摩根士丹利 (MS) 2014 Q4 法說會逐字稿

Ladies and gentlemen, welcome to the Morgan Stanley fourth-quarter earnings conference call.

Good morning.

This is Kathleen McCabe, Head of Investor Relations.

Welcome to our fourth-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 uncertainties 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.

Good morning, everyone.

Thank you, Kathleen.

As we begin another year, I'd like to share my thoughts on the current state of Morgan Stanley, discuss our progress against last year's priorities, and share our plans for 2015.

During my comments, I'll be referencing a presentation that you can find on the investor relations section of our website.

For the past five years, this management team has worked hard to do the following.

One, to put the troubles of the financial crisis clearly in the rearview mirror.

Two, to reposition our Firm to benefit from our world-class and complementary franchises in institutional securities, wealth management, and investment management, as shown on slide 3. And finally, to lay out specific plans with clear sign posts for investors to follow as we work toward sustained, higher returns.

Each year, we like to remind you of the key elements of the plan, mark those elements to market, and refresh the plan for the coming year, so investors can properly judge our absolute and relative performance.

Before I make my strategic comments, let me briefly touch on the quarter.

Our final results this year reflect a number of idiosyncratic issues, including tax benefits, compensation changes, FVA implementation, and legal reserves.

In addition, the quarter reflects a difficult market and trading environment across the industry, especially in October and the last few weeks of December.

Our trading businesses, in particular fixed income and commodity, sales, and trading, were clearly not immune to the unfavorable market environment.

While Q4 had several complicating elements, it was also an important quarter, as we continued to put residual issues from the financial crisis behind us.

In a few minutes, Ruth will take you through the quarter in much more detail.

Before doing so, let me begin with the mark to market for 2014, which you can now see on slide 4. 2014 was a year of focused execution against the strategic plan we have previously articulated.

In wealth management, we continued to improve our profit margin, and are well on the way to delivering 22% to 25% margin by the end of 2015.

In fixed income and commodities, we continue to resize and reshape the business, and doing more to drive ROE.

We continued to improve our expense ratios.

We made strong progress in Morgan Stanley's specific growth opportunities, most notably growth in the Banks.

We increased our share buyback; and for the first time in several years, we increased our dividend.

As a result of these collective actions, we have made progress towards returns that meet and exceed our cost of capital.

With that, let me turn to the six areas of strategic focus for 2015.

First, wealth management, which is on slide 6. For full-year 2014, we delivered a 20% margin in wealth management, up 200 basis points versus 2013, and we have a clear path for achieving our goal of 22% to 25% by the end of this year.

After taking into account the adjustment to our compensation deferral, the pre-tax margin improved through the year.

Our fourth-quarter 2015 target is driven by the revenue and operating leverage from deposit deployment and the ongoing benefits of scale.

It's important to note that this target does not take into account the benefit of eventual higher interest rates and stronger equity market levels.

The target also does not include the benefit of the positive secular trend towards fee-based managed accounts.

This trend plays to the strength of our advisory-based model, and generally translates into more stable revenues and deeper client relationships, a trend we have discussed with you in the past.

There are several additional drivers of upside for wealth management, as we have outlined on slide 7. We continued to grow our assets under management, and ended the year with over $2 trillion of client assets, benefiting in particular from our focus on the high-net-worth and ultra-high-net-worth client segments.

Since 2009, we've grown assets in the $10 million and above household by 82%, and assets in the $1 million to $10 million segment by 35%.

Our model, based on providing high-valued advice, helps position us to meet the broad and complex financial planning and investment needs of these clients.

We have further upside as we attract more of our clients' deposits, a goal consistent with our growing bank presence.

Given the magnitude of the client base, even a modest increase in our share of client deposits holds significant upside for us.

Greg Fleming will share more of this opportunity with you later this year.

Second is our bank strategy: On page 8, we describe for you the components of revenue growth in our Banks.

We continue to benefit from the three tailwinds of: one, growth in the deposit base and associated assets; two, the optimization of those assets, namely moving cash into [AFS] and lending; and three, eventual upside from higher rates.

We see strong loan demand among our sizable wealth management and institutional securities client base.

With no bricks and mortar, an embedded client base, and the required infrastructure investments behind us, the incremental margin on lending products is exceptionally high.

As a result of our ongoing progress in the Bank, we are providing you with updated targets for 2015, as well as growth to $180 billion in assets by year-end 2016, up from $151 billion as of year-end 2014.

Based on current market rates, and our expected asset mix at the end of 2016, the blended yield would be 2%.

If we substitute the yields indicated by the forward curve on the same asset base, the blended yield would be 3.1%.

Turn now please to slide 9: In our institutional equity and securities business, our leadership in advisory, and equity sales and trading, continues to provide further stability, along with upside.

In advisory, we finished second in global completed and announced M&A.

With continued strength in large-cap, cross-border M&A activity, we believe our global footprint and leadership across products and geographies positions us well to benefit from current trends.

In equity sales and trading, we built on the momentum of recent years, with full-year revenues of $6.9 billion ex-DVA, placing us first among US peers, and, we expect, first globally.

Our success in 2014 reflects higher-quality execution and share gains.

This brings us to our third area of strategic focus, fixed income and commodities, as seen on slide 10.

Against a challenging backdrop, we made some progress on our plan to drive returns exceeding our cost of equity.

Within fixed income, we reduced balance sheet, risk weighted assets, and non-compensation expenses.

We also maintained normalized ROEs of greater than 10% in our areas of strength, namely securitized products and credit corporates.

Furthermore, we continued to optimize returns in rates, and to roll down structured credit RWAs.

Within commodities, we reduced our exposure to physical oil, most notably by selling TransMontaigne, and we remain committed to selling our oil merchanting business.

We are also integrating the balance of our commodities business within sales and trading.

From a capital perspective, we remain on track to reduce fixed income and commodities RWAs to our $180 billion target by year-end 2015, down from $390 billion in 2011.

Furthermore, as you can see on slide 11, we will have an additional $25 billion of dead-weight risk weighted assets that will roll down by the end of 2018, providing incremental ROE upside.

Assuming we find the right opportunities, we will utilize the associate capital to maximize returns across the Franchise, either within fixed income or in other areas where client demand is consistent with the highest return opportunities.

Number four: The next area where we see upside is the benefit from lower funding costs, shown in some detail on slide 12.

As the market has recognized the improvements to our business mix and balance sheet, our spreads have contracted dramatically, more so than those of our peers.

This reduces our funding cost, as we finance older, more expensive debt.

This should result in meaningful reduction in our weighted average cost of unsecured funding on both an absolute and relative basis over the next several years, providing us with a further tailwind.

Last year, we issued new debt at an average spread of 100 basis points over three-month LIBOR, an improvement of 200 basis points since 2012.

From peak to trough, our average funding cost is expected to decline by approximately 25%.

Fifth is our ongoing focus on expenses, as shown on slide 13.

The changes to the compensation structure announced in the fourth quarter reduced the overhang of prior-year deferrals, and decreased the portion of current-year compensation deferred into future years, which was the prudent thing to do.

The result is a reduced liability in a muted environment, and greater operating leverage in an improved revenue environment.

With these changes, we have decreased our target compensation net revenue ratio in our institutional securities business to 39% or less in 2015 and beyond.

Notably, this guidance assumes a flat revenue environment.

In a better revenue environment, the compensation ratio could go even lower.

In addition, we reaffirm that we're working towards a compensation ratio of 55% or lower in wealth management, and 40% or lower in investment management.

We also remain focused on our non-compensation expenses, and achieved a 29% non-compensation efficiency ratio in 2014, excluding obviously the elevated legal expenses versus 2012 levels.

With the changes to our compensation structure, and our discipline on non-compensation expenses, we remain on track to deliver an overall expense ratio, excluding elevated legal, of 79% or lower in 2015.

Sixth is the return of capital to our shareholders.

We have repeatedly emphasized our commitment to prudently increase our capital returns over time, subject to regulatory approval.

Our plan is to increase both our share buyback program and our dividend, with greater returns of capital supported by the increased proportion of our revenue and earnings coming from more stable businesses.

As you can see on slide 14, since 2012 we have grown our total pay-out ratio from 13% to 30%, while also investing in our Business through the completion of the wealth management JV.

Critically, during that same period we have grown our capital base by 12%.

The key drivers of increased return to shareholders over time are our consistent earnings, our strong capital ratios, and a strategy that is consistent with evolving regulatory requirements.

Finally, let me address returns.

Our focus remains on generating higher returns for shareholders by improving our ROE to sustainable levels that exceed our cost of equity, independent of market conditions.

We see a clear path to an ROE of 10%, based on the levers we've just described to you, all of which are within our control.

To summarize, this includes achieving our wealth management margin target, executing on our Bank strategy, completing our exit from our physical oil business, progress on our optimization of fixed income, continued focus on disciplined expense management, and continued CCAR capital approvals.

We also see higher than 10% returns with an improved rate environment; improved global economic growth, which in turn drives our wealth management and institutional securities business performance; and higher pay-out ratios reflecting higher capital returns.

Now that we've finished the broader strategic discussion, let me return to Ruth, who will walk through the details of the fourth-quarter performance and where we finished 2014.

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.

Results for the fourth quarter include several significant items which complicate comparisons to prior periods.

They include: a net discrete tax benefit of $1.4 billion, or $0.70 per diluted share, principally related to the restructuring of a legal entity; compensation expense adjustments of approximately $1.1 billion, or $0.40 per diluted share, related to changes in discretionary incentive compensation deferrals; a pre-tax charge of $468 million reflected as negative revenue, or a loss of $0.17 per diluted share, related to the initial incorporation of funding valuation adjustments, FVA, into the fair value measurements for certain over-the-counter derivatives; and legal expenses of $284 million, or a loss of $0.12 per diluted share, associated with several legacy residential mortgage-related matters.

In addition, the impact of DVA in the quarter was positive $223 million, with $161 million in fixed income sales and trading, and $62 million in equity sales and trading.

Excluding the impact of DVA, but reflecting the impact of $468 million related to FVA, Firm-wide revenues were $7.5 billion, down 13% versus the third quarter.

Earnings from continuing operations applicable to Morgan Stanley common shareholders, excluding DVA, were $783 million.

Earnings from continuing operations per diluted share, excluding DVA, were $0.40 after preferred dividends.

Earnings from continuing operations include the impact of the previously mentioned funding valuation adjustment, net discrete tax benefit, compensation expense deferral adjustments, and legacy residential mortgage-related matters in the quarter.

On a GAAP basis, including the impact of DVA, Firm-wide revenues for the quarter were $7.8 billion.

Earnings from continuing operations applicable to Morgan Stanley common shareholders were $928 million.

Reported earnings from continuing operations per diluted share were $0.47 after preferred dividends.

Book value at the end of the quarter was $34.62 per share, and tangible book value was $29.63 per share.

Turning to the balance sheet: Total assets were $808 billion at December 31, down from $815 billion at the end of the third quarter.

Deposits as of quarter end were $134 billion, up $9 billion versus Q3, reflecting the on-boarding of deposits from Citi, and typical seasonal increases in client cash.

Our liquidity reserve at the end of the quarter was $193 billion compared with $190 billion at the end of the third quarter.

Turning to capital: Although our calculations are not final, we believe that our common equity tier 1 transitional ratio will be approximately 14.2%, and our tier 1 capital ratio under this regime will be approximately 15.9%.

Basel III transitional risk weighted assets are expected to be approximately $423 billion at December 31.

Reflecting our best estimate of the final Federal Reserve rules, our pro forma common equity tier 1 ratio, using the Basel III fully phased-in advanced approach, was 12.4% at December 31, down from 12.7% in the third quarter.

Our pro forma standardized ratio was 11.7%, flat to the third quarter.

Pro forma fully phased-in Basel III advanced RWAs are expected to be approximately $432 billion.

We estimate our pro forma supplementary leverage ratio under the US final rule to be approximately 5% at December 31, up from 4.9% at the end of 3Q 2014.

These estimates are preliminary, and are subject to revision.

Turning to expenses: Our total expenses this quarter were $7.9 billion, up versus the third quarter, reflecting the significant items I noted at the outset.

Compensation expense was $5.1 billion in the quarter, driven primarily by the change in compensation structure.

Specifically, the quarter includes an expense of $1.1 billion, representing $756 million related to the reduction in the average deferral of discretionary incentive compensation awards for the 2014 performance year, and $381 million for the acceleration of vesting for certain outstanding deferred cash-based incentive compensation awards.

This provides us with operating leverage in the upside, and reduced liability in the downside, as best evidenced by the reduced compensation ratio target for 2015 and beyond, that James noted.

Non-compensation expense was $2.8 billion for the quarter, up 13% quarter over quarter, driven by increased legal expenses.

Let me now discuss our businesses in detail.

In institutional securities, revenues, excluding DVA, were $3.2 billion, down 25% sequentially, and include a pre-tax charge of $468 million related to the initial incorporation of funding valuation adjustments.

Revenues, excluding the impact of FVA and DVA, were $3.7 billion, down 15% sequentially.

Non-interest expense was $4.3 billion, up versus the third quarter.

Compensation expense was $2.4 billion for the fourth quarter, up 37% versus the third quarter, driven by the previously mentioned compensation expense deferral adjustment.

Non-compensation expense for the fourth quarter was $1.9 billion, up 23% versus the third quarter, driven by increased legal expenses.

Including the impact of DVA and FVA, revenues were $3.4 billion.

In investment banking, revenues of $1.3 billion were down 3% versus last quarter.

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

Notable transactions included: in advisory, Morgan Stanley continued its leadership position in cross-border and large transactions, including as lead financial advisor to Cubist Pharmaceuticals in its announced $9.5 billion sale to Merck.

In equity underwriting, Morgan Stanley, as sole book runner, completed a $4.7-billion, H-share follow-on offering on behalf of China-based insurer, Ping An Insurance Group.

In debt underwriting, Morgan Stanley acted as lead left book runner on Alibaba's $8-billion inaugural senior notes offering.

This was a landmark deal; the third largest debt IPO globally, and largest bond transaction for an Asian issuer ever.

Advisory revenues of $488 million increased 24% versus our third-quarter results, driven by increased revenues in EMEA and the Americas.

Underwriting revenues of $807 million decreased 15% versus our third-quarter results, driven by equity underwriting revenues of $345 million, down 26% versus the third quarter, reflecting lower volumes in Asia and the Americas.

Fixed income underwriting revenues of $462 million, down 5% versus the third quarter, primarily due to decreases in investment grade loans, partly offset by increased issuance in both investment grade and high yield bonds.

Equity sales and trading revenues, excluding DVA, were over $1.6 billion, down 9% compared to last quarter.

Cash equities and derivatives revenues were down sequentially due to a more challenging market environment.

Revenues in prime brokerage were flat versus the third quarter.

Fixed income and commodities sales and trading revenues, excluding DVA, were $133 million, down significantly versus the third quarter, primarily reflecting a pre-tax charge of $466 million related to the initial incorporation of FVA into the fair value measurements of certain over-the-counter derivatives.

Revenues, excluding DVA and the pre-tax charge related to FVA, were $599 million for the quarter.

Commodities revenues were challenged in the quarter, due primarily to the decline in oil prices.

Credit revenues in the quarter were down versus the third quarter, driven by a difficult market environment.

Average trading VaR for the fourth quarter was $47 million, up from $42 million in the third quarter.

Turning to wealth management: Revenues were $3.8 billion in the fourth quarter, up 1% sequentially.

Asset management revenues of $2.1 billion were flat to the last quarter.

Transaction revenues were up 7% compared to last quarter, consisting primarily of commissions of $573 million, up 14% to the prior quarter, driven by a pick-up across most products; investment banking-related fees of $173 million, down 23% versus last quarter, primarily reflecting lower activity in closed-end funds; and trading revenues of $230 million, up 24% versus the third quarter, reflecting higher revenues from deferred compensation plans.

Net interest revenue increased 4% to $625 million, driven primarily by higher revenues from our bank deposit program, and continued growth in our lending product.

Other revenue of $67 million decreased 40% versus the third quarter, primarily due to the absence of the gain on sale of a retail property space we discussed in the third quarter.

Non-interest expense was $3.1 billion, up 3% versus last quarter.

Non-compensation expense was $777 million, down from last quarter.

Compensation expense was $2.3 billion, up versus the third quarter, primarily due to the compensation expense adjustments related to changes in discretionary incentive compensation deferrals previously mentioned.

The compensation ratio was 60%, up versus the third quarter, reflecting the change in compensation structure.

The PBT margin was 19%, which similarly reflects the impact of the change in compensation structure.

Profit before tax was $736 million.

Total client assets exceeded $2 trillion.

Global fee-based asset inflows were $20.8 billion.

Fee-based assets under management increased to $785 billion at quarter end, representing 39% of client assets.

Global representatives were 16,076, essentially flat to the third quarter.

Deposits in our bank deposit program were $137 billion, up $8 billion versus the third quarter.

Approximately $128 billion were held in Morgan Stanley banks.

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

Investment management revenues of $588 million were down 12% sequentially.

In traditional asset management, revenues of $432 million were down 8% versus the third quarter, driven in part by lower market levels.

In real estate investing, revenues of $103 million were down compared with the third quarter.

Merchant banking revenues were $53 million, down 38%, driven by the absence of investment gains versus the third quarter.

Non-interest expenses were $594 million, up 25% from the third quarter, including compensation expense of $381 million, reflecting the compensation expense deferral adjustment mentioned previously.

Non-compensation expense was $213 million, down 4% from the third quarter.

Profit before tax was a loss of $6 million in the fourth quarter.

NCI was $12 million versus $18 million last quarter, and total assets under management increased to $403 billion, driven by higher flows, primarily offset by market depreciation.

Finally, our outlook is consistent with data that suggests ongoing growth in the US, and the expectation that key markets outside the US will benefit from central bank support.

Both should benefit client activity levels, particularly in the sales and trading businesses.

In investment banking, the M&A pipeline is up, driven by continued strength in large and cross-border M&A, where we are well positioned, given our global franchise.

The global equity underwriting pipeline remains similarly healthy, benefiting from broad-based global activity.

The pipeline also includes additional issuance from transactions that were deferred to the first half of 2015 during the market choppiness of October.

In wealth management, which is overwhelmingly US-driven, our outlook is also positive.

Our margin target indicates upside in the business, and underscores confidence about the state of, and growing contribution from, the execution of our bank strategy.

As James noted, lower funding costs continue to provide upside in revenues for our sales and trading business.

Regarding the regulatory environment, through all the actions we have taken in the last five years, we are well positioned to deal with the requirements we face.

With the strong capital and liquidity ratios we have built, we have great flexibility to deliver for clients and stakeholders.

Thank you for listening.

James and I will now take your questions.

(Operator Instructions)

Your first question comes from the line of Brennan Hawken with UBS.

Please go ahead with your question.

Good morning.

Quick question on the outlook and the strategic update, which is much appreciated.

The potential to take FIC RWAs to $155 billion based on the passive roll down, what sort of time line should we use to think about that?

So the target as we indicated is $180 billion by year end 2015.

That includes the additional $25 billion of runoff over time.

That additional $25 billion will run off through 2018.

So that would take us to the $155 billion, unless of course we find opportunities to reinvest within fixed income as James said at attractive ROE.

So that's over 2018.

Got it.

Thank you.

If you guys find that FIC returns sort of remain at current levels, we kind of get this current environment proves to be a bit more of the steady state rather than what many of us are hoping is a cyclical weak point, how low can that number go beyond that if you find that you need to allocate more money over to the equities and the wealth management from a capital perspective?

We have ample capital and so we are supporting the client demand and activity in the equities business and don't want to leave you with the final comment you made, which is to -- is there a tradeoff between the two.

So very importantly, given the strong capital positions and given the strength and importance of the equity business to us, we have ample capital to support client activity there and are.

As it relates to fixed income, our approach has been as we've said repeatedly, to be very clinical about capital balance sheet expenses and that was the main point that we made here this morning.

We've reduced each of those in 2014, and we remain very focused on how to drive returns in the business.

So being very diligent on that.

Okay.

All right.

Thanks for that.

On FIC, there is a change of leadership in the commodities business.

Is that indicative of a new direction for that business?

And then also as we think about the commodities business, is it possible that the overall business there has been impacted by the sort of drawn out sale process of the physical business?

Brennan, I think we put in place a commodity strategy a couple of years ago which was completely independent of the regulatory environment we're in, which was essentially we did not want to be a significant player in physical businesses.

The largest physical space we had was in oil, and we competed the TransMontaigne deal and we're well under way to complete the rest of the sale when obviously it ran into other issues requiring government approval.

So we're still on that track.

So the management changes were completely independent of that.

These are big businesses.

Management evolve in companies of this size periodically.

So I wouldn't read a great deal into that.

We're well on track with commodities with where we wanted to be.

Did it affect the performance of the business, the fact we're in the sales process?

I can't really say whether it did or didn't.

Certainly I wouldn't say materially.

I think much more material was what was actually going on in the oil markets in the last several months.

We didn't have a good fourth quarter in commodities.

It happens; it's probably our most volatile business segment.

I don't expect that to be a permanent state.

Okay.

Thanks for all that color.

And then last on capital markets, you guys highlighted lower revenues in derivatives and cash.

Was there anything episodic impacting those businesses?

Because we heard some of the competitors highlight some strength in some of those businesses, especially cash recently.

No, I would say that overall client franchise remains strong and so we're continuing to see good levels of activity.

Cash tends to be seasonal as you wind out the year.

So no, I wouldn't call out anything in particular.

Choppier markets are more challenging for derivatives.

Sure, sure.

Okay, that's helpful.

And then deferred comp.

I think you guys weighed out -- I know that it can sometimes impact both the revenue and expense line in wealth management, changes in the deferred comp.

Did we -- can you quantify that for us, and did that impact the pretax margin in wealth management this quarter, aside from the noise that was going on in the change in deferrals.

You just said it.

The key point in the margin was really the change in the structure of compensation.

It's usually PVT margin neutral.

No, it didn't -- the main point was the change in structure.

Okay.

Terrific.

Thanks very much.

Thank you.

Thanks Brennan.

Your next question comes from the line of Glenn Schorr with Evercore ISI.

Please go ahead with your question.

Thanks.

So you noted the legal on the quarter.

I'm curious if you had handy the all in legal cost for the year and if it's right for us.

Because I am thinking about lot less next year, given that mortgage put to bed, You're not a LIBOR setting bank and obviously had a limited FX business.

The full year legal related expenses for 2014 were around $600 million.

And you think I'm crazy I'm thinking for next year?

The point we've made consistently is that litigation from the crisis isn't resolved.

It remains a headwind.

Appreciate the question.

It's tough to forecast, neither the timing or amount is fully in our control.

So appreciate the question but that's about all I can say.

So I like the slide on the lower funding cost.

I think lots of -- are benefiting, you're benefiting maybe a little more than most.

Can you put that in a dollar term for us in terms of what it means for next year, the year after?

I understand it's fallen and it's a pretty dynamic conversation.

I'm just curious of its dollar.

Well we realized the benefit over time given the weighted average maturity of our unsecured stack is about six years.

So as we refinance out of that we'll leg into it over time.

At this point we're refinancing some of the debt we issued post crisis.

And that's why I wanted to give you the trajectory and overall the trend line.

All right.

Two other cleanups.

One, clean comp ratio for 2014 for ISG?

There's a lot of -- ex all the FVA, DVA and comp charges.

Right.

So full year, excluding all of those, it's full year about a point.

Around to is that 40, 41?

Yes, full year --

41.

41, down from 42 last year.

Got it.

Okay.

And then last one, on the positive front the fee based flows were huge for any quarter.

Fourth quarter, I don't remember being usually a big quarter for it, usually think of it as more beginning of the year, if there was any seasonality to it all.

The questions is, has anything changed incentive wise or new product wise or is it just a continuation of the process?

No, we had strong flows during the fourth quarter and the full year.

There can be some lumpiness, as we talked about last quarter, but continued strength in it as you appropriately said.

You look at it full year and it's very strong and it underscores the point that James made which is that there's a strong secular trend here, and we benefit from it given the scale of the business we have and the breadth of products, content, and service we're providing.

Okay.

Thanks, Ruth.

Your next question comes from the line of Guy Moszkowski with Autonomous.

Please go ahead with your question.

Good morning.

Good morning.

Just trying to read into the ROE chart at the end of the strategic presentation.

Last year the baseline was 9%.

This year the baseline number you build off is 10%.

Is it really just that the 10% baseline now includes higher confidence on capital actions?

Is that the main difference?

Or should we be saying that there is a material underlying increase when all the puts and takes are taken into account?

I'm glad you pointed it out because we do think it's important.

There are a number of items that are reflected in that.

I would say the change in compensation structure is a contributor as well, and so James laid out the various items and as you know, this is without the benefit from a rising rate environment.

So it's from what we see the upside wealth management and the banks, it's incorporating the revenue benefit from lower funding costs.

We're continuing to make progress in fixed income, all that we're doing on the expense side.

As I said, that compensation structure change is important and did allow us to reduce the comp ratio in ISG to 39% or lower.

That's in a flat revenue environment.

So with better revenues we have even further operating leverage, but that's an important point.

And with all the steps we've taken over the last several years, the expectation about continued increases in returns of capital.

So we've made some tough choices, appreciate it complicated some of the comments this morning, but made these tough choices, it did have a negative impact on the quarter, but sets us up well and that's why we put it in here as we're modeling it at 10%.

I would just add, Guy, that what we've always tried to do is when we've had clarity of vision on something is to lay it out there for our shareholders.

And we have much more clarity of vision around the 10%, frankly.

And as Ruth said, because of all the things that we've checked off and some of the things we put behind us and the change in the comp and where we are with capital, much more clarity of vision.

When we see something that we think is clearly achievable that's what we're going to put out for shareholders, and we've also identified that there is obviously upside.

It's dependent on some things which are less within our control, but are not unreasonable to expect at some point in the future.

And is that additional upside about the same as it was last year?

Obviously all we have is a hopefully proportional hunk of a bar chart to compare it against, but it appears that that's largely unchanged.

I wouldn't draw too much into our graphic skills and ratios of bar sizes.

No, I think we're saying we clearly see an improved rate environment.

We're in a business mix that we think does well with the improving global economy, and we're overweighted to the US because of wealth management, which as we all know is doing best among the developed countries on a risk adjusted return basis.

And we clearly see additional capital returns because we're hitting all the capital ratios that we've talked about.

Got it.

And just as a follow-up on the capital ratios, thank you, Ruth, for the fully phased figures on both advanced and standardized.

Why did the advanced come down a little bit?

So as you know, we're governed by standardized, as flat under standardized.

The RWAs under the advanced approaches were up for a couple of reasons primarily due to volatility, but also lending growth and an ops risk growth in there.

So those were up.

It was really RWAs up.

Got it.

On the oil business, which as you pointed out ran into a roadblock because of the Russian situation in terms of trying to sell it, what's the outlook there and if it's not sold would you look to wind that business down and over what time frame?

So we do remain focused on selling it, the business, and we'll let you know when we have something to say on that.

We are clearly intent of getting out of the physical oil business.

We made that very clear.

We had a contract for sale.

We couldn't complete for reasons outside of our control.

We will get out of the physical oil business.

And I guess the question was really around if it's harder to sell in the current environment and you need to wind down elements of it, what kind of time frame should we be thinking about?

We actually don't see -- if question is really with lower oil does that affect the sale of the business, we don't see it negatively affecting the sale.

We have excess storage capacity.

So that actually sets the business up well to benefit from rising oil prices using capacity at these levels and benefiting as oil prices rise.

So it doesn't affect the sale process.

That's helpful color.

On the FIC target, just with the runoff down to the $155 billion, and this is maybe a subtle change in what you're communicating but I want to make sure I understand it.

I think you had said previously that as you got down to the $155 billion, $160 billion level from the runoff, you would look to redeploy within FIC to the $180 level billion.

But now it sounds like you are leaving the options open to redeploy more broadly across the business.

Is that right?

And if so what drives the thinking?

That is correct.

And what we're saying is, look, there have been structural headwinds in the industry.

There have been some cyclical ones as well.

We have a clear plan that includes the reductions in balance sheet capital and expenses that we've talked about, and we just want -- what we're saying is we're being very clinical here, which is we're targeting $180 billion.

There's another $25 billion that comes off.

And the right, prudent thing to do is to stow into the business is to ensure we put that incremental capital capacity to support the highest return businesses, highest return products.

And if that's within fixed income where we already have some products that are generating attractive returns, such as in corporate credit and securitized products and there's client demand for incremental capital, that's an opportunity.

But we will look across the franchise.

And so you're right, I'm glad you drew that out.

It is a change.

We just want to make it very clear how we're approaching it.

Good.

Well, I think your shareholders probably appreciate that flexibility.

So that's good to understand.

In terms of the reduction in the ISG comp target, is all of that reduction to 39% or less due to the change in the deferral strategy, or is there actually a view that in the current environment you can reduce the comp payout?

It is due to the change in the comp structure.

It was an important step for us to take.

It gives us as we said, reduced liability in the downside, importantly operating leverage in the upside by pulling forward future deferrals and changing the deferral rate.

It enabled us to set that compensation ratio at 39% in a flat rate, flat revenue environment with an operating leverage, a lower comp ratio, and a better revenue environment.

And we think underscores the importance of that change.

Cool.

And then just one final one from me on the legal cost this quarter.

Was that essentially a litigation reserve build because of things for which you had estimable and probable?

Or was it actually cleanup of current quarter expenses?

And if so can you give us a little color on what they were?

Reserves as you just said are based and estimated each quarter based on FAS 5, so probable and estimable.

Got it.

Thank you very much.

Appreciate it.

Thank you.

(Operator Instructions)

Your next question comes from the line of Mike Mayo with CLSA.

Please go ahead with your question.

Hi.

I was looking for more color on slide 15 with the ROE target.

And does this imply that going from 9% to 10% that if you have capital actions it could be 11%, and on a tangible basis it could be 12%.

Again, I'm just comparing this year's slide 15 with last year's slide 15.

Related to that, you talk about having a greater clarity of vision, but this also comes in a quarter where you missed consensus expectations.

So is this quarter a one-off in your mind, or how do you think about all that?

Firstly, the 9% to 10% reflects all of the things that are implied under the, or listed on the left hand side of that page, Mike.

It also talks about as the last of those receiving non-objection on our CCAR capital requests.

And what we've pointed out is that obviously in future years we see future upside as we make additional capital returns, as we're reshaping the balance sheet and reshaping the businesses.

So when we talk about clarity of vision, we're one year closer.

We're seeing real progress in the wealth management business with margin improvement of 200 basis points.

We expect progress to continue, which is why we set goals which are currently above where we're performing.

We see real opportunity in the lower funding costs.

It's clear that our bank strategy is being well executed and building the assets of the balance sheet.

And we're continuing to see roll-on of deposits et cetera, et cetera.

So we felt it was important to lay it out for shareholders.

And the time frame for this target?

Obviously we haven't given time frames on these targets because we can't control the market environment around us.

Okay.

Well some more specifics related to this.

In terms of higher interest rates, slide 6 you talk about the margin improvement, and you said your 22% to 25% Wealth Management pretax margin does not rely on higher interest rates.

Can you describe your interest rate sensitivity if rates did increase 100 or 50 basis points?

You're absolutely right.

This does not include the benefit of higher rates.

You can somewhat see the benefit of rates through the roll forward that we have on the bank slide.

We frequently discussed they're a real positive for us.

The factors to consider in that as you're modeling it out is we do generate higher net interest income even in a flat rate environment because we're still in relatively early stages of deposit deployment.

I think that's quite differentiated.

But in a rising rate environment, just the components again, it does drop meaningfully to the bottom line because of the cost structure of the banks, as James said, we've already invested in the infrastructure required.

We don't have bricks and mortar, FAs are not paid on the grid, all the things that we've talked about with you before.

What we did is we provided yield and asset mix to help you model the NII upside.

And we actually extended out the estimate of asset growth to 2016 on that slide.

Previously we had it out to 2015.

It builds on the strength of the performance in 2014.

In fact we ended prior to our estimate for 2014.

And I think you know the other couple of elements in it, but just no update on that.

So given deposits here are different from retail banks, they're very sticky, given the nature of deposits they're more like working capital, we continue to assume about a 45 basis point increase in deposit pricing with the first 100 basis point increase in rates.

We do believe that model's conservative, given the nature of our deposits and structural changes and deposit alternatives.

Fed funds, it continues to be the most relevant rate for our business, and the average duration of bank assets is around a year and a half.

So again rising rates benefit us quickly.

The point on the bank slide it really was to extend it out so that you can model in the benefit as you see -- as you estimate rising rates.

What is your efficiency ratio for the bank, since you're talking about that, your expense to revenue ratio?

Because you highlighted the fact you don't have bricks and mortar.

I assume the efficiency ratio would be better than the typical bank.

We don't break that out separately, but you're absolutely right, which as Larry said it drops meaningfully to the bottom line.

It's obviously better because the whole strategy around the bank is driving more throughput through an existing branch structure.

And then lastly, you highlighted compensation.

So did I hear you correctly that the compensation expense should decline from 41% on a core basis in 2014 to 39% or less in 2015?

Is that correct?

Correct.

And as far as --

And that's in a flat revenue environment, yes.

And James, you've been very vocal in the past.

I guess in hindsight giving a lot of stock to people at much lower stock prices worked, but can you talk about the tradeoff between paying your people and then meeting Wall Street expectations?

In other words, getting the desired earnings growth.

There's talk about people from brokerage firms going elsewhere such as private equity.

How do you manage that tradeoff?

Well, firstly, Mike, I'm delighted for all of our shareholders that the stock has appreciated 26%.

I think last year, 60% something, the year before ran 25%, the year before that, including our employees who frankly deserved it.

They're the ones who rode the boat.

They got the job done and they deserved it.

So no qualms about the employees benefiting from the rising stock.

Listen, it's a balance.

What we did coming out of the crisis was we deferred up to 100% of our employees' bonuses.

We did that for a very specific reason and it's an unnatural act at 100%.

We recognized that and we were working our way down over a period of years to 50%, and we decided to bite the bullet and get it done in 2014 and bring ourselves back where we think the industry will settle, which is at 50% deferrals.

We are still high relative to our competitors, certainly from a shareholder perspective it remains a very friendly concept.

It continues to tie our employees into the firm, which is what we want and what they want as evidenced by low attrition.

And no, I'm not concerned about the onesies and twosies who choose to go into different parts of the financial sector.

We get a very attractive employee base coming to this firm, and frankly it's just not an issue.

All right.

Thank you.

Thank you.

Pleasure.

Your next question comes from the line of Jim Mitchell with Buckingham Research.

Please go ahead with your question.

Good morning.

I just wanted to follow up quickly on the funding costs trajectory.

I guess first, is there any -- you highlight down 25% by 2016.

Is that a presumption of the rate environment or is that pretty much locked in?

Just how should we think about that net benefit?

So the funding cost reduction reflects the forward curve.

So it builds in those higher rates.

With respect to rate moves, we do swap our debt to floating because our assets are floating.

But it spills off the forward curve.

Okay.

But any change in the forward curve would have an impact on that assumption?

Yes.

And when we think about the funding cost target, if we just look at your interest expense from last year, which I think was about $3.7 billion, that's how we should think about the 25% reduction off that $3.7 billion?

No, there are obviously a number of components in that.

It's not quite as straightforward as that.

It would be a little less than that?

You're not going to help us, okay.

You do the modeling.

And was there any meaningful CVA this quarter?

CVA was a bit of a drag this quarter and last year a positive of last quarter.

But just a bit.

Okay.

All right, that's it from me.

Thanks.

Thank you.

Your next question comes from the line of Michael Carrier with Bank of America.

Please go ahead with your question.

Thanks.

First question just on the FIC outlook for the RWAs, just wanted to see if you had any I guess lost revenues related to going from the $180 billion down to, say, the $155 billion?

One of the points we've made over time is that these are basically call them dead weight.

It's really dead weight capital in that it's supporting assets that aren't generating revenue.

We're funding old positions.

So they're negative ROE now.

And as they roll off they go from negative ROE to neutral, to zero, and the objective is then to take that excess capital and put it behind client activity and areas that are most accretive to the overall franchise.

But the most important point is they're negative ROE because they're -- it's really just the financing costs on these long dated positions.

Okay.

And then just on expenses, for the legal the $284 million, I just wanted to be clear because it seems like each quarter there's some legal costs obviously at the firm.

But is this just related to the residential mortgage matter?

Or is that everything in the quarter?

And if it wasn't, just what was your -- kind of your normal legal in the quarter?

So what we called out was as we said related to the residential.

Okay, got it.

And then last one.

Just in terms of where your CT1 ratio is, just given that we had the buffers out there, where do you expect to run the ratio longer term?

And then based on the Basel and SFR, any update or any guidance in terms of how you guys stand?

So in terms of the buffer on the various ratios, we're in a very strong position as I said, fully phased in standardized 11, 7, advanced12, 4, well above requirements even with estimates of what may occur with the incremental buffers.

And at this point given these are required over time, not going to start quantifying a buffer above that.

But we've got a -- we're running substantially above the requirement which is again consistent with our view that we have capacity to continue to return capital.

As it relates to the net stable funding ratio, we're above 100% as currently proposed by Basel.

Obviously still awaiting the final US rules.

You've probably heard me say all too often that we firmly believe that durability of funding is imperative and that's how we run the firm.

One concern about the rule is that it actually isn't proper ALM, and certain transactions which create liquidity in practice are consumers of liquidity under the NFSR construct.

I think it's notable that this element of the rule has been left to national regulators to tailor in the final rules.

But short answer to your question, we're in a strong position with NSFRs as it stands and that keeps us in a strong position to deliver for clients.

Okay.

Thanks a lot.

Thank you.

Your next question comes from the line of Steven Chubak with Nomura.

Please go ahead with your question.

Hi, good morning.

Good morning.

James, you noted in your discussion on FIC that in addition to shrinking RWAs you also managed to shrink actual FIC balance sheet assets.

And when looking at the product level of commentary or disclosure that you provided it does appear that the businesses that are actually generating returns below their cost of equity are more concentrated in those areas like global rates where they're more balance sheet or leverage intensive than risk insensitive.

I just wanted to get an understanding as to how much more optimization potential we could see on the asset side of the equation that could help improve returns over the next couple of years?

Well, let me take that.

A couple of points.

Year over year, we had a sizable decline in our balance sheet, and just that is at the same time that we were increasing deposits.

We've had this ongoing contractual on-boarding of deposits supporting our lending business.

What that really reflects is optimization in trading businesses and that's primarily within fixed income.

We are continuing to have a tight lens on balance sheet as we go into this year.

There is some growth from deposits and -- but we're very focused on making sure to the heart of your question that we're using all assets, all resources where we can drive the strongest return, and that's been part of the optimization on balance sheet to date.

I think the other point is as I noted our FLR is at 5%.

So we've been -- we're in a good spot.

We said we'd be there in 2015.

We're here as we ended 2014.

And again, that gives us -- so we've got ample opportunity and what we're looking at is how to drive returns.

Thanks, Ruth.

And then just one more question on ISG, actually switching over to the expense side.

I appreciate the disclosure on the comp targets for 2015 assuming a flat revenue environment.

I was hoping you could give us some color as to what the non-personnel ratio should look like ex-legal in 2015, also assuming that you have a flat revenue environment for the coming year?

I don't have that with me.

Okay.

And then just one quick final one on wealth management.

Did appreciate the disclosure on the yield opportunity for the bank, but just given your expectation as to how the funding or liability profile will evolve, what's a reasonable expectation for what the NIM trajectory should look like over the coming years?

Not just assuming a flat revenue environment but also contemplating the future yield opportunity that you highlighted on the asset side.

So the reason we laid it out as we did is we wanted to give you the growth in the slide that James went through on the bank as we also broke out the split between deposits supporting growth in institutional securities versus wealth Management.

We're seeing growth in both and we laid out the yields so that you could actually -- you could model it out over time.

Okay.

Understood.

Thank you for taking my questions.

Thank you.

Your next question comes from the line of Matt O'Connor with Deutsche Bank.

Please go ahead with your question.

Good morning.

Good morning.

I was just hoping to follow up on the timing of the 10% ROE target.

You talk about relatively stable macro trends in terms of trading, investment banking, so seems like it's more about execution and call it the passage of time specifically in FIC.

I guess as you think about the timing, is this a 2015 target?

Is this a five-year target?

Just trying to push a little bit on this.

Look, as James said we've given you the key drivers of it and are not putting a date on it.

But you see the key drivers of it and certain of the steps that we took as we ended this year, put a fine point on certain of the elements that will drive ROEs, ROE higher.

For example the change in comp structure enabling us to take down the comp ratio and some of the other elements that we've delineated.

I'll be repetitive I go through.

We're not putting a date on it, but you can see the actions we've taken to give you your clarity about execution against them.

I can promise you one thing, though.

It's not a five-year target.

Okay.

And then in terms of the capital against it, obviously you've got probably more than you need on the Basel III ratio, the SLR could be the constraining factor for you guys and the peers.

How do you think about how much SLR you need to run, and is there some opportunity to optimize that more so than say the Basel ratio?

Well at this point as you said we've got a strong excess above requirements on risk-based capital.

And given the FLR it's not required until 2018, as I just said we were looking to get to 5% in 2015 and here we are at 5% now.

We don't view that as a constrain on our ability to return capital.

At this point there continues to be opportunity to mitigate as really primarily in reduction of the gross-up in the balance sheet, net long CDS sold, and compression activity, obviously the ratio will continue to benefit from earnings but more in the gross-up on the balance sheet.

When you look across the ratios given all that we've done with the business and given the strength of where we stand today on capital, that's why our view is we set ourselves up well to continue to steadily increase returning capital over time.

Our philosophy is no discontinuous moves but steady increases over time and that's what we remain focused on.

Okay.

And then just separately a follow-up question on the changes to the comp structure.

Am I thinking of it correctly that essentially taking the charge on the cash, deferred cash piece, that will benefit you the most in the early years and then less in the later years?

It will continue to benefit us.

Both of them benefit us and that's why we are resetting the comp ratio here today for IOC.

Thank you.

Thank you.

This concludes the question-and-answer session.

Please proceed with any closing remarks.

Thank you for joining us for our fourth-quarter conference call.

We'll look forward to speaking to you again in 13 weeks.

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

Thank you for your participation.