State Street Corporation

Good morning and welcome to State Street Corporation's second quarter 2023 earnings conference call and webcast. Today's discussion is being broadcast live on State Street's website at investorsatstatestreet.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 State Street's website. Now I would like to introduce Eileen Feazell-Bihler, Global Head of Investor Relations at State Street. Please proceed.

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 2023 earnings slide presentation, which is available for download in the investor relations section of our website, investors.statestreet.com. Afterwards, we'll be happy to take questions. During the Q&A, please limit yourself to two questions and then 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, also available in the IR section of our website. In addition, today's presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors, such as those factors referenced in our discussion today and in our SEC filings, including the risk factors in our Form 10-K. Our forward-looking statements speak only as of today, and we disclaim any obligation to update them, even if our views change. Now, let me turn it over to Ron.

Thank you, Eileen, and good morning, everyone. Earlier today, we released our second quarter financial results. Relative to the significant volatility experienced by investors in the first quarter, market conditions in 2Q were more subdued, and global financial market performance was varied. Global equities generated positive returns for the third consecutive quarter as investors saw continued strength in developed equity markets, but weakness in emerging markets. Fixed income markets fell as investors had to contend with still elevated levels of inflation and further central bank rate hikes, including the Federal Reserve raising interest rates above 5% for the first time since 2007. The second quarter was also characterized by falling currency market volatility, which created headwinds for our foreign exchange business. Turning to slide three of our investor presentation, I will review our second quarter highlights before Eric takes you through the quarter in more detail. Beginning with our financial performance, second quarter ROE was 13% and pre-tax margin expanded by 1.2 percentage points year over year to 29.5%. Relative to the year-ago period, 2Q EPS increased by 14 percent to 217, supported by our common share repurchases, significantly higher NII, strong front office software and data revenue growth, and an increase in securities finance revenue. Our results also benefited from the release of an allowance related to the support of a financial, U.S. financial institution, as well as an accounting adoption. Taken together, these factors more than offset headwinds in some of our other fee-based businesses and the impact of higher than desired year-over-year expense growth. Turning to our business momentum, in Q1, I highlighted that by strengthening our implementation capabilities, we had line of sight into a meaningful amount of client onboarding this year. We began to realize the benefits of this plan and onboarded $1.2 trillion of AUCA during the second quarter. primarily driven by State Street Alpha, underscoring the power of the Alpha value proposition to our investment services strategy and long-term growth. As a result, our AUCA installation backlog declined to $2.4 trillion, while total AUCA increased by 5 percent quarter over quarter to $39.6 trillion, sold at quarter end, in part as a result of this new business. We also recorded over 140 billion of asset servicing wins in the second quarter, largely driven by strong sales in the desirable asset owner, official institutions, and alternatives client segments. Our sales pipeline grew, and we expect substantial onboardings in the coming quarters. We continue to advance and broaden our enterprise outsource solution strategy across our clients' front, middle, and back office activities. as demonstrated by the expansion of Alpha's capabilities to ETFs, which we announced in 2Q. For the past 30 years, State Street has continuously innovated to support what has become a 10 trillion ETF market. Today, State Street is the largest ETF administrator in the world, with more than 2,700 ETFs serviced in 13 countries. That long cycle of innovation continues as State Street Alpha now supports the entire ETF lifecycle. By integrating CRD's front office products with State Street's industry-leading ETF servicing capabilities, Alpha now provides a centralized platform for ETF issuers across the entire ETF lifecycle, including portfolio management, trading, and compliance to enable a growth across a variety of ETF strategies and increase speed to market. Turning to front office software and data business, our overall CRD pipeline is strong. In the second quarter, we converted a meaningful number of on-prem CRD clients to recurring SAS revenue, which, when coupled with new SAS client implementations, increased annual recurring revenue by 12% relative to the year-ago period. In addition, Charles River Wealth Management solution continues to resonate with clients and drove a significant increase in on-prem revenues this quarter. Year-to-date, CRD's wealth-driven revenue has more than doubled as compared to the first half of 2022, and we remain on track to grow CRD's wealth revenue this year. With State Street Global Advisors, quarter-end assets under management totaled $3.8 trillion, supported by higher period and market levels, and $38 billion of net inflows from all three business lines, ETF, cash, and institutional. Our SPDR ETF business gathered $27 billion of net inflows in the second quarter, including $20 billion of net inflows into SPY, the industry's largest ETF. We also delivered a solid performance in our U.S. low-cost ETF segment, which gathered $7 billion of net inflows this quarter, continuing to gain market share. Our cash business gathered a solid $10 billion of net inflows in the second quarter as our U.S. government money market funds benefited from the attractiveness of the cash asset class in the higher rate environment. Turning to our financial condition, State Street's balance sheet liquidity and capital positions remain strong. Our CET1 ratio was a strong 11.8% a quarter end, well above our regulatory minimum. The ongoing capital generation of our business, coupled with effective balance sheet management and our strong capital position, has enabled us to deliver against our goal of returning significant capital to our shareholders. In 2Q, we returned approximately $1.3 billion of capital, buying back more than $1 billion of our common shares and declaring over $200 million of common stock dividends. This means that cumulatively, over the last three quarters to the end of June, we have returned approximately $4.4 billion of capital to our shareholders through a combination of share repurchases and common stock dividends. The strength of our balance sheet was also highlighted with the release of the Federal Reserve's annual CCAR stress test results in June, following which we announced our intention for the third year in a row to increase State Street's common stock dividend by 10% of the third quarter, subject to consideration and approval by our board of directors. It remains our intention to continue common share repurchases under our existing authorization for up to $4.5 billion in 2023 subject to market conditions and other factors. To conclude, financial market conditions in the second quarter were mixed. Although global equities recorded another sequential quarter of growth, there was weakness in emerging markets, and we witnessed a negative impact of persistent inflation and further central bank rate hikes on fixed income markets. Meanwhile, both equity and currency volatility continued to decline. Despite this varied backdrop, we achieved a number of positive outcomes in the second quarter, including meaningfully reducing our asset servicing backlog, further developing our alpha capabilities, continuing to record new asset servicing wins, driving strong growth in front office software and data revenue, and gathering solid net inflows of global advisors. And while we reached double-digit year-over-year EPS growth supported by our capital management and the higher interest rate environment, our results were below our potential. First, while we achieved sequential fee revenue growth in areas of our business this quarter, we need to demonstrate the fee growth every quarter, especially as NII. We need to demonstrate that fee growth every quarter, especially as NII is no longer a tailwind. And second, we are highly focused on controlling our expense base. We have a well-established track record of reengineering our processes and transforming our operations, in order to improve our efficiency and realize productivity growth. We plan to utilize additional tactical expense levers at our disposal in addition to our ongoing structural productivity efforts in order to support our financial performance for the benefit of our shareholders. Now, let me hand the call over to Eric, who will take you through the quarter in more detail.

Thank you, Ron, and good morning, everyone. I'll begin my review of our second quarter results on slide four. We reported EPS of $2.17 for the quarter, an increase of 14% relative to the second quarter a year ago. As you can see on the left panel of the slide, revenue grew by 5% year on year, driven by the expansion in our front office solutions area, where we are an industry leader, continued momentum in securities finance business, as well as strong growth in net interest income. This growth enabled us to offset some of the headwinds we saw in other fee areas, given the relatively mixed macroeconomic backdrop. We also had the benefit of an accounting change for tax credit investments, which simplifies our reporting going forward. While our overall year-on-year fee growth was less than we would have liked to deliver, we did see sequential quarter revenue momentum and a step up in the sales pipeline, which we expect to build upon in the coming quarters and which I'll discuss later in today's presentation. As we drive growth, we continue to prudently invest in the business while remaining focused on managing costs given the current operating environment, and we stand ready to further intervene on expenses should the softness in the global environment persist. Turning now to slide five, we saw period-end AUCA increase by 4% on a year-on-year basis and 5% sequentially. Year-on-year, the increase in AUCA was largely driven by higher period-end equity market levels and client net inflows. Quarter-on-quarter, AUCA increased as a result of a significant trillion-dollar alpha installation and a higher period-end market levels. At Global Advisors, we saw similar positive dynamics play out in the quarter. Period-end AUM increased 9 percent year-on-year and 5 percent sequentially. The year-on-year increase in AUM was largely driven by higher period-end market levels. Quarter-on-quarter, the increase in AUM was also due to higher period-end market levels as well as strong sequential net inflows. Turning to slide six, On the left side of the page, you'll see second quarter total servicing fees down 3% year-on-year, as net new business in the quarter was more than offset by lower client activity and adjustments, largely due to lower custody and transaction volume and better-than-usual pricing headwinds. Positive year-on-year equity markets were offset by the negative impact of fixed income markets. Sequentially, total servicing fees were up 3%, primarily as a result of higher average market levels and net new business, slightly offset by better than usual pricing headwinds this quarter. We had a more constructive market environment relative to the first quarter, as well as a significant onboarding of a $1.2 trillion of AUCA related to an alpha client in the asset manager client segment, which comes at a modest fee rate, but with services that are expected to be added in the coming years. Within servicing fees, back office servicing fees were generally consistent with total servicing fees and largely driven by the factors I just described. Middle office services performance was meaningfully more positive for the quarter. On a year-on-year basis, fees were up 3%, primarily reflecting net new business, and up 10% sequentially, largely driven by the installation that I just mentioned. On the bottom panel of this page, we've again included some sales performance indicators which highlight the business momentum we saw in the quarter. While total AUCA wins in the second quarter were not as robust in volume terms, client engagement remained healthy, and we saw wins across strategic segments, including mandates and asset owners, official institutions, and alternatives, which are key growth areas for us, as we previously mentioned. The wins, including those in the alternative segment, which are more complex to service, come with above average fee rates. We have also seen a healthy uptick in our pipeline this quarter. Turning to slide seven, second quarter management fees were $461 million, down 6% year-on-year, primarily reflecting the impact of net outflows from prior periods, a shift of certain management fees into NII as previously described, and some pricing headwinds, partially offset by higher average market levels. Quarter-on-quarter management fees were up 1% as a result of higher market levels and cash net inflows. As you can see on the bottom right of the slide, our investment management franchise remains well positioned with very strong and broad-based business momentum across each of our three lines of business. In ETFs, we saw very strong net inflows of $27 billion into SPY in our sector suite of ETFs, as well as our SPDR portfolio low-cost suite. In our institutional business, we saw net inflows with continued momentum in our well-established index fixed income and defined contribution franchises. Across our cash franchise, we continue to see strong demand for our money market funds. We've recorded net inflows of $10 billion. Turning to slide eight, relative to the period a year ago, second quarter FX trading services revenue was down 8% year on year and 11% sequentially, primarily reflecting lower client FX volumes and lower industry FX volatility. Relative to the period a year ago, both volumes and volatility were more muted. as the start of the war in Europe last year caused unusually high FX trading activity in the first half of 2022. Many clients were also risk-off during the debt ceiling discussions in April and May, with a rebound in June and client volumes following its resolution. Altogether, 2Q is muted. We are optimistic about 3Q, but it's hard to predict. Securities finance performed well in the second quarter, with revenues up 9% year-on-year, driven by higher agency spreads. Sequentially, revenues were up 7%, again mainly driven by higher agency spreads, as well as higher prime services or enhanced custody revenues from deeper client engagement and specials activity, partially offset by lower balances. Moving on to software and processing fees, second quarter software and processing fees were up 18% year-on-year and 34% sequentially, primarily driven by higher front office software and data revenue associated with CRD, which I will turn to shortly. Lending fees for the quarter were down 5% year-on-year, primarily due to changes in product mix, but up 5% sequentially, mainly driven by strong client demand for lines of credit. Finally, other fee revenue increased to $101 million year-on-year, primarily due to a tax credit investment accounting change and the absence of negative market-related adjustments. This includes the impact of the new accounting adoption. Moving to slide 9, you'll see on the left panel that front office software and data revenue increased 29% year-on-year, primarily as a result of higher on-premise renewals and continued growth in our more durable software-enabled and professional services revenue, as we continue to convert and implement more clients over to our SaaS environment. About 60% of our clients are now on our SaaS platform. Sequentially, front office software and data revenue was up nearly 50%. About two-thirds of this uptick was driven by wealth management mandates that are becoming an increasingly important growth segment for us. Our sales pipeline continues to grow and remains strong for our Charles River Development front office solutions products. Turning to some of the other alpha business metrics in the right panel, we were pleased we had three more alpha mandates go live, which brings our total live alpha clients to 15. And as I previously mentioned, we installed a significant portion of assets related to alpha this quarter. We expect to provide more services related to these assets in the future, helping us increase the share of our clients' wallet. Now turning to slide 10. Second quarter, NAI increased 18% year-on-year, but declined 10% sequentially to $691 million. The year-on-year increase was largely due to higher short-term rates, an increase in long-term rates, and proactive balance sheet positioning partially offset by lower average deposits. Sequentially, the decline in NII performance was primarily driven by our continued rotation of non-interest-bearing deposit balances and rate pressure in the U.S. back book, partially offset by higher short-term market rates from international central bank hikes. On the right side of the slide, we show our average balance sheet during the second quarter. Average deposits declined 2% quarter-on-quarter, in line with industry total deposit trends, which also fell by 2% in the second quarter, and reflect declined preferences to shift some cash to other products during periods of rising rates. Our operational deposits, as a percentage of total deposits, remain consistent at approximately 75%. Our global floating rate loan book provides upside at this stage in the cycle, and our investment portfolio positioning provides a tailwind as long rates roll through. We now also have the opportunity to selectively add some duration across the curve as we see good entry points, which could enhance NII over time. Sequentially, U.S. dollar client deposit betas were 100% during the second quarter, leading again to some sequential NII compression. We are now at the point in the U.S. rate cycle where we expect to adjust back book pricing to accommodate our larger clients, but do so in a disciplined manner and usually as part of a broader relationship discussion of balance and trade for fee opportunities. Foreign currency deposit betas for the quarter continue to be much lower in the 45 to 50 percent range. We've also included a new slide in the appendix, page 16, that shows our NII trends over the past few rate cycles. I think it will put the larger NII increases and decreases in context, which are driven by many factors, including changes in interest rates, the pacing of hikes, deposit levels and mix, Fed balance sheet changes, as well as equity markets. You can see from that page that our recent quarters have come with a much higher than usual level of NII, and we are now normalizing to a more typical level of NII that is inherent in our business activities. Turning to slide 11, second quarter expenses excluding notable items increased 6% year-on-year. Sequentially excluding seasonal expenses, second quarter expenses increased just over 1% as we actively managed expenses and continued our productivity and optimization savings efforts, all while carefully investing in strategic elements of the company, including alpha, private markets, technology and operations automation. On a line-by-line basis, year-on-year, Compensation employee benefits increased 7%, primarily driven by salary increases associated with wage inflation and higher headcount attributable primarily to operational staff for growth areas, technology staff, insourcing, and some lower than expected attrition rates. Sequentially, however, we have managed headcount to be flat. Information systems and communications expenses increased 3%, mainly due to higher technology and infrastructure investments, partially offset by benefits from ongoing optimization efforts, insourcing, and credits related to vendor savings initiatives. Transaction processing decreased 2%, mainly reflecting lower sub-custody costs from vendor credits. Occupancy increased 7% as we relocated our headquarters building, temporarily resulting in overlapping costs. And other expenses were up 7%, mainly reflecting higher professional fees. Moving to slide 12. On the left side of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios, followed by our capital trends on the right side of the slide. As you can see, we continue to navigate our operating environment with very strong capital levels, which remain well above both our internal targets and the regulatory minimums. As of quarter end, our standardized SET1 ratio of 11.8% was down 30 basis points, quarter-on-quarter, largely driven by the continuation of our share repurchases, and modestly higher RWA, partially offset by retained earnings. Our LCR for State Street Corporation was flat quarter-on-quarter at 108% and decreased four percentage points quarter-on-quarter, but still quite high at 120% for State Street Bank and Trust. We're also very happy with our performance in this year's CCAR, with a calculated interest capital buffer well above the 2.5% minimum. resulting in a continued preliminary FCB at the floor. This demonstrates we have one of the strongest balance sheets in the industry. In keeping with our results, in June, we announced a planned 10% increase for our 3Q23 quarterly common stock dividend, subject to board approval, and it remains our intention to continue common share repurchases under a current authorization of up to a total of $4.5 billion in 2023, subject to market conditions and other factors. We plan another billion-dollar buyback in third quarter. Lastly, we are quite pleased to return roughly $1.3 billion to shareholders in second quarter 23, consisting of just over a billion dollars of common share repurchases and over $200 million in common stock dividends. Turning to slide 13, which provides a summary of our second quarter results. While there is certainly still work to do, we are pleased with the durability of our business this quarter against a mixed and divergent backdrop. Robust expansion in our front office solutions area and continued momentum in securities finance, as well as strong growth in interest income enables us to offset some of the headwinds we saw in the other three areas, highlighting the resiliency of the franchise. Next, I'd like to provide our current thinking regarding our third quarter. At a macro level, while we know that rate expectations have been moving, Our rate outlook is broadly in line with the current forwards, which suggests that the Fed, the ECB, and the BOE will all continue to hike in 3Q to varying degrees. In terms of average equity markets, we currently expect U.S. equity markets to be up about 5% quarter on quarter, as we are expecting equity markets to remain flat from now to quarter end. And we expect international equity markets to be flattish on average. Regarding fee revenue in 3Q, on a sequential quarter basis. We expect overall fee revenue to be down approximately one to one and a half percent, with servicing fees down one to two percent as the below average fee repricing headwinds we saw this past quarter is expected to normalize in 3Q. This will also include a revenue headwind from the previously disclosed client exit. We expect management fees to be up around half to one and a half percent. We expect front office software and data quarter-on-quarter to be down 7 percent as we do not expect the level of on-premise renewals in 3Q that we saw this quarter. We expect the other fee revenue line to come in around 30 to 35 million in 3Q, which is higher than prior years but down post the accounting change impact in 2Q. Regarding NII, After three double-digit sequential increases in NII last year, we now expect NII to decrease 12% to 18% on a sequential quarter basis, driven by lower deposit levels and continued rotation as rate hikes continue into 3Q. Our outlook assumes that average non-interest-bearing deposits decline by approximately $5 billion from 2Q to 3Q. As we look forward to 4Q, we do expect to see some moderation to the amount of deposit rotation as we work through most of our back book and most central banks begin to pause. With that context, we expect that 4Q NII decline to be much less, somewhere in the range of down 2% to 6% versus 3Q. And we expect NII to then stabilize around those levels, but it'll depend on market conditions. And our expectation is that 4Q declines in non-interest-bearing deposits will be small as well, likely in the down to 3 billion range versus 3Q. Turning to expenses, we remain focused on controlling costs in this environment, and we expect to take action in 3Q to bend the cost curve. As such, we expect that expenses will be down half to 1% on a sequential quarter basis and intend to continue to actively manage expenses. As always, this is on an X-notable basis, and we are keeping an eye on the FDIC assessment, which could be a 3Q-notable item. And as I noted previously, given the accounting changes we adopted this quarter, we expect our effective tax rate to be between 21% and 22% for third quarter. With that, let me hand the call back to Ron.

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

thank you ladies and gentlemen we will now begin the question and answer session should you have a question please press star followed by the one on your touchstone phone due to a slight glitch with the system if you were previously in the queue you will need to press star 1 again to be placed in the question queue if you are using a speakerphone please pick up your handset before pressing any numbers Once again, if you'd like to ask a question, please press star followed by the one on your touchtone phone. One moment, please, for our first question. And our first question comes from Brennan Hawkin from UBS. Your line is now open.

Good morning. Thanks for taking my questions. Eric, I'd like to double-click on some of the comments that you made about deposits. So you talked about back book pricing in the US dollar book. Does that mean that we should be thinking about the potential for betas to exceed 100% here when that starts to work through? And what kind of magnitude do you think that could reach? And could you also help me understand the Euro, because when I look in the financial supplement in the breakout by currency, it looks like the Euro deposit costs were up about low 40s pips, quarter of a quarter, which seems like a beta that's a good deal higher than the 50% you referenced. I know there's some swap noise, so maybe that's what it is, but could you maybe flesh that out a bit for me?

Brennan, sure. Let me start on the betas that we saw, in particular on the U.S. book, because we are at a period in the interest rate cycle where we've now had multiple 50 basis points moved. It's been a very strong signal to our clients that rates are much, much higher, much more quickly, and much more visibly. And at the same time, they now have, because of the highly inverted yield curves, they have real substitute alternatives that they used to not have in the past, whether it's treasuries, whether it's money market, whether it's repo, there's a range of what they can invest in. And what we found is that our larger clients, and we primarily have large, sophisticated clients, are quite active in thinking about their alternatives and that that has been accelerated by the swiftness of this cycle and the place that we've come to and the speed. If we think about the U.S. deposit betas, they were in the 80 to 90 percent range last couple quarters. This quarter we saw 100 percent. And yes, we expect next quarter we'll be well over 100 percent. And what's driving that is really a catch up in the back book. We have, uh, you know, clients coming to us as you'd expect, just like it happens, uh, with, with retail, you know, depositors for retail banks. But we have sophisticated large clients coming back and saying, look, some of our lower transactional rate levels or mid tier rate levels are something that they'd like us to adjust. And in a way, what I think we, uh, has played out is that, uh, while, uh, spreads widen for us on the deposit, but for some period of time, we're now seeing a convergence back to where they would have been. And that's coming through. And so what we have in the cycle is actually, you know, a number of quarters of below 100% betas. Then we get to 100% beta. And then we are going to have a quarter where betas are well above that 100% level. And it's really a catch-up in the back book. And that's what's playing through. It is what is beginning to drive, you know, this higher reduction in NII this quarter, the 10% quarter-on-quarter that you saw. You saw in my outlook, you know, we are expecting 12% to 18% reduction in NII this coming quarter. if you peel that apart, some of that is the continued rotation out of non-interest bearing, but some of it, and a good part of it, is this catch-up in the back book that's playing through. We do think that over time we've seen the bulk of that, and that that will begin to moderate, and I'm certainly happy to go into that and some of our perspectives as we drill down deeply into our areas. But that's the context. On your other question on euros, we should probably follow up. I think we see betas quarter on quarter of about 50%, but we should probably just follow up offline because I think that's deep in the supplement and probably do that with you and the IR team.

Okay, no problem. And then another question just quickly on fee revenue. You flagged that the large client migration is gonna be part of the outlook. How much of that will be impacting the third quarter delta and then how much will be, how should we be thinking about the timeframe for whatever is left and when that would end up playing out?

Yeah, I think the broader context, as you recall, Brendan, is that we disclosed that the large client deconversion, you know, was going to happen over multiple years. We announced it well over a year ago, and we described it in our K at about 1.7% of fee revenues. So, you know, you can calculate that through. I think in our fourth quarter earnings call in January. I described that we had seen about $20 million on a run rate come out, but I can reconfirm that. In the next quarter, this coming third quarter, we'll see about $20 million come out sequentially. And then in the fourth quarter, there's another piece of about another $15 million that will come out as well. And then after that, it's several more quarters before we see the later and final installments. But that's incorporated into our guide.

Okay. Thanks for taking my questions.

Your next question comes from Alex Blostein from Goldman Sachs. Please go ahead.

Hey, good morning guys. Um, so just maybe staying on the deposit question for another minute. Uh, why, why do you think this catch up happening now? So sort of late in the cycle, uh, we've obviously been in a high rate environment for, for well over a year. Um, so curious if you can provide more color on particular customer segments in the U S that's driving that and sort of the discussions around that. And then maybe as you sort of think about the end state for us interest bearing deposits, I think you're at three and a half or so today. the cumulative beta on that is, I think, is around 70% relative to the Fed funds rate. Should we think of that approaching, I don't know, 85%, 90%? How do you think about where that deposit price in the U.S. will stabilize?

Alex, it's a good question. I mean, we're clearly navigating and living through an interesting environment that we've not seen in two decades. You've got to go back pre-crisis before you see 5% prevailing rates. I think if you're If you also think about how swiftly we've gotten to where we are, that's why we put some of this information back on page 16 in our materials. You see this cycle has moved twice as far in terms of the uptick in rates in half the time of the last cycle. And so what plays out as that happens is that We always have clients that, as rates move up, they begin discussing with us and engaging with us on what would be appropriate, maybe putting in place multiple balance tiers, having discussions about their expectations. We negotiate and so forth. And you can imagine large client discussions occur over three, six, sometimes even nine-month periods. And so if you, if you kind of turn back the clock and say, you know, when did some of those discussions occur? You know, some of them early ones may have started, uh, second quarter of last year, third quarter of last year, fourth quarter of last year. Um, because there was also a perspective among our clients and us for that matter that, you know, rates might continue to 5%, but they might've, you know, gone to 4% or 3%, which would have put us and our clients in a different position from a, NIM and NII and rate setting perspective. So I think it's really the speed of this that has played out on one hand. And on the other, the inverted yield curves gives clients and the prevalence of the money funds and treasuries and so forth give clients an alternative that's more vivid, I'd say, than in some of the past cycles. And so That's the kind of client behavior. What we have seen is that if you decompose our book, some of this activity is in the non-interest-bearing deposits, which have come down, and some of it is in the interest-bearing back book, because some clients with non-interest-bearing deposits come to us and say, look, can you make them now interest-bearing at a certain rate? And what we've seen is some real segmentation of that book. You know, as an example, you know, the average account in non-interest bearing, there's about 30,000 accounts. The average account is barely over a million bucks. What you can do in some of the analytic work we've done is separate out the higher balance non-interest bearing clients and client accounts from the lower balance ones. You know, not surprisingly, the higher balance accounts are down year over year in balance terms by 70%. Right. The large number of smaller accounts are down by 15 percent. And so this is where, you know, what we're starting to work through with what I'll describe is the burn down. How much of the of the of the larger deposits and non interest bearing have migrated to interest bearing? Right. At what rate? And our perspective is that We are now working through, I'll describe as a catch up on the back book. Some of that is not interest bearing deposits moving to interest bearing and some of that is interest bearing being priced up. And as we think about it, we think that the peak of that catch up will play out in third quarter as we scan the deposit types, the larger, more sophisticated clients versus the smaller clients, and that's why we expect both the catch-up to continue into the third quarter and likely peak in the third quarter and then begin to moderate in the fourth quarter and to burn down.

Got it. And then like just the end game on in terms of what you ultimately think U.S. deposit cost is going to look like relative to kind of the three and a half and the Fed funds at five.

I think it's it's I've not calculated directly on a cost versus rate basis on a NIM basis, but I guess we could we could back into it if it'd be helpful to you. As we think about the long-range view of NII on our book, I've given some guidance for 3Q NII, for 4Q NII. I think our instinct is that NII will settle in this $550 to $600 million range per quarter. And if it's helpful, we can try to calculate that back into a you know, a spread on assets or a spread or a cost of funds on deposits and follow up with you.

I got you. That's helpful. Thanks. And my bigger picture question for you guys and to Ron as well is, I think you mentioned productivity efforts in light of the fact that NAI has clearly become a bigger headwind over the next several quarters and you guided service and fees down in the third quarter. So as you think about measuring those productivities, are you solving for overall pre-tax margin stability? Are you solving for kind of, you know, fee margin stability, sort of like X and I? How should we think about sort of measuring the productivity efforts in light of a more challenging revenue backdrop?

Yeah, Alex, I mean, where we start with is, I mean, because what you're describing is outcomes of the productivity efforts where we've, and these are not new, these are ongoing. We really start with how do we create more scale in our business? How do we increase speed, lower error rates, increase client satisfaction, take out manual interventions? So the measures that we're using would be the traditional productivity measures and this has been underway now for several years. You've been seeing the results in our And we've been able to manage costs, certainly relative to others. But in terms of how we think about the business going forward, particularly given that NII is no longer a tailwind in terms of an outcome basis, we really think about the operating leverage, I think, is the key outcome we're managing to, if that's the question you're asking.

Yeah, sir. The operating leverage. Got it. All right. Thank you very much. Thanks.

Your next question comes from Rob Wildtack from Autonomous Research. Your line is now open.

Good morning, guys. I just wanted to ask about the asset side and the securities book quickly. Decent uplift in yield again, plus 21 basis points. Can you give us some color, some numbers around the front book, back book difference there, and how much repricing can sort of assist NII going forward?

Rob, it's Eric. There is a good bit of tailwind that comes from the front book, the back book. I think this, you know, on a kind of year-on-year basis, you know, long rates were quite constructive, you know, from a year-on-year NII standpoint. The long rate tailwind year-on-year was in the you know, in the $100 million basis. So, it's quite substantial. You know, on a quarter-on-quarter, the long-rate tailwind is closer to, you know, $15, $20 million. So, it's not insubstantial. And I think, you know, as we see some steepness in the curve come back, or I guess I'll describe less inversion, we've got abilities to leg into duration or curve positions, or in some cases, some amount of convexity where we'd find it helpful. From a rate standpoint, like you said, average rates on the investment portfolio in aggregate was 270 basis points or so. The runoff is you know, a good bit below that, kind of in the 180 basis point range. So, you know, 90 basis points, 100 basis points south of that. And the roll-on that occurs is well above that 270 basis point average. It's closer to, you know, 410 basis points or more. So you've got a nice tailwind there that's playing through. We also have a tailwind on the on short rates for international currencies. So that's helpful. And then we are, you know, we continue to invest and think about opportunities across currency from a basis standpoint and so forth. And we've got some latitude to do that as well, you know, given our global balance sheet.

Thanks, Eric. And then one more just on the operational deposits. If I use the numbers on page 10, overall deposits are down and operational deposits are down as a percentage of the mix. Conceptually, what would be driving that? I guess I'm confused as to why operational deposits would be down year over year more than non-operational deposits.

Yeah, I think there's a little bit of – I look at that data and I think you've got roughly similar movements in operational and non-operational deposits. I think what's happening in this part of the cycle is as deposits, or I'll say as cash, you know, for our clients is more valuable, right? They are, you know, selectively thinking about how much cash do I absolutely must keep in their deposit, in their custodial accounts. And if you think about it, they make that decision in, I think it's more than 100,000 different accounts themselves. It's a very large and disparate set of decisions and sub-decisions by 100,000 plus fund managers and many, many fund boards. And so they're trying to see, hey, can I edge it down? And that's why At this point in the cycle, you see total deposits drift down but also operational. What they end up needing to trade off, and the reason why it'll level off over time, is that they need a certain amount of deposits so they don't overdraw. Fund managers really hate the overdraw at the end of day. And then there's also a governor where we engage with our clients on intraday and make sure that they have enough cash to cover their transactional flow and throughput. But we're just at the at the period where in the core custody accounts, you've got this drift downwards where they're trying to optimize without going too far. And that's that's what you're seeing. But this is this is expected. We expect the operational deposits to stay you know, comfortably in this kind of 75% range. And, you know, it's a part of the kind of custodial operations, which is what makes them so sticky, right? Because they need to be there, you know, for the very significant daily, hourly, and minute-by-minute transactional flows that we are processing on their behalf so that they aren't overdrawn.

Okay.

Thanks, Eric. Sure.

Your next question comes from Glenn Shore from Evercore. Please go ahead.

Thanks, Eric. Maybe it's just a different attempt at the deposit discussion. So I get clients wanting more yields. I bought treasuries too. We all did. But is there any point where the client profitability discussion has teeth Like, are they able to move 100% of non-operating deposits if they want? Like, what discussions are you having with them about doing more with states trading areas like FX, SEC lending, alpha? Maybe you could update us on what you're doing to try to help impact what seems like you can't impact the deposit side. So, is there anything else you can do?

Yeah, let me start there, Glenn, and I think Ronald Wayne as well, because a number of us have these engaging conversations with clients I think from a burndown standpoint let me first take it from that angle is if you think about our 200 billion dollars of deposits we've got deposits at a number of different price tiers and we have kind of very large sophisticated clients and then kind of that large tale of smaller midsize clients of the 200 billion we think there's about 50 billion that we've been very focused on and continue to be focused on. So about a quarter of our total deposits are, uh, with these clients that, uh, as we've talked about the last couple of questions, there's been a real catch up on the back book. Um, I described that because of that 50 billion, which is either a very low price or zero price for our larger and most sophisticated clients where we have these engaging and, uh, you know, balance of trade discussions. Right? We've around, we've got about 25 billion that's behind us, where largely we've repriced those deposits, we've had those discussions, and some of those, you know, have come with some balance of trade improvements or some commitments on stability on fees, and those are behind us. Included in the outlook that I provide, beyond the 25 billion, there's another 15 billion that's underway right now that's included in my third quarter outlook, right? So that gets us to 35, almost 40 billion of the 50. And then there's a trail that, you know, we'll still have. And so I think from a client discussion and negotiation standpoint, the third quarter we expect to be the peak. I think what you'll find is that each of these uh, questions on deposits, certainly, uh, rates goes through a pricing committee from a, from a balance sheet management standpoint, but very quickly those go to the most senior client executives and all the way up, you know, to our C-suite because those are large, they're very large and, and that's where we engage. And I think what you'll see over time is some of that will come back through and, you know, FX revenues and SEC lending revenues. in the absence of fee rate reductions in the future, right, on one hand. And on the other hand, some of what we do here is also work with clients on expanding the range of what we do for them when it comes to managing their cash, right? I think some of the reason you're seeing the uptick in cash in our asset management business is because some of those clients say, look, I'd like to be in a cash money market sweep And so we've been doing that. You see our repo business continues to do very, very well. It's actually an add to, it's a stabilizer to NII or an add to NII on a year-on-year basis and stabilizing, and it's a stable source of NII income quarter-on-quarter because we've been able to shift some of the client cash to those areas. So there are some offsets as well there, but that's a bit of a start.

Yeah, Glenn, what I would add to what Eric said is that the, you know, if you think about over the last four or five years, our focus on pricing has been initially was on fee pricing and kind of addressing, if not combating, the fee compression and really working that in an institutional way and in a very high-skilled way and escalating those or elevating those decisions way above where they used to be. Deposits for, you know, up until this rate cycle really weren't part of that because, I mean, there were times that we would just assume not have had the deposits. We've now integrated that as Eric has implied into that discussion, but also included a full share of wallet analysis. And the part of this is recognizing that, you know, these institutions are very large. And when you have a pricing discussion, and I'm putting that in air quotes, it really depends on what it is. And what we have worked to avoid is to not have a series of unilateral discussions without understanding and making sure that at the highest levels of our clients, they understand the impact of this and just reminding them that, you know, you have the fee you have, because of this assumption on other services that we're going to provide you or some assumption on deposits. And those conversations are actually starting to work well. It's caused a change of process for us, another change of process for us. But more importantly, it's changed in the way how we're engaging and at what level we're engaging with these clients. More to go there, but we also think it's a skill that now developed will help us through various kinds of cycles going forward. Thanks for all that, Collin.

Your next question comes from Steven Shabak from Wolf Research. Please proceed.

Hi, good morning. This is actually Sharon Longs filling in for Steven. Just on the deposits, outside of the rotation out of NIB, can you talk about the overall trajectory of total deposits, particularly because it looks like more recent liquidity drawdown has come out of RRP instead of deposits? I just wanted to get your thoughts on the expectations for the trajectory on deposits from here in the context of QT, treasury issuance, et cetera.

Yeah, it's Eric. really gauge the deposit changes outright. I think we're a little more focused on the non-interest bearing deposits, where we've signaled another $5 billion likely outflow this coming quarter. That's less of an outflow than in the second quarter, so you're starting to see some of the burndown that I've described. You know, in the external environment, I think from the H8 reports as banks, you know, we've seen about 2% sequential, you know, fall in deposits. For the trust banks, you know, we tend to have more deposits coming in when the, you know, when deposits in the bank system increase, and we have somewhat more coming out when deposits in the bank system come out. And probably it's just the absolute sophistication of our clients. We expect a downtick in deposits again next quarter, but it's just been a little more focused on the non-interest-bearing because that's where it makes a big difference. I think there is always some movement in interest-bearing deposits, especially at the higher rate tier, because what we're finding increasingly as we get to a little more of this, as we expect to get to a time of stabilization or at least a little more of a balance with our clients, now what they're going to do is it's hard for them to move an underlying operating deposit that actually has to cover the hundreds, thousands, in some cases tens of thousands of transactions that are flowing through their particular account, but sometimes they'll move the thin margin deposits to a treasury and so we might lose 10 base points on something and they'll pick up 10 basis points on treasury. There's some of that that's going on, and I think, in truth, that's not as dominant a driver of our NII at this point.

Thanks for that. And then as a follow-up just on some of the updated capital rules that are coming, I understand you probably won't be able to give much color because we haven't seen a proposal yet, but just in terms of, like, expected ways you might be able to mitigate some of that impact and which businesses might be more impacted for you guys.

Yeah, I mean, there's, you know, obviously, we're, we're like many waiting to see more from the rules. You know, we've, the last time we saw Basel III endgame, you know, draft from either the US or international regulators was several years back. So I think we've, you know, we expect some, you know, higher capital requirements, just hard to tell, you know, how much. We do think there'll be effects on different parts of our businesses. So you know, the new rules will come with an operational capital charge. That probably will be relatively hard to influence because we actually want to build our fee-driven businesses. And so those, I think, will just come with a capital requirement that will be an add. there'll be some reduction on the lending books. So that'll be, that'll be helpful. And then I think in particular, uh, while the fundamental review of the trading book will affect the, uh, the universal banks, uh, potentially in a, in a negative way for us, the SEC finance business will tend to be a positive, uh, um, uh, will be in a positive territory where capital requirements will be less, you know, we'll no longer need to hold capital to, indemnify treasuries. So they'll finally become economically more rational in the safer areas, right, as they should be. They should obviously, capital needs to be held for the riskier activities, but we don't traffic in the riskier areas. And I think that in some ways, you know, that'll give us an opportunity to grow those areas that are quite aligned with our client base, like SEC Finance, and actually deploy capital quite more actively. And so I think there'll be a mix of impacts. We're going to see as it comes through, but like many, we're considering what's to come and we'll react accordingly as it does.

Great. Thank you. Your next question comes from Brian Bedell from Deutsche Bank. Please proceed.

Great. Thanks for taking my question. Rono, I guess I wanted to come back to your comments on basically the overall revenue per client, if I can sort of summarize it that way. Obviously, there are different components of how the asset servicing clients pay for the business, and there are many different ways, aside from the core fees, that they can do that. As you think about that across the client base, I know you have looked at this more holistically across clients over many, many years, but with the deposit beta going up, is that sort of revenue for a client going down, or do you think you're able to actually be able to improve the fee rate given that they aren't paying as much on the compensating balances?

Brian, it's a good question, and what I was referring to and what you're referring to is what I would call, you know, how we think about this tactically, client by client, but I also want to come back to the strategic element of this also. In terms of, there's no one answer for any particular client, because if you think about it, in the core back office business, you know, you've got custody fund accounting, And there's a pricing element to that along typically with associated deposits. In more and more instances, obviously, we've, you know, a client might have a middle office assignment with us, you know, where we're doing, we are their back office. And obviously going all the way to alpha. And then there's the question of, you know, are we doing FX and securities finance with them? Obviously, FX is a function of are they, do they have occasion to use FX? And increasingly, most managers do. Securities, finance, it's manager by manager. So the reason why I'm saying it's tactical, there's a holistic conversation that needs to occur here. And it's important on both sides, ours included, to lay out for the client that, you know, remember all we did for you over the past few years to get you through, you know, whatever fee challenges they were having. That was predicated on X. You know, an X might be an assumed deposit level. It might be on an assumed FX level. X isn't playing out. We need to have a conversation on this. And that could, in cases, lead to more fees, or it could, and the more typical outcome is that Well, hey, we're not doing this with you. Let's try and do that. Or even there's this set of funds over here that we've never talked about, whatever, the Cayman Islands or something, and let's see if we can move those. I mean, the positive situation is a challenge. The conversations it's spurring are opportunities. And they're real opportunities. There's senior people. intimately involved in these because, you know, we don't get a lot of redos on them. This is the moment to be doing it. So, we think it's a way to, I mean, again, the kind of NII outflow is a significant headwind, but we think it's an opportunity to mitigate some of it. The strategic side of this, Brian, I don't want to lose, right? Going back to the acquisition of Charles River, the launch of Alpha, all the development we've been doing, we're now seeing onboarding happening there. With the typical onboarding journey, tends to be the lower fee, complicated kind of middle office stuff starts first. And then there's follow-on services. And it's making sure that we are implementing addressing and implementing those follow-on services as fast as possible. So when we talked earlier and talked about the onboarding, talked about that we were able to move a little over a trillion to be onboarded to onboarded, what will follow there is other services and increase kind of the revenue per asset. I mean, that's the way alpha works and that's the way alpha is going to play out, which is why You know, notwithstanding the short-term issues that Eric has raised in terms of, you know, we've got this client transition, we're actually quite optimistic over the, you know, what I would call the short to medium term as we look into 2024 about the revenue picture.

That's a great color. And then maybe just on the expense side, Eric, you mentioned the expense levers. Are they more tactical in nature or do you see an ability to continue to re-engineer the cost base? You've already done a great job in reducing costs structurally over the last several years. I don't know if we're mostly through that and when you do have the cost saved, you reinvest them in growth initiatives or is there an ability to reduce the overall cost structure?

Brian, let me address that first and then Eric will come in. We are definitely not through this. And by that I mean, you know, when we started down this journey a couple of years ago, we obviously addressed, call it what you want, the lower hanging fruit, the kinds of things that we could get at without a lot of technology investment, without a lot of reengineering. But there is more to do, and we're making a lot of progress on it. We've got people in place now on both the operations reengineering side and on the technology side that are working this through. The way this has played through on our results, you've seen what our expenses have been, but we've also been able to invest more in the businesses than we otherwise would. And we think that that journey has more to go, and you'll You know, you'll see that and we'll report on that, you know, quarter after quarter. What we also talked about, though, is that there's some tactical things that we can do and should do, just given, you know, the kind of outlook that we've described to you. And those would be less about reengineering and more about, you know, how do we think about short-term things like incentives and those things.

And just to round that out, we've got to pay for performance. So when we deliver larger sales, we'll pay for that. When it's a little lighter, as you saw, we'll rein that in. And that's part of the execution mindset we have. We've also just given some of the evolution on salary increases that we've all worked through over the last couple quarters of the last year, you know, we also feel like it's time where, you know, we have enough staff, and so we've put in place a hiring freeze because we need to contain our staffing costs, and we need to make sure as we re-engineer, we actually redeploy our folks to, say, new business areas or to growth areas and actually pare down others And the way to do that in a more emphatic way tactically, right, is to be particularly disciplined on hiring and, you know, freeze that or just limit it. And so given the, you know, the short-term performance, we're doing that as well, which gives you a sense for, you know, our willingness to bend the cost curve.

That's a great color. Thanks very much, Ron and Erica.

There are no further questions at this time. I would like to turn the call back over to Ron O'Hanley for closing remarks.

Well, thanks, operator, and thanks to all on the call for joining us.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for your participation. You may now disconnect at this time.