State Street Corp (XLF) Q2 2022 Earnings Call Transcript

Good morning, ladies and gentlemen, and welcome to State Street Corporation’s Second 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 expressed written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. I would now like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street. Please go ahead, Ilene.

Thank you. 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 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’d 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. This morning, we released our second quarter financial results. The second quarter operating environment continued to be impacted by ongoing geopolitical events in Europe and the notable macroeconomic environment. The associated price and wage inflation, rising interest rates, and recession fears are driving declining equity and fixed income markets, currency volatility, and concerns over market liquidity. These factors created a number of fee revenue headwinds for our businesses. Despite the adverse market conditions, State Street performed well in the second quarter with a strong balance sheet and good sales momentum while delivering strong FX trading and significantly better Net Interest Income (NII) growth year-over-year, coupled with well-controlled expenses and a healthy pretax margin. We remain focused on executing against our strategy and intensely managing what we can control to navigate through uncertainty, drive further business momentum and achieve our medium-term goals. Turning to Slide 3 of our presentation, I will review our second quarter highlights before Eric takes you through the quarter in more detail. Starting with our financial performance, the second quarter EPS decreased 8% year-over-year, though it was down just 2% year-over-year excluding notable items, primarily a prior year gain on sale in 2Q '21. Weaker markets were the major driver of this decline. Total fee revenue for the quarter declined 6% year-over-year, primarily reflecting the impact of significantly lower global equity and fixed income market levels on servicing and management fees and the stronger U.S. dollar. Within total fee revenue, our Global Markets franchise continued to perform well with FX trading services revenue increasing due to market volatility, which drove higher spreads. Total revenue for the quarter declined 3% year-over-year, but was down just 1%, excluding notable items, as lower total fee revenue was largely offset by a strong NII result which increased 25% relative to the year-ago period. In the face of market-related fee revenue headwinds, we remain highly focused on controlling the expense base. Second quarter total expenses were flat year-over-year and declined 1% excluding notable items. Our ongoing productivity actions largely offset higher-than-anticipated salary increases and planned business investments. Turning to our business momentum, which you can see across the middle of the slide. We reported a strong quarter of new Assets Under Custody/Assets Under Administration wins, which amounted to $972 billion, with back office services accounting for 40% of these wins by AUC/A. As a result of this quarter’s good sales performance, AUC/A won but yet to be installed increased to a record $3.6 trillion at quarter end. During the second quarter, we also reported another Alpha client win, with 12 of State Street’s 20 Alpha clients now live as of quarter end. We were also awarded the title of Security Services Provider of the Year in the Financial News 20th Annual Trading and Technology Awards. Front office software and data also experienced good business momentum in the second quarter with annual recurring revenue increasing 20% year-over-year to $251 million. At Global Advisors, assets under management totaled $3.5 trillion at quarter end. Overall second quarter AUM inflows were negatively impacted by the weaker equity market environment, but we still saw positive net inflows into both our cash and U.S. low-cost ETF franchises during the quarter. Even in a volatile environment, we continue to innovate and expand our capabilities to drive future growth. For example, Global Advisors continues to press forward in active ETFs and ESG as illustrated by the launch of the actively managed SPDR Nuveen Municipal Bond ESG ETF and a number of MSCI Climate Paris Aligned ETFs. Lastly, in terms of business momentum, I was particularly pleased to see that State Street was recognized as the top provider in FX services by Euromoney Magazine in the second quarter. Importantly, State Street regained its number one position overall for real money clients in addition to being ranked number one for best service for real money clients. Our FX franchise supports and complements our core investment services business and has proven to be an effective deployment of our capital. Turning to our balance sheet and capital. Despite a continued rise in interest rates, our CET1 capital ratio improved significantly to 12.9% at quarter end due to our active management of risk-weighted assets and the mitigating actions we executed in our investment portfolio in the second quarter. The strength of our balance sheet was highlighted in the second quarter with the release of the Federal Reserve’s annual CCAR stress test results in June, following which we announced our intention to increase State Street’s quarterly common stock dividend by 10% to $0.63 per share in the third quarter, subject to approval by our Board of Directors. We were pleased to announce the intended increase to our quarterly common dividend as we recognize the importance of capital return to our shareholders. With that in mind, in the fourth quarter of this year, it remains our intention to resume our existing common share repurchase program in an amount reflecting interest rate levels and market conditions at that time. I’ll now turn to our proposed acquisition of BBH Investor Services business, which remains subject to regulatory approvals and other closing conditions. We continue to be excited about the business and its people, the franchise it represents and the opportunities the transaction represents for our collective clients and for accelerating our strategy. As I’ve mentioned previously, we’ve been engaged in ongoing dialog with U.S. banking regulators regarding the regulatory review process and potential modifications to the transaction intended to facilitate resolution of that process. Based on those discussions, we have developed with BBH, proposed modifications to the transaction structure that the parties believe present a path forward. The proposed modifications include changes to the operating model and legal entity structure and changes to the regulatory approvals required to complete the transaction. As part of the proposed modified transaction, State Street is seeking amendments to the transaction terms, including the purchase price. Both BBH and our Board of Directors would need to review and approve the modified transaction on amended terms. During the third quarter, we intend to finalize the proposed structure and contractual terms and confirm our approach with regulators. Assuming the financial and operational aspects of the proposed modifications are timely finalized and contracted, subject to regulatory approval and other closing conditions, the parties are aiming to close the transaction at the end of the fourth quarter of 2022. However, there exists significant timing uncertainty and risk that closing will extend beyond that timeline. There can be no assurance that a mutually acceptable modified transaction will be entered into or as to the timing or outcome of any regulatory approvals and other closing conditions for this modified transaction. After September 6, 2022, either party can terminate the transaction without penalty, absent further agreement of the parties. To conclude, as we progress towards our medium-term targets in this uncertain environment, we remain particularly focused on maintaining and further improving our pretax margin performance, which despite the challenging market conditions, increased almost 29% for the quarter, excluding notable items. To help achieve this goal, in the face of inflationary pressure and a challenging revenue environment, we will continue to exhibit expense discipline and drive our automation and productivity efforts. We also remain laser-focused on innovating for the benefit of our clients and driving organic growth, as demonstrated by the strong AUC/A wins in the second quarter, all while returning capital to our shareholders. 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 second quarter results on Slide 4. We reported EPS of $1.91 or $1.94 excluding acquisition and restructuring costs as detailed on the panel on the right side of the slide. As Ron noted earlier, the operating environment in the second quarter remained challenging, largely characterized by continued market volatility related to macroeconomic events and continued geopolitical uncertainties. As you can see on the left panel of the slide, strong growth in both net interest income and FX trading enabled us to partially offset significant headwinds from lower equity and fixed income markets in the quarter that impacted other fee areas. Also evidenced by today’s results, our approach to expense management remains very disciplined and deliberate. On a year-on-year basis, second quarter expenses were down even as we experienced higher-than-expected wage increases and continued to thoughtfully invest in the franchise. Lastly, you’ll see that in the second quarter, we had a lower-than-expected tax rate. The bulk of the discrete tax items that contributed to our lower taxes were due to the reassessment of a deferred tax asset worth roughly $60 million. All things considered during the quarter, our business model demonstrated resilience against the challenging backdrop. Turning to Slide 5. During the quarter, we saw period-end Assets Under Custody/Assets Under Administration decrease by 10% on a year-on-year basis and 8% sequentially. Amidst continued and uncertain economic conditions, the year-on-year change was largely driven by lower period end market levels across just about every equity and fixed income market around the world, partially offset by net new business and client flows. The quarter-on-quarter decline was largely a result of the same lower period end market levels, as we’ve also started to see industry outflows from investment products as the risk-off sentiment continues. Similarly, at Global Advisors, quarter-end Assets Under Management decreased by 11% year-on-year and 14% sequentially. The year-on-year decline in AUM was also largely driven by lower period end market levels and institutional net outflows, which were partially offset by positive net inflows in both our U.S. low-cost ETF complex and cash inflows in the quarter. Turning to Slide 6. On the left side of the page, you’ll see second quarter total servicing fees down 7% year-on-year, largely driven by lower average equity and fixed income market levels, normal pricing headwinds, client activity and adjustments, and the impact of currency translation, which was partially offset by net new business growth. Excluding the impact of currency translation, servicing fees were down only 4% year-on-year. I’d also highlight that from a segment perspective, we continue to see excellent revenue growth in our alternative client segment, both year-on-year and quarter-on-quarter. Sequentially, total servicing fees were down 5%, primarily as a result of the same drivers: lower average equity and fixed income market levels, client activity and adjustments, and the impact of currency translation, partially offset by positive net new business. Within servicing fees, back office fees were down 7% year-on-year and 5% quarter-on-quarter, largely driven by the factors I just described. Middle Office Services was down 12% year-on-year and 8% quarter-on-quarter, primarily due to decreased client AUM driven by lower market levels and client transaction activity and adjustments. But we are seeing some compression in our legacy middle office book. It is an important component of our Alpha proposition when it connects to both the Front office and Back office, and new wins generally come with contracts of 7 to 10 years. We continue to expect to see good growth over the medium term as evidenced by our large uninstalled middle office revenue backlog of more than $90 million, which I will talk more about in a moment. Even against this challenging backdrop, we continue to be pleased with our Investment Services business momentum and robust pipeline. We recorded another strong quarter of new AUC/A wins worth $972 billion while AUC/A won but yet to be installed amounted to $3.6 trillion at quarter end. As Ron mentioned earlier, during the second quarter, we reported another new Alpha win, Allspring Global Investments, taking the total number of Alpha clients to 20, and now have 12 implementations live. Lastly, in response to industry inflationary cost pressures, we’ve undergone a comprehensive analysis of our pricing across all our product areas. The result of this analysis has led to the decision to begin to adjust our client pricing upwards in certain areas of servicing where the wage pressure is most acute, and industry capacity is stretched. Ultimately, we believe these pricing changes will support the continued investment that allows us to best serve our clients. Turning to Slide 7. Second quarter management fees were $490 million, down 3% year-on-year, primarily reflecting lower average equity and fixed income market levels, the impact of currency translation, and a specific client repricing adjustment, partially offset by the elimination of money market fee waivers and the run rate impact of net ETF inflows. Management fees were down 6% quarter-on-quarter, largely due to equity and fixed income market headwinds, partially offset by the elimination of the same money market fee waivers. As you can see on the bottom right of the slide, our franchise remains well-positioned for growth. In ETFs, although we saw outflows in equity and commodities, we continue to see inflows into SPDR low-cost and fixed income ETFs. In our Institutional Business, there’s continued momentum in our target date franchise, notwithstanding outflows primarily from one large client with very low fee assets, which ultimately benefited the overall management fee rate this quarter. Across our cash franchise, we again saw another quarter of strong net inflows, this time worth $15 billion in the quarter, contributing to market share gains. On Slide 8, FX trading services had yet another strong quarter. Relative to a period a year ago, second quarter FX trading services revenue was up 16%, primarily driven by higher FX spreads, partially offset by lower client FX volumes. Quarter-on-quarter, FX trading services revenue was down 8% as the benefit of higher FX spreads was more than offset by lower client FX volumes too. Our second quarter securities finance revenues decreased slightly year-on-year, primarily driven by lower agency and enhanced custody balances due to lower markets, partially offset by higher spreads. Sequentially, revenues were up 11%, mainly reflecting higher spreads, partially offset by lower agency and enhanced custody balances. Second quarter software and processing fees were down 11% year-on-year and 6% quarter-on-quarter, largely driven by lower Front office software and data revenue associated with CRD, which I’ll turn to shortly. Finally, other fee revenues of negative $43 million in the second quarter declined both year-on-year and quarter-on-quarter. Both the year-on-year and quarter-on-quarter declines largely reflect negative market-related adjustments while the absence of prior period positive fair value adjustments on equity investments also contributed to the sequential decline. While we saw pressure throughout the quarter, almost half of the $43 million came through in the second half of June. Moving to Slide 9. Let me provide some details on the performance of our Front office software and data revenue in the second quarter on the left panel of this slide. As a reminder, CRD represents the majority of these revenues, but we also include Alpha Data Services, Alpha Data Platform, and Mercatus revenues since they are part of our Front office offering. On both a year-on-year and quarter-on-quarter basis, Front office software revenue declined as expected, primarily driven by the absence of several on-premise renewals in the prior periods as well as some episodic fees when compared to the prior year quarter, partially offset by higher software-enabled SaaS revenue. It is important to note, however, that the more durable and recurring software-enabled and professional services revenues have continued to grow nicely with a year-on-year growth of 15%, demonstrating success in deploying our cloud-based SaaS platform environment to more clients. Turning to some of the softer metrics enabled by CRD and Alpha on the right panel, you’ll see that our annual recurring revenue has grown 20% year-on-year as we convert more clients to SaaS, which we expect will create a stickier and more profitable business model. As for the middle office, we continue to have an extremely healthy backlog of uninstalled revenue worth $92 million, which is almost twice the prior year. Lastly, we are pleased to have announced another Alpha mandate win this quarter. We’re also excited to have expanded an existing Alpha relationship this quarter, winning approximately $300 billion of new back office assets to custody from an asset owner client. This provides another proof point that our Alpha value proposition is working as we’re gaining more of the wallet share over time. Turning to Slide 10. Second quarter NII increased 25% year-on-year, primarily reflecting the impact of higher interest rates and continued growth in loan balances. Relative to the first quarter, NII was up 15%. The sequential increase was largely driven by the improvement in both short and long-end rates, which benefited our yields, together with continued growth in loan balances, partially offset by lower investment portfolio balances. On the right side of the slide, we show our average balance sheet during the quarter. Average deposits were down 6% year-on-year and 2% quarter-on-quarter, primarily related to the impact from currency translation and dollar strengthening, which accounted for almost half of the year-on-year decline and two-thirds of the sequential decline. The investment portfolio is now down modestly, and we have almost 60% of our securities now in held to maturity. We’re pleased that our balance sheet is well-positioned to recognize this interest rate and NII tailwinds and also protect Other Comprehensive Income (OCI). Turning to Slide 11. Second quarter expenses, excluding notable items, decreased 1% year-on-year or increased 2% adjusted for currency translation. In response to the revenue environment, we have been proactively managing our expenses, including lowering our incentive compensation, in addition to carefully executing on our continued productivity savings efforts which generated approximately $60 million in year-on-year gross saves or approximately $150 million year-to-date. These savings enabled us to continue to self-fund a good portion of the 4% to 6% higher wage rates we’re facing and the targeted investments in the business, including the Alpha product, technology infrastructure, and broader automation. Compared to 2Q '21, compensation and employee benefits was down 3% as lower incentive compensation, and the impact of currency translation were partially offset by salary merit increases associated with wages and inflationary pressure as well as higher contractor spend. Excluding currency translation, compensation and employee benefits would have been up 1%. Information systems and communications expenses were down 2%, primarily due to the episodic credits related to vendor pricing optimization and infrastructure rationalization. Occupancy was down 4% due largely to currency translation. And other expenses were up 18%, primarily reflecting higher recoverable client-related expenses, which are offset in fee revenue, professional fees, and travel costs. On a quarter-on-quarter basis, expenses were down due to seasonal expenses in the first quarter. Headcount increased quarter-on-quarter as we continue to insource some strategic technology functions from vendors as well as support growth in Alpha. Overall, in light of the current macroeconomic environment, we have had a pretty healthy pretax margin for the quarter at approximately 29%, excluding notable items, supported by active expense management and strong NII growth. Moving to Slide 12. On the right side of the slide, we show our capital highlights. We are quite pleased to report CET1 of 12.9%, up 100 basis points, happy with our performance under this year’s CCAR with a calculated stress capital buffer well above the 2.5% minimum, resulting in a preliminary SCB at the floor. As a result, in June, we announced the planned 10% increase to our 3Q '22 quarterly common stock dividend, subject to Board approval, and it remains our intention to again begin our existing common share repurchase program in the fourth quarter in an amount reflecting market conditions at the time. To the left of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios. As you can see this quarter, even against the backdrop of a challenging operating environment, we drove stronger and higher capital levels. During the second quarter, we completed several of the previously announced RWA optimization actions across our trading, lending and investment portfolios, reducing RWA by $12 billion quarter-on-quarter. We also shifted about $20 billion of AFS securities to HTM. As a result, we limited AOCI from the investment portfolio to under $500 million or 40 basis points of CET1, even with a roughly 60 basis point upward interest rate move across the 2- and 5-year part of the curve. You’ll see a larger AOCI move in the GAAP books, but much of that is ratio hedged and offset by the appreciating dollar effect on RWA with an offsetting goodwill and intangibles as well. Given that we have now significantly reduced the OCI risk to interest rate shocks by 75%, we are now comfortable operating somewhat below our standard target ranges for both CET1 and Tier 1 leverage ratios. Turning to Slide 13. We provide a summary of our second quarter results. Despite the continued volatile market environment, I am pleased with our quarterly performance, which demonstrates the strength of our business model. The current macroeconomic environment and persistent geopolitical uncertainties notwithstanding, our strong growth in both net interest income and FX trading services enabled us to partially offset significant headwinds from both equity and fixed income markets highlighting the resiliency of our franchise. And our expenses remained well controlled, demonstrating the progress we are making in improving our operating model. Now turning to outlook. We would like to provide our current thinking regarding the third quarter. At a macro level, while market rate expectations have been volatile, our current interest rate outlook is broadly in line with the current forward, which suggests the year-end Fed funds rate of 3.5%. We expect other major international central banks to continue raising rates, with the ECB expected to start increasing rates in the third quarter. The current spot level of global equity markets would imply that average equity markets in 3Q would be down 7% to 8% quarter-on-quarter, and U.S. dollar appreciation to be about 1 percentage point of headwind to revenues and tailwind to expenses, which will be included in our guide. Now in terms of the third quarter of 2022 and on a standalone State Street basis. Given the implied declines in average Global Markets, we expect total fee revenue to be down about 2% on a sequential basis. And we expect both servicing fees and management fees to be down 4% quarter-on-quarter, driven by weaker market levels. Turning to NII. Following one of the strongest sequential increases in NII for many years in 2Q, we expect to deliver further growth with NII expected to increase 5% to 9% quarter-on-quarter, driven by the tailwind from Central Bank rate hikes. This outlook includes our expectation for some initial deposit outflow and rotation in 3Q. And for the full year, on a stand-alone State Street basis, we expect NII to increase 24% to 27%, which is significantly better than our prior full-year guide of 18% to 20%. Next, we expect total expenses, excluding notable items, to increase just under 1% quarter-on-quarter, driven by inflationary pressures on wages as we continue to target productivity initiatives and execute against our strategy with a deep focus on expense discipline. This focus enables us to drive positive total operating leverage, excluding notable items for the full year. Lastly, we would expect our 3Q tax rate to be approximately 20% for the quarter. And with that, let me turn the call back to Ron.

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

Your first question comes from Glenn Schorr of Evercore.

Thanks very much. In your prepared remarks, you talked about 2Q management fees driven by markets, other step-up, also a client-specific pricing adjustment. I just wondered if you could just give us a little more color on that. So we don’t know if it’s a one-off or could be other adjustments going forward?

Sorry, Glenn, I missed some of that because your audio was breaking up. Could you please repeat your question?

Absolutely. In your prepared remarks, you mentioned 2Q management fees driven by markets, which is obviously going to happen. But you also said client-specific pricing adjustment. I wonder if you could give a little more detail, say, the size and what kind of adjustment that was just in case we should be thinking about that going forward?

Sure, Glenn. Let me try to cover that. And I think you’re focused on servicing fees and management fees. So let me do them both so that we have a little bit of context for you. On Page 6 of the materials on servicing fees, about the impact of client activity and adjustments. And on a year-on-year basis, largely due to the kind of lower levels of activities and sometimes that comes through with lower markets, that was worth about 1 percentage point of headwind on a year-on-year basis and about 2 points on a quarter-on-quarter basis for that. On management fees, there was a series of impacts quarter-on-quarter. Most of that was driven by market. There was one client that we called out, but that would have been worth at most 1 to 2 percentage points of fees for that quarter.

Okay. I know this is part of your guidance, but I'm looking for some insight. In the past, when markets were consistently rising, there seemed to be a temporary boost in servicing fees because some contracts have ceilings. My question is, in the event of a downtrend in these markets, do those same contracts have floors? Should we anticipate more stable servicing fees if the markets continue to decline?

Glenn, I’ll take that. You’re accurate. We have a small number. They tend to be very large clients where you just do hit the top of the fee schedule or even in some cases, the fees continued to tail down. I don’t think we’re close to that yet in terms of that being meaningful. So I wouldn’t expect to see that as a factor in the near term unless we see a much more significant kind of market downturn.

Okay. Thank you.

Operator, the next question.

Your next question comes from Ken Usdin of Jefferies.

Ron, following up on your opening remarks and the forward-looking statements, how do you think about your options as you move forward in negotiations? Is a price concession likely to be your best outcome? If you can't achieve one, does that make it a go or no-go decision? Additionally, if either party does decide to walk away, what are your immediate next steps regarding your capital strategy or future plans? Thank you.

Yes, Ken, we are currently in the process of this. I don't want to prematurely disclose anything. First and foremost, we are still committed to the strategic combination. However, as we anticipate some restructuring that will alter certain aspects of the operating model, we believe that a price adjustment would be justified. I prefer not to speculate on the status of our discussions with BBH, which remain positive, and both parties are dedicated to making this work. We appreciate the business and are exploring various options, and we will update you at the appropriate time.

Okay. That’s fair. And then secondly, Eric, on your NII update, the new guy. Just wondering how much of that update is a new curve? And if you can help us understand where you are on that? And what are you getting on new securities yields now versus what’s rolling off the back book?

Yes, Ken, the uptick in the NII guide, I think probably both for the third quarter and then the full year, which we’ve updated is primarily driven by the higher yield curve and expectations in the U.S., plus some expectation that the ECB is going to start to seriously raise rates in the third quarter. And we’ve said that once the ECB crosses the 25 basis point positive rate threshold, that begins to be accretive. So I think those are the major drivers. On investment portfolio yields, I think you see that in our average balance sheet. They are up on average almost 15 basis points quarter-on-quarter. And you will expect that, that kind of increase will continue to flow through the books. To the question of exactly what a new security comes in at versus an old security rolls out at, I think the best way to estimate that, because it will vary by different parts of the book, whether it’s the treasuries, whether it's the MBS, whether it’s the foreign securities, is we’re basically replenishing securities that have an average duration of 2.8 years. So you can kind of see what an older security with that vintage would look like and compare it to what’s in the market today. And you’ll see a nice pickup, and that’s what’s flowing through and giving us the kind of quarter-on-quarter increase on average that you saw this quarter. And we’ll expect to see another increase on average in that order of magnitude in the third quarter.

Your next question comes from Betsy Graseck of Morgan Stanley.

A couple of questions. First, just on the discussion around the forward look. I wanted to make sure I understood what types of things are being looked to change? Is this a function of you need to keep more data servicing processing within certain countries to satisfy regulatory requirements? Or is there something else that’s more not operational but more around what parts of the business you can do? I’m wondering if it’s an expense issue or if it’s a revenue opportunity issue.

Betsy, it’s Eric. We are exploring various areas, and the essence of this situation, especially when it comes to a global banking deal, is the legal entity structure. As you know, we operate a holding company along with a bank and several banks in different regions. There are multiple entities involved worldwide. Therefore, finding an effective and viable combination path can be approached in several ways. Part of our focus has been on adjusting our initial plan to ensure the transaction is feasible and appealing. This may influence the operating model, affecting the speed at which we achieve expense or revenue synergies, which is what we are currently evaluating. We want to emphasize our commitment to maintaining the economic benefits we previously mentioned in September. Consequently, we are considering certain adjustments to the transaction, including pricing, as Ron pointed out.

Okay. And then you get this in front of regulators, but if they don’t agree by September 6, you’ve indicated you want to close by the end of the year. How should investors think about what your expected thought process is going to be between that time period from September 6 to 31?

Yes. Betsy, it’s Ron. I mean the September 6 date, it’s basically the 1-year anniversary for the deal. And like a lot of transactions, they have an outside limit. So the way you should interpret that is what we’ve said is both parties remain committed. We’ve got to work through things. I mean the regulatory world and the political world has changed significantly since we announced this deal, and what we’re looking towards as a way to breakthrough and close it in a reasonable time period, and this time period doesn’t seem reasonable to anybody, but it’s actually better than some of the alternatives that we’ve been faced with. So if you think about the September 6, it’s an existing date. And assuming everything is going along fine and parties are agreeing, then we just agree to an extension of that to the close date.

Got it.

Just disclosing and reminding everybody what the terms of the transaction are.

Okay. No, that’s helpful. And then just last for me, I think you mentioned that given the restructuring of the balance sheet that you’ve made and the success with that, that you’re now comfortable with running potentially below management targets for CET1 SLR. Could you remind us what the targets are and how much below you’re willing to dip?

Sure, Betsy, it’s Eric. The best place to find our capital ratios and targets is on Page 12 of the presentation deck. You can see our standard CET1 targets along with our Tier 1 leverage targets, which are 5.25% to 5.75%. As you mentioned, we have significantly reduced the volatility risk from OCI, allowing us to feel comfortable operating below those targets. This could mean that our CET1 might be up to 50 basis points lower. With the lower risk and volatility levels we have in OCI and our leverage, that typically results in a figure about half of that amount.

Your next question comes from Brennan Hawken of UBS. Please go ahead.

Eric, you mentioned that you are considering some adjustments to the pricing model, which makes a lot of sense given the current inflationary environment. Have you started those discussions? What has been the response from your clients thus far? Are you hearing from some clients that competitors are making similar changes? It’s important to know that you won't be alone in making these adjustments, especially since price increases in the custody sector are generally difficult to implement. I'm curious about your insights on this.

Brennan, it’s Ron. Why don’t I start on this, and Eric will fill in. We’re early in this process, but yes, we have been out with clients and walked through our planned price increases with a few clients at this point. And there’s a whole plan, as Eric alluded. It’s around the areas where we’ve got the most inflationary pressure which might be specialty areas, areas where there’s limited capacity in the marketplace, areas that are just growing very rapidly. And interestingly, the earliest ones have been in some ways, I think clients were not surprised that it was coming at them. So I’m not saying that’s the way it’s going to be. None of us enjoy paying more for something today than what we paid yesterday. But we’re going at this in a very fact-based way. These tend to be sophisticated institutional buyers, and they know what’s going on. So I can’t speak for what others are doing. I just don’t have a feel for that. But we’re running our business in the way we believe we need to. And we think this is an important component of it.

Thank you for that. When considering the expectations around ECB and the potential divergence in policy rates globally, could you remind us of the current currency mix of your deposits? Also, do you anticipate any shifts in that mix in the near future as yield differentials widen between various currencies? Thank you.

Sure, Brennan, it’s Eric. We included additional details in our financial addendum this quarter, which you can find on Page 8. It breaks down the balance sheet, highlighting total assets, investment securities, and deposits by major currencies like USD, euros, and pound sterling, as we focus on navigating the current interest rate environment. We are keen on leveraging the benefits of interest rate increases globally. Our balance sheet is positioned by currency, with pricing plans and estimates carefully developed for each currency. We don’t anticipate significant changes in the balance sheet composition. The U.S. Central Bank is moving more quickly with interest rates and quantitative tightening, which may lead to a decline in U.S. currency deposits. However, with U.S. rates being higher than other parts of the world, we can expect global investors to be attracted to the U.S. market. Therefore, forecasting currency composition and deposit levels is challenging given these dynamics. Nevertheless, we are well prepared. In fact, some of the increases in net interest income this quarter are due to the U.S. rate rises as well as those in pound sterling and other Anglo-Saxon currencies, and we are adjusting our positioning accordingly.

Your next question comes from Jim Mitchell of Seaport Global.

Eric, maybe just on the securities portfolio. You had a pretty big shift into HTM to derisk the AOCI. But I’m just looking it does have a materially higher yield. Is there something to think about in the HTM portfolio that you’ve kind of locked in longer duration or it’s a little more credit risk in there? How do I think about the HTM portfolio versus AFS and how that can evolve? Does it hold back NII sensitivity or not?

Jim, it’s Eric. We’re quite careful about managing our NII sensitivity holistically across the book. I think what you’ll see is that because we use HTM to protect against interest rate and AOCI volatility, it’s more natural that if we have a blended book of short-, medium-, and longer-term securities that we would move more of the medium and longer-term securities into HTM because thereby, we get the most protection while we give up the least amount of sale optionality. So that’s why you’re just seeing a higher yield. I think you’ll see that generally be true, and you can follow that in our disclosures accordingly.

The yet-to-be-installed business continues to grow. I understand there is a lengthy process for getting those installations completed. However, are we at a stage where we can see this growth become significant, and could we expect to see a meaningful acceleration in organic growth next year once these installations are completed?

Yes, I think you have the correct general timeline. The way I see it, the larger the deal, the more complex and transformative it is for our clients. They are fundamentally changing their operating model, harmonizing systems and processes, and we are investing alongside them to create a front-, middle-, and often back-office model that can serve them for a decade or more. With the $3.6 trillion of assets under custody/assets to be installed, 2023 is a significant year. We anticipate that about one third will likely be installed by the end of that year, potentially accounting for as much as half of the revenue related to those wins.

Your next question comes from Brian Bedell of Deutsche Bank.

Eric, if you could just repeat that comment on the one third of the $3.6 trillion. Was that by the end of next year did you say? I just missed that.

Yes, that’s correct. By the end of 2023.

Got it. Just back to the BBH strategy. It's great to hear that you’re both committed to this. If you can close it with any amended terms and structures, could you remind us or share your thoughts on the deposit strategy, specifically bringing the BBH deposits on balance sheet? There was also an opportunity to transfer a significant portion of balances from their $60 billion off-balance-sheet arrangements with third-party banks. Is that still feasible, or does the structure change that evaluation?

Brian, we are currently finalizing both the legal entity and operating model changes. We are working to establish a clear understanding of how the deposit and sweep program will function, as well as how we might utilize that program in the future to maximize cash and deposit options. This process is ongoing, and we plan to provide an update during the third quarter as we finalize the modifications.

Yes. That makes sense. And then maybe just excluding BBH and just looking at everything on a State Street-only basis, should we be thinking do you think in this cycle, we should be thinking of deposit runoff to be sort of similar to the last cycle? I think we were down more than 15% in average deposit levels from start of Fed hiking to the trough in 2019. Is that a reasonable starting point to think about that deposit runoff? Or is something different in the cycle that would make you think that you wouldn’t have that?

I believe the previous cycle will always serve as a reference point. However, it is important to remember that there were several variables during that time, such as the fluctuating SLR rule, which forced many of us in the banking sector to manage our balance sheets separately from the interest rate changes and quantitative tightening. Reflecting on the period before COVID, our deposits have increased by approximately $60 billion. We estimate that about half of this increase can be attributed to the quantitative easing, which is likely to reverse. Predicting this is challenging given how rapidly the interest rate environment is changing, and there is also a general risk-off sentiment that we need to monitor. I previously mentioned that we could experience outflows of $6 billion to $10 billion for every $1 trillion of U.S. balance sheet tightening. Due to the swift increase in interest rates, we are more inclined to see the higher end of that range initially and then possibly decrease in the subsequent years. We are currently navigating various scenarios. From our viewpoint, our liquidity position is very strong. The deposits we have are valuable, and we are utilizing them to enhance our profit and loss. Over time, we anticipate being able to achieve higher net interest income levels similar to what we experienced before. During the last cycle, we peaked at around $695 million. While it’s tricky to make precise forecasts, our projections suggest that we could match or exceed that figure in the upcoming cycle. This is partly because, despite some tightening and a reduction in total deposits, we are also seeing higher interest rates in the U.S. and globally, alongside anticipated changes in European rates based on current forecasts.

Sure. Your next question comes from Steven Chubak of Wolfe Research. Please go ahead.

So Eric, I wanted to better understand just some of the guidance items that you outlined specific to both fees and expenses. And on the fee side, certainly, the guidance that you offer suggests greater resiliency compared with some of the more acute declines that we’ve seen in some of the market proxies. Just want to get a sense as to what’s driving that better outcome? And specific to expenses, I was hoping you can give some bookends in terms of what range of expense growth we should be contemplating? You cited inflationary pressures multiple times, the need to maybe revisit pricing with some of your clients, but you also have some FX tailwinds. So I was hoping to get some perspective on what sort of expense growth range we should be thinking about for the remainder of this year?

Sure. Let me discuss fees first. The main challenge we're facing is that if we look at the current equity market levels, we expect the average daily revenue for the third quarter to be down by 7% to 8% compared to the second quarter. This impacts our revenues from servicing and management fees. We hope that certain fluctuations in other revenues won't happen again, which could provide us some buffer. Thus, I mentioned that servicing and management fees might decrease by about 4% sequentially, while total fees could be down around 2%. Market volatility also influences currency trading and other activities, so we need to see how things unfold over the summer. Regarding expenses, I'm trying to provide guidance on a quarterly basis. Adding the first and second quarters together, we're estimating just under a 1 percentage point increase for the third quarter, which you can use to estimate for the fourth quarter. Based on our overall outlook for fee revenues in the third quarter, we can make reasonable projections for the fourth quarter as well. We have a solid expectation for net interest income for the full year, which we've shared. We're confident in achieving positive total operating leverage for the year, adjusted for unique items, considering the current market conditions. We have good visibility on fees and net interest income. While we do face some wage and inflation pressures, we've proactively adjusted our incentive costs to address these challenges. We're focused on navigating this environment thoughtfully and aiming to deliver the best possible results.

That’s really helpful information. I have a follow-up regarding some of the expense comments Eric made. We've been receiving many inquiries about the long-term expense growth trend. You have successfully managed to reduce expenses significantly in recent years. It’s clear that inflationary pressures are increasing as we consider your efficiency initiatives, but these pressures are also rising at the same time. How do you anticipate the expense growth trend will change over time?

Yes. I think we'll gain more clarity as the year progresses. However, we are already facing some inflationary pressures that we can try to limit but cannot completely avoid. For instance, from our $8 billion expense base, approximately $2.5 billion is allocated to salaries. Historically, salary increases have been around 2 to 3 percent per year, but currently, due to merit increases, the higher salary rates for new hires compared to exits, and the need to attract talent, salary costs are rising by approximately 4 to 6 percent on that $2.5 billion base. This increase poses an additional challenge, potentially adding an extra point to our overall expenses. This reflects the kind of environment we are operating in. We still need to determine if these conditions will continue into next year, considering factors like the possibility of a recession or changes in labor markets. Additionally, we are addressing non-compensation expenses where some vendors are adjusting their rates, and we're working to manage those increases. We are aware of these challenges and are trying to signal them, but we remain dedicated to achieving our medium-term targets. We will explore ways to contain or offset some expenses, while also expecting favorable influences from the interest rate environment. Furthermore, we are considering selective pricing adjustments with clients. There are various factors at play, and it's still too early to provide a comprehensive outlook for the coming year. Nevertheless, we are focused on the elements we can control, and we are committed to reaching our medium-term goals.

Yes, Steve, what I would add to that is that throughout this period that we’ve been managing expenses over the last several years, as we’ve been quite clear on, we’ve also been investing in the business, particularly around automation and technology. There’s still payoffs expected from that. We’ve seen some. There’s more in the future. So the other bit of this we’ll be continuing to manage that algorithm between how much we continue to spend on automating more to get the future productivity savings.

Your next question comes from Gerard Cassidy of RBC Capital Markets.

Hi, Ron. Hi, Eric. Eric, could you provide an update on the variable rate pricing of your fee revenues? What percentage of fee revenues would you classify as variable pricing, which is significantly affected by market levels? Also, Ron, when you mentioned price increases for some of your products for customers, does that apply to both variable rate pricing and fixed-rate pricing?

Yes. Let me start. Our pricing schedules have a significant amount of history regarding the servicing fees. I would say that about half of the revenues earned through these servicing fee schedules are dependent on market levels, particularly the assets under custody levels. There is also a portion driven by transactional or activity volumes, and the remainder is fixed. So there is a mix, which is reflected in the P&L at this point. These schedules are complex; in some cases, they can be measured with a ruler because they cover various products, regions, and entities, and often have historical context associated with them. But that's a general overview.

Yes. And then, Gerard, just the second part of your question, are we going at the asset-based fee, the variable fee, or the fixed fee? I mean, it’s a little bit of both. And again, we’re trying to be reasonable firstly to our clients but also to ourselves and really tying this to where there are real inflationary pressures. And also recognizing that we have a commitment to generating really good service for our clients, right? Service better than our competitors. So it’s less about is that the variable or the fixed, it’s where are we having these pressures and therefore, where do we need a price increase.

Very good. And then just as a quick follow-up, Eric, in the held-to-maturity portfolio, the duration was 2.8 years, as you pointed out. Can you share with us the OCI accretion back into capital? About how many basis points a year do you think you’ll see in that? And then second, what’s the average yield of that HTM portfolio today? Thank you.

Sure. Let me break that down. The HTM portfolio has some informative data available in our financial addendum, specifically on Page 9. We detailed the AFS portfolio both on average and at the end of the period within the HTM portfolio. Currently, the yield on AFS is approximately 91 basis points, while the held-to-maturity yield is around 155 basis points. This difference is largely due to the duration we typically maintain in the held-to-maturity to shield it from OCI. We anticipate that the accretion will begin towards the fourth quarter, with some activity in the third quarter leading into the fourth. Our expectations for capital accretion range from $100 million to $200 million. This amount may vary each quarter as different maturities occur. Overall, this represents a robust level of capital accretion, potentially contributing 10 to 15 basis points of capital, which could assist us in financing future buybacks and returning capital to shareholders. We aim to resume these activities in the fourth quarter and continue thereafter.

Your next question comes from Mike Mayo of Wells Fargo Securities. Please go ahead.

First, thanks for changing the time of your conference call, given so much else happening today. So on the pricing due to inflation, I mean, it all makes sense. It’s all logical. But can you actually get that done? We’ve talked for the last 3 decades. Now it seems like you have more of a reason to increase pricing than ever before. Ron, you’ve been on the other side of this, you’re getting the phone call. “Hi, this is State Street. We’d like to increase the pricing by 5%.” And then you’re like, “Well, we’re going to go to these other 3 or 4 or 5 providers.” So how much confidence do you have that you can pass on some of these price increases to your customers?

It's a great question, Mike. Over the years, nearly everyone has changed. If you look back 15 or 20 years, almost all clients purchased the same service: custody fund accounting in publicly listed markets. It was quite straightforward, as you mentioned. The difference now is that medium to large managers are offering a wide range of products, some of which are quite complex, either due to the skills needed or the technology involved. We are noticing the highest inflationary pressures in these areas. We believe we provide superior capabilities, and there seems to be limited capacity in the market. Additionally, everyone has been experiencing similar pressures over the last couple of decades, benefiting from what could be described as a prolonged period of deflation. That's not the case anymore. While it's risky to say this time is different, we do recognize that in specific areas, price adjustments are necessary, and we believe our clients will understand. Early indications suggest that they do.

And as a compromise, are you talking more about compensating deposit balances, like the trust banks had in the past when rates were higher?

No.

Okay. We need to seek higher payments because our expenses, like everyone else's, have increased.

Mike, regarding deposits, we have been under-earning compared to the cost of holding deposits, specifically preferred securities. For several years, we barely managed to balance this during the peak of the last interest rate increase in 2017 and 2018. We are now working to achieve normal deposit spreads. As deposit rates increase, we will return a reasonable portion of that to our clients intentionally, as it aligns with our commitment. This process seems to be returning to normal levels, and the pressures we are experiencing related to wages, salaries, and other compensation are consistent with what others in the economy are facing. On a net basis, this situation is markedly different.

Okay, that’s good clarification. Thank you. Regarding your costs, I noticed they are increasing. It seems many banks have a similar situation as you, with $2 billion in expenses and $1 billion in compensation. However, compensation and societal costs are rising at a slower rate compared to other inflationary pressures such as food, rent, and gas, which are increasing significantly more than employee costs. I've heard from some banks that the pressure on employee costs has decreased in recent months. Is that not the case for you, or even if it is, are you still expecting to see growth that is about double what you’ve experienced historically?

Mike, I agree that the observation about compensation costs lagging behind other inflationary expenses is accurate and typical of how inflation affects labor markets. We've definitely experienced pressure that is significantly higher than the trend, especially as we compete for talent in skilled areas. Eric mentioned that we are sometimes hiring replacements at costs that are much higher than before. Furthermore, if we anticipate a recession or slower economic growth in the near future, that could relieve some pressure on costs. However, we are still seeing notable increases in specific expense areas, and I suspect similar institutions would experience the same situation.

Your next question comes from Rob Wildhack of Autonomous Research.

Ron, just a quick one for me. I wanted to ask about the drop in RWAs in the quarter. Could you talk about what the drivers are there? And what kind of RWA outlook or assumption is embedded in your guidance going forward?

Yes, as you remember, we intentionally deployed more risk-weighted assets in some of our business activities during the first quarter, specifically in trading and lending, due to an excess of capital which we utilized to generate strong revenues. This quarter, we are reducing that allocation, partly to enhance our capital ratios and, honestly, because we've identified some optimization opportunities. I previously mentioned a reduction of more than $10 billion from the previous quarter, which came from various areas like securities finance and the lending book, where some loans were eligible for margin loan treatment that has a different risk-weighted asset requirement. We also had some minimal risk exposure in the investment portfolio that was fully risk-weighted and rolled off. There were some tactical adjustments made based on these factors. Additionally, we usually experience some fluctuations in risk-weighted assets; for example, the foreign exchange derivatives book can vary by $3 billion to $4 billion, and we managed to maintain a good balance there. Approximately one-third of the $10 billion to $12 billion reduction from the prior quarter was due to that balance. However, it's possible that the $3 billion to $4 billion could rebound in the third quarter, and we are mindful of that as we continue to accumulate through the profit and loss statement each quarter. We are confident in our capital ratio progression into the third quarter, which also positions us well for potential buybacks in the fourth quarter.

Your next question comes from Vivek Juneja of JPMorgan. Please go ahead.

Firstly, I want to echo Mike’s comments about changing the timing of the call. I am glad. I would take that one step further and say it would be helpful in the future to consider another day, so it’s not on such a hectic day for all of us, allowing us to pay more attention. Moving on, regarding the price increases on the servicing contracts, since these are longer-duration contracts, Ron, when should we expect them to start? Is it a year out, or could they actually take effect in a fairly short order? What timing would you suggest?

Yes, that's a good question. We're focusing on being fact-based and linking our decisions to specific increases and areas where action is needed. The response varies; in some instances, it relates to particular transactions or asset classes where we can implement changes, while in other cases, we need to secure an agreement from the client. Our goal is to act quickly due to the current pressure, so we aim to implement changes as soon as possible. We're still early in this process, so we'll see what we can achieve regarding overall timing. However, given our fact-based approach and the realities of our clients' situations, we're optimistic about making progress.

There are no further questions from the phone lines. At this time, I’ll turn the conference back over to Mr. Ron O’Hanley for closing remarks.

Well, thank you, operator, and thank you all for participating in the call, and thank you for your support.

Ladies and gentlemen, this does indeed conclude your conference call for today. We would like to thank you all for participating and ask that you please disconnect your lines.