and middle office services to our existing back office mandates. Through the open architecture nature of our operating platform, we have been able to rapidly increase functionality through a number of partnerships, unlocking new sources of revenue and strengthening the interoperability element of our Alpha value proposition, which is appealing to clients. After quarter-end, we announced that M&G has appointed us to provide outsourced middle office services in addition to our existing fund accounting company services. State Street will administer the middle office services on Aladdin, exemplifying how we offer clients the benefit of choice regarding their front-end and middle-office systems. These deals highlight how we are uniquely positioned to win front-to-back mandates as well as to win new business as a result of the interoperable nature of our operating platform. While the Alpha platform remains an integral part of our strategy, we also continue to innovate across our franchise. For example, a growing demand exists for ESG solutions that will provide the necessary data, risk analytics, and reporting capabilities at scale. To that end, during the first quarter we introduced enhancements to our ESG solutions that can now provide clients with the ability to address new global ESG regulatory requirements for a single platform. Global Advisors’ new US corporate ESG ETF launched in EMEA in late 2020 and grew to $5.4 billion of AUM by the end of the first quarter, making it the largest corporate bond ESG fund in the US. We also continue to develop our digital asset strategy as we prepare to deploy our capabilities and servicing needs. We recently announced our intention to serve as the VanEck Bitcoin Trust ETF. Subject to regulatory approval, we will work with VanEck to provide services, including ETF basket operations, custody of the ETF shares, accounting order taking, and transfer agency in multiple jurisdictions. Next, I will review our first quarter highlights before handing the call over to Eric, who will take you through the quarter in more detail. Turning to Slide 3. First quarter EPS was $1.37 or $1.47 excluding notable items. Relative to the year-ago period, first quarter total revenue declined 4%, driven by the impact of interest rate headwinds on our NII results. However, total fee revenue increased 4%, driven by servicing and management fee growth, which increased 7% and 6% year-over-year respectively, as well as an improved software and processing fee performance. Collectively, these more than offset the year-over-year headwind from FX trading as compared to the exceptionally strong first quarter of trading last year. While our FX trading revenues are down year-over-year, first quarter revenue remains well above pandemic levels as a result of higher client volumes and the investment we have made in our platforms and talent in recent periods. Even with rising total fee revenue, first quarter total expenses were essentially flat year-over-year, excluding notable items and currency translation, as productivity improvements are paying off. Furthermore, we have successfully reduced high-cost location headcount relative to the period one year ago. As a result, we remain confident in our ability to control core operating expenses over the remainder of 2021. At the end of the first quarter, AUC/A and AUM both increased to record levels supported by higher period-end markets. AUC/A increased to $40.3 trillion, new asset servicing wins were a solid $343 billion, while servicing assets remaining to be installed in future periods amounted to $463 billion at quarter-end. Global Advisors’ AUM increased to $3.6 trillion and also benefited from a very strong flow performance in ETFs and a solid performance in the cash business. At CRD, annual recurring revenue increased 14% to $225 million, and we remain pleased with how the business is performing while also enabling our Alpha strategy. Overall, we had a strong start to the year and remain confident that we have a clear path to our medium-term targets discussed in January. To conclude, we continued to successfully navigate and distinguish ourselves in a fluid operating environment as demonstrated by our first quarter results. We remain focused on further developing and growing our Alpha strategy and are pleased with the recent client activity. Meanwhile, we also continue to innovate across and grow many areas of our franchise. During the first quarter, we returned $659 million of capital to our shareholders through a combination of common share repurchases and common dividends. For the second quarter of 2021, our Board has authorized up to $425 million of common stock repurchases consistent with the limit set by the Fed. 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. I’ll begin my review of our first quarter results on slide 4. We reported EPS of $1.37 or $1.47 excluding the impact from notable items, which amounted to $0.10 in the first quarter as detailed in the panel on the right side of the slide. On the left side of the slide, you can see that we had yet another solid quarter of total fee revenue growth while expenses were well controlled despite higher market values and client volumes. As a result of the depreciating dollar relative to the year-ago period, we also show our first quarter results excluding the impact of currency translation in the column to the right. Total fee revenue was up almost 4% year-over-year or up 2% excluding the impact of currency translation despite the significant year-on-year headwind from the exceptional FX trading services results we had in the first quarter of last year due to the pandemic. For context, total fee revenue excluding FX trading services was up 9% year-on-year or 7% excluding the impact of currency translation with strong mid single-digit growth in servicing fees, management fees, and securities finance. Expenses were roughly flat year-on-year excluding notable items and the headwinds from currency translation, which you can see at the bottom of the slide. So in total, this was a solid quarter, demonstrating the progress we’re making in improving our operating model as we drive towards growth. Turning to Slide 5, you’ll see strong business volume growth across the franchise. Period-end AUC/A increased 26% year-on-year and 4% quarter-on-quarter to a record $40 trillion. The year-on-year change was driven by higher period-end market levels, client flows, and net new business growth. Quarter-on-quarter, AUC/A increase was the result of higher period-end equity market levels, better client flows, and net new business, which more than offset the impact of lower bond markets. We’re seeing that both retail and institutional investors have moved off the sidelines and we’re seeing inflows globally across most product types that we now custody. At Global Advisors, AUM increased 34% year-on-year and 4% quarter-on-quarter to $3.6 trillion, also a record. The year-on-year and sequential quarter increases were both primarily driven by higher period-end market levels coupled with net ETF and cash inflows. Our ETF franchise had a strong flow performance again as the US ETF industry experienced record flows. Spider net inflows amounted to over $23 billion in the first quarter with both sectors and industries and low costs doing particularly well. Turning to Slide 6. First quarter servicing fees increased 7% year-on-year, including currency translation, which was worth approximately 3 percentage points year-on-year. The increase reflects higher average market levels and normal pricing headwinds. Servicing fees were also up 5% quarter-on-quarter as a result of higher average market levels and stronger client activity. This quarter, we saw good growth in asset managers, alternatives, and official institutions. I’m pleased with how 2021 has started as the first quarter AUC/A wins totaled a solid $343 billion, which is up from recent quarters. And for context, last quarter you heard me outline that we need approximately $1.5 billion of annual gross sales volumes in order to drive net underlying growth, which means offsetting typical client attrition and normal pricing headwinds in our servicing business. I’m also pleased to report that our first quarter wins span a good mix of client segments and deal sizes with an attractive overall fee rate as we continue to work on generating broad-based growth across our clients, segments, and regions. As an example, you may have also seen that earlier in the quarter we announced that we have assumed the depository bank and fund administrative activities of a subsidiary of Intesa Sanpaolo in Europe. AUC/A that has not yet been installed amounted to $463 billion at quarter-end. Positively, both our reported wins and to be installed numbers exclude the two recently announced mandates, which Ron mentioned just a moment ago, as these deals were signed after the end of the first quarter. Turning to Slide 7, let me discuss several other key fee revenue lines in more detail. First quarter management fees were $493 million, up 6% year-on-year, including a 2% impact from currency translation, but were flat quarter-on-quarter. Both our year-on-year and quarter-on-quarter management fee performance has benefited from higher average equity market levels and strong flow performance within our ETF and cash businesses, partially offset by an idiosyncratic client asset reallocation from higher fee products as well as money market fee waivers. Regarding money market fee waivers, we had about $15 million this quarter and we expect that they will increase, given the significant downward move in short end rates in March. If they persist, we expect company-wide impact could be around $50 million to $55 million per quarter for the rest of the year beginning in Q2, and of distribution fees, though higher balances should be worth roughly $10 million to $15 million per quarter, leaving the net impact closer to $40 million per quarter. FX trading services had yet another strong quarter. Relative to the exceptional first quarter of 2020, FX trading revenue fell 22% year-on-year, but it was up 7% quarter-on-quarter with higher volumes across both developed and emerging market currency pairs. While FX market volatility declined relative to the fourth quarter, we continue to see higher client volumes as our FX business continued to benefit from many years of investment across six venues and now 47 markets, three of which we added and two of which we expanded in the last year alone. Our securities finance business recorded its second consecutive quarter of good revenue growth, increasing 8% year-on-year and 13% quarter-on-quarter, mainly as a result of enhanced custody balances driven by new mandates from alternative clients and increase in fixed-income assets on loan within our agency lending program. Finally, our first quarter software and processing fees were up 55% year-on-year and down 15% quarter-on-quarter, largely due to changes in mark-to-market adjustments. Moving to Slide 8, we have here CRD standalone revenue growth and business performance metrics. We have again separated CRD revenues into three categories to help to see through the lumpy revenue pattern inherent in the revenue recognition accounting rules for on-premise revenue. Total CRD revenues increased 4% year-on-year, primarily as a result of higher software-enabled revenue and was 10% lower quarter-on-quarter, largely due to seasonally higher on-premise revenues in the fourth quarter. As shown on the slide, the more durable SaaS and professional services revenues increased by a strong 21% combined growth rate relative to the year-ago period. On the bottom right of the slide, we show some of the first quarter highlights of State Street Alpha. We reported an additional three Alpha clients during the first quarter as the value proposition continues to resonate with our client base, and this doesn’t include this morning’s first quarter and quarter-end announcement. The Alpha pipeline continues to remain promising as the economic disruption in the last year has helped clients realize the transformational potential of the Alpha platform for their technology and operations infrastructure. Turning to Slide 9. First quarter NII declined 30% year-on-year, mainly as a result of the effects of the low-interest rate environment on our investment portfolio and the absence of $20 million market-related benefits in the first quarter of 2020. Quarter-on-quarter, NII declined 6% as expected. Around 3% of the sequential quarter decline was due to the impact of lower long-end rates on our investment portfolio despite a sequential improvement in premium amortization. Approximately 1 percentage point of the sequential decline was due to just a half-quarter’s downdraft in short end rates on our sponsored member repo activity, and the rest was due to the lumpier items, including day count. These impacts were partially offset by higher deposit balances, as you can see on the right of the slide. Total average deposits increased by $20 billion in the first quarter, or an increase of 10% quarter-on-quarter, reflecting the impact of the Federal Reserve’s expansionary monetary policy. We remain mindful of OCI risk to our capital. So as the US Treasury sold off dramatically during the first quarter, we gently trimmed the investment portfolio and may selectively reinvest a bit over the coming months at higher rates. Turning to Slide 10, we’ve again provided a view of the expense base this quarter excluding notables, so that the underlying trends are clearly evident. Excluding notable items, first quarter expenses increased 2% year-on-year, which is all driven by the weaker dollar, which means we effectively held underlying expenses flat year-on-year. On a line-item basis, compensation employee benefits was up only 1% excluding the impact of currency translation as higher seasonal expenses were partially offset by reduction in headcount in higher-cost locations. Information systems and communication expenses were up 3% excluding the impact of currency translation due to higher software costs and continued investment in our technology estate. Transaction processing expenses were up just 1% ex FX as our savings initiatives offset significant volume-based growth in sub-custody and market data costs. Occupancy and other expenses were both down several points. Relative to the fourth quarter, expenses were primarily impacted by higher seasonal and deferred compensation. Overall, I’m pleased with the underlying expense performance in the first quarter as we absorbed approximately $15 million of variable revenue-related costs. We continue to demonstrate operating model improvements as we drive increased productivity through automation, reengineering, and scale. Moving to Slide 11, we show the evolution of our CET1 and Tier 1 leverage ratios. As you can see, we continue to navigate the improving operating environment with strong capital levels. As of quarter-end, our standardized CET1 ratio was up slightly year-on-year but fell 1.5 percentage points quarter-on-quarter to 10.8%. Relative to the fourth quarter, our capital base was impacted by lower AOCI as a result of the significant run-up in long end US Treasury yields as well as by an increase in intangibles related to the recently announced lift-up deal we completed with Intesa Sanpaolo. We also saw a $6 billion increase in episodic RWA, primarily related to FX trading and overdraft activity. This RWA headwind was transient in nature and has already declined by $5 billion. So at the end of the second quarter, our CET1 ratio will be over 11%, all else being equal. Tier 1 leverage was down year-over-year and fell by 1 percentage point quarter-on-quarter to 5.4%, primarily as a result of higher average assets driven by the increase in quarterly average deposit balances as well as the AOCI change and the $500 million partial call for Series F preferred securities announced in January. As you can see on the slide and as I mentioned previously, we continue to consider a CET1 target range of 10% to 11% as an appropriate level of capital for our business. Further, we consider that a Tier 1 leverage ratio between 5.25% and 5.75% as also being appropriate for our business model and can comfortably operate in this quarter this year, even with the recent growth in deposits. Last, as we look ahead and as Ron noted, for the second quarter of 2020, our Board has authorized up to $425 million of common stock repurchases consistent with the limit set by the Fed. Turning to Slide 12, we provide a summary of our first quarter results. Despite the continued headwind from historically low-interest rates, I am pleased with our quarterly performance, which demonstrates solid underlying trends within our business as well as the progress we are making within our institutional services franchise. Total fee revenue was up almost 4% year-on-year, including the significant year-on-year headwind from the exceptional FX trading services result we had in the first quarter of last year. And excluding FX trading services, total fee revenue was up 9% year-over-year or 7% excluding the impact of currency translation with solid mid-single-digit growth across servicing fees, management fees, and securities lending. And with that strong top-line fee growth, expenses were well controlled and were held roughly flat year-over-year, excluding notable items and the headwind from foreign currency translation, demonstrating the progress we’re making in improving our operating model. Next, I would like to update our full year economic outlook and provide our current thinking regarding the second quarter. At a macro level, our full year interest rate outlook assumes that short end rates remain pressured, and there is some modest steepening of the yield curve, in line with the current forwards, which suggests modestly improving premium amortization, so the pace of improvement remains uncertain. We’re also now assuming global equity markets will be flattish to the current levels for the rest of the year or up around 10% point-to-point from the beginning of 2021, as well as continued normalization of FX market volatility. In terms of the second quarter of 2021, our guide includes about 2 percentage points of currency tailwinds for fee revenue and 2 percentage points of headwinds for expenses. So we expect that overall fee revenue to be up 2% to 3% year-over-year depending on equity market levels, with servicing and management fees up 7% to 8% as we anniversary a strong Q2 2020 in FX trading and CRD. Regarding NII, given the impact of historically low short end rates as well as the impact of long end rates in our investment portfolio, we now expect NII to run around $460 million to $465 million per quarter from here in 2021, assuming premium amortization continues to attenuate. Turning to expenses, we remain laser-focused on driving sustainable productivity improvements and controlling costs. We expect that second quarter expenses ex notable items will be up around 2.5% year-over-year or relatively flat ex currency translation, with some potential for variability due to the revenue-related costs. On taxes, we expect that the Q2 ‘21 tax rate will be towards the upper end of our full year range of 17% to 19%. While it is still early in the year, we are taking up our full year fee revenue guide again and now expect full year fee revenue to be up 2.5% to 4%. We also expect that slightly higher revenue-related variable costs will add about 50 basis points to our prior full year expense guide of flat to down 1% ex notable items. Just remember, there’s a solid point of FX translation in these full year fees and full year expense guides. And with that, let me hand the call back to Ron.

Thanks, Eric. And operator, we can now open the call for questions.

Your first question comes from Alex Blostein with Goldman Sachs.

So maybe we could start with servicing fees. I was hoping, first, we could unpack sort of Q1 dynamics a bit more. So ex currency translation, servicing fees were up about 4% sequentially. Maybe you can just walk us through how much was the market and higher volumes versus more organic trends in the quarter? And then taking a step back, it really sounds like momentum in front to back is progressing pretty nicely. So I was hoping you could bridge these data points you highlighted on the call sort of back to the servicing fee algorithm that, Eric, you talked about in the past, kind of between markets pricing, new business. I think collectively, that added up to like maybe a low single-digit growth over time. How does that feel to you guys now given some of the changes you’ve seen in the business?

Let me start on the quarter, and then we’ll talk a little more about the momentum in the business. I think we felt like we had a solid quarter here. As you saw, servicing fees were up 7% year-over-year in aggregate. I mentioned about 3 percentage points of that was just currency translation. So the underlying growth was around 4%. If we were to decompose the 4%, the largest positive driver was equity market appreciation. So equity market appreciation across the low equity markets were up north of 20% on average. That translated to about a 6% tailwind in servicing fees for the quarter. And then against that, we had the normalized amount of headwinds of about 2%, which brought us down to the net 4%. So it was a good quarter. I think what we continue to focus on is there tends to be some tailwind in our model from flows and client activity. This quarter we had some of that but we also had it a year ago in a good amount, so that was relatively neutral on a year-on-year basis. And then the other component is net new business. And as I’ve said pretty clearly, we have had lighter sales quarters over the last four to six quarters. We need to take that up. And as that happens, we’ll be in a position to have net new business growth. For the time being, net new business is relatively neutral, which is okay but not enough and not at the levels that we’d like to be, and that’s, I think, partly why we have been real clear around the amount of net new business we need to win. We’ve been actioning that on a segment basis or regional basis. You’ve heard about our coverage model expansion. All those are components of that acceleration, which I think are well along and starting to show some positive results, as I highlighted in asset managers, for example, and alternative, and I think will be to our advantage in the coming time periods.

Why don’t I just add to that, the second part of your question, I think what you’re basically asking is how does Alpha fit in all this and how does it change those numbers? Clearly, we’re pleased with the progress with Alpha three reported wins in the first quarter. And as we noted, one that we reported already for the second quarter, about a third of our business to be installed, the $463 billion to be installed is Alpha related, and we would expect that to grow just given some of the things that we’ve talked about. What that means, though, is these are longer installations. Remember, in effect, we’re becoming the enterprise outsourcer to these clients. So it will be nice revenue impact, but we’re talking about 2022 and 2023 revenue impact. Relatively little of that, certainly the things that we reported for the first quarter, we will see in 2021.

And then maybe a quick one on capital. Obviously, ratios came down sequentially for the reasons that you described, not particularly surprising. I guess maybe talk to us a little bit about the willingness to dip below 5.25% Tier 1 leverage if the balance sheet remains elevated or maybe even grows from here for one reason or another. And if you guys are willing to sort of continue to execute on your capital return plan, how much flexibility do you have going below the low end, I guess, of your target and staying there?

We are following a capital return plan primarily influenced by our common equity Tier 1 ratios, which experienced some fluctuations this quarter but remain well above the expected range. We are confident in our capabilities in this area. Regarding Tier 1 leverage, there are a few important considerations. We aim to operate within a range of 5.25% to 5.75%. There is some additional flexibility in our balance sheet if we face increased deposits. Additionally, we have the capacity to adjust our strategy as needed. Over the past two years, we have increased certain discretionary deposits, which range between $10 billion and $20 billion, allowing us to selectively accommodate clients while managing our overall balance sheet size. We can occasionally operate below the 5.25% target if the situation is favorable, especially since our clients are drawn to us due to our brand strength, which is positively impacting that ratio. We are prepared to take this approach for a quarter or two if required. Throughout this period of Fed easing, we are focused on supporting our clients and have strategies in place to navigate through these changes as part of our regular business operations.

Your next question comes from Glenn Schorr with Evercore ISI.

So there are some good things going on in the quarter, but I think the ROE and the pretax margin are still pretty far below targets. I think the margin one is in, over time, given the headwinds on rates and fee waivers that you just described. But on the ROE side, do you view that as simply a function of capital built in getting down to closer to your targets, because it felt like better than an 8% ROE quarter; the momentum in the business feels better than that, but that’s a low ROE, considering all the growth that you built. So just curious on how you think about that.

A couple of things just to keep in mind first. First quarter every year is always our low point on margin and ROE because of the seasonal deferred incentive compensation expenses. So those come through, and then we’ve got to take a full year look. So I’d just be a little cautious on that. I think more broadly in terms of ROE that’s really a focus. I think you’ve seen in our proxy over the last few years, ROE has a management target. We added margin to that and now fee revenue. So we’re incredibly focused on those three major leverage points. And I’ve got to tell you I’ve got an entire management team who’s thinking about those every month and every quarter. I think the way I think about ROE is probably from a couple of perspectives in terms of its trajectory. I think, first, continued work on margin. And this year, we’re just trying to hold margins steady, notwithstanding given the falling interest rates. But you’ve seen us actually hold expenses flat and fee revenues up. That is going to, over time, extend margin and filter back into ROE, and every two points of expansion in margin is a point of ROE. So there’s real, I think, flow-through there. And then I think the second one you hinted is around capital return. We’re very pleased to return 100% of earnings this year, this quarter, in the first quarter, in line with the Fed limits. We’ve done that again in the second quarter. And we’re committed to a pattern of capital return as a way to return capital to investors and to drive up ROE. And so I think there’s a path in that way as well.

I appreciate that. Maybe one quick follow-up on the fee waivers. I heard your comments on $15 million growing to $50 million and $40 million net. Just as a sequential number, that’s a big step up. And I know how it works generically, but I’d love to hear how you think about like was a yield wire, obviously, trip, so to speak, in the quarter? And then more importantly, how much and which part of the current needs towards or which reference points need to go up over what level to get us back to a more breathable level, because $15 million to $50 million is a big step?

I think the good news here is while we have some money market fee waivers, we don’t have the size of money market fee waivers that others are seeing around the industry just because of the more institutional nature of our money market complex. So I think that’s some context to help with. The money market fee waivers are effectively driven by short-end rates. It could be everything from overnight repo to one month and three month Treasuries. And effectively, as one and three month Treasuries fell from kind of 8 basis points, 9 basis points down to 3 basis points, 4 basis points, and 5 basis points in March, you’re starting to get to the point where the reinvestment rate against the management fee rate starts to be inflected. And as a result, we are at that pressure point. And literally, the 4 basis points or 5 basis points move at the point does have the impact, as you’ve seen. I think the good news here is we’ve continuously cash inflows into our complex. Part of that comes from the easing and the monetary policy that we’re seeing. Part of that is, I think, we have an attractive set of offerings. And I’ll tell you that that’s all been factored into our guide and part of what we’re managing through.

Your next question comes from Brian Bedell with Deutsche Bank.

Just one more point on rates. Let's focus on the net interest revenue outlook, which is projected to be between $460 million and $465 million quarterly. With the expectation that the forward curve and premium amortization will likely ease over the year, even if short rates remain stable, what could prevent that $465 million from improving in the second half? Is there an assumption about mix shift that's influencing this? I would have expected improvement as we move into the later part of the year.

I believe the best way to look at this is that short rates influenced the first quarter, and now we'll experience three months of that impact in the second quarter, which causes a slight decrease from our preferred expectations. Long-term rates have been a challenge throughout last year as they declined, and even at this level, they present challenges for the portfolio. For instance, from the fourth quarter to the first quarter, they negatively affected the portfolio by about five points of net interest income (NII). However, the declining premium amortization has started to provide some positive impact, contributing about two points of NII sequentially. So, we still face ongoing challenges from long-term rates, which need to be processed. Keep in mind that the average duration of the portfolio is around three years, and we're approaching a year since this rate cycle began, indicating another year of long-term rates as a challenge. We expect premium amortization to slow down, and while we must be cautious about the rate of this slowdown, it is projected to decrease according to various models, which should help partially counteract the headwinds from long-term rates. We're looking for a turning point, likely in the second half of this year, where long-term rates will still be a challenge but premium amortization may start to mitigate that, rendering the overall effect roughly neutral. This is essentially why we do not anticipate an increase, as the long-term rate challenges will persist for approximately two to three years. Over time, we need to see substantial reductions in premium amortization to allow for some uplift, which we don't expect to occur this year. The critical question is when this trend will begin to change. I want to be cautious about making predictions too early since we need to allow time for the situation to develop, and I believe we will have more insights in the next few quarters.

Regarding the Invesco win, could you discuss the relationship between revenue and expenses? Generally, when deals are structured in installments, some expenses are incurred before the revenue is recognized. Can you clarify if this is the case here, or if you're able to generate revenue immediately after installation to balance out those expenses? Additionally, if I recall correctly, you handle most of the custody fund accounting for Invesco. This would likely result in increased revenue, but the base of your custody might not change significantly. As a result, it could seem like a price improvement since you're earning more from the same customer. Could you elaborate on that?

Brian, let me just step back a little bit because we’re not and we’ve never really talked about individual clients, individual client wins and how we onboard the revenues and expenses. You’re getting at a level of, I think, specificity that’s not something we typically go into, and we don’t because we want to be respectful of our clients and respectful of various positions. I think what I would tell you is, and you’ve seen us with other wins describe them. We often say that there’s a range of products that come over from a client as part of a win; some come more quickly and some take more time. And I think I’ve been on record saying custody tends to come more quickly often, but not always. Accounting, middle office, Charles River takes time. And the larger the installations, the more time it takes. And you are right in your view that some of those expenses, we build a bit in advance because we’ve got to onboard, we’ve got to do some of the professional development and technology connectivity for that. So anyway, I think you have the right outline. And I think what we’re going to do in general is help everyone understand the momentum of our business. Part of the reason I give the quarterly guidance is to give you a little bit of insight into what we expect. And that’s all of our client activity, all of our wins, our to-be-installed business factors in.

Your next question comes from Betsy Graseck with Deutsche Bank.

Ron, I had a question just around how you’re thinking about strategy in SSGA. I mean there have been some headlines around the fact that there’s a perception that you’ve been looking at opportunities over in Europe, and I wanted to understand how important it is for you to gain share in Europe. And maybe you could broaden out the answer, of course, to just generally the strategy in SSGA. Could you give us a sense as to what you’re looking to do and capability adds that you’re trying to accomplish?

So I mean, I’ll start by just reminding everybody that asset management is a very important business for us. It’s smaller than Investment Servicing, but we have quite a good business there. And as we’ve said oftentimes, we’re constantly looking at our strategy. We always look at, first, organic opportunities to grow, and second, inorganic opportunities to grow. And we’ve done a little bit of inorganic, but most of what you see in terms of the progress there has been a result of organic activities, including some of the, as I noted in my remarks, some of the recent growth in Europe. I mean I’m not going to comment on market rumors. We feel very good about the position we have and don’t feel that we have to do something at any point, but we also are looking for opportunities to exploit the position we have and to see if there are opportunities to grow it. But it will, for us, be primarily driven by organic activities. And secondarily, if there’s something inorganic that makes sense strategically and makes sense to the shareholders, then we’ll look at that.

And then just separately and maybe if there are any capability sets there that you’re looking to expand into, that would be helpful to understand. But just on the eye in the servicing side, we’ve also seen some announcements on servicing Bitcoin ETFs. And maybe you can give us a sense as to how long you anticipate it takes to bring that to market? And is there anything else you’re doing on the crypto side or digital currency side? In particular, are you going to be looking to service physicals, or do you expect to use others to service physicals and subcustodians? Just your strategy there would be helpful to understand.

So there’s a lot of activity in this space and crypto means a lot. It means different things to different people. We’ve been active in certainly digital ledger and blockchain technology for a long time now. We do see this as a growing segment of the marketplace. We’ve got a number of initiatives in place to figure out how we can establish a leadership position there. I think it’s fair to say that the regulatory environment has some catching up to do here, and that’s clearly on the minds of regulators, and there are clearly lots of applications in front of them. But right now, that’s part of the gating factor. But we would view this as a trend that’s here to stay. And I think it’s a combination of how do you think about cryptocurrencies and servicing cryptocurrencies in the fullest form, not just traditional currency but administration. How do you think about it in the context of an ETF? What does crypto basket creation look like? But then there’s the other side of this; it’s crypto assets, and we’re very active in thinking about how do we move from custody, something that’s physical or near physical, to custodying a token. And what does that mean for us? So it’s a very, very important part of our R&D, and it’s a very, very important part of our strategy right now.

Yes, Betsy, I’d like to add that, as Ron mentioned, there are many ways for us to engage with crypto across the entire value chain. You’ve seen us make announcements about this, including a recent one. We’re also aware of the areas where there are opportunities in the near term. We believe that crypto ETFs are significant because they elevate something that has been more niche to a mainstream level for both retail and institutional investors, increasing access for all. We are actively involved in this space and have a strong pipeline of clients who are leading innovations in crypto ETFs. While many of these initiatives will require regulatory approvals, they all need record keepers and administrators. Our credibility is key to this process, and we see a real opportunity to support our clients while also being a major player in this emerging area. The capabilities are also being brought to bear across the existing asset classes and the fiat world. Many of our existing clients are happy with our service delivery offerings. We’ve got a great track record; we are aiming to deliver a whole lot of services in alignment with the digital asset world, and we partnered with a lot of strong third parties. Custody should permit a breadth of partnerships in the near term, and we believe we can make this journey together with clients.

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

Eric, I have a couple of follow-up questions regarding the balance sheet. I've noticed that the investment portfolio has decreased at both the end of the period and on average, but you experienced significant deposit growth, which suggests you have more cash available now. How do you see that playing out in the future? Are there any changes to your reinvestment strategy affecting your net interest income outlook?

Yes, Ken, that's a good question. We need to be mindful of balancing the growth in net interest income from our investment portfolio with the amount of accumulated other comprehensive income risk we're assuming, especially since rates are likely to either remain stable or increase. The key concern is whether we will experience a rate shock. Therefore, we must proceed with caution. In the first quarter, we reduced some duration as rates increased. Keep in mind that, naturally, our mortgage-backed securities duration will extend, and that prompted us to shorten it as a precaution. I believe the team did a commendable job early in the quarter, safeguarding some of our interests regarding accumulated other comprehensive income. This strategy places us in a position to utilize some cash in the upcoming quarters, which is factored into our outlook and will help partially mitigate the ongoing decline in long-term rates that we're observing. Additionally, our investment portfolio is now approximately 10% larger compared to a year ago. While we've made that adjustment, there's still a certain capacity limit we can maintain. It's within the appropriate range, but we may need to make minor adjustments as necessary to optimize our resources.

Okay. You mentioned the episodic increase in RWA. Can you help us understand how much that impacted the 10.8% CET1? You mentioned aiming to get back above the target range, so will that happen? Also, how unusual were the ratios this quarter compared to what we observed in OCI?

Yes. The episodic items I mentioned had an impact of approximately 0.5 percentage points on CET1. Therefore, without those items, we would have reported 10.2% to 10.3%. These events can fluctuate, potentially leading to lower ratios at times or higher ratios at others, which is normal. Occasionally, we see overdrafts increase, ranging from $2 billion to $3 billion, due to our balance and derivative positions when the dollar is performing strongly. This situation can lead to positive mark-to-market results. However, this also gets significantly affected by the RWA standardized rules. Recently, there was a $3 billion to $4 billion move in RWA, which has now normalized over the past two weeks as the dollar's movement reversed. This is simply part of our business operations, and we will continue to experience this volatility. Currently, it has cost us about 0.5 percentage points on CET1, and that effect has since reversed.

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

I’m interested in understanding the servicing outlook. It appears that there is significant B-rate compression, and the relationship between AUC, AUM, and revenues shows that revenues are lagging based on the current outlook. Looking at the full year, it seems this trend may continue. Is there anything specific happening? Does your forecast take into account a normalization in the volume-driven aspects of the servicing fee that could potentially hinder that rate? Or is there a negative mix occurring? Any additional insights would be greatly appreciated.

Sure. Brennan, the most significant development right now is the substantial increase in assets under custody and administration, or AUC/A, driven primarily by equity markets. However, this is somewhat countered by lower bond markets, which causes an unusual impact on fee rates since it isn’t a straightforward point-for-point correlation. Specifically, every 10-point change in AUC/A leads to a three-point increase in servicing fees, provided the change comes from equity markets. This difference results in a naturally lower fee rate. Unlike the asset management sector, where there is a more linear relationship, servicing fees do not respond equally in percentage terms to changes in AUC/A. This is the key factor affecting our outcomes. When we compare the first quarter to the previous year, you’ll observe those trends continuing throughout the rest of the year. Therefore, we should be cautious regarding this mathematical outcome. Looking at servicing fees, we showed a healthy increase of 7% year-over-year this quarter, or 4% when adjusted for currency translation. For the second quarter, I anticipate servicing fees will again fall in the 7% to 8% range, although currency translation will slightly impact this figure. Much of this growth stems from equity market appreciation, partially offset by bond market performance, which has always been part of our business model. Whether equity markets are rising or falling, this dynamic remains. Consequently, equity market levels will drive our revenue growth, and we foresee strong year-on-year comparisons for the second quarter, allowing for projections throughout the year.

Okay. There's a bit of confusion for me because we discussed the net interest income and its outlook extensively. I want to emphasize this again. In March, we received an update indicating that conditions were improving, suggesting we might be reaching a turning point for net interest income. However, the current guidance implies there are significant factors countering those positive signs. What happened in either the portfolio or the market that led to this shift between the update and now? It's clear that LIBOR is an issue, and short rates impact your operations, which seems to be hindering some of the more positive trends we observe at the longer end of the yield curve. We were aware of this during the update, so was there something that occurred behind the scenes that we missed, which could have influenced the outlook, making it seem less positive?

Brennan, thank you for your question. I appreciate your straightforwardness. Since early March, two significant external factors have affected us. Firstly, short-term interest rates have remained much lower than expected. Back in March, we were uncertain whether one-month and three-month Treasuries would stay at four basis points for the remainder of the quarter and the year, or if they would rebound. They have indeed held steady, which I estimate has impacted us by about $5 in the first quarter and another $5 in the second quarter, totaling approximately $10 for both quarters, and similarly for the third and fourth quarters. If these rates do rebound, we could see some positivity, but that loss is real. The second point we need to consider is the slowdown in the amortization of mortgage-backed securities (MBS) premiums. Many industry commentators have noted this trend. The latest data from Fannie and Freddie showed a slight increase in prepayment rates rather than a decrease, which has caused concern. However, this could be the final surge in prepayments as interest rates have surged, and we may be entering a burnout phase. I believe this will be temporary and industry-wide, reflected in the Fannie and Freddie data. We must be cautious about the rate at which the MBS premium amortization declines. If this process accelerates, I'll be quick to share that information, as many of us are looking for not just stabilization, which we feel confident in now, but actual improvement, even though we aren't quite there yet.

Your next question comes from Gerard Cassidy with RBC. Your line is open.

Eric, can you share with us, obviously, pre-pandemic, State Street’s balance sheet deposits roughly averaged about $175 billion, and now they’re sitting around $247 billion in the current first quarter. And during this time, the Fed, of course, increased its balance sheet dramatically from about $4 trillion to over $7.5 trillion. They’re going to continue with QE, as we all know, at least through the end of the year into next year at $120 billion a month in securities purchases. Can you share with us how are you guys calibrating what kind of deposit growth you’re likely to see as the Fed continues with QE for the remainder of this year and into next year?

Gerard, it’s Eric. The key question many banks are grappling with is how to navigate the changes in regulations regarding SLR and leverage ratios. We are clearly in a different environment now. After the global financial crisis, we witnessed the Federal Reserve expanding its balance sheet and then later compressing it, and now we are entering a new chapter. Our perspective is that the trajectory of the banking system will closely align with the expansion of the Fed's monetary policy, occurring in waves. We observed significant growth in the first and second quarters of last year, followed by some stabilization in deposit balances. As the Fed's buying activity continued, alongside the compression of the treasury's portfolio, we experienced a further increase. We are seeing this pattern continue into this year. We anticipate ongoing growth as we expect the Fed's balance sheet to expand further, which should return to banks. Our aim is to remain available for our clients consistently, as it is crucial for them. We have the capacity to support some of this growth, though it isn’t limitless. We need to be mindful of when the Fed may start to limit their bond-buying activities; when that happens, we will need to manage some of our discretionary deposits. We do have the ability to adjust our approach. We offer a variety of options for clients, and while our deposit rates are currently around zero, we can facilitate other activities for them when the time is right. This isn’t necessarily immediate or in the upcoming quarter, but potentially within the next year or two. We can assist them in moving to money market funds, treasury securities, or the repo market, and we will navigate these changes as they arise. We feel confident about our position now and in the upcoming quarters, but we will need to address any shifts that occur.

And just as a quick follow-up to that. Have you guys disclosed what percentage of your deposits are operational for your customers versus excess, where you would have that flexibility to move those deposits maybe elsewhere?

Gerard, there is some useful information in the post-quarter-end LCR details that we and other banks can share. We can follow up with you on this.

Great. As a follow-up question, I understand that you are not major lenders, and your loan portfolio compared to your total assets or deposits is quite low. However, I noticed that the average loans for the quarter decreased, but at the end of the quarter, they increased by about 13%. Can you provide any insight into what caused that increase in loans at the end of the quarter?

Yes. We do experience some volatility. One factor is that overdrafts are categorized as loans within our portfolio, which caused a noticeable increase at the end of the quarter. Additionally, a significant portion of our loan portfolio consists of capital call financing for private equity firms. This has shown a seasonal impact, and toward the end of the quarter, as these funds began to deploy more capital, we started seeing draws on those loans. These draws have positively contributed to our balances, which is a key reason for the robust growth we are experiencing in lending.

And your next question comes from Mike Mayo with Wells Fargo Securities. Your line is open.

I had a big picture question and specific question. Let’s just go with the big picture first. Originally, you were talking about converting SSGA to Charles River, and that would be a flagship client that you could use to sell to other asset managers, is that still something that’s contemplated proceeding? Do you have a time frame for that? How is that looking?

Yes, Mike, that project is in progress and is developing as expected. It's a large and complex initiative, making it a valuable one to focus on, especially since it was our first client. We've since gained many other clients, some of which are much simpler. But yes, the project is very much in motion and on schedule.

Okay. Regarding the new business situation, you mentioned it's neutral. Is this mainly due to the current environment, such as challenges from the pandemic making it harder to reach out to potential clients, or is it an area where you believe execution could improve? You've discussed the expansion of the coverage model, which understandably takes time. Internally, do you attribute the difficulty in acquiring new customers to the pandemic, or do you hold the team to a higher standard and emphasize the need for better performance and increased effort?

Yes, Mike, we’ve been very open about this over the last few quarters. It’s the latter. Much of the natural growth in this industry is no longer present. If you look back 10 years, a significant amount of growth came from existing clients launching new funds or expanding fund ranges globally. Much of that has already happened. In many instances, we are now seeing fund closures as distributors narrow their offerings, reflecting a desire for less choice, not more. It’s definitely about increasing intensity, and we are beginning to see positive results. While we can discuss Alpha extensively, it's important to recognize that Alpha and front-to-back should be viewed together, not separately. We still have an established core business where we see opportunities to increase penetration among medium-sized asset managers and continue to expand our efforts with asset owners and insurance companies. So, it is very much focused on the latter, with Alpha contributing to our growth, particularly as we secure new assignments and implement them for further growth in the medium to long term.

Are you approaching the lowest point for the net interest income and the fee waivers? Your guidance for net interest income is slightly lower than it was in the first quarter, but it doesn’t seem to be dropping significantly. The fee waivers are expected to be $40 million worse moving forward. Could you clarify once more about the net interest income and fee waivers? When do you anticipate reaching the lowest levels?

Mike, it’s Eric. Regarding net interest income, I believe the second quarter marks the lowest point, which is why I’ve indicated it will likely be between $460 million and $465 million per quarter for the remainder of the year. I think we’re at a stabilization level, with some minor fluctuations in that range. Given our current understanding, we feel confident about this position. The major question now is how long this level of stability will last and when we might see an increase. We expect to have more clarity in the upcoming quarters. As for the fee waivers, we have projected an approximate net impact of $40 million for the second quarter, which is offset by balances compared to around $15 million in the first quarter. This projection assumes short rates will remain at their current levels, which have been relatively stable over the last 30 to 45 days. We’re hopeful that short rates either stay flat or increase, rather than decrease.

Your next question comes from Rob Wildhack with Autonomous Research. Your line is open.

On the call in January, you talked about converting SSGA to Charles River, and that would be a flagship client that you could use to sell to other asset managers; is that still something that’s contemplated proceeding? Do you have a time frame for that? How is that looking?

Yes. I mean, to give you a sense of where we are in terms of scaling the implementation, we are well-across multifactor for future phases to drive the performance over the implementation stage. We’re actively communicating with them to give them the behind-the-scenes perspective as to how we would have flexibility and help deliver the services they need. So far in the process, we have been successful, and it has been well-received by other clients searching for similar flows.

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

Just two quick questions for Eric kind of around the guidance. More clarification questions here. On that full-year fee revenue guidance that you gave, was that inclusive or exclusive of the money market fee waivers?

That was inclusive. So it’s all in guidance. It covers all the ins and outs of the business, including the update on money market fees.

Okay. And then also on the guidance, Q2 and full year, were you giving that as of where the equity markets were as of quarter-end or as of today; obviously, the move in the markets quarter-to-date thus far?

I think I’ve split the difference on that. For equity markets, we’re still assuming the point-to-point increase in the period last year and the period this year of 10 percentage points. We’ll see if that stays or not, given where we are, and we wrote this over the last week. So, we’re also assuming equity markets stay around where they are now, which would line up with that endpoint as well.

There are no further questions at this time. I will now turn it back to Mr. O’Hanley for closing remarks.

Thank you, operator, and thanks to all for your questions. Thanks for joining us, and we look forward to speaking with you throughout the quarter.

This concludes today’s conference call. Thank you for participating. You may now disconnect.