摩根士丹利 (MS) 2014 Q2 法說會逐字稿

Good morning.

This is Celeste 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 statements.

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

This presentation, which is copyrighted by Morgan Stanley and may not be reduplicated 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, and thank you, everyone, for joining us.

In the second quarter of 2014, we again grew our earnings on a year-over-year basis.

Excluding DVA and excluding a discrete tax benefit in the quarter, earnings increased 46%.

The fruits of our strategy were evident, with the stability of our Wealth and Asset Management businesses providing significant ballast.

The trust and partnership we have with our clients in Investment Banking and Institutional Equities, offset historically low levels of volatility and reduced client activity.

Our role as the strategic advisor for clients across our franchise, including M&A, prime brokerage, credit, research, and other deep content-rich businesses, positions us to benefit significantly from accelerating positive trends.

I will now take you through the six points we laid out for you in January, and then turn the call over to Ruth.

First, we continued to improve Wealth Management margins through cost discipline and revenue growth.

For the first time since the acquisition from Citi for the remaining stake in the Wealth Management JV, we've achieved a greater than 20% margin in our Wealth Management business, and record earnings since the inception of the joint venture.

We reached this level through a combination of revenue growth, our revenues grew 5% on a year-over-year basis despite reduced industry-wide transaction activity, and continued expense discipline.

We drove our non-compensation expenses down by 9% during the same period, and our total expenses grew only 3%.

We continue to expect to drive our margin to the 22% to 25% target set for the end of 2015.

Second, we have improved our ROE in Fixed Income & Commodities, and continue to optimize that business to be appropriately sized for this Firm.

Although our revenues excluding DVA were flat in the first half of 2014, we've also reduced average RWAs and expenses; thereby, increasing ROE in this business year-to-date.

At the end of the second quarter 2014, our RWAs in Fixed Income & Commodities were $192 billion.

In addition to this systemic reduction of dead weight capital, more broadly, we've taken significant steps in commodities to improve returns.

We closed on the sale of TransMontaigne on July 1st, the first of two physical oil businesses we're selling, and continue to work towards closing the sale of the other physical business later this year.

And as discussed at our financials conference in early June, we're optimizing headcount and reducing grossed up balance sheet in Fixed Income, while maintaining a global franchise by leveraging our clearing and electronic capabilities.

Our objective remains to deliver a global offering to the Firm's clients, and an attractive return for shareholders.

Third, we're driving additional expense reductions and improvements in our expense ratios.

In the first half of 2014, we grew our revenues by 3%, while keeping expenses flat.

Our non-compensation expenses have declined, while the Firm-wide compensation ratio is also lower.

In aggregate, overall expense ratios have improved from 79% to 76%, compared to the first half of 2013.

We continue to see opportunities to increase efficiency through both tactical and strategic moves, investing in technology and systems that simplify our business and position us to better serve our clients.

Fourthly, we continue to make progress regarding Morgan Stanley specific growth opportunities, most notably in the bank.

In the last several months, we drove new production records in both mortgages and securities based lending, despite sluggish demand for mortgages across the industry.

Our success has been driven by the relatively low penetration of our product within Wealth Management versus peer firms.

We've seen a network effect build within our system.

As financial advisors use the products and find them effective for their clients, they discuss opportunities with additional clients.

The successes are then being shared throughout the system, leading to more activity.

As we've said before, lending growth will enhance the stability of revenue in earnings for the Firm as a whole, and make our client relationships deeper and stickier.

Of great importance to us, however, is that we grow our banks in a prudent and measured fashion.

We have known since 2009 that we would have a very significant deposit base, and have spent the last five years investing in risk management, technology, and client service.

Turning to the fifth point.

We continue to steadily increase capital returns to shareholders.

We discussed our plans for capital returns with you on our last call in extensive detail, and we remain committed to increasing returns over time, subject of course to regulatory approval.

Of note, a key driver of capital returns are stable and consistent earnings, which we continued to demonstrate this quarter.

Finally, we're working towards achieving returns in excess of our cost of capital, and of course subject to our capital returns.

We did achieve our target of 10% this quarter, though it was obviously flattered by the discrete tax benefit.

However, excluding DVA in the first half of this year and last year and excluding the tax benefit of this quarter, our underlying ROE was still higher.

Of greater significance, we demonstrated improved performance and momentum in many areas across the Firm that are important to driving our ROEs sustainably higher including the following.

One, in Investment Banking we had a very strong quarter, driven by the strength in our underwriting and advisory franchises.

Two, we continued to drive industry-leading results in institutional equities, despite lower market volumes around the world, and this is due to the depth and breadth of our franchise, and the partnership that we've built with our clients over many years.

Thirdly, we drove our Wealth Management margin higher, even in a relatively subdued transaction environment.

We also reached importantly $2 trillion in client assets, a tremendous achievement, and more than three times the assets we held in 2006 on behalf of our clients.

Fourthly, our relative performance in Fixed Income was solid, and we made progress towards one of our last strategic business change objectives with the closing on the sale of TransMontaigne on July first.

Fifthly, we also successfully raised our first major post Dodd-Frank Merchant Banking Fund in Asia.

This was coming in ahead of our expectations, with significant institutional representation, and with decidedly less Firm capital versus earlier funds.

And finally, as Ruth will discuss in more detail, we increased our pro forma SLR estimate under the US proposed rule to 4.6%, up from 4.2% last quarter.

I will now turn the call over to Ruth to discuss the quarter in more detail, and look forward to your questions at the end.

Thank you.

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 positive $87 million, with $50 million in Fixed Income sales and trading and $37 million in Equity sales and trading.

Excluding the impact of DVA, Firm-wide revenues were $8.5 billion, down 3% versus the first quarter.

The effective tax rate from continuing operations for the second quarter was 1.6%, reflecting a discrete tax benefit of $609 million or $0.31 per diluted share, principally related to the remeasurement of reserves and related interest.

Earnings from continuing operations applicable to Morgan Stanley common shareholders, excluding DVA, were $1.8 billion.

Earnings from continuing operations per diluted share, excluding DVA, were $0.91, after preferred dividends.

On a GAAP basis, including the impact of DVA, Firm-wide revenues for the quarter were $8.6 billion.

Earnings from continuing operations applicable to Morgan Stanley common shareholders were $1.9 billion.

Reported earnings from continuing operations per diluted share were $0.94 after preferred dividends.

Book value at the end of the quarter was $33.48 per share, and tangible book value was $28.53 per share.

Turning to the balance sheet.

Our total assets were $827 billion at June 30, down modestly from $831 billion at the end of the first quarter.

Deposits as of quarter end were $118 billion, up $1 billion versus Q1.

Our liquidity reserve at the end of the quarter was $192 billion, compared with $203 billion at the end of the first quarter.

The decline was primarily driven by the deployment of excess cash from deposits into loans, which reduces our bank liquidity, and is consistent with the bank's strategy we laid out previously.

Turning to capital.

This quarter, the required Basel reporting regime moved to a Basel III advanced denominator.

Whereas last quarter, the required denominator was based on Basel I plus 2.5%.

In both quarters, the numerators calculated based on the transitional Basel III rules.

Although our calculations are not final, we believe that our Common Equity Tier 1 transitional ratio will be approximately 13.8%, and our Tier 1 capital ratio under this regime will be approximately 15.2%.

Basel III transitional risk weighted assets are expected to be approximately $423 billion at June 30.

Reflecting our best estimate of the final Federal Reserve rules, our pro forma Common Equity Tier 1 ratio using Basel III fully phased in advanced approach was 12.1% at June 30, up from 11.6% in 1Q.

Our pro forma standardized ratio was 10.8%, up from 10.2% in 1Q.

Pro forma fully phased in Basel III advanced RWAs are expected to be approximately $431 billion.

We estimate our pro forma supplementary leverage ratio under the US Regulatory Proposal to be approximately 4.6% at June 30, up from 4.2% at the end of the first quarter.

These estimates are preliminary, and are subject to revision.

We continue to expect to exceed the required 5% level in 2015, including an assumption for increasing returns of capital to shareholders.

Turning to expenses.

Our total expenses this quarter were $6.6 billion, flat versus the first quarter.

Compensation expense was down 2% versus the prior quarter.

Non-compensation expenses was $2.4 billion, up 5%, reflecting seasonal trends.

Let me now discuss our businesses in detail.

In Institutional Securities, revenues excluding DVA, were $4.2 billion, down 8% sequentially.

Non-interest expense was $3.2 billion, down 1% versus the first quarter.

Compensation was $1.7 billion for the second quarter, down versus the first quarter on lower revenue, reflecting a 41% ratio excluding DVA.

Non-compensation expense for the second quarter was $1.5 billion, up versus the first quarter, also reflecting seasonality.

The business reported a pretax profit of $927 million, excluding the impact of DVA.

Including the impact of DVA, revenues were $4.2 billion, and pretax profit was $1 billion.

In Investment Banking, revenues of $1.4 billion were up 26% versus last quarter, reflecting broad-based strength across products and regions, with substantial growth in EMEA.

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

Notable transactions included: in advisory, Morgan Stanley is acting as a defense advisor to Shire in its discussions with AbbVie regarding a potential $55 billion combination.

Morgan Stanley also acted as lead financial advisor and lead left arranger on the bridge financing for Tyson Foods in its $8.6 billion acquisition of Hillshire Brands.

In Equity Underwriting, we again evidenced the strength of our global franchise.

Notable deals include: acting as joint global coordinator and joint book runner, we priced a $3.5 billion capital increase for the National Bank of Greece, and Morgan Stanley successfully executed a $1.3 billion unregistered block trade of YPFSA, amongst other international offerings.

In Debt Underwriting, Morgan Stanley acted as global coordinator on the successful $40 billion consent solicitations of debt securities for PEMEX.

In addition, acting as joint book runner, the Firm sourced $9.9 billion of debtor in possession financing for energy future holdings.

Morgan Stanley and its partner, Bank of Tokyo Mitsubishi USJ, played a leading role in structuring underwriting and syndicating the debt facilities.

Advisory revenues of $418 million increased 24% versus our first quarter results, due primarily to increased activity, with particular strength in EMEA and Asia Pacific.

Underwriting revenues of $1 billion increased 27% versus our first quarter results, driven by Equity Underwriting revenues of $489 million, which were up 55% versus the first quarter on higher issuance volumes in a strong market, and a meaningful uptick in EMEA.

Fixed Income Underwriting revenues were $525 million, higher versus the first quarter, primarily driven by higher investment grade and high yield volumes.

Equity Sales & Trading revenues, excluding DVA, were $1.8 billion, an increase of 5% from last quarter.

Prime brokerage revenues were up, reflecting the benefit of increased client balances and the dividend season.

Cash revenues remained resilient against declines in market volumes across regions.

Derivatives revenues were down, as lower volatility reduced client activity.

Fixed Income & Commodities sales and trading revenues, excluding DVA, were $1 billion, down sequentially, driven in part by typical seasonality.

Commodities revenues were down substantially from a very strong 1Q.

Outside of Commodities, revenues in most product areas declined due to lower volatility, which resulted in lower client activity.

In contrast, rates revenues were modestly higher quarter-over-quarter, due to improvements in both the United States and EMEA.

CVA continued to be a drag in the quarter, due to the tightening of our credit spreads.

Average trading VaR for the second quarter was.

$48 million, down slightly to the first quarter.

Turning to Wealth Management.

Revenues were $3.7 billion in the second quarter, up 3% sequentially.

Asset Management revenues of $2.1 billion were up versus last quarter, reflecting the benefit of higher market levels and positive flows.

Transaction revenues were essentially flat to last quarter, consisting primarily of commissions of $511 million, down 5% versus the prior quarter, due to lower activity consistent with lower exchange volumes.

Investment Banking related fees of $213 million, up 18% versus last quarter, reflecting higher equity and preferred stock underwriting activity.

And trading revenues of $267 million, down 3% versus the first quarter, reflecting a decrease in Fixed Income trading, partially offset by higher returns on deferred compensation plans.

Net interest revenue increased 7% to $578 million, driven primarily by higher revenues from our bank deposit program, and continued growth in our lending product.

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

Non-compensation expense was $762 million, also flat to last quarter.

The compensation ratio was 59%, down versus the first quarter, driven by seasonal trends.

The PVT margin was 21%.

Profit before tax was $767 million.

Total client assets surpassed $2 trillion.

Global fee-based asset in-flows were $12.5 billion.

Fee-based assets under management increased to a record $762 billion at quarter end, representing 38% of client assets.

Global representatives were 16,316, essentially flat to the first quarter.

Deposits in our bank deposit program were $127 billion, down versus the first quarter, due primarily to outflows related to tax season.

Approximately $109 billion were held in Morgan Stanley banks.

Our Wealth Management lending balances continued to grow, reflecting the ongoing execution of our bank strategy.

Our PLA balances increased $1.9 billion, and mortgage balances increased $1.6 billion.

Production in the second quarter was at record levels for both products.

Investment Management revenues of $692 million were down 6% sequentially, predominantly driven by the deconsolidation of certain legal entities associated with a real estate fund sponsored by the Firm.

A number of years ago, we provided a liquidity facility for the fund, and thus, had to consolidate revenues and capital.

The liquidity facility has expired.

Accordingly, certain legal entities associated with the fund were deconsolidated.

The deconsolidation eliminates the related revenue, as well as a portion of our non-controlling interest, and is net income neutral.

Additionally, the deconsolidation reduces both balance sheet and risk-weighted assets.

In Traditional Asset Management, revenues of $436 million were flat to the first quarter.

In Real Estate Investing, revenues of $111 million were down 15%, driven by the deconsolidation.

Merchant Banking revenues were $145 million, down 16%, driven by lower gains in investments.

Non-interest expenses were $487 million, up 2% from the first quarter.

The compensation ratio was 42%, up versus the first quarter, driven primarily by the revenue impact of the deconsolidation.

Non-compensation expense was $196 million, up from $192 million in the first quarter.

Profit before tax was $205 million, down 22% sequentially, due to the deconsolidation.

NCI was $7 million versus $54 million last quarter, again, driven by the deconsolidation.

Total assets under management increased to $396 billion, driven by market appreciation and positive flows.

We also successfully completed a fund raising for Morgan Stanley Private Equity Asia IV in the quarter, our first major post Dodd-Frank fund raising effort.

Turning to our outlook.

While June was stronger than the first two months of the quarter, recognizing that trading markets remain uncertain, we are of the view that it is too early to determine conditions for the balance of the rest of the year.

However, we see strength and opportunities across our businesses with several encouraging trends.

First, M&A volumes remained strong, with a healthy backlog and growth in larger transactions, which is our sweet spot.

Last quarter, we discussed three catalysts for heightened M&A activity, and they remain.

Healthy corporate, cross-border, and activist activity, suggesting M&A will remain vibrant.

Second, financing markets remain receptive, with a strong pipeline in Equity Underwriting and a positive outlook for Debt Underwriting benefiting from M&A activity.

Third, we are seeing an increase in activity in Europe.

The second quarter was the strongest in Europe since the beginning of 2012, with notable improvement in both Investment Banking and Fixed Income product.

Given the strength and breadth of our corporate and institutional client relationships, we are well-positioned to benefit from these trends, and are focused on delivering for our clients.

More specific to Morgan Stanley, we are also increasingly seeing the fruits of the many steps we have taken during the last five years to better position the Firm, with three tailwinds worth noting.

First, we continue to benefit from lending growth, which is supported by our leading client franchises in both Wealth Management and Institutional Securities.

Given the scale of each of these franchises, we have ample opportunities with our existing clients, while maintaining tight credit standards.

As evidenced by the growth in our funded loan book again this quarter, we continued to execute against this opportunity, and there remains significant upside.

We are prudently building a balanced portfolio on our way to being the 10th largest depository in the US.

Second, as discussed before, Wealth Management continues to deliver higher profitability, with growing revenues on a higher PVT margin.

Now, with 100% ownership of the Wealth Management business, the operating leverage translates into a growing contribution to the Firm.

Finally, the outperformance of our cash bond spreads enable us to finance the Firm more efficiently.

That, over time of course, will result in additional upside.

Thank you for listening.

James and I will now take your questions.

(Operator Instructions)

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

Good morning.

I was wondering if you could clarify how you treat something that you mentioned but didn't quantify in your remarks, which is the CVA on the derivatives books of the markets businesses?

I think everyone's pretty clear in the industry now about calling out DVA, but I'm not sure that CVA gets very consistent treatment.

And in particular, since we're also focused on how FIC and equities are trending, I just want to make sure that I understand how you treat CVA and how much your credit spread swings might have impacted FIC in particular in regard to CVA this quarter.

As much as we call out DVA and talk about revenues excluding DVA, because that does not flow through to capital.

CVA does and so it goes right to the P&L.

So when we discuss our Fixed Income & Commodities revenues, it reflects the impact of CVA.

And to your point, firms do it differently, but it does reflect that Morgan Stanley the impact of CVA.

And given the meaningful spread tightening we had, in particular year-over-year, it's pretty notable.

So for example, year-over-year our Fixed Income business was up in all major products, except foreign exchange.

However, given the spread tightening, we had a big drag in CVA, and if you exclude the impact of CVA, our Fixed Income & Commodities business actually would have been up.

Got it.

And was the impact much more in FIC than in equities?

Yes.

Okay.

Thanks.

Also just to pick up on something else that you mentioned.

I seem to recall that in years past, like before the last couple of years, your prime brokerage business did a very strong seasonal business in the European dividend arm in the second quarter in particular.

Can you give us a sense of you how much that might have contributed in the second quarter this year?

So that does continue to be a benefit in the second quarter.

And again, along with the strength we had in PV, more broadly with growth in revenues, clients and client balances, we continue to benefit from the seasonality.

So if you look at year-over-year performance in equities, that would normalize for what continues to be a second quarter seasonal event.

Got it.

Thanks.

Okay, one more question which is really more on capital.

You moved equity capital it looks like from the parent into the business units.

$2 billion on the average in the institutional, about $500 million in investment management, which is a fairly sizable percentage increase for that business.

Is this also because of the regime change that you talked about in terms of going to the Basel III, or is there something else going on there?

No, you've nailed it.

The way we disclose the allocation of capital across the various businesses is based on the capital regime in place at that point in time.

And so, this quarter as a result of yet another regime change, both the numerator and denominator are under Basel III transitional.

Last quarter the denominator was Basel I plus 2.5%.

This quarter, the denominator is Basel III transitional advance.

So it's the regime change.

We're just following the required regime quarter after quarter.

The result is more capital moved from the parent to Institutional securities.

Got it.

Okay, that's great.

Thanks for taking my questions.

Thank you.

The next question will come from Brennan Hawken with UBS.

Good morning.

So, a quick question first on the $192 billion RWA in FIC.

Does that include TransMontaigne?

We closed TransMontaigne as of July 1. So that would include TransMontaigne, because that's the second quarter number.

Perfect.

Can you help us think about how much that might help reduce that number in 2Q -- or 3Q rather?

Excuse me.

So TransMontaigne is about $2 billion of risk-weighted assets, and there's also a modest liquidity benefit.

Great.

Thanks.

So we noticed that deposits in the bank deposit program fell this quarter.

Was that seasonal, and can you help us think about that this year, because it didn't seem like we noticed as much of a seasonal decline in prior years?

So was there anything unusual going on there?

So Firm-wide, the deposits are reported in two lines.

You've got the bank and then the parent, and we've had the on-boarding of deposits from Citi.

So the deposits overall were up $1 billion, $5 billion from contractual on-boarding of deposits.

But to your point, that was offset by the typical season outflows for tax payments.

So tax payments were actually greater than outflows, and what we saw was increasing use of PLA, our securities-based lending product, by clients to pay taxes.

I think what's worth noting is in the fourth quarter, deposits tend to be higher, due to year-end selling.

And then on the flip side, we see deposits going down some in the second quarter with tax payments.

So net-net, year end selling and tax payments do tend to even each other out over the period, but what you're seeing here is the second quarter seasonality.

Great.

And then just clarifying, because I got a handful of questions about it before the opening, the bank program deposits include Citi's portion, right?

And if we look down at the footnote, we can see Morgan Stanley's piece, and that went from $108 billion to $109 billion this quarter.

So the rate slowed, but it still was headed in an upward direction, correct?

In the Wealth Management line?

Right.

Yes, Wealth Management went down, right.

Perfect.

Okay.

And then also on the comp in the Wealth Management business, is it possible to think about how much of that is from the amortization of forgivable loans written to recruit brokers?

Because the past several years, we've gone through elevated recruiting environment.

And if we think about, I think maybe James made some comments at the Morgan Stanley FIG conference, about how recruiting and competition may be moderating a bit.

And so if we think about turnover staying at current levels, is it possible that you guys can help us think about how much the roll-off of maybe an elevated amortization expense might be a tailwind to Wealth Management comp over time?

Let me give you a couple pieces.

So the comp ratio is down this quarter, and that reflects the typical first quarter seasonality with FICA and is typically down.

It was here.

The reason we're guiding down to the 55% or lower comp ratio over time really goes to the growth in net interest income, and the execution of our bank strategy, and the tremendous operating leverage that we have as we continue to deploy deposits into lending product.

And so if you, again, looking at the overall business, we will be driving it to 55% or lower, because the margin on that product, the lending product, is pretty significant, and the lending product is not on the same formulaic comp grid.

So I think if you're trying to gauge where is the comp ratio going, the biggest driver of it will be NII, and the growth in lending product.

Sure.

Hey, Brennan, just to separate it.

I think your issue was around the amortization also of the deals, in addition to what Ruth just described.

Long term, strategically in an oligopoly structure, you would expect there would be less movement of financial advisors between firms.

That doesn't translate yet into the financials, but over the long term, we think it will.

Okay, great.

And you were exactly right, Jim.

I was kind of -- I completely get the NII and how that's a not necessarily on the grid type of a payout, and therefore, should help the comp.

I just was hoping to try to get at maybe some of that amortization.

So I guess the only color you guys can give is over the longer run, assuming competition stays down, that should also help as a tailwind overall as well too.

Yes, it will.

Okay.

And then last one for me.

Touched on it a bit prior, but prime brokerage was definitely a positive.

You hit on seasonality.

But, as you said, when we look year-over-year, that should normalize for the seasonality.

And you guys were flat, which, in this quarter, flat is the new up.

So maybe could you help us in parsing out maybe any other benefits that you might have had, and was it mostly in prime brokerage?

And aside from seasonality, were there any drivers and tailwinds there?

As we've talked about for many quarters, this is a stellar franchise.

They've had consistency of performance for many quarters.

It's a diversified global franchise across products and geographies.

We often talk about managing it, leading it across a nine box strategy, with the products cash derivatives and PV on the one hand.

The regions of the world, Americas, EMEA and Asia on the other dimension and looking for leadership and delivering for clients within each of those boxes and then looking for opportunities to build adjacencies across those various boxes.

We had strength this quarter led by prime brokerage, as I noted already, with growth in revenues, clients, and client balances.

And then in terms of cash products, we continued to have strong performance in cash.

We do believe we took wallet share there.

We had good client engagement in index rebalancing.

Derivatives was a bit lower on the back of lower volatility.

But overall, it's a very strong franchise that continues to deliver.

Terrific.

Thanks so much, and congrats for good results in a tough quarter here.

Thank you.

Thanks, Brennan.

The next question will come from Mike Mayo with CLSA.

Hello.

Ruth, you mentioned you're moving to leverage your status as the 10th largest depository in the US.

And looking at the bank data from call reports, it looks like the ROA of the bank is only 60 basis points.

And I'm not sure if we should just look at the bank in isolation.

Also, if we look at the information in your package today, it looks like a loan to deposit ratio of 39% or so.

If you could just confirm whether this is at least one way to look at your Company, and to highlight where you want to go with, say, the loan to deposit ratio or the ROA of the bank.

So, what we've tried to lay out in a number of presentations is the contractual growth in deposits, where we are in terms of asset mix.

And as you look over time, how we look to deploy those deposits moving more from cash into lending products.

And clearly the yield today continues to be pretty low, given where we are still overweight in cash.

Philosophically, the way we're looking at it, is deposit growth is going to support lending -- is supporting lending, in both Institutional Securities and Wealth Management.

Both are leading franchises with a large base of untapped clients, and we have a very strong opportunity, therefore, to continue to build out a nice diversified asset mix here, while maintaining strong credit standards.

So I think if you look at the decks that we put out, you'll see where the yield on that should go over time.

There's a lot of noise in the call reports that directionally it will give you a sense of the mix between these two franchises, Wealth Management and Institutional Securities.

How much would Morgan Stanley benefit if interest rates increased by 100 basis points, maybe just on the bank side or for the Firm as a whole?

I don't think you guys have articulated it in that way.

Quite meaningfully.

What we have articulated is the cost structure in the bank.

And so again, we -- our AFS portfolio continues to be very short duration.

And as we're looking at continuing to deploy deposits into lending products, a rising rate environment is quite meaningfully the margin in the bank, given we have no bricks and mortar.

We have no customer acquisition costs, because we're really lending to our existing client base.

Which is not only a cost benefit, but a credit risk management benefit.

We've already built the infrastructure to support the loan growth.

And I've already commented on the compensation approach.

It's not on the formulaic grid.

So the bank has a very high margin.

Rising rates would be significant.

What we did in the deck, that I have already alluded to, is we indicated where we were at a point in time.

And just following the forward yield curve, what kind of lift you would see in the yield if we were just following the forward yield curve.

And what we tried to do, is give you all of the various levers, so that between the on-boarding in deposits, the current mix of assets, the deployment plan over time, you can toggle it how you want.

Then lastly, James, you gave a comment, it was almost an aside, in talking about your ROE targets, saying well, perhaps 15% ROE is possible some day.

And it was the first time I heard you say that 15% would even be possible for an ROE.

And that's a long way from where you've been, and it's a nice stretch from where you are now.

But, did you say that?

And why did you mention it?

Do you feel more positive about the outlook, or is this just a hypothetical one day sort of statement?

I think the time that I said that was in the context of what was available for the industry.

And this had been an industry market, as you know, where ROEs of 20%-plus were the norm.

You double the capital, you shrink the balance sheet, and unless you create new businesses, your 20%-plus ROEs immediately drop to sub 5%, which is exactly what happened with the industry.

The industry is now working its way back to 10% ROEs through buybacks, more efficient capital usage, further balance sheet management.

And in our case, building diverse businesses that use less capital, and obviously contribute to ROE.

So I think I certainly aren't making an immediate projection, this is a staged view of where the industry is going.

Is it probable the industry returns to 20%-plus ROEs?

No, I don't think that's probable.

Is it probable the industry stays below 10%?

No, I don't think that's probable.

So, it's sort of framing it now.

You'll draw your own conclusions about Morgan Stanley's business mix, versus obviously lots of other financial institutions.

And I think your point about the bank you just asked Ruth about, is exactly at our strategic core.

Part of the next evolution of this Firm is to develop $130 billion deposit bank within Morgan Stanley, which is a very exciting prospect.

It's not going to happen immediately, and it's going to be done with you prudence as respect to lending.

But it will be done, and it will be done over several years.

I was just -- if you have a superior business mix it should eventually mean a superior ROE.

Otherwise, it might not be a superior business mix.

So at some point, with higher rates, is it possible Morgan Stanley could get an ROE of 15% or so?

There's a great old phrase of, a journey of 1,000 miles begins with a single step.

And we're working our way towards 10%.

When we get there, we'll have another conversation with you.

All right.

Thank you.

The next question will come from Christian Bolu with Credit Suisse.

Good morning, James.

Good morning, Ruth.

Morning.

Firstly, a first quick question, first [clean-up] question on the Investment Management business, Ruth.

In the Investment Management business, the core Asset Management fee line was up 10% in the quarter, which is a little bit surprising just given AUM growth was closer to 4%.

Any color you have on what's driving that would be appreciated.

We've continued to execute in that business.

We had good flows in the business, have been investing in distribution.

You can see flows were up across the board in Traditional Asset Management, and I think that the team continues to execute well.

Okay.

Got it.

And, James, on the Wealth Management business -- first of all, congratulations to getting to the $2 trillion club.

But while asset growth has been strong, both financial advisor headcount and branch growth have been more muted.

I appreciate your focus in that business has been on increasing productivity and efficiency.

That said, I'd be curious if you guys actually have plans to grow your core advisor base and locations going forward.

So as we've talked about for quite some time, we're focused on productivity and quality of FAs rather than sheer number.

And in fact have over time reduced the lower productivity financial advisors.

We feel very good in and around this level, we're not managing to a specific number.

And as it relates to the number of locations that we have, we've had an opportunity, in particular post closing the acquisition of the joint venture, to look at places where we could consolidate offices within major cities.

And again, that's done on a case by case basis as we look at leases rolling off.

The question is within any particular area, is there logic in combining an office where you have a fully staffed office with a great culture working really well, it doesn't necessarily mean you want to try and merge two offices together.

That may not be the most effective for clients, or the best experience for financial advisors.

So we've reduced the number of locations quite a bit.

Over the last couple of years, I think the big bulk of the opportunity we've really achieved there, and now you'll see ones or twos depending on any particular market.

But no plans, we feel good about where we are.

Okay, thanks.

And then lastly from me, just on the prime business, you spoke about it a lot today.

Just curious what you're hearing from your clients in terms of pricing trends, just given the implications for supplementary leverage ratio across the industry?

We are starting to hear some peers are repricing balance sheet as it affects this business and Fixed Income product as well, very much to your point as a result of the SLR.

Okay.

Thank you.

Thank you.

The next question will come from Eric Wasserstrom with SunTrust Robinson Humphrey.

Thanks very much.

Ruth, just circling back to the SLR for a moment, I'm looking at the slide that you and James put out for the update in January, which highlighted the potential sources of increase.

And I'm wondering if you can help me understand what the approximate contribution of these categories were to the 40 basis point improvement sequentially?

The biggest driver in taking us from 4.2% last quarter to 4.6% this quarter was the numerator.

That was most of the improvement.

And that was due to the combined benefit from earnings, the preferred issuance we did early in the quarter, the multiplier effect with DTA and investment capacity deductions we've talked about previously.

We've continued to focus on mitigating some of the other numerator deductions.

And then the remaining improvement is from the denominator items that we've talked about previously.

Some ongoing compression, RWAs were obviously down in Fixed Income where you see the PFE growth is up.

Some mitigation, just early days of mitigating the net long CD as sold, and some modest balance sheet reduction.

But the overwhelming -- the majority of it was in the numerator.

And we're executing against the opportunities now in the denominator.

And is there any change to the guidance given at that point of those various benefits generating 180 to around 200 basis points of potential improvement?

Well, the rules changed.

So with now the inclusion of net long CDS sold, and we've obviously had a big move in the ratio from 4.2% to 4.6%.

We're still very comfortable with greater than 5% in 2015 with higher returns of capital, which may not surprise you given we're sitting here at 4.6% today.

And as I said, across the various work streams, we're continuing to execute to reduce PFE where it makes sense, while still supporting our client activity and client franchise.

There are certain areas, the best example of which is compression, which I characterized in the past as just good hygiene.

It's effective to reduce the overall PFE through compression activities, and we're executing there.

The pace is strong.

We've accomplished a lot year-to-date.

The protocol around it has improved, and so we expect the pace will continue to be good.

So we're continuing to execute against each of these.

The mix may change a bit as we've added now net long CDS sold mitigation as an added opportunity given the rule change.

Great.

And if I can just transition quickly, on page 7 of the supplement in the other funded loans category, which I recognize is small relative to the balance sheet, but up very significantly.

And I think the footnote suggests that much of this could be purchased loans.

And I'm just wondering what would be the strategy behind growing a purchased loan portfolio?

No, I'm glad you asked.

Because the growth within the lending book, again, across Wealth Management and Institutional Securities, is really executing with our clients and areas where we have a strong franchise, strong client base, domain expertise.

And so within Institutional Securities, it is in areas consistent with what we've discussed today.

I've talked about it as small sleeves across a number of different areas, including commercial real estate, warehouse, project finance.

That's really the bulk of what -- that's what drove the increase in funded loan balances, up about $5 billion.

Which, as you said, is a good increase but small relative to the scale of our franchise.

As an example, commercial real estate we've got a 20 year track record, built leadership with a high quality franchise there.

And we have history originating loans outside the bank, we're now doing more in the bank.

But we're targeting very much our client base in areas where we have domain expertise.

Great, thanks.

And just finally, speculating that the fact you called out on legal costs suggests that they were di minimus in the period?

I'm sorry, I didn't hear the question.

That there was no call-out on legal costs suggests they were low in the quarter.

Right.

There was really not much to note.

Great.

Thanks very much.

The next question will come from Glenn Schorr with ISI.

Hello.

Thanks.

Ruth, you mentioned the lower funding costs earlier, and it's clear they've gone down a lot.

How should we think about how long it takes to work its way through?

Is it really just the inverse of maybe the average maturity?

So in other words, do you get a 15% to 20% of that benefit each year as your debt rolls?

That's a fair way to think about it.

Okay.

And so that could -- I wouldn't call it material, but it can move the needle in the Firm's overall earnings on a year by year basis?

Yes.

And our view is that you've seen real compression across the industry, but we've outperformed peers.

And I think that our view is that reflects all that we've done over the last number of years to reposition both the business mix and the balance sheet.

And so we view it as yet another tailwind that we'll leg into to your point over time.

But it's a benefit, and it will be a benefit even in a rising rate environment on a relative basis given our spreads have come in more than peers.

Okay, yes.

That's fair enough.

I don't know if you've already addressed it in pieces across the other questions, but are there -- you mentioned bits of pieces of repricing -- or attempts to reprice in prime brokerage.

Maybe a broader question of how you think the SLR is mostly impacting the big banks or brokers or impacting the markets, and how it impacts how you do your balance sheet planning?

Well, we do think it continues to be the bigger constraint for banks on both sides of the Atlantic, and you're seeing the reduction of balance sheet in lower return assets.

And, as I noted, some peers are repricing balance sheet using a harsher lens on allocation of balance sheet.

So we are seeing wider bid offer in certain financing markets.

There was some dislocation in Treasury sales, which we see as transitory, and the Fed prevented additional dislocation with the buy side using the RRP program, prevented a more painful readjustment period.

But you're the impact on a ripple through in a number of different ways.

But, it sounds like a lot of that stuff has made its way through.

In other words, it's rippled through, but it's not creating sea change.

I'm putting words in your mouth, I realize.

I think you're still seeing an evolution here.

I would agree, for example, on Treasury sales, we view that as transitory.

But as firms reposition where they're using balance sheet and putting balance sheet behind client activities, I think it continues to evolve, in particular, given some of the requirements for the European banks.

We feel good about where we are, because we've evolved our business mix.

Not to keep coming back to that, but it's a really important way we think about our business, given the changes that we've made over the last several years with the strength of Wealth Management, blends we have on balance sheet within Fixed Income going back quite some time now.

We feel we've taken the steps we need to take, and have clarity about the execution path within Fixed Income equities continues to be performing as it consistently has.

And we have opportunity to support our banking clients with the growth in lending products.

So we feel good about where we are, but I wouldn't say that it's necessarily done across the industry.

Okay.

And then just a little cleanup.

You have a market gain in the quarter, and where was it?

That was in the investments line.

It wasn't a meaningful impact.

Okay.

Cool.

Thanks, Ruth.

Thank you.

The next question will come from Steven Chubak with Nomura.

Hello, good morning.

Morning.

So I had a follow-up question on operating leverage at the bank.

And what I was hoping to clarify is, when we go through the modeling process for Wealth Management earnings in higher rate scenario, the implied comp ratio that we derive is actually closer to I would say the very low 50%s.

So about 300 or 500 basis points better than your stated target of 55%.

And I was wondering whether your mid 50%s target contemplates the benefit from higher rates?

And maybe even in that same vein, where do you see operating margins peaking in a more normalized rate backdrop?

So the 55% comp ratio and the PVT margin guidance of 22% to 25% assumes a flat rate environment.

And we specifically did that so that you could model in your outlook for a rising rate environment.

But very much to your point, there's tremendous operating leverage in a rising rate environment for the Wealth Management business.

And through that, the growth in that lending book and through what we're doing in the AFS portfolio.

So there is upside, and you will see that flow through as rates rise, and we'll let you forecast when that happens.

Okay, great.

And just switching gears for a moment to -- I have a capital question pertaining to FIC.

And just in an effort to help us better monitor your ongoing FIC ROE progress under all the different binding constraints that exist today, it would be really helpful if you could help clarify the current level of required capital as measured under the SLR to support the FIC business specifically.

And also given how proactive you've been on the mitigation front, how we should think about required capital levels trending over the next couple of years?

So we've broken out a lot of detail here, in particular, risk-weighted assets within Institutional Securities, breaking it down to the Fixed Income level.

So that you could get a sense of what the progress we're making in that business, you can see revenues year-to-date, and I think that's where we're going to leave it.

We've been indicating ROE is higher, and I think that's intuitive given the lower required capital.

Separately, we're breaking out a lot of the components of the various capital ratios and the leverage ratio, and are on a good path forward to this greater than 5%.

Okay.

And has there been any change to -- I guess there's roughly $5 billion-plus or -minus of FIC revenues that were required to achieve your targeted 10% ROE within FIC.

Presumably, it would be a little bit lower, just given that you've been more proactive, once again, on the mitigation front.

Well as we indicated, we're very much focused on increasing ROE.

There are multiple levers to get there between revenues, expenses and capital.

But as an example, a couple quarters ago when I was talking about our commodities businesses, the physical oil commodities businesses that we're selling, they have revenues but are PVT breakeven with some capital tied up in them.

So exiting physical oil may reduce revenues, but it's accretive to capital and accretive to earnings.

Again, that's why as we're looking at it, we said we want to be very clear.

We're not looking at revenues for revenue's sake, we're looking at what's the most vibrant Fixed Income business unto itself.

When we talk about our Fixed Income business, we're looking at a return on capital greater than 10% within Fixed Income, and moving in that direction.

And then beyond that, it's accretive to the returns of the Firm.

And I talk about this often on these calls, but it is key.

Within Investment Banking, yet again this quarter, we had about $500 million of Fixed Income Underwriting revenues, which is accretive to those client relationships where are clients are looking for from us, but really does benefit from the execution capabilities within Fixed Income.

And similarly, within our Wealth Management business, our clients want Fixed Income product, municipal product, more specifically, and that benefits from the strength of what we have within Fixed Income.

But we're holding Fixed Income to a standard like all of our businesses of generating an appropriate return on capital, and systematically using each one of those levers to drive to a higher return.

And then everything else that's accretive to the other businesses, benefits the bottom line.

Okay.

Great.

That detail was extremely helpful, Ruth.

Thank you for taking my questions.

Thank you.

Our final question will come from Michael Carrier with Bank of America.

Thanks.

Just one quick last one.

When we think about the outlook on the Institutional Securities business -- and this is either James or Ruth.

Can you give us some sense, I guess two parts, just on the Investment Banking side given the pipeline of M&A, when -- from a timing standpoint, when a lot of those things will close once announced?

And any other revenues that can shoot off from there.

And then on the trading side of the business, we're used to normal seasonality based on the last 20 years.

Given that the business has changed and firms have restructured, some parts of it.

Has anything changed on that front, whether it's because of client mix or because of its product mix that we see less seasonality than we have in the past?

So starting with the first part on M&A and closing and implications for revenues as you look through the year, it obviously varies depending upon the nature of the deal, the industry, whether regulatory approval is required.

So it can be from a month to many months, I think three to nine months just to indicate that it can cut across a number of different periods.

And typically, much of the financing is done towards the latter end of that as you're closing, although there can be some hedging activity up front.

I think the main point that is encouraging is the pipeline continues to be very healthy across all products.

And in M&A, I noted, the momentum with these key drivers cross-border, corporate activity, and activist activity, and now we're seeing larger deals.

But probably one of the most additional encouraging elements for the team is that the velocity of deals is really picked up as well.

In other words, if you go back a year or two, we talked a lot about a healthy pipeline that just wasn't crossing the finish line, and getting into execution and being announced.

Whereas now, what you're seeing is much greater clarity and velocity going from identification of a strategic opportunity to announcement and execution.

That velocity we think is encouraging, and the underwriting calendar does remain strong globally.

It remains strong in particular in the equity side outside of the US.

So that should be -- that should give us, again, all things equal, some momentum going through the balance of the year.

And then on the trading side, it's tough to call.

As I said, we saw a pickup in June, but too early to call whether that has real legs to it.

Given most of this year we saw lower trading volumes, lower volatility, and so a bit of a pickup in June is not something I would say is fair to extrapolate from yet.

And as you pointed out, Summer seasonality is in front of us.

Whether the trends change over time in trading businesses as the result of regulatory requirements, tough to say.

I think the one that's clear is Summer seasonality.

Okay.

Thanks a lot.

Thanks so much for joining us for our second-quarter call, and we look forward to speaking to you again in three months.

Ladies and gentlemen, thank you for participating on today's conference call.

You may now disconnect.