State Street Corp (XLF) Q2 2021 Earnings Call Transcript

Good morning. And welcome to State Street Corporation’s Second 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’d 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 second 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 strong second quarter financial results, which demonstrate the meaningful progress we are making towards achieving our medium-term targets as we continue to execute on the multiyear strategic pivot of our business to that of an enterprise outsourced solutions provider. I am particularly pleased with our results, as quarterly total fee revenue exceeded $2.5 billion for the first time in the company’s history. We delivered a fourth consecutive quarter of servicing fee growth, with servicing fees at the highest level in three years, propelled by both strong equity markets and the impact of our actions to strengthen relationship management and sales effectiveness. We continue to differentiate State Street through our unique product and operational capabilities, as well as through delivering enhanced client service quality. Our pipeline continues to deliver, as evidenced by another quarter of strong servicing and Alpha client mandates, which I will discuss shortly. Additionally, we continue to invest in our business and innovate across the franchise to drive growth and enduring shareholder value creation. For example, we announced the formation of State Street Digital in the second quarter, a new division focused on addressing the industry’s evolving shift to digital finance, both as product offerings and as a business model. This is just one example in a long history of innovation that State Street has and is continuing to drive within our industry. We also continue to develop State Street Alpha, our front-to-back offering. This unique capability has created an attractive value proposition that is resonating with both new and existing clients, as well as contributing to client retention and growth opportunities, which I will also discuss shortly. Turning to slide three, I will review our second quarter highlights before handing the call over to Eric, who will take you through the quarter in more detail. Second quarter EPS was $2.07 or $1.97 excluding notable items. Despite the impact of interest rates on our NII, earnings per share excluding notables reached the highest level since 4Q 2019 when quarterly NII was notably higher—more than 35% more than it was in 2Q 2021. Relative to the year-ago period, quarterly total fee revenue exceeded $2.5 billion for the first time, increasing 6% year-over-year, driven by solid servicing and management fee growth, which increased 10% and 14% year-over-year, respectively, as well as better securities finance results. The strong performance was partially offset by the year-over-year impact on total revenues from lower software and processing fees, continued moderation of FX market volatility and ongoing interest rate headwinds. Even with record quarterly fee revenue, expenses were well controlled. While second quarter total expenses were up 1% relative to the year-ago period, they were down almost 0.5 percentage point year-over-year excluding notable items and currency translation, as our productivity improvements continued to yield results. We have created a culture of expense discipline over the last two and a half years, and we remain confident in our ability to effectively manage core operating costs over the remainder of 2021. Our strong fee revenue performance, coupled with continued cost discipline, delivered a 200-basis-point improvement to our pretax margin year-over-year, which reached nearly 30% in the second quarter, excluding notable items. Further, return on equity was 12.6% or 11.9% excluding notable items in the second quarter. AUC/A increased to a record $42.6 trillion at quarter end, supported by higher period-end equity market levels and new business onboarding. New asset servicing wins increased to $1.2 trillion for the quarter, including the large Alpha mandate with Invesco announced in April. We reported two new Alpha wins in the second quarter, taking the total number of Alpha clients to 15. After the second quarter close, we also entered into an Alpha mandate with Legal & General. While Invesco is an example of how Alpha is helping to expand and deepen existing client relationships, the Legal & General win demonstrates how the Alpha strategy is also helping us forge new client relationships with the world’s most sophisticated investors. Our experience to date gives us confidence that Alpha relationships will drive stronger retention rates for existing clients, while also allowing us to broaden and deepen those relationships as we add additional products and services to these existing mandates. Additionally, we are signing Alpha clients that are new to State Street, demonstrating that Alpha is enabling us to reach new clients and deliver front, middle and back office services in a differentiated manner. We also create these new relationships to help drive revenue growth across client segments and regions. For example, earlier this week we announced a new strategic alliance with First Abu Dhabi Bank. The alliance will create a full-service enterprise offering for institutional investors in the Middle East and North Africa region. It will provide investors with extensive reach into more than 100 markets around the world. Clients will have access to State Street’s full suite of front, middle and back office capabilities in addition to our extensive data management and analytics solutions, which seamlessly integrates with First Abu Dhabi Bank’s regional suite of securities services products, local expertise and regional direct custody network. At CRD, annual recurring revenue increased 11% year-over-year to $230 million and we remain pleased with how the business is performing, while also enabling and propelling our Alpha strategy. Global Advisors continued to demonstrate strong performance: AUM increased to $3.9 trillion and management fees increased to $504 million, both records benefiting from strong second quarter flows of $83 billion across the ETF, institutional and cash businesses, as we continue to leverage the strengths of our asset management franchise. In ETFs, our low-cost and sector funds, as well as our ESG and commodity products, continued to enjoy good market share with low-cost ETFs expanding share in the second quarter. And in institutional, our sales force and relationship management realignment, coupled with strong products, led to good revenue growth. Turning to our balance sheet and capital, we returned over $600 million of capital to our shareholders during the second quarter, inclusive of $425 million of common share repurchases consistent with the limits set by the Federal Reserve. I am pleased with yet another strong performance under this year’s annual stress test. The new SCB framework provides us with additional flexibility to manage our capital pace. As examples, yesterday we announced that our Board of Directors has approved a 10% increase of our third quarter common dividend to $0.57 per share and authorized a common share repurchase program of up to $3 billion during the third quarter of 2021 through the fourth quarter of 2022. To conclude, we had a very strong quarter, business momentum is building and we have demonstrated meaningful progress towards our medium-term financial targets. As I look ahead to support our strategic vision and help us achieve those targets, we are continuing to prioritize improvement in our fee revenue growth, while controlling costs by transforming the way we work and building a higher performing organization for the future. 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 will begin my review of our second quarter results on slide four. We reported EPS of $2.07 or $1.97, excluding the $0.10 positive impact of notable items, which was driven by a previously announced sale of a majority stake in a legacy business. On the left panel of the slide, you can see strong results as we continue to drive fee revenue growth while controlling expenses. We delivered pretax margin expansion and solid earnings growth. As a result of the weaker dollar relative to the year-ago period, we continue to show our year-on-year results excluding the impact of currency translation in the right column. We also show results excluding notable items on the bottom of the slide. Turning to slide five, you will see our business volume growth. Period-end AUC/A increased 27% year-on-year and 6% quarter-on-quarter to a record $42.6 trillion. Both the year-on-year and quarter-on-quarter increases were largely driven by higher period-end market levels, net new business growth and client flows. At Global Advisors, AUM increased 28% year-on-year and 9% quarter-on-quarter to $3.9 trillion, also a record. The year-on-year and quarter-on-quarter increases were both primarily driven by higher period-end market levels coupled with net inflows. Turning to slide six, you can see another quarter of strong business momentum. Second quarter servicing fees increased 10% year-on-year, including currency translation, which was worth approximately 3 percentage points year-on-year. The increase reflects higher average market levels, positive net new business onboarded and client flows, only partially offset by normal pricing headwinds and the absence of elevated prior-year client activity. AUC/A wins totaled $1.2 trillion in the second quarter—substantially up from recent quarters—primarily as a result of the large Alpha client mandate announced in April that Ron just mentioned. AUC/A won but yet to be installed also amounted to $1.2 trillion at quarter end, as we smoothly onboarded over $400 billion of client assets this past quarter. We remain focused on reigniting business growth across both client segments and regions. This quarter, we had strong growth in the EMEA region, aided by our intense coverage efforts, which now extend to approximately 350 of our top clients. We continue to estimate that we need at least $1.5 trillion in growth AUC/A wins annually in order to offset typical client attrition and normal pricing headwinds, and we have clearly exceeded that mark this year. I will remind you that installations typically occur in phases and over time and deals will vary by fee and product mix. At this time, we expect the current won-but-yet-to-be-installed AUC/A will be converted over the coming 12- to 24-month time period with the associated revenue benefits beginning in 2022 and the majority occurring in 2023. As we said in June, we are pleased with our pipeline and our momentum. Turning to slide seven. Second quarter management fees reached a record $504 million, up 14% year-on-year inclusive of a 2-percentage-point impact from currency translation and were up 2% quarter-on-quarter resulting in investment management pretax margin approaching 35%. Both the year-on-year and quarter-on-quarter management fee performance benefited from higher average equity market levels and strong ETF flows. These benefits were only partially offset by the run-rate impact from the previously reported idiosyncratic institutional client asset reallocation, as well as about $25 million of money market fee waivers this quarter. While we previously estimated that money market fee waivers on our management fees could be approximately $35 million per quarter, as a result of the recent improvement in short-end rates following the June FOMC meeting, we now expect that they will be about $20 million to $25 million per quarter for the rest of the year, which is about a third lower than we had previously expected. Global Advisors had record solid flows across institutional, ETFs and cash for the quarter, which totaled $83 billion. We have taken a number of actions to deliver growth in our long-term institutional and ETF franchises, which are driving this momentum as you can see on the bottom right of the slide. Turning to slide eight, let me discuss the other important fee revenue lines in more detail. Within FX trading services, we are pleased that we continue to generate strong client volumes, which remain above pre-pandemic levels in the second quarter. Relative to a strong second quarter in 2020, FX revenue fell 12% year-on-year as declining FX market volatility compared to the COVID environment last year more than offset higher client volumes. FX revenue was down 17% quarter-on-quarter due to moderation of client volumes from index rebalances experienced in the first quarter and lower market volatility. Our securities finance business recorded strong revenue growth, with fees increasing 18% year-on-year and 10% quarter-on-quarter, mainly as a result of higher enhanced custody and agency balances as clients' leverage rebounded. Finally, second quarter software and processing fees were down 12% year-on-year, largely due to the absence of prior-year positive mark-to-market adjustments. Software and processing fees increased 24% quarter-on-quarter, mainly as a result of higher CRD revenues. Moving to slide nine, I’d like to provide some further updates on our CRD and Alpha performance. We delivered strong standalone CRD results in the quarter, primarily reflecting higher client renewals and episodic fee revenues. The more durable SaaS and professional services revenues continue to grow nicely and were up 10% year-on-year, resulting in an increase in standalone annualized recurring revenue to $230 million. This quarter marks a three-year anniversary since announcing the CRD acquisition and we are very pleased with how the business has performed. We are winning in part thanks to State Street’s brand and reputation, and the benefit to clients of our integrated Alpha offering. On the bottom right of the slide we show some of the second quarter highlights from State Street Alpha mandates. We reported two new Alpha mandates during the second quarter, as the value proposition continues to resonate well with clients. Notably, since inception through the second quarter, we now have five Alpha client mandates that are live. Although Alpha deals usually take somewhat longer to implement given the size and scope, the payoff outweighs the longer implementation period as we are able to further expand share-of-wallet to generate attractive revenue growth rates and increase the contract length, which can be up to 10 years in length for Alpha services that span the front and middle office. Turning to slide 10, second quarter NII declined 16% year-on-year, mainly as a result of the lower interest rate environment, our investment portfolio yields and sponsored member repo products. These impacts were partially offset by balance sheet expansion driven by higher balances. Relative to the first quarter, however, NII was flat as lower investment portfolio yields and the impact of short-end rates were offset by further expansion of the investment portfolio and lending activity. On the right side of the slide, we show the growth of our average balance sheet during the second quarter. Total average deposits increased by $16 billion in the second quarter or an increase of 7% quarter-on-quarter, reflecting the continued impact of the Federal Reserve’s expansionary monetary policy. While we continue to remain mindful of OCI risk in the current rate environment, we tactically added about $5 billion quarter-on-quarter to our investment portfolio a few months ago, before the recent downdraft in rates. We also increased our average loan balances by approximately 5% quarter-on-quarter to over $29 billion, driven by higher utilization by asset managers and private equity capital call clients. We also have a number of initiatives in flight to reverse and reduce this recent deposit uptake that we saw during the quarter. Turning to slide 11, second quarter expenses excluding notable items increased 2% year-on-year, mainly driven by the weaker dollar. Excluding the impact of notable items and currency translation, total expenses were down nearly 0.5 percentage point year-on-year, as productivity savings for the quarter more than offset higher revenue-related expenses and targeted investments and client onboarding costs. Compared to 2Q 2020, on a line item basis and excluding notable items and the impact of currency translation, compensation and employee benefit costs were flat as we reduced high-cost location headcount, which offset higher medical costs as claims began to normalize to pre-pandemic levels. Information systems and communications were up 5% due to continued investment in our technology estate. Transaction processing was up 10%, primarily driven by higher revenue-related expenses for subcustody balances and market data costs. Occupancy was down 13%, reflecting benefits from our footprint optimization efforts and some timing benefits. And other expenses were down 11%, primarily driven by lower-than-usual professional services fees. Relative to the first quarter, expenses were primarily impacted by the absence of seasonal and deferred compensation reported in the first quarter. So, overall, we are pleased with our continued ability to demonstrate expense discipline, as we have effectively managed total expenses excluding notables and currency down year-on-year in the second quarter, while driving strong total fee revenue growth. Moving to slide 12, on the right of the slide, we show our capital highlights. We are pleased with our performance under this year’s CCAR with a calculated stress capital buffer well below the 2.5% minimum, resulting in a preliminary SCB at that floor. The new SCB framework provides us with additional flexibility to deploy our capital base in a number of different ways, including investment opportunities, dividends and buybacks. For example, yesterday we announced a 10% increase to our third quarter common dividend to $0.57 per share and our Board has authorized a common share repurchase program of up to $3 billion from the third quarter of 2021 through year-end 2022. In addition, we are also pleased that the Federal Reserve has provided State Street with one additional year until January 1, 2024, to retain its current G-SIB surcharge of 1%. To the left of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios. As you can see, we continue to navigate the operating environment with strong capital levels in excess of the requirements. As of quarter end, our standardized CET1 ratio improved by 40 basis points quarter-on-quarter to 11.2% as we had expected and sits above the upper end of our 10% to 11% CET1 target range. The improvement was driven by solid capital appreciation and we also managed down RWAs despite balance sheet growth. Our Tier 1 leverage ratio remains well above the regulatory minimum, but declined by 20 basis points quarter-on-quarter to 5.2%, primarily as a result of the further increase in average client balances as the Fed’s quantitative easing continues. We continue to think that our Tier 1 leverage ratio in the 5s is appropriate for our business model. And we can operate at the lower end of this range for a number of quarters, while we consciously limit and reduce client deposits and offer them a range of liquidity alternatives. Turning to slide 13, in summary, our quarterly performance demonstrates solid business momentum on our topline and the scale we are driving within our operating model. Total fee revenue was up almost 6% year-on-year and exceeded $2.5 billion for the first time, with double-digit growth in servicing and management fees, despite the year-on-year headwind from the strong FX trading services results we had in the second quarter of last year during COVID. Our expenses remain well controlled as a result of our productivity program. As a result, we were able to drive pretax margin and ROE close to our medium-term targets, notwithstanding the low rate environment. Next, I’d like to update you on our economic outlook for the remainder of the year and provide our current thinking regarding the third quarter outlook. At a macro level, our rate view broadly aligns with the current forward rate curve and assumes that short-end rates remain low and there is some modest steepening to the yield curve. We are also assuming global equity markets will be relatively flat to quarter end for the rest of the year, as well as continuing normalization of FX market activity. In terms of the third quarter of 2021, we expect overall fee revenue to be up 7% to 8% year-over-year, with servicing and management fees each expected to be up 7% to 9% year-over-year. This means full-year fee guidance is likely to be better than the upper end of the full-year range we previously provided. Regarding NII, despite the recent flattening of the yield curve, we have seen an increase in short-end market rates and we now expect a modestly improved quarterly NII range of $460 million to $470 million per quarter for the rest of the year, assuming rates do not deteriorate and premium amortization continues to attenuate. Turning to expenses, we remain confident in our ability to effectively manage core operating costs. We expect that third quarter expenses excluding notable items will be flattish, plus or minus 0.5 percentage point year-over-year in 3Q. These fee and expense guides for 3Q include approximately a point of currency translation year-over-year. On taxes, we expect that the 3Q 2021 tax rate will be in the middle of our full-year range of 17% to 19%. And with that, let me hand the call back to Ron.

Thank you, Eric. And with that, Operator, we can now open the call for questions.

Thank you. Your first question comes from the line of Betsy Graseck with Morgan Stanley.

Hi. Good morning. Thanks very much.

Hi, Betsy.

I just wanted to start off by talking a little bit about the fee guide that you just went through. Could you just give us a sense as to the major drivers? I mean, I realized that throughout the call, you were talking about the pipeline being up and you have got a reinvigorated sales effort going on. Is that what’s driving this so quickly or is there something else that’s happening that leads you to the fee guide raise? Thanks.

Yeah. Betsy, why don’t I start and Eric will comment. I wouldn’t describe it as happening so quickly. What you are seeing here is the product of a lot of months and years of work that’s now coming together and starting to bear fruit. We are not done; we have more work to do. But I think it is about some of the things that we have told you in the past that we have been up to that are coming together and starting to have the desired impact here.

Okay. Thanks. And then maybe you could just refresh how you are thinking about the asset management business and where you would like to lean into growth, what pockets you are looking to invest in and if that’s by geography, too, that would be helpful?

We think of the business as having three core elements to it: the ETF business, the institutional business and the cash business. All three are well-established franchises. The areas that we like to lean into are the institutional business first, and I will come back to the ETF business. The institutional business has very strong client relationships around the world but a limited product set. We have spent a lot of time thinking about how to take those relationships and that distribution channel and leverage it by enhancing our product capabilities. On the ETF side, we have been on a long path to developing the products there, as well as deepening our presence in geographies outside the U.S. You have seen a lot of payoff from that, particularly in EMEA. We will continue to grow that. Areas of growth include ESG, which continues to do very nicely for us, as well as continuing to emphasize the advantages of our core product set: institutionally designed products with a lot of liquidity, which is important to many investors. The cash business is, obviously, a function of interest rates. But we have a very sophisticated cash business that works in different interest rate environments and we will continue to present that to both existing asset management and asset servicing clients, as well as clients that don’t have either of those relationships with us.

Thanks, Ron. Thanks, Eric.

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

Hi, Brennan.

Good morning. Thanks for that. Hey, how are you, Ron? Hi, Eric. I have another follow-up on the updated outlook. I noticed, Eric, that you said we are going to be above the upper end of the range for the full year, which doesn’t seem that challenging given how strong the second quarter was and how good the third quarter looks at this point. Is it possible to narrow that full-year fee revenue outlook to something more specific than just a greater-than sign? How are you thinking about it and how should we think about it? And what assumptions for balance sheet size are embedded in the updated NII outlook? Thank you.

Sure. Brennan, it’s Eric. Let me describe it this way. I think we are seeing very good performance across a number of our businesses. In addition to some of the tailwinds that you get from equity markets—equity markets were up globally quarter-on-quarter about 5%—we are seeing strength in net new business revenues. Last quarter, I said, we were relatively neutral on net new business and servicing fees. This quarter we are nicely positive on that front on the servicing fee side. In management fees, we have been booking a couple of quarters in a row of very nice inflows. They have come with annualized net new revenues that are solidly positive and create a tailwind as well. And then you saw we have had good performance across our securities lending franchise, CRD had another good quarter and so we are comfortable with a higher guide. I think I gave you primarily third quarter information and maybe to answer the question directly: the full-year fee guide, if you recall, was taken up last quarter to 2.5% to 4% year-over-year. Remember that includes lapping the COVID-related FX bumps from a year ago. So our guide had been 2.5% to 4% for total fee growth. Given what we know today, you can count on around 5% growth. So we are going from that range to about another point up over the top end of that range for the time being.

Okay. Great. That’s fair. And the balance sheet size piece of the NII?

Yeah. The balance sheet always has puts and takes in this environment of quantitative easing. What you have seen us do is try to put some of the additional deposits to work. You have seen us take advantage of the increase in IOER and the Fed floor on the repo rate. That’s been constructive. We do need to manage the size of the balance sheet, because as we compress the balance sheet that frees up leverage ratio capacity and then that feeds back into our ability to return capital. We are pretty serious about compressing some of those deposits. We had more of an uptick in May and June; April was roughly in line with the first quarter. We are starting to chip away at that and we see a path to do that. I don’t think that will have much of an effect on NII. At these low rates, incremental deposit is worth a little, but not a lot. But it will be the right way to manage the balance of NII, which I think will comfortably sit in that new range that we have provided, while also freeing up space for capital return, which is an important priority for us.

Great. Thanks for providing that clarification, Eric. You also in your prepared remarks mentioned that fee rates vary. When you think about the nice uptick in your won-but-not-funded mandates here, what do those fee dynamics look like? How should we start modeling those? Are those influenced by the success of Alpha and CRD? Does that help support fee rates or is competition still intense? How should we think about those fees that are oncoming? Thank you.

Sure, Brennan. I think there’s a real range here. It’s not whether it’s Alpha deals or classic custody deals; it’s really the size of the deals tends to come at different fee rates. We saw some larger deals this quarter and because the denominator of assets is larger, they will come a little lighter in terms of fee rate. On the other hand, in the first quarter, we had a set of wins that were well above our traditional fee rate. So fee rates will bounce around from one quarter to the next. We are always making sure that as we add revenues, we do it at healthy margins. We are pleased that the fee rate for the first half of the year is well in line with our overall fee rate for the company and that bodes well as we implement some of these new wins.

Great. Thanks for that color.

Sure.

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

Thanks. Good morning, Eric and Ron. Just wanted to ask a little bit more on the capital return, in terms of how you landed on the $3 billion number vis-à-vis your balance sheet uses and also your capital ratio targets. Are you aiming for a total return payout? Under this new SCB, how do you land on that number and how should we be thinking about whether there would potentially be more room depending on some of those other factors? Thanks.

Ken, it’s Eric. There are always facts and circumstances on individual capital returns at any time. Let me give you the envelope and how we think about it. One of the things we start with is: what is our CET1 ratio? As you saw, we are at 11.2%. The first thing you can do is compare that to the target range of 10% to 11%. You can say, look, first step is: how do we float down that ratio to the midpoint of that range and that provides $700 million to $800 million of return capacity. Secondly, you go through earnings—earnings next quarter, the quarter after—and what we do with those earnings is determine how much to give back to shareholders in the form of capital return. One part of that is the dividend and then the balance can often be returned as buybacks. So you can add those buybacks that cover the difference between earnings and dividends for the next several quarters. Finally, the balance sheet always grows a bit; our RWAs might grow by around 5%, so there’s always a modest amount of capital retention necessary just to fund that. If you go through those pieces—the floating down to target, what earnings can support net of the dividend going into buybacks, and the modest retention for underlying growth—it pencils out to that up-to-$3 billion range.

Got it. Thanks for that color. Second question just on your NII guide and the range: you mentioned that premium amortization would continue to attenuate. How much attenuation would you expect and where was it this quarter versus other factors that are working against it to kind of keep us in the zone? Thanks.

Premium amortization is a bit bouncy from one quarter to the next given where individual bonds are. What’s happening is you have the grind on the investment portfolio, which can be in the $15 million to $25 million range. Premium amortization can work in the opposite direction in the upcoming quarter; we’re thinking it’s in the $15 million range but it will bounce around. So you have this headwind of rates and premium amortization can go the other way. It can bounce around plus or minus $5 million easily from one quarter to the next. What is nice is we are starting to get to a leveling off of the net yields on the portfolios—roll-offs are starting to get better matched with roll-ons—and you saw we printed net yield on the investment portfolio at about 1.11% to 1.12%. We are close to the bottom of that yield and that’s what gives us comfort we are in this range for the time being, though we took the upper end of that range up a bit because of improvement in front-end rates.

Understood. Okay. Thanks, Eric.

Sure.

Your next question comes from the line of Glenn Schorr with Evercore ISI.

Hello there.

Hi, Glenn.

So it’s good to see the margin back to the 30% range and if I listen correctly, I hear good markets, good organic growth, better commentary about fees, NII and fee waivers and continued control of expenses. So is the 30%-ish margin here to stay for now, because it sounds like everything is moving in the right direction?

I think 'here to stay' is a pretty definitive term. I think what you can see is a solid progression over time in our margin. One quarter doesn’t make a year, but you can see progress over quarters and over years. There was a time when we would have taken the equity market tailwind and expenses would have crept up more than they did this quarter. You are seeing discipline that’s pushing margin in the right direction. We are pleased with the performance and we would like to do it again and again. This has taken quarters and years to get to this point, but we need to keep at it to consistently deliver this kind of result.

What I would add is that margin is a part of our medium-term targets. We laid out those targets at a time when there was a very different NII picture. So it’s taking longer than we would have liked, but it’s very much part of what we said we were going to deliver. It’s built into management compensation. You should expect as much intensity around it going forward as you have seen up to now.

I appreciate that. Just one quick follow-up on First Abu Dhabi: is this eventually replacing outsourcing global custody in the region? Is there a broader mandate? I wonder if you could expand on what you expect or hope out of the relationship.

We have intensified efforts in the Middle East. We have been there for a while and we have taken steps to augment our presence there, including licenses in Saudi Arabia. Think of First Abu Dhabi Bank as doing two things: one, we become the global custodian for their client base; two, they become our subcustodian in regions where we don’t have local custody, replacing other subcustodians in our network.

How quickly can that happen based on subcustodian fees?

It’s starting now. There are contracts that need to move, but it will happen pretty quickly over months and a couple of quarters, not years.

Excellent. Thank you for all that. I appreciate it.

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

Hi. Good morning everybody. I was hoping to get a couple of questions on CRD. One, can we get an update on the uninstalled revenue backlog of $93 million? What’s the typical timeframe of those installations? And when it comes to new bookings of $19 million, any color around client types and service types embedded in the $19 million would be helpful. And did you mention how much episodic benefit contributed to the quarter in CRD specifically?

Sure, Alex. Let me touch on each of those. We are pleased with CRD performance. The new bookings of $19 million for the quarter was a five-quarter high. Some of that you can ascribe to the Invesco win, which included front office, middle office and back office as we continue to expand that relationship—so the front-office piece of that win is in the $19 million. On the uninstalled backlog of $93 million, it’s a mix of installations that come over six months, 12 months, 18 months, and in some cases 24 months. The longer installations tend to come with professional services fees as you prepare and implement. Those fees get reimbursed and paid as part of many of the contracts until you get to go-live, which for smaller installations can be short and for larger ones can take longer given the size and complexity. I’d also note on the on-premise revenues, we hit another high of $63 million, similar to last year. Some of that was classic renewals of installations and that kind of thing. Some of the most episodic items in there are probably in the $20 million to $25 million range. I encourage you to take an average of quarters over five to nine quarters to get a sense for what’s typical in the on-premise line.

That makes sense. And then a quick follow-up around capital: given you’re a bit below the low end of your target on Tier 1 leverage, you have room to manage deposits out over time. How should we think about the pace of buybacks from here? Should we think of the $3 billion authorization as evenly spread through end of 2022 or back-end loaded as you work through balance-sheet dynamics?

That’s a fair question. We have to balance a number of factors. On Tier 1 leverage, we are comfortable operating in the 5s; this is appropriate given our business model. Some deposits came in a little heavier in May and June. We have ongoing client discussions around roughly $10 billion of items that are literally happening now, and there are ways for us to chip away at deposits. In terms of buyback patterning, while it’s always dependent on facts and circumstances, we don’t have an interest in back-loading buybacks necessarily; we would rather do them relatively smoothly, all else being equal. We think we have plenty of capacity given our higher capital ratios and confidence in our deposit-management efforts to deliver buybacks in a relatively consistent way that shareholders would appreciate.

Awesome. Thanks very much.

Your next question comes from the line of Brian Bedell with Deutsche Bank.

Hi. Good morning, folks. I just want to come back to the balance sheet one more time in terms of size and how you are managing that. I may have missed it for the $460 million to $470 million quarterly guide—what’s embedded in the size of the balance sheet, given that it spiked in the second quarter? Is your expectation for that to moderate? And then longer-term over the next six quarters in conjunction with the $3 billion buyback, do you plan to continue to grow the balance sheet on a year-over-year basis and how does that contrast with trying to reduce excess deposits?

Brian, a couple of factors get at total balance sheet and RWAs. On the NII range of $460 million to $470 million per quarter, that fully takes into account some of our deposit-management efforts. Incremental deposits don’t earn a ton these days and so that’s been factored into the range. The improvement in front-end rates helped. In terms of balance-sheet growth, we need to contain the size of the leverage balance sheet. Under the surface, there’s always healthy growth in risk-weighted assets because we support our clients in FX, securities lending, lending, etc. Our RWAs are around $120 billion and they typically grow at around 5% a year, plus or minus a couple points. Growing RWAs does not necessarily increase the leverage balance sheet in the same way—leverage balance sheet is driven primarily by deposits, which is separable from RWA growth typically.

Okay. Got it. That’s clear. And then just maybe back to the Abu Dhabi relationship: should we think about any impact to AUC/A for State Street and asset servicing fees related to that or is it less material?

I would say our expectations would drive AUC/A. It will be a modest amount at the beginning and will help us to continue to manage subcustody costs. Most importantly, over the medium term, given the relationships there, it will help further our penetration in the region. That’s probably the most important reason to be doing it. They are a terrific partner.

Okay.

The other point is sometimes subcustodians and we compete with them; in this case we now have a subcustodian that we are not competing with.

Right. Right. That makes sense. Okay. Thank you.

Your next question comes from the line of Steven Chubak with Wolfe Research.

Hi. Good morning.

Good morning.

I wanted to start off, Eric, with a question on securities growth and more specifically related to the LCR. You had strong deposit growth. The LCR ratio is running a little tight at 104% versus the 100% minimum. Can you give us some sense philosophically how you are managing LCR constraints? Given the poor liquidity treatment of QE-related deposit growth, how does it impact your ability to deploy at higher yields and even grow the securities growth book incrementally from here?

Steve, the LCR has some anomalies. What’s most pertinent to us as an institution is actually the bank LCR, which is at 131%. That’s extremely flush and has plenty of room. What happens at the corporate level is additional deposits get haircut because of transferability, which creates an odd result where as the bank becomes more flush the corporate LCR goes down. If we reduce deposits, mathematically the bank LCR starts to flow down from 131% and the corporate LCR floats up. We are actually quite flush with LCR and operating comfortably.

Thanks for that color, Eric. And the follow-up I had is on expenses. You have done a great job of reining in expense growth in 2Q, and the 3Q guide reinforces a similar trend, but there is growing investor concern given other large banks are guiding higher on expenses for accelerating investments. Can you give us context on what the full-year expense might look like this year and the growth algorithm heading into next year—whether you might need to step up investments to keep pace with peers?

Steve, expense has been a focus for several years now. We got expenses down, excluding notables and adjusted for currency, down 2% and 1.5% last year. This year, on a nominal basis, we expect expenses full-year to be flattish, plus or minus 0.5 percentage point. Adjusted for currency and notables, it would be down about a point. The biggest thing this year is revenue-related costs—custody fees, market data, etc.—that scale with AUC/A or AUM. We have a programmatic approach: systematically implement productivity programs that save significant amounts, and then reinvest a portion of those savings in the business. Sometimes we expand coverage and sales forces; sometimes we reinvest in product functionality; sometimes we invest in onboarding clients. Typically we target taking 4-5% off the expense base through productivity programs, which is hundreds of millions of dollars on an $8 billion base. That approach allows us to save meaningfully while selectively reinvesting. How it plays out for next year is premature to specify, but our focus on productivity and disciplined reinvestment continues.

That’s great color, Eric. Thanks so much for taking my questions.

Sure.

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

Good morning, Eric. Good morning, Ron.

Hi, Gerard.

Hi.

Eric, can you clarify: I think you said on the call that new business wins this quarter contributed positively to earnings versus last quarter it was neutral. First, could you clarify if it was earnings, and second, what changed between the two quarters that enabled this quarter to be positive versus last quarter being neutral?

Gerard, yes. On servicing fees, part of the increase year-on-year came from positive net new business—more wins installed than the typical attrition. Last quarter I said net new business was neutral and I was not as pleased as we would like to be. Over the last couple of quarters, we have accelerated our wins and win rate. You see that in AUC/A, though it’s bouncy. Custody can install quickly when it’s won, and we have focused on some of those wins that can be implemented faster. The momentum reflects our more intense coverage process across clients, and we are seeing the results. It doesn’t mean it will be this way every quarter, but we are pleased with this quarter and believe momentum is building.

Very good. My follow-up is on the Alpha product: what percentage of your client base do you think is eligible or would be interested in Alpha? And what challenges have you found in convincing them it’s in their best interest to adopt Alpha?

In theory, many clients are eligible; the practical set is those with a trigger point like aging technology or costly operations. The obstacles are that these are large change programs and typically driven from the CIO and COO, sometimes on the CEO’s agenda. Given industry trends—aging technology and data management challenges—these issues are on most CEOs’ agendas. We built Alpha with interoperability in mind, so we can integrate with other front-office systems like Aladdin. We recognize clients have complex estates; Alpha is designed to work across a broad variety of clients.

As a quick follow-up, have you found with Alpha customers that you have better success expanding share-of-wallet once onboarded compared to a traditional client?

Yes, that’s exactly the result we are seeing. As we expand front and middle office services, it’s natural to consolidate custody or connect trading activity directly into Charles River. The underlying benefit is expanded share-of-wallet and stickier relationships; these become true partnerships rather than just service arrangements.

Great. Thank you.

Your next question comes from the line of Jim Mitchell with Seaport Research.

Hey. Good morning. Ron, you noted that you want to lean into the institutional asset management business and this quarter was one of the best flow quarters in five years. Can you describe in more detail what you are doing on the sales and distribution side to drive the improved growth? And when you talk about adding products and capabilities, what areas would you look to add? Is that organic or would it need acquisition?

Over the past couple of years we have taken a very good sales and relationship management force and made it better. Because of our core passive products, when we are in a client, we often have a seat at the table as they consider asset allocation. We have systematically built out and upgraded our capability to have those conversations and increase share-of-wallet. ESG has provided a real tailwind; we have a long history and strong reputation there. In terms of products, we tend to dominate one end of the barbell and there’s opportunity across the rest. Our focus is on multi-asset products and building some of those ourselves or creating bespoke offerings for very large clients using capabilities we already have. We see significant organic opportunity; inorganic opportunities must make strategic sense for clients and shareholders, and we would consider them if appropriate.

All right. Great. That’s helpful. Thanks.

Your next question comes from the line of Mike Mayo with Wells Fargo Securities.

Hi. In late 2018 you had around 40,000 employees, now you have 39,000. I was wondering to what role technology has played into that and what are your expectations going forward? What’s the state of your tech backbone in terms of how much is in cloud, public versus private? After the issues years ago, it seems like it’s going better now. Can you update on that and tie it back to headcount?

In terms of headcount, the composition has changed. We continue to leverage lower-cost locations, so the mix has changed. Technology is the critical factor. Service productivity has been elusive for a long time and we are getting better at it. Much of it is automation—automating many tasks that constitute a job so what remains is higher value-added work requiring judgment. We are instituting AI for tasks like NAV calculation so the final checking is the human piece. We are investing in measuring productivity across the organization; having metrics drives improvement. On technology, we have an outstanding team making progress. Some investments are new capabilities and ongoing resilience, including cybersecurity. As a global systemically important bank, we need to be at the lead and we are. The progress is showing up in the numbers and we expect more payoff in the future.

When you automate a services business, how much can you automate leaving the value-added parts at the end? And going forward, do you expect headcount to start going up again given initiatives and backlog?

We don’t yet know the ceiling, but there’s a lot more we can do. For example, NAV processing involves many tasks and AI can shift much of that work earlier in the day, leaving final checks to humans. Regarding headcount, you should expect a breaking of the old relationship where headcount and compensation rose in lockstep with revenue. We are driving more scale out of the system so that revenues can grow without proportional increases in headcount. In the past challenges came from serving very sophisticated, demanding clients; we are getting better at achieving scale and standardization where appropriate.

Got it. Thank you.

Your next question comes from the line of Rob Wildhack with Autonomous Research.

Good morning, guys.

Hi, Rob.

Another question on CRD: can you comment on the trajectory of software-enabled and professional services pieces? Do you think the 10% growth this quarter is sustainable? Also, what about the longer-term profitability or margin profile of CRD?

Rob, that growth is certainly sustainable. The combination of professional services and software-enabled revenue has been growing nicely in the double digits and in some cases closer to 15%. You have take-up in the market for new installations and over time conversion from on-premise to SaaS as clients realize the value of a cloud offering. That component should be in the double-digit teens typically, though it will bounce with professional services. On profitability, we bought Charles River three years ago and reinvested in the platform; we needed to do that. Now we are getting to the point where it has scale and functionality and can deliver earnings growth over time and take advantage of the momentum we’ve seen.

To add, investments in Charles River were in two categories: enhancing the core offering and integrating Charles River into Alpha. We migrated the cloud offering to Microsoft Azure which gives us standardization and flexibility for data locations, which is important for clients outside the U.S. That’s now being installed with clients and strengthens the SaaS offering.

Got it. Thank you, guys.

And your next question comes from the line of Vivek Juneja with JPMorgan.

Hi. A couple of questions. Ron, you mentioned leaning into products on the asset management side. Where does active equity stand in your mind given it has been stuck for the last four quarters? Is that still something you want to be in or exit? And would moving the needle meaningfully on active require an acquisition?

It’s small and much of our active equity is in value, which hasn’t been in favor, but we believe active should play a part in portfolios. The move to active ETFs can help propel that by providing a different vehicle to construct portfolios. The institutional relationship management channel can accommodate a broad set of products including active equity. Our organic agenda is full in terms of product development. Inorganic opportunities are possible if they make sense for clients and shareholders, but that would be speculation at this point.

A separate question: the Invesco win is a huge existing client. Given they were already a large client, what incremental services and incremental fee revenue should we think about from that $1 trillion? Did you add middle office and front office? How meaningful is that win given the existing relationship?

It is a large client and we are not the only servicer for them. The services include additional back office, front office via Charles River as the core operating platform, and middle office. It’s across the board. We are partnering with them to help achieve their technology and operational goals. They have also helped us develop new features and functionality into the Alpha platform that will be extendable to other clients in the future.

And the middle office would take longer to install?

Yes, typically it takes longer for middle office implementations.

Okay. Thank you, both.

There are no other questions at this time. I will now turn the call back over to Ron for closing remarks.

Thank you, Operator, and thanks to all of you on the call for joining us.

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