State Street Corporation (STT) Earnings Call Transcript & Summary

Thanks, everybody, for joining us this afternoon. I'm pleased to have with me State Street's Donna Milrod, Head of Global Clients Division; and Eric Aboaf, Chief Financial Officer of State Street. I have a quick research disclosure that I have to read. For important disclosures, see Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. And if you have any questions, reach out to your Morgan Stanley sales representative.

So Donna, I wanted to kick off with you. You're Head of the Global Clients Division. And I did just want to ask a couple of questions here about the fact that market volatility has been through the roof. And wanted to understand how that's impacted your clients and client demand for State Street services.

Great, Betsy. Thanks so much. Nice to meet you virtually. So I guess I think about market volatility, especially around the crisis in late March related to COVID, in 2 ways. One is kind of immediate demand of dealing with market volatility that clients were dealing with and maybe kind of a longer-term demand. So in the first instance around the market volatility, I'd highlight operational resiliency. Our clients really needed -- be providing operational resiliency. And our global operating model was certainly called on with volumes that, as you say, were through the roof. We saw a 50% increase in back office transactions, something like 80% or more in middle office transactions, volumes we've never seen before even with the global financial crisis. So our follow-the-sun model, our ability to move work around is super meaningful and impactful for our clients, and that's really what they needed to kind of get through each and every one of those days in late March. Similarly and from a liquidity point of view, all of our clients needed some version of help as it relates to liquidity. Some had excess liquidity, some muted liquidity with redemptions, et cetera, and they really access to our full suite of capabilities, from deposits to sweeps to SSGA, to sponsored repo, enhanced custody credit facilities that are on our balance sheet. And it was incredibly important that we were able to provide kind of timely help in accessing that liquidity. Also, we were really important partners to the Fed and on fiscal stimulus, especially the MMLF, which is the money market liquidity facility that's spun up pretty quickly during March, and we bridged our clients even before that facility got going. Also, I'd say -- I would just highlight our FX trading services as well. We had very strong demand for that. We've spent a few years now positioning that business to be competitive, and we believe we outperformed there as we did on the other aspects that I just discussed in our -- especially with Real Money managers, where we ranked first in the Americas and in EMEA. And that market dislocation for the FX part of the market was equally crazy in terms of market volumes increased like 40% for sales and trading and over 50% for our FX trading platform -- platforms. And then I'd say on the longer term, operational resiliency still is super important. The conversations we've been having with our clients now is really about reflecting back on what happened during the peak trading volatility -- excuse me, during March and April. And the realization that those -- the conversations that we're expecting to happen around maybe outsourcing, where they still manage asset servicing in-house or they don't have the size and scale to really manage multiple providers in a multi-provider model. And they really need to think about product consolidation, how they're looking at their operating model from many different vantage points, all of those conversations have accelerated. There's also a realization that the IT investment that's required on their behalf to maintain their systems in a BCP kind of mode is maybe not where they want to spend their marginal investment dollar. They'd rather focus on making investment decisions and figuring out asset allocation and focusing on distribution for their own clients. So the long-term demand is there, and we see it in the conversations we're having every day. And that kind of strategic dialogue is becoming more and more important. We're finding post-market volatility. And I'd say maybe to sum it up a little bit, our outperformance during the heat of the moment in March and April is really showing in the kind of dialogue we're having now.

All right. No, that's really helpful backdrop. Just one follow-up question here on just RFPs in general. They're effective life for your business. I mean you obviously are responsible for State Street's biggest, most complex clients. So I wonder if you could talk through how you work through the risk of things like the recently rumored BlackRock RFP. Maybe you can put it into context of what you're just mentioning.

Yes, sure. Happy to. So first of all, I'd say RFPs happen all the time in our business. It's a fact of life. And RFP is truly our request for proposals. There's no predetermined outcome. And people -- clients do RFPs for a variety of different reasons. It could be for repricing, consolidation, feeling out the market, et cetera, in terms of capabilities. For the companies themselves, the asset managers themselves are not the only ones involved. It's their fund boards as well because they have a fiduciary responsibility. So it is a fact of life. We win some, we lose some. We happen to win more than we lose, so that's always nice. But not everyone has a predetermined outcome where assets may either deconsolidate or consolidate. As it relates to BlackRock, we have a wonderful relationship with BlackRock. It's been over 20 years. We do a variety of servicing for them, not just ETFs. We manage their -- we service their alternatives business, their active management funds. We even manage other ETFs of theirs that are not subject to the RFP that's been announced, and we've been in a long dialogue with them about their strategy as they grow. I mean as you know probably better than most, they've had exponential growth on their ETF platform. And so as they think about our kind of operational risk there as they continue to aspire for more growth as a fiduciary, it made sense for them to think about diversification given their size and scale. It's not about service. They're very clear about that, and we partner with them all the time to get the right outcome for themselves. And I would just say as RFPs go, they are extremely complicated. It takes many years. And we would expect in BlackRock's case that they will continue to grow just as they have. So you never really know when and if something deconverts, what actually is the AUM that you have when the deconversion happens. And we have some experience with that in 2017. And of course, the institutional book, they diversified as well and that took over 3 years. And that's a lot less complex than the business that they've got here on ETFs. And given what we've serviced for all this time and helped provide the platform for BlackRock's growth, we know pretty intimately how complicated their complexes for their U.S. and Irish funds. And we are pretty sure that anybody else who wanted to service those funds would have to make a pretty significant investment.

Got it. Okay. That's helpful context. I guess just -- go ahead.

Hey, Betsy, it's Eric. Just to -- because you've got your legal disclaimer, and I think I need to get mine in as well, just even though we're doing this virtually. So just for the record, today's discussion may contain some forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors, such as those articulated in our SEC filings and 10-Q. Our forward-looking statements speak as of today only, and we disclaim any obligation to update them even if our views change. Let's keep going.

That was great. I was going to ask you for that when I kicked off with you. So let's keep the conversation going with Eric. Eric, you -- wanted to broaden the conversation a little bit to the rest of State Street. And maybe you can help us understand just the Charles River piece, how the synergies are going there. What are the technology investments you think or you're getting from the line management to invest in, to deliver on client needs? Maybe you could answer those 2 questions and then a couple of other follow-ups.

Sure. Happy to cover those, Betsy. If you think about the Charles River acquisition was really about supplementing what we've historically done, which is our anchor offering in the back office into the middle office, and then Charles River was really the front office offering which really put us in direct contact with the Chief Investment Officer of the -- of our client, which is where many of the important decisions emanate. And I think what we really brought to it was we brought a State Street brand to the software offering and functionality and analytics that those CIOs are looking for. Because they've historically had a patchwork of software providers, some mostly small, mostly boutique, sometimes in-house. And we really provided a sort of functionality and features and continued investment and reinvestment in those that they could count on, they could count on from years to come as opposed to feeling like they had to replicate it internally. In terms of the near-end functionality we're adding, we're -- literally the first 18 months of owning Charles River was really about connecting the trading functionality that we have, whether it's in securities lending, whether it's in FX into the SaaS installations of CRD so that you could do a short locate. You could find what securities in your portfolio are trading special and what -- how special and what kind of earnings you could earn if you were to repo them out. So it's that kind of, I think, kind of a technical feature functionality that we're adding first because that kind of connects us, the historical State Street offering to Charles River. And then with that comes a series of analytics and other kind of offerings and what I'll describe as the Charles River platform. In terms of investments, Charles River is our #1 area of investment as we think about the business activities. You all know that we're driving down expenses this year, somewhere between 1% and 2% for the year. But what that really means is we're actually investing 3% to 4% of our expense base, right, expense base of $8 billion. 3% to 4% is $250 million, $300 million. And then we're finding other areas in which to save 4% to 5% of our investment -- of our expenses. And so that's how we drive investments. And if you say, where are the core areas of investment in that $250 million to $300 million of investment that we make in a year, I think the first one is around Charles River. The second one is what we describe as the Alpha platform, our front-to-back offering, which is the front office, middle office and back office and how it connects Charles River and the offering it provides with the middle and back office offering. And then the third really is around technology and technological resiliency and automation, right, because we need to continue to refresh our tech stack on one hand, and we need to continue to make it -- to make our processes more and more efficient which makes them faster, smoother and more resilient for our clients.

And so you've outlined medium-term targets for pretax margin growth. Would that strategically come more from expenses now in this post-COVID environment? Or are you expecting that revenues will reaccelerate here in the back end?

I think it's a little more of the latter. I don't know if revenues have -- really reaccelerate. But in some ways, what we are finding is that we went through a difficult time period in 2018, back in the 2017, beyond 2019 and started to turn the corner on revenues in a way that we feel comfortable now and proud of, to be honest. And at the same time, we committed ourselves that as we take up revenues that we continue to execute on driving down expenses. So I really describe it as a balanced model. This is a slower growth industry than it historically was. So it's on us to drive growth with our key segments, whether it's asset managers, asset owners, the alternative providers, it's the front-to-back offering, and that we think can drive growth. But we think this is an industry where we need to continue to drive down the expense base and drive for productivity. And so it's really, really about both right now. And I think what we find from the COVID environment is it affected all of us in dramatic ways for 1, 2, 3 months. But I think because of where the equity markets have bounced back to, we're kind of on the path that -- closer to the path that we were on. And so now it's about driving for the top line growth and driving down expenses on an ongoing basis.

And then just to wrap up on this conversation. Just on pricing, I know, I think in '17, '18, '19, you really changed how you're thinking about the pricing. I'm just wondering with the BLK RFP, does that -- does pricing reemerge as an issue? Or do you feel that those 2 things are kind of separated, that BLK is not really about a pricing situation?

Let me start, and Donna might weigh in as well. I think we've made a lot of headway on pricing. Pricing, as you said, end of '17, '18, we were seeing pricing headwinds of 4%, right, which was over and above the 2% that we had historically seen for the last, call it, decade. Last year, we drove -- we started to implement a series of different initiatives, and Donna can certainly talk more about those. And this year, we expected that pricing headwinds would be closer to 3%, so controlled. And we still feel confident that we'll deliver at that level. And I think it's -- pricing usually is something that's always come up. I think what we've learned over time is how you manage pricing, how you interact with the clients at the most senior levels, and that's what makes the difference. And so we don't see -- at this point, we don't see another uptick. And in fact, what we're really working towards is delivering on the 3% level of pricing headwind this year. And at some point, seeing if we can, and we don't know if we can yet, but we're trying to work through, can we get back to that historical norm?

Yes. So I would just add, Betsy, that our focus, as Eric is saying, is really on how we add value, and we're not competing really on a commodity basis. It's really where we add value, and what we are doing is essentially providing solutions to problems. And what I was talking about earlier around kind of what the effects of COVID were really lays this whole thing there. As we talk about front-to-back and the fact that clients are really thinking about their operating model in a completely different way, and that could not just be about asset servicing. That is also about their front office platform that Eric talked about as it relates to CRD. They need scale. Clients really need scale and resiliency. And that's what we are providing them, and that's where the value comes in. So I think you know already that we set up the executive deal review committee. That's about elevating the discussion of value across the relationship at our firm. And we had the groundwork laid for that last year when we established that. And I would say the same about the Global Clients Division. So how do we think about our largest, most complex clients and how we provide solutions to them. And that dovetailed completely into the whole notion and thesis around Alpha that we are seeing play out now as we add more deals to our pipeline. Those deals are very much about how you connect value to helping our clients change their operating model, their operating platform, whether or not they're doing asset serving in-house or not. And it just reinforces kind of what I said before about that strategic dialogue as they kind of figure out what works for them.

So do you see the pipeline accelerating here or running at the same rough run rate that you've been operating at?

Yes. So we see the pipeline holding up really well. It's very healthy. And we see the timing. Any kind of timing changes that happen in our pipeline are pretty much the exact same levels as last year, so very normalized. The quality of the pipeline, the nature of the deals in the pipeline are of these higher strategic value deals that I just described.

Okay. So Eric, let's flip now to second quarter outlook. Just wanted to get an update. We're about 2/3 of the way through, maybe a little bit more now. How are you thinking about the quarter? And any updates that you can share with us?

Sure, Betsy. Let me give you the kind of 2/3 of the way through update as you described. I think it's fair to say that the market conditions have changed favorably as compared to our expectations when we announced earnings in mid-April. And if you recall, we had assumed, as part of the guidance that we had given, that average equity levels in the second quarter would be consistent with March daily averages and thus down significantly from the first quarter averages that we had just been through. However, quarter-to-date, while the S&P average is now up compared to March and the end of periods are up even more, the S&P average quarter-to-date is still down 6% from the first quarter average. In international market, equity average -- equity index averages, are still down closer to 12% from the first quarter averages. And I say all that because, as you know, market averages matter more to servicing and management fees than spot levels, at least in the near term. So with all that said, while things can still change, we expect fee revenues should come in better than our previous guidance, which had been down 5% to 9% sequentially. And so probably we expect closer to down 2% to 4% sequentially. And primarily, that downtick is driven by the absence of the outperformance of FX trading in the first quarter. As part of that, we now expect servicing fees to be better than our previous guidance of down 5%, and we expect them to decline just 1% to 2% sequentially, while management fees should also come in better than our previous guide of down 9%, and they should decline just 5% to 6% quarter-over-quarter. If I turn to NII, we expect NII to be down 11% quarter-on-quarter, excluding the $20 million episodic items we experienced in the first quarter, so in line with the previous guidance. And that's driven by the full quarter impact of the lower interest rate environment that we're operating through. And while we expect 2Q deposits to remain elevated, they've recently fell down to approximately the $180 billion level. And I do need to remind you because it's something we operate with is that the -- with rates where they are, deposits are unfortunately worth less than they were pre-crisis. Finally, we expect 2Q expenses to be down 1% to 2% year-over-year, consistent with our full year guidance and excluding any notable items. And in regards to our provision costs, our 2Q results will be driven by updated economic forecast embedded in our new CECL model plus any specific reserves.

Okay. That was very fulsome. On the deposit side, one question we've been getting is, how long you have to hold them before you can take some duration on them. Maybe you can give us a sense as to how sticky you believe your deposits are at this stage.

Sure. And I guess for context, our deposits have been running, on average, about $160 billion through the second half of last year. They popped up on average to $200 billion in -- closer to $200 billion in the first quarter, and they actually peaked at $250 billion. So just think about the enormous inflow from a flight-to-quality perspective. More recently, the last 4 or 5 weeks, they've been in the $180 billion, $185 billion range. So what's effectively happened is something that we had predicted and to your point, how do we think about it. We really think about deposits in a couple of buckets. We think about deposits as the, I'll call it, the 3-week deposits, the ones that fly in quickly because you're the flight-to-quality that clients count on and then they quickly recede. There is the kind of, I'll call it, the 3-month deposits, the ones that stay around a little longer until clients figure out how to reapportion, restack their book. And then there are the 3-year deposits. And so what we've been doing since we saw the deposits go from the $160 billion level to the $200 billion to $250 billion level, it's literally tranching out our deposits, where are they from, what clients, what parts of the world, what currency? And I think what we're seeing now is that the flight-to-quality, what I'll call the 3-week deposits, they're largely gone. I think the 3-month deposits are mostly -- a good part of those are gone. There may still be some. And I think what we're looking for is to see of the, call it, $180 billion deposits, which is up $20 billion, some proportion of those, maybe it's half, maybe a little more, maybe a little less, should be pretty sticky especially given that the Fed has embarked on quantitative easing, right? They've expanded their balance sheet from $4.5 trillion to $7 trillion. And so that added monies to the money supply and thus bank reserve. And so I think we're now at the point where we can begin to leg in to more lending in support of our clients, perhaps some expansion in the investment portfolio. And so that's the -- the to-do now is to start putting them to work. Now you put them to work carefully in this -- especially in this kind of environment, but we've already started to do that, and we'll continue on.

And then you're reinvesting those incremental deposits primarily in securities. I think you mentioned securities yield could go to like 150 in the third or fourth quarter. Do you expect it to grind lower from there? Or is that kind of the extent to which you're anticipating a decline, too?

Yes. I think the way I'd say it is the immediate reinvestment deposits was an overnight funds at the Fed, right, so we earned very little. What we're trying to do now is begin to leg in to a bit larger securities portfolio, lending portfolio. And that will take some time before it offsets the natural decline in -- that long rates have on the existing investment portfolio. So what we did say is that investment portfolio yields will float down to the 150 basis point level. We said that in the back half of the year, we said that NII would continue to float down a little more sharply in second quarter relative to the first, a little less sharply in the third quarter and then tend to stabilize around fourth quarter. And what you have is you have 2 offsetting factors. You have the effect of the low rate environment continuing to be a headwind through that period on the portfolio but starting to burn out; and at the same time, you have the investment and the expansion of the balance sheet, tactical repricing initiatives and so forth working in your favor. And we think that the stabilization point is around the fourth quarter this year. But as we move through time here, we'll be able to update you on how that plays.

And any need to issue some pref just to give yourself a cushion against Tier 1 leverage ratio? Or now that the deposits have pulled back down, you don't really need that?

I'd say no. We don't see a particular need for prefs now. As you know, we called a couple of tranches. We're pleased we did do that. And I would actually tell you, of all of our capital ratios, the most important ones are actually obviously, the risk-weight ratios, right, CET1. We're quite comfortable. If we have healthy CET1 ratios, we're quite comfortable letting our leverage ratio, our Tier 1 leverage ratio fall into the 6% range, 5% range, maybe even crossing below 5% because the minimum -- the requirement is 4%. But if that's what we need to do to accommodate our clients, we'd like to. I think that's what the Fed means when it says we'd like banks to use their buffers. I think the leverage buffers are the ones with most the -- were mostly used most quickly because they are not risk buffers, right? They're effectively -- it's a different kind of buffer, and we think that's the one to put to use. So we don't see any -- but the net of it is, we don't see any need at this point to supplement our Tier 1 stack. We're pleased we did the calls we did.

Got it. Okay. And then just lastly, you were part of a larger group of banks that put a pause on buybacks. And I know Ron previously mentioned the decision to turn back buybacks on would be made independently. So just wanted to get a sense as to what indicators State Street, the Board would be looking for to turn those buybacks back on eventually.

Yes. I think there are both external indicators, kind of economic indicators. And then I'd say there are other indicators around stress testing in CCAR and SCB. So all the banks are going to be -- are going through the CCAR process. We know there's a little more going on than usual because we're, number one, moving to the SCB in the fall as the Fed has said, but also the Fed's running some extra sensitivity tests. So we just need to see what that looks like and see if there's anything different than expected. I think more broadly, the real questions we're asking ourselves that our Board is asking and so it's a much more management and Board discussion, as you'd expect, is what are the economic indicators? What are we seeing ahead of us? How long do we think this economic -- this health and economic crisis will last? Could there be a rebound or not? So those are the questions we're asking. And I think what the point Ron made is we're not asking about how those economic trends and indicators will affect banks generally, right? That's the Fed's purview. We're asking, how would those economic indicators going to affect State Street? And you know we have a vanilla investment portfolio. We have one of the smallest lending books. It's barely 10% of our balance sheet. So we're just trying to factor all that in, and we think over the course of the next few weeks and as we see the CCAR results and then prepare for second quarter earnings, that will be a natural time to kind of do a check on all those indicators and then come back to you with our game plan.

Perfect. Well, thanks for that. I really appreciate your time, Eric and Donna. It was a great rundown. Thank you.

Our pleasure. Thank you.

Thanks, Betsy.

Okay. Have a good day. Bye.