Northern Trust Corp (NTRSO) 2014 Q2 法說會逐字稿

Good day everyone, and welcome to the Northern Trust Corporation second-quarter 2014 earnings conference call. Please note today's call is being recorded. At this time, I would like to turn the call over to Director of Investor Relations, Ms. Bev Fleming, for opening remarks and introductions. Please go ahead, ma'am.

Thank you, Joshua. Good morning everyone, and welcome to Northern Trust Corporation's second-quarter 2014 earnings conference call. Joining me on our call this morning are Rick Waddell, Northern Trust's Chairman and Chief Executive Officer; Mike O'Grady, our Chief Financial Officer; Jane Karpinski, our Controller; and Allison Quaintance from our Investor Relations team. For those of you who did not receive our second quarter earnings press release or financial trends report via e-mail this morning, they are both available on our website at Northerntrust.com. In addition and also on our website, you will find our quarterly earnings review presentation, which we will use to guide today's conference call.

This July 16 call is being webcast live on Northerntrust.com. The only authorized rebroadcast of this call is the replay that will be available through August 13. 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 expressed or implied by these statements because the realization of those results is subject to many risks and uncertainties that are difficult to predict. I urge you to read our 2013 annual report and other reports filed with the Securities and Exchange Commission for detailed information about factors that could affect actual results.

During today's question-and-answer session, please limit your initial query to one question and one related follow-up. This will allow us to move through the queue and allow as many people as possible the opportunity to ask questions as time permits. Thank you again for joining us today. Let me turn the call over to Mike O'Grady.

Good morning everyone, and let me join Bev in welcoming you to Northern Trust's second-quarter 2014 earnings conference call. A usual, I'll review our results for the quarter, after which Bev and I would be happy to answer your questions.

Starting on Page 2, this morning we reported second-quarter net income of $182 million and earnings per share of $0.75. Our reported return on equity was 9.2% in the quarter. As outlined in our earnings press release issued this morning, we remain focused on sustainably improving our financial performance and returns. To that end, we recorded charges and write-offs in the second quarter of $42 million. Excluding these items, our earnings per share would have been $0.87 and our return on equity would have been 10.6%. I'll discuss the charges in more detail later in today's call.

Environmental factors which impact our businesses and our clients were mixed in the second quarter, a theme which has been ongoing for some time. Equity and bond markets were higher at the end of the second quarter, both year over year and sequentially. In the US, the S&P 500 was up 22% and 5% versus last year and last quarter, respectively. International equities, as measured by the EAFE Index, were up 15% and 2%, respectively. With markets trending up as the quarter progressed, average daily markets were also higher, although lagged the end of period comparison by about 4 percentage points year over year and 1 percentage point sequentially. In bond markets the Barclay's US Aggregate Bond Index was up 1% both year over year and sequentially.

Client assets under custody ended the quarter at $6 trillion, up 20% over last year, and assets under management ended at $924 billion, up 15%. On a sequential basis, client custody and managed assets were up 4% and 1%, respectively.

Currency markets had multiple impact this quarter. Currency volatility, which influences foreign exchange trading income, was lower in the second quarter, having decreased each month in 2014 to multiyear lows, and is even lower in July. Currency rates, which influence the translation of non-US currencies to the US dollar, increased revenue and expense by about 1 percentage point each, due in particular to the strengthening of the British pound during the second quarter.

Short-term interest rates remained at very low levels and continue to pressure our net interest margin, and result in fee waivers on our money market mutual funds. Three-month LIBOR averaged 23 basis points, down 5 basis points year over year and down 1 basis point sequentially. The Fed funds effective rate at 9 basis points was down 3 basis points year over year but up 2 basis points sequentially. Average overnight repo was 8 basis points in the second quarter, down 3 basis points year over year but up 3 basis points sequentially.

With those comments providing context on the environment, let's move to Page 3 and discuss the financial highlights for the second quarter. Starting with the year-over-year comparison, revenues were up 6% and expenses were up 11%. Revenue growth was the result of higher trust investment and other servicing fees and net interest income. Expense growth reflects the $42 million in charges and write-offs. Excluding those items, expenses rose 5% due to increases in compensation and benefits, outside services, and equipment and software. We had no loan loss provision in the quarter, as credit quality continued to improve.

Reported net income was 5% lower year over year. Excluding the charges and write-offs, net income was 10% higher year over year. Compared to last quarter, revenues were up 4% primarily driven by higher trust investment and other servicing fees. Expenses, excluding the charges and write-offs, were essentially flat sequentially as higher compensation and equipment and software expenses were offset by lower business promotion and occupancy expense. Reported net income was essentially flat from the prior quarter. Adjusted for the charges and write-offs, net income increased 16% sequentially. Earnings per share was $0.75, and our return on equity was 9.2%. Adjusted for the charges and write-offs, earnings per share was $0.87, and our return on equity was 10.6%.

Let's look at the results in greater detail, starting with revenue on Page 4. Second quarter revenues on a fully taxable equivalent basis were approximately $1.1 billion, up 6% year over year and 4% sequentially. Trust, investment, and other servicing fees, the largest component of revenues, were $707 million in the quarter, up 8% year over year and 4% sequentially. Fees in our corporate and institutional services business increased 9% year over year and 4% sequentially, while fees in our wealth management business grew 6% year over year and 4% sequentially. Higher equity markets and new business were both drivers of growth, with higher money market mutual fund fee waivers partially offsetting in the year-over-year comparison.

Fee waivers were approximately $31 million in the second quarter, an increase of $8 million over last year but $2 million lower sequentially. The higher waivers on a year-over-year basis were primarily due to the gross yield of the funds declining by approximately 5 basis points on average from the prior year. On a sequential quarter basis, yields increased 1 basis point. Overnight repo rates, a key driver of money market mutual fund yields, were down 3 basis points year over year and up 3 basis points sequentially. I'll go into further detail on trust fees shortly.

Foreign exchange trading income was $53 million in the second quarter, down 26% year over year but up 5% sequentially. Currency volatility was lower in the second quarter, having decreased each month in 2014 to multiyear lows. Client trading volumes were lower year over year, yet higher sequentially.

Other non-interest income was $75 million in the second quarter, up 5% year over year and up 15% sequentially, primarily reflecting gains from currency-related hedging activity. The sequential quarter increase was also due to higher securities commissions and trading income and an other-than-temporary impairment item booked in the first quarter. Net interest income, which I will also discuss in more detail later, was $253 million in the second quarter, up 11% year over year and down slightly sequentially.

With that backdrop, let's look at the components of fee revenues on Page 5. For our Corporate and Institutional Services business, fees totaled $395 million in the first quarter, up 9% year over year and 4% sequentially. Custody and fund administration fees, the largest component of C&IS fees, were $261 million in the second quarter, up 11% year over year and up 4% sequentially, while assets under custody for C&IS clients were $5.5 trillion at quarter end, up 21% year over year and 5% sequentially. Growth in fees and assets primarily reflects favorable market conditions, including higher equity in bond markets and favorable movements in foreign currency rates as well as new business. Fees were also impacted in the sequential quarter comparison by higher sub-custodian recoveries.

Investment management fees in C&IS of $78 million in the second quarter were up 5% year over year and up 4% sequentially. Assets under management for C&IS clients were $702 billion, up 17% year over year and up slightly sequentially. The year-over-year increase in C&IS assets under management was due to higher equity and fixed income markets and new business, as well as higher securities lending collateral. In the sequential quarter comparison, higher equity and fixed income markets was partially offset by lower cash balances.

C&IS investment management fee growth was dampened on a year-over-year basis by higher waivers on institutional money market mutual funds. Waivers impacting C&IS fees equaled $59 million in the second quarter, $5 million higher year over year, primarily reflecting the lower gross yield achieved in the underlying funds that I previously mentioned.

Securities lending fees were $30 million in the second quarter, down 4% year over year and up 32% sequentially. The year-over-year decrease primarily reflects lower spreads, while the sequential quarter increase reflects the traditional second-quarter impact of the international dividend season, which resulted in wider spreads. Other fees in C&IS were $27 million in the second quarter, up 7% year over year and down 9% sequentially. The year-over-year increase primarily reflects new business in investment risk and analytical services. The sequential quarter decline primarily reflects seasonally lower revenue from benefit payment services.

Moving to the our Wealth Management business. Trust, investment, and other servicing fees were $312 million in the second quarter, up 6% year over year and up 4% sequentially, and assets under management for Wealth Management clients were $223 billion at quarter end, up 10% year over year and up 3% sequentially. The increase in Wealth Management fees due to higher assets under management was partially offset in the year-over-year comparison by higher waived fees in money market mutual funds. Fee waivers in Wealth Management totaled $16 million in the current quarter compared to $13 million in the second quarter of last year and $18 million in the first quarter.

Moving to Page 6. Net interest income was $253 million in the second quarter, up 11% year over year and down slightly compared to the first quarter. The year-over-year increase in net interest income was driven by a larger balance sheet, as client interest-bearing deposits averaged $66 billion in the quarter, up approximately $10 billion or 18% year over year. These increased deposits compared with the year ago were primarily invested on the asset side in Federal Reserve deposits at 25 basis points. Partially offsetting the impact of a larger balance sheet was a lower net interest margin, which at 1.06% in the second quarter was down 4 basis points year over year. In the sequential comparison, higher average earning assets was offset by a 6 basis point decline in the net interest margin.

The yield on the securities portfolio decreased 16 basis points sequentially, primarily reflecting higher premium amortization in our mortgage-backed securities portfolio due to faster prepayment speed assumptions. Adjustments to premium amortization in the second quarter decreased the yield on the securities portfolio by approximately 7 basis points and the net interest margin by approximately 3 basis points compared to 4 basis points and 1 basis point increases, respectively, in the first quarter. Average loan balances were approximately $1 billion higher in the second quarter compared to the first quarter, with growth coming primarily from commercial and institutional, private client, and commercial real estate. The yield on the loan portfolio decreased 6 basis points sequentially, primarily due to yields on commercial loans and day count.

Turning to Page 7. Reported expenses were $811 million in the second quarter, up 11% year over year and up 6% sequentially. As I mentioned earlier, we recorded charges and write-offs in the second quarter of $42 million. Of that total, $28.5 million relates to severance and other costs associated with the elimination of approximately 200 positions. As outlined in our earnings press release, $25.5 million of that charge appears in the compensation line of our income statement, $1.9 million in the employee benefit expense, and $1.1 million in outside services expense. Another $4.3 million relates to the ongoing realignment of our real estate portfolio, and appears in occupancy expense. In addition, we recorded $9.5 million in software write-offs in the second quarter. Our actions taken this quarter reflect a continued focus on improving profitability and return, and specifically we expect the charges to produce annual ongoing savings of approximately $25 million once fully implemented.

Turning to Page 8. Expenses excluding the charges and write-offs were $769 million in the second quarter, up 5% year over year and flat sequentially. Expense growth is primarily driven by a combination of the costs and investments to support the growth of the business, along with certain expenses that can vary by quarter. Expense growth was higher in C&IS, where we are experiencing faster fee growth, and lower in Wealth Management, which maintained attractive margins.

Compensation expense, excluding the charges, increased 6% year over year, primarily reflecting staff growth, annual merit increases, and the unfavorable impact of movements and currency rates. Staff levels increased 4% year over year with about half of staff growth supporting the growth of Global Fund Services and C&IS, a business which has experienced above average growth, and in which we are investing for future growth across traditional, hedge and other fund structures. The majority of the remainder of staff growth was in our operations, technology and risk management groups.

On a sequential basis, excluding the charges, compensation expense increased 1%, primarily driven by annual merit increases. Staff growth was less than 2% sequentially. Employee benefit expense, excluding the charges, was 4% higher year over year, as higher employee medical expense and payroll tax expense more than offset lower pension expense. On a sequential quarter basis, employee benefit expense decreased slightly excluding charges, as higher medical expense was offset by lower pension expense.

Outside services expenses, excluding the charges, increased 5% year over year and decreased 1% sequentially. Higher volume-driven sub-custodian and higher legal expense drove the year-over-year increase, while lower technical services expense was partially offset by seasonally higher sub-custodian expense in the sequential quarter.

Equipment and software expense, excluding the write-off, was up 16% year over year and up 5% sequentially. Spending in support of our technology strategy continues as we invest to support clients, improve employee efficiency, and meet regulatory and compliance requirements.

Occupancy expense, excluding the charges, was down 1% versus the prior year and 3% sequentially. Other operating expense decreased 7% year over year and decreased 11% sequentially. Both comparisons reflect lower charges associated with account servicing activities, which can be uneven from quarter to quarter. The sequential quarter comparison also reflects lower business promotion and marketing costs associated with the Northern Trust Open held in the first quarter.

Turning to Page 9, we continue to be focused on improving profitability and returns. As Rick will discuss later, we are reorganizing to allow our client-facing groups to focus on growth, and our operations and technology functions to efficiently enable this growth. This structure, along with the actions announced today, will create the opportunity for future productivity gains, and the expected cost savings will allow the Company to simultaneously increase profitability and invest in future growth opportunities that we expect will produce targeted returns over time. Our success in achieving our overall productivity goals can best be measured by our return on equity, and pretax margin is significant contributor. We track both closely.

However, given the impact of macroenvironmental factors can have on pretax margin, we also closely track the ratio of expenses to fees. Although by no means immune to external factors, we believe it's a useful metric to gauge our progress. As Page 9 demonstrates, in 2011 when our return on equity was 8.6%, our pretax margin was 24.2% and the expenses-to-fees ratio was 131%. Since then, we've made progress in improving our pretax margin to 29.4% in the second quarter, due in large part to reducing the ratio of expenses to fees to 109%, both adjusted for this quarter's charges and write-offs.

Capital is outlined on page 10. As Northern Trust exited parallel run for the calculation of Basel III advanced risk-weighted assets, we are required to report our ratios on both an advanced and standardized basis. The ratios calculated on a transition basis for both advanced and standardized remain very strong, with common equity Tier 1 and Tier 1 capital ratios of 12.7% and 12.9%, respectively. Based on our interpretation of the final Basel III rules released by the Federal Reserve on a fully phased in basis, our common equity Tier 1 capital ratio under the standardized approach would be approximately 11.1%, and under the advanced approach would be approximately 12.3%. Both of these ratios are well above the fully phased in requirement of 7%, which includes the capital conservation buffer.

The supplementary leverage ratio at both the Corporation and Bank are above 5%, which exceeds the requirement applicable to Northern Trust. As Northern Trust progresses through the fully phased in Basel III implementation there could be additional enhancements to our models and further guidance from the regulators on the implementation of the final rule, which could change the calculation of our regulatory ratios under the final Basel III rules.

In the second quarter, we repurchased 1.2 million shares at a cost of $75 million, bringing to $238 million our total share repurchase activity in the first half of the year. Our 2014 capital plan provides for repurchase of up to an additional 350 million of common stock through March of 2015.

In closing, we remain focused on growing and steadily improving profitability in order to drive returns into our target range. Year to date fees have grown 8%, revenues have grown 6%, and excluding charges and write-offs, expenses have grown 5%. Our pretax margin improved to 28%, and our return on equity was 9.9%. With that, let me turn the call over to Rick.

Thank you, Mike. Let me extend my thanks to everyone listening to Northern Trust's earnings conference call today. We appreciate your interest and continued support. Yesterday we announced several leadership changes that will become effective on September 1. These changes have two key objectives. First, to sharpen our focus on profitable growth; and second, to further develop our leaders by exposing them to different roles.

Jana Schreuder will assume the rule of Chief Operating Officer, with operations, technology, and enterprise change reporting to her. Jana and her teams will be focused on enabling accelerated growth by making Northern Trust more efficient and nimble. Bill Morrison, our President since 2011, will continue to lead our Wealth Management, Asset Management, and Corporate and Institutional Services businesses, as well as our corporate marketing and strategy efforts.

We are very excited about the strategic and competitive positioning of Northern Trust across the markets and segments we serve. Bill and the leaders reporting to him will be focused on maximizing our strong positioning and significant marketplace opportunities to accelerate growth. To leverage and further develop our leaders, Steve Fradkin, will become head of Wealth Management and replace -- and Mike O'Grady will become head of Corporate and Institutional Services. Biff Bowman, who formerly was head of C&IS in both North America and in EMEA, and most recently head of our human resources group, will become Chief Financial Officer.

These changes are a testament to the depth and breadth of our leadership team at Northern Trust, and will further our efforts to accelerate profitable growth. Thank you again for participating in Northern Trust's second-quarter earnings conference call today. Mike and I would be happy to answer your questions. Joshua, would you please open the lines.

Yes, sir.

(Operator Instructions)

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

Great, thanks. Good morning everyone, and my congrats on the new role and new responsibilities.

First question, I guess around the expense program that I guess you guys announced today. I just want to make sure that I got the numbers right. So the savings that you expect to get are about $25 million on an annualized run rate basis. Do you guys think of that as a gross number or a net number, meaning that, do you think of that as a expense reduction or just a way for you guys to invest in other areas of the firm?

Two parts to that, Alex. The first part would be that we think about that number as a net number.

So we will be reducing compensation related to the positions that we talked about, which is in excess of the $25 million. However, there are certain areas that we're reorganizing where we'll need to reinvest in people to take on some of those responsibilities. So that's a net number, if you will.

More broadly speaking, as we've been doing with driving performance, all of the savings that we generate and pretax benefit that we generate from the various initiatives are used first to improve our profitability, but then also to allow us to continue to invest in the business. So even with the over $250 million, if you recall that we generated on a run rate basis through 2013, a portion of that was redeployed back into growing the business and improving technology as well.

Got it. Thanks. And then my follow-up question was around trends and foreign exchange during the quarter.

As you pointed out, we think we've all observed painful heat throughout the course of quarter volatility being quite low and volumes across many asset classes being low as well. So a little surprised to see, I guess, sequential growth in expense -- sorry in FX trading for you guys. I know you've spend some time trying to develop some new capabilities there. Do you think it's more of a function of you gaining new business from clients that just haven't traded with you in the past, or something else that's driving the sequential increase in those revenues?

Alex, I think it's a combination of factors. Certainly there's a broader market volatility levels. Those certainly impact the broader market volumes.

And then more specifically, as you know, most of our activity is with our custody clients, and those custody clients may or may not have consistent transaction and volume activity that the rest of the market does. The dynamic that we saw in the second quarter is that our client base, if you will, was more active. And so the volumes that we saw through our custody clients were higher on a sequential basis in contrast to market volumes overall, which were lower. So that's one.

Two, as you mentioned, we have had a number of initiatives in the foreign exchange area, particularly looking to transact with a broader group of clients in more third-party FX, as we call it, so non-custody clients. As I've mentioned in previous calls, we've begun to see the benefit of that. I would say that we've seen much more volume related to that activity, and more recently including in this quarter, we've seen the benefit of increased revenue from that as well. But it's still early days in the financial impact from that.

Got it, great. Thanks for the color.

And we'll take our next question from Ashley Serrao with Credit Suisse.

Good morning. Within the Wealth Management division, the Eastern Region saw great growth this quarter. Is this really a function of New York gaining traction?

And then if we just step away, and on a higher level, how would you categorize the running potential here, both here and in Houston, what innings are we in?

So the growth of the Wealth Management business has continued to be relatively broad-based within the US and across all three regions. And from quarter-to-quarter, as you would expect, one region may do better than another.

And interestingly, where we've even seen the Central Region for example, which as you would expect we have higher market shares if you will, it's continued to grow at a nice rate. At the same time, we've talked about increasing the investment that we make into certain markets where we have lower penetration or market share, and we're in the early innings of those strategies, if you will.

You mentioned a couple of the markets, Ashley, there. So certainly in the Texas market more broadly and Houston specifically, we're looking to expand the business more quickly. But I would say that that's still in the early stages of that. And likewise in New York, which clearly is the largest marketplace, as you've identified, we've had nice success, but I would say it's still very early relative to the strategies that we have there.

Okay. Then on other expenses, this is the second quarter in a row where numbers look good.

Do you feel that you're in a spot where you're somehow structurally lowered these account servicing charges through process improvements? Because it feels like you're run rating a fair bit below last year's levels. Any color there would be appreciated.

In the other category, as you highlighted, there are a number of different items that fall into that category and they can vary by quarter, from quarter-to-quarter. We have had, I would I say, very good experience in the last two quarters with regard to charges related to client activities there. That's not something that we're able to predict going forward.

There's no question that we are focused on not only serving our clients very well but minimizing any type of errors that we may have that require financial remunerations that you would see there. But all the same, I can't by any means say that we can expect that we'll see these low levels going forward.

All right. Thanks for taking my questions.

And we'll take our next question from Brennan Hawken with UBS.

Hi. Good afternoon. Quick question on the timing of these savings.

How should we think about that rolling into results? Can you give us a sense about how these are going to phase in?

Sure. Some of the actions that we talked about today we've already begun to take, and so there will be some impact from that in the third quarter, but it will be very small. And even in the fourth quarter we would expect the run rate to be very low as we begin to work through the plans that are related to the charges.

For 2015, we would expect to see the majority of the $25 million that we talked about. And beyond that 2016 we would be fully implemented.

Okay. And then so would the majority, are we talking about $20 million of the $25 million there by the time we get through? And as you go through 2015, would it continue to phase in over the year? Is there any sort of additional sense you can give on that?

Sure. It will phase in over the year, because the activities here are not in one particular area of the Bank but across the Company where we think we have opportunities to reorganize and become more efficient in how we execute in those areas. And so the implementation of that takes time because the time lines are different for each of those areas.

So the actual activities themselves will roll out over the next few quarters, and as a result the savings will phase in along with those. And when I say majority, it's certainly over half, well over half, but beyond what the amount is, there's not a specific number that I would give.

Okay, okay. All right, that helps, thanks.

And then I guess question on capital. Can you -- is it your sense that Wealth Management clients believe that capital strength is an important differentiator for you? I'm just trying to sort of get my head around why not return more capital, get closer to your regulatory capital minimums. Is it that you feel as though you're compared with maybe some of the other trust banks and those firms are held to a higher standard, therefore you have to be up at that level as well? Just can you maybe walk us through if there's a competitive factor coming into play here?

Sure. Capital strength is critical to our business, and that's true both with Wealth Management as well as our Corporate and Institutional clients as well. We believe that our clients definitely take comfort in the fact that Northern currently is and has been very well-capitalized. Whether that's on a standalone basis or in comparison to other competitors that they may be considering doing business with. So that will continue to be a factor for us as we look at our capital levels going forward.

As to exactly where we are relative to a competitor, we don't necessarily determine our capital levels based on any one or even small group of competitors. They're just relative data points that we take into account, along with a number of other data points from our own internal analysis related to our own risks, and certainly with regard to the regular regulatory required levels. That's the framework that we use. It's a broader framework of factors and the commercial aspects and competitive aspects are a part of that.

The last thing I would say is certainly we're very focused on returning capital to our shareholders which we've done in increasing amounts over the last few years. And yet that's also obviously an exercise that we go through with our regulators that have a clear say in the amount of capital that we can return.

Okay. Thanks for the color.

And we'll move next to Glenn Schorr with ISI.

Hi, thanks. Maybe start with a quickie on capital ratios. I agree, you got a ton of it. Just curious on how come it went down in the quarter and barely up on the year on a ratio basis? You're making a lot of money, not buying back too much, positive OCI benefits, it's just logic test.

Yes. I would say that for the most part, Glenn, we have returned this year basically what our net income has been. So we were much higher in the first quarter and a little bit lower in the second quarter with regard to share repurchase. Between the two quarters there plus the dividend, it largely offset the net income impact from that.

And then I would say beyond that, we're into a time period where the capital ratios, depending on the methodology approach, are being transitioned in. So there's a number of factors that happen on a transition basis. I'll hit just a couple, but from a numerator perspective, we have trust preferreds, for example. Those, the equity credit for those, are being phased out over a time period here. That's going to reduce our capital levels.

And then on the denominator side, there's a transition period from essentially what our Basel I risk weights to the Basel III standardized risk weights. You'll see that impact on the ratios. And then certainly with the advanced methodologies, those are always subject to updated modeling and assumptions that go into that. That can affect either operational risk capital or credit risk capital or any other of the capital categories.

Okay. Definitely helpful.

And then on the, I guess this question's on both expenses and net interest income merged together in this, where you mentioned most of the deposit -- higher deposit funding was invested at the Fed. By the way, I had the same problem. I don't know what to do with cash either. I'm just curious if that's a comment about what you think the duration of those deposits might be, or an interest in not taking on too much credit risk, not extending more on the duration side?

Well, we would be glad to help you out with your problem if you'd like to be a client of ours. We'll talk about that separately.

You're right that we have seen the balance sheet expand significantly, more so over the last year and somewhat over the last quarter. And as you've seen, we have increased the size of the securities portfolio. So that is a way for us, Glenn, to extend out the duration and get a higher yield on those investments.

I would say that we look very closely at the nature of the deposits that are coming in. As much as we would consider all of these client-related deposits, as you know with the extreme amount of liquidity that's just in the system. What we don't know exactly is what the impact or behavior will be to the extent that interest rates head in a different direction. So we have to be careful just on how much duration we add to the portfolio. We've been relatively constant on that front.

And then the last thing I would say is, as you saw in the quarter here, we actually had about $1 billion of growth in the loan portfolio. That's certainly a positive development. One, it indicates just the fact that in our view the economy is improving and our clients are in a position where they're taking on additional loans to expand their business or do other things. But that is an ideal way for us to deploy those assets because we're deploying them in client needs, or for client needs.

I think that's all completely reasonable. And to your point, when you -- you're clearly managing expenses a little bit more, getting us to focus more on fees to core revenues versus the ancillary revenues. If and when we ever live to see the higher rates, does that just imply the higher incremental margins is super high on NII?

Very, very high, yes.

Awesome. Thank you.

And we'll take our next question from Betsy Graseck with Morgan Stanley.

Hi. Thanks a lot. Just had a follow-up on the last question where you're talking about what happens with NII increase.

So one of the concerns that people's had is that as interest rates have come down and soft dollar benefit has declined, you've been able to -- the industry has been able to move more towards hard dollar as a percentage of total. As interest rates go up, does that cap ability to continue to grow the hard dollar fee side of the business as much? Will investors turn around and say, I'm giving you more soft dollar now so I can peel back hard dollar?

I think, Betsy, it's a very interesting question in the sense of that's very tactically close to the business. And we, as you point out, we've gone through a time period here where whether you want to characterize certain revenue streams as hard dollar or soft dollar, that's not the terminology we use. So let me state it the way we would, which would be the fee component of our service offering versus some of the other services that we provide where the revenues come in the form of whether it's spread income, foreign exchange, securities lending, things like that.

And so we've been on the down side, if you will, of those revenue streams coming down. I think that has had some impact on the fee side in the sense that just for the entire marketplace, if the ancillary side is lower then there's firmer pricing, if you will.

To your point then, the question is to the extent rates turn around, do we lose that? Hard to say. It all depends on the competitive dynamic. But my expectation is that some of that discipline that we've seen will be maintained in the marketplace as the rates go up, at least for some extended time period.

Okay. Then the disclosures that you put around benefit from a rising rate environment into revenue stream, earning stream in the Q, are you anticipating that similar behavior of clients as in past rate rise cycles? Are you assuming like static balance sheet analysis? So I guess the basic question is, is that Q disclosure more of a minimum as opposed to in a dynamic environment what you think you could get?

So it is a static balance sheet analysis. It is, as you point out, difficult at this point to have a very high level of confidence in all of the assumptions that go into that analysis, given that we haven't had this type of rate environment for this time period. And so predicting the behavior as rates increase is particularly difficult. And being more specific, particularly difficult on the deposit side of that calculation.

And so what we've had to do is look at both the nature of the deposits, so whether we think that those deposits are core, if you will, or are operational. But then also our ability to maintain the level that we're paying on those deposits as rates increase and as we see the benefit on the asset side of the equation.

And so we've tried to incorporate the fact that we are in a unusual interest rate environment. But it is just that. It's a set of assumptions that we put in there, and we'll obviously have to see how it plays out to the extent rates move up.

Right. Then again, as rates do move up, there will clearly be a benefit. The question is how much to you -- and you have some room there to determine how much you're going to allow to fall to the bottom line or not. I would expect that at least some of that improvement in II would be able to fall to the bottom line, is that fair?

Absolutely.

Okay.

Absolutely.

All right. Thank you.

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

Hey, guys. Thanks.

So just maybe some more thoughts on the management reshuffle. I know you've done this a lot over the last few years. I get that it's part of your management philosophy, and maybe there's some succession planning here.

But at the same time, I think Mike was only in the seat for a short time. He's a good communicator, and I do believe that investors value some consistency in a CFO seat. So maybe you could comment on what the catalyst was here and why the objectives you listed are more important than maybe providing some continuity in the dialogue with the investment community?

Well, Luke, it's Rick, and I appreciate the question. I would point out that Mike's been in the role for three years. This is not what I would call just a quick change.

And I'd also note that Mike is not leaving the Company. He's still a very valuable member of our Management team.

The CFO role has, quite frankly, historically been one at Northern where we put high potential, talented individuals who get to see the Company with a different lens, but across the Corporation. And if you go back to Steve Fradkin and Bill Morrison, I would highlight two individuals who were in that role and have moved on into other roles. So that really is the context with Mike.

With Biff, you're going to get an individual who has -- his entire career has been with Northern. He started in audit. He's been on the commercial banking side.

He was part of our acquisition strategy in 2005 in Europe. He's ran Europe. He's run North America. So he's a very seasoned, talented leader with a terrific financial background.

So I think I'd say personally I've been spoiled by Mike, but Mike has a unique background. I don't think the investing community externally, nor do I think internally from a financial leadership perspective that we're going to miss a beat when we make these changes.

Okay, fair enough. I guess I've got someone new to try to pester into enhancing the organic growth disclosures.

That's your job.

Maybe an update on what you're seeing in terms of regulatory expense trends. Are you comfortable maintaining the view that it's going to be in line with 2013, but with the mix shift that you stated away from outside services and towards permanent or maintenance spending? And was there anything that was pulled into Q2 or pushed out that might affect the run rate over the next two quarters?

So on that front, Luke, I would say that so far this year it's been consistent with what our expectations were in the sense that you've seen, for example, that our comp and ben expenses have gone up. That's one of the areas where it's gone up. We think that the most economical way for us to address the improvements that we're making within our control functions.

And at the same time, as you've seen in outside services, it's not as much that you can see the detail per se. But as you probably noted, I didn't talk about consulting expenses being higher either year-over-year or sequentially, and that's because we have been successful in doing more ourselves and having less on the outside.

Now, the trend from quarter-to-quarter can certainly change. There does tend to be more activity on the regulatory front as we get into the back half of the year as there are a number of items that we're trying to clear, whether that's for the CCAR process or any one of the other -- any number of regulatory initiatives that we do have. So it's not to say that we've locked into a low level, it's just that it's been consistent with what our expectations were.

The other thing I would I say is that one of the areas that has been a focus for us this year has been AIFMD over in Europe. So we've incurred the costs and the investment to build that capability out. In the first half of the year, that's all you've had is just the cost and expense related to that. We'll continue to have both some implementation costs, but ongoing costs related to providing that service. But we'll also have revenues in the latter part of the year as clients are using that service and compensating us for that. So that won't show up in the expense line as much but it will show up on the revenue side.

Okay, thanks. Very helpful.

Our next question will come from Ken Usdin with Jefferies. Ken, your line is open. Go ahead, sir.

Hello. Sorry about that.

Hey, Mike. Can you actually talk through about the net new business wins? And the growth rates of the C&IS and PFS ex fee waivers have been at a pretty consistent rate, both in upper single digit last year. I was wondering if you could talk about the pace of new business wins, and if either the size or constitution of what buckets they're coming from has changed at all?

Sure. On the C&IS front, the business continues to have quite a bit of momentum. So it's very positive, and I would say it's also relatively broad-based.

So both from a geographic perspective, again there are certain areas where you might think the business is more mature and it's going to grow at lower rates, in North America for example. But it continues to be very successful in both getting new additional business or revenue opportunities from existing clients, but also winning new clients.

And then within GFS, success not only in North America, but very much so in Europe. And that's after going through a time period when Europe had more difficulties and we did see the new business levels go down in Europe. Now we've had a number of quarters of very positive net new business in EMEA for us.

And then you've heard us talk about certainly our success in the APAC region, broadly speaking and specifically in Australia, and I would say that that momentum continues as well. All very good, and we would expect that that continues in the sense that we're still very active in pursuing opportunities in all those regions in those businesses.

On the Wealth Management front, I talked about it a little bit previously, just about the different regions. And I would say there that we're at a time period in the market where I sense that, or I should say our Wealth Management professionals and experts see a certain level of nervousness, if you will, on the part of clients given the high equity market levels. That can always cause fits and starts with moving business to new providers.

We continue, as you would expect, to have very high retention levels and are very focused on trying to increase the level of new business that comes into the Company. And so at this point I would characterize that as steady, not as high as we've seen in other time periods where there's just more activity in the marketplace.

And Mike, just on an on-boarding question, is Bridgewater still on track for coming on this quarter, and presumably again without the related AUCs so we'll see that in the capture rate as well?

Correct. So we are on track for Bridgewater to be online in the third quarter and their assets will be assets under administration.

Okay. Mike, one question on that fees, that expenses-to-fees number. If we presume that rates really don't change, how much more progress do you think you guys can make on that, just from an organic growth and expense control relative to the 115% that you are at this quarter?

Ken, we still think we have significant opportunity to improve that ratio. And with the changes that Rick has talked about today, that's all an indication of our efforts to try to do what it takes in order to continue to improve that ratio.

This particular set of actions happens to be around the structure of the organization. In my mind it's a way for us to structure in a way that we think will create new opportunities to deliver efficiencies. But that's on top of things that we've been doing for the last 2.5 years, which we will continue to do because we think it's important to our long-term success, to be able to continue to drive that ratio down.

Okay. Thanks a lot, Mike.

We'll move on to Brian Bedell with Deutsche Bank.

Great. Thanks for taking my questions. Maybe a question for both Rick and Mike.

As you think about the business realignment or the -- and the leadership changes and really trying to drive profitable growth over the longer term, aside from the expense components of that, can you talk about profitable growth from a business mix perspective within the businesses? So what I'm trying to get at is to what extent would you prefer to invest in higher margin areas within C&IS servicing, such as hedge fund administration, alternative administration?

And then similarly on the Wealth Management side, what do you view as the more profitable components in the Wealth Management, higher end versus the medium area?

Brian, it's Rick. Our businesses fortunately present tremendous opportunities to grow. So as Mike has indicated and we've been saying for some time, we continue to invest in a variety of initiatives to take advantage of growth opportunities.

For example, in Australia, that business continues to grow. We're adding headcount. We're putting more capabilities in there.

Asia writ large, we opened an office in Kuala Lumpur earlier this year. There's just a number of markets on the institutional side where we're seeing strong client demand, and therefore we need to invest in those markets in order to grow them.

On the wealth side, we've talked about our mega-market strategy. We're in the East Coast, specifically New York. Our business in Texas, and specifically in Houston. Those are markets where we are allocating more resources because the growth opportunities, the margins, the revenues, and the profitability are there.

We're also expanding in capability. So our ETF strategy where we're north of $8 [billion] now and continue to add product, broaden our product mix, leveraging our mutual fund and passive capabilities. That's an investment that we're making.

So it's fairly broad-based. It's in both businesses. Each of them have different dynamics, granted, but we're seeing very, very good investment opportunities to grow our businesses in geographies and in markets throughout our business.

And I guess, Brian, the only thing I would add to what Rick laid out there is to your question around the profitability of the service offerings that we have for our clients where we're doing and have been doing quite a bit of analysis, as you would imagine, around those products and services to determine where are the best opportunities for us to move that mix. And so you marry that up with the businesses and the growth opportunities we have to determine the best way to allocate capital and resources.

And then just a follow-on for that. Maybe your view of the alternative servicing business, so I'm thinking really of the Omnium, the legacy Omnium business, and with bringing Bridgewater on. To what extent do you think you can leverage that to much stronger growth in that area? And do you view that as a more longer term profitable area than the legacy core pension, custody, and investment management business?

We continue to think that that area presents tremendous opportunity for us. And when we think about resource allocation we would say that that's an area where we have invested and dedicated resources to over the last few years. And that's because we do believe that it not only presents growth, but presents attractive returns to the extent that we grow that business out.

And it's a situation where I would say at this point that we have had success there. Certainly adding large clients like Bridgewater, which will be onboard shortly here, changes the dynamic for us as well as to the economics of the business, the ability to continue to invest in the business as well. So that is clearly one of the areas of opportunity.

Great. Thanks very much.

We'll move on to Cynthia Mayer with Bank of America Merrill Lynch.

Hi, thanks a lot. Most of my questions have been gone over. But just maybe circling back to the asset growth.

It seemed like this quarter there was a real disparity between the Wealth Management AUM, up 3%, and the Corporate and Institutional, which was basically flat. So I think you mentioned that was a matter of cash outflows on Institutional side. I'm just wondering if there was any other dynamic? And put another way, whether it's just focusing on the assets under management, what the pipeline is looking like?

Sure. On the assets under management, and I think Cynthia, just to clarify, you said on a sequential basis?

Yes.

Sure. So on a sequential basis, part of it is that cash certainly does factor in from quarter-to-quarter. And given the nature of our client base and what they look to us to provide, that is one of the key areas, which is liquidity and liquidity management, and so that can you affect the numbers in assets under management.

The other part of it is that we do have some very large asset management clients, and they do make allocation decisions from quarter-to-quarter. And on a sequential basis we did have two very large clients who made reallocation decisions in the quarter. And so they allocated out of the product, if you will, that which was on the equity side into other categories and that was a drag, if you will, on the AUM growth on a sequential basis.

Okay. And looking forward, any color?

Difficult, other than just I would say consistent with my broader commentary on the opportunities being relatively broad-based in that business as well across both industry groups as well as geographies.

Okay. And then maybe just a quick specific follow-up, the lack of provision this quarter, how do you think about that going forward, given where the trends are?

The trends continue to be very positive. We did see a nice decline, if you will, over 10% in our non-performing loans from quarter-to-quarter. We'll have to continue to see if -- we'll have to see if that continues going forward.

And as you know, we're obviously -- we size the reserve to what the appropriate level is and the provision falls out of that. So don't have a view as to where that would be necessarily, but we certainly do hope that we continue to see the positive credit quality trends.

Okay. Thank you.

And we'll move on to Marty Mosby with Vining Sparks.

Hey, wanted to ask specific question on the write-off that you had in the securities portfolio with faster prepayment speeds. When the re-fi market has been flowing, not accelerating, to have such a large adjustment this quarter, I just was curious what the catalyst for that was?

Sure, Marty. On the premium amortization, it is something where it's difficult likewise to predict exactly what is going to happen in the portfolio because it is a collection of a number of these mortgage-backed securities. And admittedly we've done analysis on our own, looking to be able to better predict or forecast what the adjustments will be from quarter-to-quarter.

And there isn't a single index, if you will, whether that's the MVA purchase index or re-fi index or necessarily even interest rate levels, where the 10-year is, that will give you a clean read on what to expect as far as prepayments because there's just a number of drivers as to what can drive it in a particular MBS pool.

So hard to necessarily give you a view on what to expect on that going forward, other than the fact that the adjustments will move from quarter-to-quarter. But all the same our view is that on balance, of course, it's just a matter of ultimately amortizing all of the premium that is booked at the time of purchase. So it doesn't change the ultimate return we'll receive on the securities.

Got you. Going to non-interest expense and some of the charges you had this quarter, the write-off that you had in the software, was that related to a system that was being replaced, or is it an outdated system? Or was it a new system that just wasn't getting to the point where it could fulfill what you thought the objective was?

Sure. It's some collection of, I don't want to say all the things that you mentioned, but a number of the things that you mentioned there. So this was not one large system where we had a write-off that totaled the $9.5 million. It's a combination of a number of applications that fit the profile that you talked about here where we no longer are using that or expect that we're going to sunset it in a short time period, and therefore it's not appropriate to continue to amortize it over a longer time period.

Certainly we have been and we will continue to be very focused on the IT capital investments we're making going forward. And at times that does present, I'll call it important financial decisions to make because we may still have asset value on the books. And we have to determine whether it makes sense to continue to use that particular application or platform or to replace it, write it off as we have on certain things here, and then move forward with the new investment.

Thanks.

And we'll move on to Mike Mayo with CLSA.

Hi. This management change, that's a lot of change at one time. What was the catalyst for that? I guess you said to improve profitable growth, but was there any extra reason why it's now?

And when you say to improve profitable growth, to what? What sort of EPS growth, ROE, efficiency, pretax margin ratio are you seeking?

Mike, it's Rick. The reason why now is a lot of inputs into the decision. People's careers and where they are and length in job and time to get them exposed. So a lot of this is continuing to build out our leadership team and give people new roles.

But really the impetus was as a result of all the work that we've done over the last 2.5-plus years, beginning with our driving performance efforts and to leverage that, that learning that I call it the muscle memory that we've build up around in this environment which we don't expect to dramatically improve, to continue to drive efficiency, drive productivity, drive nimbleness throughout our organization in order to continue to grow profitably our businesses. Which are well positioned, client franchise, very, very strong brand, financial strength, et cetera.

It really is to take the last 2.5 years and what we've done around driving performance and the strategy review we put in place for the Board last year around our businesses. And what we felt it would take in order to grow profitably in order to reach our -- we have said publicly to get to the second part of your question, we've said we want a 10% to 15% ROE return.

We've been inching our way along and doing all the right things. But I think we've got an opportunity to accelerate that and not just to get into the 10%, the lower end of that range, which we did in the second quarter, but to get to the upper end of that range in the near term. And if we're going to do that, I feel we need a different organizational structure that brings the focus and the expertise and the talent that we have to bear on what Mike referred to as the things to enable this growth to grow, or these businesses to grow profitably.

And that was really the impetus, and it's a good time. We had a Board meeting yesterday, and I've been working with the Board and working with the Management team over the last several months to put this in place. And I'd say everybody, including me, is extremely excited about their new roles and the opportunities that we have, again, to leverage what we've been doing the last couple of years in order to accelerate the profitable growth of the Company.

Is there a new name for the new program?

Stay tuned.

Okay. Just a separate follow-up. If I hear you correctly, you think you can get to the high end of the ROE in the near term without higher interest rates, or is that a little too aggressive?

Certainly we wouldn't have a target range out there if we didn't think that we could ultimately get to it. And as Rick said, all the plans around this are to try to drive not only into the range, and well into the range, but ultimately get to that top end of the range. And trying to do so without the assumption that the macroenvironment gets much better and that takes us there.

As far as the timing to get there, very difficult, as even the Chairman of the Fed has a difficult time giving time frame for things. I think it's difficult to say when that will be. It's more that we just need to make sure that we're on the path towards getting there.

Let me ask it one way differently. The pretax margin was 28% core this quarter. Pre-crisis, it was 35%. Can you get back to that pretax margin, pre-crisis of 35% without higher interest rates?

I would say, Mike, that first of all that framework and looking at the margins is a good framework to look at and something that we do as well. So we know that we need to get that pretax margin into the 30%s in order to achieve the returns that we're targeting. Whether it's exactly 34%, 35%, whatever it may be, there's more to the calculation than that. But that is what we are driving towards is to get to those types of margins, absent just looking for the interest rate environment or the FX currency volatility environment to be better.

Actually, last question. When should we get additional updates on these initiatives that you're taking? I guess you'll have several new people in new seats, and how long will it take to get their plans out to the investment community?

I would say at this point, Mike, there's no grand plan, if you will, or roll-out of something. As Rick said, the businesses are extremely well positioned.

This is not a change in strategy. He's not looking to change the course of the strategy. This is an acceleration of what we've been doing.

Having said that, as far as the checkups and the monitoring along the way, every quarter we'll certainly be back like we are now to talk about the progress we're making towards those financial goals.

All right. Thank you.

And we'll take our final question from Geoffrey Elliott with Autonomous Research.

The 20% year-on-year growth in assets under custody, if we strip out the market performance from that, isn't that kind of a sustainable pace of organic growth? Or would you say that there are some lumpy wins in there and obviously the market performance is what it is, but if you take that out, are those -- is that basic growth on an underlying basis sustainable? Or was it driven by lumpiness that would be difficult to maintain that?

Geoffrey, if I understood the question correctly, that growth rate, if you will, in AUC year-over-year, so 20%, definitely a high rate, if you will, in the sense that it's being driven by very strong markets. And so markets are driving that, more than half of that growth, at least as best we can attribute the growth.

You also had a favorable foreign exchange impact to that, meaning just from a currency perspective, assets under custody that are denominated in pounds, for example, were up significantly on a year-over-year basis. So that helped it. And then the differential, if you will, is more towards the organic growth. And I would say that the organic growth, once you peel those other factors back, is consistent with both historical levels and also what we've been talking about.

And then one quick second question. The ECB move to negative deposit rates. Have you started charging for deposits in Europe, have you seen any of your competitors doing that?

I can't speak to exactly what all the competitors are doing. From our perspective, we are not charging clients, if you will, for deposits. It is certainly something that we are monitoring very closely, given the fact that the ECB is at a negative 10 basis point rate.

And that does certainly have an impact on the spread that we can earn on euro deposits that we have, because to the extent we're at 0, we have to reinvest those in some way. And as market rates come down it squeezes the spread on those deposits. So we'll continue to not only monitor the marketplace closely, but we've been in close communication with our clients as well.

Great. Thanks very much.

And that concludes today's question-and-answer session. At this time, I would like to turn the conference back over to our speakers for any additional or closing remarks.

We'd like to thank everybody for joining us today. Any follow-up questions, please contact myself, Bev Fleming, or Allison Clayton. Otherwise, we'll look forward to updating you on our third quarter performance in October.

Thank you very much. Have a nice day.

This concludes today's conference. We thank you for your participation.