State Street Corp (XLF) Q1 2023 Earnings Call Transcript

Good morning, and welcome to State Street Corporation's First Quarter 2023 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 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.

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 first quarter 2023 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 two 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; also available on the IR section of our website. In addition, today's presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors such as those factors referenced in our discussion today and in our SEC filings, including the risk factors in our Form 10-K. Our forward-looking statements speak only as of today and we disclaim any obligation to update them even if our views change. Now let me turn it over to Ron.

Thank you, Ilene, and good morning, everyone. Earlier today, we released our first quarter financial results. Before I review our financial highlights, I would like to briefly reflect on the eventful operating environment in the first quarter. Investors had to contend with significant market movements and volatility, driven by persistent inflation, continued central bank interest rate increases, and the recent disruption to certain segments of the banking industry. First quarter global financial market performance was choppy. January produced a very strong start to the year with gains across most asset classes, including equities recording the strongest start to a year since 2019. However, investors remained cautious about the prospect of enduring inflation and a potential recession in the United States. February saw that encouraging start recede as strong U.S. employment data led to growing concerns about the persistence of inflation, which in turn saw market expectations for central bank rate hikes increase, fixed income and equity markets declined, and the U.S. dollar strengthened. March saw a continued rise in central bank rates, which in turn drove shocks to both the U.S. regional and international banking sectors and the need to resolve a number of banks. All this drove negative market sentiment, contributing to large inflows into money market funds and a reversal of a number of the macro trends from the prior month. Both current interest rates and rate expectations decreased and the U.S. dollar weakened, although relative calm returned to markets by the end of the quarter. Notwithstanding these events, all told, global financial markets performed relatively well in the first quarter compared to the fourth quarter of last year with broad-based gains recorded across global equities, while U.S. treasuries experienced their best quarter since the first quarter of 2020. However, daily average equity and bond market levels both remained significantly below the year-ago period with average equity markets down approximately 10%, which created headwinds for our fee-driven businesses impacting our year-over-year financial results, which I will discuss shortly. Before I discuss our financial highlights, I would like to briefly comment on the recent events in parts of the banking sector. As the globally systemically important financial institution, State Street plays a critical role in the world's financial system. Our strong capital and liquidity positions, size, scale, and sophisticated risk management allow us to help safeguard investors and assist in providing market stability during uncertain times. We demonstrated this ability at the start of COVID three years ago when we helped establish the Money Market Mutual Fund Liquidity Facility and the Main Street Lending Program. During the first quarter, in concert with 10 other large U.S. banks, State Street once again used its financial strength to help assist in stabilizing the financial system through the provision of liquidity to a financial institution in the U.S., reflecting our confidence in the American banking system. We stand ready to support the world's investors and the people they serve during this time of uncertainty through our investment servicing and asset management products, which offer clients opportunities, insights, and liquidity. Turning to Slide 3 of our investor presentation, I will review our first quarter highlights before Eric takes you through the quarter in more detail. Relative to the year-ago period, first quarter EPS was $1.52, down 3% as the positive year-over-year benefit resulting from our continued common share repurchases as well as significantly stronger NII growth were offset by lower servicing and management fee revenues, which were impacted by weaker average market levels, continued business and personnel investments to support growth, and a loan loss provision related to State Street support of the U.S. banking system, which I just mentioned. Turning to our business momentum, we remain highly focused on continuing to advance our enterprise outsourced solutions strategy across our clients' front, middle, and back-office activities. For example, in March, we announced our agreement to acquire CF Global Trading. This transaction will further expand State Street's current outsourced trading capabilities, giving our firm the ability to provide these services to new clients and markets. Importantly, the acquisition will allow State Street to expand its liquidity providing capabilities and offer a complete global trading solution as part of our Alpha front-to-back platform. The transaction is expected to be completed by the end of 2023, subject to customary closing conditions. AUC/A amounted to $37.6 trillion at quarter-end and we recorded asset servicing wins of $112 billion in the first quarter, about half of which were higher fee rate alternative mandates, consistent with our strategy. Encouragingly, this was our second best quarterly sales performance by projected revenue within the alternative segments over the last six years. We also reported an additional Alpha mandate during the first quarter as this strategy continues to resonate with clients. Our AUC/A installation backlog amounted to $3.6 trillion at quarter-end. At State Street Global Advisors, quarter-end assets under management totaled $3.6 trillion, while flows across our asset management businesses were negatively impacted by the various market factors in the first quarter. We continue to see a number of bright spots where we are focusing our efforts. For example, in the U.S., our SPDR ETF franchise gained market share in both low-cost equity and low-cost fixed income, while we also had strong inflows into our gold ETFs amidst investor demand for safe haven assets. While aggregate flows to cash were slightly negative for the quarter, this largely resulted from seasonal outflow activity in January. However, Global Advisors gathered strong money market inflows of over $24 billion in the latter part of March amidst the market volatility. Turning to our financial condition, State Street's balance sheet, liquidity, and capital position remained strong. Our CET1 ratio was a high 12.1% at quarter-end, well above State Street's regulatory minimum. This balance sheet strength enabled us to continue to return capital to our shareholders in the first quarter, while simultaneously supporting our clients and the U.S. banking system. We returned $1.5 billion of capital to our shareholders in Q1, including buying back $1.25 billion of our common shares and declaring over $200 million of common stock dividends. As we look ahead in this uncertain environment, we remain highly focused on maintaining a strong balance sheet position, while continuing to generate and return capital as part of our previously announced common stock repurchase program of up to $4.5 billion for 2023, subject to market conditions and other factors. To conclude, the first quarter included a number of significant events in global financial markets and with the broader banking industry. While market conditions were volatile, many asset classes saw sequential quarter gains, although asset prices remained depressed relative to the year-ago period, which created year-over-year headwinds for our fee-driven businesses in the first quarter. While our year-over-year revenue performance was durable, supported by significantly higher net interest income growth, our results this quarter were below our expectations. We need to do better, and I believe we are equipped and on track to do so by focusing on areas within our control and effectively executing our strategy. In keeping with the strategic priorities I outlined in January, we are driving forward with a number of actions. For example, our AUC/A to be installed is strong, and by strengthening our implementation capabilities, we have line of sight into a meaningful amount of client onboarding beginning in Q2. Within our software and data business, we expect to convert a meaningful number of CRD on-premises clients to more recurring SaaS revenue in the second quarter. Last, given the revenue inflationary environments, we will continue to selectively reprice some services, proactively manage our costs, execute on our productivity efforts, and stand ready to utilize additional expense levers at our disposal. With the focus on accountability and execution of our strategy, I continue to firmly believe in the ability of our diversified franchise to successfully meet the needs of the world's investors and the people they serve, while delivering value for and capital to our shareholders. Now, let me hand the call over to Eric, who will take you through the quarter in more detail.

Thank you, Ron, and good morning, everyone. I'll begin my review of our first quarter results on Slide 4. We reported earnings per share of $1.52 for the quarter, which included a $29 million provision or $0.06 of EPS impact associated with the expansion of liquidity for U.S. financial institutions, as we participated in an industry consortium supporting the banking system. We were pleased to do our part. On the left panel of the slide, you can see that our first quarter '23 results reflected the year-on-year decline in both equity and fixed income markets, but was more than offset by strength in net interest income and strong momentum in our securities finance business. EPS was down just 3% as another quarter of significant buybacks reduced the number of shares outstanding. Against this challenging backdrop, we again held total expense growth to just 2% year-on-year, even as we continued to thoughtfully invest in product and client growth initiatives. Turning now to Slide 5. During the quarter, we saw period end AUC/A decrease by 10% on a year-on-year basis, but increased 2% sequentially. Year-on-year, the decrease of AUC/A was largely driven by lower period end market levels across both equity and fixed income markets globally, which were both down in the 10% range. Quarter-on-quarter, AUC/A increased as a result of higher period end market levels and client flows. At Global Advisors, we saw similar dynamics play out. Overall, our first quarter AUM was negatively impacted by volatile markets. Period end AUM decreased 10% year-on-year, but increased 4% sequentially. The year-on-year decline in AUM was largely driven by lower period end market levels and net outflows. Quarter-on-quarter, the increase in AUM was primarily driven by higher quarter-end market levels, partially offset by some outflows. Turning to Slide 6. On the left side of the page, you'll see first quarter total servicing fees down 11% year-on-year, largely driven by lower average market levels, client activity and adjustments, and normal pricing headwinds, partially offset by net new business. Excluding the impact of currency translation, servicing fees were down 10% year-on-year. Sequentially, total servicing fees were up 1%, primarily as a result of higher average equity market levels, partially offset by lower client activity and adjustments. On the bottom panel of this page, we've included some sales performance indicators, which highlight the good business momentum we again saw in the quarter. AUC/A wins in the first quarter totaled $112 billion with about half driven by wins across the growing Alternatives segment, especially in private markets. The fee rate on these alternative wins are generally more than 4 times the total servicing fee average, which makes this a strong win quarter from a projected revenue standpoint. At quarter end, AUC/A won, but yet to be installed totaled $3.6 trillion with Alpha representing a healthy portion, which again reflects the unique value proposition of our strategy. Given the planning and preparation since these deals were announced, we expect significant onboardings of this uninstalled AUC/A next quarter. Turning to Slide 7. First quarter management fees were $457 million, down 12% year-on-year, primarily reflecting lower average market levels and a previously reported client specific pricing adjustment. Quarter-on-quarter, management fees were flat as higher market levels were partially offset by outflows and day count. As you can see on the bottom right of the slide, notwithstanding the difficult macroeconomic backdrop in the quarter, our franchise remains well positioned, as evidenced by our continued strong business momentum. In ETFs, we continued to build on strategic growth segments, which is reflected in net flows in our SPDR portfolio low-cost equity and fixed income suites. In our institutional business, we saw net outflows while sustaining continued momentum in defined contribution with the Target Date franchise recording inflows of $6 billion. Across our cash franchise, consistent with industry trends late in the first quarter, we saw a flight to quality with significant net inflows worth 7% of cash AUM into SSGA money market funds since the week ending March 10th, which largely reversed the seasonal outflows experienced earlier in the quarter. Turning now to Slide 8. Relative to the period a year ago, first quarter FX trading services revenue was down 5%, primarily reflecting lower client FX volumes partially offset by higher spreads. As a reminder, the start of the war in Europe last year caused some unusually high FX trading activity in 1Q '22. Sequentially, FX trading services revenue excluding notables was down 1% with lower spreads offset by 6% higher client volumes. And consistent with the significant increases into industry-wide money market flows, our GlobalLink franchise experienced an increase of $20 billion or 13% into its money market cash sweep program during the last three weeks of March. Securities finance performed well in the first quarter with revenues up 14% year-on-year, driven by higher specials activity and an active focus on business returns, partially offset by lower balances, which was consistent with the industry. Sequentially, revenues were up 6%, again mainly driven by higher specials activity, which was consistent with the market and securities lending industry environment. Moving onto software and processing fees. First quarter software and processing fees were down 18% year-on-year and 24% sequentially, primarily driven by lumpy on-premise renewals in the front-office software revenues, which I'll turn to shortly. Lending fees for the quarter were down both year-on-year and sequentially, primarily due to a shift away from products with higher fees but lower returns. Finally, other fee revenue increased $16 million year-on-year, primarily due to positive market-related adjustments and $27 million sequentially, largely due to fair value adjustments on equity investments. Moving to Slide 9. You'll see on the left panel that front office software and data revenue declined year-on-year, primarily as a result of lower on-premise renewals, partially offset by continued growth in software-enabled revenue. Timing of installations will vary quarter-on-quarter based on the size and scope of prior business wins and we expect several SaaS conversions and several on-premise renewals to come through in the second quarter. Year-on-year, our annualized recurring revenue was 16%. Our software-enabled revenue was up 11% year-on-year, but down sequentially due to the absence of an accounting true-up in fourth quarter. Turning to some of the other Alpha business metrics on the right panel. We were pleased to report another Alpha mandate win in the asset owner client segment. In addition to the reported win this quarter, we expect significant middle-office installations in Q2 as we've completed the preparations to begin to onboard a portion of a large mandate won back in 2021. Turning to Slide 10. First quarter NII increased 50% year-on-year, but declined 3% sequentially to $766 million. The year-on-year increase was largely due to higher short-term rates and proactive balance sheet positioning, partially offset by lower deposits. Sequentially, the decline in NII performance was primarily driven by additional client rotation out of non-interest bearing deposit balances, partially offset by higher short-term market rates from central bank hikes. On the right of the slide, we show our average balance sheet during the first quarter. Year-on-year average assets declined 6% and 2% sequentially. Average deposits declined 3% quarter-on-quarter, which is relatively consistent with our expectation for first quarter seasonality and client pricing preferences during periods of rising rates. Of note, average weekly deposit levels at quarter end increased 5% as we compare with week of the week ended March 10. The stress in the regional bank space primarily affected consumer and corporate depositors rather than the institutional asset manager and asset owners that we serve. In contrast, we saw some risk-off deposit inflows at the end of the quarter. Our operational deposits as a percentage of total deposits remain consistent at 75%. These are determined by regulatory guidance. U.S. dollar client deposit betas were 80% to 90% during the quarter, as expected. Foreign currency deposit betas for the quarter continued to be much lower, in the 30% to 45% range, depending on currency. Our international footprint continues to be an advantage. Turning to Slide 11. Our first-quarter expenses excluding notable items increased just 2% year-on-year or up approximately 4% adjusted for currency translation. In the light of the current revenue environment, we're actively managing expenses while continuing to carefully invest in strategic elements of the company, including Alpha, private markets, and technology and operations automation. Compensation and employee benefits increased 5% year-on-year, primarily driven by higher salary increases associated with wage inflation and higher headcount attributable to lower attrition rates and in-sourcing. Total non-compensation expenses, on the other hand, decreased 1% year-on-year as continued productivity and optimization savings more than offset increases in certain variable costs and professional services. On a line-by-line basis for non-compensation expenses, information systems and communications expenses were down 2% due to benefits from ongoing optimization efforts, partially offset by technology and infrastructure investments. Transaction processing was down 9%, mainly reflecting lower sub-custody costs from declining market levels as well as lower broker fees. And other expenses were up 9%, mainly reflecting the higher professional fees, travel, and marketing costs. Moving to Slide 12. On the left side of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios, followed by our capital trends on the right of the slide. As you can see, we continue to navigate the operating environment with extremely strong capital levels, which are well above our targets, let alone the regulatory minimums. As of quarter-end, our standardized CET1 ratio was up slightly year-on-year, but down 1.5 percentage points quarter-on-quarter to 12.1%, which was largely driven by the continuation of our share repurchase program and the expected normalization of RWAs that we discussed last quarter. Tier 1 leverage ratio was flattish at 5.9%. Our LCR for State Street Corporation increased a couple of percentage points quarter-on-quarter to 108% and 4 percentage points quarter-on-quarter to 124% for State Street Bank and Trust where most of our businesses transacted. We were quite pleased to return $1.5 billion of capital to our shareholders in the first quarter, consisting of $1.25 billion of common share repurchases and $212 million in common stock dividends. Lastly, given the high level of capital across every measure, positive pull-to-par in AOCI and our strong earnings trajectory, we continue to expect to return up to $4.5 billion of capital in the form of buybacks at pace this year, subject to market conditions of course. Turning to Slide 13, which provides a summary of our first quarter results. While there is certainly still work to do, we are pleased with the durability of our business this quarter against a very challenging backdrop and the continued competitive strength of our global franchise. Next, I'd like to provide our current thinking regarding the second quarter. At a macro level, our rate outlook is broadly in line with the current forwards, which suggest the Fed, ECB, and Bank of England all continue to hike to varying degrees in Q2. In terms of markets, we currently expect average U.S. equity and global bond markets to be up about 1% to 2% quarter-on-quarter and international equity markets to be flattish. Regarding fee revenue in Q2 and on a sequential quarter basis, we expect overall fee revenue to be up 4% to 5% with servicing fees up 1% to 2% and management fees approximately flat to up 1%. We expect to see a significant increase in front office software and data revenues as we have line of sight to a number of on-premise renewals and SaaS conversions in Q2. In our other fee revenue line, which we know is difficult to forecast, we intend to adopt in Q2 the new accounting guidance recently issued regarding renewable energy investments. We would expect to see a sequential quarter uptick in total other revenues of between $5 million to $15 million, but this estimate always depends on market levels. As we adopt this accounting change, our effective tax rate for Q2 '23 is expected to be approximately 21%. The adoption will be roughly neutral to EPS. Regarding NII, we now expect NII in the second quarter to decrease 5% to 10% sequentially, primarily driven by the non-interest bearing deposit rotation and interest-bearing deposit betas as quantitative tightening and rate hikes continue into Q2. Turning to expenses. We remain focused on driving productivity and controlling costs in this environment. We expect that second quarter expenses will be flat on a sequential quarter basis, excluding the Q1 seasonal compensation cost of $181 million. Overall, we will offset some of the Q2 NII trends with higher fee revenues as business momentum builds in Q2 and through the year, and we continue to actively manage expenses. And with that, let me hand the call back to Ron.

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

Ladies and gentlemen, we will now begin the question-and-answer session. The first question comes from Ken Usdin of Jefferies. Please go ahead.

Thanks. Good morning. I wanted to follow up on the net interest income. Eric, could you explain how much of the 5% to 10% increase in the second quarter is due to averaging effects? Additionally, you mentioned in your release that dollar type has increased since early March. What are your expectations for deposit growth both at the end of the period and on an average basis moving forward? Thank you.

Sure, Ken. It's Eric. The main factor impacting our net interest income trends currently, whether looking from the fourth quarter to the first or from the first to the second quarter, is the level of non-interest-bearing deposits. These deposits decreased by about $5 billion last quarter, while we had anticipated a decline of around $3.5 billion. We conduct extensive forecasting on this, and typically, we observe a U-shaped pattern through January, February, and March. However, we saw some contrary movement in March, which has influenced the changes in net interest income. On the other hand, we've been experiencing positive inflows in interest-bearing deposits simultaneously, indicating a lot happening beneath the surface. As we move into the second quarter, we project that the trend of decreasing non-interest-bearing deposits will continue. Last year, we had fluctuations where non-interest-bearing deposits increased by $1 billion, then decreased by $2 billion, followed by a drop of $4 billion, and then another decrease of $2 billion. It's been quite unstable. Currently, we predict these deposits may drop another $4 billion to $5 billion in the second quarter. Considering that earning 5% or more on those deposits can significantly affect our net interest income, the impact is substantial. Each billion is valued at about $12 million to $15 million per quarter. What we are trying to do in our forecasting, which is always challenging, is to understand how these trends evolve. We've examined the last peak and the last low for non-interest-bearing deposits: the peak was 22% and the low was 18%. In dollar terms, the peak was $50 billion, and the low was about $30 billion, and we are currently around $39 billion. This is crucial for our net interest income forecast. We anticipate that some of the non-interest-bearing deposits will shift into interest-bearing accounts. However, many of our clients, particularly sophisticated institutions, are considering other high-yield options like treasuries or money market funds. At this stage of the cycle, given the high prevailing rates, we expect deposits to likely decrease a few billion more into the second quarter, but this ultimately depends on client behavior and activity as we refine our forecast.

Thank you, Eric. I have a follow-up question regarding the changes in client activity. Is the current behavior different from what you've observed in the past concerning the sources of inflows and outflows? We anticipated a decline in deposits, as did you, but recent events changed that. Are clients making different decisions about their operational cash? How would you characterize the situation across your client base? Thank you.

I think clients are making a variety of different decisions. One reason for what we're observing is that we haven't experienced an environment where interest rates are at 5%, whether from the Fed or in three and six-month treasuries. Clients have numerous alternatives and are considering how to deploy their funds to maximize interest and yields for themselves, particularly since our clients tend to be price-sensitive over time. Regarding the operational aspect of deposits, our disclosure shows that clients are very stable and sticky operationally. Operational deposit balances have remained steady, and the percentages continue to stay within a narrow range. Many clients have several billions of dollars, but they usually maintain hundreds or even thousands of individual accounts with substantial transactional and payment flows, which is why we classify them as operational. This behavior hasn't changed. The nature of core custodial deposits is deeply embedded in the structure of those accounts and how we process their transactions while avoiding overdrafts, which they seek to prevent. However, we're noticing that some clients are becoming rate-seeking for the last dollar of their discretionary deposits. At the current rates, they're exploring various options. Sometimes, we meet those rates by offering deposits at exception rates or assisting with their sweeps and treasury repo interest. We provide several different ways to serve our clients and will continue to do so. However, at this point in the rate cycle, we are experiencing some patterns that align with what we would expect.

Thank you. The next question comes from Brennan Hawken of UBS. Please go ahead.

Thank you and good morning. This is Adam Beatty in for Brennan. Just a quick follow-up on NII, and in particular, the geographic mix of deposits. So you've got kind of fairly steady trends, U.S. kind of going up and a higher beta, as you've called out in the past, and then non-U.S. somewhat going down with a lower beta. Just wondering if you expect based on what you're seeing right now with your clients, those trends to continue. In particular, will we continue to see pressure on non-U.S. deposit balances? And could those betas maybe be going up outside the U.S. as you say, the competing yields are somewhat higher? Thank you.

Thank you for your question. I believe we will observe a variety of behaviors across different regions. In the U.S., with current interest rates, there's a shift from non-interest-bearing accounts to interest-bearing ones, alongside clients pushing for better pricing. We're at a stage where clients, much like us, have incentives to settle on terms with us. In Europe and with the pound sterling, the situation is still developing. We are in the early stages of rate increases, and the betas remain quite appealing, typically ranging from 20% to 50%. This is beneficial for clients as they have fewer options in international markets compared to the U.S. Additionally, there is generally less sensitivity to pricing on deposits in these areas. We anticipate this trend will persist. As more rate increases are implemented internationally, we expect to continue offering deposit rates that lag slightly behind those increases as they take effect.

Great. That makes sense. Thanks, Eric. And then just turning to the buyback, pretty healthy in the quarter. You still got the kind of not-to-exceed target out there. So just wondering how you're thinking about that in terms of deposit trends and capital needs and whether some of the disruption in the banking backdrop has maybe affected your thinking around the buyback. Thank you.

We have been very deliberate and thoughtful about our approach, especially considering the events in March. We continuously evaluate the stability of the broader banking system. Our starting point is our strong balance sheet, with capital ratios around 12%, which is significantly above regulatory requirements. We maintain a healthy buffer compared to others in the industry. Our strong position influences our decisions on capital return, but we also take into account the broader market conditions related to the banking system. If we faced the same economic and banking environment we had in early March, our capital buyback statements would be different. However, we believe there has been a fair amount of healing since then, which plays a role in our decisions. We will keep evaluating conditions weekly. Our buybacks aren't a one-time event; they occur over the next eight to ten weeks, and this quarter, we will be executing them more steadily. While we will assess ongoing conditions, our strong position gives us the flexibility to proceed confidently.

Great. Good context. Thanks, Eric.

Thank you. The next question comes from Betsy Graseck of Morgan Stanley. Please go ahead.

Hi. Good morning.

Hi, Betsy.

Could we talk a little bit about the expense outlook and how you're thinking about managing it? I know that you mentioned 2Q specifically, but I just wanted to get your thoughts on how you are thinking about operating leverage either on a total rev basis or more on a fee basis. Really what I'm trying to get at is how you think about the NII piece as we think about operating leverage for the 2Q and for the full year. Thanks.

Betsy, there are a few different perspectives we have on this. It's still early in the year, and we've started to provide some guidance for the second quarter. We need to observe how market conditions develop, as fluctuations in equity or bond markets by even a percentage point can affect our revenues. Though we aim for positive operating leverage and seek ways to achieve it, we require more information about external conditions to assess that accurately. Looking ahead, while net interest income is expected to trend positively for the year, it may not be as favorable as we initially anticipated. We have raised our fee guidance for the second quarter, which provides us with some additional stability and momentum. We'll continue to actively manage expenses. Over the past year and a half, as net interest income rose significantly, we were mindful of controlling our spending. We aimed to balance our investments with productivity and keep our expense growth in check. Going forward, we'll maintain this approach while monitoring revenue trends and adapting when necessary.

And then just a quick follow-up on the other fee line that you discussed, the $5 million to $50 million increase in Q2. Could you just give us a sense of how we should think about the trajectory of that? Are you going to be increasing your investment into renewables and so that should be a growing line in line with increase in investments to renewables? Or is that a one-time step-up in that? So just a little color there. Thanks.

The revenue impact on that line includes a mix of factors, and we are still working to clarify the specifics for our forecasting. For the second quarter, we need to accumulate the year-to-date figures as per the accounting guidance. We anticipate some additional revenues in the third and fourth quarters, although not as substantial as the catch-up expected in the second quarter. We are currently mapping that out and will aim to provide more clarity as the quarter unfolds. This particular line should be slightly above zero in the upcoming quarters, and we'll offer guidance on that as we refine our forecasts.

Okay. Thank you.

Thank you. The next question comes from Gerard Cassidy of RBC. Please go ahead.

Good morning, gentlemen. Eric, can you share with us how you guys are investing your cash in your securities portfolio in terms of durations that you're looking at? Are you trying to shorten the duration of the portfolio as you reinvest the cash proceeds that come off with every quarter? What's your thinking about that?

We've been careful over the years to manage a portfolio with a modest duration, typically around 2.5 to 2.8 years. This allows us to benefit from the historically steep yield curve and provides some stabilization in net interest income without missing the chance to take advantage of rising interest rates, something we've successfully navigated over the past two years. We appreciate this level of duration because it also safeguards our income statement as rates decline, and we are monitoring potential rate cuts this year or in the following years for added stability. Additionally, we focus on the shape of the duration curve while carefully managing some mortgage-backed securities portfolios for extra yield, being cautious about the convexity risk involved. Given our global deposit franchise, we have about a third of our balance sheet in international markets, which allows us to explore opportunities in currencies like the pound, euro, Canadian dollar, and Australian dollar. In those currencies, we may adjust our duration, being shorter in some and longer in others based on our views of the rate cycle. Our flexible approach enables us to deliver attractive yields in net interest income while remaining cautious not to chase duration or yield. We intend to continue managing a conservative portfolio as we have for many years.

Very good. Following up on your comments regarding deposits, you mentioned that the low point for non-interest-bearing deposits was $30 billion, and that you are currently at $39 billion. If interest rates remain stable, assuming the Fed does not begin to cut rates later this year or next year with a Fed funds rate around 4.75% to 5%, do you believe that non-interest-bearing deposits could fall toward that $30 billion level going forward? Additionally, do you need to pay any interest on your operational accounts?

Let me address that in reverse. The operational accounts can be either interest-bearing or non-interest-bearing, resulting in a variety of pricing structures. However, the key focus is not so much on the pricing but on the nature of the accounts and the payment transactions clients are facilitating with their deposits. Regarding non-interest-bearing deposits, I believe we will continue to see a downward trend. This past quarter, there was a $5 billion decrease, which was $1 billion to $2 billion more than we had anticipated at our last guidance. We expect another $4 billion to $5 billion decrease in the second quarter. We do think stabilization will occur eventually. I believe we may reach the $30 billion mark later this year, although it's challenging to predict precisely. There can be fluctuations in non-interest-bearing accounts of about $4 billion to $5 billion month to month. In April, for instance, there were days when non-interest-bearing deposits reached $44 billion, exceeding the recent average by $5 billion, while on other days they fell to $34 billion. This illustrates the range and volatility we are trying to navigate, but clearly, the trends suggest we might approach that $30 billion level later this year.

Very good. Appreciate the insight. Thank you.

Okay. Yeah.

Thank you. The next question comes from Jim Mitchell of Seaport Global. Please go ahead.

Good morning. I'd like to discuss the fee income aspect. You mentioned significant sequential growth, although it doesn't seem to be coming primarily from the servicing line. However, you noted strong momentum in servicing and onboarding. How should we view the trajectory of servicing fees as you continue onboarding? Is this more of a second half story, and what are your expectations for servicing fees for the full year?

Yeah, Jim. It's Ron. I’ll start by addressing the servicing fees. As Eric mentioned, we anticipate growth driven by a couple of factors. First, we have had a significant amount of assets under custody currently awaiting implementation. Much of this was related to necessary systems development that is now taking place, so we expect to see a substantial amount of those assets installed. Additionally, while this quarter had a lower amount of assets under custody, the wins included more traditional back office and a large alternatives segment, both of which are easier and quicker to implement. We're quite satisfied with how 2023 is progressing in terms of sales, especially since it's shaping up early in the year. Therefore, we do expect to see significant growth in servicing fees. This outlook is also influenced by market conditions; if you believe in some level of market stability, we feel optimistic about the year ahead.

And Jim, it's Eric. Just to add to that, Ron has addressed servicing fees. Management fees should provide us with some boost, along with equity market appreciation as well as bond market appreciation heading into the second quarter. Typically, the second quarter performs well. We'll have to monitor how much volumes contribute to the spread, but we have made significant progress given the market volatility with specials and securities finance, which is likely to continue. In the software and processing segment, we experienced one of the lowest on-premise renewal quarters in Q1, which can vary significantly. According to some of the materials in the presentation, this could range from $6 million to $60 million, highlighting the swing from the fourth to the first quarter. We anticipate some notable increases there as well. Therefore, we are focused on all opportunities and businesses to leverage the client momentum we've been experiencing.

I appreciate your insights, Eric. Regarding the sequential increase of 4% to 5%, it appears that much of this growth is driven by irregular revenue sources that may not be consistent in the future, such as catch-up revenue or rebounds in software processes. As we consider the momentum for the second half of the year, I wonder if the new run rate established in the second quarter can be maintained as we build momentum in more stable revenue streams, or if we may need to extend our timeline. I’m looking for clarity on whether the significant increase in the second quarter can be sustained beyond that period.

I understand your perspective. I want to remind you that we experienced an unusually low revenue in the first quarter for software and processing. The focus for the second quarter is on recovery and continuation. Typically, our on-premise revenues average about $30 million per quarter, but we only recorded $6 million last quarter. We expect this rebound in the second quarter to align more with the averages. Additionally, as you pointed out, there are more reliable revenue streams such as software-enabled and SaaS revenues, along with our FX and securities finance operations. We are also seeing increasing momentum in servicing and management fees, with growth noted in both back office and middle office areas, which adds to our diversity. Predicting the second half of the year is challenging, and I hesitate to revise our full-year estimates in April, but I believe we'll have a clearer picture by June and July. I can assure you that we are observing increased client activity that should lead to more onboardings. We anticipate that this will result in a positive step-up, and we expect continued growth beyond the second quarter.

All right. Well, thanks for all the color.

Yeah.

Thank you. The next question comes from Steven Chubak of Wolfe Research. Please go ahead.

Good morning. This is Sharon Leung speaking on behalf of Steven. Regarding NII, I understand that you mentioned it will still increase, but perhaps not as significantly as the previously guided 20%. Can you provide any specific numbers regarding that, for instance, if the NIB rotation proceeds as expected and you reach the $30 billion target sometime this year?

Yes. The forecasts have a wide range of outcomes. Based on the first quarter report and our expectations for the second quarter, we don't anticipate reaching the previously guided 20% growth for the full year. We're currently assessing the pace of portfolio rotation and the price sensitivity observed in our U.S. clients at this stage of the cycle, which makes it challenging to determine a precise outlook. If one adopts a more pessimistic view, factoring in greater rotation and increased price sensitivity, net interest income could rise by 5% to 10% this year instead of 20%. Conversely, if one takes a more optimistic stance, considering historical trends where there's a significant reduction in non-interest-bearing deposits, net interest income could increase by 10% to 15%. Consequently, our forecasts show a larger range than usual. Additionally, in line with the recent year-to-date data we've shared, we expect broad variability in outcomes, making predictions quite difficult. This may provide some perspective. The range is likely wider than you anticipated, but we aim to be as transparent and forthcoming as possible with the available information.

Great. Thank you very much.

Thank you. The next question comes from Ebrahim Poonawala of Bank of America. Please go ahead.

Good morning. I have a couple of quick follow-ups, Eric. One is on net interest income. I heard all your comments during the Q&A. I'm trying to understand whether the change in customer behavior you observed today is different from January, considering you might have expected rates to rise a bit more than they were in January, or if recent events have altered customer behavior and led to a greater urgency in repricing.

No, I don't think the events of the last month are really relevant because they pertain to very different client segments and geographies than those we serve. There was a bit of a risk-off sentiment with deposits, but that represents a different ecosystem than our clients. What's happening is difficult to estimate, particularly regarding how clients behave with prevailing rates at 5% in the United States, which many of us have not experienced recently. The data on this is limited. Back in January, when we provided our guidance for non-interest-bearing deposits, we saw fluctuations: one quarter they increased slightly, then decreased by $5 billion, followed by a $2 billion drop from the third to the fourth quarter. This puts us in a position where we’re trying to forecast and estimate, and while we thought we might have found some stability, that has not been the case. Clients have shifted from non-interest-bearing to interest-bearing accounts, and some have even moved across currencies due to their expertise. Interestingly, we gained more deposits in the U.S. but saw net reductions in Europe and Asia, showing a diverse scenario. We're realizing that we lack sufficient data on deposit or pricing behavior, which is what we're trying to better understand. Nonetheless, the momentum in our business is evident. While NII increased faster than we expected, there is a slight sequential decline, but it will still be up for the full year—we just need to monitor how much.

Got it. And just a separate question. I know it's small for you, but the other element that your provision is higher, the credit portfolio rating, remind us of the credit sensitivity that we should expect from the balance sheet from an economic downturn, if there are more rating agency downgrades, like what that means from a credit cost provisioning perspective as we look forward.

It's a good question. Aside from the provision calculated using CECL techniques, which was about $15 million for the one cash placement we've made, our provisions have typically ranged from $5 million to $15 million. We've noticed some changes in ratings in a few credits, but that's something we manage. Higher prevailing rates are putting pressure on various parts of the economy, which is fairly typical. We maintain a high-quality lending portfolio, with most ratings in the A or A- range, even when looking at lower market segments. While there is some sensitivity to economic conditions, we are currently well reserved based on both economic factors and the individual credits we hold. Our portfolio is highly diversified and of high quality. We'll continue to monitor it but believe it remains reasonably stable, with a slight downward drift given the current economic trends.

Got it. Thank you.

Thank you. The next question comes from Mike Mayo of Wells Fargo Securities. Please go ahead.

Hi. As you know, the markets that’s a little generations. And can you just make it crystal clear? I mean, I think I know the answer, but I need you to really explain why this is an earnings issue and not a liquidity issue. And on the earnings issue, just to make sure I heard you correctly, your non-interest-bearing deposits went from $44 billion down to $39 billion. You think base case, it might go down to $34 billion, but the low end of the range, which is possible later this year would be $30 billion. That would be going maybe non-interest-bearing deposits from $44 billion down to $30 billion, that would be $14 billion less than free money. You said it was $12 million to $15 million per $1 billion. So just taking the worst case, you go down to the $30 billion, it hurts you $15 million, we're talking about $200 million of earnings lost which might be around 7% or 8% of your EPS, if you look at kind of a run rate sort of thing. So first, is my math correct there that that is the earnings issue? And then reassure if it's appropriate, that this is not a liquidity issue.

Mike, let me begin. I believe your calculations for the worst-case scenario are fairly accurate. We're taking every possible measure to prevent that outcome, and your assessment of the earnings impact is correct, with the assumption of a complete margin on the deposits. Regarding liquidity, there isn't anything here that resembles a liquidity problem. These are custody deposits and, as Eric mentioned, they are operating deposits. This gives you a clearer understanding of why we have a certain number of clients but multiple accounts. For instance, a mutual fund company typically has at least one account for each fund they manage with us, if not more, to effectively manage their funds. Looking at the liquidity coverage ratio, which Eric discussed, it currently stands at 124%, showing an increase rather than a decrease. Therefore, while this does present an earnings concern, we plan to counterbalance it as much as possible through our primary revenue source, which comes from fees, along with careful expense management.

And then a follow-up to that. You said you're not changing your buyback. So you have $4.5 billion for the year. You've done $1.25 billion. So you have $3.25 billion left. With the current market decline, that would be 14% of your market cap. So to the extent you see this as a step down, but not life-threatening, what's your appetite toward completing that buyback and how soon are you able to enter the market?

I think Eric explained it well. If you look at our capital levels and the fact that we held off buying back shares for most of last year, we feel comfortable continuing the buyback. We are obviously aware of the current environment, but we feel confident moving forward. However, if the situation were to change significantly, like it did in March, we would take that into account. Based on what we know now and our financial strength, we believe it is prudent to proceed. Our focus is not on market capitalization but on our CET1 ratio and capital ratio, which will remain within our targets. At this point, we feel very comfortable moving ahead with the buyback.

And Mike, it's Eric. I want to emphasize that our capital and liquidity strength, as well as our ratios, are extremely high by any standard. We have shared a lot of that information, which is why we feel confident moving forward with our buyback program. As I mentioned in my prepared remarks, we plan to continue this throughout the year and at a steady pace. Typically, we begin buybacks the day after earnings are reported, and we execute them based on market conditions over the eight to ten weeks available in the quarter. We have strong confidence in the overall system and a great deal of confidence in our specific position. Regarding earnings, we will address the earnings issue. Our net interest income is something we can adjust our balance sheet to earn when interest rates rise, and we will see some adjustments when rates fall. We will continue to focus on fees, manage expenses, and pursue what truly is a long-term trajectory.

One last time, crystal clear. So there is nothing about the reduction in the, quote, free money non-interest-bearing deposits or anything else in your results that would give you pause to continue buying back your stock.

None.

All right. Thank you.

Thank you. The next question comes from Rob Wildhack of Autonomous Research. Please go ahead.

Hi, guys. I wanted to unpack some of the RWA dynamics in the quarter. RWAs were up 7% sequentially, but the overall balance sheet, I think, was down 3% or 4%. So can you just give us some color on what was going on there?

Sure, Rob. It's Eric. And I think there's some materials on RWA both in the earnings deck on Page 12 and then further back in the addendum. I think if you remember, fourth quarter, we had a particularly low print in RWA, which we had signaled at our fourth quarter earnings call in January. Overdrafts came in lower than expected. Some of the risk-weighted assets associated with the FX books came in lower because of the late December move in dollar rates. And so we had expected a rebound of about $10 billion, $15 billion of RWA from fourth quarter to first quarter. And you saw we got about $8 billion or $9 billion of that. We still came in a little light on overdrafts, which is fine. Part of that is the amount of cash in the system and the cash and deposits that we're holding on behalf of our clients. You see RWA is still down year-over-year, and that's because of a fair number of optimization efforts. We felt like there's real opportunities for us to grow the franchise on one hand, but deploy RWAs in very high-quality and higher returning ways on the other and support our clients. And so we've been adjusting the deployment across the FX books. You think about how much we want to deploy in the forward space and the long-dated forwards versus spot and securities finance, there are different amounts. But we're quite well off when it comes to capital and our plan is here really to continue to find ways to smartly deploy additional capital and additional RWA to drive organic growth.

Thank you. And then I appreciate the color on the to-be-installed business and the on-prem enterprise trajectory from here, but could you just remind us how long those installs typically take to convert to revenue?

Yeah. When we described the installation going into the second quarter, we were describing those as realized revenue installations. So in effect, the way the accounting works typically is when we win, we don't book the revenues, but it's only at the installation date that you begin to book them. So you'll see both the backlog assets under custody in the second quarter begin to come down and some of the servicing and middle office revenues float upwards. And similarly, for the software and data processing areas, you'll see something in that direction as well.

Okay. Thank you.

Thank you. The next question comes from Vivek Juneja of J.P. Morgan. Please go ahead.

Hi Eric, hi Ron. I have a couple of questions. First, regarding CRD revenues, you mentioned that on-premise revenue should recover in the second quarter. However, I would like to take a broader view and ask for your expectations regarding full-year growth for all three components of CRD revenues.

I’m not sure we went into that level of detail in January. Historically, we've indicated that our various fee categories exhibit a range of revenue growth. We've noted that traditional back office is expected to grow towards the lower single-digit range. In contrast, the middle and front office, which includes CRD, is projected to experience high single-digit growth, with potential for double-digit growth in certain years. Regarding software, while on-premise revenues might not be as significant over time, we do see substantial momentum with software enabled and SaaS products. Overall, we anticipate higher single-digit revenue growth, though there will be some variation from year to year.

Okay. And then going back to this question that's come up on the large amount of new business that remains to be installed in servicing, and you said you should see a pickup in 2Q. Ron and Eric, what's your expectation for how much of that do you expect would get installed over the course of this year, 2Q, 3Q, 4Q? And by the time we exit this year, how much should be done? And therefore, what benefit should there be to from that?

I think there are a few ways to approach this. The onboarding of assets happens in stages. We may onboard assets under custody and administration, but we often provide multiple services for those assets. Over the past couple of years, we secured a few significant wins totaling $1 trillion. These wins included custody, accounting, and performance analytics, along with middle office services in many cases since they were Alpha mandates. Each of these balances we refer to as assets under custody and administration generates several revenue streams. We expect about half of the backlog in custody and administration to be realized this year, although this can vary. The revenue will not align directly with that number as it accumulates over time based on the various layers of services provided related to those assets. Each quarter, we aim to offer more visibility as we reach implementation milestones. It’s important to note that these implementations require not only our configuration of the front-to-back offering designed for clients but also clients needing to adjust many of their own processes and systems simultaneously, making it a collaborative effort.

If I may sneak in one more, just CF Global, any color on what that could add to your fee revenue, Eric? And when do you expect that to start to add revenues?

CF Global represents a very appealing opportunity for us. We have previously engaged in some outsourced trading in the U.S. and Asia, but our presence in Europe has not been substantial. This acquisition enhances our credibility and impact in the European market. It is expected to be finalized by the end of the year, making it more relevant for discussions in 2024. We anticipate that the combined revenues from CF Global and our existing business could reach between $30 million to $50 million next year. While we already have some revenue in this area, the acquisition of CF Global brings unique capabilities and product offerings that enable us to expand and achieve significant growth. We are enthusiastic about this development as it aligns with our strategy to be the primary enterprise outsourcer for custody, accounting, middle office, and front office services tailored for the CIOs of small and midsized companies, and it complements our positioning and strengths effectively.

Thank you.

Thank you. There are no further questions at this time. I will turn the call over to Mr. O'Hanley for closing remarks.

Thanks, operator. And thanks to all on the call for joining us.

Ladies and gentlemen, this does conclude your conference call for today. We thank you for your participation and ask that you please disconnect your lines.