Northern Trust Corp (NTRSO) 2012 Q3 法說會逐字稿

Good day, everyone, and welcome to the Northern Trust Corporation third-quarter 2012 earnings conference call. Today's call is being recorded. At this time, I'd like to turn the call over to Director of Investor Relations, Bev Fleming, for opening remarks and introductions. Please go ahead.

Thank you, Tim. Welcome to Northern Trust Corporation's third-quarter 2012 earnings conference call. Joining me on our call this morning are Mike O'Grady, Northern Trust's Chief Financial Officer, Rick Kukla, our Controller, and Allison Quaintance from our Investor Relations team. For those of you who did not receive our third-quarter earnings press release or financial trend report via e-mail this morning, they are both available on our website at NorthernTrust.com. In addition, and also on our website you'll find our quarterly earnings review presentation, which we will use to guide today's conference call. This October 17th call is being webcast live on NorthernTrust.com. The only authorized rebroadcast of this call is the replay that will be available through November 14th. Northern Trust disclaims any continuing accuracy of the information provided in this call, after today.

Now for our Safe Harbor statement. What we say during today's conference call may include forward-looking statements, which are Northern Trust's current estimates and expectations of future events or future results. Actual results, of course, could differ materially from those indicated by these statements because the realization of those results are subject to many risks and uncertainties. I urge you to read our 2011 Annual Report, and our periodic reports to the Securities and Exchange Commission for detailed information about factors that could affect actual results. Thank you again for joining us today. Let me turn the call over to Mike O'Grady.

Thanks, Bev. Good morning, everyone, and welcome to Northern Trust's third-quarter 2012 earnings conference call. This morning, we reported third-quarter earnings per share of $0.73 and return on equity of 9.6%. Our results were consistent with last quarter, and improved over last year. We continued to see trends similar to previous quarters.

A few overview comments. First the addition of new business is increasing our asset levels and trust fees. Winning mandates and gaining new clients is the primary driver of growth for Northern Trust over time, and we continue to be successful at achieving this. Second, the mixed macro environment continues to pose challenging operating conditions. The equity markets rebounded in the third quarter after having declined in the second quarter, and are up strongly compared to this time last year. This benefited our client asset levels, with assets under custody ending the third quarter at $4.8 trillion, up 4% sequentially and 14% year-over-year and assets under management ending at $750 billion, up 6% sequentially and 16% year-over-year. Given our trust and investment fees are generally calculated based on a lagged asset value, the weaker market performance in the second quarter generally had a dampening effect on third-quarter fees. However, rising markets clearly impact us favorably over time.

Foreign exchange volatility and volumes deteriorated even further in the third quarter, as evidenced by the significant drop in our foreign exchange trade and income, which we'll discuss in more detail later. Interest rates also declined further in the quarter, with the European Central Bank lowering its rates in July and the Federal Reserve announcing incremental quantitative easing initiatives in September, we saw short-term interest rates decrease in many markets around the world and across most currencies. Low short-term rates pressure our net interest margin, and result in ongoing fee waivers in connection with our money-market funds.

Third, through our driving performance initiative, we continue to focus on improving the profitability of our business and enhancing our capacity for investment in future growth, regardless of the macro environment. We made further progress on this critical priority in the third quarter on both the revenue and expense fronts. By executing on our initiatives and managing costs closely, expense levels were lower both sequentially and year-over-year. As a result, our pre-tax margin increased to 28.2%, the highest level we've achieved since the second quarter of 2010.

Let's move to page 2 and discuss the financial highlights of the third quarter. Net income of $179 million and earnings per share of $0.73 were unchanged sequentially, and increased approximately 4% to 5% year-over-year. Compared to last quarter, revenues were down about 1%, and expenses were down 3%. Trust investment and other servicing fees were down 1% for our corporate and institutional services business, due to the seasonal decline in securities lending, and were flat for our Personal Financial Services business. Lower foreign exchange trading income and net interest income were partially offset by higher other operating income, which included a $5.3 million gain related to hedges of certain investments in our foreign currency denominated subsidiaries. The 3% decline in expenses was primarily the result of lower outside services and the write-off of certain software in the previous quarter.

Our return on equity of 9.6% for the third quarter was lower than last quarter, due to higher equity, and was just below our long term target range of 10% to 15%. On a year-over-year basis, revenues were flat and expenses were down 1%. Trust investment and other servicing fees, the largest component of revenues, increased 8%, but this growth was offset by lower foreign exchange trading income and net interest income. The decline in expenses was primarily the result of lower outside services. I'll also note that we recorded restructuring, acquisition and integration charges of $2.9 million in the third quarter compared to the $3.6 million last quarter and $4.2 million one year ago. We expect further charges in the fourth quarter as we complete the integration of the Bank of Ireland Security Services and Omnium acquisitions, and as we continue to execute on our driving performance initiatives.

With that background and summary, let me get into more details behind our third-quarter results, beginning on page 3. Trust, investment and other servicing fees were $602 million in the quarter, down 1% sequentially and up 8% year-over-year. As you can see, the performance was relatively consistent across the businesses. The addition of new business drove the healthy year-over-year growth, but was muted sequentially by the impact of lower lagged markets and other factors.

Looking first at CNIS, fees totaled,$334 million in the third quarter, which was also down 1% sequentially, and up 8% year-over-year. Let me explain some of the key drivers behind this performance. While equity markets were stronger in the third quarter, with the S&P 500 up 6% and the EFA up 4%, some of our custody and investment management fees are calculated based on a quarter lag methodology. Given that markets were down in the second quarter with the S&P 500 down 3% and the EFA down 7%, sequential performance was dampened by the quarter lag markets.

Looking more closely at the components, custody and fund administration fees for CNIS were $214 million in the third quarter, flat sequentially, and up 4% year-over-year. In the sequential quarter comparison, new business was unable to offset the impact of lower second-quarter equity markets and lower transaction volumes. The year-over-year increase was primarily the result of new business, offset partially by the adverse impact of weaker quarter lag international markets and a stronger dollar. Investment management fees for CNIS were $73 million in the third quarter, up 2% sequentially and 13% year-over-year. The sequential quarter increase reflects new business, primarily in index and mutual fund management. In the year-over-year comparison, new business and lower fee waivers drove the increase.

Waived fees associated with institutional money-market mutual funds and impacting CNIS were approximately $7 million in both the third and second quarters, and $10 million in last year's third quarter. Lower fee waivers on our institutional money-market mutual funds primarily reflect higher gross yields achieved in the underlying funds. Securities lending fees were $24 million in the third quarter, down 22% sequentially reflecting the traditional second-quarter impact of the international dividend season, which resulted in wider spreads last quarter. Securities lending fees were up 15% versus last year, as wider spreads more than offset continued weakness in borrower demand. Securities lending collateral of $98 billion decreased 2% versus last year, but was up 4% sequentially.

CNIS assets under custody were $4.3 trillion at quarter-end, up 4% sequentially and 14% year-over-year, while CNIS assets under management were $566 billion at quarter-end, up 7% sequentially and 18% year-over-year. We continue to be pleased with the pace of new business in CNIS, with the results in the first nine months of 2012 being our best ever.

Moving to our personal business, PFS Trust investment and other servicing fees were a record $267 million in the third quarter, up slightly on a sequential quarter basis, and up 9% year-over-year. The slight sequential quarter increase primarily reflects new business having been offset by lower estate settlement and tax preparation fees, which tend to fluctuate from quarter to quarter. The 9% year-over-year increase primarily reflects strong new business, the impact of the January 1 change in our fee structure, and lower fee waivers. Money-market fund fee waivers in PFS were $10 million in the third quarter, essentially unchanged from the second quarter. Waivers in PFS were down from $19 million in the year-earlier quarter reflecting higher gross yields achieved in the underlying funds, and a lower fee rate in our retail money-market family, which is effective on the first of the year. Fees for the PFS regions were flat sequentially as new business and a modest market impact was essentially offset by the lower estate and tax preparation fees. Recall that our PFS regions use a one-month lag methodology for fees, and on that basis, equity markets were up less than 1% on a sequential quarter basis.

Our global family office business, where we serve approximately 20% of the Forbes 400 most affluent families, reported a 1% sequential increase in fees, with new business offsetting the adverse impact of lower equity markets at the end of the second quarter. Global family office fees are calculated based on a one quarter lag methodology. PFS assets under management were $184 billion at quarter-end, up 5% sequentially and 13% year-over-year, reflecting higher equity markets and new business.

Total revenues, as summarized on page 4 include trust investment and other servicing fees which were down 1% sequentially and up 8% year-over-year. This growth was offset by declines in other revenue categories, particularly foreign exchange trading income, which was $44 million in the third quarter, down 26% compared with last quarter, and 49% year-over-year. The two primary drivers of foreign exchange trading income, client volumes, and currency volatility continued to trend lower. Consistent with reported market volumes, our client volumes were lower in the quarter. Daily average FX volumes as reported by ICAP were 17% lower sequentially, and 43% lower year-over-year, and were lower than any quarter since before the financial crisis. Likewise, volatility, whether measured for individual major currencies or by the broader VIX index, was lower by varying amounts sequentially, and by over 30% year-over-year. Our analysis suggests that with volatility across the major currencies is at the lowest level in five years.

Other operating income was $47 million for the quarter, which was up 36% sequentially, and 10% year-over-year. This line includes several items and tends to fluctuate. The sequential quarter increase was primarily due to the $5 million gain on foreign exchange contracts related to certain hedges that I mentioned earlier, as well as higher income on employee benefit assets held in trust, and higher commercial banking fees. The year-over-year increase also reflects the gain. All the other fee revenue categories collectively were down 1% sequentially, and up 8% year-over-year.

Net interest income was $257 million in the third quarter, down 3% sequentially and 4% year-over-year. Earning assets averaged $85 billion in the third quarter, up 2% sequentially and unchanged compared to last year. The net interest margin was 1.21%, down from 1.28% last quarter, and 1.25% last year. Excluding a $5 million adjustment for previously-amortized premium on certain investment securities, the net interest margin would have been 1.19%. The lower margin primarily reflects declining spreads in the Euro, Sterling, and Australian dollar. We also experienced lower yields on certain loan and lease categories, as new loans and leases are coming on our balance sheet at lower yields than those rolling off. The decline in yields was slightly offset by higher percentage of funding from non-interest bearing demand deposits. So in total, revenues on a fully taxable equivalent basis were $984 million, down 1% sequentially, and were flat year-over-year.

Now let's look at third-quarter expenses on page 5. Total expenses in third quarter were $696 million, 3% or $21 million lower than the prior quarter. Expenses were lower in equipment and software by 13%, outside services by 5%, and employee benefits by 6%. Recall that equipment and software had a $10.5 million software write-off in the second quarter. Absent the write-down, equipment and software would have been down 3% sequentially, primarily due to lower computer maintenance and depreciation, and lower software amortization.

Outside services reflect a decline in sub-custodian expense, primarily due to lower transaction volumes, as well as lower technical services. Partially offsetting these sequential declines was a 1% increase in compensation expense on a similar increase in staffing levels. Hiring in the third quarter was again concentrated in the Asia-Pacific region. Occupancy expense also increased by 3% sequentially, due to higher international rent expense. Expenses were down 1% year-over-year, primarily due to lower outside services and employee benefits expense. Good expense management resulted in an increase in our pre-tax margin to over 28% and we remain focused on the expense-related goals outlined in our driving performance initiative.

Let's move to page 6 for a brief update on driving performance. In January, we indicated our goal to improve pre-tax income by $250 million by the end of 2013, with over half the $250 million coming in 2012. In the third quarter, we produced approximately $45 million in pre-tax operating income improvements from driving performance initiatives. Increased benefits from revenue initiatives were primarily the result of successful pricing and cross-sell efforts in CNIS. On expense initiatives, we achieved greater benefits from the continued implementation of a variety of corporate-wide initiatives. This brings our 2012 in-year total to over $100 million, split roughly 40/60 between revenue expense items. Overall, we are pleased with the progress of our driving performance efforts and its contributions to our 2012 financial goals. Based on the results achieved to date, we remain on track to meet our 2012 and 2013 targets for driving performance. We believe that we will continue to successfully implement the initiatives to enhance our revenue and improve our productivity.

Let me make a few comments on the strength of our balance sheet which continues to differentiate Northern Trust through the challenging economic cycle. On page 7, we outline the three key components of earning assets, all of which have been managed conservatively. Our lending strategy represents $30 billion in earning assets and is focused on our clients with a majority of loans to PFS clients. While loan growth has been moderate through this economic cycle, we did grow loans by over $800 million compared with last year. Non-performing loans increased $29 million sequentially to $269 million at quarter-end, but were down $39 million year-over-year. The sequential increase reflects continued weakness in the commercial and residential real estate markets. Non-performing assets were 0.98% of total loans and other real estate owned, up from 0.89% in the second quarter.

Charge-offs were $16 million in both the third and second quarters. Recoveries, however, were $4 million in the third quarter, compared with $13 million last quarter reflecting uneven nature of resolving troubled loans. As a result, net charge-offs were $12 million in the third quarter versus $3 million last quarter. Our loan loss provision was $10 million in the third quarter, up from $5 million last quarter. As a result, the allowance for credit losses assigned to loans and leases was $299 million at quarter end, essentially flat with the prior quarter end, and representing 1% of total loans and leases, and 1.1 times our non-performing loans.

Our securities portfolio, which also has about $30 billion at quarter end, continues to be managed in high-quality fashion, with 91% of the portfolio invested in US Treasury, agency and AAA securities. The portfolio at quarter end had a maturity duration of a little over two years, and repricing duration of about one year, up slightly from last quarter. Interest-bearing deposits with banks at $19 billion, our third-largest earning asset category, continued to be managed conservatively as well. Duration remains short at less than one month on average. Euro zone exposures within this portfolio had been monitored and managed closely. At the end of the third quarter, we had less than $5 billion in exposure to banks in the Euro zone. We continue to place deposits with a select group of stronger banks at short tenders.

Capital, outlined on page 8, remained very strong with Tier 1 capital and Tier 1 common ratios at 12.8% and 12.3% respectively. We estimate that our Tier 1 common ratio under the Basel III advanced framework, as we currently understand the regulations, including the impact of the proposed rules issued by the Federal Reserve on June 7, would equal 13.1%, exceeding all anticipated requirements. Under the common stock repurchase authorization approved our Board of Directors in March, we repurchased approximately 1.1 million shares of common stock for $50 million during the third quarter. Under our capital plan reviewed without objection by the Federal Reserve in March, Northern Trust may repurchase up to an additional $140 million through the first quarter of 2013.

I would like to close by reiterating a few key points made during today's call. Although our financial performance in any given time period will be affected by macro environmental factors, we aim to create long-term value for our clients, shareholders, partners and the communities we serve by staying focused on executing our strategy, and remaining true to our enduring principles. Our third-quarter financial performance was consistent with the prior quarter, and improvement over last year's third quarter. We continue to execute on our strategy of growing our business by building on existing client relationships and adding new clients, while at the same time, focusing on improving profitability and returns through driving performance.

More importantly, through the first three quarters of this year, we've made solid progress towards our financial goals. Trust investment and other servicing fees are up 10%. Revenues are up 4%, despite a 35% decrease in foreign exchange trading income. We are on track to meet our driving performance targets for 2012. Our pre-tax margin has improved 100 basis points, earnings per share are up 10%, the return on equity is higher and approaching our long term target of 10% to 15%, our balance sheet and capital position remains strong, and we've returned an increasing amount of capital to our shareholders as the year has progressed.

Overall, thanks to the exceptional efforts of Northern Trust partners and support from our clients throughout the world, our core businesses, wealth management, asset management, asset servicing and banking are performing well, and positioned to continue to do so. Thank you again for participating in Northern Trust's third-quarter earnings conference call. Tim, please open the line for questions.

(Operator Instructions)

We'll take our first question from Alex Blostein with Goldman Sachs.

Wanted to just start off by focusing on expenses a little bit here. Looks like clearly a solid job this quarter with maintaining the dollar amount of expenses at a lower level. How sustainable is that? It sounds like there's still a good chunk of expense initiatives that are not in the run rate that we're going to get from you next year, so if you look at next few quarters and thinking about the absolute dollar expenses weighing in against business initiatives, et cetera, is this a decent run rate knowing what has to come through from the expense savings?

Sure. So on expenses as you point out, Alex we have been successful in managing our costs as we continue to drive the business. So as I talked about, our trust, investment and other fees up 8% year-over-year and yet our costs have been very much in line with where they were a year ago, and a lot of that is due to driving performance and executing on those initiatives. And as I mentioned we're $100 million into that and that's a mix between revenue and expenses, but we still have a number of initiatives that will bear fruit in 2013 and beyond, so we do expect to see the positive impact of driving performance in our expense run rate as we go forward.

Having said that, we also expect to continue to grow the business, and there are costs that are associated with growing the business, so as the business grows, expense levels will grow but on a relative basis. Our goal is certainly to have them grow at a slower rate than our revenue growth. The other thing I would say as far as run rate, from any quarter-to-quarter comparison, there are various categories that do fluctuate. As I mentioned, outside services, a category that we had an improvement in this quarter and that included sub-custodian expenses. That's a category for example, which can fluctuate with transaction levels and be seasonal, so it's not something where I would say quarter-to-quarter every line item is going to move exactly the same.

Got you, helpful. And then my second question was on how you are thinking about net interest income. I know there's a few things that tend to move around between excess deposit, et cetera. But focusing on NII as opposed to the NIM, can you just give us your updated thoughts on when you think potentially either extended duration or reshuffling some of the buckets? You have 30% of your balance sheet basically in cash or sitting with other banks, so when you think about NII and the outlook, knowing what you see the interest rate backdrop, is there anything you could do or planning on doing to protect just the actual NII as opposed to just thinking about the NIM?

So as you know, obviously, the net interest income is a product of the average earning assets and our NIM, and on the average earning assets side, you've seen that our level of assets has been relatively consistent over the last few quarters here and that is because our balance sheet, as we talk about often, is driven by our clients and the deposits that they place with us, and then we then turnaround and try to deploy those on the asset side. And we've been in this environment where there hasn't been much activity one direction or another, and I think that it's difficult at this point to really look out and determine what direction that could go, when you have situations such as the fiscal cliff, you have TAG at the end of the year which may or may not go away. It's difficult to determine whether our clients will place more deposits with us, or if they will look to do other things, because they are more comfortable with the environment. So that's the first part of it.

Now within that, the mix of earning assets and how we deploy those, certainly to the extent that we can provide credit to our customers, to our clients, that is a priority. It's a priority, one, because it is clearly a service and product that they value, but also just from an earnings standpoint with the yield on that overall being, in this quarter, 2.85%, that's the highest earning category for us out of the three. The securities portfolio is one where we have tried to maintain the yield on that portfolio through a very difficult and decreasing interest rate environment, and we saw further pressure on that in the quarter. Now we do try to manage it in a way to keep our income levels at where they've been, and you did see us extend our duration in the quarter, so this quarter, our index duration was one year, which is up from about 10 or 11 months last quarter, and if you look back to last year, it was closer to eight months. So we have been comfortable, given the outlook for interest rates to extend our duration, but we're going to be prudent about how we continue to do that. But that's one thing we can do and have done.

And finally the last category is the one, frankly, where we probably have the least amount of control to manage what we're doing there, and that is with our bank placements, because those are so short-term in nature, where we're taking deposits primarily from our custody clients, and then we're looking to place those with other institutions on a short-term basis. And there, the maturity of that, the average maturity is closer to a month, so it's very short, and we are much more subject to short-term market rates, so what we saw in the quarter was clearly a decline in the spreads on those deposits. If you look at that I'll call it deposit and placement portfolio, which is about $19 billion, $15 billion of that is in non-US dollar currencies, and so if you just look at what happened to interest rates on some of those securities during the quarter, those currencies during the quarter, we saw the ECB take the overnight rate down to zero, and that clearly put pressure on our ability to redeploy those in a short-term fashion and get spreads. So that's the part that we have the least control over, and the one that created the most pressure.

Got it, thanks, and then my last question is with respect to new business, clearly saw momentum this quarter. I think in the past you talked about the Omnium deal or your new rebranded hedge fund solution service performing a little better than you thought. I was wondering if could you give us a little more color on where you see incremental benefits, how big are these for you nowadays, what that could do to the overall fee rate on the whole institutional business, and things of that nature?

Sure, so as you pointed out, the Omnium acquisition clearly had strategic value to us, and we see that in the new business that we're winning, and it's -- the new business itself has been very robust and very diverse, and I say that in a sense of it has been a combination of what I would call mid-size wins with mid-size hedge funds, but then also we've been very successful with some of the largest hedge funds as well. So the key there has been that our technology solution for clients is one that we feel we clearly have a competitive advantage with, in the marketplace, so we expect that to continue. The other aspect of it is that it does allow us to win additional business with some of these hedge fund clients, so given that Northern Trust has a much broader service offering than where Omnium was previously positioned, it has enabled them to expand the breadth of their business as well. So far the results have been excellent, and I would say that we continued to be very optimistic about the growth there.

Got it. Thanks for taking my questions.

Sure.

We'll take our next question from Glenn Schorr with Nomura.

First one, I know these numbers jump around a little bit, but the non-US interest-bearing deposits both ticked up in size, but also in the average yield paid. Now we're coming off a quarter where it went down, but I'm just curious on what circumstances lead to a pick-up in the average fee paid, because I just haven't seen that in awhile. I'm not used to it. Forgive me.

No need to ask for forgiveness on that. The reason for that is the mix of the currencies that are in there, and a portion of our deposits are from institutions in Australia and are in Australian dollars. So the Australian interest rates, as you know, are much higher than they are in other parts of the world and so depending on that mix, we will see an impact on our cost of funds, so that's the driver. If you take out the impact of the Aussie dollar on that line, on our non-US office interest-bearing deposits, the cost would be flat quarter-over-quarter, which I think is more consistent with what you'd expect.

Perfect, thank you. Did you spell out the one and not yet funded number, and I missed it, in terms of new business flows have been good, but I'm not sure what's in the run rate versus not yet?

Glenn, that's not a number that we've disclosed.

Okay, Bev, no problem. And just last one, I think you pointed out all of the areas where Northern is making progress on the capital front, on the asset growth and new business front, on the expense initiatives, it all is executing on the plan. I think we're hanging out in that same earnings run rate, because of the obvious on the revenue headwinds. So it feels like we're biding time but improving the operating leverage potential of the Company. So I'm curious on how you think about incremental margins might be on new revenues, if and when, if we ever get past some of these headwinds, so it's a question of incremental margins and margin improvement as revenues pick up.

Yes, maybe one way I can address that, because I think you're right on with the way we are looking to drive the financials for the business, which is control those things that we can control, and try to manage the other areas as best we can. And so, we have been successful in increasing our pre-tax margin despite the headwinds that we've talked about, and in trying to think about the type of leverage that might provide us though, in a different environment, one of the things that we look at is our expense base relative to our trust investment and other servicing fees.

And if you look at that ratio just over time, we've made consistent improvement in that ratio, so if you look back in 2011, I think it's and 127%, and then consistently through the quarters, I think we went down to 125% in the first quarter and then 118%, and then this quarter 115% so we are consistently bringing down the costs relative to the major fees in our business. That doesn't mean that we're not looking to also optimize on the other revenues in our business. It just means that we think we have greater control over the relationship between those two.

I appreciate that. Finally the last one, no other way to ask it than just ask it. You have got a ton of capital. If you look a very crude view of, even if earnings hung out in this area, you can return a whole lot more than you're returning now without denting the industry-leading capital ratios. Just curious, do you feel like you're holding back on areas that you'd like to grow? Or am I misreading this, that the capital return potential of Northern is a lot bigger than what's currently happening?

So on the capital front, you are correct, we feel very good about our capital position and it certainly is adequate and more than adequate to support all of the capital needs that we have, and I mean that in the sense of all of the growth that you're seeing in the business, and other growth initiatives that we have, we have adequate capital to fund those. As far as returning capital to shareholders, it is absolutely a priority for the management team and the Board to do that, and as you've seen, we've looked to do an increasing amount of that within the context of the environment we're in.

I say that with regard to not just the evolving capital standards, but also the interaction with the regulators and your ability to return capital. So we were able to repurchase $50 million of stock in this quarter, we still have another $140 million from our 2012 capital plan. We're approaching the 2013 capital plan. As I mentioned, in addition to just feeling good about our capital position, we'll get to the end of the year before we submit that, see what the environment looks like, and look to put together a plan that we feel addresses both our desires, but also those of shareholders, and also meets with what the regulators would expect and one that we believe they would not object to.

Excellent, thank you.

Let's take our next question from Ken Usdin with Jefferies.

I was wondering if you could just give us a little bit more color on the PFS business. Obviously, we knew about the pricing lag from last quarter as a drag on revenues, but I was wondering if you could talk about client flows and wins, given that the overall revenue line was kind of flattish, so can you just kind of walk us through the net market impact versus what you're seeing and continuing to see on the client side within the private bank?

In PFS, Ken, I would say that the market impact in this quarter was relatively neutral. As you know, the global family office part of the business is on a quarter lag and markets were down. The regions are on a monthly lag, and that was basically flat to up just a little bit so overall, not much market impact. We continue to be very successful in winning new business. As you know, the nature of that business is, it is more singles and doubles, if you will, so it's a very consistent growth rate and we continue to see that in the third quarter. Having said that, we think that we're also seeing the effects of the uncertain environment on PFS as well, as far as prospective clients making decisions. So our pipeline is as strong as ever, and we are winning new business, but the rate at which we're converting has slowed down a little bit here, or slowed down, I should say in the third quarter, as a result in our view of elections, fiscal cliff, et cetera. So we still feel very good about the longer-term prospects, but it is one that I would say in this environment makes it a little more challenging.

Ken the only thing that I would add to that to reiterate a point that Mike made during the prepared remarks, is that we do have some fees that we earn in our personal business which are not tied to asset levels, and they can be either uneven from quarter to quarter or in some cases seasonal, and the two that we highlighted were estate settlement and tax preparation, and those can have an impact on the overall numbers. So I just want to reiterate that, as Mike said, in the prepared comments.

Yes, I appreciate that, great. And then I just want to extend that conversation to the custody side. I know you hit on this a little bit in custody, which is also a lag business, but pipelines also seem like they continue to be strong and I know we talked recently about the elongation there too. Can you give us a flavor for types of mandates that are in the pipeline, complexity and kind of time to sell, if anything has changed on that front?

Yes, so as far as the types of wins that we're achieving here, I would say that they really do run across the institutional business. So as I mentioned earlier, we're seeing very nice new business in HFS, our hedge fund services business, but we're also seeing very nice wins in our more traditional large corporate area as well. And then as far as size, the size also, very diversified, but I would say that we do have certain wins which given the larger size, have a longer time frame to get implemented. So if anything I don't think its changed as much on the decision-making time frame as much as we see some extension on the implementation front. So overall good, very good, but as far as when they actually flow into revenue, in certain cases, it's a little bit longer.

Okay, and thanks for that. My last one is just I know it's brought up most quarters, but again, just given what we see and what you talk about volatilities and being low in the foreign exchange business. Can you just talk about where FX is from a structural perspective, and if there is any change in flow activity that you're seeing? Better or worse from the custody base?

Yes, so overall, and I think this is consistent with what you can see in the observable market, clearly just flows are down in the market, generally speaking, and so our client flows or volumes have been down pretty consistent with that. As far as structural changes, Ken, I mean what I would say on that front just for us, is that we continue to execute foreign exchange for our core custody clients, but we certainly are looking to expand that business to non-custody clients as well, so third-party clients. On that front, while we've begun to do it, I think that there's still much more opportunity for us. Like most things, we're approaching it in a very methodical way, trying to make sure that it's something that we do that both provides growth to us, but also in a very profitable way and with the right amount of risk. So I would say that's the structural change, that in addition to just the technological change in the business where certainly more of it is electronic, and likewise on that front, we are adapting our means of execution to match up with what clients prefer to do.

And does that take an element of investment, or is this stuff that's already on the books from the cost perspective?

Yes, it certainly requires investment, but it's investment that is part of, I would say, our normal capital expenditures, it's not something that's going to be incremental to that.

Okay, got it. Thanks a lot.

We'll take our next question from Brian Bedell with ISI Group.

Just to tag on to Ken's question on the FX trading, going forward, if currency volatility is improved and generally client volumes improve, over the next say, I don't know, you're looking at a couple years, would you expect your FX trading to move up in lock step, or do you think some of those structural headwinds will potentially overcome that early slowdown, of the normal cyclical pick up?

So to the extent that volumes and volatility improve, we certainly expect that we would see an improvement in our foreign exchange trading income, in the same way that we've seen the decline as a result. Having said that, with the structural point that you make there, we look at that as an opportunity, so not as a threat per se. So I don't, whether things move in lockstep or not, hard to say, but it's an important area for us, one that we've been focused on making sure that we are well-positioned vis-a-vis the marketplace. So as the environment changes, we would like to think that we're at least as well-positioned if not better-positioned as it goes forward.

Great, that's helpful. Just going over to the average balance sheet, can you explain what you did in the government sponsored agency portfolio to get the yield up to 74 basis points from 64 basis points? Was that purely a duration extension strategy, or are there other elements of that?

No, as I mentioned, in net interest income, we had $5 million in an adjustment for premium amortization in the quarter, and that relates to that particular line. Basically, as you know, within our investment portfolio we have securities that have either premiums or discounts, and those need to be amortized or accreted through net interest income over their estimated lives. The estimated lives were revised due to our ability to better project out what the lives are on those types of securities, securities where you have variable cash flows. In doing so, we needed to essentially have a catch up in the premium amortization that's in there, so it was lower during this time period. It is strictly a timing element, so it doesn't change the ultimate amount that goes through the income statement and it's a, I'll call it a small portion of our overall total premium on our securities in the portfolio.

What kind of duration are you, or maturity profile are you looking for in that segment of the portfolio, the GSA?

Yes, in that part of the portfolio, that tends to be a little bit shorter than our average duration, where average duration I mentioned were closer to a year right now, so it will be inside of that, because a portion of that is for our liquidity profile. We want to have a shorter duration on that piece, given those types of securities.

Okay, great. You described the Australian deposit mix shift impacting the non-US office time deposits. How about the asset side of that? Is there a lag impact of that in terms of being able to realize the higher growth yield on that, that would be laid off on interest bearing deposits on the asset side?

There's no lag, but there's definitely an affect. We have both assets and liabilities that are de nominated in Australian dollars, and the impact on that you see and I would say somewhat makes it a little more difficult to understand some of the trends you see in the yields, and the cost there. If you were to exclude the impact of the Australian dollar, what you would have seen in the quarter is that instead of our yield going down by 3 basis points, they would have gone down by 6 basis points and that again is because Australian dollar rates are higher than rates around the world for the most part. Having said that, on the cost side, instead of the costs going up 6 basis points, they would have been flat so the spread there would have been 6 instead of 9 so the decrease in Australian dollar spreads essentially accounted for 3 basis points of the decline in our net interest spread overall.

There's no way to mitigate that with investing in different types of -- going out and investing in securities in that part of the portfolio at all?

Well the nature of what we're doing there right now is very short-term, with regard to the clients, so that portfolio is similar to the rest of the bank placement profile, which is about a month on average. At this point, given the size of Australian dollar portfolio and the need for liquidity, there really isn't much opportunity to significantly extend duration.

Just last question. Can you talk a little bit about the effort to reprice the core business up? I know it's a multi-year conversation that you have with clients, maybe just update us on the progress, and your ability to reprice the core fees up, in lieu of the lower tech lending and FX that you're getting from the fund?

Sure, so as I did mention, we did see incremental success in the third quarter with CNIS, with regard to their driving performance initiatives on the revenue side. Its come through a combination of, as you mentioned, repricing parts of the business, but also through improved cross-sell. So where we have with the client determined other opportunities for us, which improves the overall client profitability, at this stage we have gone through over half of all of the clients in that business and had discussions with them with regard to the relationship, and where we see opportunities to work with them more, and where we see opportunities for us to do less, in the sense of not provide certain -- whether it's reports or services or whatever it may be that they don't value. It's really all about aligning the value propositions we've talked about with them So as I mentioned, third quarter we saw improved revenue as a result of that, and yet we're still in the early stages, as much as I say we've had conversations with over half of the clients on that front, we don't think that we're near half way through what the revenue upside will be there.

So more to come on that. Great. Thanks very much for taking my questions.

We'll take our next question from Robert Lee with KBW.

A couple questions. First one, maybe in terms of new business initiatives. A couple of your competitors have pointed to collateral management, and one is obviously in it, one has talked about building a capability. Do you have any thoughts about that as potential area for future growth for yourselves or any other new businesses you may be pondering?

Yes. We do some collateral management, although it is not a large business for us and I would not say that it's necessarily an area that we would highlight as a strategic initiative to grow, but there are definitely areas that we have targeted. One area which we've talked about within our investments business is the ETFs, and with that, we have taken a very differentiated approach to the marketplace. We're not looking to compete with the more commoditized side of the ETF market, but rather, developing products that are customized for our client base. We've seen significant growth in that from a standing start, so that would be an example of a new area or business that we've gotten into.

And maybe going back to thinking about the balance sheet a little bit, I mean as pointed out earlier, maybe it was Glenn, I forget, that the balance sheet has been kind of flattish more or less last year or so. I'm just kind of curious, some of your peers have seen fairly reasonable balance sheet growth, and they tend to tie it oftentimes to growth in their underlying custody business, just to the extent that they're expanding relationships and taking on new clients. You certainly have had plenty of success in growing that part of your business, so is there something about the mix of the clients you're bringing on, that for whatever reason, you aren't seeing as much flow through in terms of deposits from them? Or is it just not, any color you could provide on that?

Sure. We definitely see an increase in our balance sheet related to the growth of our business overall. However, it is not going to always be linear because we don't lead with the balance sheet, if you will. So it has more to do with also what their behavior is, or what their needs are. Let me break it down between the personal business and the institutional business.

On the personal side, we have seen this increase in deposits, particularly demand deposits over the last couple years, and then it has stabilized and much of that is more because of our clients' behavior, if you will, which is, they were looking for safety. They wanted to have a higher proportion of their assets on the balance sheet in the form of cash. To the extent that changes over time, and we have seen a change over time a little bit, they tend to then move those assets from our balance sheet into other products or services. Often cases it can be some of our funds, so that's how that behavior works. But over time, if you looked at the deposits and the loans related to our personal business, you would see that it has increased over type as the business has grown and as the fee part of the business has grown as well.

On the institutional side, likewise in general, there clearly is the relationship between the growth of the business overall and the deposits, and even in this quarter, you did see a sequential increase in our non-US office deposits, and that does relate to just the underlying growth of the business. But their cash needs and balance sheet needs also fluctuate, depending on their own needs and their own perspectives on the marketplace. I would say the environment that we're in right now has been for some time period a relatively low-risk environment, and we haven't seen that necessarily change. But when that does, or if that does change to a different type of environment, it can affect not only the level of deposit they have with us, and it could even go down, but it usually results in some other type of activity that is favorable to us. Certainly, the securities lending part of our business benefits from greater activity and a greater risk appetite, and the same thing for the foreign exchange part of our business. So the balance sheet there is something that in general grows with it, but I wouldn't say it's something that's lock up.

Maybe just one more question, if I could on the CNIS asset management business. You touched on the DPS business but any color you could provide on new business flows? I'm assuming it's still clearly dominated by index, but any kind of change of the invested behavior or pipelines? Then maybe also brief update on the Manager of Managers business, if you're seeing any traction there or improved traction?

Yes. So as far as the institutional business, again we have seen nice growth there. And as you pointed out and I mentioned in my earlier comments, we've seen nice growth in the index business, and we think that's consistent with the broader trends, and that the indexing that we're providing is essentially customized indexing, if you will, where we are looking to not just provide a traditional or commoditized index product, but rather something where we create a proprietary index for a client and then provide the indexing for them. That business has grown nicely, both equity index as well as fixed income index. We've also seen assets grow in the money market funds as well. And again, I think that can fluctuate over time and depends on the profile, the investment profile of our clients but we have seen growth there in the recent quarter.

Great, thanks for taking my question.

We'll take our next question from Howard Chen with Credit Suisse.

The pace of buyback accelerated to $50 million this quarter, but it still looks like that amount is a lag in the current capital plan. Is that consistent with the way you look at it Mike, and if so, what's the constraining factor to maybe not buying back faster right now?

Yes, it's very, it is higher than we were previous quarters so we've seen an increase each quarter, it was $15 million and then $35 million, and then $50 million, and as you mentioned, we have $140 million remaining and our capital plan did break out the repurchases into quarters, and I would just say we are executing consistent with our capital plan.

Okay, great, thanks. Realizing credit quality is fairly de minimus in the context of your entire business, but was just hoping you could provide a bit more detail on the new NPA formation you felt during the quarter. What's driving that, is that focused on any specific geographic or customer segment?

So we did see an increase in our non-performing assets, and the nature of our portfolio, as you would expect, is relatively granular, given both the size and the nature of the credits What happened is, if you go back to first quarter versus second quarter where there was a decline there, that was a result of a couple large credits that previously were non-performing and went back to performing or paid off, and in this quarter again, it was a handful of credits that went from performing to non-performing. These were split between commercial real estate and residential real estate. So when these couple went non-performing, you're going to see it in our numbers just given both the low number of credits that we have and the size of those credits. As far as geographically, there's no area of concentration. Our footprint as you know in the US and with our personal businesses, West Coast, the Central Region, and East and I would say it was a little bit of each of those, that we saw in the quarter.

Okay, thanks and then just a quick numbers one. With respect to the other income bucket, if you strip out this quarter's gain, you noted the higher income related to employee benefits held in trust and then some increased credit and leasing-related revenues. Can you provide a sense of how significant those were and did those recur?

Yes, so those three items that you mentioned account for the vast majority of the remainder. There were a couple, as I mentioned that category includes a number of items, but the employee benefit-related assets -- so those are for non-qualified benefit plans, which we hold on our balance sheet, but generally they offset each other between other operating income and other expense, and it just depends on what happens to the assets in the portfolio during that time period relative to the liability in the plan. Those are generally correlated until you see it in both line items, and then the higher credit-related fees, mostly in commercial but that category also includes them in our personal business as well.

As far as recurring and non-recurring, certainly the credit-related service fees, that's a more recurring fee stream. It's included in that category, but it fluctuates less, whereas the employee benefit-related depends more on the market activity, Howard, so it does tend to go up and go down. You'll see it on the revenue side, it's generally offset in the expense side, but it can cause fluctuations in both line items.

Great, thanks Mike. Finally for me, as I imagine you're pretty deep in the budgeting process right now. I'm trying to visualize the ultimate pay off for the driving performance program, balanced with just ongoing franchise reinvestment over the next few years. Maybe as a rough benchmark if revenues were just flat from today, where do your expenses ultimately shake out, and what do your expenses do if revenues are up or down 10% from current overall levels?

Yes, so you're right, we're in the middle of budgeting, certainly. It's difficult to deal with a hypothetical, but let me try to address it this way. Even in a flat revenue environment, we are going to face, like most companies, natural expense headwinds. There are just certain costs that are going to go up whether that's because you have incremental depreciation from continued capital investment in your business, whether it's related to inflation for certain costs, whether it's related to transaction volume levels that don't necessarily translate into incremental revenues for you overall, because we can have our fees up and our transaction levels up, but we could have FX or net income down like we did this quarter. You still have that. What we're attempting do is to offset that with driving performance, which is what you've seen and we've more than offset that.

In this year, as I mentioned, we're over $100 million now, we'll see where we end up the fourth quarter, but clearly we'll achieve over half of the $250 million we talked about. And then next year, the incremental amount is going to be less than what we had, and that's just natural with some of this. Of course we went after the larger dollars first, and so with each year, Howard, it gets more difficult to offset those, I'll call it natural expense headwinds unless you get revenue growth. Now, the key is, to the extent that you do get some revenue growth, that the expenses don't just go up with that at the same rate, but rather that we create some operating leverage with that. So that is our objective, both with driving performance and in general, is to be able to offset this low to no revenue growth environment that we've been in, because of the headwinds, but also then create operating leverage for when we think that those revenue headwinds subside.

Makes sense, thank you, for taking all of the questions.

We'll take our next question from Mike Mayo with CLSA.

So a pretty tough environment, I can imagine. You said you've had some success in repricing CNIS, but even with that repricing, the way we look at it, total processing fees to assets under custody are at a seven-year low in the third quarter and you can slice and dice that a lot of different ways, but it's tough. So one question is, how much is structural and how much is cyclical? And I know it's a very difficult question, but you need to have some answer for yourselves to determine how much you really want to cut. Or is my logic wrong here?

So a couple comments, Mike, which is I would agree that some of it is cyclical and some of it is structural. And as a result, we do not look at it and say, we're just at a time period where the cyclical piece is down and we don't need to worry about that longer-term. We do. Now apportioning the amount that should go to cyclical versus structural is more difficult. Clearly, the headwinds that we faced here with regard to the revenues, are with regard to rates and FX. Structurally, and you can also put in there in general securities lending, structurally, I think that there are also aspects that have changed, particularly with regard to FX and securities lending, so the expectations that we would have with regard to a client and the level of FX activity, securities lending activity and the profitability from that is reduced on a structural view going forward.

We still think that is a service that clients are interested in, and that we are well positioned to provide to them, and we can price very effectively for them, and still be very profitable for us, but not necessarily expecting it to go back to the levels that it was before. So as a result, we have to look at how do we rationalize the expense side so that we maintain the level of profitability that we think is appropriate for the business, and that have capacity to invest in it longer term, so that's everything where I talk about driving performance. Yes, it's to deal with the immediate impact of it, but it's also to have a longer term approach to the business that is not just focused on the growth but also focused on productivity.

When you say, how do you look at that longer-term, I mentioned a little bit earlier in the call where we look at that expense base, not necessarily just to revenues, you have to look at that because that's the way the financial statements work, but also looking at that expense base relative to the fee lines that we think we have greater control in growing over time. We've been successful over the last several quarters of bringing that ratio down, but we still have further to go with that ratio.

And then to ask the same question a little bit differently, how much would you attribute to volume, what you said was at a five year low, or maybe more than five years' volatility, which you also said is at a five year low and late.

Yes, I'm trying to think of how to estimate between the two, because they hit two different lines, if you will. But I would say that the more immediate impact here, we've been able to offset the rate part, Mike, more effectively than we have the reduction in the volatility in volumes and FX. So right now the impact has been greater on that line.

And when you say offset the impact on rates, how so, because you waived some service charges, and stuff like that?

Yes, so that has been one area that has come down. So in this quarter, for example, it's $17 million and that compares to $29 million a year ago quarter so we have, in that way that's come down. But also I was focused a little more on net interest income, whereas much as it is down this quarter, we've been able to generally maintain about the same level of net interest income, by trying to manage the balance sheet through that. Some of it, the balance sheet had increased as a result of more deposits on the balance sheet, but it's also how we manage the securities portfolio, as well.

Last question, two or three people asked this question but your Tier 1 Basal III ratio is at 13%, you trade at 1.5 times book value, and you only bought back 1.1 million shares. Are you not allowed to buy back more or it seems to me that you'd want to buy back a whole lot of stock. Are you constrained somehow, and if not, why not be more aggressive?

Yes, we are clearly constrained by the capital plan that we submitted at the beginning of this year, and was not objected to by the Federal Reserve. So we have to execute according to that. We will submit a new plan at the end of this year for 2013, and as I mentioned earlier on the call, we'll take a lot of things into account, but certainly some of the comments that you mentioned there are things that we take into account in about how we feel about our capital position as well, which is very good.

Okay, thank you.

We'll take our next question from Luke Montgomery with Sanford Bernstein.

I know you discussed it a lot already, but I did want to try to take one more stab at FX. You came out of the industry litigation looking pretty smart. You appear to have kept your nose clean, and as far as we know, you aren't named in any lawsuits. But your FX results over the last year have been a lot weaker than your peers, so I'm wondering is there something structurally different about your FX business, that's driving that result? You mentioned plans to grow third party execution in your earlier comments, but is that the entire difference between you and peers? Any additional insight there would be really helpful.

Sure. So I would say that we didn't have what I would call significant negative impacts as a result of what's happened in the FX area over the last couple of years. But we haven't been able to, as you put it, take advantage of any dislocation there. Part of that is because our business has been focused on our custody clients. So we largely have been able to maintain those clients, grow clients over time, but at the same time, the market has been down.

But to the extent that a non-client has been interested in doing their FX elsewhere, because we haven't been very active in third-party, we haven't been able to take advantage of that. Instead, where you would see is a longer term effect, where if a client is upset about a different situation, enough that they actually switch their custody business and their asset servicing business, and we win that business, then we would be in a position to do it. So it would have had a lag effect to it. Having said that, as I mentioned, that's one of the reasons why we are doing more in the third party area and look to do more going forward, so that not only we can just compete in that but take advantage of any opportunities that we should have.

Okay, thanks. That's very helpful. Second one is, could you talk a little bit about where you are in terms of expanding back office support? I know that there was some discussion a while back about being at capacity in Bangalore and you had plans to expand into other geographies, and there's been some anecdotal concern that you could use a little more scale just in terms of people or personnel, if you're going to win some of the larger deals, particularly in middle office outsourcing. I think that was also one of the reasons you didn't announce bigger targets on the efficiency program, the fact that you needed to add to back office. So just where are we on that front?

Yes, so we have a global operating model that we utilize, and as you mentioned, Bangalore is one of the locations there, and helps to serve clients in that region, as well as around the world. We continue to look at how we would expand that. That does involve looking at our capacity levels in Bangalore, but it also looks at other markets where we can expand. We've expanded in Ireland more recently, and we are looking at new locations around the world as well. The key to it is that we don't want to be overly concentrated in one region, and we want to be in a place where we cannot only service clients in a particular geographical region, but that we can also continue to have the most efficient around-the-clock processing for our clients. I would say that global operating model is one that we feel good about right now, but at the same time are constantly looking at how we would expand that.

Okay, thanks and last one for me. I tried this question on one of your competitors, but I figured I'd try it with you. Is there any clarity around the potential capital impact under new regulations related to securities lending indemnifications, and could that be a big deal for you? I know you have a good capital position, but--

Sure, unfortunately, there is not clarity around that. It is something that we are focused on and others in the industry are focused on, in order to get clarity. Depending on the final rule on that, it could definitely have an impact on securities lending. That's one of the categories, there are several others, but it's on our list. It would not change how we feel about our capital adequacy, though.

Okay, great. Thanks a lot. That's it for me.

That concludes our question and answer session. I'll turn it back to our presenters for any closing remarks.

Thank you for joining us today. We look forward to speaking with you in January on our fourth-quarter call. Have a nice day.

Great, thanks.

That concludes today's conference call. We appreciate your participation.