摩根士丹利 (MS) 2013 Q2 法說會逐字稿

Good morning.

This is Celeste Mellet Brown, Head of Investor Relations.

Welcome to our second quarter earnings call.

Today's presentation may include forward-looking statements which reflect management's current estimates or beliefs and are subject to risks and uncertainties that may cause actual results to differ materially.

The presentation may also include certain non-GAAP financial measures.

Please see our SEC filings at www.Morganstanley.com for a reconciliation of such non-GAAP measures to the comparable GAAP figures and for a discussion of additional risks and uncertainty that may affect the future results of Morgan Stanley.

This presentation, which is copyrighted by Morgan Stanley and may not be duplicated or reproduced without our consent, is not an offer to buy or sell any security or instrument.

I will now turn the call over to Chairman and Chief Executive Officer, James Gorman.

Thank you, Celeste.

Good morning everyone, and thank you for joining us.

We will again review the progress we've made towards the six strategic priorities we delineated in January that will drive our return on equity and return on tangible equity, excluding DVA to greater than 10% and 12%, respectively.

We're pleased with the progress we made during the quarter and we met or exceeded several of the goals.

Let me just go through them quickly.

First was to acquire 100% of the Wealth Management joint venture.

As you know, we closed on the final 35% of that joint venture on the last business day of the quarter.

As we've taken you through the benefits numerous times, I'm not going to spell them out again.

Suffice to say however, the deal was a game-changer for this firm and for our shareholders, now and for decades to come.

Secondly, we put out a goal to achieve Wealth Management margins through expense management and through revenue growth.

In addition to owning 100% of the business, one of the key drivers for ROE upside is the revenue and margin upside in the Wealth Management business.

Both were higher this quarter.

The margin of 18.5% represented the fifth consecutive quarter of margin improvement, excluding non-recurring costs associated with the integration in Q3 2012.

We reached our highest margin level since the first quarter of 2008.

In addition, we increased our margin goals for Wealth Management business at our financials conference in June to 20% to 22% by the end of 2015, without the benefit of high rates or markets, and more than 23% if markets or rates increase.

Why the increase?

The margins reflect the simple math of the upside from 100% ownership with ongoing investment in the business using the first quarter of 2013 results as a base.

Our third objective was to significantly reduce RWAs in fixed income and commodities.

We continue to make progress regarding our fixed income RWA reductions, ending the quarter at $239 billion, down from the first quarter.

We continue to expect fixed income RWAs to be below $200 billion by the end of 2016.

Our fourth goal was to drive expenses lower in 2013, '14, and beyond.

We're on track to meet our expense reduction targets and Ruth will take you through these in more detail.

As you can clearly see, our expense ratios have improved as we said they would with revenue growth.

Our fifth point was to grow earnings through Morgan Stanley specific opportunities.

We recently received approximately $16 billion of deposits in the initial wave due to us now that we own 100% of Wealth Management.

The team is executing against our plan to prudently deploy those deposits in support of loan growth in both Institutional Securities and Wealth Management.

Now that we own 100%, we can execute more of the initiatives we have in place to better align Institutional and Wealth Management, including a deeper partnership between the businesses and their trading desks.

Because order flow is no longer split with our former partner, we expect deeper and more efficient markets for both our institutional and retail clients, as well as greater revenue opportunity for fixed income in addition to the order flow benefit we discussed for you for Wealth Management.

We're also looking forward to launching new products and increasing the efficiency of firm funding.

So our sixth point asks what did it all add up to.

Despite difficult markets, our results this quarter evidence strength and resilience.

Revenues in all of our major businesses were up double-digits year-over-year, with Institutional Securities, excluding DVA, up 40% and investment management up 48%.

In addition, we are pleased to commence the share repurchase we announced this morning which will offset some of the dilution relating to employee stock programs and also benefit ROE.

We recently received a non-objection from the Federal Reserve to return 1% of our Tier 1 capital and we'll execute on the buyback in the forthcoming quarters.

We've been on a long journey to generate stronger, more sustainable long-term returns with businesses that balance each other in volatile markets.

With the acquisition of 100% of Wealth Management, that business model is solidly in place.

Our Wealth Management business complements our leading Institutional Securities business and the adjacencies across the entire platform will drive upside for all of Morgan Stanley.

We have strengths across areas of fixed income and are consistently in the top three in equity underwriting and M&A league tables, with increasing momentum in fixed income underwriting.

Our investment banking franchise is a leader globally, and we demonstrated the power of our footprint with important cross-border deal announcements in the quarter.

I'd now like to draw particular attention to our institutional equities franchise which consistently ranks top two globally in market and wallet share.

In the second quarter, we continued to execute extremely well against challenging markets.

In the cash product, we benefited from the hybrid voice and electronic model centered around integrated client coverage.

We approached this business with the delivery of research-driven content, market insight, and state-of-the-art trading technology to a wide variety of client types.

Our electronic offering spans cash, synthetic cash and derivatives, and has more than doubled market share over the last three years.

In equity derivatives, our team is capitalizing on the investments we've made over the last several years, driven by the breadth of our client reach, deepening relationships and partnerships across the firm, and ongoing strong risk management.

Last but not least, in prime brokerage with significant balances we have a practiced focus on market access, service excellence, and innovative solutions for clients, all leading to an outstanding performance by institutional equities this quarter.

With Morgan Stanley's global reach, we're confident there is continued upside for this business and for the firm.

Thank you, and I will now turn the call over to Ruth, and look forward to your questions later on.

Good morning.

I will provide both GAAP results and results excluding the effect of DVA.

We have provided reconciliations in the footnotes to the earnings release to reconcile these non-GAAP measures.

The impact of DVA in the quarter was $175 million, with $114 million in equity sales and trading, and $61 million in fixed income sales and trading.

Excluding the impact of DVA, firm-wide revenues were $8.3 billion, down approximately 2% versus the first quarter.

The effective tax rate from continuing operations for the second quarter was 31%.

Earnings from continuing operations applicable to Morgan Stanley common shareholders, excluding DVA, were approximately $720 million, which included a negative adjustment of $152 million, related to the acquisition of the remaining 35% stake in the Wealth Management joint venture.

Earnings from continuing operations per diluted share, excluding DVA, were $0.37 after preferred dividends.

EPS included a negative adjustment of $0.08 per share from the acquisition of the remainder of the Wealth Management joint venture.

On a GAAP basis, including the impact of DVA, firm-wide revenues for the quarter were $8.5 billion.

Earnings from continuing operations applicable to Morgan Stanley common shareholders were $831 million.

Reported earnings from continuing operations per diluted share, also inclusive of the negative adjustment of $0.08, were $0.43 per share after preferred dividends.

Book value at the end of the quarter was $31.48 per share.

Tangible book value was $26.27 per share, reflecting a reduction of $1.49 due to the completion of the acquisition of the Wealth Management joint venture, partially offset by earnings.

Turning to the balance sheet, our total assets were $806 billion at June 30, essentially flat versus last quarter.

Deposits were $82 billion, basically unchanged from the prior quarter.

Quarter-end deposits did not reflect the first tranche of deposits that are transferred to Morgan Stanley in conjunction with the acquisition of the remainder of the joint venture.

The initial deposits come in on a lagged basis with $16 billion transferred this week.

We will receive the remaining deposits on a monthly basis through the middle of 2015.

Our liquidity reserve at the end of the quarter was $181 billion, compared with $186 billion at the end of the first quarter.

The decline was driven by a reduction in bank liquidity as we deployed excess liquidity to support loan growth.

Although our calculations are not final, we believe that our Tier 1 common ratio under Basel I will be approximately 11.8%, and our Tier 1 capital ratio will be approximately 14.1%.

Risk-weighted assets under Basel I and including the final market risk rules are expected to be approximately $404 billion at June 30.

Reflecting our best assessment and expectations of the recently received Federal Reserve rules, our pro forma Tier 1 common ratio under Basel III was 9.9% as of the end of the second quarter.

We note that this ratio reflects our best interpretation at this time and is subject to change as we further study the new rules.

We estimate our pro forma supplementary leverage ratio to be 4.2%.

This estimate reflects the most recent United States proposed regulatory rules for the numerator and the denominator and is also subject to change as we study the guidelines.

We have a clearly identified path to exceed in 2015 the 5% regulatory requirement.

Turning to expenses, total expenses this quarter were $6.7 billion, up 2% versus the first quarter with compensation expense down 3%, and non-compensation expense up 11%.

Relative to the expense reduction targets that we articulated in January, we remain on track as best evidenced by our expense ratios, relative to our 2014 target.

Recall that we expected the sum of our expense reduction efforts to result in $1.6 billion decline from 2012 reported expenses to 2014 full-year expenses.

Our $1.6 billion target was set based on revenue consistent with 2012 levels notwithstanding our expectations for growth.

Thus, we further indicated that on higher revenues, our variable expenses would grow but that our overall expense ratios would improve.

Our revenues, excluding DVA, were up 8% in the first half, while our expenses were up 5%.

Excluding higher litigation costs, our expenses would've been up 2%.

Our $1.6 billion cost reduction target on flat revenues implied an expense ratio of approximately 79% for the firm for 2014.

We were at that level in the first half of 2013, and would be even better than 79% without higher litigation, with still more expense savings to be realized over time.

As a reminder, our targets are two-year targets and expenses have and will likely continue to vary from quarter to quarter.

Recall that we had some non-recurring expenses in the second half of last year.

In addition, we had severance and certain Wealth Management items in our results in the first half of this year.

Our targets include an expectation for continued elevated legal expenses, but of course those tend to be (inaudible) and difficult to forecast.

We continue to work through our cost-cutting programs, and they will drive operating leverage through the end of 2014.

Let me now discuss our businesses in detail.

In Institutional Securities, revenues excluding DVA were $4.2 billion, down 5% sequentially.

Non-interest expense was $3.4 billion, up 3% versus the first quarter.

Compensation was $1.8 billion for the second quarter, down 7% versus the first quarter, reflecting a 42% ratio, excluding DVA.

Non-compensation expense of $1.6 billion increased 16% from last quarter, driven by increased litigation expense, as well as revenue and activity-related costs.

The business reported a pre-tax profit of $785 million, excluding the impact of DVA.

Including the impact of DVA, the business reported a pre-tax profit of $960 million.

In Investment Banking, revenues of $1.1 billion were up 14% versus last quarter with strong growth in EMEA.

According to Thomson Reuters, Morgan Stanley ranked number two in global completed M&A, number three in announced M&A, number two in global IPOs, and number three in global equity at the end of the second quarter.

Notable transactions included, in advisory, Morgan Stanley acted as lead financial advisor to Kabel Deutschland on the proposed EUR10.7 billion takeover offer from Vodafone.

In equity underwriting, Morgan Stanley successfully priced the $4 billion IPO of Suntory Beverage and Food, Limited.

Morgan Stanley acted as joint global coordinator and lead-left bookrunner on the international tranche.

Our JV partner, MUFG, also acted as joint bookrunner on the domestic tranche.

And in debt underwriting, Morgan Stanley acted as an active bookrunner on Petrobras Jumbo $11 billion six-tranche senior notes offering, as well as Chevron's $6 billion four-tranche senior notes offering.

Advisory revenues of $333 million were up 33% versus our first quarter results, driven by cross-border activity and improved performance in EMEA and the Americas.

Equity underwriting revenues were $327 million, up 16% versus the first quarter, driven by a significant increase in IPO activity and the highest level of sponsor-related activity in several years.

We had strength in the Americas and Asia, particularly Japan.

Fixed income underwriting revenues were $418 million, up 2% versus a strong first quarter, driven by loan syndication fees.

Equity sales and trading revenues, excluding DVA, were $1.8 billion, an increase of 13% from last quarter.

Equity revenues were up broadly across products, regions, and client segments versus the first quarter.

Client revenues were the highest level in over a year, driven by higher market volumes, increased volatility, and greater prime brokerage balances.

In cash equities, the revenue increase was driven by continued strong market share and volume growth, in particular in the Americas.

Derivatives revenues were up versus last quarter, with strength across regions, particularly in Japan and the Americas and in part driven by higher volatility.

Prime brokerage revenues also increased, driven by increased activity during the European dividend season and higher client balances, which increased with overall market levels.

Fixed income and commodity sales and trading revenues, excluding DVA, were $1.2 billion.

Fixed income revenues decreased versus the first quarter due to higher volatility that resulted in lower client activity, however, a reduction in our risk levels during this period helped offset price volatility.

FX delivered its fourth consecutive quarter of revenue gains, benefiting from ongoing strong contribution from the firm's electronic trading platform.

Commodities results were up meaningfully versus the first quarter, benefiting in particular, from increased client activity in North American power and natural gas, as well as precious metals volatility.

Generally, however, the oil liquids market which over time has been the most important driver of our commodities business, continues to operate at historically low levels.

Finally, there was a modest CVA benefit in the quarter.

Other sales and trading, negative revenues of $57 million compared with positive revenues of $73 million last quarter.

Average trading VAR for the second quarter was $61 million, versus $72 million in the first quarter, driven by a reduction in risk in May in fixed income and commodities.

Turning to Wealth Management, we achieved revenues of $3.5 billion in the second quarter, a record level.

Asset management revenues of $1.9 billion were consistent with the first quarter, benefiting from higher market levels that were offset by lower deposit referral fees, due to a rate reset late in the first quarter.

Transaction revenues decreased 7% from last quarter, consisting primarily of commissions of $567 million, which were flat to the prior quarter; investment banking related fees of $258 million, down 6% versus last quarter, reflecting lower new issue volumes; and trading revenues of $223 million, which were down 25% versus the first quarter, reflecting the impact of lower activity due to difficult market conditions in June.

Net interest revenue increased 8% to $446 million, driven primarily by growth in our lending product.

Other revenue increased to $139 million in the quarter, primarily due to a gain on the sale of our global stock plan business, and our investment portfolio gains.

Non-interest expense was $2.9 billion, flat to last quarter.

The compensation ratio was 58%, versus 60% in the first quarter, reflecting a higher level of net interest income and higher non-compensable revenues in the other revenue line.

Non-compensation expense was $834 million, up 3% versus last quarter, due to a number of expense items incurred in conjunction with the closing of the Wealth Management joint venture, including software write-offs, branch consolidation, and increased advertising expenses.

The PBT margin was 18.5%.

Profit before tax and the PBT margin benefited modestly from the net impact of the unusual revenue expenses in the quarter.

Profit before tax was $655 million, the highest level of absolute profitability since the inception of the joint venture.

We reported non-controlling interest of $100 million the quarter, reflecting a full quarter of earnings.

Prospectively, we will not have the NCI deduction.

Total client assets were basically flat to 1Q at $1.8 trillion.

Global fee-based asset in-flows were $10 billion.

Fee-based assets under management increased to $629 billion at quarter end.

Global representatives were 16,321, up slightly from the first quarter.

Bank deposits were at $127 billion, effectively flat to 1Q.

Approximately $70 billion were held in Morgan Stanley banks.

As mentioned previously, we received the first wave of deposits associated with the final 35% ownership this week.

Investment Management revenues of $673 million were up 4% versus the first quarter.

In traditional asset management, revenues of $419 million were up from the first quarter, driven by higher performance fees in asset management and administration fees.

In real estate investing, revenues decreased 11% versus the first quarter when the firm realized strong principal investment gains.

Due to the ownership structure of these funds, the majority of these revenues are passed to third-party investors in the non-controlling interest line.

In merchant banking, revenues were up 31% compared to the first quarter, driven by higher principal investment gains.

Expenses were $513 million, up 12% from the first quarter, reflecting a change in revenue mix.

Profit before tax was $160 million, down 14% sequentially.

NCI was $21 million, versus $51 million last quarter.

Total assets under management increased to $347 billion, driven by net in-flows of $9.8 billion.

In terms of our outlook, in the US, positive economic data suggests that headwinds are abating.

Improving employment, signs of strength in discretionary consumer spending, a healthy outlook for housing, and a declining deficit are encouraging signs for our clients and our businesses.

Recent Federal Reserve guidance is also constructive, in particular, its emphasis on interest rate policy.

Institutional clients are repositioning in response to the Fed comments.

Equity activity in the US remains strong with US equities viewed as a relative safe haven.

Our M&A pipeline remains healthy with corporate clients increasingly focused on executing strategic priorities ahead of potential rising rates, and our retail clients remain engaged in the markets.

In the Euro zone, our outlook for GDP remains subdued.

We expect to see higher activity levels but only relative to anemic lows in recent periods.

Japanese markets remain strong and we are well-positioned, given our partnership with MUFG.

In short, we benefit from our leading positions globally, our franchise momentum continues, and we are increasingly leveraging strength within business units to the benefit of the entire firm.

Thank you for joining us, and James and I will now take your questions.

(Operator Instructions)

The first question will come from Mike Carrier with Merrill Lynch.

Thanks, Ruth and James.

First question, just on the Wealth Management business.

You're hitting the margins.

You do the buy-in.

The one area that seems like for that business still looks a little bit on the low side would just be on the returns.

And granted, this quarter there's a lot of charges and you don't get the full benefit.

But it just seems like, even on an adjusted basis, it might be in that 7%, 8%.

Just going forward, what's the driver there of improving those returns?

Obviously as the margins pick up, that's going to benefit it.

What's the long-term opportunity for the return in the Wealth Management business?

Well, a couple of points.

Given there was an acquisition, there's goodwill associated with this so the return on tangible equity in the business is about 30% today and we do see the profitability, the profit margin, and the returns on that business increasing.

Up nicely year over year, increased versus the last quarter and that really reflects the ongoing strength on the revenue line, the benefit of the cost moves that we've made on the expense line.

I did call out that there were some higher expenses this quarter, but fundamentally the benefit on the expense line.

And we do see longer term upside as we continue to execute on the lending product.

Again, upside from lending.

We revised our target to 20% to 22% by the end of 2015, and again to be clear, that was with no assumption about higher equity market levels or rate changes, and we expect that we would be above 23% with the benefit of markets and rates.

The other thing I'd note is that this quarter, we did take the charge associated with buying in the balance of the Wealth Management business.

That's $152 million charge, so the return on equity excluding that's 10%.

Again, I'd focus you to the return on tangible equity given the acquisition.

Okay.

That's helpful.

Maybe just as a follow-up on the capital side, you gave the color on the leverage ratio in the outlook in terms of 2015.

How do you get there?

What are the different leverage points that you have?

And then any impact on the revenues of the business?

More importantly, given you've got the buybacks this quarter and for the rest of the year, how do you think that plays in?

Because obviously the earnings power is improving.

The leverage ratio's lower, but you're getting some buyback opportunities.

So, when we think about buybacks going into '14 and '15, just any view on that, just given the different dynamics.

Thanks.

Sure.

Let me start with the leverage ratios.

I indicated we estimate we're spot at about 4.2% this quarter, and as I said, we expect to be above 15% in 2015.

We do see opportunities with both the numerator and the denominator, and most important, they're very consistent with the strategy against which we've been executing.

So, starting with the denominator where we see a big opportunity, there are a couple things to note.

First, with our focus on reducing risk-weighted assets in fixed income, this is not model approval but passive and active mitigation, and as a result, we're taking balance sheet down because there's a relationship between risk-weighted assets and gross balance sheet.

So that's the first point.

As we repeatedly said we're taking risk-weighted assets down in areas that are not accretive to revenues, so we don't see that as impacting the business.

The second is our focus on central clearing.

We've talked about that on many calls.

We've invested meaningfully in central clearing.

We're well-positioned to increase the volume of our derivatives through central clearing and back loading old trades leads to an elimination of the gross-up in the denominator.

We're obviously accreting capital which benefits the numerators, so when you incorporate those items, $500 million share repurchase we talked about, and an assumption that we do continue to return capital in the future, that takes us to this glide path to above 5% in 2015.

Now, to be clear, on top of those items, we do believe there are additional opportunities to reduce the denominator but it's too early to quantify.

A couple of examples.

With banks on both sides of the Atlantic, focused on reducing balance sheet, we believe there could be lower derivatives notionals by compressing offsetting trades between clients and counterparties for non-clearable derivatives.

A second opportunity is more upside in central clearing.

In our calculation, we only incorporated our expectation for the amount to be cleared in the next 12 months.

We didn't go beyond one year.

This is an important area and so we do see, again, upside in the reduction in the denominator from the amount that's centrally cleared.

Then finally, consistent with all that we've been doing to optimize capital, business unit leaders have analytics to optimize their returns.

We've talked about this in the past.

We charge them for the capital balance sheet and liquidity needed to support their business.

And when you look at the way we're organized with our bank resource management effort, we've talked about that in the past, BRM, it's a centralized resource governance structure, we're well-positioned to make appropriate resource allocation adjustments.

So, we do feel good about the strength of our capital base.

We've baked in that we're returning more capital into that calculation, and I would note that we're already above 6% at the bank.

Okay.

That's helpful.

Thanks, Ruth.

The next question will come from Guy Moszkowski with Autonomous Research.

Good morning.

Very encouraging to see the buyback.

Can we assume that that was something that was approved as part of your approvals process with the Fed just ahead of the joint venture buy-in?

Just to break it down, in the 2013 CCAR, the only request we put in as we've talked about on prior calls was for the Wealth Management acquisition, given how strategically important that is.

There is a provision, though, within CCAR, once you have capital approval you can apply for an additional 1% of Tier 1 capital for capital actions.

So, upon closing it, I think this is where you were going, but just to make sure I'm very clear on it, as we went to the final closing of the Wealth Management acquisition, we put in the request to use this incremental 1% of Tier 1 capital for capital actions.

We thought it was the logical next step and are pleased to have the approval, no objection, and to be commencing the share repurchase.

It hasn't yet started.

We just got approval for it, so it gives us the ability to use it as James said in his opening comments.

I think, Guy, the key as we've said consistently is to focus on the strategic platform, get Morgan Stanley in the shape that it needs to be in for the next decade and more.

And then the financial management through buybacks and other capital actions obviously follow from that.

We were very careful to make sure we got the deal done even though it was a modest capital outlay of $400 million and some before we started anything on the capital action and we've taken this first step and obviously we're pleased to do it.

Thanks for that.

But just to follow up on it then, as we think about the platform and the capital that's needed in it, I look at the capital allocations that you give for the different business units, which is as I told you before a very, very helpful disclosure which a lot of people don't do.

So, thanks for that.

I noticed that you brought the capital in ISG down this quarter by a little over $1 billion, and with the accumulation of retained earnings, you brought the parent unallocated capital up by a little over $2 billion.

Are we supposed to read, or can we read anything, into that and to what you think you need for the different business platforms, and how much you might be accumulating for ultimate return?

Well, let me first clarify what's in the allocation of required capital.

You're absolutely right, the parent capital number went up.

The allocation is based on the final Basel I, Basel I plus 2.5, if you want to call it that.

With the reduction in risk-weighted assets in fixed income, that meant we require less capital in fixed income which is why the ISG number went down and the parent number went up, accretion of earnings plus the reduction of capital required in the business.

Now, the way we are managing the business is with a Basel III lens, as we've talked about, and we will shift to this table of Basel III as soon as the industry is reporting on the Basel III basis completely.

But fundamentally, what you see here is that we are continuing to accrete capital.

That's why we said we believe we are increasing our degrees of flexibility.

That's reflected in our Basel III Tier 1 common ratio, and in particular, the clarity we think we have with the execution path on the leverage ratio.

Directionally, yes, and the numbers just change a little as it moves to Basel III.

Thank you.

That's it from me.

The next question will come from Howard Chen with Credit Suisse.

Hi.

Good morning, James.

Good morning, Ruth.

Good morning, Howard.

Congratulations on the buyback and the results.

On the core client fixed franchise, it's been a challenging backdrop.

But I think you've expressed some level of disappointment on an absolute basis and the results somewhat lagged the peers.

As you look at broader fixed franchise performance, what do you attribute the underperformance to, and what's within your control from here to improve those results and the trajectory of it?

Well, it was a tough quarter.

And we reduced risk in May, given our concerns about the potential market volatility within fixed income product.

You can see that when you look at VAR.

We ended the quarter with VAR down about 15%.

As I noted, risk-weighted assets were down, down to $239 billion.

In our view, it does set us up well going forward to support higher client activity and we do think that we have upside at quite a number of the product areas, and we're continuing to benefit from leadership positions across our franchise given the benefit of adjacencies.

I would just add, Howard, there's a little bit of an obsession in comparing for size.

We don't, frankly, compare for size.

We have a different structured business from a lot of other institutions for very important reasons.

We're not a global commercial bank in the traditional sense, so we're always going to have smaller foreign exchange and rates businesses.

But we focus on our returns.

We've been through a period where we had to clean up a lot of stuff that we had.

We did that going back to NBIA and longer.

We had to then build out our [flow] footprint which we've been doing over the last couple of years, and now the business is aligned the way we like it.

We're now working on each of the parts as we laid out at the last analyst call, getting to their individual returns.

The sum aggregate obviously gives us a decent return for the business, so we're much more focused on returns than on size.

Understood.

Thanks.

Switching gears over to GWM, Ruth, asset administration fees grew but maybe not as much as we expected with the lagged pricing dynamic.

So I was hoping you could walk through the dynamics of the moving parts of the referral fees this quarter and any other notable trends, ex the referral fees, that you might've seen through the business.

Well, you went right to the key point which was the referral fees.

That referral fee is set on an annual basis.

It's based on rates at the time.

It was reset late in the first quarter, so this is the first full quarter of the lower deposit referral fees.

It gets reset again next year.

The deposit referral fee, just like the higher FDIC fee from [Citi] as well, both of those roll off as the deposits roll over to Morgan Stanley.

Okay.

Great.

Thanks.

Then my final question -- thanks for all the thoughts on the supplemental leverage ratio -- just if I heard you correctly it sounds, Ruth, like most of the mitigating actions you could take are mostly on fixed income.

I guess when I take a step back, I inherently think of your sales and trading franchise equities being inherently more levered business than fixed.

How do we marry that with you having fantastic equities results with that inherently being higher leverage business with you achieving the glide path?

If that makes sense.

Thanks.

So, a couple of things.

One, we are looking at both leverage-based capital and risk-based capital and a portfolio actually when you manage those two results in the highest overall return.

Second, in terms of the gross-up for the balance sheet, the areas that we're running down are areas entirely consistent, as I said, with the strategy we're executing upon.

So back to James' comment that we're not focused on income size for size sake, we're looking at the returns on the business.

So, the run down in risk-weighted assets enables us to focus on the areas that are core to our client franchise, where we're continuing to put risk behind clients.

And the reduction in denominator associated with the move to central clearing, again, we've repeatedly said on calls that we believe that central clearing's not only good for the markets because it increases transparency and standardization but it does play to Morgan Stanley's strengths.

Because it's less about competing on size of balance sheet and more about content and service and execution.

We were moving in that direction in any event and the opportunity to back load old trades into central clearing and thereby reduce the denominator, again, consistent with our ability to have a right -- a focused fixed income business that plays to our strengths, and again, benefits from all that we're doing across the franchise.

Okay.

Maybe just one follow-up on that.

I guess what I'm asking is, it doesn't sound like there's a high level of concern that this supplemental leverage ratio and mitigating to that will disrupt these great results and share gains that you've all made in equities business over the last few years.

I know.

As I said, I think what the elegance of the run down to 2014, if that's the right word to use, is it is consistent with the strategy that we've already articulated and against which we're executing.

Our equities franchises, a stellar franchise, continued strength across products and geographies, balanced across the franchise and so, again, able to continue to execute.

Great.

Thanks for clarifying that and for taking the questions.

The next question will come from Mike Mayo with CLSA.

Hi.

I just wanted to clarify, Ruth, when you said getting the leverage ratio of 5%, that has an assumption for return of capital in the future.

What did you mean by that?

We included an assumption but I don't want to prejudge where 2014 CCAR comes out and given flexibility that we have as I enumerated the various other items to further reduce denominator, we've built in levels of flexibility so that, again, it will be based on where is CCAR at the end of this year and managing the mix of levers that we have.

I noted it because $500 million is a good first step, in terms of share repurchase.

And it is a tool that we believe we built flexibility to use on a go-forward basis but don't want to prejudge 2014 CCAR by putting a number out there.

I'd just point out, though, since the last CCAR, we've had earnings of -- round numbers -- $800 million, $1.2 billion, and $900 million, so we're obviously accreting reasonably healthy levels of capital quarter by quarter.

Still on the topic of capital, the ROE is about 50% of where your target is.

Any general thoughts on how you're going to improve the ROE from where it is in this quarter?

Yes, James laid out in January the six-point ROE plan.

And as he said, we've already made progress, substantial progress, on a number of the items, completing the Wealth Management acquisition, obviously a key step.

The earnings this quarter don't have the benefit of that incremental 35% we closed on the last day of the quarter.

That starts July 1. The revenue and margin upside we've delivered, but as we indicated, we think there's more upside there.

The reduction in risk-weighted assets in fixed income, we're very much on track, if not ahead of track.

We do believe that there's upside in that business.

We're continuing to execute on the expense ratios and expenses were a bit higher this quarter, as we noted.

Litigation was a bit higher.

Again, we're on a good trajectory to have tighter expense ratios as we go through to 2014.

We're executing on the bank's strategy which against gives us some upside and capital as well.

So, the ROE this quarter was obviously also depressed by the charge associated with buying in the Wealth Management business.

But when you roll those items together, excluding the charge, about 6%, and then we see upside from the six items that we've consistently taken you back to.

Mike, I would just say, there's nothing that we have seen in this quarter that changes our view on what we laid out on our ROE projections, and we stand by them.

And you mentioned backlogs a little bit, but could you elaborate a little bit more?

Sure, the pipeline does remain healthy.

US activity's the strongest.

I did note Europe is up but that's versus a very weak prior 12 months.

Japan continues to be strong.

Emerging markets are mixed.

China's slow.

Brazil has a big pipeline but is challenged.

We think that's on pause at least for now.

But we're seeing greater opportunity in Asia-Pacific, so it's very country-specific.

I think the intriguing element is this backlog in M&A which has been sitting for quite some time and I've said on prior calls we attribute that to CEO confidence.

What we are increasingly hearing is a reassessment of timing.

In particular, as Fed comments are that any moves are data dependent, where there are signs of improvements in the economy, that is inspiring in conjunction with concern about higher rates and what that means if there's a delay.

So, we are hopeful to see that backlog start moving through to execution.

The drivers to date on activity have been more cross-border, as I noted, in the sponsor- and activist-related activity.

The equity pipeline's stable.

It's skewed more toward the US, Mexico, and Japan.

Two more small ones.

Litigation, how much was it this quarter?

And where do you expect that to go and what's normal?

The second quarter was up $140 million relative to the first quarter.

It's proven to be an ongoing cost for the industry, associated with all the pre-crisis matters.

It's proven to be lumpy.

Tough to forecast.

We called it out in terms of the expense comparison because at some point, the financial crisis is behind the industry and these start to abate.

Just to give you a sense, first half this year, versus first half last year we're up $250 million.

And then lastly, your VAR was down.

At some others, it was up.

What is that?

Is that just a more cautious risk profile?

Or is this just temporary?

Yes, the VAR was down in particular on the interest rate and credit line.

And that really goes to my comment that we reduced risk in May, given concerns about potential market volatility within fixed income product.

I think the team did a good job managing that but it does set us up well to support client activity this quarter going forward.

We have capacity there.

Thank you.

The next question will come from Brennan Hawken with UBS.

Good morning.

Quick one on leverage.

Does the new rule change your view on moving derivatives over to the bank sub?

You know, that's a great question because I indicated that we're above 6% at the bank now.

The way we're looking at it, it's obviously just come out and it's still in the proposal stage, but if we move derivatives to the bank, we get a dollar-for-dollar benefit because we're not obviously funding them with unsecured anymore but with deposits.

So, there is some optimization there and I think the way we're thinking about it is client preference, efficiency, logic of it, how the market's evolving.

We have some capacity in the bank.

We have a clear flight path for the holding company.

It's much more about looking at the specific asset classes and assessing it, and it's too early to actually answer it more specifically than that.

That's fair.

So switching gears then, as you guys continue to work to improve margins in the Wealth Management, is there a way we should think about FA headcount going forward?

I'd say FA headcount is up a bit this quarter.

We continue to be very focused on FA productivity, which as I noted, is at a record high.

In and around this level, it is logical and, again, our focus is primarily on FA productivity, so there's not a line in the sand here.

It will bounce around a little bit quarter to quarter.

Honestly, I wouldn't think about it too much.

But really, productivity is probably the bigger driver and the way that we should think about it more so than actually the number of heads?

Yes.

By far.

Great.

Last one from me.

As NII becomes more important to you all and the asset leverage increases, paying a lot more attention to that, and so this question's a little dated but I had not paid as much attention to NII for you guys for a while.

It seems as though, NII in ISG has been really weak since 2008.

What's been behind that?

Is there any way to think about that?

Or what are the drivers there?

I think your opening comments actually answered it.

[NIM] is much more a banking book than a trading book concept.

It's much more relevant for the Wealth Management business and it has been improving nicely and should continue to as we deploy deposits.

Really, it's less relevant in the trading business.

Okay.

And on that, the latter business, the Wealth Management business, we have seen a move here in the two- and three-year Treasury.

Is there any benefit that we can expect down the line for you guys from that move?

Or is the deposit investment far shorter and only really like the six-month LIBOR would have an impact?

Yes, we've indicated that it really is -- we focus on the much shorter end, so the first 150 basis points in Fed funds is about $1.1 billion in PBT for the business.

To the extent we're seeing rising rates because there's improved economic activity that's constructive for all of the businesses.

But the guidance that we provided was really anchored at the short end.

Fair enough.

Thanks a lot.

The next question will come from Jim Mitchell with Buckingham.

Good morning.

Could I just ask a follow-up question on the derivatives business as you move to central clearing.

We talk a lot about the numerator benefit.

If you done any work trying to figure out if any capital benefit would be on a Basel III basis, and moving more and more to the derivatives to a centralized clearing platform?

Still too early.

Is it at least in your gut, it makes sense that you get some benefit?

Or there's just no way to tell at all?

No, our assumption is there is some benefit.

There is benefit to it.

And trying to quantify it for our call, it's too early.

Our assessment is, there will be capital.

Too early.

Just a follow-up on the spread question on the deposits.

As you pull in $55 billion over the next 24 months, you talked about your leverage is more on the short end but in the near-term I assume you're putting it mostly in AFS portfolio.

Correct.

With the backup in yields in intermediate bond area, wouldn't you get some benefit?

I know your target was 1% spread before the rate spike.

Should we be assuming a little bit better than that?

We are still fairly short and it's been our philosophy, given we've been in a low interest rate environment, is keep duration short, given the inevitable rise in rates would prove to be financial drag.

I think that was the right thing to do.

All right.

Thanks.

The next question will come from Roger Freeman with Barclays.

Hi.

Good morning.

Just on the fixed business, you're talking about risk having come down in May.

With markets more normalized, is the level of liquidity provision gone up?

Was the decline in May just the volatility?

I know you had some management changes, too, so I'm not sure if that's factored in there.

There was concerned from the team that about potential market volatility and just thinking that it was prudent risk management to bring risk down in the business, given that concern.

And we're pleased that they did.

Okay.

Market normalcy is returned from your perspective so far this quarter.

It seems like we're hearing that from others?

It does seem that way, yes.

Okay.

Just back on the buyback and CCAR, I know you've probably said what you can.

But just thinking about the 1%, is that a mechanical outcome of this provision to be able to apply for that, and not to read into that one way or another as to the Fed's thinking on approving capital stock buyback requests, with say your leverage ratio where it is, against the target?

Are they separate issues?

Well, there's a provision that you have the opportunity to apply to use 1% of your Tier 1 capital.

But it's still an approval and so we were pleased to have received the approval, no objection, and to be able to proceed.

Okay.

The clearing roll out, how's that in the swaps businesses?

How's that going from your perspective?

It seems like what we're hearing from others is no real impact on customer volumes.

Have you found the same thing?

Yes, and the big event was obviously category two.

The move went well.

Clients were ready.

We didn't have operational issues.

We do think the staggered roll out of clients was constructive between category one and category two.

At this point, it's premature to judge I think the impact fully on market activity because there were so many other exogenous events.

But it went well and we feel we're well-positioned.

Thanks a lot.

The next question will come from Fiona Swaffield with RBC.

Hi.

Good morning.

Two things.

Firstly, on the Basel III look-through, the 9.9% versus Q1, I don't know if you could talk about the numerator and the denominator because the RWAs keep on going down in fixed income.

There seems to be something offsetting it, was the first question.

The second question was, the total exposure number, so the supplementary average ratio exposure, and the move to that to [4%].

If we look back and you've had that big reduction in [FIC] Basel III RWAs, could you tell us where the exposure would have been, or the leverage ratio would have been at a bottom, to work out what the correlation is potentially?

On the first question, the Basel III firm-wide RWAs are $426 billion.

Some of the movement between the first quarter and the second quarter, obviously there's earnings accretion.

There's obviously the charge associated with the Wealth Management acquisition and then just finalization of the rules.

That gets you to the 9.9%.

Then could you repeat the question regarding the leverage ratio?

Just trying to understand the moving parts in the total exposure, because we've obviously seen the fixed income RWAs come down a lot in the last 18 months and you're getting more towards the end of that process.

So how much of the total exposure going down is really due to the fixed income?

Is it total exposure number would have been much higher before you started reducing the fixed income book?

It would have been much higher before we started reducing the fixed income book.

And I think the two buckets that I broke out, one, the RWA reduction, the RWAs in fixed income were $390 billion at the peak.

They're down to $239 billion.

Most of that really is in areas that are relevant to the gross-up, in particular our structured, credit correlation business.

Yes, we've absolutely benefited from what we're doing and we continue to be on an execution path to take it down even more which is what gives us the confidence we can continue to do so.

Similarly, we've already moved quite a bit.

We were early in central clearing.

We're already seeing some benefit in the denominator from the move to central clearing and look forward to executing on that portion.

Great, thanks.

The final question will come from Matt Burnell with Wells Fargo.

Good morning.

Thanks for taking my question.

I appreciate the disclosure, particularly specific to Wealth Management loans on Page 12.

I guess I'm just curious as to if there's any dollar target or growth target of those loans now that you've got deposits obviously flowing in from the MSSB transaction, given your ongoing statements about trying to grow the spread revenue within Wealth Management?

I may give you a somewhat unsatisfactory answer because I'm not going to be able to quantify it by buckets.

And the reason is, we've said consistently we're leading with credit risk management and it will be a prudent build out of the portfolio.

That's how we're continuing to build it.

The deposits are going to continue to grow and support growth and lending product, both for Wealth Management and Institutional Securities.

On the Wealth Management side, the biggest growth is on the security space lending, and secondarily, on residential mortgages.

We have 5% penetration of our clients, relative to our peers who have 10%, so our view is that there's tremendous upside.

We've got a tailwind there.

But we're, again, leading with prudent, steady growth and that's going to be the continued philosophy around it.

Then on the institutional side, that's also how we're going to be utilizing some of the deposits.

We do get a dollar-for-dollar funding benefit when we substitute unsecured debt with the more efficient deposits.

So, certain product does move to the bank and obviously our relationship, or maybe not obviously, our relationship in event lending is in the bank.

Then, we have an attractive opportunity growing bank appropriate product in the bank.

So areas where we already have very strong teams, domain expertise, client base, like commercial real estate lending, asset-based lending, project finance, we can grow the lending suite, an area we hadn't heretofore been focused on.

It is a real diversified portfolio of assets supporting growth on both Wealth Management and the Institutional Securities businesses that will build over time.

We'll sharing more about the bank and the bank strategy over time, given the growth that we're seeing there.

Just switching gears a little bit, James, maybe a question for you, in terms of how you're thinking about the long-term total payout ratio of the firm, given that you've now taken a big step towards that with the announcement of the $500 million share buyback.

Well, as they say, journey of a thousand miles begins with a single step, and we've had our first step.

That's really what mattered.

We don't want to get ahead of that, obviously.

It's what payout ratios are, it's going to be a function of where our absolute earnings are and managing against the changing regulatory environment.

What we wanted to do was put ourselves in a position where we could launch a buyback and begin that process, which is what we did.

Fair enough.

Thanks for taking my questions.

You're welcome.

Thank you so much for joining our second quarter call, and we look forward to speaking to you again in October.

Ladies and gentlemen, that concludes your conference call for today.

Thank you for your participation.

You may now disconnect.