State Street Corp (XLF) Q1 2022 Earnings Call Transcript

Good morning, and welcome to State Street Corporation's First Quarter 2022 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 express written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. Now I would like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street.

Good morning, and thank you all for joining us. On our call today, our CEO, Ron O’Hanley, will speak first. Then Eric Aboaf, our CFO, will take you through our first quarter 2022 earnings slide presentation, which is available for download in the Investor Relations section of our website, investors.statestreet.com. Afterwards, we'll be happy to take questions. During the Q&A, please limit yourself to 2 questions and then requeue. Before we get started, I would like to remind you that today's presentation will include results presented on a basis that excludes or adjusts one or more items from GAAP. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measure are available in the appendix to our slide presentation. In addition, today's presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors, such as those factors referenced in our discussion today and in our SEC filings, including the risk factors in our Form 10-K. Our forward-looking statements speak only as of today, and we disclaim any obligation to update them even if our views change. Now let me turn it over to Ron.

Thank you, Ilene, and good afternoon, everyone. Earlier today, we released our first quarter financial results. Before I review our results, I would like to briefly reflect on the operating environment in the first quarter, which included both significant geopolitical events as well as notable macroeconomic developments and market movements. Turning to Slide 3 of our presentation. First, I would like to acknowledge the ongoing events in Europe following Russia's invasion of Ukraine. In March, I traveled to Krakow to visit some of State Street's approximately 6,400 employees in Poland. During my visit, I was moved by the selflessness of our colleagues in Poland, who continue to support displaced Ukrainian people in a number of important ways from opening their own homes and providing shelter to offering professional support, such as interpretation services. While State Street's direct exposure to Russia and Ukraine is very small, our teams are responding fluidly to the situation and delivering for our affected clients and other stakeholders with dedication and professionalism in what continues to be a stressful time. We have well-established and regularly tested business continuity plans designed to continue critical services for our clients and support for our people. The first quarter also saw dramatic market movements, driven partially by the conflict in Ukraine, plus a broader set of macroeconomic forces. A tight labor market, rising energy prices, continued supply chain disruptions and the ongoing effects of significant COVID-related fiscal stimulus has contributed to inflation reaching multi-decade highs. As a result, in March, we saw the first interest rate hike from the Federal Reserve since late 2018, a substantial upward move in long-end interest rates as well as volatile currency and equity markets and a stronger U.S. dollar. Each of these factors in part shaped State Street's financial results in the first quarter, which I will now discuss before Eric takes you through the quarter in more detail. Starting with our financial performance. First quarter '22 EPS increased 15% year-over-year and was up 8%, excluding notable items, with earnings growth supported by both higher total fee revenue and stronger net interest income, leading to an improved year-over-year total revenue performance in the first quarter. Within fee revenue, our global markets franchise performed particularly well, driven by higher FX market volatility. And while State Street's revenue performance improved, we also remain highly focused on controlling the expense base. Notwithstanding continued new investments in our business and operational capabilities, first quarter total expenses were flat year-over-year and increased just 1%, excluding notable items, supported by ongoing productivity efforts and the stronger U.S. dollar. Taken together, we delivered both positive fee and total operating leverage as well as pretax margin expansion, good earnings growth and higher return on equity relative to the year-ago period. Turning to our business momentum, which you can see across the middle of the slide, we recorded another quarter of solid new AUC/A asset servicing wins, which amounted to $302 billion in the first quarter, while AUC/A won but not yet installed amounted to $2.9 trillion at quarter-end. Front office software and data also experienced good business momentum with annual recurring revenue for the first quarter, increasing 15% year-over-year to $235 million. At Global Advisors, assets under management totaled $4.0 trillion at quarter-end. Importantly, we saw another quarter of solid net inflows of $51 billion despite the volatile market environment in the first quarter. Our ETF business continued to perform well as we further focused on innovation and enhancing our ETF product offering. For example, in January, Global Advisors launched three new ESG-oriented SPDR ETFs across small-cap international and emerging market equities, aimed at helping investors incorporate ESG considerations into their portfolios. In February, Global Advisors expanded its fixed income offering with the debut of the actively managed SPDR Blackstone high-income ETF as we continue to innovate in the active ETF category, which accounted for 13% of U.S. net industry flows in the first quarter. At State Street Digital, we announced a number of exciting developments. In March, we entered into a licensing agreement with Copper.co, a provider of institutional digital asset custody and trading infrastructure. We intend to leverage Copper.co's technology to develop an institutional-grade digital custody offering where clients can store and settle their digital assets within a secure environment operated by State Street. Turning to capital. Our ratios remained healthy, although CET1 declined quarter-over-quarter, largely due to lower AOCI, driven by the significant moves in interest rates. In the coming quarters, we remain focused on maintaining strong capital ratios. Regarding BBH, the regulatory review process for the proposed acquisition of the BBH Investor Services business has progressed more slowly than we anticipated. While many required approvals have been obtained, some required regulatory approvals, most notably approval from the relevant federal banking agencies, remain outstanding. We are evaluating potential modifications of the transaction that are intended to facilitate resolution of the bank regulatory review. We are working towards concluding regulatory reviews during the third quarter. While we are engaged in an ongoing dialogue with the relevant federal banking agencies, there can be no assurance of the timing or outcome of their regulatory review. Both parties, State Street and BBH, continue to be excited about the overall financial and strategic opportunities of combining BBH Investor Services with our business. We are continuing to work closely with the BBH team on pre-integration planning. This includes all the preparatory work in product, operations, technology as well as employee communication and client planning. We still expect the transaction to be accretive to earnings per share in the first year post closing. To conclude my opening remarks, the first quarter was defined by both unexpected significant geopolitical events and notable macroeconomic and market developments, in the face of which State Street delivered an improved year-over-year financial performance and solid business momentum metrics while supporting our clients and colleagues. As we look ahead in this environment of heightened geopolitical uncertainty and market volatility, we remain laser-focused on delivering what is within our control, including excellence of strategic execution across the front, middle and back office, maintaining the recent improvement in our sales effectiveness and expense discipline all while continuing to provide valuable insights and promote better outcomes for the owners and managers of the world's capital. And with that, let me turn it over to Eric to take you through the quarter in more detail.

Thank you, Ron, and good afternoon, everyone. I'll begin my review of our first quarter results on Slide 4. We reported EPS of $1.57 or $1.59 excluding acquisition and restructuring costs. On the left panel of this slide, you can see we had yet another solid quarter of total fee revenue growth with strength in many of our businesses, notwithstanding the macroeconomic environment. At the same time, we held total expenses roughly flat year-on-year as we continue to both invest in the franchise and control expenses. As a result, we generated positive operating leverage of about 5 percentage points in the quarter and continue to improve our pretax margin year-over-year. All things considered, this was another strong quarterly performance, demonstrating the progress we are making as we continue to improve our operating model and drive growth. Turning to Slide 5. We saw period-end AUC/A increase by 4% year-on-year and decreased 4% quarter-on-quarter. The year-on-year change was largely driven by higher period-end equity market levels, client flows and net new business growth. The quarter-on-quarter decline was largely the result of lower period-end market levels in both equity and bond markets. Similarly, at Global Advisors, AUM increased 12% year-on-year, but declined 3% sequentially. Relative to the period a year ago, the increase was also driven by higher period-end market levels coupled with strong net inflows across all three of our franchises, our ETF, institutional and cash businesses. The sequential decline was primarily driven by lower market levels, which was partially offset by strong net inflows of $51 billion in the quarter. Turning to Slide 6. Before I start, I would like to remind you that we are expanding our servicing fee revenue disclosures by disaggregating the line into back-office servicing fees and middle office services. With that, on the left side of the page, you'll see first quarter total servicing fees were flat year-on-year as higher client activity and flows average equity market levels and net new business were offset by normal pricing headwinds and a 2% currency translation headwind. We continue to see good growth in both our insurance and official institutions client segments. Sequentially, total servicing fees were down 1%, primarily as a result of the seasonal pricing headwinds and lower average equity market levels partially offset by strong client activity. Within servicing fees, back office fees were flat both year-on-year and quarter-on-quarter, largely driven by the factors I just described. Middle office servicing was down 3% year-on-year and 5% quarter-on-quarter, primarily due to a partial transition from a legacy client and lower professional services fees in the quarter. Notwithstanding the decline in the quarter, middle office is an important component of our Alpha proposition when it comes to both the front office when it connects to both the front and back office, and we expect to see good growth over the medium term. As evidenced by our uninstalled revenue backlog, which I'll talk more about in a moment. In terms of business momentum, I'm pleased with how 2022 has started. As we report another quarter of solid new AUC/A wins of $302 billion, while AUC/A won but yet to be installed amounted to $2.9 trillion at quarter-end. We continue to be happy with our pipeline, and I'm also particularly pleased to report that our first quarter wins span a good mix of strategically important premium and preferred clients. Turning to Slide 7. First quarter management fees were $520 million, up 5% year-on-year, primarily reflecting higher average equity market levels and strong ETF inflows. Management fees were down 2% quarter-on-quarter, largely due to equity market headwinds, partially offset by the tailwind of lower fee waivers and net inflows. Of note, our management fee performance for the quarter was supported by strong net inflows of $51 billion with positive inflows across our entire business franchise, institutional, cash, and ETF. With respect to money market fee waivers, the fee waiver impact on management fees for the quarter was roughly $10 million, down from about $20 million in the fourth quarter. I would note that following the 25 basis point Fed hike we saw in March of this year, we no longer expect money market fee waivers to be a headwind to management fees starting in April. As you can see on the bottom of the slide, our franchise remains well-positioned for growth. I'm particularly pleased that the strategic actions that we've previously taken in our long-term institutional and ETF franchises are now helping to draw inflows even in the current volatile market environment. On Slide 8, you can see that FX trading services had yet another strong quarter. Relative to the period a year ago, FX trading services revenue was up 4% year-on-year and 20% quarter-on-quarter. Both the year-on-year and quarter-on-quarter performance benefited from high FX market volatility while higher client FX volumes also contributed sequentially. Part of the revenue uptick has come from about $5 billion in higher risk-weighted assets we put to work this quarter, which demonstrates our balance sheet flexibility and which I'll come back to in a moment. Our securities finance revenues decreased 3% year-on-year, primarily driven by lower average agency assets alone, partially offset by solid new business wins in enhanced custody. Sequentially, revenues were down 6%, mainly reflecting lower average agency and enhanced custody balances due to the declining market levels and fewer specials. First quarter software and processing fees were up 26% year-on-year and 7% quarter-on-quarter, largely driven by higher front office software and data revenue associated with CRD, which I'll turn to shortly. Finally, other fee revenue of $29 million almost doubled year-on-year and quarter-on-quarter, mainly reflecting fair value adjustments on equity investments. Moving to Slide 9. We've provided a breakdown of our consolidated front office software and data revenue on the left. We've broken down the revenue into software categories you have seen us use before, on-premise, professional services, and software-enabled revenue. While CRD represents a large majority of this line, Alpha Data Services, Alpha Data Platform, and other revenues are also included here as well. As we've highlighted earlier, front office software revenue growth was particularly strong, up 44% year-on-year, primarily driven by on-premise renewals as well as the continued strong growth in software-enabled and professional services revenues. On the right of the slide, we've provided some key growth metrics enabled by CRD and Alpha. As I mentioned earlier during today's presentation, you'll notice that we've broken out both the front office and middle office uninstalled revenue backlog, both of which are key components of our alpha proposition going forward. The front office backlog of $93 million is up 43% and the middle office backlog has more than tripled year-on-year to $63 million. The backlogs reflect expected annualized revenue, which can be compared to the $900 million of annual revenue base in 2020 across both the front and middle office businesses and is an indicator of future revenue growth once fully installed. The Alpha pipeline remains promising despite the current geopolitical environment as clients realize the transformational benefits to their technology and operations infrastructure. Turning to Slide 10. As we see the start of another rate tightening cycle, first quarter NII increased 9% year-on-year, primarily driven by growth in our investment portfolio coupled with higher loan balances, which will also benefit us in future quarters. Relative to the fourth quarter, NII was up 5%, which came in better than expected due to higher long-end rates. The sequential increase was largely driven by the improvement in both short and long-end rates, which benefited our yields together with higher investment portfolio balances. Turning to Slide 11. First quarter expenses, excluding notable items, increased 1% year-on-year or 2% adjusted for currency translation. Productivity savings and targeted investments remain on track for the first quarter as we generated approximately $90 million in year-on-year growth savings and self-funded most of the strategic investments we've been making in the businesses, including technology infrastructure, broader automation, Alpha, and State Street Digital. Compared to the first quarter on a line item basis, excluding notable items, compensation and employee benefits were down 1% as lower headcount in high-cost locations and the tailwind of currency translation were partially offset by higher seasonal expenses. Information systems and communication expenses were up 5% due to continued investment in our technology infrastructure and resiliency. Occupancy was down 13% due to footprint optimization and lower maintenance costs, and other expenses were up 9%, primarily reflecting higher professional fees. Relative to the fourth quarter, expenses were primarily impacted by higher seasonal expenses, partially offset by productivity and footprint optimization savings. Headcount increased slightly quarter-on-quarter as we began to in-source some technology functions from vendors and growth in Alpha. Overall, we remain focused on delivering positive total and fee operating leverage and have demonstrated that this quarter amidst the current macroeconomic environment. Moving to Slide 12. We show the evolution of our CET1 and Tier 1 leverage ratios. As of quarter-end, our standardized CET1 ratio decreased by 2.4 percentage points quarter-on-quarter to 11.9% due to both numerator and denominator effects. RWA increased by roughly $15 billion or 160 basis points of CET1 during the first quarter of 2022 compared to year-end, driven by three factors: a modest rebound from an unusually low fourth quarter; a strategic and temporary allocation of additional RWA capital to our markets businesses to generate the higher-than-expected first quarter revenues that we just discussed; and lastly, the RWA impact from the SA-CCR implementation that started on January 1 of this year, which we had planned for. At the same time, our capital base was also impacted by the substantial reduction in AOCI of about $1.3 billion, worth 110 basis points of CET1 relative to the fourth quarter as we saw a significant and historic quarter-on-quarter movement in long-end rates, particularly in the belly of the curve. For instance, the rise in the 5-year U.S. treasury of roughly 120 basis points was the largest in the last 30 years. Taken together, the increase in RWA, coupled with a meaningful reduction in AOCI, partially offset by about 35 basis points of earnings accretion, net of dividends, drove the decrease in our CET1 ratio this quarter. In contrast, first quarter Tier 1 leverage was down only slightly to 5.9%, mainly driven by the substantial decrease in AOCI, reflecting a significant change in the interest rate environment and a stable balance sheet. While capital return remains an explicit priority for us, and we recognize it's important to our shareholders, given this $1.3 billion move in AOCI related to higher interest rates, we no longer expect to resume our share repurchase program in the second or third quarter as we operate with a conservative balance sheet philosophy. Given the volatility in rates and the possibility of further significant increases, we are in the process of taking several actions to reduce AOCI risk by about half. This primarily includes shifting additional AFS securities to HTM as well as shortening the portfolio duration through swaps, lowering extension risk and consciously allowing some portfolio runoff. Some of these latter actions can be reversed in the future when we choose to reinvest at higher rates. Turning to Slide 13. We provide a summary of our first quarter results. Despite the continued volatile market environment, I'm pleased with our financial performance, which demonstrates solid underlying trends within our businesses. Total fee revenue was up 4% year-on-year, primarily driven by higher management fees, FX trading, software and processing fees and other fee revenues. Expenses were well-controlled and were held roughly flat year-on-year, demonstrating the progress we are making in improving our operating model. Next, I would like to provide our current thinking regarding the second quarter outlook and some of our economic assumptions as we look out over the year. At a macro level, while we know that rate assumptions have been moving, our rate outlook is broadly in line with the current forwards, which suggests a year-end Fed funds rate of 2.5%. In terms of second quarter of 2022, we expect overall fee revenue to be down about 2% on a sequential basis, with servicing fees up about 1% and management fees up 2% to 3%, assuming equity markets remain flat to March 31 levels for 2Q and some downward normalization in FX trading revenues. In terms of some of our newer fee revenue line items that we started to disclose this quarter, we would not expect to see a repeat of the size of on-premise renewals in the front office software line nor the positive equity investment markups in the other revenue line in 2Q. Regarding NIIs, we now expect 2Q NII to increase 7% to 9% sequentially, which will be driven by the expected Fed rate hikes, partially offset by the AOCI mitigating portfolio actions that I outlined earlier. For full-year 2022, we now expect to see year-on-year NII growth of around 18% to 20% depending on Fed actions and rate moves as well as the shape of our portfolio. 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% to 3% on a sequential quarter basis, excluding notable items and seasonal compensation of expenses of $208 million. On taxes, we expect that the 2Q '22 tax rate will be around 20%. We continue to expect to deliver on our goals of margin expansion and positive total and fee operating leverage for the year. And with that, let me hand the call back to Ron.

Thank you, Eric. And operator, we can now open it up to questions.

We have our first question from Ken Usdin with Jefferies.

Eric, I want to follow up on the rate environment. Regarding the commentary about exploring alternatives related to the Brown Brothers deal, could you provide more details on what that might entail? Are there specific capital issues that need addressing, or is this more about timing and deal structure? Any clarification would be helpful.

Ken, it's Eric. No, capital from a capital perspective, we're quite comfortable with closing. We've got almost 12% capital ratios today. We've got a very, I think, smooth path to being prepared for a close from a capital perspective. The modifications we're talking about are just around the underlying structure of the transaction. And you've seen this done from time to time before. But we're working through legal entity and subsidiary structure, the exact transfer of systems and third-party contracts. Some of the transition servicing agreements, those kind of structure and modifications that we think will make this a cleaner process and be favorable on several fronts.

And then is there any updated thoughts about general zone of what you might think about for potential closing?

As Ron mentioned, the regulatory review process has taken a bit longer. We have been heavily involved in this process due to some modifications we are working on together with Brown Brothers leadership. We are currently in the process of preparing additional refined submissions, which will require several months for review and further discussion. I believe you understand how this unfolds. That is why, in the prepared remarks, Ron indicated that we anticipate these reviews to be completed during the third quarter. At that point, we will move quickly towards closing. Depending on when these reviews are completed, we will carefully plan our closing timeline, taking into account weekends and ensuring that we properly manage the usual financials and controls that need attention.

Okay. I have a question regarding the impact of the restructuring actions on net interest income compared to what you initially expected for net interest income.

There's a range of that. I think you've seen us guide to net interest income for the quarter of up 7% to 9%. On a year-on-year basis, that's actually going to be quite nice. I think it's worth about 0.2 or 0.3 percentage points. These kinds of adjustments are what we're willing to make to manage an appropriate portfolio in what could be a highly volatile rate environment, with the possibility of rates moving another 50 or 100 basis points. We want a portfolio that can withstand that. To be honest, we're prepared to sacrifice a few percentage points of net interest income growth sequentially to achieve that. So I think it's a balance, and that's the range. Even with some adjustments, a lot of what we'll be doing involves the move from available-for-sale to held-to-maturity, which does not impact net interest income. There are other margin impacts, but that's the range I'd like to share with you.

Your next question is from Glenn Schorr with Evercore ISI.

So the SEC wants to implement T+1 by the end of next year. I saw the comment letters, including yours. My personal opinion is nobody is ready for it in the industry. So I'm curious why the move from T+2 to T+1 everybody seems to be pushing back. Is it the complexity and shorter time horizon? Is the money to spend on the technology? It's just a little weird to me.

Yes, Glenn, it's Ron. I can address that. Historically, there has always been some resistance to these changes because they require financial investment and adjustments in systems. We've dedicated significant time to this and have engaged in discussions with regulators. While it may present an additional challenge, we believe the industry can manage it within a reasonable timeframe. I haven't reviewed other companies' feedback, but from our perspective, this transition will resemble the LIBOR situation in that it will take considerable time and effort. However, I don't believe it will set us or other major players back.

Our next question is from Brennan Hawken with UBS.

I just want to clarify something. The expense guide indicated a 2% to 3% increase quarter-over-quarter, but we need to account for seasonality, right? So what is the correct baseline we should use? Should we take the $2,318 million and subtract the $208 million before calculating growth?

Let me just open up the slide. So I think you're doing it, Brennan, in line with how we've described it. Yes, you can take the first on Slide 11 of the slide deck that $2.318 billion of expenses. That includes the seasonal expenses, which are on the footnote, right, of $208 million, you can pull that out and then you can add 2% to 3% sequentially and get an estimate for second quarter. That's correct.

Okay. Regarding the deposits, you mentioned the decline in deposits is typical seasonal behavior, indicating there hasn't been anything out of the ordinary. However, we've noticed rates in the market are increasing. Following the recent policy hike, which is expected to continue at a steady pace in upcoming meetings, how are you communicating with your customers? What are your updated expectations regarding deposit activity? Do you have an estimate for where you foresee deposit growth or decline may settle in the next quarter or two?

Sure, Brennan. For the time being, we've seen little movement in deposits other than a little bit of seasonality, a little bit of currency translation has also played through. But this is all within the bounds of what we'd expect. And we've obviously been watching deposits carefully across currency pools and across client segments. And for the time being, it's been flattish, regardless of which way we look at it. As we go forward, we like many others have tried to guesstimate, and I use the word guesstimate not estimate, the level of shift in deposits, movement of deposits that we'll see with the amount of quantitative tightening that the Fed has announced. And I guess the best context I have for you and others is if we go back to the kind of pre-COVID era, we've grown our deposit base since then by $60 billion to $70 billion. We've also increased our AUC/As by about 25% during that time period. And because of those quarterly, we estimate that about half of the increase of $30 billion to $35 billion has come from the quantitative easing as the Fed extended the sediment the other central banks primarily that expanded its balance sheet by effectively $3 trillion. And so we see that reversing over time with the rough math being for every $1 trillion of balance sheet, we'd expect a $6 billion to $10 billion runoff in our deposits. And they started in May or June, we'll see exactly when they get going at their announced pace. Yes, you could see a little trickle down, we think, in the fourth quarter and then the kind of the $6 billion to $10 billion per year after that. So that's our guesstimate. We're obviously plus with deposits, and we're happy to be plus with deposits as rates drive. So we'll monetize them for the time being. But that's our guess right now. The other factors are how the interest rate hikes play out. We expect betas to be similar, but they're never exactly the same as they are before. And so we'll be sharply focused there. So those are some of the moving parts in some of our thinking at this point.

Our next question is from Betsy Graseck with Morgan Stanley.

Last year, you announced State Street Digital. And I wanted to get a sense as to how that's going relative to expectations. What you've been able to execute on there? And what your clients are asking you to do more of?

Yes, they have a lot happening. I'll start by addressing your last question because it's a decision that requires significant client involvement and we've been dedicating considerable time to it. The primary request from clients is for assistance with a comprehensive regulatory framework. This issue is particularly pressing in the U.S., where the absence of clear guidance and an agreed-upon framework has created uncertainty regarding what institutions, especially banks, can do. Beyond that, we're focusing on enabling clients to invest in digital assets, which includes not just trading but also moving, controlling, and managing the custody of these assets, as well as portfolio accounting. In addition, we are concentrating on how State Street can transition into a more digitalized world and what that entails for our core operations like custody, securities movement, and control. We are actively collaborating with major industry players as these ecosystems evolve, and in certain cases, we aim to be a vital part of the ecosystem while in others, we seek to engage with it. There's a lot happening in this area.

And would you say that yes, go ahead.

And Betsy, it's Eric. I wanted to add that we are providing services to clients, particularly institutional clients, who have added crypto holdings to their funds. We have assessed our client base, which includes around 73 funds with approximately $0.5 billion in crypto exposure, and we are essentially handling the record-keeping for those assets as part of their underlying funds. Moreover, as clients develop specific ETFs and exchange-traded products, we are proactively signing them up for administration and record-keeping. This is important to us as we see it as a major opportunity, anticipating significant inflows as these ETF and ETP products mature.

Okay. And would you say you're at scale for these offerings? Or is there more investment to do to get to scale?

Yes. I mean, I think where we are now is of adequate scale, but one would expect that more scale will be required. But as much excitement as there is around this, it's still a relatively small proportion of total investment assets. So I think we're at adequate scale. I think the focus now is more on how do we think about additional capabilities growing.

Yes, I completely understand. However, as central bank digital currency fees begin to materialize, having the necessary infrastructure will be essential.

Next question is from Brian Bedell with Deutsche Bank.

Just to revisit the timing of the BBH closing, it might possibly extend into the fourth quarter. Can you say for certain that this will close before the end of the year? Is there any risk of it not closing without significant changes to the terms? Is the majority of the risk related to U.S. regulations rather than those outside the U.S.?

Yes, Brian, the regulatory environment has become more uncertain over the last couple of years. However, we are making progress, even though it's taking longer than we expected. We are actively engaging in discussions, and there’s ongoing dialogue regarding this matter. The restructuring we mentioned earlier is specifically aimed at speeding up the process because we believe that timeliness is crucial. Nonetheless, there is still a significant amount of uncertainty. As I mentioned earlier, our target is to complete this review in the third quarter. Once the review is finished, finalizing the close should not take much time since everything is prepared and the funding is in place. We've done extensive integration planning, but the uncertainty lies in both the timing and the results of the regulatory reviews, primarily with the U.S. banking regulators. We have received numerous approvals from regulators worldwide, including those in financial services and antitrust. I don’t want to downplay the progress we’ve made, but the finalization may take longer depending on those last approvals.

Yes, that makes sense. That's great information. Regarding deposits, Ron, BBH has provided you with good capacity to add incremental deposits, although it seems to be delayed a bit. Eric, could you update us on your views regarding the anticipated level of BBH deposits that would be available if everything were to close today? Also, please share your willingness to bring in additional deposits, which I believe is up to $20 billion at some point. Could you explain your current thinking on this, and whether there have been any changes in that perspective aside from the delay? Additionally, I assume the core BBH fundamentals, particularly in terms of interest, are tracking positively given the recent Fed rate hikes.

We are pleased with our collaboration and monitoring of Brown Brothers' business performance. It concluded last year well, and the first quarter results have met our expectations. There is a bit of a net interest income tailwind, slightly countered by a decline in equity markets. Overall, the business is performing well, and we are excited about it. The nine partners managing this business who are transitioning to us are doing an excellent job, which is great to see. Regarding deposits, closings, asset modifications, and the underlying economics of the transaction, I won't go into detail now. Ron confirmed in his remarks that the economics are solid and expected to be accretive within the first year. As we work through modifications, often involving legal structure adjustments, our finance and treasury teams are closely collaborating with our legal colleagues to ensure we maintain the desired economics and accretion. We remain optimistic about the positive impact for shareholders.

Our next question is from Gerard Cassidy with RBC.

Eric, can you elaborate on your comments regarding the CET1 ratio? You mentioned a temporary allocation of additional RWA to capture some market business that increased your revenues for the quarter. If you decide to pull back on that allocation, would it result in a decrease of the RWA capital in the second quarter? If so, could we expect your CET1 ratio to improve slightly, assuming all other factors remain constant?

Gerard, it's Eric. Those are the kinds of scenarios and navigation we do for our capital ratios, which can depend on market opportunities, whether it's the FX trading desk here in the U.S. or abroad, the sec finance unit, or even the lending unit. We're in close partnership with them. They are sophisticated and operate within their limits, and sometimes we engage in constructive commercial discussions. If there's a little more capacity at the top, can that be put to use? That's where we were this quarter. We saw a nice increase in FX trading revenues, up 20% quarter-on-quarter, which was facilitated by giving them larger limits, partly because we have an abundance of capital right now. What you will see is that we'll do this selectively for the next couple of months and reassess towards June. We want to keep our RWA asset levels at or below their current state. We do expect them to remain within those boundaries and will work through it selectively. Part of the discipline here is ensuring that we can generate real incremental revenues if we're going to deploy incremental capital, and that was the situation this quarter.

Very good. Very helpful. Eric, I know it's not a giant number, but you mentioned in the outlook that the adjustments and the fair value adjustments to equity investments were significantly higher in Q1 compared to both the fourth quarter and the same quarter last year. How large is that portfolio? And were these private equity investments? Could you provide us with a bit more detail on that?

These are mostly minority investment opportunities we have made in various companies over the years. We have around 5 to 10 investments in the crypto space, focusing on software, infrastructure, and other capabilities. We also have investments in more traditional technology areas that support AI capabilities crucial for our automation and engineering efforts. We are not aiming to create an investment portfolio; instead, we typically invest $5 million to $15 million in early to mid-stage companies. Many of these companies provide utility services to several large banks. This allows us to benefit from network effects shared among multiple banks, and we gain advantages from some of the services offered. Our investments primarily support revenue growth, enhance automation capabilities, and improve our product offerings. Additionally, we have a strong understanding of this market, which generally leads to appreciation over time. This approach fuels innovation, and I am happy to report that we observed notable appreciation in some investments this quarter, which is encouraging.

And our next question is from Jim Mitchell with Seaport Global.

Eric, you updated the guidance on net interest income for the full year. Is there any change to the expense or fee revenue guidance that you provided in the previous quarter for the full year?

Jim, I didn't go that far, partly because the market environment has just been volatile whether it's equity markets, whether it's rate hikes. And so there's a number of drivers that are moving around. I think NII, we felt just because the Fed forecast were so explicit between the dot plot and the new consensus that we should just describe that for all of you. But the other lines, we think it's still early to go through. It's still early to really call what the equity markets will do, both in the U.S. and internationally, where they've been more depressed. We'll obviously navigate and adjust our expenses to some extent as we go through the year. I think what we did do as part of the outlook commentary after I finish the quarterly description was a firm that we're committed to both positive total operating leverage and positive fee operating leverage. And so I think that gives you some boundaries that we're working within.

I have a question about Series Finance. I understand that balances and specials are down, which are significant factors. However, I have always perceived that the spreads on securities lending benefited from a steepening at the short end of the curve. I haven't noticed that benefit in the spreads. Is that something we can expect in the future, or is my perspective off? How should I approach security lending spreads, not including specials and volume?

Yes, I believe you are correct that there is some correlation. However, we have noticed that the special activity and the specific mix of assets being borrowed or lent are more influential on the profit and loss in any given quarter. While this does relate to the rate environment, it is primarily the volumes and the mix that have a greater impact.

Next question from Alex Blostein with Goldman Sachs.

Maybe just taking a step back for a second. And when you sort of think through the capital mitigating factors and the steps you guys have taken to sort of the capital position here ahead of BBH closing. When you think on a multi-year basis and maybe sort of lessons learned from the move in interest rates and effects that had on your guidance capital position this quarter and maybe after. What is the more appropriate mix of kind of cash, securities and loans for us to think about over time as well as just the duration of the securities portfolio? How much of that will look different perhaps as we look forward?

Yes, Eric?

Yes, Alex, that's a good question. We haven't been in this environment for 20 or 30 years, where interest rates may rise quickly or remain high. Over time, we've developed a few thoughts on this. First, the more we can add high-quality lending assets to our balance sheet, the better off we'll be. You've seen our lending book grow consistently by 10% to 12%, though it's starting from a small base, and we'll continue to focus on this area, even though it will take time. Another consideration is the kind of investment portfolio we manage. Due to our trust and custody background, we believe it should be high-quality and secure. As we work towards that, we are more comfortable increasing our holdings in held-to-maturity securities because, from an accounting standpoint, this doesn't immediately affect capital ratios. However, we wouldn't want to put all our assets in held-to-maturity since, during a down market, which usually occurs when the Federal Reserve acts to intervene in a recession, the appreciation of securities is something we want to leverage to offset credit or reserve builds. Additionally, if interest rates are stable or vary within a small range, the available-for-sale classification allows us to adjust our positions, which is advantageous. Over time, we've found that this approach contributes positively to our net interest income and profits. Therefore, while you might see us allocate more to held-to-maturity securities, there are limits to that. Lastly, regarding composition, we've adjusted our mix of treasuries, mortgage-backed securities, and collateralized mortgage obligations. Given our status as a global bank, as international rates rise, foreign sovereigns will likely become a larger part of our strategy for growth. So, the mix and composition of our portfolio will evolve over time.

Got it. All right. That's helpful. And then maybe a little bit more of a tactical near-term question. When we look through the NII guide, just extrapolating the full year from the second quarter, I guess how surprisingly the benefits of subsequent rate hikes seem to have a smaller effect on NII. But curious how you guys are thinking about deposit beta assumptions beyond sort of the first 100 basis points. Maybe looking at the U.K. market as kind of lessons learned there a little bit further ahead of us, I guess, on the hike in terms of both pricing and client behavior.

Yes. I think the first 100 basis points are a bit easier to interpret. For the initial rate hike, we generally assume a beta in the 20% range, which makes the first one or two hikes relatively comfortable. However, as we move to the third and fourth hikes, the beta increases to the 30% to 45% range, which introduces some variability. Once we exceed the first four or five hikes, we're looking at betas in the 60% range for subsequent quarters. This is a typical outcome. To be honest, we want to return to a situation where net interest income is strong enough to support our preferred security stack from a capital standpoint, while also being fair and considerate to our clients, as we've maintained a long-standing partnership with them. It's something we're actively considering. The pace of rate hikes can influence this, and while some of those factors have been included in our estimates, I prefer to call them guesstimates since these cycles aren’t perfectly analogous. We’ve also taken some quantitative tightening into account, which will impact our outlook. Another consideration is how the macro economy performs. If rates rise another 100, 200, or 300 basis points in a strong economy, there will be significant demand for lending, leading to a substantial need for deposits to fund loans. Conversely, if there's a slowdown in the real economy, lending may reduce, which could benefit deposit rates. This is another aspect we are closely monitoring.

Our next question is from Steven Chubak with Wolfe Research.

So Eric, I wanted to ask a multi-part question about the capital impact of BBH and how that might inform the buyback schedule moving forward. Considering the pro forma effect on your capital ratios, if we assume the deal closes in the next quarter or two, and we pause the buyback through the third quarter, the estimated capital hit is around $3.5 billion from goodwill and deal intangibles, which translates to about 120 basis points of Tier 1 leverage. Your ratio at the end of the third quarter would likely be below your lower limit of 5.25%, significantly under that threshold, but approximately close to 5%. I wanted to confirm if the $3.5 billion capital reduction from BBH is the correct figure for our modeling purposes. Additionally, as we consider the buyback schedule, will you still be operating at or below that lower limit? How soon should we expect you to return to your normal payout target, which is roughly 80%?

I believe it's easier to consider this in terms of CET1. Essentially, CET1 divided by 2 gives you the leverage. It's important to stay within our target range of 5.25% to 5.75%, especially in the current economic climate. However, I've mentioned that as long as we stay around 5%, leverage is manageable since it's not sensitive to risk. Looking back at CET1, we're nearly at 12%, compared to our target range of 10% to 11%. This gives us almost a 200 basis point buffer of excess capital. If we assume a third quarter close, the goodwill and intangibles from the Brown Brothers transaction amount to about $3.3 billion, which translates to just under 300 basis points in CET1 terms. We would prefer, though it’s not mandatory, to have about 300 basis points of capital to close that transaction. Currently, we have around 200 basis points. The pathway to bridge this gap over the next two quarters is fairly straightforward. We will accrue capital net of the dividend, which contributes about 35 basis points per quarter, totaling 70 basis points. Additionally, we've been utilizing our excess capital through the risk-weighted assets. We can easily reduce risk-weighted assets by $5 billion or more, which could provide another 30 to 50 basis points of capital for closing. Hence, we have effective strategies in place, making this a manageable closing process from a capital perspective.

Our next question is from Mike Mayo with Wells Fargo.

I just want to make sure I understood what you said on the call. So on the one hand, you're still guiding for positive operating leverage for 2022. You still expect a higher pretax margin. Your backlogs are up. So that's all good. I guess just to clarify your answer just now, the Brown Brothers acquisition all else equal reduces your CET1 ratio by how much in basis points?

Just shy of just around 300 basis points, Mike.

Okay. And so you're at 11.9% now. So if you close the deal now, you'd be below the low end of your target. So are you delaying the deal because of lack of capital? Or I didn't understand why the delay in the deal.

No, it has nothing to do with capital. If we had been able to close it now, we would not have deployed $5 billion, maybe even $10 billion of risk-weighted assets, and we would have comfortably completed the deal. It's not about capital. It's about the underlying regulatory process taking more time, as we mentioned earlier.

That's clear. Lastly, how much do fee waivers contribute to your guidance for positive operating leverage? Is it all of it, or about 10% or 50%, just roughly?

The guidance indicates a positive total operating leverage and fee operating leverage. If I do a quick calculation, the IR team can assist you further, Mike. This quarter, we experienced fee waiver impacts of 10%, and we will not have any fee waivers for the remainder of the year. Last year, fee waivers were present, and I remember them starting in the second half at around $20 million per quarter. Based on our total fees of $10 billion, a rough estimate suggests that the absence of money market fee waivers may contribute about 0.5 points to fee operating leverage. However, this is a quick calculation without detailed notes, so we can follow up offline to clarify further.

I think I have. I mean so in terms of ZIP code, most of it does not relate to the fee waivers. There's the lion's share of it. So I think I got it.

And our next question is from Rob Wildhack with Autonomous.

Just on fee revenue in the quarter, how would you describe about organic growth there?

Yes, Rob, I'll start here. We've seen several strong quarters of organic growth in both servicing and management fees. Last year, much of the growth in servicing was driven by Alpha, and now a significant portion of that is being implemented, contributing to the $2.9 trillion figure. The growth we observed in servicing fees was mainly in our traditional back office business, which is efficient and quick to implement, and we appreciate that mix. Regarding management fees, as Eric pointed out, we've seen broad growth across our core businesses, including ETFs, Institutional, and a bit from Cash. We are pleased with the current levels, although we always strive for more, and importantly, we value the diversity of that growth.

Okay. And then on the $2.9 trillion to be installed, can you just remind us of the timeline for when that gets installed and when it starts to hit revenue?

Sure, Rob. It's Eric. We mentioned that the installation process is starting now. The bulk of this involves two significant deals announced in the second and third quarters of last year, each exceeding $1 trillion. Additionally, there are smaller and midsized projects. The two large deals are complex and transformative for the clients, which is why they generally take longer to implement. We anticipate that the installation timeline ranges from 6 to 36 months, with a middle ground of around 24 to 30 months. Currently, we estimate that a substantial portion, though not the majority, will begin to be installed by late this year. The revenue impact from this will primarily be seen in 2023.

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

Well, thanks very much. Thank you all for joining us. I know it was a busy day for you, so we appreciate your time and questions. Thank you.

Ladies and gentlemen, this concludes today's conference call and webcast. Thank you for participating and have a wonderful day. You may now disconnect.