State Street Corporation

Q1 2022 Earnings Conference Call

4/14/2022

spk07: Good morning and welcome to State Street Corporation's first quarter 2022 earnings conference call and webcast. Today's discussion is being broadcasted live on State Street's website at investors.statestreet.com. This conference call is also being recorded for replay. State Street's conference call is copyrighted and all rights are reserved. This call may not be recorded for rebroadcast or distribution in whole or in part without the express written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. Now, I would like to introduce Eileen Fizzo-Beeler, Global Head of Investor Relations at State Street.
spk06: Good morning, and thank you all for joining us. On our call today, our CEO, Ron O'Hanley, will speak first. Then Eric Abloff, our CFO, will take you through our first quarter 2022 earnings slide presentation, which is available for download in the investor relations section of our website, investors.statestreet.com. Afterwards, we'll be happy to take questions. During the Q&A, please limit yourself to two questions and then re-queue. Before we get started, I would like to remind you that today's presentation will include results presented on a basis that excludes or adjusts one or more items from GAAP. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measure are available in the appendix to our slide presentation. In addition, today's presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors, such as those factors referenced in our discussion today and in our SEC filings including the risk factors in our Form 10-K. Our forward-looking statements speak only as of today, and we disclaim any obligation to update them, even if our views change. Now, let me turn it over to Ron.
spk01: Thank you, Eileen, and good afternoon, everyone. Earlier today, we released our first quarter financial results. Before I review our results, I would like to briefly reflect on the operating environment in the first quarter. which included both significant geopolitical events as well as notable macroeconomic developments and market movements. Turning to slide three of our presentation, first, I would like to acknowledge the ongoing events in Europe following Russia's invasion of Ukraine. In March, I traveled to Krakow to visit some of State Street's approximately 6,400 employees in Poland. During my visit, I was moved by the selflessness of our colleagues in Poland will continue to support displaced Ukrainian people in a number of important ways, from opening their own homes and providing shelter to offering professional support, such as interpretation services. While State Street's direct exposure to Russia and Ukraine is very small, our teams are responding fluidly to the situation and delivering for our affected clients and other stakeholders with dedication and professionalism in what continues to be a stressful time. We have well-established and regularly tested business continuity plans designed to continue critical services for our clients and support for our people. The first quarter also saw dramatic market movements driven partially by the conflict in Ukraine, plus a broader set of macroeconomic forces. A tight labor market, rising energy prices, continued supply chain disruptions, and the ongoing effects of significant COVID-related fiscal stimulus has contributed to inflation reaching multi-decade highs. As a result, in March, we saw the first interest rate hike from the Federal Reserve since late 2018, a substantial upward move in long-end interest rates, as well as volatile currency and equity markets, and a stronger U.S. dollar. Each of these factors, in part, shaped State Street's financial results in the first quarter which I will now discuss before Eric takes you through the quarter in more detail. Starting with our financial performance, first quarter 22 EPS increased 15% year-over-year and was up 8%, excluding notable items, with earnings growth supported by both higher total fee revenue and stronger net interest income, leading to an improved year-over-year total revenue performance in the first quarter. Within fee revenue, our global markets franchise performed particularly well, driven by higher FX market volatility. And while State Street's revenue performance improved, we also remained highly focused on controlling the expense base. Notwithstanding continued new investments in our business and operational capabilities, first quarter total expenses were flat year over year, and increased just 1%, excluding notable items. supported by ongoing productivity efforts and the stronger U.S. dollar. Taken together, we delivered both positive fee and total operating leverage, as well as pre-tax margin expansion, good earnings growth, and higher return on equity relative to the year-ago period. Turning to our business momentum, which you can see across the middle of the slide, we recorded another quarter of solid new AUCA asset servicing wins, which amounted to $302 billion in the first quarter, while AUCA I, but not yet installed, amounted to $2.9 trillion at quarter end. Front office software and data also experienced good business momentum, with annual recurring revenue for the first quarter increasing 15 percent year-over-year to $235 million. At Global Advisors, assets under management totaled $4.0 trillion at quarter end. Importantly, we saw another quarter of solid net inflows of $51 billion, despite the volatile market environment in the first quarter. Our ETF business continued to perform well as we further focused on innovation and enhancing our ETF product offering. For example, in January, Global Advisors launched three new ESG-oriented SPDR ETFs across small-cap international and emerging market equities. aimed at helping investors incorporate ESG considerations into their portfolios. In February, Global Advisors expanded its fixed income offering with a debut of the actively managed SPDR Blackstone high income ETF, as we continue to innovate in the active ETF category, which accounted for 13% of U.S. net industry flows in the first quarter. At State Street Digital, we announced a number of exciting developments. In March, we entered into a licensing agreement with CopperCo, a provider of institutional digital asset custody and trading infrastructure. We intend to leverage CopperCo's technology to develop an institutional-grade digital custody offering where clients can store and settle their digital assets within a secure environment operated by State Street. Turning to capital, our ratios remained healthy, although CET1 declined quarter over quarter largely due to lower AOCI driven by the significant moves in interest rates. In the coming quarters, we remain focused on maintaining strong capital ratios. Regarding BBH, the regulatory review process for the proposed acquisition of the BBH Investor Services business has progressed more slowly than we anticipated. While many required approvals have been obtained, some required regulatory approvals most notably approvals of the relevant federal banking agencies, remain outstanding. We are evaluating potential modifications to the transaction that are intended to facilitate resolution of the bank regulatory review. We are working towards concluding regulatory reviews during the third quarter. While we are engaged in an ongoing dialogue with the relevant federal banking agencies, there can be no assurance of the timing or outcome of their regulatory review. Both parties, State Street and BBH continue to be excited about the overall financial and strategic opportunities of combining BBH investor services with our business. We are continuing to work closely with the BBH team on pre-integration planning. This includes all the preparatory work in product, operations, technology, as well as employee communication and client planning. We still expect the transaction to be accretive to earnings per share in the first year post-closing. To conclude my opening remarks, the first quarter was defined by both unexpected significant geopolitical events and notable macroeconomic and market developments in the face of which State Street delivered an improved year-over-year financial performance and solid business momentum metrics while supporting our clients and colleagues. As we look ahead in this environment of heightened geopolitical uncertainty and market volatility, we remain laser-focused on delivering what is within our control, including excellence of strategic execution across the front, middle, and back office, maintaining the recent improvement in our sales effectiveness and expense discipline, all while continuing to provide valuable insights and promote better outcomes for the owners and managers of the world's capital. And with that, let me turn it over to Eric to take you through the quarter in more detail.
spk11: Thank you, Ron, and good afternoon, everyone. I'll begin my review of our first quarter results on slide four. We reported EPS of $1.57, or $1.59, excluding acquisition, restructuring costs. On the left panel of this slide, you can see we had yet another solid quarter of total fee revenue growth that strengthened many of our businesses, notwithstanding the macroeconomic environment. At the same time, we held total expenses roughly flat year on year, as we continue to both invest in the franchise and control expenses. As a result, we generated positive operating leverage of about five percentage points in the quarter and continue to improve our pre-tax margin year over year. All things considered, this was another strong quarterly performance, demonstrating the progress we are making as we continue to improve our operating model and drive growth. Turning to slide five, We saw period-end AUCA increased by 4% year-on-year and decreased 4% quarter-on-quarter. The year-on-year change was largely driven by higher period-end equity market levels, client flows, and net new business growth. The quarter-on-quarter decline was largely the result of lower period-end market levels in both equity and bond markets. Similarly, at Global Advisors, AUM increased 12% year-on-year, but declined 3% sequentially. Relative to the period a year ago, the increase was also driven by higher period and market levels, coupled with strong net inflows across all three of our franchises, our ETF, institutional, and cash businesses. The sequential decline was primarily driven by lower market levels, which was partially offset by strong net inflows of $51 billion in the quarter. Turning to slide six. Before I start, I would like to remind you that we are expanding our servicing fee revenue disclosures by disaggregating the line into back office servicing fees and middle office services. With that, on the left side of the page, you'll see first quarter total servicing fees were flat year on year as higher client activity and flows, average equity market levels, and net new business were offset by normal pricing headwinds and a 2% currency translation headwind. We continue to see good growth in both our insurance and official institutions' client segments. Sequentially, total servicing fees were down 1%, primarily as a result of the seasonal pricing headwinds and lower average equity market levels, partially offset by strong client activity. Within servicing fees, back office fees were flat both year on year and quarter on quarter, largely driven by the factors I just described. Middle office servicing, was down 3% year-on-year and 5% quarter-on-quarter, primarily due to a partial transition from a legacy climb and lower professional services fees in the quarter. Notwithstanding the decline in the quarter, middle office is an important component of our alpha proposition when it comes to both the front office, when it connects to both the front and back office, and we expect to see good growth over the medium term, as evidenced by our uninstalled revenue backlog, which I'll talk more about in a moment. In terms of business momentum, I'm pleased with how 2022 has started, as we report another quarter of solid new AUCA wins of $302 billion, while AUCA won, but yet to be installed, amounted to $2.9 trillion at quarter end. We continue to be happy with our pipeline, and I'm also particularly pleased to report that our first quarter wins span a good mix of strategically important premium and preferred clients. Turning to slide seven. First quarter management fees were $520 million, up 5% year on year, primarily reflecting higher average equity market levels and strong ETF inflows. Management fees were down 2% quarter on quarter, largely due to equity market headwinds, partially offset by the tailwind of lower fee waivers and net inflows. Of note, our management fee performance for the quarter was supported by strong net inflows of $51 billion, with positive inflows across our entire business franchise, institutional, cash, and ETF. With respect to money market fee waivers, the fee waiver impact to management fees for the quarter was roughly 10 million, down from about 20 million in the fourth quarter. I would note that following the 25 basis point Fed hike we saw in March of this year, we no longer expect money market fee waivers to be a headwind to management fees starting in April. As you can see on the bottom of the slide, our franchise remains well positioned for growth. I'm particularly pleased that the strategic actions that we've previously taken in our long-term institutional and ETF franchises are now helping to draw inflows, even in the current volatile market environment. On slide eight, you can see that FX Trading Services had yet another strong quarter. Relative to the period a year ago, FX trading services revenue was up 4% year-on-year and 20% quarter-on-quarter. Both the year-on-year and quarter-on-quarter performance benefited from high FX market volatility, while higher client FX volumes also contributed sequentially. Part of the revenue uptake has come from about $5 billion in higher risk-weighted assets we put to work this quarter, which demonstrates our balance sheet flexibility and which I'll come back to in a moment. Our securities finance revenues decreased 3% year-on-year, permanently driven by lower average agency assets and loan, partially offset by solid new business wins and enhanced custody. Sequentially, revenues were down 6%, mainly reflecting lower average agency and enhanced custody balances due to the declining market levels and fewer specials. First quarter software and processing fees were up 26% year-on-year and 7% quarter-on-quarter. largely driven by higher front office software and data revenue associated with CRD, which I'll turn to shortly. Finally, other fee revenue of $29 million almost doubled year-on-year and quarter-on-quarter, mainly reflecting fair value adjustments on equity investments. Moving to slide 9, we've provided a breakdown of our consolidated front office software and data revenue on the left. We've broken down the revenue into software categories you have seen us use before, on-premise, professional services, and software-enabled revenue. While CRD represents a large majority of this line, alpha data services, alpha data platform, and marcatus revenues are also included here as well. As we've highlighted earlier, front office software revenue growth was particularly strong, up 44% year-on-year, primarily driven by on-premise renewals as well as the continued strong growth in software-enabled and professional services revenues. On the right of the slide, we've provided some key growth metrics enabled by CRD and alpha. As I mentioned earlier during today's presentation, you'll notice that we've broken out both the front office and middle office uninstalled revenue backlog, both of which are key components of our alpha proposition going forward. The front office backlog of $93 million is up 43%, and the middle office backlog has more than tripled year-on-year to $63 million. The backlogs reflect expected annualized revenue, which can be compared to the $900 million of annual revenue base in 2020 across both the front and middle office businesses, and is an indicator of future revenue growth once fully installed. The alpha pipeline remains promising despite the current geopolitical environment as clients realize the transformational benefits to their technology and operations infrastructure. Turning to slide 10. As we see the start of another rate tightening cycle, first quarter NII increased 9% year-on-year, primarily driven by growth in our investment portfolio coupled with higher loan balances. which will also benefit us in future quarters. Relative to the fourth quarter, NII was up 5 percent, which came in better than expected due to higher long-end rates. The sequential increase was largely driven by the improvement in both short and long-end rates, which benefited our yields together with higher investment portfolio balances. On the right of the slide, we show our average balance sheet during the first quarter, which has been relatively steady. Average assets were down 3% quarter-on-quarter, largely driven by seasonally lower 1Q deposit balances, which are down slightly from the seasonally high fourth quarter, but up year-on-year. Turning to slide 11, first quarter expenses excluding notable items increased 1% year-on-year, or 2% adjusted for currency translation. Productivity savings and targeted investments remain on try for the first quarter as we generated approximately $90 million in year-on-year growth savings and self-funded most of the strategic investments we've been making in the businesses, including technology infrastructure, broader automation, alpha, and State Street Digital. Compared to first quarter, on a line-item basis, excluding notable items, compensation and employee benefits was down 1% as lower headcount and high-cost locations and the tailwind of currency translation was partially offset by higher seasonal expenses. Information systems and communication expenses were up 5% due to continued investment in our technology infrastructure and resiliency. Occupancy was down 13% due to footprint optimization and lower maintenance costs, and other expenses were up 9%, primarily reflecting higher professional fees. Relative to the fourth quarter, expenses were primarily impacted by higher seasonal expenses partially offset by productivity and footprint optimization savings. Headcount increased slightly quarter-on-quarter as we began to insource some technology functions from vendors and growth in alpha. Overall, we remain focused on delivering positive total and fee operating leverage and have demonstrated that this quarter amidst the current macroeconomic environment. Moving to slide 12. We show the evolution of our CET1 and Tier 1 leverage ratios. As of quarter end, our standardized CET1 ratio decreased by 2.4 percentage points quarter on quarter to 11.9% due to both numerator and denominator effects. RWA increased by roughly 15 billion or 160 basis points of Set 1 during the first quarter of 2022 compared to year end, driven by three factors. a modest rebound from an unusually low fourth quarter, a strategic and temporary allocation of additional RWA capital to our markets businesses to generate the higher than expected first quarter revenues that we just discussed, and lastly, the RWA impact from the SA CCR implementation that started on January 1st of this year, which we had planned for. At the same time, our capital base was also impacted by the substantial reduction in AOCI of about $1.3 billion worth 110 basis points of Set 1 relative to the fourth quarter, as we saw a significant and historic quarter-on-quarter movement in long-end rates, particularly in the belly of the curve. For instance, the rise in the five-year U.S. Treasury of roughly 120 basis points was the largest in the last 30 years. Taken together, the increase in RWA coupled with a meaningful reduction in AOCI partially offset by about 35 basis points of earnings accretion net of dividends drove the decrease in our set one ratio this quarter. In contrast, first quarter tier one leverage was down only slightly to 5.9%, mainly driven by the substantial decrease in AOCI, reflecting a significant change in the industry environment and a stable balance sheet. While capital return remains an explicit priority for us, and we recognize its importance to our shareholders, Given this $1.3 billion move in AOCI related to higher interest rates, we no longer expect to resume our share repurchase program in the second or third quarter as we operate with a conservative balance sheet philosophy. Given the volatility in rates and the possibility of further significant increases, we are in the process of taking several actions to reduce AOCI risk by about half. This primarily includes shifting additional AFS securities to HDM as well as shortening the portfolio duration through swaps, lowering extension risk, and consciously allowing some portfolio runoff. Some of these latter actions can be reversed in the future when we choose to reinvest at higher rates. Turning to slide 13, we provide a summary of our first quarter results. Despite the continued volatile market environment, I'm pleased with our financial performance, which demonstrates solid underlying trends within our businesses. Total fee revenue was up 4% year on year, primarily driven by higher management fees, FX trading, software and processing fees, and other fee revenues. Expenses were well controlled and were held roughly flat year on year, demonstrating the progress we are making in improving our operating model. Next, I would like to provide our current thinking regarding the second quarter outlook and some of our economic assumptions as we look out over the year. At a macro level, while we know that rate assumptions have been moving, our rate outlook is broadly in line with the current forwards, which suggests a year-end Fed funds rate of 2.5%. In terms of second quarter of 2022, we expect overall fee revenue to be down about 2% on a sequential basis. with servicing fees up about 1% and management fees up 2% to 3%, assuming equity markets remain flat to March 31st levels for 2Q, and some downward normalization in FX trading revenues. In terms of some of our newer fee revenue line items that we started to disclose this quarter, we would not expect to see a repeat of the size of on-premise renewals in the front office software line, nor the positive equity investment markups in the other revenue line in 2Q. Regarding NII, we now expect 2Q NII to increase 7% to 9% sequentially, which will be driven by the expected Fed rate hikes, partially offset by the AOCI mitigating portfolio actions that I outlined earlier. For a full year 2022, we now expect to see year-on-year NII growth of around 18% to 20%, depending on Fed actions and rate moves, as well as the shape of our portfolio. Turning to expenses, We remain laser focused on driving sustainable productivity improvements and controlling costs. We expect that second quarter expenses ex-notable items will be up around 2% to 3% on a sequential quarter basis, excluding notable items and seasonal compensation of expenses of $208 million. On taxes, we expect that the 2Q22 tax rate will be around 20%. We continue to expect to deliver on our goals of margin expansion and positive total and fee operating leverage for the year. And with that, let me hand the call back to Ron.
spk01: Thank you, Eric. And operator, we can now open it up to questions.
spk07: Thank you. To get in the queue, you may press star and then the number one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. As a reminder, please limit yourself to two questions and then we cue. We have our first question from Ken Usden with Jefferies.
spk02: Thanks. Hey, Eric, just a follow-up on all things related to the rates environment. Just wondering, first of all, on the commentary about considering some alternatives with regards to the Brown Brothers deal. Can you elaborate what that might mean? Is that potentially some type of that thing you might have to fix on the capital side, or is that related to just timing and deal structure? Any help there would be appreciated.
spk11: Ken, it's Eric. No, capital, from a capital perspective, we're quite comfortable with closing. We've got the 12% capital ratios today. We've got a very, I think, smooth path to being prepared for a close from a capital perspective. The modifications we're talking about are just around the underlying structure of the transaction. And you've seen this done from time to time before. But We're working through legal entity and subsidiary structure, the exact transfer of systems and third-party contracts, some of the transition servicing agreements, those kind of structure and modifications that we think will make this a cleaner process and be favorable on several fronts.
spk02: And then is there any updated thoughts about general zone of what you might think about for potential closing?
spk11: As Ron had said, the regulatory review process has taken a bit longer. We've obviously been heavily engaged in that process. Because of some of the modifications that we're working through, you know, jointly with the Brown Brothers leadership team, you know, we're deeply in the process of, you know, getting additional and refined submissions in. You know, those will take, you know, several months for review and further dialogue. I think you have a sense for how this, you know, plays out. And that's why in the prepared remarks, I think Ron described that we expect those reviews to, you know, to come through during the third quarter. I think at that point, you know, we obviously then, you know, sprint to a close. And, you know, depending on exactly what month and what, you know, week those come through, you know, then we look for, you know, you take out the calendar, you look at the weekends and do the usual. How do we now just... But we've got to always close carefully just given the usual financials and controls that you want to be mindful of.
spk02: Okay. And just I guess I'll ask a starter one on NII and then leave it to others. But just, you know, do you know just the impact related to the restructuring type of actions versus what you might have thought for NII?
spk11: You know, there's a range of that. I think you've seen us guide to NII up for the quarter of, you know, up 7% to 9%. And, you know, that on a year-on-year basis is actually going to be quite nice. I think, you know, it's, you know, is it worth a percentage point, two or three? It's those kinds of, I think, adjustments that we're willing to make so that we both you know, run an appropriate portfolio in what could be a highly volatile, you know, rate environment, including, you know, another possibility of, you know, rates could move another 50, 100 basis points. And we want to have a portfolio that can withstand that. And to be honest, you know, we're willing to take a few percentage points of NII growth off the table on a sequential basis to do that. So I think it's a balance, but that's the range. And, you know, even with some of those adjustments, you know, a lot of what we'll be doing is in the move from AFS to HTM, which is not, you know, NII impacting. There are others on the margin that are, but that's kind of the range that I'd share with you. Thanks, Eric.
spk07: Your next question is from Glenn Shore with Evercore ISI.
spk10: Hello there. So the SEC wants to implement T plus one by the end of next year. I saw all the comment letters, including yours. My personal opinion is nobody's ready for it in the industry. So I'm curious why the move from T plus two to T plus, I'm sorry, T plus three to T plus two was kind of easy and T plus two to T plus one, everybody seems to be pushing back. Is it the complexity and shorter time horizon? Is the money to spend on the technology? It's just a little weird to me.
spk01: Yeah, Glenn, it's Ron. Why don't I take that? I mean, I think that if you look back in history, everybody has resisted these moves to some degree because it does involve some spending of money and changing in systems of all that. And we've spent a fair amount of time on this and thought about this and have been in conversations with regulators. And, you know, it'll be an added burden, but we don't think it's something the industry can't get done in a reasonable amount of time. So, you know, I haven't read other people's comment letters. I know how we've thought about it. So, you know, we think it'll be one of these things like a LIBOR, if you will, more recent history, that'll take a lot of time, take a lot of effort, but it's certainly not something that's going to, in our mind, sideline us or sideline other major players.
spk10: Okay, I appreciate that. I'm good. Thanks.
spk07: Our next question is from Brandon Hawken with UBS. Yes.
spk15: Good afternoon. Thanks for taking my questions. Just sort of a clarification here. The expense guide, Eric, that was plus 2% to 3% quarter over quarter, but we're supposed to X out the seasonality, right? So do we back out? What exactly is the right base that we're supposed to do? Do we take the 2318 and then back out the 208 and then grow that?
spk11: Let me just open up the slide. So I think you're doing it, Brennan, in line with how we've described it. Yeah, you can take the first on slide 11 of the slide deck, the $2.3 billion of expenses. That includes the seasonal expenses, which are in the footnotes. Right of two away, you can pull that out and then you can add two to 3% sequentially and get a estimate for a second quarter. That's correct. Okay. Okay.
spk15: Thank you for clarifying that. And then I'm thinking about the the deposits. What When you were talking about the decline of deposits, you flagged normal seasonality, which would suggest that there wasn't anything unusual that you've been seeing. But we've started to see rates back up in the market. The policy hikes, we've already seen one policy hike, likely to see quite a pace here in the next few meetings. How is dialogue with your customers? What are your expectations, updated expectations around that? deposit action? And, you know, do you have any kind of estimate about where you might think you could see, you know, deposit growth or runoff end up shaking out here in the at least, you know, next quarter or two?
spk11: Sure, Brennan, you know, for the time being, we've seen, you know, little movement in deposits other than a little bit of the seasonality, a little bit of currency translation has also played through. But this is all within the bounds of what we'd expect. And we've obviously been watching deposits carefully across currency pools and across client segments. And for the time being, it's just been flattish, regardless of which way we look at it. As we go forward, We, like many others, have tried to guesstimate, and I use the word guesstimate, not estimate, the level of shift in deposits, movement of deposits that we'll see with the amount of quantitative tightening that the Fed has announced. And I guess the best context I have for you and others is if we go back to the kind of pre-COVID era, You know, we've grown our deposit base since then by $60 to $70 billion. We've also increased our AUCAs by about 25% during that time period. And because those correlate, you know, we estimate that about half of the increase, so $30 to $35 billion, has come from the quantitative easing as the Fed expanded. The Fed and the other central banks were primarily the Fed expanded its balance sheet by, you know, effectively $3 trillion. And so we see that reversing over time, you know, with the rough math being, you know, for every trillion dollars of Fed balance sheet, we'd expect a $6 to $10 billion, you know, runoff in our deposits. And if they start in May or June, you know, we'll see exactly when they get going at their announced pace. um yeah you could see a little trickle down we think in the fourth quarter um and then the kind of the the six to ten billion you know per year after that so that's our that's our guesstimate um you know we're we're obviously you know flush with deposits and we're happy to be flush with deposits as rates rise so we'll uh you know we'll monetize them for the time being um but that's that's our guesstimate right now you know the other factors are you know, how the interest rate hikes play out. You know, we expect betas to be similar, but they're never exactly the same as they are, you know, before. And so we'll be, you know, sharply focused there. So those are some of the moving parts and some of our thinking at this point. Okay. Thanks for that, Keller. Sure.
spk07: Our next question is from Betsy Gracek with Morgan Stanley.
spk08: Hi. Good afternoon.
spk01: Hi, Betsy.
spk08: Last year you announced State Street Digital, and I wanted to get a sense as to how that's going relative to expectations, what you've been able to execute on there, and what your clients are asking you to do more of.
spk01: Yeah, they've had a lot going on, Betsy. Maybe I'll focus on that last question first. because this is a very client-intensive division and spending a lot of time with clients. I think the single biggest thing clients are asking for is help with a kind of a comprehensive regulatory framework. This is particularly acute in the U.S. The lack of guidance and the lack of really an agreed-upon framework is left a lot of uncertainty into what institutions can do, particularly banks. So, you know, that's out there. I think most of it, though, beyond that, Betsy, would be around, and where we're spending a lot of time, is firstly around enabling clients to invest in digital assets. And that's not just the trading of them, but it's the movement of them, it's the control of them, it's the custodying of them, it's the portfolio accounting of them. So it's really, if you think about what we do now for digital assets, tokens, coins, et cetera. I think the other very large thing that the group is focused on, which is less about external products and much more about You know, how does State Street itself move into a digitalized world more than it is already? And what does it mean for the core operations, such as custody, securities movement, and control? You know, which is really about, for lack of a better term, the next stage of digitalization. We are working a lot with the major players in the industry because these ecosystems are forming. And in some case, we actually want to be a very integral part of the ecosystem. In other cases, we actually want to access that. So there's quite a bit going on there, is the way I would summarize my answer to you.
spk08: And would you say that... Yeah, go ahead. Thanks.
spk11: That's it, Derek. I was just going to add, you know, the other thing we're doing is obviously where clients, especially institutional clients, have added crypto holdings within their fund, right, where effectively providing some of the services you'd expect. And so, you know, we've gone through there's across our client base, they have about 73 funds, I think, at last count, you know, with half a billion dollars of crypto exposure, you know, we're effectively record keeping, right, those assets as part of their underlying funds. And then I think more broadly, where clients are developing you know, specific ETFs and exchange-traded products, right, that's where we are in an industrious way, you know, signing them up for, you know, the administration record-keeping because that, in a way, is our view as one of the next land grabs because as ETF and ETP, you know, products that comes of age, You know, that's where we'll see some significant inflows.
spk08: Okay. And would you say you're at scale for these offerings or there's more investment to do to get to scale?
spk00: Yeah.
spk01: I mean, I think where we are now is of adequate scale, but one would expect that more scale will be required. But, I mean, as much excitement as there is around this, it's still a relatively small proportion of total investment assets. So I think we're at adequate scale. I think the focus now is more on how do we think about additional capabilities when.
spk08: Yeah. No, I totally get that. But as CBDCs come through, you know, it's going to be critical to have this infrastructure.
spk01: Yeah, I agree with that.
spk08: Central bank digital, right? Central bank digital currencies. All right. Thank you.
spk01: Thanks, Betsy.
spk07: Our next question is from Brian Bedell with Deutsche Bank.
spk13: Great. Good afternoon, folks. Just back to BBH, just on that timing of closing one more time, I guess potentially could move into the fourth quarter. Is it safe to say that you think this would certainly close before year end, and is there any risk to it it not closing under, you know, without changing the terms dramatically? And is it mostly the U.S. regulatory side as opposed to non-U.S.?
spk01: Yeah. I mean, Brian, the regulatory environment is uncertain, probably gotten more so over the last couple of years than less so. But we are making progress. It is taking longer than we anticipated. We're in dialogue with So it's not like we're not doing anything or there's silence on all this. We're in a fair amount of dialogue and working the restructuring that we referred to earlier is explicitly aimed at trying to accelerate this. We view speed as of the essence here, but there's a fair amount of uncertainty. So as I said in my remarks and Eric just reiterated, what we're we're targeting at this point and assuming that there'll be a, you know, this review will get done in the third quarter. And then as Eric noted, the actual, once the review's done, the close itself isn't going to take a lot of time. I mean, everything's ready. The money's in place. There's been a fair amount of integration planning, but it really is around the uncertainty of both the timing and the outcome of, of these regulatory reviews. And yes, it's mostly, right now the open ones are mostly the U.S. banking regulators. We've received lots of approvals from around the world, both from financial services regulators and the antitrust regulators globally. So I don't want to minimize what's been done, but this is one of those things that's basically not done until the last one's done.
spk13: Yeah, that makes sense. That's a great color. And then just maybe on the deposit side again, so obviously BBH gave you pretty good capability to bring on incremental deposits, and I know it's getting pushed out a little bit, but maybe, Eric, if you can sort of update us on your thoughts or just reconfirm your original thoughts, about the level of EVH deposits that would be coming on, you know, if it were to close today, for example, and then your appetite for bringing more deposits on. I think it was up to $20 billion of additional deposits at some point. Maybe just to talk about how you're thinking about that, if there's any change in that thought process other than the delay. And is the core BBH... uh, uh, fundamentals right now, I assume at least on the interest side, those are probably tracking better given the additional Fed hikes since the last God.
spk11: Ryan, it's Eric. Uh, you know, we, uh, um, we're, we've been pleased as we've been, uh, you know, monitoring and working closely with the Brown brothers on, on the business, the business performance, um, It's, uh, it done, uh, it had a good finish, uh, last year. It's had, it's, uh, had a, uh, performance in the first quarter that's, you know, within, uh, the, the, the bands that we had expected. Um, and obviously there's, you know, there's a little bit of, and I, I tell when in there offset by a little bit of equity market, uh, um, you know, uh, a downtick, but it's, uh, it's a business is performing, uh, well, we're, we're, uh, uh, we continue to be excited about it. And, uh, you know, the partners, the nine partners that have been operating that business that are coming over to us are doing a fine job as we'd expect, which is really nice to see. In terms of, you know, the deposits and the close and the assets and the, you know, the modifications and, you know, the broader questions, you know, you're asking about the underlying economics of the of the transaction. I'm not going to go into detail on that at this point. I think Ron in his prepared remarks affirmed that the economics are sound, that they'll be accretive within the first year. And what I tell you is as we work through the modifications, which is oftentimes a legal entity kind of structure, You know, we in the finance and treasury side are working very closely with our legal colleagues to navigate those modifications and make sure that they, you know, they preserve the economics and the accretion that we're looking for. And so we continue to be positive and we think it'll be positive for shareholders.
spk13: Okay, great. Fair enough. Thank you so much.
spk07: Our next question is from Gerard Gassidy with RBC.
spk00: Good afternoon, Ron. Good afternoon, Eric. Hi, Gerard. Eric, can you share with us, I think in your comments when you were talking about the CET1 ratio, that you used a temporary allocation of additional RWA to capture some markets business that generated some better revenues for you in the quarter. Can you elaborate on that? And if you pull back, does that mean in the second quarter the RWA – capital that was allocated would decline, meaning that all other things being equal, your CET1 ratio could bump up a little bit?
spk11: Gerard, it's Eric. Those are the kinds of scenarios and I'll say navigation that we do for our capital ratios, and they are sometimes dependent on market opportunities, whether it's the FX trading desk here in the U.S. or abroad, whether it's the SEC finance unit or sometimes even the lending unit, we're in close partnership with them around, on one hand, they are sophisticated operating within their limits, and sometimes they come by and we have real, I think, constructive commercial discussions about, hey, if there's a little more capacity at the top of the house, you know, can that be put to use? And that's where we were this quarter. And you saw we had quite a nice uptick in FX trading revenues, you know, up 20% quarter and quarter, which I think had not been anticipated, was facilitated as we gave them larger limits. You know, partly because we're sitting on an abundance of capital right now. I think what you will see is that we'll do that selectively. We'll probably do that for another couple months. We'll see how we're feeling towards June. We would like to keep our RWA asset levels at or below where we are today. So we do expect them to be within those boundaries. And, you know, so we'll selectively work through it. But, you know, part of the discipline here is we also want to make sure that there's real incremental, you know, revenues that we can bring to bear if we're going to deploy the incremental capital. And that was the scenario of this quarter. Very good. Very helpful.
spk00: And then, Eric, I know it's not a giant number, but you touched on it in the outlook. regarding the fair value adjustments to equity investments were up so strong in Q1 versus both the fourth quarter and the year-ago quarter. How big of a portfolio is that, and was it private equity investments? Can you maybe give us a little more color there?
spk11: Sure, Gerard. These are primarily or primarily almost exclusively minority investment opportunities uh and uh investments that we've made in a series of companies over the over the years you know there is a there's five to ten of them that are in the in the crypto space sometimes providing you know software sometimes providing infrastructure sometimes providing different capabilities uh for some in the more classic uh technology areas where you know we've invested over time again in minority positions that help facilitate some AI, you know, capabilities and capacities that have helped us with our automation and engineering efforts. And so there's a group of them, but we're primarily, you know, we're not trying to build an investment portfolio. What we have is as investments typically of five, 10, maybe $15 million in, you know, early to mid stage companies, Oftentimes they are companies that are providing a utility type service for multiple large banks. So we're in there with sometimes the other GSIBs or an international bank or what have you. And so we get effectively, the entity gets a network effect from multiple banks and we participate because we get upside in some of the services. So we're doing it to help facilitate primarily either either, um, you know, revenue growth, automation capability, or just general capabilities to build up our, uh, uh, our, um, uh, you know, our product set. And, you know, the, the, the, I guess the, the, the, the, the knock-on benefit of that is because, you know, we know this market space well, you know, these tend to, you know, to appreciate over time. Um, and, uh, You know, it's one of the ways we've been, you know, driving, I think, innovation would probably be the broader word to use. And, you know, we've made some, I think this particular quarter, we saw a couple of these really, really appreciate, which is good to see.
spk07: Thank you. And our next question is from Jim Mitchell with Seaport Global.
spk03: Sorry, I was on mute there for a second. Just, Eric, you updated the guidance on NAI for the full year. Any change to the expense or fee revenue guidance that you gave in the prior quarter for the full year?
spk11: Jim, I didn't go that far, partly because the market environment has just been volatile, whether it's equity markets, whether it's rate hikes. And so there's a a number of drivers that are moving around. I think NII, we felt just because the Fed forecasts were so explicit between the dot plots and, you know, the new consensus that we should just describe that for all of you. But the other lines, you know, we think it's still early to go through. It's still early to really call what the equity markets will do, both in the U.S. and internationally where they've been more depressed. We'll obviously navigate and adjust our expenses to some extent as we go through the year. I think what we did do as part of the outlook commentary after I finished the quarterly description was affirm that we're committed to both positive total operating leverage and positive fee operating leverage. And so I think that gives you some boundaries that we're working within.
spk03: Right. Maybe just one curious question on securities finance. You know, I appreciate that balances were down, specials were down, and those are important factors. But, you know, I've always thought that spreads on SEC lending were kind of the spread between you benefited from a steepening at the short end of the curve. Didn't really seem to see any of that benefit in the spreads. Is that to come or are we just not thinking about that right? How should I think about securities lending spreads, you know, excluding specials and volumes?
spk11: Yeah, I think directionally you're right. It tends to have some correlation. And I think what we find, though, is that the specials activity and the underlying mix of assets that are being borrowed or lent tend to be a little more dominant in terms of their effects on the P&L in a given quarter. So that has a piece to it, the rate environment. But tends to be the volumes and the mix that dominates. Okay, great. Thanks.
spk07: Our next question is from Alex Blasting with Goldman Sachs.
spk14: Hey, good afternoon. Thanks for the question. Maybe just taking a step back for a second, and when you sort of think through the capital mitigating factors and the steps you guys are taking to shore up the capital position here ahead of VBH closing, When you think on a multi-year basis and maybe sort of lessons learned from the move in interest rates and the effect that had on your guys' capital position this quarter and maybe after, what is the more appropriate mix of kind of cash, securities, and loans for us to think about over time, as well as just the duration of the securities portfolio? How much of that will look different perhaps as we look forward?
spk11: Yeah, Alex, it's a good question. In a way, we've not been in this environment for 20 or 30 years, right, where rates either are going to move quickly to the upside or maybe move quickly to the upside and stay high either. I think there are a couple thoughts that we've developed over time. I think the first is that the more we can add lending assets, classic loans to our balance sheet, You know, they have to be high quality, but the more we can add, you know, lending to the mix of the asset side of the balance sheet, the better off we are. And you've seen us, you know, you've seen us, you know, consistently grow our lending book, you know, you know, 10, 12%. It's just, you know, it's off of a small base. So that's an area we'll continue to evolve in. I think given that that will, though, take some time, you know, we, the other elements here is what kind of investment portfolio do you run? You know, we, just because of our trust and custody heritage, you know, believe it should be a high quality, pristine one that is unassailable. And our perspective as we do that is, I think we're more comfortable putting more of that over time into HTM, just because it's an accounting convention that while you all can read through in our 10 Ks and Qs, you know, what the underlying market is, doesn't immediately, or doesn't affect, you know, the capital ratios. The one governor on that, and, you know, you'd say, well, why not put it all in HTM and put it in the drawer, is that in a down rate environment, which typically happens when the Fed, you know, moves into intervene on a recession, you know, you tend to get an appreciation of securities and you want to be able to monetize or take advantage of that to offset, whether it's credit or reserve bills. And so that's one of the reasons why you don't want to put all of it in, in HTM. And the other reason is if you're, uh, if, uh, you know, if rates are flattish or moving within a band of, you know, 25 base points here at 50 base points there, the AFS convention allows you to rebalance to, adjust your position a little shorter, a little longer. And, you know, that's beneficial. And I think over time, we found that that's been additive to our NII and P&L. And so I think over time, you'll probably see us put more in HTM, but not, you know, there are some limits to that. But that's some of the ways we're thinking about it. And then I guess there's a last layer, which is what's the composition. And I think you've seen us adjust You know, the mix of treasuries, MBS, CMOs, because we're such a global bank, you know, the foreign sovereigns, especially as, you know, euro and international rates rise, I think will over time become a bigger part of what we do, supra. So there's a bit of, I think, the mix, the composition will evolve as well over time.
spk14: Got it. That's a couple things. And then maybe a little bit more of a tactical near-term question. When we look through the NII guide, just extrapolating the full year from the second quarter, I guess, not surprisingly, the benefits of subsequent rate hikes seem to have a smaller effect on NII. But curious how you guys are thinking about the positive beta assumptions beyond sort of the first 100 basis points, maybe looking at the UK market as kind of lessons learned. They're a little bit further ahead of us, I guess, on the hiking cycle. in terms of both pricing and client behavior. Thanks.
spk11: Yeah, I think the first 100 basis points, I think, are a little bit easier to read, to your point. Like the first rate hike, the betas, we generally assume, are in the 20% range. So that's the first one or two. So that's comfortable and pleasing, I guess I should say. Once you get to the third and fourth, you're now you know, floating up in betas in the, you know, 30 to, you know, 45% range. And this is where, you know, kind of depend. And then I think once you get past the first, you know, four or five hikes, you know, you are looking at, you know, sequential, you know, quarter betas, you know, in the 60% range. I think you're just, that's just what happens. And to be honest, we want to, go back to a position where the NII is healthy, the NII can support the preferred security stack that we should run from a capital perspective. But we also want to be fair and thoughtful with our clients and the embedded sharing that's been a partnership here for decades and decades with them. So that's what we're looking at and thinking. You never know how the speed of rate hikes affects that. Some of that's been taken into account in some of those, you know, guesstimates I've given you, but I use the word again, guesstimates here, not estimates, because we think these cycles, you know, aren't perfectly comparable. And, you know, some amount of quantitative tightening has been factored into some of our thinking here as well. You know, but that'll have an effect. And then I think the last one that we'll have to see is, you know, depending on how the macro economy does, whether it's you know, if the economy, if rates move up another, you know, one, two, 300 basis points and the macro economy is strong, then there's a lot of demand for lending. And so there's this bid ask between deposits to fund loans. If you have a slowdown in the kind of real economy, then there's not as much lending that's going to be done, and that's more beneficial to deposit rates. So that's another feature that we're keeping a close eye on. Great. Thanks very much. Yep.
spk07: Our next question is from Stephen Trueback with Wolf Research.
spk12: Hi. Good afternoon. So, Eric, I was hoping to ask a multi-part question on the capital impact of BBH. and how that maybe informs the buyback cadence from here so if we think about the pro forma impact your capital ratios if we were to assume the deal closes in the next quarter or two and we shut off the buyback through the third quarter given the large pro forma capital hit i believe it's about three and a half billion from goodwill and deal intangibles so about 120 bps of tier one leverage your ratio exiting 3Q would still shake out below your lower bound of 5.25%, not meaningfully below, but somewhere close to 5%. I just wanted to confirm if the $3.5 billion capital drawdown from BBH all-in is the right level for us to be contemplating for modeling purposes. As we think about the buyback cadence, if you're still running at or below that lower bound, how quickly should we think about you returning to normal course payout target of roughly 80%?
spk11: Yeah, I think it's probably a little bit easier to think about it in CET1 terms, but the translation is kind of the CET1 divided by 2 gives you the leverage. And remember, on leverage, especially in these economic times, we certainly want to stay within the target range of 5.25 to 5.75, but I've been on record saying getting closer to, as long as you stay in the fives, leverage is quite comfortable, given that it's not a risk-sensitive measure. If you then pivot back to CET1, you know, we're at almost 12% relative to the target range of 10 to 11. So there is almost 200 basis point spread there of excess capital that we have. If you then, you know, fast forward and let's say it's, you know, we've had discussion on this call, it's exactly, you know, what we should assume. But if we were to assume a a third quarter close, for example. The way to think about it is the goodwill and intangibles for the Brown Brothers transaction is about 3.3 billion. I think if you translate that into CET1, it's just below the 300 basis point mark. So the comparison is we would prefer, it's not absolutely required, but we'd prefer to have about 300 basis points of capital, you know, to close it. We've got about 200 basis points today. And then the, you know, logical way you think about how do you get from here to there over the next two quarters is actually pretty straightforward, right? On one hand, you know, we accrete capital net of the dividends that's worth about 35 base points a quarter. So you got 70 there. And on the other hand, as we talked about earlier, you know, we've been deploying our excess capital through the RWA lines, through the risk-weighted assets. And we can easily rein in risk-weighted assets by $5 billion or more, which creates another 30, 40, 50 basis points of capital as part of a closing process. So there's good levers here. And that's why I said earlier, from a capital perspective, it's a comfortable closing process and plan.
spk12: Very helpful caller, Eric. Thanks for taking my question.
spk01: Sure.
spk07: Our next question is from Mike Mayo with Wells Fargo.
spk09: Hey. I just want to make sure I understood what you said on the call. So on the one hand, you're still guiding for positive operating leverage for 2022. You still expect a higher pre-tax margin. Your backlogs are up, so that's all good. I guess just to clarify your answer just now, the Brown Brothers acquisition All else equal reduces your CET one ratio by how much in basis points?
spk11: Just shy of just around 300 basis points, Mike.
spk09: Okay. And so you're at 11.9 now. So if you close the deal now, you'd be below the low end of your target. So are you delaying the deal because of lack of capital? Or I didn't understand why the delay in the deal.
spk11: No, it has nothing to do with capital. If we had been in a position to close it now, we would not have deployed five, maybe even $10 billion of RWA, and we would have had a comfortable close of the deal. It's not about capital. It's about, as we described earlier, the underlying regulatory process just taking more time. Okay.
spk09: And then as it relates to the suspension, the lack of resumption of buybacks, is that solely due to the timing of the closing of the deal?
spk11: I guess we're just factoring it in, right? Because of where we are on the regulatory process, we're estimating a potential third quarter close. And to just navigate comfortably with capital, because we had that large AOCI hit of $1.3 billion, and I usually buy back for almost $500 million of shares per quarter, that would be my usual cadence, that AOCI hit has effectively put us in a position where it's best not to do those two quarters worth of buybacks during the second and third quarter.
spk09: All right, that's clear. And then lastly, your guidance for positive operating leverage, how much do fee waivers contribute to that? Is that like all of it or 10% or 50% or just roughly?
spk11: Well, the guidance is to positive fees. total operating leverage and fee operating leverage. I think the, if I just try to do the math quickly, but the IR team can probably help you offline, Mike. This quarter we had fee waiver impacts of 10, and then we won't have any fee waivers for the rest of the year. Last year we had fee waivers, I can only remember the second half of the year, because I'm trying to remember when it started, in the 20 million per quarter range. So on our total fees of $10 billion, I don't know, rough estimate, maybe about half a point of fee operating leverage is caused by the tailwind absence of money market fee waivers. But I'm doing mental math without even a pencil and paper in front of me. Maybe we could follow up with you offline, but maybe in that order of magnitude, at least.
spk09: I think I have. I mean, in terms of zip code, most of it does not relate to the fee waivers. There's the lion's share of it. So I think I got it. That's correct.
spk11: It's real underlying momentum.
spk09: Yep. Okay. All right. Thank you.
spk07: And our next question is from Rob Wildhack with Autonomous.
spk04: Hi, guys. Thanks for taking the question. Just on fee revenue in the quarter, how would you describe the organic growth there?
spk01: Yeah, I mean, Rob, why don't I start? It's Ron. I mean, we've had several now good organic growth quarters, both on the servicing line and the management fee line. I think that if you think about last year, there was In the servicing line, a fair amount of that would have been in alpha front to back. A lot of that now is being installed, and a big chunk of that is what you see in the $2.9 trillion. The growth that, or at least the sales that we reported on the servicing fee line were kind of disproportionately in the traditional back office business, which is highly scaled and relatively quick to install. So we like that mix. And then management fees have been, as Eric noted, it's been across the board in the core businesses. It's ETFs, institutional, and even a little bit of cash. So we like both the level of it. We always like more, but we like the level of it. But as importantly, we like the diversity of it.
spk04: Okay, thanks. And then on the 2.9 trillion to be installed, can you just remind us of the timeline for when that gets installed and when it starts to hit revenue?
spk11: Sure, Rob. It's Eric. We've said that that begins to get installed. Remember, the bulk of that, there were two very large deals that were announced in second and third quarter last year. Those were trillion-dollar-plus deals, and then there's obviously a a set of kind of smaller and mid-sized activities. For those two large deals, they are complex and they're transformational, right, for those clients and what we're delivering. And so those we've said tend to take a little longer. They're closer to the, you know, I think we've said for insulations, insulations range from kind of six months to 36 months. But for those where, you know, the The middle ground is probably 24 to 30. So right now our estimate is that a good piece, but probably not the majority, begins to get installed by late this year. And then this is really a 2023 lift of revenues. Got it. Thank you. Sure.
spk07: There are no further questions at this time. I will now turn it back to our CEO, Ron O'Hanley, for closing remarks.
spk01: Well, thanks very much. Thank you all for joining us. I know it was a busy day for you, so we appreciate your time and questions. Thank you.
spk07: Ladies and gentlemen, this concludes today's conference call and webcast. Thank you for participating and have a wonderful day. You may now disconnect.
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