State Street Corporation

Good morning and welcome to the State Street Corporation's fourth quarter of 2018 earnings conference call and webcast. Today's discussion is being broadcast live on the State Street's website at .statestreet.com. This conference call is also being recorded for replay. State Street's conference call is copyrighted and all rights are reserved. This call may not be recorded for rebroadcast or distribution in whole or in part without the express written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. Now I would like to introduce Eileen Fasel-Bieler, Global Head of Industrial Relations at State Street.

Good morning and thank you all for joining us. On our call today, our CEO Ron Ohanley will speak first. Then Eric Abloh, our CFO, will take you through our fourth quarter and full year 2018 earnings presentation, which is available for download in the investor relations section of our website, .statestreet.com. Afterwards, we'll be happy to take questions. During the Q&A, please limit yourself to two questions and then re-queue. Before we get started, I would like to remind you that today's presentation will include results presented on a basis that excludes or adjusts one or more items from GAAP. Reconciliation of these non-GAAP measures to the most directly comparable GAAP or regulatory 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. Our forward-looking statements speak only as of today, and we disclaim any obligation to update them, even if our views change. With that, let me turn it over to Ron.

Good morning, everyone. As you know, this is my first opportunity to address you since becoming State Street CEO at the start of 2019. Let me turn to slide three. We announced our fourth quarter and full-year 2018 financial results this morning, and I want to start by providing some context in terms of the overall environment, addressing our performance, and then importantly, focus the bulk of my comments outlining what we are going to do differently going forward. Market dynamics are changing for our clients. The shift from active to passive means thinner fees, as well as more competition amongst managers who are increasingly challenged to outperform their peers and, consequently, face lower volumes and thinner fees themselves. The resulting margin compression for investment managers has led them to increase pressure on their providers. Asset owners facing inadequate returns are similarly pressuring providers to do more for less. In turn, these same clients need better technology and streamlined operations to increase their ability to generate alpha more efficiently and reduce operating costs. Given these headwinds for our clients, we are adapting strategically to become increasingly more competitive, offer greater functionality, and be the essential partner to our clients. I have made it clear to my colleagues at State Street and want to make it clear to you. We want to better drive our own destiny and more effectively manage our exposure to market headwinds. That means change, real change, that I will talk about today and in the year ahead. Year over year, our revenue growth in the fourth quarter was driven by strong performance in net interest income and FX trading, as well as the contribution from the recently acquired Charles River Development business. We are encouraged by the continued interest we are seeing in CRD, with a total of 98 client engagements since announcing the deal. These positive trends were offset by unfavorable market conditions, including the significantly downed markets during the fourth quarter and ongoing fee compression, which impacted our servicing fee revenues. Assets under custody in an administration decreased quarter over quarter, reflecting lower equity market levels and client transitions. Fourth quarter new servicing business wins were $140 billion. Additionally at quarter end, AUCA, yet to be installed, totaled approximately $385 billion. At $1.9 trillion for the full year of 2018, we experienced a record level of new servicing wins. State Street Global Advisors was also impacted by the market environment, as our business has a disproportionate exposure to equity markets and other risk on asset classes, such as high yield. Assets under management decreased quarter over quarter, primarily driven by weaker equity markets as well as institutional and cash outflows, partially offset by ETF net inflows. While SSGA results are not yet where we would like them to be, we have been working to diversify our business mix, leverage relationships across State Street, and fill in offerings as we take advantage of the shift from products to solutions. These offerings include asset allocation, exposure management, and outsourced CIO, as well as demand for our range of ETF products. For example, this quarter we saw good organic growth in our European ETFs and our low cost US ETFs, and remain confident that our strategy of targeted growth in areas such as ETFs, OCI, Ocio, and other multi-asset solutions, and ESG, just to name a few, will drive future growth. Regarding our overall bottom line performance, simply put, we need to and can do better. That means reigniting servicing fee growth in a sustainable way, reducing costs across our organization, and building upon the advances that we have made in digitization and automation. Collectively, this means being faster and smarter about how we deliver solutions that solve our clients' greatest challenges. Our capital position is strong. Moreover, we are optimistic that balance sheet repositioning actions completed during 2018 better position us for the 2019 CCAR cycle, supporting stronger levels of capital return for our shareholders. In light of our recent results and ongoing industry dynamics, we are taking immediate action on expenses to ensure that we become a more efficient organization for our clients and shareholders alike. I have implemented a firm-wide hiring freeze for all non-critical roles. We are rolling out a rigorous new performance management system and are structurally compressing and reducing the senior management pyramid by 15%, while improving spans and reducing layers across the bank by 25% to create a more agile and accountable organization. These actions are enabled by the beacon work and the consolidation of work into our global hubs. Thus, we are confident in our ability to execute quickly. In fact, initial reductions have already occurred. Additionally, we are focused on addressing inefficiencies across our entire expense base and have launched a new cost savings program that will continue through 2019 to reduce structural expenses while also enabling us to invest in the business appropriately. As part of that program, which Eric will cover shortly, we recorded a $223 million pre-tax repositioning charge, the benefits from which we expect to fully realize within 12 to 15 months. Let me turn to slide 4. Slide 4 outlines my vision for State Street. We intend to be the leading asset servicer, asset manager, and data insight provider to the owners and managers of the world's capital. This vision will be driven by five strategic priorities. One, we will increase core fee growth by becoming an essential partner to our clients, gaining share of wallet and building enduring institutional relationships. The issues faced by our clients have moved services, technology, and operations to the C-suite agenda. Thus, we are upgrading our client coverage model to meet these needs. These changes, including new senior leadership, are already underway. Two, we must deploy the industry's leading -to-back asset servicing platform as a technology-driven scale provider. Three, we will continue to innovate to grow diversified revenue streams, including new markets and NII opportunities. Four, we must generate structural expense saves by automating key processes to reduce unit costs and by leveraging our global hubs and scale, among other initiatives. And five, become a more high-performing organization through flattening our structure, increasing the speed of decision-making, and evolving our employee skill base around our technology and data priorities. Executing against the strategic vision will require concerted action and select investments, which I am driving forward across the business. At the same time, we need to do more to improve performance in the short term, which is evidenced by our actions announced today. And with that, let me turn it over to Eric to take you through the quarter in more detail.

Thank you, Ron, and good morning, everyone. Before I begin my review of our fourth quarter and 2018 results, I'd like to take a moment on slide five to discuss notable items and how they impacted our financials. In 4Q18, we recognized $223 million of pre-tax repositioning costs consisting of severance and real estate write-offs. This charge is in response to the challenging industry conditions and includes the organizational streamlining and delaying actions that Ron announced last month. I'll have more to say on how we are tackling expenses later in the presentation, including details in our new $350 million expense initiative announced today. In addition, we also had $24 million of acquisition and restructuring costs related primarily to Charles River, which was below our original estimate, $24 million related to the sale of a small alternative servicing business in the Channel Islands, and $50 million of legal and related costs. In total, we recognized notable items of $321 million pre-tax, or $0.64 a share. On page six, we show our gap results in the top two panels, as well as our results, X and notable items I just described, for those of you who want to see some of our underlying trends. On this basis, we didn't achieve our fee operating leverage goal, but we did deliver positive operating leverage overall in 2018. Now moving to slide seven, 4Q18 EPS of $1.04 was down 44% quarter on quarter, but up 17% -over-year, primarily reflecting the impact of our 4Q18 repositioning charge and the 4Q17 tax reform costs. For the full year 2018, our gap EPS of $6.40 was up 22% over 2017. Looking at 4Q18, return on equity was down 6.5 percentage points sequentially, primarily related to the quarter's notable expense items. For the full year 2018, ROE was up 1.6 percentage points from full year 2017. Overall we saw growth in both EPS and ROE on a full year basis, driven by NII growth through active balance sheet management and higher interest rates, FX trading, where we continued to gain share, the acquisition of CRD, and lower taxes. We are, however, disappointed by our performance in several of our fee businesses, and I'll describe the drivers and our additional actions on the next few pages. Turning to slide eight, our end of period AUCA and AUM levels were significantly impacted by the sharp sell-off in equity markets during the end of the fourth quarter, as well as the cumulative effect of industry flows in the past year. As you know, and as we have summarized on the right side of this page, global equity markets were down 6 to 17% in 2018, after posting double-digit gains in 2017. At the same time, cumulative industry flows were dramatically down after significant inflows during last year, and client transaction activity was muted as investors sat on the sidelines. As a result, we saw AUCA levels fall 7% -on-quarter and 5% -on-year, while AUM levels fell 11% and 10% respectively. Moving to slide nine, I want to spend some time unpacking total revenues, which were up 1% -on-quarter and up 5% -on-year. Servicing fees, shown in the dark blue piece of the stacked bar on the left side of the page, were down 4% -on-quarter and 7% -on-year. Let me give you some color. On both a sequential quarter and -over-year basis, we had a two- to three-point reduction in servicing fees due to falling global equity markets. In addition, we've recently been seeing industry pricing pressure of about 1% point per quarter over the last year. The cumulative effect has caused a material -on-year downdraft in servicing fees. And we also had one previously disclosed client transition, which was worth about 2% points -on-year, which was offset by net new business and client activity. To put these numbers in context, the long-term appreciation in equity markets has typically lifted servicing fees on average by about 2% points annually over the last five years. Positive client flows and client transactional activity have added another 2% points annually. And net new business has also generated 2% points of annual growth, all of which have been partially offset by typical pricing headwinds of just under 2% points annually. This year has been particularly challenging, though, since we've seen twice the average historical pricing headwinds, without the tailwind of market appreciation nor client flows and activity that are inherent in our pricing structure. We have thus undertaken meaningful initiatives to combat these headwinds, such as upgrading our client coverage program and strengthening pricing discipline through our new pricing governance process. And since we need to focus on what we can control, we are even more resolute that we need to actually manage our expense base lower, which I will discuss further in a few minutes. Turning to slide 10, let me briefly discuss our other fee revenues. Beginning with management fees, 4Q revenue was up 5% -on-year, primarily driven by revenue recognition adoption, but down 7% -on-quarter, driven by lower equity markets, as well as net outflows in our equity-focused institutional business. SSGA continues to focus on expanding our relationships and product categories that offer a higher margin. 4Q FX trading services saw continued strong performance, up 19% -over-year, driven by higher FX volumes and volatility. We continue to differentiate our FX offerings with clients, driven by the breadth and depth of our capabilities. 4Q securities' finance revenues were down 6% -on-quarter and 18% -on-year, reflecting lower assets on loan and lower spreads as clients deleveraged and industry demand fell. I would note that the business continues to evolve after the CCAR-related counterparty adjustments. We've navigated these changes quite smoothly in FX, but continue to work through the effects in agency lending. Finally, we saw a significant step up in processing fees with the addition of CRD for the first time in our 4Q financials. We continue to be excited by the acquisition, we're pleased with its performance and remain confident in our previously announced revenue and cost synergies. As you can see on the lower right of the slide, CRD saw net new bookings of $14 million for 4Q 18. We have announced our new Client Advisory Board and delivered higher than expected fourth quarter revenues of $121 million on $39 million of expenses. We also incurred $18 million of amortization costs and $24 million of acquisition costs associated with CRD this past quarter. While CRD is enjoying real momentum, I would caution you again simply annualizing these 4Q results given the lumpiness inherent in the 606 revenue accounting reporting standard. Now on to slide 11, we saw continued NII growth and NIM expansion during the fourth quarter. Our NII was up 4% quarter on quarter due to the Fed hikes we saw on September and December, as well as a one-time benefit of approximately $6 million from hedging activities. 4Q NII was up 13% year on year, driven by higher U.S. interest rates and disciplined liability pricing, while NIM expanded 7 basis points quarter on quarter and 17 basis points year on year. As you can see on the bottom right of the slide, our average level of deposits remained fairly steady and our betas remained similar to last quarter at just over 50%. We were also pleased to see an increase in our lending activity during the quarter. All of this bodes well for full year 2019. Now turning to expenses. As we indicated earlier in the call, we are extraordinarily focused on managing expenses in this challenging revenue environment. I'll start by summarizing our expenses on an underlying basis, excluding notable items in Charles River, and then discuss our efforts during 3Q and 4Q to keep our second half expenses flat to the first half on that basis. I'll then summarize the new expense savings program we just announced today. Beginning on slide 12, you can see that our underlying basis, 4Q 18 expenses were up 5% year over year and 1% sequentially, driven largely by the year over year adoption of the new revenue recognition accounting standard as well as technology investments. From a line item perspective and relative to 4Q 17, competent employee benefits were well controlled, increasing just 1%, reflecting technology contractor and annual merit increases, partially offset by beacon savings and lower performance based incentive compensation given our disappointing results. Information systems increased, reflecting infrastructure enhancements as well as additional investments to support growth. Transaction processing costs were down as we renegotiated subcustodian savings for a second quarter in a row. Occupancy costs were down as a result of continued progress in optimizing our global footprint. Now turning to slide 13, as the extent of the challenging revenue conditions became clearer last spring, we committed to actively managing our quarterly expenses so as to keep second half expenses flat to first half on an underlying basis. As you see on the left side of this page, we deliver on this commitment, but we know we need to do more. On the right side of the page, we summarize the progress in our beacon savings which totaled in 2018, as well as additional tactical actions and savings, which included a down payment on our 2019 program. These savings include the start of management delaying, contract vendor savings, the renegotiation of certain subcustodial relationships, and better control of discretionary spending. Now to slide 14. In light of our current macroeconomic and industry conditions impacting revenues, we have launched a significant new expense savings program. In total, this program is designed to achieve 350 million of in-year expense savings during 2019, or approximately 4% of our expense base, which is larger than our previous efforts. On the right side of the page, you'll see the two major categories we've identified, resource discipline and process engineering and automation, with expected savings of approximately $160 million and $190 million, respectively. Resource discipline includes a previously announced 15% reduction in senior management, the rollout of a more rigorous performance management system to better control headcount, and further vendor management savings, and the continued tackling of our real estate footprint. Process engineering and automation benefits are expected to include the reduction of approximately 6% of our workforce, or 1,500 roles in high-cost locations. Staffing assessments were recently done as part of our shift to a more globalized model, and we are now able to take further advantage of automation and standardized processes and lower costs per person. We also intend to streamline three operational hubs and two joint ventures, as well as continue the drive towards common technology platforms and the retirement of legacy applications. The initiation of certain portions of this program results in the 4Q repositioning charge that I mentioned, which we described on the left side of the page. Even though this charge has good payback, we know we need to reduce the size of these charges going forward, which is why we've rolled out a new performance management system and headcount controls. Moving to slide 15, our capital ratios end of the year similar to those of a year ago, with tier one leverage of .2% and a standardized set one of 11.5%. We also undertook certain balance sheet and counterparty actions in the fourth quarter to be better positioned for the 2019 CCAR process. As you see on the left side of the page, we shifted the investment portfolio during 4Q to further increase the percentage of HQLA securities and adjusted the health to maturity holdings, thus reducing the associated AOCI volatility to our capital under stress. This portfolio rebalancing, including turning over about 10% of the book, and is not expected to have a negative impact on further NII growth. Lastly, and consistent with our previous announcement, we will resume share repurchases this month and intend to repurchase up to $600 million through June 30, 2019. Turning now to slide 16, I'd like to focus on our 2019 outlook. Before I start though, I'd like to first share some of the assumptions underlying our current views. At a macro level, we are assuming continued, albeit slowing, global growth. Market interest rate forwards and only a modest uplift from equity markets, but with continued volatility which will keep investor flows muted and transactional activity light. I would note that this operating environment is materially worse today than it was just 45 days ago when I presented at the Goldman Conference. Since then, we've seen a significant sell-off in equity markets through year-end 2018, with the US equity indices down almost 10% in December versus the first two months of the fourth quarter. This sell-off has put a material drag on our quarterly fee revenue run rate since it is geared off of the 2018 year-end step-off of AUCA and AUM levels. And over the same period, the rates picture has markedly changed too, with consensus moving from two Fed hikes in 2019 to nearly none. Amidst this uncertain revenue environment, we will be laser focused on expenses. As you can see in the walk, we believe we can achieve approximately 4% in productivity driven by our -than-usual 2019 expense program, which includes both resource discipline and process re-engineering improvements, partially offset by an approximately 3% of ongoing business and necessary IT investments. This should yield a net 1% reduction in 2019 total underlying costs aside from the full year effect of CRD and notable items. In addition, given the severe market environment, we currently expect to reduce expenses to percentage points from 4Q18 to 1Q19, excluding seasonally deferred compensation via our recent hiring freeze and senior management exits. While a material percentage of our revenue is informed by markets and not in our control, we can control expenses. We will intervene further if necessary. Turning to fee revenue, with the December market sell-off and increased volatility, there is a scenario where 1Q19 total fee revenue could be down quarter on quarter by 3 to 4 percentage points, driven by known factors including the market step-off, the -than-historical pricing headwinds, and the fiscal effects of lumpy revenues in CRD and trading. And because of the year-end 2018 step-off, even with a modest linear uptick in equity in markets during 2019, we could see this 1Q fee revenue as our quarterly run rate for several quarters. At this point, we're operating the company under this scenario. Should we see sustained market uplift or further retreat, however, this picture could change. For example, in terms of market sensitivity, a 5 percentage point instantaneous uplift in markets is worth about $25 million per quarter to our servicing fee revenue, with a lag of half a quarter. In regards to NII, we expect to see low to -single-digit growth for the year. For 1Q, we expect a downtick which would be fully accounted for by two fewer days and the absence of the 4Q episodic hedging benefits I mentioned earlier. Taxes should be in the 15 to 16 percent range for the year. So we expect 1Q19 to be higher at 18 percent. And finally, given the balance sheet repositioning undertaken in the fourth quarter, we are optimistic that we are better positioned for the 2019 CCAR process, subject, of course, to the Federal Reserve scenarios and associated approvals. Depending upon the specific CCAR scenarios, we would expect to target a total payout of over 80 percent for the upcoming CCAR cycle. Finally, to slide 17, in summary, full year 2018 was a mixed year. We had a solid start to the year with record new servicing wins of $1.9 trillion, which reflects our distinct servicing capabilities. Revenue started strong, but we had a difficult second half given our exposure to weaker equity markets and challenging industry conditions. We continue to distinguish ourselves in FX trading as well as how we have effectively driven NII growth as we have engaged with clients. All told, EPS increased 22 percent and ROE increased 1.6 percentage points. On the capital front, we are better positioned for the 2019 CCAR cycle. And one of our top priorities is to return substantial capital to shareholders this year. Finally, as I outlined a few moments ago, we are taking immediate action to adjust our expense base for this new revenue environment, and we are confident the actions we announce today position us well to reduce our 2019 underlying expense base relative to last year. And with that, let me hand the call back to Ron.

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

If you would like to ask a question at this time, please press star, then the number one on your telephone keypad. Your first question comes from the line of Glenn Shore with Evercore.

Hi, Glenn.

Further comment on the pricing, because I think we all get that the market dropped, and so fees start out lower. That's, I don't think, a surprise at this point. The worst pricing, what I'm curious about is how it manifests itself. In other words, I think you used the phrase this year. I mean, this year is like two weeks old. So are we talking about each new contract that comes up as it comes up, and it kind of rolls over like the next five years? I just want to understand a little bit more about what's new about the, you know, because pricing has gone down like the last 30 years straight.

Yeah, Glenn, this is Ronald. Let me start on that, and then Eric will probably want to say something on it. The way pricing works in the, or historically has worked in this business, and particularly for us, since our business is disproportionately for asset managers, is that when you reprice, there are some assumptions built in around market, and as importantly, around flows. I mean, if you serve asset managers, you get the business, and then over time it accumulates. We've gone through, the industry has gone through a very large number of repricings for all the reasons that I have outlined earlier in terms of the pressure that clients are under, and those same assumptions, at least on our part, have been applied, and I assume on everybody else's part. We had a year of a very sharp down market, and as importantly, no flows. So, between the volume of pricing and the fact that the usual kind of assumptions haven't yet played out, that's what's led to, one, our results, particularly towards the latter half of 2018, and second, for our outlook. Now, obviously, we have to, as part of the pricing discipline that we've talked about, we're rethinking these assumptions in terms of market and how much, if at all, to rely on flows, but that's really what we're referring to here. Do you want to add anything?

Yeah, Glenn, I'd just add that historically we've seen pricing headwinds for decades in this business, just part of the underlying assumptions, there's some pricing headwinds offset by flows and activity and market appreciation. That's how the structure of the contracts are set up, and those have historically been in the one and a half to two percent range, literally over the last half decade. We've gone back a decade, and we've got that history. We've seen closer to four percent headwinds this year, and if we think about the coming year, we expect about the same. That said, we've been renegotiating our contracts and extending term. We've been putting in place some clarity around expectations on volumes and market levels and so forth. While we're a bit more than halfway through those contract negotiations, the negotiations happen, then the fee changes occur, and then we actually have to live through that. So we're just a bit below the majority of what we are going to need to live through, and that's just part of what we have to navigate. I will say that the fee headwinds tend to hit a little more in the earlier part of the year than the latter part, just because of the kind of calendarization, and so that's incorporated in our forecast. The net is that at the end of the day, this is part of our industry. We feel like this is a wave. It's a larger wave than we've seen in the past and than usual, and we think there will be some reversion to the mean. But that said, it strengthens our resolve, and we've got to work on expenses. We've got to take expenses out. We've got to improve productivity, and we've got to adjust our cost structure to be in line with what the revenues are that we can earn.

Great. That actually leads to just my other follow-up, is if you could talk about the timing and ramping of, say, both the cost-save program because it's more headcount than comp-focused, and then also while we're at it, the timing and ramping of the one but not yet funded pipeline, because those could be partial offsets as well, obviously.

Yeah, let me start on the expense side, because that's, you know, I've been spending a lot of my time personally with Ron and the management team on that, and I think you saw in my prepared remarks, I gave you a sense of what we expect to do in terms of expenses for the year, you know, on an underlying basis down 1 percent, and because we've been intervening, you know, month by month and quarter by quarter, we expect total expenses to be down on an underlying basis by about 2 percentage points from 4 to 1. We're trying to just adjust, and that just comes in stepwise increments. I think at the same time, there are some ramping of some of the ongoing investments that we need to do, and so that's what, you know, that's what will get the lines to meet at about that 1 percent down for the year. But, you know, we're trying to peel off expenses. We've got a relatively, you know, fixed cost base, so we've got to take it down in steps, and at the same time, we've got to do it carefully so that we, you know, we continue to serve our clients well and, you know, and deliver the services in the highest quality manner.

Okay, thank you.

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

Hi, good morning. Hey, Eric, I was wondering if you could help us flush out the point you made about not run the rating CRD, and can you help us understand just what your expected contribution would be, if possible, both on the revenue side for, you know, for more of a full year 19 basis and also on the cost side? I think what you've given us is the underlying on the expense, but it would be helpful if we could, you know, give us a sense of how you're thinking about the CRD ads. Thanks.

Sure. Let me describe CRD in a little more detail, and I think we provided the fourth quarter of the year for P&L here on page 10 of the materials. Think about it this way. Revenues have a seasonality in CRD because of the kind of natural calendarization that happens in sales in a software-oriented business, and I think you'll see that in most of the software businesses that you or some of your colleagues may cover. We disclose that the fourth quarter is typically 30 to 35% of full year revenues. That's a rough amount. It'll vary a bit, but that's probably at least something to start with. And so, you know, part of the guidance I gave on total fees for four Q to one Q includes the natural down pick that you'd see after that fourth quarter seasonal position, and I think you can kind of build models off of that. In terms of expenses, you know, these are our first quarterly expenses. What we are doing in CRD is all the things you'd expect and we've described, right? We're tackling those 80 or 90 client engagements. We've begun to build out the sales force further. That was part of our intentions. We've added and we are adding, you know, product engineers for installation because that tends to be the bottleneck, not just sales, but actually the ability to install in a timely manner. So the expenses for CRD will ramp during the year as we integrate. That's all part of the accretion dilution analysis and commitments we made. And so I think you've got to assume some ramp that would be representative of what you might do, you know, where you'd run a software company where you're trying to effectively double the revenue growth rate because that is the underlying goal. Remember, the original growth rate in this business historically over the last four or five years has been about 7% top line. The kind of on Charles River synergies should take that through a series of different actions to double that. And so we need to invest in the earlier quarters and years to deliver on that.

Okay, got it. And then if I just take that back up to the top of the house, I think the comments you gave us on the fees were an all inclusive basis. So if I think about what you just added on the CRD, what's your concept of just the – and I know it's harder given your opening comments, but just the ability to deliver positive operating leverage and given the tougher market environment and some of the pricing points and how are you trying to balance that? Can you do positive fee operating leverage with this outlook or is it just going to be one of those, hey, we've got to make it through this and then the longer term we come back to it as the market improves?

Ken, it's more of the latter to be honest, right? I've been real clear about the change in the market environment just over the last month and a half, right, whether it's equity market levels, whether it's even lower flows. I think December long term outflows between US and Europe were just in December were $100 billion negative. Through November of the year, they weren't even $200 billion negative. And then we have all the geopolitical and macroeconomic and trade questions. And so that makes us feel that we should be conservative and careful in how we run the company. And as a result, I think what we've done here as part of our prepared remarks is be real clear about what we can do and should be doing on expenses. We are – we think there's a range of – I think there's a range of scenarios on revenues. And what I'd rather do is just give you good visibility into the coming quarter or quarters on revenue as I get that and then real commitments on the expenses and just be in touch as developments change. Understood.

Okay.

Thanks, Eric.

Ken, what I would add to that is that we believe we need to manage the company with this somewhat muted outlook. There's so much uncertainty out there in terms of the macro environment, what it means for markets, and what it means for investor flows. Having said that, we continue to be very encouraged by the client activity that we see. Some of it Charles River driven, some of it driven simply by our increase in service quality and the drive for clients to think about more consolidation. But we really do understand that those macro effects can actually overwhelm anything that we might do and that I'm actually confident we will do on the revenue side. So it makes sense for us to manage the company on an expense basis with that muted outlook.

Understood. Thanks again, Ron.

Your next question comes from the line of Brennan Hawkins of UBS.

Good morning, guys. Thanks for taking the question. I just want to try to think about this in the context of the medium-term targets that you guys laid out in early December. I believe the targets included a 10 to 15% gap EPS. And it was my understanding that that was the one medium-term metric that actually intended to apply for each year. It would apply to actually 2019. So number one, now that we know what gap EPS for 18 is at 640, I want to make sure that that is still intact. And then maybe help me understand how to get there because to think about adding in CRD operating expenses of, you know, 160 and amortization and such to the expense guide that you give in the deck with that of the cuts you're making and then also layering in the air cure reference to some sustained Fibrate pressure, which seemed like we had stability in 4Q, but maybe you're indicating that that's temporary and we should think about some further Fibrate pressure from here. So maybe I might not be thinking about it correctly. Hopefully you can provide some clarity. Thanks.

Brennan, it's Eric. Let me take that. You know, we made some very clear commitments for the medium-term across a series of different financial elements from capital return to reigniting revenue growth, EPS and so forth. I think in the last month and a half, as I said in my remarks, the environment has really changed for this year, 2019. And, you know, whether it's the equity markets off 10 percent, whether it's long-term flows racking, you know, one of the worst months of the last few years, whether it's the geopolitical and economic environment, you know, taking another step down or sideways. You know, we now think there's a wider range of revenue scenarios than I think we consciously had in mind in early December as we put up those medium-term targets. So I think from my perspective is we are going to hold to the medium-term targets. I think the 2019 year itself is going to be a more challenging one. And, you know, at this point, what I would not like to do is be too optimistic. I think a year ago, you know, in this call, we were a bit too optimistic as the environment changed and didn't react quickly enough. And I think our perspective is we've got to take a more conservative perspective here and, you know, update you as it comes. But I think 2019 will be more challenging than we had expected just a couple of months ago.

Okay, great. Thank you. Thanks for clarifying that. Good to know my math isn't totally way off. And then thinking about the deposit cost front for my follow-up, you guys continue to show a 50% beta, which is encouraging. It looks like the likelihood of a further rate hike has deteriorated. So can you walk us through maybe how we should think about deposit cost pressure and your expectations for deposit costs in a 2019 where we don't see further increases in short-term rates? Could we still continue to see upward pressure on that deposit cost and what are your expectations there? Thanks.

Sure, Brennan. Deposit costs and betas, you know, will continue to float upwards. I think we've been, you know, two years ago, you know, early on we were in the 20% range for betas. We moved into the -35% range for a while. This year we're, you know, right smack in the middle of the, you know, -55% range. And, you know, we certainly expect that during the year that will continue to tick up. And we've seen that in other, you know, in other firms. And so that's inherent in our forecast. We think it'll jump up to, you know, very, very high levels. We don't have any indication that that would be the case. And so we just expect a continued grind up of betas and a continued, you know, modest transition from non-interest bearing into interest bearing. I think one of the things that gives us confidence in the NII outlook of, you know, low single digits to mid single digits is that just by virtue of the fourth Q step off, right, we build off of that during the course of the year. As we've, you know, expanded our client coverage program, one of the earliest efforts that Ron and I started, I'd say it was probably about a year ago, was actually client engagement on deposits, right, the full suite of what they need to do with their cash. And that in our minds has actually really solidified the, you know, the deposit gathering with our clients and gives us some capability to put the right amount of volume of deposits on our balance sheet. And so, you know, what we would like to do this year and obviously, you know, subject to ebbs and flows in the market is to, you know, not only hold deposits steady, but see if we can drive them up somewhat because that would be part of how we deploy the balance sheet in a positive way. And if we can do that, plus get some of that, you know, high quality lending that the, you know, Fortiac fund, you know, leverage fund needs or the private equity capital call lending that they need, you know, that would be that would also be positive. So there are a couple of different dimensions there that we're working on to drive some growth in this coming year.

Thanks for the cover here.

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

Thanks. Hey, good morning, guys. So I was hoping we can double click on some of the things we talked about here in more detail. So I guess starting with fee pressure, I guess one, I guess what gives you guys confidence that the pressure will normalize beyond 2019? So sort of why doesn't the 4% annual drag doesn't continue beyond that period? And if you guys could provide a little bit of color in terms of customer segments in particular, you know, client types, geographies, things like that to help us get a better flavor where the pain points are.

Alex is Ron. I think that where I begin on that is that the much of the pricing discussions have occurred and started in earnest with the combination of the ongoing pressure on the big active managers or managers in general, but certainly big active managers. While at the same time, markets were running up and clients were seeing that, you know, state straight and bony melon, everybody else is gathering more revenues for doing really the same things. So it led to what we would view as an accelerated amount and a heightened amount of fee discussions. As Eric outlined, though, when we as we've gone into this period, one, we've moved in and pretty much insisted upon term for our pricing. So to, in other words, to make it a little less variable than it's been in the past. And second, in most cases, we've actually gathered more business as part of the pricing discussion. So the reason why we feel confident that it will abate, it's never going to go away, but that it will abate is one, as Eric noted, I think we're through about just over 50% of our clients in terms of discussions on this, a little bit more than that. And for the ones that we've done it, we've extended term and gotten more business. So that's why we would feel that this is a bit of a cyclical low here, but feel confident that it should improve.

Alex, it's Eric. I'd just also say that this is obviously a phenomenon that started in the U.S. The U.S. asset managers were under more pressure sooner and earlier, right, because of the flow of the flows of active to passive. We've had now, you know, similar discussions in Europe. There we think it's not going to be quite as difficult, partly because, you know, the kind of the ETF mutual fund, you know, differential isn't as sizable, but we'll see. So it's affecting, though, primarily the asset managers as the segment that's seeing, you know, where those are most intense. And a little less so some of the other, you know, the other pension or insurance type companies. You know, that said, you know, the we've had run ups in the marketplace and oftentimes these fee negotiations become more intense after run ups in the marketplace. Why? Because if you just think about yourself being an asset manager, right, you're paying us on fees that are scaled to market levels. And so as the markets appreciate, you look at your bill, your bill is going up and your natural inclination will be, well, let me go and talk to my bill provider about how can I get some of that back? And so we have seen as we've gone back for half a decade, a decade or more, some connection between run up in markets, followed by a by by by more severe adjustments in pricing. And so I think if we get some normalization to kind of more steady growth in markets, you know, we think we'll get some reversion of the mean, whether this 4% level goes back to the one and a half to 2%. We'll see whether it goes back to somewhere between them. We'll see. And obviously, as we we see more, we'll we'll share more with you.

Great. That's helpful. Color. Thanks. And then my second question was around securities lending, you know, looking at one hundred and twenty million dollar run rate this quarter. Can you help break out what's kind of still enhanced custody versus traditional agency model? And again, assuming environment stays roughly the same, is this sort of the low at one twenty run rate or you guys still working through how to reposition the enhanced custody business for CICAR? I thought you said earlier in the call that that's still a bit ongoing. So I'm just trying to get a better sense of what the jumping off point is.

Yeah, at this point, the you know, the revenues and securities lending were, let's see, about one hundred and twenty for the quarter. It's, you know, roughly 60, 40, 55, 45, classic agency lending versus enhanced custody. So it's kind of been that in in that range. I think the the there are two things going on right now in this area, and it's really around the agency area. I think we've seen some stability, you know, reasonable stability in enhanced custody. But on the classic agency lending, we've seen some real, you know, market, you know, with with market levels falling, you have, you know, there are just, you know, assets on loans are lower. We've seen the leveraging by some of the hedge funds who need to borrow. And so there is less demand out there. And as a result, you know, spreads, spreads have come down as well. And I think the question is, what happens? One question is, what happens to market levels and demand in first quarter? And if you remember, you know, you know, we ended December, I think, at close to 10 percent below, you know, S&P levels for October, November. You know, we've had a little bit of a bounce back. But if that persists, we're still likely to have a lower average, highly likely to have a lower average first quarter than fourth quarter. And so that's going to create some dampening measures on demand. And you still have some hedge funds continue to to deleverage. So there's a there's clearly a market demand element here that makes us feel careful about the four Q to one Q and is embedded in my, you know, my my sequential fee guidance. I think the other part is, you know, the the counterparty work that we've had to do with CICAR does have more of an effect on SEC lending. And while I think we've been through most of it, I don't think we've been through all of it in the agency space, which is kind of just a little more than half of SEC lending in FX. I think we've done a terrific job in diversifying counterparties, novating, doing compression trades. Right. The tools are quite vast and the number of counterparties out there are quite significant. And the the teams really turned on a dime to kind of adjust their processes in agency lending. It's a much more concentrated business. There's fewer kind of transaction types available to us. And so it's something we're we're working through and and need a little bit of time on. That said, I would tell you, you know, agency lending and securities lending and enhanced custody continues to be an area of innovation for us. So the question is, how can you structure trades and various approaches to actually refine and actually connect counterparties as opposed to always be the intermediary and still earn a fee and effectively add innovation in what's been a historically unchanged marketplace? So more to come on that. We'll certainly talk more over the coming quarters.

Great. Appreciate you taking the questions.

Thanks. Your next question comes from a line of Bessie Kracik with Morgan Stanley. Hey, good morning.

Hi, Beth.

Hi, Eric. Just to follow up on that, could you give us a sense of if you ran through your new positioning on last year's CICAR, how much it would have changed the results?

I'm chuckling, Betsy, because, you know, that's the question we our capital team would like to ask the Fed, right? That's the you know, how do you know how do the models work? I tell you this, that on the investment portfolio, we and I think the other, you know, large banks have done quite a bit of work on the mark to market effect and how the mark to market on the OCI position could be modeled. And we've now got five, six, I think we've got six or more data points, but they're data points with changing portfolios. So, you know, how much is it worth? It's it's it's it's I think we've got a range of estimates. I think the the reason we felt comfortable saying that we're, you know, optimistic about our capital positions, if you think about it, you know, if we have, you know, if we have earnings of, you know, what it's been, you know, two and a half, three billion a year, we know how much we'd like to return. We know what, you know, every 10 percentage points of those earnings are in terms of capital return. And so, you know, if, you know, 10 percentage points of capital return is three hundred million dollars, right? You know, we have some sense for how much you'd have to adjust the mark to market impact to create another 10 percentage points or 20 percentage points of return. And that's kind of the math we've done. So I don't I don't really want to be in a position to to predict, you know, AOC impacts on our portfolio. You know, we we you know, we could all do rough estimates, but that's how we've thought about it. And that's maybe the kind of the the quantitative context I'd share with you.

OK, and then just separately, you know, the feds talked about proposing C-car stress tests that's only run on RWAs and not on leverage ratios. Have you thought through what that could mean for you?

Yeah, I think we've done the modeling of that. I think there's been a fair amount of outside in modeling. And right now, I think, you know, tier one leverages are finding constraint under the stress test. You know, the difference between a tier one leverage binding constraint versus an RWA binding constraint, while it's not perfectly discernible, you know, rough estimates, you know, billion dollar range, maybe a billion and a half. But it kind of depends on exactly how the test is run, what the timing is of the various market factors and so forth. But that has some real material benefit. And I think we are optimistic that with the, you know, CREPO bill having passed and the Fed working on the implementation of that and some of the vice chairmans, I think there's a, you know, comment that there's some real movement and it's just a matter of time and hopefully, you know, months, not quarters when we hear more. But it'll be it's an important positive for us.

Okay, thanks. And then just a little bigger picture. I know you've talked a bit about, you know, if then scenarios on revenues and expenses. And I guess I'm just trying to understand if you have a more muted revenue outlook. Ron, maybe you could just give us a sense as to do you have to invest to get further cost saves or do you feel like there still is opportunity? Because I know you did a big restructuring here and I'm just trying to understand is further potential expense opportunities really incremental or, you know, is there more wood that you can chop?

Yeah, so we've what we've done is gone after the expenses that we just should go after. And second, what we believe we need to go after, given what you're hearing from us, is a cautious outlook going forward. If your question is, is there more to go after? Of course there is. And we've got, as we've noted, a comprehensive program in place that we actually expect to be able to drive more. We also have the work that's been done in the past that I can't emphasize enough in terms of beacon, the work that's underway in terms of consolidating our delivery and all of our operations. And those efforts will continue to pay off in 2019 and beyond. And then finally, to the extent to which we saw an environment that was even worse than the cautious one that you're hearing from us, we'd obviously start to look at things like the pattern of investment. I mean, that's the last thing we'll go after because we do believe that it's important. We have what we think is a sensible investment program adjusted to the opportunities and market realities. But if we had to, we'd look at that again too.

Okay, thanks. Your next question comes from a line of Brian Bonnell with Deutsche Bank.

Maybe I'll just start with expenses and then move on to a revenue growth question. So first, just on expenses, just to clarify for 2019, I'm getting basically to about an $8.6 billion core expense run rate. And what you exclude from that is the CRD amortization and any CRD acquisition-related expenses. But it would also include delivery costs to achieve the revenue synergies that you outlined when you did the deal, which would be some portion of that $180 to $200. And maybe if you can, Eric, if you can talk about how you're looking at those delivery costs for 2019. And then the trajectory of expenses going into 2020, given that we're potentially gliding down on expenses and saves as the year goes on.

Yeah, Brian, it's Eric. Let me try to do this from a couple of different interactions. I think page 16 of the deck is probably a helpful starting point because we kind of define the underlying 2018 expenses, as you know, that's XCRD and so forth. And then where we expect those to end at the end of 2019. I think you do need to put CRD in there. We talked about the first quarter, scale it up. And I think while we will be investing, I'd ask you to think through how quickly can you invest well in a business, right? There's a little bit of a bounding limit there. And if you're at a $40 million run rate in 4Q, you know, it's just think about I think there's a range, but I think you can quickly come to what's reasonable versus an unreasonable set of expense growth rate off of that level. So I think you can work off of that. You do have to factor in the intangible amortization, which we've defined there. And then the acquisition restructuring costs will also flow through. I think this quarter is a good example of what a run rate could be on a quarterly basis, but we'll obviously take those as they come, you know, in line with the actions we take and the appropriate accounting. So those are the pieces. Happy to, you know, work with you and our IR team to, you know, to take a look at how you're modeling it out and take things from there.

Okay. We'll do that offline. And then just on the revenue side, maybe Ron, if you could just characterize how those conversations are going. You mentioned the 98 client engagements with Charles River customers. And if you could give some perspective, maybe some refresh perspective on the trajectory of revenue synergies. Appreciate that. That's a 2021 goal. But if you could sort of give us a sense of how optimistic you are on winning new business, you know, from the game plan of talking with the CRD clients, you know, and the concept that you mentioned at the outset of the pressure the asset managers are facing on whether they're, you know, very receptive to, you know, the partnering concepts.

Yeah. So let me start with the question on optimism. We're very optimistic about achieving, if not exceeding, those revenue synergy goals. The nature of the conversations, let me give you some sense of those. Some of them are simply that they're CRD clients. They like the new owner. The new owner is in private equity, so they see stability. And there's just more CRD activity happening, more movement from shrink wrap to cloud, all of which is good from a revenue and profitability perspective from CRD. There's also a series of client conversations where it may be a State Street client with no CRD presence or a CRD client that sees the value of having more of their activities with State Street and CRD together. And the attraction of those, of course, is simplification of the internal operations and operating stack and technology stack. And then there's a set of conversations that we, in all honesty, hadn't expected to be having, which is clients where we either don't serve them now or we serve them in a minimal way or even in a couple of cases where there was a competitive bidding situation and we didn't have the capacity to do that. And then there's also the conversations that we have with the market, which is a lot of the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years, the things that we've talked about in the last couple of years,

the things that we've talked And do you think you can, based on those conversations achieve those revenue synergies in a potentially a linear fashion over the next three years, or more hockey stick towards 20 and 21?

It's a little bit too early to tell them whether the pattern is going to change, Brian, because these are pretty comprehensive discussions. You try and move them along as fast as you can, but they take time because you're really talking about a once in a generation change in these firms in terms of how they're going to run their business. So right now we're sticking to the timeframe, but I would emphasize that we're highly confident in achieving the amount.

Great. Great. Thanks very much.

Your next question comes from the line of Mike Carrier with Bank of America, Maryland.

Good morning. So first question, just on expenses, I guess I want to kind of step away from the expense program, the 350, but just thinking about sort of the core business, what has been done to make the cost structure maybe more variable, just given some of the uncertainties that you have on the revenue side, some of the pricing trends that you're seeing. And basically the revenue is going to be hard to predict. I'm just trying to gauge when we think about some of the lines like comp, transaction, other, how much of that is variable that can kind of have a flow with the revenue backdrop versus what's fixed or more structural.

Mike it's Eric. Let me start on that one because the nature of our business has actually become, in terms of expenses, more fixed than variable. And partly that is as we automate, as we put more capital work and labor, and we need to make that shift be even more dramatic, to be honest. And I think as Ron describes, we feel good about some of the investments we've made and some of the automation, but I don't think we've sufficiently adjusted the stack of labor that we have against it. But our business is actually becoming more fixed than variable over time. And I think that means two things. I think that means from an expense program and programmatic standpoint, we need to find ways to take out step level, kind of step function expenses out of our expense base. So as we automate, we need to take labor out. As we work with vendors, we need to find ways to adjust downwards as we get larger and they get larger and we force the scale benefits to accrue to both parties. So that's part of what we just need to do because of the nature of how this business has evolved relative to where it was as a highly manual, highly variable business 10, 20, 30 years ago. I think the second perspective that we've developed as a senior team here is because it's more fixed than variable, we actually need to find ways that in good times, we create more margin expansion and more leverage. Because in truth, while we have an ability to take some step wise and step function reductions in the expenses in difficult times, it's hard to adjust the level that we would like given that revenues could move as much as they are moving up or down. And so I think our historic belief that we should run with operating leverage of maybe a point in good times, I think that's not really something that makes sense as we step back and think about how this business has been operated. It may have made sense in the past, but that's something that we need to change. And so we first need to work through this particular market environment, but that gives you at least some context as to how we're thinking about this going forward as well.

Mike, I want to add to Eric's last point there because I think part of the challenge that we're facing now is that in the past, the costs have been too variable as the business has grown. And it's not that there were people who were being spendthrift. We had these distributed operations and we just weren't achieving scale benefits as rapidly as we could have been. With the work that's been done over the last year, not just beacon but this consolidation of our operations into this global delivery group and the creation and running of these hubs, that is the goal, is to achieve much better scale benefits. And as a consequence, we should be able to deliver what Eric's talking about in terms of in good times actually more operating leverage than we have in the past.

Okay, that's helpful. And then just a quick follow-up. You guys mentioned some of the pricing challenges across most of the asset service and asset management industry. We're seeing that. But when you think about some of the other products, services that you're offering, where are you seeing the areas where you're not seeing maybe the same level of pressure? There's more maybe growth opportunity that you can allocate resources to.

Mike, it's Eric. I think the answer to your question really is around the product stack that we offer. If you think about it, custody, for example, is the most commoditized of our products. Then there's accounting. Then there's fund administration, the prospectus creation. Then there's middle office where I think we've actually gotten to be better about how we and smarter about how we price and operate that business. As you move up the product stack, I think we see, and actually more recently with some of the new SEC reporting requirements and so forth, we see more pricing power. I think in fact in terms of something like CRDR software, there's actually effectively inflation escalators in contracts because of the nature of that business and of that industry. Part of this is where you are in the stack, which actually I think encourages us to continue to pivot and make sure that when we're offering custody, we also do accounting. When we do accounting, we also do administration and so on and so forth. That's maybe a little bit of flavor as to where you have strength. I think the other place is we have found that where we have clients that are moving in different directions, deleveraging or what have you, and as their books adjust downwards, we have gone back and said, look, we need to adjust pricing accordingly. In particular in the hedge fund space, that's been an important part of the back and forth. Then lastly, I tell you the other place that we're working through as pricing is not only as we have price discussions, we ask for more share of wallet in a much more rigorous and disciplined manner and controlled manner. Ron and I have put in place with some of our most senior folks very rigorous processes there, but we've also had very active discussions about being paid for in different ways, being paid for with more deposits left with us than with some of the other players. That's been another area where I think we've found some ability to be paid appropriately for the service we provide.

Okay. Thanks a lot.

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

Good morning. Maybe just a follow-up on, Eric, on your outlook on NII and NIM. If the Fed were to stop, historically state trade has seen leverage once the Fed stops as assets repriced and deposit betas typically, or deposit repricing has stopped pretty quickly because you have high deposit betas during rate hikes and then we stop. Sounds like you didn't reinforce that view. Has something changed or should we, how do you think about Fed deposit pricing once the Fed stops and given where your securities portfolio yield is, it's still well below 2% to your treasury. Should we expect your securities yield to grind a little higher over once the Fed stops? So just thoughts on NIM.

Yeah. Let me tackle it from a couple different directions. I think if the Fed stops now, there are a couple ways that we will get some incremental growth in NII. First, you just get the fourth quarter run rate over the earlier quarters will create a full year effect in 19 relative to 18. That's the first piece. The second piece as you described is that the investment portfolio tractor continues to work upwards and that's worth, we continue to have investment coupons higher than those that are falling off. It's a little more complicated for our book because we operate not only in the US geography but also the international geography. There is more there. I think third, there is a continued mixing of the portfolio. We've historically run with a very large kind of a barbell portfolio of credit and treasuries. I think you've seen in some of the changes that we made the first quarter of 19, of 18 and then the fourth quarter of 18, you've seen we've shifted into more of an agency MBS portfolio. That gives us some pick up relative to treasuries and then we've also shifted in the foreign sovereigns. You can't see it directly but out of some of the sovereigns versus some of the supras and the other types of global government agencies. We think there is some amount of grind upwards. Then I think the final one which in some ways is most connected to the business is how do we continue to engage with our clients on cash and how do we find ways to create better solutions for them on cash. I think that's where it's not only their cash position but it's their needs for repo, whether it's direct repo or FIC repo. It's their money market sweeps and so forth. Each one of those is a very engaged conversation to the extent that we can drive some amount of volume growth. We feel like that can fall to the bottom line and that we can just report on as we see developments.

On the deposit pricing point, deposit prices go up still despite no rate hikes?

No, I think you get a little bit of a tail end of December flowing through the first quarter but you get some relative stability in deposit pricing I think on a direct basis. I think the question is how much competition is there out there in a flat rate environment? I think what happens is what happens to the competition for deposits in the banking system? While we don't directly compete, there is always some spillover effect. If we get a situation where lending grows relatively quickly for a time period, back to the 5, 6, 7, 8 percent range and banks need to fund that lending with deposits and there is more deposit competition, then you can see pricing go in the favor of clients and against the favor of the banks. I don't think we see that at this point but we are always watching carefully.

As a follow-up question, just on your fee revenue forecast, can you just for our modeling purposes help us understand what market levels you are kind of assuming? I see that in the footnote you talk about 5 percent growth from December levels. Obviously right now we are up 6 to 8 percent in the U.S. depending on which index. What are you assuming in your first and second quarters to give us that kind of fee guidance?

At this point what we have done is we have started off with the December 31st step off. We have done that for the U.S. and for the international markets as well. I am a little cautious on a particular quarter. That is why I gave some guidance on total fees for 1Q. The way our pricing works is some of it is geared to the month end. Some of it is geared to daily averages. Sometimes it is a two-point average. There is a mix. It was not helpful that you get that December 31st print. I think the other part that is going on here is flows and client activity matter. I think in my remark that described that flows, the natural course of business on flows, and remember we get because of the size of our business in the U.S. and in EMEA for asset managers, we get about a third of the inflows that you see in the industry. We get that in our books and records, in our custodial accounts. Those kinds of flows and then the client activity, all that transactional activity is material. That is historically been two percentage points of growth over the course of annually. Right now we are not seeing very much of that at all. That is another reason why we are quite cautious on the first quarter. We added a little bit of wording around that as well. Thank you.

Our next question comes from Brian Klein Hansel with KBW.

Good morning. A quick question on the market sensitivity that you gave. You mentioned that a 5% uplift is $25 million in servicing fees. If you put that relative to what the 2018 revenues are, it is about a 1% revenue uptick for the 5% uplift in the markets. Last quarter when you gave that, it was 10% gives you a 3% increase, so a 30% pull-through rate. This quarter now it is down to a 20% pull-through rate. When you finish all these renegotiations that you have ongoing, how does the market sensitivity look when all is said and done? Do you expect it to be another step down for market sensitivity from here?

Brian and Serik, I think we gave relatively consistent guidance. The historical guidance that we have given is around 10% change in equity markets is worth about 3 percentage points. On a base of $5 billion of servicing fees, that is about $150 million. I think what I said earlier today in my prepared remarks is that 5 percentage points, about 10, is worth about 25 a quarter, but you lose part of that first quarter. You get a little more than 75. You call it 85 to 90. You are within the range of that 10% and 3%, which would give you $150 million. The other part of that is you get a little bit of sensitivity on management fees that you also have to work through. We can go through that with you offline, but just trying to give some ranges there so that you could do a little bit of estimation.

The general assumption is it should be moving lower as you are trying to move to more fixed pricing in the asset servicing business?

Just to clarify, what has happened on the cost structure is the cost structure has become more fixed and less variable. That is on the cost side. On the pricing side, I don't think we have really seen shifts in pricing and pricing structures at this point. At this point, we still have pricing which has asset levels as the basis. We have some pricing that is around transactional fees, and then we have some pricing that is fixed, but there is still some real variability baked into our pricing. We don't see that pricing structure as having changed in new contracts that we are negotiating now relative to those that we have had. It is where the level of pricing has been adjusted downwards. What we are trying to do in several different ways is put controls around our internal processes on how those are negotiated, what we get for them not only in terms of servicing fees and markets and FX and security planning and deposits, but also who is engaged at what level of seniority in those discussions because those are in some ways the most important discussions that we should be having at the most senior levels in our counterparty.

I just want to clarify one thing on that fee guidance that you had mentioned. You were talking about AUM and AUC right before you gave the guidance, but you were talking about total fee revenues being down 3% to 4% in the first quarter from fourth quarter, correct?

Yes, that is correct. That just includes all of our fee categories. Okay, thanks.

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

Hey, Ron, I hear what you are saying. You have a new expense program, merger synergies with Charles River, you are increasing intensity, but here is my question. What assurance can you give that savings will be sustainable and what is your new pre-tax margin target? Before answering, here is what is in my head. State Street said that it achieved all savings from business ops and IT transformation and almost all the savings from Project Beacon and had a target at the start of the decade to improve the pre-tax margin from 29% in 2010 to 33%. But over this eight-year period, State Street not only missed its own pre-tax margin target, but the pre-tax margin declined from 29% in 2010 to 28% last year. So while the pre-tax margin got worse over eight years, State Street took victory laps on earnings calls and press releases and its proxy. And Ron, I know this predates you, but still this is a question. To what extent is the board looking after shareholder interest? To what extent would State Street apply callbacks to the prior CEO's pay? Jay, a great A person, he has always treated me well, you guys have given me access, but at some point don't you have to look at the business and say, well, actually the targets were not met. But again, the question is what assurance can you give that the new potential savings are sustainable? Thank you.

Mike, I'm not going to spend too much time on what happened in the past, although a lot happened over that decade in terms of regulatory costs and things like that that may or may not have been in any forecast or presented. But let me talk about going forward in the assurances here. One, there's been a lot of work done and I keep coming back to Beacon. I keep coming back to what we're doing in terms of consolidated operations that we have not realized the full promise from. We need to accelerate that. But this is not something that we're just thinking about. This is actually work that's underway, has been completed, and we need to make sure that we realize the benefits from that. Two, as we were talking about earlier, the business, as revenues have come on in this firm, costs have gone up almost at the same rate. We have not gotten sufficient scale advantages. Because of the work that's been done and frankly because of the way we're going to manage the business going forward, we will capture more scale benefits. Three, the board is very involved in this. We've worked with them on our new performance management and accountability system. And there's a very, very close tie, more so than ever, between pay and performance. And so we've got incentives aligned across the firm. So I'm confident that we will deliver on what we've said here. And we need to do that because we understand that firstly, just to be in a position to be able to service the business that we see coming down the road, we have to achieve all this. Secondly, we recognize that while there's certain things we can control, there's a lot of things we can't, such as markets, such as client flows and things like that. So therefore, that's why we need to redouble the efforts around there so in those periods like a 2018, that we don't see that same kind of fall off.

And just a follow-up, again, from someone who's covered State Street for a while and again this pre-Day 2, a lot of comments about the success of these prior programs. When Business Ops and IT Transformation was first launched, it talked about improving scale and you think you'd see the scale benefits in the pre-tax margin. So what's your more fresh view? Do you say what should investors think about State Street for the past decade, given the success of these programs, but then the bottom line not really changing as much? What's your more fresh perspective?

I'd point to two things. One is that I don't think that anybody at the beginning of the last decade anticipated the significance of regulatory costs increase and just what that would be. Second, we have been slow to achieve scale. We have not achieved as much scale at the pace that we should have and that's where we've got laser focus right now. Thank you.

Our next question comes from the line of Gerald Cassidy with RBC.

Thank you. Good morning, guys. Eric, can you share with us when you look at your fee revenue for this quarter, let's call it $2.3 billion, you gave us some color on the servicing fee, you know, sensitivity to the markets. But out of the total $2.3 billion, how much is that equity related? Ron mentioned that you've got a disproportionate amount of equity customers in your client base. So what would be a good estimate of that number being tied to equity type customers?

I think we I'm trying to think if we have a quantitative estimate in our disclosure on that, we do disclose the mix of some of the AUCAs in our supplement, the mix of equities in for our asset management business. And then obviously, SEC lending is a heavy equity based, you know, underlying business. So I do think that we have higher equity exposure than then then then kind of the servicing industry in aggregate. I don't I don't know that I have a you know, an excellent estimate because remember, even when we custody for, you know, for funds, there are multi asset funds. There's you know, there's a there's a wide range. If you do turn to page nine in our financial supplement, you will see that there is one part of our $31.6 trillion of assets under custody. And we described 18 billion of those being being equity based. So I think that's a good indication on the custodial side. And then on the asset management side, you know, we also do the the equity cut on page 10. So, you know, it's significant. It's in the, you know, you can see it's in the, you know, 55, 60, 60, 60 ish percentage range. And so we are somewhat dependent on equity markets. I think that's why, you know, in good times, we need, you know, we're going to be able to benefit from that. But we also need to make sure that we are, you know, heavily that we're we're always careful on expenses and create that that scalable cost base so that we don't actually add too many costs in good times so that we can navigate through. But it is it's certainly part of our business model.

Very

good. And then to follow up, I think, Ron, you touched on the pricing headwinds, you know, historically, or maybe Eric, you brought it up that one and a half to 2% was something that was common. But it looked like in 2018, it bumped up to 4%. You're looking for something similar in 2019. What's driving that? Is it competitors are just being much more aggressive and they're willing to price products? I think that maybe, you know, leading a loss is just a way of getting the business and maybe cross selling other products. But what do you think has driven it up to doubling and what it used to be?

Right. I think it's what we said earlier, the the the amount of these clients are under quite high. The typical asset manager, whether you're large, medium or small. So there's just inordinate pressure coming from the client base would be number one. Number two, this assumption, particularly when you're pricing an asset management client, that they'll be both market and fees that will over time actually make what looks like an entry level price. That takes an entry level price that may look like it's too thin, kind of make it fuller over time as flows and market help out. When that assumption goes away, it just lays bare that the that the that the price that you had as an initial price on a sustained basis, in fact, isn't sustainable. So, you know, at least for us can't speak for the rest of the industry. It has caused us to be much more careful about how we think about this, that in addition to getting more term so that pricing can't change overnight, looking at what other products. And as Eric talked about earlier, the product stack as you move up from custody becomes it tends to be less. It's not price insensitive, but less and less price sensitive or less and less commodity like, if you will. And looking hard at deposits and then, as importantly, making sure that we try and get another part of the wallet or some consolidation out of it. And in most cases, we're getting some or all of those kinds of things.

Great. I appreciate the color. Thank you.

Next question comes from the line of Stephen Choulock with Wolf Research.

Hi, good morning. So I wanted to ask a follow up question on capital return. Last year in CCAR, you were about 50 basis points short of that stress tier when leverage target. Your capital ratios are flat year on year. Eric, you gave a lot of really helpful color talking about the actions you've taken to improve your CCAR standing. What I'm wondering is if the Fed stress test assumptions are similar to last year, what gives you that confidence that you can achieve an 80 percent payout target? Should we view that more as a medium term target or do you think you can get there in the upcoming test?

It's Eric. We're optimistic about this upcoming task. There's no certainty on it. So we are optimistic. I think we're optimistic for two reasons that we have under control. And then there's one that we don't. The two that we do have are under our control are number one, the shape of the investment portfolio. And if you remember, we made adjustments in the first quarter of last year where we saw the results and how those played through into CCAR. So we had a good understanding of the kind of the change this and then results in that. And then we made some more adjustments the fourth quarter of this year based on some of those learnings and the other six data points we've had over the last year. The second one is because of the way we've now better understood the counterparty stress test that the Fed runs, right, we've actively intervened in terms of how we actually structure and limit our counterparty exposures across our businesses, whether that's in FX, whether that's in securities lending. And so we've made very conscious choices, some of which have impacted revenue. And you've seen that in particular in SEC lending to actually adjust our exposure levels. Now, we're trying to transact with our best clients as much as we used to before. But in some cases, we've had to be more calibrated. So we have literally, if we go down to the trading floor and the risk management team, they've literally had new parameters that they've installed that we've been operating at since the late summer and early fall. So both of those give us some confidence that we should be able to do better this year. You know, the obvious unknown is the test itself, right? There's the macroeconomic shock. What's in that? There is the global market trading book shock, which has the counterparty piece to it. And then it's everything else in the test, including assumptions for balance sheet growth and so forth. And on those areas, we don't have any new information, obviously won't until we see some of that in late this month or early next month. And then we see the test come through in June.

And just one more follow up for me on capital optimization efforts. You know, you've continued to have a significant amount of preferred in your capital stack, certainly well in excess of many of your GCEP peers. I was hoping you could speak to your capacity or appetite to maybe redeem some of those preferreds and how we could possibly think about the timing of redemptions and the associated savings.

Yeah, I think the way I would describe the capital stack is the capital stack is proportioned relative to how the current rules are written and implemented through through CICAR where leverage ratios matter. And so, you know, there's obviously an importance of having preps in the stack. If that were to change, we'd obviously reconsider. And so that would give us an opportunity to call or to adjust the alternative tier one component, which is the preps. I do think, though, as we go into CICAR, you know, our first priority is to return capital to our common equity holders, right? We're quite conscious of some of our deal activity and our issuances this past year. And we feel like the first priority is to get capital back to our common equity holders as we as we go through the CICAR process this year.

And just one quick follow up relating to that common equity remark. Just given the Fed's willingness to green light payouts north of 100 percent, the fact that they've clearly indicated that they're low to have this binary pass fail outcome, given the confidence levels that you have in all the changes that you've made to reposition yourself ahead of CICAR, would you actually look in the near term to maybe exceed that 80 percent in order to more aggressively mitigate the dilution impact from CRD?

We have said that we'd like to and we're optimistic that we can do better than 80 percent. So that's exactly the intention and intention and hope that we have. And I'll just be clear that that that there are some of both that that's necessary for that. But that is that is what we'd like to be able to deliver this year. And we believe we've made some of the adjustments necessary at our end of the the the that are under our own control to to effectuate that. So we're you know, we'd like to be able to deliver on that. That would be our intention given what we've how how how we're proceeding.

Understood. Thanks very much, Eric.

Your next question comes from the line of Jeffrey Elliott with Autonomous.

Good morning. Thanks for taking the question on the income guide. Just to be clear, first of all, the three to four percent down points to about two point two billion and then annualizing that. We'll kind of get to an annual run rate of about eight point eight. If that if that was sustained, is that is that right?

Yes, it's all right. That's that's right. I mean, that's where we're trying to start with where we are today. We're trying to adjust for the markets, the flows, the limited amount of client transaction activity. And then you have the lumpiness from trading from 40 to one cube. Right. So we're we always want to be careful and appropriately conservative there. And then there's just the you know, the six oh six effects of of Charles River. So we've tried to factor all that in to our to our estimates. And then we've said that, you know, that's that's a good run rate for several quarters. We'd like that to be, you know, just a quarter or two. Not not not very long, but we're trying to be careful here. And to be honest, we're trying to be careful about revenues because we think if we're doing that, then we're going to be even more effective and a droid intervention. It's on expenses and we think that's what we should demand of ourselves and what you would all expect of us. I think the scenarios on revenue, though, are very wide, to be honest, because there is the you know, a range of different market assumptions, flow assumptions and and underlying transaction activity. We just have some you know, we just have a little more visibility into the first quarter, including the usual adjustments on on market flows, macroeconomics and a little bit of pricing, which tends to be a little deeper in the first quarter than the out quarters, just the way the calendar works. And so we're just trying to factor that in. But off of that base, I think there's a range of scenarios and we'd obviously like to see more positive ones. And if we see those, you know, we will we've got a set of conference schedules set up in February and March and in May, where we'll certainly update for for for changes.

Got it. But it sounds like in the sort of markets assumptions that you're showing on slide 16, that could be a run rate that sticks around for a couple of courses. Is that is that fair? I just want to make sure that we're understanding it right.

Yeah, that could be the case. And that's what we're calibrating our expense work to.

Thank you.

Next question comes from the line of Isaac, Jr. with Morgan Stanley. Sorry, JP Morgan.

Hi, this is the back. Thanks. Hi, couple of questions. Hi. Couple of questions for you folks. Firstly, Eric, on CRD, the operating margin of the same Q4 because of fast six or six is a little bit inflated. What on a full year basis, what would you guide us to as a sort of a more normalized operating margin before you put in any cost savings or anything else?

The back. I think we disclosed back in July an operating margin for that business at around 50 percent on the old ASC 605 basis. I think the way the current year adjusts a bit, you might get for going from 605 to 606, just given the pattern of how you know what they've how they've done the accounting historically versus now, you get a small uptick in margin from there. I think then the modeling becomes has probably two facets going in. One is the the investments that we're making in the business and then the revenue ramp up relative to those investments. And that that will tend to, you know, to trend the margin rate down a bit as we as we, you know, in the early year or two of building the business.

OK, all right. Good. Because while you're you say you cautioned us and not analyzing the revenues, I'm presuming the cost we can analyze if we have modeling out CRD separately. Right. OK, different question. You called out in your name one time benefits from hedging activities. Now you quantify that and how is how much of that in the fourth quarter?

Yeah, in the fourth quarter, it was about six million dollars roughly. And a little bit comes from some of the dislocation is from change swap market. We've taken our swap positions down over the years, you know, but there's always some dislocations towards the obvious over the holiday season in particular towards the end of the quarter. So we saw a little bit of that and it was a it was a it was a positive dislocation because of how the currencies between euro and some of the and yen actually played through. So that was a positive. And then on long term debt, you get a little bit of this mark to market adjustment in the in the underlying accounting as you've got rates and credit spreads move a little bit. So about six bucks and it'll just which won't reappear in first quarter.

Can I speak in another one, which was you combined an accounting with FX and brokerage. I know a lot of broker, a part of brokers used to have electronic FX trading. What the rest of it, things like transition management, have they just diminished to a smaller base or something else changed?

No, I think we're trying to do is literally simplify the disclosure. And if we did something that took, you know, helpful materials away, we can certainly revisit. But we had a line that was historically called total trading services, which is both our direct foreign exchange trading plus our what I'll call electronic foreign exchange venues. Those were in what was called brokerage and then some of the other, you know, kind of fun connect like our money market electronic venue, a little bit of transition management and a few other smaller items like portfolio solutions. So we've just I think we labeled that total FX trading services just to give it the kind of the the description that's appropriate. I think within that, I'm just scanning through about 80 percent of those revenues are foreign exchange related. The rest tend to be a little bit of the money market or or portfolio solutions type type activity.

Great. Thank you.

And there are no further questions at this time. This concludes today's call and we thank you for your participation. You may now disconnect. Thank

you.