Northern Trust Corporation (NTRS) Earnings Call Transcript & Summary

Good afternoon, everybody. This is Gerard Cassidy from RBC Capital Markets. Thank you for joining us for our afternoon fireside chat with Northern Trust. This is our 25th Annual Financial Institutions Conference. And we're very pleased to have Northern Trust. And as many of you know, Northern has about $170 billion in assets. It's the 14th largest bank in the United States. It has a very impressive market cap of $21 billion. And most importantly, its assets under custody today are a little bit over $11 trillion, assets under management are $1.4 trillion. The company's capital strength, as measured by the CET1 ratio, is 12.8%, and the company is similar to other banks, has a buyback in place for 2021 of about $635 billion. We're very pleased today to have the Chief Financial Officer, Jason,Tyler, with us today for Northern Trust. He has assumed this role in January of 2020. Prior to that, he was the CFO of the wealth and management -- Wealth Management Area in 2018 and joined Northern back in 2011. And Jason, welcome. Thank you for joining us.

Thanks, Gerard. And before we start, I've got to say congratulations. 25 years of this conference and not skipping a beat this year. And it's been a great conference. And you've got this and one more to go, so I hope you're feeling good about how your part went.

Yes. No, thank you so much, Jason, and we're in the fourth quarter, and we're still getting ahead of the goal line. So we're almost there. And I know you will help me get there, so thank you.

I'll try.

Okay. Maybe to start off, last year, and I know this is an overused word, unprecedented, but it was an unprecedented times in our lifetimes. Can you share with us the surprises that Northern Trust saw and manage through? And how you -- that will maybe guide you going forward in handling what you had to handle during the pandemic?

Yes. I'd say I'll try and be disciplined and not talk about it as if the whole thing is over because we're still in ways of managing through it, but it is a good time to reflect on it. And particularly, it's right in about a year. It was a year ago yesterday, I think, that most places went to quarantine. And I think the thing that jumped out at me, if I think back, this time last year, was just the incredible velocity with which the liquidity ramped up. And I looked at it a few weeks ago, we were at $80 billion, $85 billion in deposits. And that went in just a few weeks to over $130 billion. And you just think about every day, just so people have a sense of how we're managing that, every day large clients calling saying, we're going to send in $100 million, $200 million, $1 billion. And it creates stress in the system. And we were lucky to have a great balance sheet. But if you think about our traditional stress, which we all planned for, usually, we always think about capital strength as the amount of capital we have, divided by the amount of business that we have in some context. And we always stress our capital by saying, what if our base of business stays the same and our capital shrinks? But this was a stress and the capital staying the same but the base of business just dramatically expanding so quickly. And so everyone wanted these liquidity stress test environments and thinking about what would be the ultimate strains and constraints on the system and the velocity with which that happened was amazing. But every -- I have to say, banks get a tough rap sometimes, but I felt great about how the collaboration was between banks and regulators and banks ensuring that everyone knew that there was -- they were open for business and providing liquidity to their clients when they really needed it.

No. That's so true. And it differs so much, not that you guys are ever in this camp, but I wouldn't even consider that. It's such a difference from '08, '09 in the crisis versus this one. I couldn't agree with you more. One of the things that Northern has always done is kind of given us a reference point on return on equity. And I always like to emphasize return on equity because you're one of the few that actually talk about that, which is what I think investors prefer, and not return on tangible common equity. So with that, can you share with us what your targeted ROE is? And in the current environment, how should we think about your performance within this targeted range maybe? And how do you improve from the year-end 2020 levels?

Yes. Well, if you -- first of all, you're right, we really think about total common equity. And ultimately, what financial services companies like banks do is they go to the capital markets, and they take a certain amount of capital. And our view is that's the contract that exists between us and the capital markets. And the one result we should post every time, every year, is how are we doing in terms of returns on the capital that we've taken from the market. And it's just the most fundamental way to think about banking in a lot of ways. And so we've said that over time we should be able to operate in that 10% to 15% return. And there's -- we have to admit some of that is just us saying what's a good level. But I have looked back on it periodically and said how would -- not just how is our own return on equity rank among our peers. And we've done well in that regard. We posted top quartile in most periods relative to our peers, for sure. But even if you think about that 10% and 15%, those thresholds, those bookends, those actually ranked pretty high as well. And so we actually do think it's a good approach to thinking about what an appropriate return on that contract is that we've taken with capital markets.

Very good. And it is you -- again, you stand out amongst many of the banks of achieving that, which obviously is reflective in your stock valuation because you're right it's truly one of the best constructs for bank investors to use, in our view, is comparing the ROE and the people that can maintain it through a cycle. When we look at interest rates, clearly, things have changed, very recently, since the beginning of the year, at the long end of the yield curve, of course. And also, we've always got to keep an eye on the front end of the curve. Now the forward contracts, the futures market, is calling for the Fed funds rate to go up in 2023. I'm not asking you to predict interest rates. But in an environment of a steeper yield curve, maybe we get to 2% 10-year at the end of the year, maybe inflation picks up and we get a Fed funds rate increase in 2022 rather than 2023. But can you just share with us the effects and the impact for net interest revenue or net interest margin for your organization if we get into this rising rate environment over the next 12 to 18 months?

Yes. It's such an important dynamic for us. And in some ways, our business is -- the income statement has 2 stacks to it. One is the trust fee component of our business, which is obviously very stable. It will move with equity markets a little bit. But then on top of that is also, it's the net interest income, and there is a lot of volatility in that component of the stack. And if you think back until -- into 2019, I'm doing this from memory, but I think net interest income was $1.7 billion, give or take.

Yes.

And then if you just think about where we are now and what we're anticipating, even if you take fourth quarter and annualize it, $350 million in NII, it translates to $1.4 billion. As you get $300 million just in net interest income coming off of the revenue base, that's a lot. And then you couple that with what's very correlated to money market mutual fund waivers. And so there, $100 million, $200 million in waivers. And so all of a sudden, you add those -- the interest rate impact, and you can get to $400 million, $500 million. And that's a lot for a company of our size. And so in one way, to tie it to your first question, Gerard, of the ROE is that we've looked at this in good interest rate environments, our 15% ROE, it's going to come pretty naturally. We've got to do work to make sure we get there, but it -- then at the -- when rates are 0, harder to do that. We really have to scratch and claw and make sure we're doing everything right and pinching every penny. So any lift in interest rates helps us a lot, not just on the NII side, but taking away waivers, which, again, no expense is truthfully correlated to that. So a big driver of profits.

Yes. Would you have an idea to share with us on the money market mutual fund waivers? At what level do you need short-term rates to -- and I know it's not one specific level, but it's kind of graduated. But to recapture all of them, where would we need to see short-term rates go?

Yes. Well, our money market mutual fund family is very institutional. And even though our wealth clients are institutional in their size effectively, and the reason that's important is that our funds are priced in a very institutional way. And so we actually don't have funds that are priced over 35 basis points, nothing to speak of. And so we just need to clear that 35 basis points. And as you know, the funds are able to invest with a little bit of duration. And so even a 25 basis point lift in short-term rates, you couple that with some duration that the funds you'd be able to take, and you'd clear the waivers. And if the yield curve was super flat, then you might need a second, but it happens pretty quickly. Now one thing I think people need to appreciate, it's not a linear relationship because we've got -- there's a large set of funds that are priced at 15 basis points or 20 basis points. And then another set that comes in at 25, another at 35. And so as the yield curve comes up, some funds get out of waiver mode first, and same thing obviously coming down. So it's much more of a step function than people realize.

Got it. Yes. No, that's very good. Speaking of fees, obviously, that's the dominant form of revenue for you folks, of course. And investors, obviously, know that. Can you share with us the organic growth? When you look at your fees and you look at the different business lines, if you look out over the next 2 or 3 years, within those lines of business, where do you see the best growth opportunities? And second, what kind of investments do you have to make to support those lines that maybe are growing faster than the overall fee revenue?

The institutional business has been -- has seen faster growth over the last 5 years. And -- but that's also a business that takes investment. And those clients demand that we are up to snuff on our technology. And so we've got to make sure we're making the investments there to stay with our peers and to -- not just that, but periodically try to innovate. And we're not always going to be first, but we also can't not be able to provide a service that our clients have grown to expect in that landscape. And so the institutional business is the one that I'd say, at least it has been in recent times, growing faster, but also requires the higher investment. And those investments have tended to be around technology. And we started to talk more externally about the integrated trading solutions, which is a platform we have where we're working more to execute in a broader way for our clients from a trading perspective. . There's a front office solutions business where we're working with our clients to provide more front office-type platforms that portfolio managers can use and asset owners as well. And so those are the types of investments that are expensive, but our clients are expecting them. And that's what -- especially as we're talking to the more sophisticated asset owners and all the asset managers, they want that information, risk exposure information, portfolio management information as well.

And you brought up in your answer about technology and the importance of technology. And we, as outsiders, have limited amount of information for all the banks, not Northern in particular. And so is there -- and we all know that size dictates how much is going to be spent on technology, just like personnel expenses, of course. So you take it relative to maybe assets or revenue, whatever you prefer. But do you have any suggestions on what can we as outsiders look at to see if a company is kind of short on its technology spending, where it's doing a good job? Any suggestions on what might be out there for us outsiders to look at?

Yes. It's a neat topic, and firms all report differently, but I'm always trying to triangulate to what are the key areas that a business is reporting. And anything that businesses talk about strategically, asking the question, how can we tie this to what you show us on your income statement or on the balance sheet? And so for us, for example, we actually -- we report 6 lines externally in our expenses. And the 2 of them that are most important to watch, one is equipment and software. And that's where our big investments are going to show up in technology and the depreciation is going to eventually flow through. And then outside services. And a lot of the expenses around technology come working with consultants or in other areas that will classify and account for as outside services. And so those are the 2 areas. And so as you look historically, you've seen those are the 2 expense line items that have actually grown faster than others. And so as we've talked about being on this journey to invest in technology, investors should look to that area to evidence it. And then also eventually to say, has it flattened out? And has it flattened out because we've accomplished what we wanted? We've gotten to scale or because we've stopped investing? But to me, that's the way to tie those strategic components of what we've talked about with the income statement.

Got it. No. Speaking of expenses, over the years, Northern has, from time to time, have had expense savings programs, where they're very focused on reducing a certain amount of expenses. And I know you're always managing your expenses, but maybe you can share with us any color on how you're managing expenses today and as we go forward on the outlook for that?

It's incredibly high priority for us. And ultimately, we've -- our success over the last several years hasn't come from doing a lot of acquisitions. We've done a few, some, not many, and they haven't been enormous in terms of investment dollars. Our business has been mostly about getting good organic growth and then trying to manage the expenses again. And that's why we talk all the time about operating leverage. And if we can do that, and that's the one thing, back to your earlier question, that's the thing people can see externally. How do we tie the revenue growth to the expense growth? And because we've had good organic growth, we don't say we want our expenses to be flat or down 100 basis points. We're always going to tie those 2 together. And the more detailed we get, we can say, well, let's take out that volatility of interest rates and just look at trust fees. And so then we can say what are trust fee growth relative to expenses. And the reason that's so good for us is because those 2 numbers happen to be about the same level. They're both right at about $4 billion. And so somebody looking at our trust fees and expenses and how they correlate to each other. It's a good litmus test for how the business is doing, but even that gets some exposure to the equity markets. And so what we do internally is go a step further and say, what is the organic trust fee growth compared to the expense growth that we're having? Now we don't do the organic component, but that gives you a very good lens on the conversations we're having at management levels inside the company. And so we have gone on over the last 10 years, we've gone through 2 different initiatives to get expenses out. And Gerard, we have to earn it from here. But if we can get out of the initiative business and just have these thoughts of exceptional discipline around expense management embedded in our business every day and make sure we're being efficient every day in how we do things, that's when we're going to be clicking on all cylinders. And so we're trying very hard to get out of that initiative business, but we acknowledge, we have to earn that. And we have to earn it by not saying expenses are going to be flat, but by saying expenses relative to trust fees or internally relative to organic trust fee growth, it has to be aligned well.

Yes, which brings -- that's a very good point because expense growth, if it's managed properly, is not necessarily negative, particularly if you get the positive operating leverage. And that was going to be my follow-on question to your answer is if you can share with us just how you focus on positive operating leverage. And maybe you don't get it every quarter, but I know it's a focus for your organization. Any color you can add to that?

Yes. Well, when we go through our planning process, we know there's some -- we try to separate things by thinking about where's inflation in the business? What are the investments we're making in the business? And a couple of other components. But the big ones to really think about at this point, really coming back to where is inflation happening across the business? And can we get that managed very, very tightly? And so we think about that. It's -- what we have to get right is compensation, and it's the biggest line item that we report. We have kind of walked through the expense component of the income statement in a good way. And so we have to win that war and make sure that over time we want to make sure our partners are paid well and we're doing well. But we have to make sure we're analytical and thoughtful about how much to put in our expense base, and it's got to align properly with the growth in fees in the business. And so that's what we spend a lot of time thinking about, making sure when we hire someone, we really need to hire them. And if we are going to hire them, we put them in the right place, whether that's here or if it's somewhere offshore where the current wages might be better. But that initial component of the income statement of thinking about the organic trust figure and where is compensation going, that's the one we've got to make sure we win that component of the overall discussion around expense management.

Speaking about the compensation for a moment, are you finding it more challenging lately to find skilled labor? I mean there's some reports, not so much in our financial industry, but homebuilding, which is obviously not financial. But are you guys running into anything like that where it's hard to find some of the skilled labor you need without having to really pay up for it?

Yes. And that's what -- again, this is a good talk through of how we line up expenses. And that even shows up in some of those other technology lines. And so as we're thinking about how do we invest in technology and make sure that we've got cybersecurity locked down the way that we want. And in other platforms, front-office solution, we've talked about a matrix platform to invest in the scalability of our institutional business, all those things that you can see and feel inflation. And then on the Wealth Management side of the business, the reality is our partners, our financial advisers, our wealth advisers are known as exceptional in the industry. And so they're going to be coveted. And so we've got to be careful and thoughtful and use our culture as a way to ensure that we're making sure partners. Again, we want our partners to do really well. And at the same time, we've got to manage this expense algorithm in a good way.

Oh, no doubt. No doubt. And quality people, you don't want to lose them, that's for sure. And I think we're shifting over -- we're 2 months into the quarter right now. Any updates you'd like to provide to us on trends you're seeing this quarter?

Yes. Well, one, we didn't talk as much maybe about waivers, and I am trying to make sure people understand that dynamic and how that plays through. And I go back to the January call and people -- some people said, well, yields are up since then. So shouldn't waivers have gone down? But it's really the long end of the curve, obviously. As you know well, it inflected up and -- whereas the short end of the curve has come down. And if you go back to -- I think I actually pulled it, there's -- if you think about the January 20 call, the 10-year, which everybody is focused on, was [ 109 ], it's up to [ 160 ]. That's great. But then the 1-year is flat at 10 or 9 basis points. But then if you look at 1-month treasuries, they were 7 down to 3 -- 3-month treasuries, 8 down to 4. Overnight repo, it was at 8 basis points, and it's down to 1 or 2 basis points. And the majority of the money of our mutual fund assets are going to be honed in on that 30-day or less, 60-day or less, you pick up maybe 50%. And so at the time, we had a run rate, we talked about an annualized run rate of the business. And now if we look at what the run rate is, so if you take what we see today, today's yield curve, today's investment environment and where the portfolio is size-wise, and we'd be at about 55 to -- $55 million to $60 million on a quarterly run rate basis. So if you took today's run rate for 90 days, you'd be at $55 million to $60 million higher than where we were before, again, the short end of the curve coming down. But other than that, I think your questions talk through a lot of the things that we're talking about internally and how the business is doing. It's just focusing on continuing to grow organic fee growth over the long run, dealing with the net interest income and waiver environment based on low rates and then laser, laser focus on expense management.

Very good. Thank you for those insights. Maybe shifting over to capital. Obviously, Northern has always been considered a very well capitalized bank, and that's something that you guys, obviously, you're very proud of. Can you share with us your thinking on return of excess capital, what you might do in the forms of dividend? I know the Fed has limited your ability and others to raise dividends. But just your view of, philosophically, as we go forward, we would expect that the restrictions will be lifted, possibly in the second half of the year, but maybe just to get your feel on how you guys approach it.

Yes. We -- I'm a broken record on our framework on this, but it's worth going through because it literally is how we contemplate it all the time. So 4 legs of a stool. The first is our Board, and they have opinions on where we should be. And that's not to say that there's ever been a difference of opinion between management and the Board, that's not the case. It's just we don't want to be presumptuous and saying we think it should be x without having talked that through with our Board. They exist for a good reason. They're very thoughtful. Second leg is absolute. And we want to make sure that we've got high absolute levels of capital. And where we are relative to the regulatory minimum, you'd certainly say we've got good room there. And then the third is relative. We want to make sure we can look our clients in the eye and say that our balance sheet is strong, not just anecdotally, but relative to what they can see where our peers are. So we always want to make sure we're keeping an eye on what our peers are doing. And then the last is the regulatory environment. And 2 years ago, nobody would have thought that, that fourth leg would have come into play. But [indiscernible] really does come in because they've said no -- in the short run, they limited what we can do from a share repurchase perspective. That said, we're always testing -- and this is something I think it does surprise investors a little bit, the rigor with which we go about it, is that 10% to 15% return on equity, we're using that as a litmus test, too, for how we deploy capital. And we think about that test if we're buying back stock. We're thinking about it if we're doing an acquisition or if we're reinvesting in the business. And sometimes you say, well, how would you reinvest in the business? Well, anything we do to increase the denominator of risk-weighted assets is going to -- can increase the exposure that we have, that size of business. And if you think about something like Tier 1 and -- so for us, it's testing all of those things, the stock repurchase, reinvestment in the business, which comes very organically or stock buybacks against that threshold.

Yes. The other opportunity for you folks -- and in the past, you've used this for excess capital for acquisitions. And you're not an active acquirer or I wouldn't suggest that. But from time to time, opportunities arise. And just how does that look for you folks at this time? Again, I know it's episodic, and it's not that -- I'm not asking you to say, oh, yes, we're going to do a deal in 6 months. But just your views on that.

For us, it would -- first of all, I don't think there's a big strategic gap anywhere that we need to solve. And so as we -- just as we talk through with stock buyback, anything we do from an acquisition perspective, in size, it's got to chin the bar economically, same framework that you and I just talked through. And then that said, Mike has even said externally we've done some things on the institutional side of the business. And so if we were going to do something of size, more likely, not definitely, but more likely we'd look towards the Wealth Management side of the business. And so where do we look there? The first test is that we always talk about when we see opportunities is what's the client base look like? And for us, we -- something that's mass affluent in a large amount might not be ideal for us. And -- but if we can take the client base that's more consistent with what we have, clients in $10 million, $25 million or multifamily offices, we can do well with that. And we feel like we know how to run that business well and expand what we know how to do well. And so that's important. And then the second component of it is what would the size of the business be? And all the regulatory dynamics and compliance take place if you're buying something that's $200 million in assets or $200 billion. And so finding something that's the right size, it's important. And then we don't report it through the external numbers, but it shows into the C&IS and Wealth business, but our Asset Management business, you started with it, is it's almost $1.5 trillion in AUM. And so there, the business is focused a lot on the quant side. And they feel like that's a very good area to continue to invest. And we also -- it's almost 10 years that we launched FlexShares, which is our ETF platform. And so those are the things -- and then also ESG. They've done a phenomenal job, well over $100 billion in AUM in ESG. And so you can imagine, those are the things that the asset management group is looking at and talking about as options.

Great. Well, we're up against the clock, so I wish I could continue on with you because I find this very insightful and helpful. And again, Jason, thank you so much for joining us. We really appreciate it. It really enhances our conference to have Northern Trust with us. So thank you.

Thanks, Gerard. And congratulations. You got one more to go. You've been a great [ captain ] so far.

We're on the 5-yard line, so we're going to put it in.

All right. All right. Take care.

Okay. Take care. Great seeing you. Thank you, Jason.