State Street Corporation (STT) Earnings Call Transcript & Summary

Starting with the afternoon part of the conference. With me is Eric Aboaf. Many of you know him as the Chief Financial Officer over at State Street Corporation. State Street, as many of you know, is the 10th largest bank in the United States with over $300 billion in assets. But as the real distinction, of course, is the assets in the custody, which and administration, which are over $35 trillion, hard to say that word. And then assets under management are over $3 trillion. Eric, as you know, was at Citigroup as their Treasurer for a number of years and had a brief stint as a CFO over at Citizens. And now, as I mentioned, the Vice Chairman and CFO at State Street. So Eric, thank you for coming.

And I think I have my usual...

Please do...

In the currency of our General Counsel. Just to remind everyone before we get started, today's discussion may contain some forward-looking statements. And as you know, actual results may differ materially from those statements due to any of the number of important factors, including those risk factors in our 10-K and our SEC filings or forward-looking statements speak only as of today. We may not update them even if our views change. And with that, we can get going.

Great. It reminds me of the old commercial was a FedEx that guy that used to do the speed talk...

He was faster than I was. I'll have to practice.

Okay. Anyway, thank you again. And maybe we could start off, Eric. Obviously, you and Ron gave guidance in the third quarter about the update with BBH. I don't know if there's anything at this point that you'd like to expand upon or any further updates?

No. It's just in a couple of weeks, Gerard, there really is no update. As you know, this is in front of our regulators, we're working through the process with them. But there's no update over the last 2 weeks. We would like to get to a decision and sell one way or another by the end of this quarter. That's what Romanian that's our general timeline.

And one maybe follow-up to that. First, to keep our eyes on, is it the Federal Reserve, which regulators or should we all just be keeping out for in terms of news releases regarding this transaction?

It's not -- it's #1 in particular. There's always a group of regulators. They work in concert and generally collaboratively with us, but they have views, and we need to respect those. I think what will happen is they'll give us an indication of their views, and we'll be able to communicate our confidence in either being able to proceed in a constructive manner or deciding that it's not feasible at that point. That will probably be the signal that will come through. Okay.

The reason I ask is the logjam of deals are starting to loosen up traditional deals. So okay, good. We all know markets have been very challenging over the last 12 months for yourself and your peers. And so when you look out over the next 12 months or so, and if the markets remain challenging still because of Federal Reserve monetary policy, what are some of the opportunities that you might be able to capture in those types of markets? And also, what are some of the challenges?

It's striking. If you look where we are today, given where equity markets are U.S. and internationally, interest rates, there's been a lot happening. I think just for context, before I go into opportunities and risks, we're pleased with our overall performance. We've got a diversified revenue model. And if you step back on a year-to-date basis, servicing fees and management fees, some of our core activities down 7% and 4%, respectively. On the other side of the ledger, we've had our markets activities, FX trading services up 8%. Software and data services, up 9%. So we've got some offsetting areas performance. The trading is driven by volatility. That's an opportunity for us in spite of the market soon. And software is part of that continued alpha value proposition. And then with that, NII has been up on a year-to-date basis, 23%. And so revenues are still up a bit. Not a lot, but up a bit notwithstanding how the external environment has played out and how I think anxious some investors are, and we're quite pleased for that. I think given the economic environment and what we're looking at, what we've been working through, opportunities certainly continue in -- on the upside in NII. Rates are going to continue to move upwards. We've relearned that yesterday, including after the press release and during the conference, we've all seen the Bank of England continue to raise rates, and we're going to continue to see that across the world, and I think that's a positive for us given our global deposit footprint. I think the -- we continue to see volatility in currency markets, and that's an opportunity for us to earn on flows and spreads. We have opportunities that we're generating through our sales force when it comes to our front office, our CRD and Alpha services and private markets continues to be a real area of growth for us. So there are -- I think there are a number of different areas where we see opportunities. In terms of the headwinds, I think they're the same ones that probably you think about and you write about, clearly, equity markets down and bond markets down that doubleheader creates a pall on our top line in some areas, not in all the areas. I mentioned 2 are down and 2 are up, which is a real positive, notwithstanding the situation. I think the inflationary elements are still there and becoming more embedded and ingrained. And that's a headwind for us, and we've been trying to cover that. Year-to-date, our expenses are flat, not bad. Now I do have to say they're flat on a nominal basis. They're up just 3% adjusted for currency translation. So even when you do the adjustments, we've been trying to find ways and we've continued to find ways to offset wage increases, supplier price increases and so forth, but that's going to continue to be a headwind into next year. And then I think there's a general question around interest rates, how high they go, how quickly, what the pace, which currencies and then are their policy mistakes. And I don't mean that in a negative way. Our policymakers are trying to do the best they can. But do they go too fast? Do they go choose slow, do they cause a recession? Does a recession happen that they have to come back? I think there's a range of outcomes there that are hard for us to anticipate. But what there's -- I think there are enough opportunities to keep our revenues solid which is good, and we'll just keep working on expenses in the meantime because that we can control.

Yes. Many of us obviously have known State Street for a number of years, but there are always new folks that come into the fold. And even for the folks that know you really well. maybe can you touch on 2 to 3 data points or important fact trends that investors really need to know because you're not your traditional commercial bank that people can understand. But what would you highlight as maybe the top 3 data points, trends, et cetera, that people really need to and to understand you? I think there are probably 3 -- if I hold myself to 3. Yes. You can...

So let me start with 3. I think we have a diversified but growing revenue model and diversification I talked about servicing fees, management fees, tend to be offset by foreign currency trends -- foreign currency trading, in bad times and good times or seeing fees and management fees are up. So it's a diversified revenue base with I think some accelerants. The accelerants are around software. Our alpha services, our front-to-back offering which is quite different than what other custodians have and our private markets business. Those are areas that we can accelerate growth off of what's been a historical base. And so I think diversified revenues with some growth areas that we're trying to resource even further. Secondly, I think I want to say a culture of expense management, productivity and reinvestment in the franchise -- you've seen expenses, as I said, up only 3% this year adjusted for currency translation flat on a nominal basis. And we've actually held our expenses the last few years to flat to up 2%. So we have -- I think we've built a discipline in what that is, is an expense discipline on one hand and a scalable platform on the other. And we have a scalable platform as we expand. A lot of that revenue growth can fall to the bottom line, one because we have a fixed cost business. So we can build off that. And then thirdly, I think capital from a -- in the sense that we're a capital-light business. We're not RWA intensive like other banks. We don't have large, large loan books that will go in different directions if there are recessions or not. And so we have an ability and we've got a commitment to return north of 80% of earnings back to shareholders each year. So it's both capital light and its capital returning in its design. So I think there's good revenue diversified with growth. There's an expense scalability or a platform scalability and expense discipline and then a capital-light and capital return model that I think, for some investors is what they're looking for.

You just touched on the front-to-back office product mix. Can you share with us what percentage of your customers or your clients actually use all 3 of the different mixes, front office, middle office and back office. And with the concentration of customer use? Is it still the back office from years ago, the mutual fund accounting and all the other different products that you get is in the custom products, of course. Maybe you can share some color there.

Let me do it this way because we could talk about our entire franchise you talk about subsets by region, by -- let me describe it to you this way. We've over time done some tiering of our client base, just so we can talk about them. We've got our Global Client division, which has 65% of our largest accounts, which accounts for probably 60%, 65% of our revenues. And then we have our next group, our next group, which we've talked about in different forms. If I take a look at the top clients, the top 6 -- and I'll do this on a client basis -- it's a little different and different ways to calculate it. But almost all of them have back-office services, like say that's our heritage. That's custody, it's accounting, it's oftentimes performance analytics. It's a set of services that are really were born and designed as a custodian. If you are the next layer and say, well, how many of those have a middle office service where we're providing a processing service for asset managers as an example? North of 40% of those top 65 clients tend to have a middle office service that we provide. And this is where we're doing the back office operations of an asset manager -- we call that our middle office -- we just need a full [ tabularly ] for -- and then if you go one step further and say what percentage of those clients have the back office, which is 100%, the back and the middle office, which is north of -- or it's around 45% is you have north of 30% that have the back office, the middle office and the front office in different combinations. And that's in a way what we've been building out is how do we continue to offer more middle and front office services to those clients. And remember, the share of wallet of our typical large client is in the 30%, 35% range. So there's upside. We actually measure that by back-office upside, mill office upside, front office upside. And we're always working with our clients on how can we bring more State Street to them. And it's part of our growth model.

When you sit down with your clients, particularly the ones that use all the -- is it for them an opportunity for them to grow revenues more effectively you being there with them? Or is it more cost savings that they're looking to become more efficient, and that's what they're really counting on you for?

It's really a combination of both. And I'm not saying that just because it's the easier the 2 answers, but clients, especially at the CEO and COO level, and it's those -- it's really at that level where you get this excitement and engagement and, hey, can someone like State provide the casing accounting, the operational support of what we call middle office and the front -- the CIOs tool and Charles. Because the CEOs and shares of our asset managers and our asset owners and our insurers are looking out and saying, look, what do I want to be good at, I want to be good investors. I want to choose stocks, think about bond trading spend because I want to think about hedging. Like that's what they want to be good at. I'm actually not that excited about running all those different operations. And I think some of the ones that meet with Ron or Lou Maiuri, our President or with me, they're looking out ahead and saying, "Can I actually find a way to do some of that stuff that's not my forte in a simpler way, which is why the front middle and back when we offer it comes together. And then in a way that lets me focus on what I'm good at?” And that's what's in it for them. Sometimes, it's around the cost efficiencies. And we think there is some real cost efficiencies for them that they can realize over time. And sometimes it's about their ability to be nimble, their ability to use data about that we hold as a custodian so that they know what assets are on special that they can immediately through our OMS go and lend out. And sometimes it's about creating new products that they can quickly bolt on and actually use as a venue for growth. So there are different ways, but it's really a mix from their standpoint. It's about focus, it's about speed of execution on the revenue side, and it's about efficiency.

On the third quarter call, you were talking about the percentage of revenues that are generally tied to market values, if you want to call it, variable rate pricing. Can you remind us what those numbers are? And then is it a number you're comfortable with? Do you want to lower it, increase it? Or how do you come around to changing that should you want to do that?

I think what we disclosed, which we're comfortable with is that on servicing fees with the core fee line, which we book our custody accounting, back office and also our middle office activities is about 55% driven by a combination of equity in bond markets. The other 45% is split roughly between transactional fees, number of derivatives, wires, DTCs, there's a set of different factors. And then the other half of that 45% is flattish or it's generally flattish. And that's just how our contracts have been built and developed, and our perspective is that's how we operate. And so revenues will have a flex upwards with the equity markets and a flex downwards for the equity markets. And part of what we want to make sure we do is that as we see upward moves in equity markets, we're being very disciplined about how much we spend because we don't want to spend that a way. We want to actually deliver that to shareholders. And when we see downdrafts, we need to try to tighten what we can and adapt. But that's the -- those are the areas of, I'll call it, market sensitivity. The good news, as I mentioned, is equity markets when they go up or down more sharply, we create more volatility, volatility tends to be good for the currency markets and then we make a little more money there. So there's some natural offsets in our business as well.

Do you find with the new business you win, is there a preference on your part or the client's part to have a fixed rate contract or variable rate contract? How does that work on the new business that you're coming in the front door?

I think the way I describe it is the core custody and accounting business that we win tends to be priced like it's been priced for decades. There's a little bit of continuity there. Let's call it. The business that's priced differently is middle office and front office services. Those tend to have less variability with equity or bond markets. In fact, front office and software most none. They also tend and pick in that middle office area tend to be longer stickier relationships because once we take on an asset managers or insurers rationales with their back office, their processing, like they don't really want to move that around very often. That's far. And so they tend to be longer and stickier relationships. And then what we find is if you offer the front middle and back and you sell as a package, that's a partnership that will lengthen and endure and that creates even more stability, I think, in the pricing and revenue levels.

Is there -- we'll be reaching out to the audience for questions in a second. On the ideal market conditions that the State Street cells that, is it one that's more volatile, less volatile up into the -- or when you think about that, what's -- if you had your druthers, what would be the ideal market?

It’s the Goldilocks question. Remember, not too hot, not too cold. Some bars back there. So if we can…

All right.

What's good. Let me do what's a positive market that's realistic. Because I think a positive market that's realistic is some modest upward movement in equity markets. If acuity markets go back to trend line of up 6%, 7% a year and without -- that's good. Because that creates a tailwind of revenues, that's a positive. -- that's positive. I think some amount of -- I used to say, rising interest rates. I actually think at this point, they've risen a good bid. We don't mind a little more rise, especially in our international markets. And then I think moderately elevated interest rates. I think it was harder to run our business because of the compression in a low rate environment. We have a moderate rate environment we target Fed funds and so forth are in 4% or 5% range. That's helping for us because we near reasonable amounts in NII that supports our earnings and that creates buyback opportunities directly for our shareholders. And then I think on the trading side that is part of what we do, some amount of moderate volatility we don't want to VIX in the sky. But some amount of equity markets where you have some specials, you have some warms, you've got currency moves moving around some. That creates opportunities for us to help for clients. And that's what we're there for. If it's dead quiet, it's a little -- not quite as -- there's not as much to write home about. But that's probably the mix.

Yes. Maybe we'll move to -- if there are any questions out in the audience [ mic away ] from the microphone, if we could bring to the gentleman over here.

I'm really confused about Brown Brothers and I don't think I'm alone. And the first question is really is it's New Year's for watching Dick Clark rock 'n' roll New Year's, waiting for the ball to drop, and we're trying to figure out will State Street buy Brown Brothers or not. So why the arbitrary deadline of year-end to make or break? And then if you can't get approval for this deal, does this mean you're in a permanent strategic box not allowed to pursue acquisitions? Or another question that's come to me, is there something wrong at State Street that we don't know about. So as you can imagine, there's a lot of talk about this. I know it's frustrating to you guys, but can you give us any more color on some of these questions?

Yes. No, that's all fair questions, Mike. I think first, there's no arbitrary deadline. I think you guys have asked when are you going to know and I think we'd like to know this quarter. We -- if it slips a little bit or if it can get accelerated, like we're trying to do the right thing by our shareholders for any of you in the audience or on the phone, own us. We're trying to play out the opportunity here. There aren't that many opportunities to consolidate custodians like there were, whatever, 10, 15, 20 years ago. So if we can get it done, if it can get done right with the right value equation for shareholders, we'd like to do it. On the other hand, we want to be careful. You can't take a franchise like this and it goes on and on and on because then there's going to be some turnover and some client attrition. And so there is a back end that we don't want to let it go too far. So we've said fourth quarter as an area. We'd like to, but it's not in a -- I don't know, big Clark as well as you do probably but not in us with as much finality as you described it in Times Square. In terms of the opportunity, I mean, you've seen State Street before do acquisitions. We did it with the GE Asset Management business with Charles River, multibillion-dollar acquisitions. We've got one here. We'll do the right ones at the right time. I think if we felt like we couldn't do an acquisition, we would have told you by now. So this is not a yes or no. We're just finding it, as we've said, more complicated right now. We have a multitude of regulators who sometimes have a variety of perspectives, and that's okay. We've got to respect that. And we're navigating through. But I don't think there's a defining. We would have known and we would have communicated that if we felt like this was -- this was a broader discussion. For now, this is around this particular transaction, and we're -- we just need to play it out.

Is there some issue with State Street that's causing this deal not to get approved? Or is this solely due to the mechanics of the deal and who you're acquiring?

It's always hard to --it's always hard to tell exactly what it is. And usually, it's a mix. I mean you saw one of the other large we get to the right and appropriate answer for our shareholders.

Two-part question, just one as a follow-up. Did you indicate there that your December 31 is not a hard deadline. Is that what you meant?

Well, I think... How do I say that? Mike was asking me, is there any small tiny possibility that we might go a minute after the ball drops. And I was like, it's hard for me to answer that is there's 0 possibility. Our intention is to try to address and make a decision this fourth quarter, and that's our plan.

Okay. Just because I got pinged a couple of times to clear that up with you just now.

Yes. We'd like to do it in the fourth -- we'd like to make a decision in the fourth quarter. That's our plan. And to be honest, it's been going on for a while. We've -- it's time for us to come to a conclusion. It's hard for me to give anyone a 110% guarantee on anything.

Okay. So then a separate topic, just -- we talked a lot about fees. Can we talk a little bit about NII and NIM and -- and you mentioned earlier about a rate environment that's positive for you. I guess I just want to dig in a little bit about the rate environment we have in front of us right now with this acceleration, potentially staying higher for longer are going higher than what the forward curve is expecting. How are you thinking about that impact on your NIM? Is there any change versus what you've been experiencing over the last couple of quarters? How are you dealing with the liability side that's accelerating here?

Yes. Let me do it this way. Year-to-date, our NII is up 23%. I think for the full year, we gave guidance that our NII would be up 28, 29 that range, and we're comfortable with that. And then during earnings, I described that we see NII continuing to move upwards. -- next year. I think we're at a level of continued rate increases that support that positive view. Now that positive view is both interest rates up and deposits transitioning because we have quantitative tightening. We have clients being more disciplined with their cash. But this is -- this is a positive environment and continues to be. I think there's another layer on your question, Betsy, which is terminal rates go from 4% to 5%, 6% to 7%, you continue to get a boost. And I think it starts to level off. I think the answer is no, because at some point, our betas move to a point where there's not additional NII. But that's not 2022, and it's not 2023. I think we'll have to see where we go in and how much further rates go. But I think right now, the -- we're in a positive zone, and we'll continue to take advantage of it and effectively monetize that rate trajectory with our balance sheet.

Any other questions?

You gave us a little bit of a reference point about how the top 65 customers start to grow their business with you. Can you also give us some flavor for how that progression into different layers of business start to shape the margin profiles as customers move into those other layers of your business?

Yes. I think the margins, what's interesting and what we've done over time. Is generally think about the all-in margin for a client because there's a mix of -- the next product, in some cases, is variable cost intensive. In other cases, it's fixed-cost intensive. And it depends. If you think about it, back office custody, pure custody tends to be a very fixed cost-intensive back-office accounting has more of a variable cost has a mix of fixed and variable because of reconciliation, some of the other transactional processes. The middle office tends to be a little more variable cost intensive. So there, we need to be careful about who we sell that, too, and make sure that it comes with custody because middle office and back office together actually have a better margin than on its own. And then the front office tends to be relatively fixed cost and has some good margins. So there's a mix in nuance within them. But our view is, as you'd expect, there's a range of products we're trying to offer. We're trying to extend relationships. We want to manage the margin as a collective with the client. Some clients are willing to pay more in deposits than in fees or vice versa. Some will say, "Hey, I need a fee adjustment here, but I will give you more FX trading.” Or they may not be -- they may not have any FX trading or securities finance to give us. And so they realize they have to pay directly in fee. So there's a mix. And because these are such large complex relationships, that's why while there are some margin differentials, what we've done over time is just created -- I'll describe it as an intense deal and pricing review process that as these deals come through, we look at the current margin, we look at the incremental. And there's a very senior group that is evaluating those and making choices. And in some cases, saying, yes, that's not going to work for me or going back to the sales force and saying, "Look, you got to ask for something different. We're saying, "Hey, I need Ron or Eric or Lou Maiuri to actually have a different conversation with the CEO or COO to find a win-win. So it's a -- there's a -- it's a multiproduct sale, and these are long partnerships. And what we found over time is clients actually want us to make a reasonable return because they know then we'll reinvest in the offering. And so I know I'm not giving you a black-and-white question. I think there's quite a bit of texture in there, but maybe that's something to build off.

Right. And just if you can also give us some flavor for this, which is to what degree is labor becoming a constraint in the growth of the business?

I missed that one…

To what degree is labor becoming a constraint in the growth of the business?

The area where labor is more of a contra it's primarily in our -- some of our more I'll call it, the faster growing, the more complex areas that are, in fact, manually intensive. And what we've found over the years is core custody for an equity fund, not labor-intensive. -- private markets, customer and accounting for an alternative provider in private market real estate, loan operations, bank loan processing. No one's really automated that. There are no clearing houses. There are no blockchains that are actually operating. So there's no new technology and there's no old technology that really makes that efficient. So most of the private equity through private markets seems to be labor-intensive. And so there's an experience base that matters. And so in fact, that's the area where we're doing -- we need to do more hiring. It's more variable cost-intensive, too, as we add a client. We have to do more hiring. As our clients are expanding their product lines, and launching a new fund, we actually have to hire -- and that's where there is, I think, more of a demand for talent. And in fact, those are the areas where we're also going back selectively to clients and say, look, we need to adjust pricing because we need some pricing flexibility to, in some cases, address some of the elevated wages and wage rates and find the talent that they will be pleased to have on their accounts. So that's -- there's a nexus there that has some constraints and we're focused a little more on the margin.

Can you give us any update on deposit flows over the course of the last month? Have you seen any change in the pace of outflows or any change in the mix, whether it's U.S., non-U.S., noninterest-bearing, interest-bearing and how’s that's changing?

There's not been a lot of changes from either the direction we saw from 2Q to 3Q or the guidance we gave. We've -- in third quarter on an average basis, we saw about $15 billion deposits rotate out on our base that's well north of $200 billion. Some part of that was currency translation. But so just the interest-bearing, noninterest-bearing. It's a mix and it was across both the U.S. and international as rates generally rose. And the guidance we gave for the fourth quarter is that we expect to continue to see some amount of rotation out not quite as much as we saw in the third quarter. And when I looked at the October trends, that guidance is holding. There's still -- we're still on that trajectory on a -- if I run rate that out a little bit less than what we had in the third quarter. I think what I'm watching is a couple of things as I try to forecast out next year because I think that's the next question. And you guys are interested in it. I'm trying to figure it out from a budgeting perspective. It's the same question. There are some questions around where will equity markets go because as custody markets are up or down, then we get movements in deposits up or down as well. There's always quarterly by quarter, there's some seasonality. But that's well by the quarter. And then just how much clients react to higher rates, how they try to optimize. And then the interesting part from a budgeting standpoint is we do work on where are they going to take their deposits. Will they put them in our money market sweep. Will they put them in State Street Global Advisors, Will they put on repo with us. And that's part of what working on as well. But trajectory is in line with what we had expected so far.

I think we have time for maybe one more question. And maybe, Eric, you can share with us with the rate environment we've been running into investment portfolios, of course, have taken some sizable unrealized losses. Maybe can you talk to us about AOCI, how you guys approach it? What it means for your tangible common equity ratio as well as, of course, CET1 since you're an advanced approach bank. And then just how you think about held-to-maturity versus available for sale in setting aside those different portfolios within the securities portfolio?

I think I'd make a couple of summary points here. I think AOCI is just part of banking part of the interest rate cycle in banking, you've got AOCI impacts. I think what we've done, especially starting around April, May was protect a lot of the investment portfolio through a mix of swaps and HTM accounting. We have more than 60% of the portfolio in HTM. And you saw our performance in second quarter, third quarter, I think we distinguished ourselves and protected the AOCI. We do have a negative mark in the portfolio. You'd expect that because we always have to run some duration. We have duration on the liability on the deposit side. We need duration on the investment portfolio side, even though there's not a symmetry in the accounting. We still need the duration. And so there's going to be a natural accretion back into earnings directly out of the held-to-maturity portfolio, so roughly about $50 million a quarter next year. We'll come back in the AFS portfolio, if current rates in the past move as expected, there's another $100 million or so that's accreting back each quarter next year. So collectively, there's an extra $150 million that's going to come back that goes to capital, and that creates an opportunity for what we described, which is comfortably over the 80% capital return next year.

And we're looking forward to giving that back to shareholders. Well, with that, we've run out of time. I could stay here all afternoon, but we have others. But Eric, thank you, and please join me in a round close thanking Eric.

Thank you.