Northern Trust Corp (NTRSO) 2017 Q2 法說會逐字稿

Good day, everyone, and welcome to the Northern Trust Corporation Second Quarter 2017 Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Biff Bowman, Chief Financial Officer; and Director of Investor Relations, Mark Bette, for opening remarks and introductions. Please go ahead.

Thank you, Anthony. Good morning, everyone, and welcome to Northern Trust Corporation's Second Quarter 2017 Earnings Conference Call. Joining me on our call this morning are Biff Bowman, our Chief Financial Officer; Aileen Blake, our Controller; and Kelly Moen from our Investor Relations team.

For those of you who did not receive our second quarter earnings press release and Financial Trends Report via e-mail this morning, they are both available on our website at northerntrust.com. Also, on our website, you will find our quarterly earnings review presentation, which we will use to guide today's conference call. This July 19 call is being webcast live on northerntrust.com. The only authorized rebroadcast of this call is the replay that will be available on our website through August 16. 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 2016 annual report on Form 10-K and other reports filed with the Securities and Exchange Commission for detailed information about factors that could affect actual results.

(Operator Instructions)

Before turning the call over to Biff, I would like review with you some of the larger nonrecurring items that are impacting the year-over-year comparisons. These items are outlined on Page 12 of today's presentation.

In the current quarter, we recorded a charge of $22.8 million related to severance and personnel-related costs. As outlined in our earnings release, $19.5 million of that charge appears in the compensation line, $2.5 million in employee benefit expense and $0.8 million in outside services expense. Excluding this charge, our expense in the second quarter totaled $915 million. Our actions taken this quarter reflect a continued focus on improving profitability and returns, and we expect the charge to produce annual ongoing savings of approximately $18 million once fully implemented.

In the prior year's results, you'll recall that there were several items that we reported to you last year: a pretax charge of $118.2 million and other operating income on the sale of 1.1 million Class B Visa shares; a pretax loss of $21.6 million associated with our loan and lease portfolio. Of the $21.6 million in losses, $18.9 million was reflected on the other operating income line, with the remaining $2.7 million reflected within net interest income; a pretax charge of $46.5 million and other operating expense in connection with the settlement of certain securities-lending-related litigation; a pretax charge of $18.6 million in other operating expense relating to contractual modifications associated with existing C&IS asset servicing clients; and a pretax charge of $17.5 million related to severance and personnel-related costs. Excluding these items, the prior year quarter's revenue was $1.2 billion and expense was $842 million.

Thank you again for joining us today. Let me turn the call over to Biff Bowman.

Good morning, everyone. Let me join Mark in welcoming you to Northern Trust's Second Quarter 2017 Earnings Conference Call.

Starting on Page 2 of our quarterly earnings review presentation. This morning, we reported second quarter net income of $268 million. Earnings per share were $1.12, and our return on common equity was 11.6%.

Excluding the current quarter's severance charge that Mark noted, net income was $283 million, earnings per share were $1.18, and our return on common equity was 12.2%. Our assets under custody and administration, assets under custody and assets under management increased 15%, 16% and 14%, respectively, compared to the prior year, reflecting favorable markets and our continued success in winning new business.

A number of environmental factors impact our businesses as well as our clients. Before going through our results in detail, let me review how some of those factors unfolded during the second quarter.

Equity markets performed well during the quarter. In U.S. markets, the S&P 500 ended the quarter up 15.5% year-over-year and up 2.6% sequentially. In international markets, the MSCI EAFE Index was up 18.9% year-over-year and up 1.7% sequentially. Recall that some of our fees are based on lagged market values and first quarter markets were also up compared to the prior year as well as sequentially.

In bond markets, the Barclays U.S. Aggregate Index was down 3.4% compared to the last year and up 0.7% sequentially. Currency volatility, as measured by the G7 Index, was 28.3% lower compared to last year and 21% lower sequentially.

Foreign exchange market volumes were also lower during the quarter. As measured by 2 of the interbank brokers, volumes were down 6% to 14% year-over-year and down 2% to 8% sequentially. You'll recall that currency volatility and client activity influenced our foreign exchange trading income.

Currency rates influence the translation of non-U. S. currencies to the U.S. dollar and, therefore, impact client assets and certain revenues and expenses. The British pound ended the quarter down 3% compared to last year, while the euro ended the quarter 3% higher. On a sequential basis as compared to the U.S. dollar, the British pound and euro both strengthened by 4% and 6%, respectively. U.S. short-term interest rates were higher during the quarter, most evident in 3-month LIBOR, which averaged 121 basis points during the quarter compared to 107 basis points in the prior quarter and 64 basis points 1 year ago.

Let's move to Page 3 and review the financial highlights of the second quarter. Year-over-year, revenue was flat. Excluding the items Mark noted, revenue was up 8% compared to the last year with noninterest income up 7% and net interest income up 13%. Expenses increased 1% from last year. Again, adjusting for the items that Mark noted, expenses were up 9% from 1 year ago. The provision for credit losses was a credit of $7 million. Net income was 2% higher year-over-year. Excluding the previously called out items, net income was up 11% from the prior year.

In the sequential comparison, revenue was up 3%, with noninterest income up 5% and net interest income down 3%. Expenses were up 5% compared to the prior quarter, and net income was down 3%. Excluding the current quarter's severance charge, both expense and net income were up 2% sequentially.

Return on average common equity was at 11.6% for the quarter, down from 12.3% 1 year ago and equal to the prior quarter. Excluding the current quarter's severance charge, return on average common equity was 12.2%, up from last year's adjusted 11.9% and up from last quarter's 11.6%.

Assets under custody and administration of $9.3 trillion increased 15% compared to 1 year ago and 4% on a sequential basis. Assets under custody of $7.4 trillion increased 16% compared to 1 year ago and 4% on a sequential basis. For both the year-over-year and sequential comparisons, strong new business and favorable market impacts were the driver. On a sequential basis, currency translation was [also a] benefit.

Assets under management were $1 trillion, up 14% year-over-year and up 3% on a sequential basis. Favorable market impacts were the primary driver of both the year-over-year and sequential comparisons.

Let's look at results in greater detail, starting with revenue on Page 4. Second quarter revenue on a fully taxable equivalent basis was $1.3 billion. Excluding last year's call-out items that Mark highlighted, revenue was up 8% from last year and up 3% sequentially. Trust, investment and other servicing fees represent the largest component of our revenue and were $848 million in the second quarter, up 9% year-over-year and up 5% from the prior quarter.

Foreign exchange trading income was $50 million in the second quarter, down 22% year-over-year and up 4% sequentially. Both comparisons were primarily impacted by lower currency volatility.

Other noninterest income was $82 million in the second quarter. This was down 53% from 1 year ago. Excluding last year's net gains on the sale of Visa Class B shares, other noninterest income was up 8% from 1 year ago and up 10% sequentially. Both the year-over-year and sequential performance were primarily driven by higher securities, commissions and trading income as well as net gains on hedging activities. Net interest income, which I will discuss in more detail later, was $350 million in the second quarter, increasing 14% year-over-year but down 3% sequentially.

Let's look at the components of our trust and investment fees on Page 5. For our Corporate & Institutional Services business, fees totaled $487 million in the second quarter, up 9% year-over-year and 5% on a sequential basis.

Custody and fund administration fees, the largest component of C&IS fees, were $327 million, up 12% compared to the prior year and up 7% sequentially. Both the year-over-year and sequential comparisons benefited from strong new business and favorable equity markets, with the year-over-year growth partially offset by the unfavorable impact of currency exchange rates. On a sequential basis, currency exchange rates were a benefit.

Assets under custody for C&IS clients were $6.8 trillion at quarter end, up 16% year-over-year and 4% sequentially. These results primarily reflect new business and favorable markets.

Currency exchange rates were also a benefit on the sequential comparison. Recall that lagged market values factor into the quarter's fees with both quarter lag and month lag markets impacting our C&IS custody and fund administration fees.

Investment management fees in C&IS of $99 million in the second quarter were up 5% year-over-year and up 6% sequentially. Both the year-over-year and sequential comparisons were driven mainly by favorable markets.

Assets under management for C&IS clients were $763 billion, up 13% year-over-year and 3% sequentially. Favorable market impacts were the primary driver of both the year-over-year and sequential comparisons.

Securities lending fees were $25 million in the second quarter, 8% lower than 1 year ago and up 3% sequentially. The year-over-year decline was driven by lower spreads partially offset by higher volumes. The sequential increase was driven by higher volumes but partially offset by lower spreads. Recall that during a rising-rate environment, spreads can at first narrow as the maturity profile of investments results in a lag before the cash reinvestment yields adjust to the higher rate environment. Securities lending collateral was $131 billion at quarter end and averaged $133 billion across the quarter.

Average collateral levels increased 14% year-over-year and 8% sequentially. The growth in collateral amounts and associated loan volumes compared to a year ago was driven by loans of U.S. and international fixed income securities. The sequential increase was driven by loans of both U.S. and international equities.

Other fees in C&IS were $36 million in the second quarter, up 10% year-over-year, reflecting higher fees from investment, risk and analytical services, benefit payments and other ancillary services. In the sequential comparison, other fees were down 6%, primarily reflecting the normal seasonal pattern in our benefit payment business.

Moving to our Wealth Management business. Trust investment and other servicing fees were $361 million in the second quarter, up 9% year-over-year and 5% sequentially. Within Wealth Management, the Global Family Office business had strong performance with fees increasing 17% year-over-year and 6% sequentially. Each of the regions also performed well during the quarter. Across Global Family Office in each of the regions, both the year-over-year and sequential growth was driven by favorable markets and new business. Assets under management for Wealth Management clients were $266 billion at quarter end, up 14% year-over-year and 2% sequentially.

Moving to Page 6. Net interest income was $350 million in the second quarter, up 14% year-over-year. Earning assets averaged $110 billion in the second quarter, up 3% versus last year, driven primarily by higher level of deposits.

Non-U. S. office interest-bearing deposits, which averaged $57 billion, were up 12% year-over-year. Loan balances averaged $34 billion in the second quarter and were down 2% compared to 1 year ago.

The net interest margin was 1.28% in the second quarter and was up 12 basis points from a year ago. The improvement in the net interest margin compared to the prior year primarily reflects a higher yield on earning assets due to higher short-term interest rates. On a sequential quarter basis, net interest income was down 3% as the net interest margin declined 7 basis points sequentially, as the favorable impact from higher U.S. short-term rates was more than offset by higher premium amortization and a change in the currency mix of our balance sheet.

During the quarter, we saw U.S. dollar-denominated deposits decline. These declines were more than offset by increases in non-U. S. dollar deposits, mainly in British pounds and euros. These non-U. S. dollar deposits are lower margin than U.S. dollar deposits, given the low interest rates still persisting in Europe. Thus, this currency mix shift adversely impacted the net interest margin. Premium amortization was $15 million in the second quarter compared to $20 million 1 year ago and $1 million in the first quarter.

Turning to Page 7. Expenses were $937 million in the second quarter and were 1% higher than the prior year and up 5% sequentially. Excluding the charges in both years, current quarter expenses of $950 million increased 9% year-over-year and were up 2% sequentially.

Compensation expense was $433 million and increased 11% compared to last year and 2% sequentially. Excluding the severance-related charges in the current quarter and the prior year's results, compensation was up 10% year-over-year and declined 3% sequentially.

The year-over-year growth was attributable to base pay adjustments, staff growth and higher performance-based compensation, partially offset by the favorable translation impact of changes in currency rates. Recall that for this quarter, we have 2 sets of base pay adjustments in the year-over-year comparison as the 2016 increases were deferred until October 1 of last year and the 2017 adjustments were effective April 1 of this year. Staff levels increased approximately 6% year-over-year with the growth all being attributable to lower-cost locations, which include India, Manila, Limerick, Ireland and Tempe.

The higher level of performance-based compensation was driven by long-term equity-based compensation as well as a higher level of accrued cash-based incentives. Equity-based compensation increased $8.5 million compared to the prior year. This increase was primarily attributable to a change in the vesting provisions associated with the retirement-eligible employees, which allows their restricted and performance stock units to continue to vest upon retirement.

Recall that we discussed this change on last quarter's call, and we highlighted that with this change, approximately 50% of the expense associated with this year's grants would have been recognized by the end of the second quarter compared to only 15% to 20% having been recognized under prior plan provisions. Therefore, this change is largely an expense timing issue. The sequential decline of 3% in compensation expense, excluding severance charges, was driven by a $27.6 million decline in equity-based compensation, primarily relating to the timing of retirement-eligible expense, partially offset by base pay adjustments, higher short-term cash incentives and staff growth.

Employee benefit expense, excluding severance costs, was $73 million and was up 3% year-over-year, primarily reflecting higher payroll taxes and retirement costs, partially offset by lower medical costs. On a sequential quarter basis, benefit expense was down 6% reflecting lower medical costs and a decline in payroll taxes.

Outside services expense, including severance-related costs, was $166 million and was up 5% compared to the prior year, driven primarily by higher market data costs within technical services, higher subcustody costs and higher third-party adviser fees, partially offset by lower consulting spend. On a sequential basis, outside service expense was up 8%, primarily driven by higher consulting, legal, subcustody and market data costs.

Equipment and software expense of $134 million was up 13% from 1 year ago and up 5% sequentially. Both the year-over-year and sequential growth were driven by increased software amortization as well as software support and rental costs, continuing the implementation of our technology strategy as we invest to support clients and improve employee efficiency. Occupancy expense of $46 million was up 2% both on a year-over-year as well as a sequential basis, driven by higher rent and building operational costs.

Other operating expense of $82 million increased 12% from last year after adjusting for last year's special items. The year-over-year growth was primarily related to higher charges associated with account servicing activities, higher business promotion spend as well as higher FDIC insurance costs. On a sequential basis, the category increased 27%, driven by higher charges associated with account servicing activities, higher business promotion spend and an increase in staff relocation costs.

Turning to Page 8. A key focus has been on sustainably enhancing profitability and returns. This slide reflects the progress we have made in recent years to improve the expense-to-fee ratio, pretax margin and, ultimately, our return on equity.

The ratio of expenses to trust and investment fees is a particularly important measure of our progress as it addresses what we can most directly control. Reducing this measure from where it was previously, as high as 131% in 2011, to the levels we see today is a key contributor to the improvement in our return on equity. Although this ratio has flattened in recent periods, we remain committed to driving it lower by continuing to focus on what we can directly control: Winning new business to drive fee growth and driving efficiencies in our cost base. Our productivity efforts include further implementing our location strategy, driving procurement efficiency and using technology to drive productivity.

Turning to Page 9. Our capital ratios remain strong, with common equity Tier 1 ratios of 13.2% and 12.3%, respectively, calculated on a transition basis for both advanced and standardized. On a fully phased-in basis, our common equity Tier 1 capital ratio under the advanced approach would be approximately 13.1% and under the standardized approach would be approximately 12.1%. All of these ratios are well above the fully phased-in requirement of 7%, which includes the capital conservation buffer.

The supplementary leverage ratio at the corporation was 7% and at the bank was 6.2%, both of which exceed the 3% requirement, which will be applicable to Northern Trust in 2018. With respect to the liquidity coverage ratio, Northern Trust is above the 100% minimum requirement that became effective on January 1, 2017. As Northern Trust progresses through fully phased-in Basel III implementation, there could be additional enhancements to our models and further guidance from 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 1.8 million shares of common stock at a cost of 180 -- excuse me, at a cost of $158 million. The repurchases during the quarter did include our utilization of the de minimis exception as we finished the 2016 capital plan year.

As we announced in June, our 2017 capital plan received no objection from the Federal Reserve. In it, we requested authority to increase our quarterly common dividend to $0.42 per share. Yesterday, our Board of Directors formally approved the planned dividend increase. The capital plan also provides the flexibility to repurchase up to $750 million of common stock. The timing and amount of shares repurchased will depend on various factors, including but not limited to, Northern Trust business plans, financial performance, other investment opportunities and general market conditions.

In closing, the second quarter of 2017 was characterized by favorable global equity markets, rising short-term interest rates in the U.S. and low currency volatility. Northern Trust delivered solid financial results in the quarter, growing earnings per share by 10% and delivering return on average common equity of 12.2%, both on an adjusted basis. We achieved positive fee operating leverage, both on a sequential and year-over-year basis when excluding the previously called out items in both periods. Our assets under custody and administration, assets under custody and assets under management were up 15%, 16% and 14%, respectively, compared to the prior year. During the quarter, we also returned $252 million to shareholders through dividends and stock repurchases while maintaining strong capital ratios and funding our growth.

Our Wealth Management business grew revenue 10% year-over-year and continued to produce attractive margins, achieving a 39% pretax margin. Our success in Wealth Management has been well diversified across our regions and our Global Family Office.

Our C&IS business also continued its strong growth trajectory with revenue growth of 12%. During the quarter, we've been working diligently toward closing the previously announced acquisition of UBS Asset Management's fund administration servicing units in Luxembourg and Switzerland. And we continue to expect the transaction to close before year-end. This transaction, which remains subject to applicable regulatory and fund board approvals and other customary closing conditions, will significantly enhance our client capability in these 2 very important global fund marketplaces.

As we discussed on last quarter's call, we are looking forward to being the title sponsor of the lead FedEx playoff event next month. The event, to be named "The Northern Trust", will be held in the New York area. Recall in past years, we had expense associated with the Northern Trust Open in our first quarter expenses. While moving ahead, the expense associated with our sponsored event will now be carried in the third quarter when the new tournament will be held.

We are expecting the expense associated with the sponsorship, advertising, marketing and surrounding events to be approximately $0.05 per share in the quarter. Our sponsorship of this event is in line with our strategic focus of continuing to grow our business in the Northeast and in particular, the greater New York area.

Finally, earlier this morning, we announced that we will be establishing an EU banking presence in Luxembourg. We are implementing these plans to continue to meet client and business needs in a post-Brexit environment. And this, combined with the pending acquisition, underscores our continued focus of growing our business in continental Europe.

Thank you again for participating in Northern Trust's second quarter earnings conference call today. Mark and I would be happy to answer your questions. Anthony, please open the line.

(Operator Instructions) It appears our first question comes from Ken Usdin with Jefferies.

Biff, just -- I'll focus on the net interest margin and balance sheet side. Can you help us explain, if you separate the sides of the balance sheets, how much of that mix shift effect from U.S. to non-U. S. was either temporary, permanent, something you control, something you can't control? Meaning, is this the new run rate? Or are there some certain things across the business that just happened that were out of your control?

So let me break that into 2 parts, because the first part of that was the growth in the foreign office deposits that you saw. I would characterize that growth that we saw, which is $4 billion to $5 billion that we saw grow there, as largely business as usual. It reflected new business, and it reflects our client's normal activities where they're transitioning in and out of portfolios and in and out of different currencies. I would call that growth that we saw there business as usual, nothing structural. The $3 billion that you see that left the balance sheet from the noninterest-bearing deposits in dollars, I would say, has been driven by clients' reactions to a rising-rate environment. So in that noninterest-bearing component, we have clients who heretofore have remained in that bucket. But as we've seen the rate rises, many have come and said, "I need to look at alternatives for my cash." Of the $3 billion that moved off, $1 billion or so moved into our cash fund, so they chose that off-balance-sheet solution. $1 billion or so, we retained but have moved to an interest bearing, because they represent broader clients of the Northern. And about $1 billion left the balance sheet, where that relationship with us was either very narrow or did not exist other than it just being a deposit. So that bucket of noninterest-bearing deposits, I think, is a very important part of the story, Ken. That $3 billion runoff, it sits in a line item today that represents about 20% of the balance sheet, which is noninterest-bearing deposits. Precrisis, that represented about 12% of the balance sheet. It's been as high as 23% of the balance sheet. We're looking at how that part of the balance sheet will move in a rising-rate environment. I can tell you that much of it is still core operating deposits, but there is a portion that has been here temporarily, particularly as we've grown our hedge fund servicing business and our GFS business, our Global Fund Services business. They attract large-asset-base clients. So we probably need to calibrate -- or the analysts need to calibrate between kind of where we're at 20% and that historical 12% as to where do you think, as a portion of the balance sheet, those could go in a rising-rate environment. Our current dialogues, in many cases, have led them to consider, as I just pointed out, our own off-balance-sheet opportunity. So this may move from a net interest income line to an investment fee line in that case.

Okay. So that explains the right side of the balance sheet, which makes a lot of sense. Can you now also just follow-up? I think the bigger surprise than that is the fact that a lot of the asset-side line items on the average earning interest statement actually had flat to down yields. So can you just give us kind of that same kind of understanding of why the assets of the asset side sensitivity did not show through on many, if any, lines at all, aside from the expected premium amortization?

Yes, so -- sure. First, let me give the -- $14 million of that was premium amortization, and you can see that flowing largely, if you're on our trend report, through the government-sponsored agency that you would've expected probably to see move up with a rate rise and, in fact, it moved down. If you go to the loans -- let's look at the asset side. So if we go to the loans, while that did move up, there are a couple of factors inside of loans that I think are worthy of call out. The first is that we actually had about $2 million worth of lease residual write-downs in the quarter, so that constrained it by about 3 basis points, the loan yield. And then we also have somewhat of the phenomenon of the repricing timing in those loans based on their structural elements, that we see more of that repricing happen in the first quarter just from a unique timing of that component. So that probably -- people were looking for a larger yield move on that loan and lease line. Those are some of the factors that somewhat constrained that. If you look on any of the other asset lines that -- I don't know if you had any, Ken, in particular that you wanted to highlight rather than me going through asset by asset. But...

I would just say, if you can just focus on even the ones that were just down, like interest-bearing deposits was down. The fed funds line only moved up 5. U.S. government was down. Munis was flat. So -- and the Other was flat. So the rates -- the short-term nature of the securities book just didn't pull through in most of those lines. So I don't know if there is a specific reason on each, but that's what people are asking.

So Ken, on interest bearing due from banks, the 91 bp move in the first quarter down to 74, that would mainly be a currency impact. So the fact that we've highlighted that the -- we've had U.S. dollar deposits decline, but we had non-U. S. dollar deposits increase. And that mix would also come through on the asset side. So that's a little bit of what we're seeing on the asset side as well and especially on that interest-bearing deposit with bank line.

Okay. So I guess, if you could wrap up NIM, just any thoughts, Biff, just on the trajectory of NIM from here? I'll leave it there.

Sure. Obviously, there's a series of factors in there. You know them well, Ken. The -- if we talk about the deposit betas that we've seen are on the retail side, they've remained low, although we are sensing that maybe there is some movement in the marketplace for that to come under pressure. And we monitor and track that to remain competitive. So the deposit betas on the retail side, that's the story. On the institutional side, we've seen the deposit betas obviously move up, and you can see that in our cost of funding flowing through the balance sheet. It's continued to move kind of on a trajectory that we would have anticipated and continues to be competitive on that front. On the asset side, remember that in the third quarter, traditionally we have seen premium amortization be high, so that could be a factor into the third quarter, as second and third quarters typically are our highest 2 quarters for premium amortization. Generally, because the retail deposit beta is low and because the institutional deposit beta isn't to 1, there is still upward possibilities in the NIM. Those factually say there are still upward NIM possibilities that we will see in a normalized environment. In any given quarter, that can be masked with the premium amortization. But we still think that there is, based on the beta story I just gave you, upward NIM possibilities.

Our next question comes from Brian Bedell with Deutsche Bank.

The -- maybe just to switch to expenses, if you could talk a little bit about some of the legal and consulting expenses in the outside services bucket as -- do you see that as sort of continuing to recur or more oriented to the second quarter? And then in the Other expense line, you mentioned the account service -- servicing charges. Are those more like processing errors or something related to that, that are also onetime?

Sure. Let me, if I could, maybe walk through a little bit of the expense story in some detail. And I'll start with the last question you had, Brian, is -- we did see a higher-than-normal run rate, if you will, in the costs associated with account servicing. Those are operational costs and errors associated with servicing clients. We had approximately 1 point -- 1 full point of expense growth above our normal run rate in that area. So if you look at our 8.5% expense growth rate that we talked about early, about 1% of that was in a couple of instances in the quarter in that line item. The second item that I would point out in the expense structure is that we did have about 1 point of expense growth that was still residual from the LTI, the long-term incentive decision around equity that we took in the first quarter, which we said would be in this quarter as well and told you it will be about $8 million. That was -- flowed through in this quarter. That was about another 1 point of the expense growth, of our 8.5%. So that explains 2. And the third item is, which we talked about in the script, is the fact that our comparison for salary increases, we have 2 salary increases in this quarter versus none in the comparative quarter a year ago. If you had a normalized view where you were, if you will, lapping just one, that would've produced about 1 more point of growth. So those areas drop 3 points of growth -- or they explain -- I shouldn't say drop. They explain 3 points of the growth. In terms of your question around the sequential increase on consulting and legal, I think what's important here is, year-over-year, both of those are down. Consulting is down meaningfully year-over-year. But in a sequential period, you can have some -- a spiky nature to that. It could be that we need assistance on specific regulatory matters for instance or specific operational initiatives that we've embarked on. But we look at it in kind of 6-month buckets, and over the last 4 sets of those 6-month periods, we've actually seen the consulting spend come down. It did have a spike in the second quarter around some specific items that we're working on, resolution planning, which you would be familiar with, being one of those. And I think legal just -- you can read our 10-Q, but our RPL is very modest. So legal could just have some spikiness in any quarter.

Great. And just looking forward, I guess, into the third and fourth quarter as, of course, you've got the golf outing in the third quarter and then you're establishing the bank in Luxembourg. Is that mostly in the run rate in terms of that cost? Or is that still in process?

So we gave you the Northern Trust ramp in the third quarter. There are some costs that we've already incurred as we've embarked on the Luxembourg. And there will be some going forward. Those are modest in terms of the way you should think about those flowing through in terms of the cost of those, and they will be spread out over the coming quarters. So probably in any 1 quarter, not worthy of any special call out.

Great. And then just a clarification. Thanks for all the detail on the balance sheet. The loan repricing if I recall, that's about a 1-year lag. So would we expect, I guess, to the December '16 hike fee material loan repricing in the -- shifted to the fourth quarter of this year? Or do you think it's a little bit either before that or after that? And then, do you plan on changing our investment strategy on the balance sheet as a result of the things that you're monitoring for client deposit behavior in a rising-rate environment?

Brian, this is Mark. I can take on the loan. So actually, about 75% of our loans reprice within a year. But that repricing, that's not necessarily been a floating repricing necessarily, so a lot of it will depend on the timing. And there are, I think, more of those renewals that kind of come up in the fourth quarter or early in the first quarter. So they would've been more fully realized in the first quarter run rate than what we saw come through on the second quarter. So it can fluctuate just based on the timing of when certain renewals come up.

And in terms of changing the portfolio strategy or the investment strategy, again, we're liability-driven. So we're out trying and winning new business and serving our existing client base, and they bring their balances and others. And we always have and continue to have a philosophy of conservatively managing those liabilities and turning them into what is and what you see as a relatively conservative portfolio but one that's produced, I think, consistent net interest income for the firm.

Our next question comes from Michael Carrier with Bank of America Merrill Lynch.

Biff, just looking at -- on Page 8, where you have the operating leverage and the efficiencies, and since like 2015, both the fee to expenses and the margin has kind of flatlined, yet the environment's been fairly favorable, both rates and markets. Just want to get your perspective, like is something changing on the investment side that the run rate of expenses is so much higher than maybe we would expect? And going forward, I know you guys have talked about some of the things that you're working on to try to bring efficiencies, but the expense growth rate continues to be elevated. So just wanted to get some sense when we can start to see those -- like the profitability metrics improve.

Let me -- you're right, the line has flattened out. And I would suggest in this quarter, we remain focused on it and would like to see that continue to widen out. And we did not -- we did have some fee leverage in the quarter, but it's with the backdrop of a pretty strong market. So we remain focused on that. Let me try to pull that apart a little bit. Take the equipment software line, it's up 13%. Underpinning that has been a capital expenditure program over the past 1, 2 and 3 years that we think will drive investment for our franchise going forward. But you're seeing right now run through that depreciation and amortization, in some cases, ahead of the expense savings and initiatives. We clearly have got to keep that balance correct. As I just highlighted, there were some unique items in this quarter's expense rate, so that fee leverage can be different depending on how you look at those items that I called out. So there was probably wider than the sort of flat leverage. But we continue to remain focused on the initiatives around location and moving our people to the right place to drive that fee leverage as wide as we can but yet still produce what we think was pretty strong top line repeat growth, at 9%. So we need some expense to do that. And the last part of that question, Mike, was -- in some areas like the outside services line, remember that while that item grows, when you saw sequentially or year-over-year, much of the expense in there is actually sort of tied to market levels and revenue levels and volume levels. For instance, market data is often priced off of AUM or AUC. We've got sub-custody expense that's tied to our holdings around the globe. So there is a linkage that will naturally flow in the growth in some of those line items to that. How far we can widen that out from our fee growth is what we remain focused on.

Okay. And then, just as a follow-up, getting back to the net interest income, I get your comment on -- that the balance sheet is liability-driven. When you look at some of those clients that is, what you mentioned, is the normal course of business on the non-U. S. deposit side, how do you guys think about that client like overall for Northern? Meaning, obviously, it pressures like the net interest income. But what else is going on with that client as his balances are coming in? Are you benefiting more on the fee side? Are there new transaction revenues? And then anything on the cost that, over time, you'll increase scale? Just trying to put the pieces together.

So we actually look at our clients and their profitability on a client-by-client basis. And we do it not only on a margin, but we do it on a return on capital. So we look at our clients individually to understand that do they bring the right mix of services, albeit they may bring deposits. They may bring fee-based business. In some cases, they bring credit and loan income. We look at that blend, and we look at the capital allocated to it at a client level. And so to your question, clearly, that the growth rate that you saw there, certain clients were utilizing capital. And they were utilizing or pressuring, if you will, in some cases, our net interest margin. But we look at them across that broad array of services and have great dialogues with them about -- if they're not producing the right kinds of relationship with us, we have dialogues about other products and services and capabilities that we can bring to the table to help balance that out. And that's generally -- this quarter, that allowed us to generate a 12.2% return on equity, that type of approach and one that we're, as we say, we're committed to deliver between that 10% to 15% range on a client-by-client kind of approach.

Our next question comes from Brennan Hawken with UBS.

I just wanted to follow up on some of Ken's questions. But instead of a -- start out maybe on the funding cost side. We saw the U.S. office interest-bearing deposit costs increase this quarter. And given that there's growth there and given how low the yields are overseas, I guess, I'm just -- I get how putting those assets to work could weigh on yields. Wouldn't that though also -- or shouldn't that translate into cheaper funding costs? So could you help me understand either why I'm thinking about that incorrectly? Or what was going on that might've created some noise there?

So Brennan, this is Mark. On an -- I think you're referring to the non-U. S. growth and the fact that the interest expense on that increased as well. Is that one -- is that part of the question?

Yes. No, that's exactly it.

Yes, so we do have -- so for the non-U. S. office deposits, a significant part of those deposits are actually in U.S. dollar. But we -- they're on that line of the balance sheet because we collect them in non-U. S. offices. So if we look at the totality of deposits though, we're at about, for this quarter, about 71% of our total deposits were U.S. dollar, and that compares to 74% of our total deposits 1 quarter ago and 75% 1 year ago. So the movement that you see in the interest rate on the non-U. S. office interest-bearing from 17 bps to 24 bps is actually a function of the U.S. dollar or the U.S. dollar interest rates and there being a significant proportion of U.S. dollar within that category. And then on the savings, money market and Other line, I think you referred to the U.S. deposit rates going up. And that there would be -- most of that is retail, which we haven't seen a lot of movement. But there is some institutional that sits on that line. So when we have U.S. rates going up, we expect both the non-U. S. office deposit line as well as the savings, money market and Other line to move higher.

Okay. So I guess, following up on that, the non-U. S. side, if you collect in non-U. S. offices, and you put it on the balance sheet in U.S. dollar, but then you put it to work in other markets where the yield may not be as favorable, aren't you basically allowing our clients to negatively [AARB] yield geographies? And is that the best way necessarily to price out the funding construct for those assets? I'm just a little confused there. So if you could help out, that would be great.

Yes, so we do match off the currencies on the balance sheet. So if we do collect in our non-U. S. office locations, if we collect U.S. dollar deposits, we do put those to work in U.S. -- on the asset side, in U.S. dollars. So we do match those off. It just so happened that the growth that we had this quarter in non-U. S. offices was not in the U.S. dollar part of it. It was in the non-U. S. dollar part of it.

Yes, sterling and euro.

I'm still a bit confused, but I can follow up. No need to drag on the call.

Our next question comes from Gerard Cassidy with RBC.

Can you give us your 30,000-foot kind of view with the Federal Reserve's actions that are coming with the unwind of the balance sheet? There's an expectation that the deposits in the banking system will be affected by this, whether there'll be a decline. Can you give us a view of what you guys think you may see on your balance sheet from the Fed action as it goes full speed next year?

Sure. As you know, when the QE was put in place, many -- and in particular, the trust banks saw their balance sheets grow. If you believe that the unwind will drive the interest rates up faster than expectations, it's not unreasonable to think that our clients and money that's on balance sheets will be looking at alternative places to find that: treasury portfolios and funds, et cetera. Our view right now, our house view is that it will be very orderly, and that we would see any rate rises be reasonably measured, and that deposit flows would be measured too in their movement on and off balance sheet in that environment. I think one of the things that we have to think about is we're not constrained, not really terribly constrained by leverage ratio and other items. So if there's opportunities to take some of those deposits onto the balance sheet, if they make sense from a relationship standpoint, we don't have some of the regulatory constraints if they're flowing between banks or between funds and banks' balance sheets. I think right now, we think it will be done in a measured way and have a moderate to modest impact for us.

Okay. And can you also share with us -- quite often, business customers use compensating balances to pay for services rendered by you and your peers. And obviously, as rates go higher, I would assume then that the amount of the compensating balance doesn't need to be as great when we're in a lower rate environment. Is that a safe assumption? And if it is, should we see some deposit outflow if rates continue to move for compensating balances?

So I think compensating balances is generally only linked to our treasury management business, which is fairly modest on our revenue line. Our trust and custody balances are not traditionally billed on a compensating balance-type format. So I would say that for our overall financial statements, that would have a very limited potential impact for us.

Good. Good. And then, just a technical question. You gave us that, I think, $0.05 per share for the golf expense in the third quarter. Was that after tax or pretax, the $0.05, if I heard it correctly?

$0.05 after. After, sorry, after.

Our next question comes from Glenn Schorr with Evercore.

Just a couple of quickie follow-ups. Share count, flat to drop up year-on-year, but you had a pretty big buyback in place. Can you just talk about the offsets and if any of that's related to timing?

Yes. Largely, you have option exercise and other share issuances in the quarter but largely from an option exercise driver.

With the cap rates...

That's share count -- that's capital, excuse me. That's the capital. On the share count -- yes, sorry, that's on the capital. On the share count, you had asked share count, not capital. On the share count, I'm going to have to get back to you. I'm not sure. We bought back, but we stayed relatively flat. So we'll get back to you.

Okay. I meant, it's something that I assume would trend down given the size of your capital return. You mentioned, when you talk about sec lending down 8% year-on-year, you talked about the spread lags but eventually lifts in a rising-rate environment. Is there a particular reason why that is? Is just that a market dynamic? In other words, it gets passed through initially off a low base and then eventually you get to keep a little bit more?

Glenn, it's Mark. Yes, on that, it's -- there's really -- there's a lag from the time when the -- we do think a higher interest rate environment is a positive factor overall for sec lending. So eventually, when you get to the higher level, that's a positive thing. But the process getting there sometimes pinches the margin. It's really because the rebate rates on loans against a cash collateral adjust more quickly than the cash reinvestment returns. Those cash reinvestment returns are pretty short. So it doesn't take long for them to reprice. But if they're out 30 days or so, then it could have a minimal impact on the spread. And the spreads were -- they were minimally down sequentially. It wasn't a large decline, but they were minimally down.

Got it, okay. And last one, I had heard that there might've been some strategic decisions on passive versus active in part of your Asset Management businesses. Is that something that you've been thinking about and have been contemplating lately?

I don't have any comment to add on that. I'm not sure what that -- it's in reference to.

Just -- I can ask it a different way. I guess, you have a fantastic passive franchise and good-in-parts active franchise. And I guess, how are you growing the Asset Management presence? I know it's -- there's a piece that's there to service the current client base, but there's also another great piece that's -- has Asset Management-only customers.

Okay. So we remain on -- we remain focused on all of the capabilities. From passive, we've grown our ETFs to about $14 billion in AUM, and we continued to grow our engineered equity program across all asset classes. Internally, we have traditionally distributed through our -- and maybe this is what you were trying to get to, we've traditionally distributed through our existing client base. We continue, though, to be committed to distributing through third party and intermediaries as well. And there is investment and that product and capability that we've really been going after for a few years, but in earnest in the last year or so.

And as an example, the growth that we've seen on the ETF side, a pretty good share of that has come through a third party as opposed to directly through the Wealth Management or C&IS channels.

Our next question comes from Betsy Graseck with Morgan Stanley.

I just wanted to get a sense of when you do close the acquisition of Luxembourg bank, could you give us a sense as to how we should anticipate the impact on the balance sheet and on the income statement, if there's going to be a mix shift even further in certain currencies that we should anticipate?

Yes, for the acquisition, I don't know that the balance sheet will -- we would see a significant impact on the balance sheet side unless...

No, there will be limited to no balance sheet impact from the acquisition. So we are acquiring fee-based services from -- in the acquisition.

Right. So there's no deposits coming in?

I don't know if we've disclosed that at this point, but we bought the fund administration and the fees associated with that business. So yes, that's a reasonable assumption.

Okay. And then, at the end of the quarter, you mentioned that there was an influx of deposits in the European region. Could you just give us a sense as to what drove that? Because the end-of-period balances obviously did go up quite a bit relative to the average. And I'm just wondering what type of activity would drive that big of a move.

So they're likely 2 areas that could drive that: One could be, we could have clients with large pools of assets, particularly in Europe, that could be restructuring portfolios and moving certain portions of their assets around in transitional-type periods while they reconfigure or restructure portfolios. And that could have very short-term impacts. And then we also have an [Edge Act] subsidiary that does certain clearing for certain foreign entities. And they can, at any point in time, keep large euro or other balances that could be -- or the clients could leave those balances with us at period ends. So we do typically see some spiking from those 2 types of activities.

So one is transition management and one is [Edge Act] clearing related? I guess, yes...

So clients themselves transition -- not necessarily our transition management business, but the clients are moving some of their assets around in periods near quarter ends, typically.

Sure. And then, is there anything in there around just the rate outlook on the euro that would -- that you think, based on what you saw in this quarter, that you would expect would drive increased behavior like this going forward? I'm just wondering if there's a link-in at all to improving outlook in rates in the -- in Europe that would lead us to expect that this kind of activity would continue.

Yes, I don't believe so. I don't know that there's anything fundamentally that's triggered the activity and the growth that we saw that's fundamental to either an improving or an increasing rate environment in Europe, at least at this stage.

Our next question comes from Brian Kleinhanzl with KBW.

Kind of a quick question, follow-up, on the loan yields here. So if I'm thinking about this right, is the right way to think about it, that since most of your loans repriced in the -- later in the fourth quarter and beginning of the first quarter, you're not really seeing much of the pickup in the March fed funds increase? You're not seeing the pickup in the June? And if there is another fed funds increase in December, that you'll really be -- you'll have a 3 fed funds hike catch up in your loan yields in the first quarter of 2018?

Yes. So I think,, it's a portion of the story that you just described is because of that, what I will say, earlier in the first quarter. I think you also have to look at the loan mix, where some of our loans that are driven by more fixed basis may not follow the pattern you just described. So you really have to decompose that loan portfolio and look at the repricing structures of that loan portfolio. To make the assumption you just did, might be a little -- it may be on the high side to think that it's all going to catch up in 1 year from now from a repricing perspective. But we do think there could be some lumpiness to that.

Right. I'm not saying it goes up by 35 basis points, what I am saying is, can you refresh, maybe, our memories as to what the percentage of variable is as a percent of the total loans?

Well, 75% -- I don't have the actual floating, but 75% does reprice within a year. The -- I did -- but we're not necessarily implying that most of that all happens around year-end. It's just that there would be, on average, probably a larger part of it that would happen at the beginning of a year, which would impact the first quarter. But that's not to say that every year, it would be in the first quarter when we would see the step up for loans.

Yes.

The -- you mean, they don't follow a similar repricing schedule? (inaudible) year, so...

Well, it would depend on the timing. It would depend on the timing of loan renewals. And a lot of those might be -- a handful of those, more in proportion, might be set up to roll over at the beginning of the year versus the beginning of April, let's say, as an example. So in this sequential comparison, we picked up a little more on the -- in the first quarter than what we would've picked up just from a timing perspective in the second quarter.

But if I compare first quarter '18 to first quarter '17, shouldn't that be an accurate comparison?

On a year-over-year basis, yes, you would probably end up -- you're right, yes.

Yes, yes.

Okay. And then, just a second question on the Other operating expenses. I mean, how much of that spend this quarter was discretionary? I hear you say business promotion. To me that sounds discretionary. You could pull that back to help improve operating leverage, staffing, maybe or maybe not. But how much of that $17 million increase that you saw sequentially really could drop off next quarter?

In the Other operating?

Other operating.

Yes. So first of all, we saw, as I said, about 1 point of growth, so you can do that. That was due to account servicing losses. So call that $8 million to $9 million. I can't tell you if it will repeat. We certainly hope it doesn't repeat, but the reality is, is that's -- you can call that discretionary. That's one item in there. And there is clearly items, while the Northern Trust Open is in the next quarter and we gave that, there are clearly discretionary items in there, like business promotion. There's other discretionary items in there that we look carefully at and manage carefully on an ongoing basis. But we'll continue to be laser-focused on them going forward.

The other thing, Brian, I would mention on the expense side is the -- we did take the $22.8 million severance charge in the current quarter and indicated approximately an $18 million run rate savings on that. And it will be -- the timing of that will come in over the next 6 quarters, so the full run rate impact of that wouldn't really be in place until the end of 2018. So that's just one other thing on the expense side as far as looking out beyond the current quarter.

And at this time, I like to turn the conference back over to our presenters for any additional or closing remarks.

Appreciate you joining us for the quarter, and we look forward to talking to you next quarter. Thank you.

Thank you.

That does conclude today's conference. Thank you for your participation.