State Street Corporation

Good morning, ladies and gentlemen, and welcome to State Street Corporation's second quarter 2022 earnings conference call and webcast. Today's discussion is being broadcast live on State Street's website at investors.statestreet.com. This conference call is also being recorded for replay. State Street's conference call is copyrighted and all rights are reserved. This call may not be recorded for rebroadcast or distribution, in whole or in part, without the expressed written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. I would now like to introduce Eileen Fizell-Beeler, Global Head of Investor Relations at State Street. Please go ahead, Eileen.

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

Thank you, Eileen, and good afternoon, everyone. This morning, we released our second quarter financial results. The second quarter operating environment continued to be impacted by the ongoing geopolitical events in Europe, and the notable macroeconomic environment. The associated price and wage inflation, rising interest rates, years of recession are driving declining equity and fixed income markets, currency volatility, and concerns over market liquidity. These factors created a number of fee revenue headwinds for our businesses. Despite the adverse market conditions, State Street performed well in the second quarter with a strong balance sheet and good sales momentum. while delivering strong FX trading and significantly better NII growth year over year, coupled with well-controlled expenses and a healthy pre-tax margin. We remain focused on executing against our strategy and intensely managing what we can control to navigate through uncertainty, drive further business momentum, and achieve our medium-term goals. Turning to slide three of our presentation, I will review our second quarter highlights before Eric takes you through the quarter in more detail. Starting with our financial performance, 2Q22 EPS decreased 8% year-over-year, though it was down just 2% year-over-year, excluding notable items, primarily a prior year gain on sale in 2Q21. Weaker markets were the major driver of this decline. Total fee revenue for the quarter declined 6% year-over-year, primarily reflecting the impact of significantly lower global equity and fixed income market levels on servicing and management fees and the stronger U.S. dollar. Within total fee revenue, our global markets franchise continued to perform well with FX trading services revenue increasing 16% year-over-year, benefiting from higher FX market volatility, which drove higher spreads. Total revenue for the quarter declined 3% year-over-year, but was down just 1%, excluding notable items, as lower total fee revenue was largely offset by a strong NII result, which increased 25% relative to the year-ago period. In the face of market-related fee revenue headwinds in the second quarter, we remained highly focused on controlling the expense base. Second quarter total expenses were flat year-over-year, and declined 1%, excluding notable items. Our ongoing productivity actions largely offset higher than anticipated salary increases and planned business investments. Turning to our business momentum, which you can see across the middle of the slide, we reported a strong quarter of new AUCA asset servicing wins, which amounted to $972 billion, with back office services accounting for 40% of these wins by AUCA. As a result of this quarter's good sales performance, AUCA won, but yet to be installed, increased to a record $3.6 trillion at quarter end. During the second quarter, we also reported another alpha client win, with 12 of State Street's 20 alpha clients now live as of quarter end. We were also awarded the title of Security Services Provider of the Year in the Financial News 20th Annual Trading and Technology Awards. Front office software and data also experienced good business momentum in the second quarter, with annual recurring revenue increasing 20% year-over-year to $251 million. At global advisors, assets under management totaled $3.5 trillion at quarter end. Overall, second quarter AUM inflows were negatively impacted by the weaker equity market environment. but we still saw positive net inflows into both our cash and U.S. low-cost ETF franchises during the quarter. Even in a volatile environment, we continue to innovate and expand our capabilities to drive future growth. For example, Global Advisors continues to press forward in active ETFs and ESGs, as illustrated by the launch of the actively managed SPDR Nuveen Invisible Bond ESG ETF and a number of MSCI Climate Paris-aligned ETFs. Last, in terms of business momentum, I was particularly pleased to see that State Street was recognized as the top provider in FX services by Euromoney Magazine in the second quarter. Importantly, State Street regained its number one position overall for real money clients, in addition to being ranked number one for best service for real money clients. Our FX franchise supports and complements our core investment services business and has proven to be an effective deployment of our capital. Turning to our balance sheet and capital, despite a continued rise in interest rates, our CET1 capital ratio improved significantly to 12.9% in quarter end due to our active management of risk-weighted assets and the mitigating actions we executed in our investment portfolio in the second quarter. The strength of our balance sheet was highlighted in the second quarter with the release of the Federal Reserve's annual CCAR stress test results in June. following which we announced our intention to increase State Street's quarterly common stock dividend by 10% to 63 cents per share in the third quarter, subject to approval by our board of directors. We were pleased to announce the intended increase to our quarterly common dividend as we recognize the importance of capital return to our shareholders. With that in mind, in the fourth quarter of this year, it remains our intention to resume our existing common share repurchase program in an amount reflecting interest rate levels and market conditions at that time. I'll now turn to our proposed acquisition of BBH's Investor Services business, which remains subject to regulatory approvals and other closing conditions. We continue to be excited about the business and its people, the franchise it represents, and the opportunities the transaction represents for our collective clients and for accelerating our strategy. I've mentioned previously that we've been engaged in ongoing dialogue with U.S. banking regulators regarding the regulatory review process and potential modifications to the transaction intended to facilitate resolution of that process. Based on those discussions, we have developed with BBH proposed modifications to the transaction structure that the parties believe present a path forward. The proposed modifications include changes to the operating model and legal entity structure, and changes to the regulatory approvals required to complete the transaction. As part of the proposed modified transaction, State Street is seeking amendments to the transaction terms, including the purchase price. Both BBH and our Board of Directors would need to review and approve the modified transaction in amended terms. During the third quarter, we intend to finalize the proposed structure in contractual terms and confirm our approach with regulators. Assuming the financial and operational aspects of the proposed modifications are timely finalized and contracted, subject to regulatory approval and other closing conditions, the parties are aiming to close the transaction at the end of the fourth quarter of 2022. However, there exists significant timing uncertainty and risk that closing will extend beyond that timeline. There can be no assurance that a mutually acceptable modified transaction will be entered into or as to the timing or outcome of any regulatory approvals and other closing conditions for this modified transaction. After September 6, 2022, either party can terminate the transaction without penalty, absent further agreement of the parties. To conclude, as we progress towards our medium-term targets in this uncertain environment, we remain particularly focused on maintaining and further improving our pre-tax margin performance, which, despite the challenging market conditions, increased almost 29% for the quarter, excluding notable items. To help achieve this goal in the face of inflationary pressure and a challenging revenue environment, we will continue to exhibit expense discipline and to drive our automation and productivity efforts. We also remain laser-focused on innovating for the benefit of our clients and driving organic growth, as demonstrated by the strong AUCA wins in the second quarter, all while returning capital to our shareholders. And with that, let me turn it over to Eric to take you through the quarter in more detail.

Thank you, Ron, and good afternoon, everyone. I'll begin my review of our second quarter results on slide four. We reported EPS of $1.91, or $1.94 excluding acquisition and restructuring costs, as detailed on the panel on the right side of the slide. As Ron noted earlier, the operating environment in the second quarter remained challenging, largely characterized by continued market volatility related to macroeconomic events and continued geopolitical uncertainties. As you can see on the left panel of the slide, strong growth in both net interest income and FX trading enabled us to partially offset significant headwinds from lower equity and fixed income markets in the quarter that impacted other fee areas. Also evidenced by today's results, our approach to expense management remains very disciplined and deliberate. On a year-on-year basis, second quarter expenses were down, even as we experienced higher-than-expected wage increases and continued to thoughtfully invest in the franchise. Lastly, you'll see that in the second quarter, we had a lower-than-expected tax rate. The bulk of the discrete tax items that contributed to our lower taxes were due to the reassessment of a deferred tax asset worth roughly $60 million. All things considered, during the quarter, our business model demonstrated resilience against the challenging backdrop. Turning to slide five, during the quarter, we saw period-end AUCA decrease by 10 percent on a year-on-year basis and 8 percent sequentially. Amidst continued and uncertain economic conditions, the year-on-year change was largely driven by lower period-end market levels across just about every equity and fixed income market around the world. partially offset by net new business and client flows. The quarter-on-quarter decline was largely the result of the same lower period and market levels, as we've also started to see industry outflows from investment products as the risk-off sentiment continues. Similarly, at Global Advisors, quarter-end AUM decreased 11% year-on-year and 14% sequentially. The year-on-year decline in AUM was also largely driven by lower period and market levels, and institutional net outflows, which was partially offset by positive net inflows in both our U.S. low-cost ETF complex and cash inflows in the quarter. Turning to slide six, on the left side of the page, you'll see second quarter total servicing fees down 7 percent year on year, largely driven by lower average equity and fixed income market levels, normal pricing headwinds, client activity and adjustments, and the impact of currency translation. partially offset by net new business growth. Excluding the impact of currency translation, servicing fees were down only 4% year on year. I'd also highlight that from a segment perspective, we continue to see excellent revenue growth in our alternatives client segment, both year on year and quarter on quarter. Sequentially, total servicing fees were down 5%, primarily as a result of the same drivers, lower average equity and fixed income market levels, client activity and adjustments, and the impact of currency translation, partially offset by positive net new business. Within servicing fees, back office fees were down 7% year-on-year and 5% quarter-on-quarter, largely driven by the factors I just described. Middle office services was down 12% year-on-year and 8% quarter-on-quarter, primarily due to decreased client AUMs driven by lower market levels and client transaction activity and adjustments. But we are seeing some compression in our legacy middle office book It is an important component of our alpha proposition when it connects to both the front office and back office, and new wins generally come with contracts of 7 to 10 years. We continue to expect to see good growth over the medium term, as evidenced by our large, uninstalled middle office revenue backlog of more than $90 million, which I will talk more about in a moment. Even against this challenging backdrop, we continue to be pleased with our investment services business momentum and robust pipeline. We recorded another strong quarter of new AUCA wins worth $972 billion, while AUCA 1, but yet to be installed, amounted to $3.6 trillion at quarter end. As Ron mentioned earlier, during second quarter, we reported another new alpha win, all spring global investments, taking the total number of alpha clients to 20, and now have 12 implementations live. Lastly, in response to industry inflationary cost pressures, we've undergone a comprehensive analysis of our pricing across all our products areas. The result of this analysis has led to the decision to begin to adjust our client pricing upwards in certain areas of servicing where the wage pressure is most acute and industry capacity is stretched. Ultimately, we believe these pricing changes will support the continued investment that allows us to best serve our clients. Turning to slide seven, second quarter management fees were $490 million, down 3% year-on-year, primarily reflecting lower average equity and fixed income market levels, the impact of currency translation, and a specific client repricing adjustment, partially offset by the elimination of money market fee waivers and the run rate impact of net ETF inflows. Management fees were down 6% quarter on quarter, largely due to equity and fixed income market headwinds, partially offset by the elimination of the same money market fee waivers. As you can see on the bottom right of the slide, our franchise remains well positioned for growth. In ETFs, although we saw outflows in equity and commodities, we continue to see inflows into SPDR low cost and fixed income ETFs. In our institutional business, There's continued momentum in our target date franchise, notwithstanding outflows primarily from one large client with very low fee assets, which ultimately benefited the overall management fee rate this quarter. Across our cash franchise, we again saw another quarter of strong net inflows, this time worth $15 billion in the quarter, contributing to market share gains. On slide eight, FX Trading Services had yet another strong quarter. Relative to a period a year ago, second quarter FX trading services revenue was up 16%, primarily driven by higher FX spreads, partially offset by lower client FX volumes. Quarter on quarter, FX trading services revenue was down 8% as the benefit of higher FX spreads was more than offset by lower client FX volumes too. Our second quarter securities finance revenues decreased slightly year on year, primarily driven by lower agency and enhanced custody balances due to lower markets, partially offset by higher spreads. Sequentially, revenues were up 11%, mainly reflecting higher spreads, partially offset by lower agency and enhanced custody balances. Second quarter software and processing fees were down 11% year-on-year and 6% quarter-on-quarter, largely driven by lower front office software and data revenue associated with CRD, which I'll turn to shortly. Other fee revenues of negative $43 million in the second quarter declined both year-on-year and quarter-on-quarter. Both the year-on-year and quarter-on-quarter declines largely reflect negative market-related adjustments, while the absence of prior period positive fair value adjustments on equity investments also contributed to the sequential decline. While we saw pressure throughout the quarter, almost half of the $43 million came through in the second half of June. Moving to slide nine, let me provide some details on the performance of our front office software and data revenue in the second quarter on the left panel of the slide. As a reminder, CRD represents the majority of these revenues, but we also include Alpha Data Services, Alpha Data Platform, and Mercatus revenues since they are part of our front office offering. On both a year-on-year and quarter-on-quarter basis, front office software revenue declined as expected, primarily driven by the absence of several on-premise renewals in the prior period as well as some episodic fees when compared to the prior year quarter, partially offset by higher software-enabled SaaS revenue. It is important to note, however, that the more durable and recurring software-enabled and professional services revenues have continued to go nicely, with a year-on-year growth of 15%, demonstrating success in deploying our cloud-based SaaS platform environment to more clients. Turning at some of the softer metrics enabled by CRD and Alpha on the right panel, you'll see that our annual recurring revenue has grown 20% year-on-year as we convert more clients to SaaS, which we expect will create a stickier and more profitable business model. As for the middle office, we continue to have an extremely healthy backlog of uninstalled revenue worth $92 million, which is almost twice the prior year. Lastly, we are pleased to have announced another Alpha mandate win this quarter. We're also excited to have expanded an existing alpha relationship this quarter, winning approximately $300 billion of new back office assets to custody from an asset owner client. This provides another proof point that our alpha value proposition is working as we're gaining more of the wallet share over time. Turning to slide 10, Second quarter NII increased 25 percent year-on-year, primarily reflecting the impact of higher interest rates and continued growth in loan balances. Related to the first quarter, NII was up 15 percent. The sequential increase was largely driven by the improvement in both short and long end rates, which benefited our yields, together with continued growth in loan balances, partially offset by lower investment portfolio balances. On the right side of the slide, We saw our average balance sheet during the quarter. Average deposits were down 6% year-on-year and 2% quarter-on-quarter, primarily related to the impact from currency translation and dollar strengthening, which accounted for almost half of the year-on-year decline and two-thirds of the sequential decline. The investment portfolio is now down modestly, and we have almost 60% of our securities now in health to maturity. We're pleased that our balance sheet is well positioned to recognize this interest rate and NII tailwind and also protect OCI. Turning to slide 11, second quarter expenses excluding notable items decreased 1% year-on-year or increased 2% adjusted for currency translation. In response to the revenue environment, we have been proactively managing our expenses, including lowering our incentive compensation in addition to carefully executing on our continued productivity savings efforts, which generated approximately $60 million in year-on-year growth saves or approximately $150 million year-to-date. These savings enabled us to continue to self-fund the good portion of the 4 to 6 percent higher wage rates we're facing and the targeted investments in the business, including the alpha product, technology infrastructure, and broader automation. Compared to 2Q21, compensation employee benefits was down 3%, as lower incentive compensation and the impact of currency translation were partially offset by salary merit increases associated with wages and inflationary pressure and higher contractor spend. Excluding currency translation, compensation employee benefits would have been up 1%. Information systems and communications expenses was down 2%, primarily due to the episodic credits related to vendor pricing optimization and infrastructure rationalization. Occupancy was down 4% due largely to currency translation, and other expenses were up 18%, primarily reflecting higher recoverable client-related expenses, which are offset in fee revenue, professional fees, and travel costs. On a quarter-on-quarter basis, expenses were down due to seasonal expenses in the first quarter. Headcount increased quarter-on-quarter as we continued to insource some strategic technology functions from vendors, as well as support growth in alpha. Overall, in light of the current macroeconomic environment, we have had pretty healthy pre-tax margin for the quarter at approximately 29 percent, excluding notable items, supported by active expense management and strong NII growth. Moving to slide 12, on the right side of the slide, we show our capital highlights. We are quite pleased to report the ET1 of 12.9%, up 100 basis points quarter-on-quarter. We're also happy with our performance under this year's CCAR with a calculated stress capital buffer well above the 2.5% minimum, resulting in a preliminary SCB at the floor. As a result, in June, we announced a planned 10% increase to our 3Q22 quarterly common stock dividend subject to Board approval, and it remains our intention to again begin our existing common share of purchase program in the fourth quarter in an amount reflecting market conditions at the time. To the left of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios. As you can see, this quarter, even against the backdrop of a challenging operating environment, we drove stronger and higher capital levels. During the second quarter, we completed several of the previously announced RWA optimization actions across our trading, lending, and investment portfolios, reducing RWA $12 billion quarter-on-quarter. We also shifted about $20 billion of AFS securities to HTM. As a result, we limited AOCI from the investment portfolio to under $500 million or 40 basis points of CET1. even with a roughly 60 basis point upward interest rate move across the two- and five-year part of the curve. You'll see a larger AOCI move in the gap books, but much of that is ratio hedged and offset by the appreciating dollars effect on RWA with an offset in goodwill and intangibles as well. Given that we have now significantly reduced the OCI risk to interest rate shocks by 75%, We are now comfortable operating somewhat below our standard target ranges for both CET1 and Tier 1 leverage ratios. Turning to slide 13, we provide a summary of our second quarter results. Despite the continued volatile market environment, I am pleased with our quarterly performance, which demonstrates the strength of our business model. The current macroeconomic environment and persistent geopolitical uncertainty is notwithstanding, Our strong growth in both net interest income and FX trading services enabled us to partially offset significant headwinds from both equity and fixed income markets, highlighting the resiliency of our franchise. And our expenses remained well controlled, demonstrating the progress we are making in improving our operating model. Now, turning to outlook. We would like to provide our current thinking regarding the third quarter. At a macro level, while market rate expectations have been volatile, our current interest rate outlook is broadly in line with the current forwards, which suggests the year-end Fed funds rate of 3.5%. We expect other major international central banks to continue raising rates, with the ECB expected to start increasing rates in third quarter. The current spot level of global equity markets would imply that average Equity markets in 3Q would be down 7% to 8% quarter-on-quarter, and U.S. dollar appreciation to be about a percentage point of headwind to revenues and tailwind to expenses, which will be included in our guide. Now, in terms of the third quarter of 2022 and on a standalone State Street basis, given the implied declines in average global markets, we expect total fee revenue to be down about 2 percent on a sequential basis. And we expect both servicing fees and management fees to be down 4 percent quarter-on-quarter, driven by weaker market levels. Turning to NII, following one of the strongest sequential increases in the NII for many years in 2Q, we expect to deliver further growth, with NII expected to increase 5 to 9 percent quarter-on-quarter driven by the tailwind from central bank rate hikes. This outlook includes our expectation for some initial deposit outflow and rotation in 3Q. And for the full year, on a standalone state street basis, we expect NII to increase 24% to 27%, which is significantly better than our prior full-year guide of 18% to 20%. Next, we expect total expenses excluding notable items to increase just under 1% quarter-on-quarter, driven by inflationary pressures on wages as we continue to target productivity initiatives and execute against our strategy with a deep focus on expense discipline. This focus should enable us to drive positive total operating leverage excluding notable items for the full year. Lastly, we would expect our 3Q tax rate to be approximately 20% for the quarter. And with that, let me turn the call back to Ron.

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

Thank you, sir. Ladies and gentlemen, we will now begin the question and answer session. If you would like to ask a question, please press the star followed by the number 1 on your telephone keypad. If you would like to withdraw your question, please press the star 2. One moment while we compile the roster. Your first question comes from Glenn Shore of Evercore. Please go ahead.

Hi. Thanks very much.

In your prepared, you talked about management fees by market. You also said a client-specific pricing adjustment. I just wondered if you could just give a little more color on that so we know if it's a one-off or this could be other adjustments going forward. Thanks.

Sorry, Glenn. It's all right. You're breaking up on the audio. Could you... I got bits of that, but could you repeat that, please, for the first?

Absolutely. ...driven by markets, which is obviously going to happen. But you also said adjustment. I wonder if you could give a little more detail, say the size, what kind of adjustment that was, just in case we keep thinking about that going forward.

Sure, Glenn. Let me try to cover that. And I think you're focused on servicing fees and management fees. So let me do them both so that we have a little bit of context for you. On page six of the materials on servicing fees, you asked about the impact of client activity and adjustments. And on a year-on-year basis, largely due to the kind of lower levels of activities, and sometimes that comes through with lower markets. That was worth about a percentage point of headwinds on a year-on-year basis and about two points on a quarter-on-quarter basis for that. On management fees, there was a series of uh impacts uh quarter on quarter most of that was driven by uh by market um you know there was uh there was one client that we uh we called out um but that would have been worth uh you know at most uh one to two uh percentage points of uh of fees uh for that uh uh for that quarter okay and then i have just i know this would be included in your guidance

but I'm looking for a little color. When markets, I remember when they used to go up all the time, you'd keep temporary enthusiasm on fees in general, servicing fees, because some contracts have ceilings in them. My question is if and when we continue any downtrend in these markets, do those same contracts have floors? Should we expect more stable servicing fees if and when the markets continue to drag lower. Thanks a lot, Eric.

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

Okay, thank you. Operator, the next question.

Your next question comes from Ken Houston of Jefferies. Please go ahead.

Thanks. Good afternoon. Ron, just following up on your opening remarks and what we saw on the forward-looking statements, as you go forward and try to negotiate, I guess just how do you think through your optionality, meaning that, of course, a price concession is probably your best outcome. If you can't get one, is that a go, not go decision right there? And then if for some reason you do walk away one side or the other, what becomes your next immediate steps in terms of either capital strategy or go forward strategy? Thanks.

Yeah, Ken, we're very much in the midst of this. So, you know, I don't want to get out ahead of it. Firstly, we remain committed to through the combination on a strategic basis. But given that we foresee this being restructured in a way that, you know, it changes some of the operating model, some of the circumstances change, we do believe, well, we know we believe some kind of a price adjustment would be warranted. I don't want to get ahead of where we are in discussions with DBH. They remain very amicable, and both sides are committed to making this happen. We're committed to, you know, we like the business. We like the people. So, you know, obviously, if we don't get there, then there's a lot of options in front of us, and, you know, we'd come back to you at that time.

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

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

Okay, great.

Thanks, Eric.

Your next question comes from Betsy Grasset of Morgan Stanley. Please go ahead.

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

Betsy, it's Eric. You know, those are all the kinds of areas we're working through. And I think the heart of this, when you do a banking deal, a global banking deal of this sort, is the legal entity structure. And you obviously know we run a holding company, a bank, a series of banks, and there's a series of entities that we have around the world. And obviously, creating a workable and a good path of combination can be done in different ways. in different ways. And part of what we've been working through is modifications on what might have been our original plan to make the transaction workable and attractive. That then has some ramifications, to your point, on the operating model that will have some amount of effect on perhaps the pace of expense or revenue synergies. And that's what we're working through. What we have said, and we'd want to reiterate, is that we are committed to finding a way to preserve the economic accretion in the range that we had previously disclosed back in September. And so we're highly focused on that. And as a result, there are some changes that we're seeking on the transaction. including price that Ron mentioned.

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

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

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

Sure, Betsy. It's Eric. I think the best place to see our CAPRA ratios and targets is on page 12 of the presentation deck. You see what I'll call our standard CET1 targets, our 10 to 11 percent, our standard Tier 1 leverage targets, five and a quarter to five and three quarters. And, you know, what we've done is, as you mentioned, is we've dramatically reduced the volatility risk from OCI, which means that, you know, we're quite comfortable running below that. You know, directionally, that means on CET1, for example, you know, could be up to 50 basis points below that, you know, while we run at much lower risk and volatility levels in OCI. And on a leverage basis, it tends to be about half of that amount.

Thank you.

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

Actually, good afternoon. Thanks for taking the questions. It's been a long day. So, Eric, you referenced that you were considering some adjustments to the pricing model, which make a lot of sense. You know, obviously, we're dealing with a very inflationary environment. Have you begun those discussions? And what has been the reaction from clients so far? Are you hearing from some of your clients that some of the competitors are also making similar moves, just to be assured that you're not going to be out on your own pushing in that regard? Because normally when we think of pricing, of course, in the custody world, it's typically a tougher place to get price increases. So kind of curious about that.

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

Okay.

Thanks for that. And then when we think about You laid out, Eric, the expectation around ECB and whatnot. But as we see potential policy rates in different parts of the world diverging, could you give us a reminder about the currency mix of your deposits as it stands now and whether or not you expect in the foreseeable future that to shift at all? as yield differentials widen between different currencies. Thank you.

Sure, Brennan. It's Eric. And we actually added some additional disclosure in our financial addendum this quarter. You'll find it on page 8. That actually breaks out the balance sheet, including the total assets, the investment securities, and deposits by the major currencies, USD, euros, pound sterling, and so forth, because we are quite focused on navigating this interest rate environment, and to be honest, you know, securing the benefits of interest rate increases around the world, right? We position the balance sheet currency by currency. We have pricing, you know, plans, and you know, betas that are carefully developed currency by currency. I don't think we expect a lot of change in the composition of the balance sheet. I mean, the U.S., you know, is clearly, the U.S. central bank is clearly moving much more quickly and, you know, with not only interest rates but quantitative tightening, and that will potentially have a downward trend on U.S. currency deposits. On the other hand, with U.S. rates, prevailing rates, higher than what you see around the rest of the world, there's a natural draw into the U.S. from global investors. So it's hard to, I think it's hard to actually, you know, the currency composition and the deposit levels, you know, given those movements. But we're well prepared. And, in fact, some of the interest rate or some of the NII increases that you saw this quarter are coming not only by virtue of the U.S. rate rises, but also those in pound sterling and some of the other, you know, Anglo-Saxon currencies. And, you know, we're positioning currency by currency as a result.

Great. Thanks for that.

Your next question comes from Jim Mitchell of Seaport Global. Please go ahead.

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

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

Okay, great. And then when I think about the get-to-be-installed business, I mean, it continues to grow. I know there's a long tail to getting those installed, but are we at a point where this – I mean, I think we've looked in the past and I think we all get a little frustrated that we see these big wins and it's hard to determine or see it in the numbers. Are we at a point where this is getting to materiality and that we could see a nice acceleration in organic growth next year when this stuff gets installed?

Yeah, I think you've got the right broad time frame. I mean, the I guess the way I would describe it is the larger the deal, the more complex and more transformative it is for our clients, right? They're fundamentally changing their operating model, they're harmonizing systems and processes, and we're co-investing with them to build for them a front, middle, and often back office model that will suit them for a decade or more. As you think about the $3.6 trillion of AUCA to be installed, 2023 is an important year. We expect that about a third, this will move around, but about a third will likely be installed by the end of that year, and perhaps as much as half of the revenue associated with those wins.

Okay, great. That's helpful. Thanks.

Your next question comes from Brian Bedell of Deutsche Bank. Please go ahead.

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

Yeah, that's correct, by the end of 2023. Okay.

Got it. Back to the BB-8 strategy. Good to hear that you're both committed to this. If you are able to close it with any amended terms and amended structures, can you just remind us, or I guess if you have comments on the deposit strategy, which was obviously bringing the BBH deposits on balance sheet, and then there was an opportunity to bring potentially a large portion of balances from their $60 billion of off-balance sheet, or third-party bank, I should say, arrangements. Would that still be doable, or does the structure change that calculus?

Brian, it's, you know, we're still in the process of, you know, nailing down, you know, both the legal entity and the operating model changes, you know, and we're working through those and, you know, working towards developing a firm view of when and how the deposits and suite program is operated and how, you know, we may in the future, you know, use that program, take advantage of some of the cash and deposit optionality. But that's in process at this point and, you know, You know, we'll certainly provide an update, you know, over the course of the third quarter, I expect, as we nail down the modifications.

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

I think the, you know, the last cycle, you know, is always going to be indicative, but you remember there were moving parts in the last cycle, including, you know, the, you know, the SLR rule was in flux, and there was, you know, we, many of us on the banking side had to navigate the size of our balance sheets independently of what was happening at the interest rate environment and quantitative tightening. I think what I've said in the past is relevant over the Since the pre-COVID time period, our deposits are up roughly $60 billion. We think that half of that can easily be ascribed to the quantitative easing that we had, and that'll reverse out. you know, that's an estimate, and it's always, you know, hard to forecast this because, you know, the interest rate environment is moving up quickly. There's also a risk-off environment, so we've got to see how that plays out. You know, I've said that, you know, we could see, you know, $6 to $10 billion of outflows, you know, per year, per trillion dollars of U.S. balance sheet tightening. I do think because the interest rate environment is higher and has moved faster. We're likely to see closer to the $10 billion per trillion in the first year and then maybe lighten out in the second and third year. But those are all the scenarios we're working through. I think from our perspective, we're extremely flush from a liquidity standpoint. You know, the deposits are valuable, so we're monetizing them for the purpose of the P&L. And, you know, we expect over time to be able to, you know, not only get to the higher levels of NII that we have in the past. I think we were in the $695 million range, you know, with our peak. during the last cycle, I think, you know, our forecast, and it's hard to, you know, forecast this perfectly, but, you know, the forecast that we've built put us at or above that level, you know, in this next cycle. And part of that is that while there is some, you know, tightening and erosion of total deposit levels, you also have higher US rates, higher global rates, and in particular, we'll have a move in ECB and European rates, at least based on the current forwards. Right.

That's great, Collier. Thank you so much.

Sure.

Your next question comes from Stephen Schubach of Wolf Research. Please go ahead.

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

Sure. Let me start on fees. You know, the real environmental challenges, if you just extend out the current spot levels that equity markets are sitting at. You know, the average, you know, the daily average for third quarter is going to be down, you know, 7% to 8% versus the average for second quarter. And that's the basis by which, you know, we earn revenues, both servicing fees and management fees. So that's the headwind that we have. You know, we're – we're hoping that some of the market-related, you know, the lumpy stuff that we have in other revenues doesn't repeat, and that might, you know, give us a little bit of, you know, of insulation. So, you know, that's why I said servicing and management fees, you know, could be down the 4% range sequentially, but total fees perhaps, you know, closer to 2%, so less so. And obviously, volatility levels in markets help currency trading and other activities. But we've got to play out and see how the summer months happen. I think on expenses, I'm just trying to guide quarter by quarter. I think if you add up first quarter, second quarter, the guide of... just under a percentage point for the third quarter. And you can put a range around that and estimate fourth quarter. And so I think that's what we've done from a guidance standpoint. I think what we are willing to say is because we have kind of an overall view of fee revenues for third quarter, we can guesstimate into fourth quarter as can you. I think NII, we have quite a solid view of the full year, which we've provided. You know, we're comfortable saying, and we said in our prepared remarks that, you know, we expect to drive positive total operating leverage for the year, you know, adjusted for notables. But, you know, we feel confident in that, you know, given the current market environment. And part of that is you know, we have some visibility as we've described on fees, a good bit of visibility on NII. And to be honest, while there are some wage and inflationary pressures, you know, because the P&L is lighter, we've proactively adjusted the incentive line to compensate for that. And, you know, we're committed to navigating through this environment, you know, in a in a thoughtful way and deliver results that are as positive and as appropriate as possible.

That's a really helpful color. Just one follow-up on some of the expense commentary, Eric, you offered. One of the questions we've been fielding from a lot of folks pertains to the longer-term expense growth algorithm. You guys have done a really good job of reining in David Wiltshire- Expenses on absolute basis over the past few years, clearly, the inflationary pressures are starting to build as we think about your efficiency agenda that you guys have prosecuted on. David Wiltshire- But at the same time, the inflationary pressures building simultaneously, how do you see that expense growth algorithm evolving over time.

Yeah, I think we'll know more over the course of the year, but I think there are some inflationary pressures, some of which we can look for ways to at least limit, but we can't really avoid. So let me give you an example. On the $8 billion expense base that we have, about $2.5 billion of that is salaries. Now, salaries historically have moved up, you know, about, you know, two percentage points a year, maybe three. But, you know, right now, if you look at merit increases, the higher salary replacement rates for new hires versus exits, you know, bidding back collectively talent, you know, salary costs are up closer to 4% to 6%. on a run rate basis, you know, on a base of $2.5 billion. So you could do the math there and start to get a sense that, you know, that creates an additional headwind, you know, that we didn't have, and that headwind could be worth an extra point of expenses on the total $8 billion base. It's that kind of environment that we're operating in. I mean, we need to see if that's that persists into next year? Do we have a recession or not? What happens to labor markets? Um, and then, and then, you know, the other part of that is working through, uh, where we are on non-comp expenses, you know, where vendors, uh, you know, come to us sometimes and say, look, you know, we, we, uh, we feel the need to adjust and we're obviously trying to manage and rein that in. And I think that's, uh, that's another factor. So I think we see some of those. We're trying to telegraph them, but we're also committed to achieve and deliver on our medium-term targets. And some of that's going to be by finding in some ways to maybe limit or contain or offset, but in other ways they may come through. You know, the industry environment will give us a tailwind. And then you heard us describe some of the you know, selective changes that we're discussing, you know, with clients around, you know, pricing and, you know, top line pricing. So there are a number of different factors. I think I'm not, I'm not, I'm not, it's early to give, you know, a fulsome view of what next year pretends. But I would say that we're conscious we're in a dynamic environment. We're conscious that there are some elements that we can control and others that aren't as controllable. but we're also committed to getting to our medium-term targets, and I think that provides a good set of goals for us and that we're committed to.

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

That's great, Collier. Thanks so much for taking my questions.

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

Hi, Ron. Hi, Eric. Guys, maybe Eric, you've in the past given us an update on the variable rate pricing of your fee revenues. What percentage of fee revenues today would you consider variable pricing, which are greatly influenced by market levels, of course? And secondly, And Ron, when you talked about, you know, talking about price increases for some of the products for your customers, is that for both the variable rate type pricing as well as fixed rate pricing?

Yeah, Gerard, let me start. Our pricing schedules, you know, there's a lot of history behind them on the servicing fee side. I would say that and we disclose this in our queue with some specificity, but about, you know, half of the revenues earned through the servicing fee schedules are market-level dependent. So, you know, the kind of assets under custody levels. There's then a portion that is driven by transactional or activity of volumes, and then the balance is fixed. So there is a mix. And that's what you're seeing flowing through the P&L at this point. They are complex schedules. You can measure them with a ruler in some cases just because they span the world. They span products and regions and entities and often have some history associated with them. But that's a broad basis.

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

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

Sure. Let me do that in pieces. The HTM portfolio, I think there's good data for you and others in the financial addendum. And you can find that on page nine of our addendum. We describe the AFS portfolio both on average and on an end-of-period basis in the HTM portfolio. And I think in total, you know, the yield on AFS right now is about – 91 basis points. On the health to maturity, about 155 basis points. That's just because of the duration that we tend to put in health to maturity to protect it from OCI. In terms of the accretion that will come through, we expect the accretion to start towards the fourth quarter in particular, a little bit in the third, and then into the fourth quarter. And we're looking at accretion in the $100 to $200 million range of capital. It'll bounce around quarter by quarter as different maturities come through. But that's a healthy amount of capital accretion. And that could be worth 10, 15 basis points of capital and could certainly help us fund future buybacks and other returns of capital to shareholders, which, as we've said, we'd like to restart in the fourth quarter and continue on from there. Thank you. Sure.

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

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

That's a good question, Mike. I would say that what's changed over the years is virtually everybody, you know, you go back 15, 20 years ago, virtually everybody bought the same service. You know, it was custody fund accounting. It was publicly listed markets. You know, it was fairly consistent and plain, and it was very easy to you know, do as you said. I think what's changed is that, you know, even, you know, certainly in the medium to large managers, you're seeing a broad product base, some of which are actually reasonably complicated to do, whether it's complicated because of the skills required, complicated because of the technology that's required. And it's in those areas where we're seeing the highest demand inflationary pressures. And we think that we offer a superior capability. We think that in many cases, there's just limited capacity in the marketplace. And we also think that it's a time where everybody's seeing the same kind of pressure. The last 10, 15, 20 years, the world's been enjoying, in effect, the great deflation And that's not what's going on now. So it's always dangerous to utter those words, you know, this time is different, so I won't. But we do think there's a set of circumstances and a targeted set of areas where pricing adjustments are required and that we believe that clients will understand. And again, very early reads, but they seem to be.

And as a compromise, are you talking more about compensating deposit balances like the trust banks had in the past when rates were higher? No.

Okay.

It's just plain old we want to get paid more because our costs are up for us and everybody else.

And so one third of wait, wait, wait, wait, Mike, but that's on deposits. Remember, we've been under earning on deposits against, you know, what costs us to hold deposits, which is preferred securities, right? For now, you know, several years, we barely offset that, you know, at the height of the last interest rate increase in 2017, 18. And so We're just trying to get to par on deposit spreads. And obviously, as deposit rates rise, we give a reasonable proportion of that back to our clients. And we do that purposely. That's part of the social contract. But that feels like it's going back to a normalized level. The wage and salary and non-comp pressures that we're seeing are not different than what others are seeing in the rest of the economy, and that on a net basis is quite different.

Okay, that's good clarification. Thank you. And then just last on that, your cost going higher, I thought a lot of banks seem to have an advantage, just like you. You had $2 billion of expenses, $1 billion in comp, but comp in society is going up less than other inflation, right, like food, rent, gas, everything else is going up a lot more than employee costs. And what we've been hearing, at least anecdotally, among the banks is that some of those employee cost pressures have been waning in the most recent months and weeks. But what I hear from you is that that's not the case, or even if it is the case, you're still talking about kind of 2x historical growth than in the past.

Mike, what I would say is, you know, what you say about comp costs lagging behind other inflationary expenses, I mean, that is true and that's typical, right? That's typically how, you know, kind of inflation works its way into and through labor markets. I would say that we've certainly seen a much higher than trend pressure on labor us, and I would venture, since we're swimming in the same pool of skills here, I would say certainly with our near-end competitors, particularly in the skilled areas that we need, and as Eric noted, when we're replacing somebody that's come in at a much or a significantly higher cost than before. Now, I think it's also true that if you believe that that there's a recession facing us or that in any event, there'll be less kind of economic growth going forward than what we see now for a period of time. That's likely to take pressure off it, but there's still a very real move up in select areas around our expenses. And I actually don't think it would be different for a comparable institution.

All right, thank you very much.

Your next question comes from Rob Wildhack of Autonomous Research. Please go ahead.

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

Yeah, as you recall, Rob, we had in the first quarter consciously deployed more RWA in some of our business activities, in particular in trading and in lending, just because we had a surplus amount of capital, and so we put it to work and had some good revenues. This quarter, we ran that back in partly because we were committed to driving our capital ratios upward. And partly, to be honest, we found some opportunities for optimization. So I talked about more than a $10 billion reduction quarter on quarter. That came across businesses and securities finance. It came in the lending book where some of the loans qualified for margin loan treatment, which comes at a different RWA. level. And then we had some amount of credit, I'll call it sort of credit light in the investment portfolio that was 100% risk-weighted that we allowed to roll off. So there were some tactical adjustments that we made on that basis. We also tend to have some volatility in RWA. The FX derivatives book can move around by you know, $3, $4 billion, and that was a, that we got a good bounce there. So I think about a third, I'd say, was of the $10 to $12 billion quarter-on-quarter reduction was a good bounce, and we'll take those. But that could actually, that, you know, $3 to $4 billion could bounce back up in the third quarter, and we're obviously, you know, we're obviously, you know, considering that We continue to accrete through the P&L every quarter, and I think we're quite comfortable with our capital ratio trajectory into the third quarter, and also in such a way that we can prepare for buybacks in the fourth quarter as well. Very helpful.

Thank you, Eric. Sure.

Your next question comes from Vivek Junega of JP Morgan. Please go ahead.

Thanks. Firstly, I want to echo Mike's comment about changing the timing of the call. I'm glad. I would take that one step further and say in the future it would be helpful if you'd even think of another day so it would be not on such a crazy day for all of us so we could actually pay a little more attention to it. But moving past that, the price increases that you're talking about on servicing contracts, given that these are longer-duration contracts, Ron, when should we expect that they could start to go through? Is it a year out, or do you think these could go into effect in a fairly short order? What kind of timing would you point to?

Yeah, Vivek, it's a good question. And again, because we're trying to be very fact-based and tie it to where there's increases and where we feel we need to do this, the answer is it varies. In some cases, it's around particular transactions or asset class types where we can institute. In other cases, there is an agreement that we need to secure from the client. But our goal is to, I mean, obviously the pressure is now. So, you know, we want to put it in as soon as possible. Again, we're early in this process. So, you know, we'll see what we accomplish in terms of overall timing. But I think given our approach, which again is based on facts and the realities of client situations, we're optimistic that we can, we can accomplish something here.

Thank you.

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

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