道富銀行 (STT) 2015 Q2 法說會逐字稿

Good morning, and welcome to State Street Corporation's second-quarter of 2015 earnings conference call and webcast. Today's discussion is being broadcast live on State Street's website at www.StateStreetcom/stockholder. This conference call is also be recorded for replay.

State Street's conference call is copyrighted and all rights are reserved. This call may not be recorded for a rebroadcast or redistribution in whole or in part without the expressed written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street website. Now, I'd like to introduce Anthony Ostler, Senior Vice President of Investor Relations at State Street.

Thanks, Holly. Good morning, and thank you all for joining us.

On our call today, our Chairman and CEO, Jay Hooley, will speak first. Then Mike Bell, our CFO, will take you through our second quarter 2015 earnings slide presentation, which is available for download in the Investor Relations section of our website at www.StateStreet.com. Afterwards, we'll be happy to take questions.

Before we get started, I would like to remind you that today's presentation will include operating basis and other measures presented on a non-GAAP basis. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measure are available in the appendix to our 2Q 2015 slide presentation.

In addition, today's presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors, such as those factors referenced in our discussion today, in our Q2 2015 slide presentation under the heading forward-looking statements, and in our SEC filings including the risk factors section of our 2014 Form 10-K. Our forward-looking statements speak only as of today, and we'll disclaim any obligation to update them even if our views change.

Now let me turn it over to Jay.

Thanks, Anthony, and good morning, everyone. Our second quarter 2015 results reflect the strength of our core business as evidenced by a 4% growth in service fees compared to the first quarter of 2015, and the benefit of the seasonal increase in securities finance activity. Net interest revenue in the second quarter of 2015 continued to experience pressure as a result of the ongoing low interest rate environment. Overall we remain on track for the growth rate of operating basis fee revenue to exceed the growth rate of operating basis expenses by at least 200 basis points in 2015.

We remain focused on returning capital to our shareholders. During the second quarter of 2015, we repurchased approximately $350 million of our common stock and have approximately $1.45 billion remaining on our March 15 common stock purchase program, authorizing the purchase of up to $1.8 billion of our common stock through June 30, 2016. We also increased our quarterly common stock dividend to $0.34 per share in the second quarter of 2015.

Now I would like to provide a brief overview of economic and market developments and how our business was affected. Europe has been a major source of market instability in the recent past. First modest signs of recovery against the backdrop of zero or even negative yields contributed to the sharpest rise in European bond yields since the resolution of the European debt crisis back in 2010. European equity markets responded by giving back half of their year-to-date gains from the peak of May 21 with some recoveries more recently.

The European debt crisis is still of course very much with us in the form of Greece and has monopolized the headlines for much of the past few weeks. The uncertainty as to whether a deal with Greece could first be reached, and now implemented, has helped to push investors to move assets away from emerging markets and also contributed to increased foreign exchange volatility and volumes compared to the second quarter of 2014. However, volatility in FX market was lower than first quarter 2015.

Not all the risk and global markets has been driven by Europe. Chinese equities fell by more than 30% from their peak, giving back more than half of their gains for the year amidst concerns about the growth in China, although recently government intervention has provided some support to equity markets there. Combined, these significant disruptions drove markets down in June and into July and have reduced risk appetite.

Despite these international risks, our view of divergence in 2015 still holds as we've seen easing of monetary policy outside the US, but we still expect to see tightening in the US. This led to a much stronger US dollars so far in 2015. Much of the initial change occurred in the first quarter of 2015 in anticipation of US tightening, and the US dollar has generally moved sideways since then as the markets are waiting to see when tightening might actually start in the US.

Together these events and trends impact our business in several meaningful ways. First and most significantly, the low interest rate environment continues to negatively impact our net interest revenue and net interest margin as our higher-yielding portfolio investments mature or experience prepayments and then those funds are reinvested in lower yielding investments.

Second, amidst the various central bank actions in changes to various market structures, we continue to experience high levels of deposits. As you know we imposed charges for holding euro deposits in the fourth quarter of 2014 with a number of increases in the charges so far this year. We're continuing to have discussions with our clients regarding excess deposits given the negative effect of these deposits on our capital.

Third, the stronger US dollar has slowed the growth of our servicing fee revenue relative to 2014. However, it's important to note that excluding the impact of the stronger US dollar, our core business performed well benefiting from growth in our client relationships. Furthermore, towards the end of the second quarter of 2015, we saw a number of significant market disruptions, which reduced risk appetite.

Now I'd like to discuss our asset servicing and asset management businesses. Demonstrating a continuing priority to provide solutions to our clients, we added $143 billion of new servicing commitments during the second quarter. Importantly, these wins were broadly diversified across sectors and geographies. New assets to be serviced that remain to be installed in future periods totaled $174 billion at June 30, and we continue to see deep and diverse pipelines.

Our asset management business experienced net outflows of $65 billion during the second quarter of 2015, driven primarily by net outflows of $36 billion from institutional passive equity, $17 billion from ETFs, primarily institutionally oriented market index funds, and $17 billion from cash products. The significant drivers of passive equity outflows included rebalancing and cash needs by some of our clients due to lower commodity prices. Despite the net asset outflows, the impact on net new business revenues were relatively minimal because much of the redemptions were priced lower than the net contributions we received in the quarter.

Our asset management business continues to be innovative and has launched 45 new products in the first six months of 2015. One launch off to a fast start is the SPDR DoubleLine Total Return Tactical ETF, which is an active fixed income ETF launched in partnership with DoubleLine. It's attracted $800 million in net flows post-launch, which ranks as the second most successful ETF launched in the US this year.

Now, I'll turn the call over to Mike, who will review our financial performance for the second quarter, and after that Mike and I will be open to take your calls.

Thank you, Jay. Good morning, everyone.

Before I begin my review of our operating basis results, I'll comment on a nonoperating charge included in our 2Q 2015 GAAP basis results. We recorded an after-tax charge of $156 million, or $0.37 a share, in 2Q 2015 to increase our legal accrual associated with indirect foreign exchange matters. Although we believe these recorded legal accrual's will address the financial demands associated with the previously disclosed claims and active investigations regarding our indirect foreign exchange business asserted in the United States by government entities and civil litigants, significant non-financial terms remain outstanding and settlement agreements have not been finalized.

Consequently, there can be no assurance that we will enter into these settlements, that the cost of any settlements or other resolutions of any such matters will not materially exceed our accruals, or that other potentially material claims relating to our indirect foreign exchange business will not be asserted against us. As I'm sure you can appreciate, settlement discussions are confidential, and we are not able to make more specific comments on these matters at this time.

Now I'll refer to slide 7 for a discussion of our 2Q 2015 operating basis results and for the six months ended June 30, 2015, which I'll refer to as year-to-date. By way of summary, 2Q 2015 results were driven by strong servicing fees and the seasonal increase in securities finance revenue, offset by lower FX trading revenue and continued pressure on NIR. Year-to-date EPS increased approximately 7% compared to the year-ago period.

Total revenue increased 3.3% from the year-ago period reflecting strength in core servicing and management fees, trading services revenue, and securities finance, partially offset by lower NIR and the impact of the stronger US dollar. Compared to the year-ago period, year-to-date fee revenues were negatively impacted by approximately $149 million from the stronger US dollar largely offset by a similar benefit in total expenses.

Our operating basis effective tax rate for 2Q 2015 was 29.6%, which is lower than our current expectation for the full year. The first half of 2015 operating basis effective tax rate of 29.1% is also lower than our current full-year 2015 expectations, primarily due to some one-time items in the first half of 2015 and the timing of our tax-advantaged investments. We continue to expect the operating basis tax rate to average within a range of 30% to 32% over the course of the full year.

On the capital front in 2Q 2015 we declare a common stock dividend of $0.34 a share and purchased approximately $350 million of our common stock. In addition, we issued $750 million of preferred stock during 2Q 2015 with the first semiannual dividend to be paid in the third quarter of 2015.

On slide 8, year-to-date fee revenue increased 5.1% while expenses increased 2.4% versus a year ago. Importantly, on a constant currency basis, year-to-date fee revenue increased 8.8%. We continue to make progress against our target for operating basis total fee revenue growth to outpace operating basis expense growth by at least 200 basis points for the full-year 2015 relative to 2014.

Turning now to slide 10, I'll discuss additional details of our operating basis revenue for 2Q 2015. First I would note that the stronger US dollar adversely impacted total fee revenue by approximately $71 million as compared to 2Q 2014 with a similar benefit to total expenses. Net interest revenue was also adversely impacted by the stronger US dollar by approximately $17 million compared to 2Q 2014. Foreign currency translation did not materially affect sequential quarterly results.

Servicing fees were up from 2Q 2014 primarily due to net new business and stronger US equity markets, partially offset by the impact of the stronger US dollar. On a constant currency basis, sourcing fees were up approximately 7% compared to the year-ago period. Management fees increased modestly relative to a year ago, primarily due to higher US equity markets and net new business partially offset by the impact of the stronger US dollar. On a constant currency basis, management fees increased approximately 6% compared to the year-ago period.

Total trading services revenue increased from 2Q 2014 due to higher FX trading revenue, reflecting higher volatility and volumes. Compared to 1Q 2015 FX trading revenue decreased due to lower volatility. Securities finance revenue increased from 2Q 2014 primarily due to new business and enhanced custody, and was higher than 1Q 2015 reflecting the seasonal increase of revenues in this business, which tends to peak in the second quarter. Processing fees and other revenue increased primarily due to higher revenue associated with tax-advantaged investments.

Moving now to slide 11, you can see our operating basis net interest revenue and net interest margin continue to be challenged in the prolonged low interest rate environment. Operating basis NIR decreased from 2Q 2014 primarily due to lower market interest rates, partially offset by higher client deposits.

Now let's turn to slide 12 to review 2Q 2015 operating basis expenses. Total operating basis expenses increased 3.5% compared to 2Q 2014. As reminder 1Q 2015 expenses included an incremental $137 million associated with the seasonal deferred incentive compensation for retirement eligible employees and payroll taxes. Compared to the 2Q 2014 result, compensation and benefits expenses increased modestly, reflecting increased costs to support new business and regulatory initiatives mostly offset by the benefit of the stronger US dollar.

Transaction processing service expenses increased primarily due to higher volumes. Occupancy expenses decreased from 1Q 2015 reflecting certain one-time positive items in 2Q 2015. For 3Q 2015 we expect occupancy expenses to increase as the beneficial items of 2Q 2015 are unlikely to repeat. Other operating expenses increased sequentially and from a year-ago quarter primarily due to additional regulatory and compliance costs.

Turning now to slide 13, I'll provide a brief overview of our June 30, 2015, balance sheet. During 2Q 2015 we took several actions to move towards our balance sheet optimization and regulatory compliance objectives. The impact included a small increase in the duration of our investment portfolio assets. Now, turn to slide 14 to review our capital position. As you can see we remain well-capitalized, which has enabled us to accomplish a top priority of returning capital to shareholders through dividends and common stock repurchases.

At June 30, our common equity tier 1 ratios under the Basel III fully phased-in standardized approach increased from March 31 principally due to lower credit risk. Under the fully phased-in advanced approach, our common equity tier 1 ratios remained relatively unchanged from March 31. The fully phased-in holding company supplementary leverage ratio increased from 1Q 2015, primarily due to the issuance of $750 million of preferred stock in 2Q 2015.

On Monday, the Federal Reserve issued the final GSIB rule which contains the methodology used to determine the capital surcharge for the 8 systemically important US banks. The Federal Reserve's estimate for State Street indicates a surcharge of 1.5%, and this is consistent with our discussion of the potential impact of the proposed rule during our Investor Day this past February. The primary driver of the higher surcharge under the final rule is the level of non-operational deposits from clients which the rule classifies as short-term wholesale funds.

Now that the rule is final, we will incorporate these surcharge into our balance sheet and capital optimization efforts. Since excess deposits are the primary driver of the higher surcharge, this final rule increases the importance of our objective to materially reduce these excess deposits.

Now I'll address a question is likely on investors' and analysts' minds, and that is how was our program tracking to reduce the level of excess deposits on our balance sheet? We continue to have discussions with our largest clients regarding the implications for our balance sheet associated with excess deposits and to work together to identify solutions. Although these discussions were constructive, our average excess deposits in 2Q 2015 did increase as the external factors driving these balances did not abate.

We continue to take actions appropriate for each market. For example in Europe, we have increased the rate we are charging for euro deposits. Overall, we are targeting a net reduction in excess deposits over the remainder of the year from the 2Q 2015 levels.

Turning out to slide 15, we continue to maintain our outlook for the full year of 2015. Despite the weaker euro exchange rate, we continue to expect 2015 total operating basis fee revenue to increase 4% to 7% compared to full year 2014. We also continue to target our operating basis total fee revenue growth to outpace our operating basis expense growth by at least 200 basis points for the full year 2015 relative to 2014. Regarding NIR, we expect full year 2015 operating basis NIR to be between $2.16 billion and $2.22 billion.

The range assumes that the Fed increases rates in December 2015, the administered rates do not change in Europe, and client deposits will decline over the remainder of the year from their 2Q 2015 levels. We expect to be near the lower end of the range if there are no rate increases in the US.

Lastly, we continue to expect our operating basis effective tax rate to be approximately 30% to 32% for the full year of 2015. Since our 2015 year-to-date tax rate was 29.1%, we expect the operating basis effective tax rate for the back half of 2015 to be in the range of 32% to 34%.

In summary, our 2Q 2015 results were driven by positive momentum in servicing fees and securities finance seasonality, offset by softer FX trading revenue and continued pressure on net interest revenue. We continue to focus on our key priorities of delivering value-added solutions to our clients, investing in growth initiatives, diligently managing expenses, and returning capital to shareholders.

With that, I'll turn the call back to Jay.

Thanks, Mike, and I have nothing further to say, Holly, so we can open the call up to questions.

(Operator Instructions)

Ashley Serrao with Credit Suisse.

Good morning.

Good morning.

How are you thinking about the duration of your portfolio and capacity to extend in light of 58% of your portfolio now been fixed, which is the highest it has been in a while, and only $1 billion of purchases in 2Q which is the lowest it's been in a while?

Good morning, Ashley. It's Mike. First of all, there's been no change in our overall philosophy, Ashley, and that is that as it relates to the investment portfolio, we continue to invest through the cycle. We continue to have the same type of AML risk management practices that we've had in the past. Related to your specific question around the duration, yes, it is the case that we did sell in particular some floating-rate ABS securities in 2Q, and as a result, what's left in the portfolio does in fact have a longer average duration.

Again importantly, the overall duration of the asset side of our balance sheet did not change materially quarter-over-quarter. We did have a higher amount left in cash at the end of the quarter. Again I would expect that there would be no material change over the remainder of the year in terms of our philosophy, but we will continue to make these tactical changes to work towards balance sheet optimization particularly under the new regulatory requirements.

Does this also mean that the timeline that you provided on Analyst Day for NIM to reset to higher levels remains unchanged?

That is correct, Ashley. At this point no change to those longer-term expectations. Obviously, there's a lot going on in the environment in terms of how long will it take to get there between the market interest rates and regulatory environment, but no change at this point in terms of our long-term expectations.

Okay. Final question here, can you just give us an update on your efforts to bolster your European ETF business, and also to drive of focus in return on capital from a compensation standpoint?

Yes, let me start that one, Ashley. The ETF business is present in North America, Europe, and Asia, although as you rightly point out, we're much more heavy in the US than in Europe, and we been focusing on the European ETF business. It's been really two dimensions. One is adding distribution, wholesalers that largely sell into the private bank and banking networks on the continent in Europe. That's going well. We've made several hires over the course of the last six months, so from a standpoint of feet on the ground distribution, we continue to ramp up.

I'd say the second place that our efforts are going is in the product development side which is a two-key elements of successfully ETF franchise. As I noted in my comments, 45 new products were introduced so far this year. Some portion of those are in Europe, so I would say the effort is underway. We think it's a robust opportunity for us, one of the key opportunities for SSGA. Your second question, Ashley, was our efforts to improve our return equity?

Yes, from a compensation standpoint on when you look at new business?

When we look at new business, I'm not sure I get the source of the question. Let me try it. Maybe what you're referring to is that recently as return on capital has been a more prominent part of how you look at us and how we look at our business, we've turn to looking at return on capital from a customer standpoint. We will have by the end of the year I think our top 200 customers all calculated out with regard to what their return on capital is. Those statistics end up with the client relationship people, and their challenge is to improve that return on capital.

I think the closer we get that to our top customers, the better shot we have at rebalancing mix, whether it's product mix or client profitability in order to drive improve return on capital for initially that top 200 customers. We think between what we're doing at the top of the house principally on the balance sheet and in excess deposits and what we're doing with those 200 customers, that's the right blend of strategies in order to make sure that we consistently improve our return on equity over time.

Ashley, it's Mike. I would add two other points. One is we have incorporated that same discipline in terms of looking at returns at the client level on prospective new business as well. It is both a new business initiative as well as the existing customers that Jay described.

The second point I would do is just reinforce something that Jay said, and that is in the near-term the most important thing we can do to improve the Company's ROE is to reduce the non-operational deposits and/or get those priced. If they're going to stay on the balance sheet, get those priced to pay for the required capital that's associated, and I can assure you that the entire management team is aligned around that effort.

Great. Thanks for taking my questions.

Glenn Schorr, Evercore ISI.

Hi. Thanks very much. I'm curious. On slide 24, you gave us the ex-currency impact on both revenue season and expenses. I guess my question is with the operating expenses up 7.4% year-over-year, ex-currency, a lot of that's driven by the other line, and that's legal and regulatory. Are you able to parse that out on what's legal and what's regulatory because obviously going forward we're going to be able to strip out what's the bottom line. There's a lot of moving parts here. Fees, we get are still growing. Currency's impacting it, but it seems like expenses are just still keeping pace with the revenues.

Sure, Glenn. It's Mike. It is the case that the major driver on the year-over-year increase in the other operating expenses is the regulatory compliance expenses, and in particular the outside consulting expenses. We had communicated to you at Q1 that we thought those were seasonally low, and they have certainly rebounded here at Q2. Basically, the work that we have underway right now is, number one, over time to reduce those outside consulting expenses by completing the projects, completing the getting up to fully acceptable regulatory expectations, and also second, over time replacing those outside consultants with full-time staff. I do expect that we will see a reduction in the second half of the year in terms of the other operating expenses related to both of those.

I'd rather at this point not put a precise number on it because it depends upon a number of factors, not the least of which is our success rate in terms of hiring full-time staff to replace these people. It is the case that the big driver is the regulatory compliance expenses. Now I would point out just to be completely balanced that we are still on track to meet our full-year expectation, and that is to have the revenue growth outpace our overall expense growth by at least 200 basis points. We view that as positive accomplishment in this environment. As I've described to before that's a better result than we had in that metric in 2014, so again in light of the regulatory situation, we view that as a positive step forward

Okay. Just one other follow-up on the securities finance revenue, it's up I guess 5%. A lot of it is new business and the environment, and I'm just curious what's enhanced custody, and if you're seeing any pressures on either rate spreads for fee splits?

Sure, Glenn. In terms of enhanced custody, enhanced custody was a little less than a third of the securities finance revenue in Q2, so specifically it was $48 million of revenue out of $155 million in Q2. In terms of the spreads and fee splits, I would say no material change in that environment. I would note that the seasonal trade was in fact less valuable than it's been in the prior years. There wasn't as much benefit from seasonality given the European economic situation, so that in fact was a modest headwind in Q2 versus what it's been in prior years.

Got it. Just the tiniest follow-up on the expense commentary we just had, does that mean the second half on the other line stays at this level, given that you're still building out the BSA/AML systems and things like that. Should we look for that on the year-on-year basis still grow but on an absolute dollar basis be level?

Glenn, relative to Q2, I would expect the other operating expenses to be lower in Q3 and Q4, subject to the caveat that does assume that, number one, we are effective in executing the initiatives that we have on the table right now, and number two, that we are successful in hiring additional full-time staff to replace those outside consulting expenses. Again, neither of those are trivial, but my expectation at this point is that $338 million will not be the run rate going forward to the second half of year. It will be something lower

Okay, thanks very much.

Ken Usdin with Jefferies.

Thanks. Good morning. Mike, if I could ask you a question about balance sheet leverage and the deposits, first of all, can you try to help us understand how much you're going to try to move off the balance sheet on those excess deposits? What kind of effect do you think it could have on the leverage ratio, and whether the impact of those deposits outflows reflected in your outlook for NIR?

Sure, Ken, good morning. First on your specific question on how much do we expect to get off the balance sheet, at this point, Ken, I'd really prefer not to put a precise number on it. We are in the midst of client communications as we speak, and it is a sensitive issue. We're really looking for a win-win with our clients.

Just to give a couple of examples, several of our 40 Act fund clients, for example, are feeling more pressure to hold more liquidity as a result of their own regulatory pressures. Again, it's not just a question of basically demanding that liquidity comes off. Instead, we're really looking for the win-win there. Another example would be in Europe where certainly with all the turmoil going on economically there we have been viewed as a safe haven by several of our import clients. We're obviously charging more for European deposits than we were earlier this year, and we recognize that given the economics of having to issue additional [prefs] to ultimately pay for these deposits, that ultimately we need to earn something in the 60- to 70-basis point range of interest margin to pay for the [prefs].

It is important either to charge enough to make the economics work or to get the deposits off the balance sheet, and the latter we think could occur either through us charging more or through finding a different win-win with our clients, or in fact we think it will naturally happen as interest rates rise. Again at this point, I'd rather not to commit to a number, but I'd rather tell you that we are expecting a reduction in deposit levels in the second half of the year.

As it relates to your question around NIR, what I would remind you is that on average right now for excess deposits, we estimate that we are earning a spread in the high teens. Based on that you could conclude that a $10 billion drop in our average excess deposits would reduce near-term NIR by $4 million to $5 million in a quarter. That is built in to the updated NIR range that I gave you in the prepared remarks. I'd rather not give you a specific number, but that is the thinking that is in the overall range.

Okay, Mike. Just as a quick follow-up, then how do we understand the go, no-go decision tree on timing and magnitude preferred potential?

Sure. Ken, regarding [prefs], it really will depend upon a number of things including the overall environment. It will include our success rate, both that were seeing to date, but also are expected continued success rate on reducing the level of non-operational deposits. It will include our analysis of our balance sheet for the next CCAR period which is Q4 of this calendar year, so again I'm confident that we could issue [prefs] if we need to. At this point, I would not tell you that we've drawn specific conclusions on a [pref] issuance plan.

Thanks, Mike.

Brian Bedell, Deutsche Bank.

Hi. Good morning, folks. Maybe just staying on the excess deposits, can you just give us some numbers on what they currently are, or what the range that you view for excess deposits, and then the deposit levels in Europe and the UK?

Okay. Sure, good morning, Brian. It's Mike. Regarding our current level of excess deposits, if we look at Q2 average in particular, we estimate that our Q2 average excess deposits were approximately $62 billion which is an increase relative to Q1 of approximately $8 billion. Now importantly, I would add for completeness please remember here that the LCR rules are now in effect, and therefore because of our interpretation of those rules and the regulatory expectations related to those rules, some of the deposits that we've historically thought of as operational deposits don't in fact qualify under the LCR to be operational deposits.

Specifically, for example, our hedge fund clients and private equity clients just as part of their normal operations, as part of us being the custody service provider, we have viewed those historically as operational deposits. They're specifically excluded under the LCR regulations to be included as those. The round number is S20 billion of deposits from those clients. A portion of those need to be ultimately added to the $62 billion as we calculate LCR over the future. It's another example of the regulatory environment forcing us to be more conservative than what we've done historically. Again, $62 billion under our traditional method, and (inaudible) as TBD as the LCR further unfolds.

As it relates to your question around European deposits, we did see an increase in deposits in Europe. Specifically, Q2 average European deposits were $40.5 billion, so call that EUR36 billion to EUR37 billion of euro balance. That was up about $4.5 billion relative to the Q1 average levels.

Okay.

Brian, this is Jay. Maybe I'll provide a little bit of nuanced color. I was just in Europe a few weeks ago, and I was directly involved in some of these discussions with customers. For the major customers who have meaningful excess balance, we are speaking to all them, and I would say that a couple things to me are encouraging. I'm convinced we'll make headway against this. I don't know how much or when, but (inaudible) acknowledge the issue. It's a broad-based issue. There's even some pressure on a European banks finally to shed some of these deposits as well, so it's become a more broad-based issue.

I think the discussions are leading to some creative alternatives for sweeps and other approaches to move these deposits off. While Mike mentioned the average quarter to quarter, we've actually seen some progress in some of the specific customers. It helps that we are out in front of it. I think the discussions are going well. I think we'll find ourselves with lower excess deposits as we end the year, hard to say how much.

Right. The end of period ended up much higher, but we should probably ignore the June 30 end of period numbers, I would assume. Your idea is really head the direction the deposits go down (inaudible) average cases, correct?

That is correct, Brian. Again, we typically see spikes at quarter end, but I think the average is more relevant because in fact the capital ratios, for example, are calculated based on the average.

Okay, great. My follow-up would be as you were talking before about looking at the top 200 customers and trying to assess the return on capital for those customers, and then I think, Mike, you also mentioned you're using this framework for new business. Maybe either Jay or Mike, you could comment on. I know Bank of New York has one that large office deal with T. Rowe. That's something [in the zone of what] you would typically win since you're by far the leader in middle office. Maybe if you could frame the view on assessing that for new customers and the go-forward dynamic of middle office, whether you think you might be more competitive or more disciplined going forward?

Yes. I'd say broadly, Brian, when you put the return on capital lens on a prospective customer, the places that get accentuated are things like any loans that we might have, securities lending, particularly indemnified repo. Within the products, from services to foreign exchange to securities lending to fund accounting, they all have slightly different return on equity calculations. By looking at through a return on capital lens, you do get a more holistic view.

I would say relative to middle office, it's really a profitability equation. It doesn't draw any capital necessarily. It's really, can you drive sufficient profitability in order to make a middle office deal make sense in the construct of a piece of a larger relationship? I view it probably more as a traditional accounting and custody relationship as far as its return characteristics, but the key component is can you make money.

As you know, we have I think it's over $10 trillion in assets that we administer in the middle office, and have been at this for 15 years maybe. We've learned a lot through the 15 years about what makes a successful middle office deal. For me, it's largely about the complexity factor, whether it involves lift-outs, the degree of customization on the system side, so we continue to have a handful of middle office prospects out there. We look pretty closely at whether or not we can think we can make them create the right return over a reasonable period of time

Right, and you're favorable on this business, I assume? On middle?

Yes. I would say just from a broader trend basis, Brian, you've no doubt heard more than you'd probably want to hear about us and our regulatory compliance challenge here. It's hitting asset managers. It's hitting asset owners, and so middle office will continue to be a very important incremental product that we sell. We just need to make sure that it's done well with good pricing discipline.

Great. Thanks very much.

Luke Montgomery, Bernstein Research.

Good morning, guys. Another stab at the securities portfolio, I know you've been realigning the mix of securities for the LCR and then fine-tuning the balance sheet overall for the SLR. In dollar terms, what's driving the shrinkage of the portfolio? Should we expect that to continue? Is that part of managing the overall duration of the balance sheet?

Sure, Luke. It's Mike. First, in terms of what's driving our optimization work, I would really put into three different buckets. The first is that overall we want to improve our capital ratios, and that includes the risk-based ratios as well as the leverage ratios. Second, we are looking to improve our mark-to-market sensitivity as measured at the next CCAR cycle, so that's a consideration. Third of course, is meeting the heightened liquidity expectations, so specifically if we look, for example, the sale of our floating-rate ABS, that's a good example where we were getting a relatively low credit spread, that we viewed it as having a relatively high mark-to-market sensitivity during the CCAR cycle. Of course it doesn't count as [HQOA]. That would be an example of something to shrink.

I would not characterize the changes in the securities portfolio as part of an overall change in the duration of the assets on our balance sheet. As I said in one of the earlier answers, the overall duration of the asset side of our balance sheet did not change materially sequentially. In fact, what we did was we decreased the floating-rate ABS securities which meant that the remaining duration of the remaining portfolio got longer but that money for the most part is sitting in cash. I would expect that we would be deploying over the second half of the year round numbers, approximately $5 billion that at June 30 was sitting in cash.

Again, it is based on a lot of different factors, but I would not expect additional shrinkage in the overall investment portfolio in dollar terms over the remainder of the year. Again, importantly this optimization is somewhat of a Rubik's Cube. There's a lot of different considerations, so it will be work that will continue for a while

Okay. Helpful, thanks. Then this is the fourth quarter in a row you've provision for legal contingencies. I know you can't talk about particulars but just any sense of how far along you are on the need for further provisioning? Don't take this as combative, but you exclude from operating basis results, but it's getting to the point of usual unusual or recurring nonrecurring, and I think it as an impact on your capital ratios. Any help there would be helpful.

Let me take a cut at that, Luke. This is Jay. The provision relates to the indirect foreign exchange issue that predates 2010, just to put a box around it. As you noted over the last couple of quarters, we've been taking incremental provisions. We believe that we've reached financial terms with the counterparties that we have this dispute with.

What we haven't done is complete the terms and conditions of the agreement and specific language. We would expect that not only financially but relative to all the agreements that we can reach a conclusion shortly and that we can put this behind us. I don't know if that helps, but we hope that this is from a financial standpoint the end of that issue.

Okay, thank you very much.

Betsy Graseck, Morgan Stanley.

Hi. Thanks. Two follow-ups, one on just what you're going through, Jay. I noticed there was an update to the operational risk model, and putting the pieces together it seems like that's probably due to the fact that you're close to an end in the FX charges. Is that accurate read across?

Betsy, it's Mike. It is the case that we did update the operational risk capital model as we typically do once a year. That was updated in Q2 and that was part of the divergence between the improvement on the standardized approach risk-based capital ratios and the advanced approach risk-based capital ratios. However, that is not driven by our own FX settlement discussions. Instead, it's driven by a number of other factors including what the industry experience has been historically.

Okay. Then is the conclusion when you do conclude the FX legal situation, there's no further update to the risk model, the operational risk model?

Betsy, the operational risk model in particular has a lot of different moving parts, so I wouldn't try to speculate on future updates to that level. I would remind you that at this point, our binding constraint tends to be the standardized approach. I would expect that to be the case for a while.

Right. Fair point. Then just separately, a follow-up on the non-operating deposits, I guess I'm wondering if we could get a little bit of color, Jay, from the kind of things that clients could do with you to potentially either reduce or bring on. I'm not sure if this is what you're referring to but bring on new business that would enable you to potentially change some of the definitions from non-operating to operating, for example, if there's a broader set of businesses that folks are doing with you?

It was really less the latter, Betsy. Let me just give you a few things. One, I think I mentioned this last call, and Mike referenced the SEC is very focused on liquidity management and 40 Act, and even the broader based asset management world. We've introduced a pretty sophisticated tool that allows asset managers to stress their liquidity. The one way we're helping is we're helping them optimize their own liquidity stress testing which sometimes adds to the liquidity, and sometimes reduces their liquidity needs.

With regard to the conversations, it's usually around can we sweep some of the deposits? Can we use repo facilities? It gets into that level of how do we move deposits out of [pure] cash which end up on our balance sheet? There are a handful of approaches, and depending on the customer and their view of required liquidity and capital, we have different outlets.

Probably the most important thing that I would leave you with is these are constructive conversations where our customers, as we would help them, they're looking to help us. It's not contentious. It's just how can we move these deposits, ad do it on a sustainable basis? At period ends, we tend to get spikes in deposits. We want to manage those, down but we are really looking for the more durable sustainable solutions which will allow us to manage these things and control them over time.

The last point I would make is that pricing is always usually a pretty good way to create behavior, and in Europe around the euro, we've introduced pricing. I think we've moved it up three times. It feels like we're reaching that point of equilibrium where it has a cost associated with using our balance sheet, and therefore our customers are more sensitive to the cost. We are thinking about not only cost on an ongoing basis, but also think about surge pricing that if deposits were to go past a certain point, the cost of using our balance sheet would go up by a lot. Those discussions and those mechanisms are starting to give us, one, we're having better conversations, and I think that we are likely to improve our situation with regard to excess deposits.

Okay. Make sense. Thanks.

Mike Mayo with CLSA.

Hi. Can you just reconcile two thoughts? On the one hand, you are the port in the storm. You're a source of strength in Europe. Your earning assets when up 3% over 3 months, and on the other hand, NIR declined, and you expect that to perhaps go lower. Is that all due to the excess deposit issue, or is there something else going on too?

Mike, it's Mike. Related to Europe, it is the case that we are viewed as a safe haven in Europe, and that certainly is a significant contributor to the increase in the deposit base that we saw in Q2 relative to Q1. Another issue though is just the lack of good alternatives for our European clients which relates to your second point, and that is that the interest rate environment there generally along with the credit environment is not particularly attractive. There is downward pressure on our own NIR related to the assets that back the European deposits.

One of the other point I would note, Jay was talking earlier about specific client discussions in Europe. I would note that where we've had additional success with some clients in Europe, relates to encouraging them through discussions, but also with the implied lever of pricing to move out of cash deposits on our balance sheet into, for example, short-term government bonds. I would expect that over time, we'll see more of that movement in Europe for all the reasons that I just mentioned.

Your peers also had earning asset growth but NIR was higher, whereas years was down. It really just the degree that you're in Europe that's the difference or anything else?

Again, Mike, I don't like to really speculate on our competitive results. My interpretation of the comparison that you're drawing here is more from the starting point as opposed to some fundamental difference in mix, and therefore our outlook has really remained relatively unchanged throughout this year in terms of NIR. It's for all the reasons that we've talked about.

We expect the excess deposits to come off in addition. Until we do get a meaningful improvement in market interest rates, we're going to continue to be negatively impacted by this grind of the turnover in our portfolio. Those dynamics have not changed.

You lowered your NIR, upper end of your range just a little bit. Is that right?

That's correct. That's mainly driven by our view now that it is unlikely that the Bank of England will raise rates in August. If you recall, that was one of the assumptions that we had flagged in the rising interest rate scenario at the Investor Day. We think that is unlikely to happen, at least in August. That's really the primary reason for the drop in the very upper end of the positive interest rate environment range.

Last one on NIR, you have $62 billion of excess deposits. You plan on reducing that. That reduction is in the updated NIR guidance. You're just not telling us how much excess deposit reduction you expect to have for competitive and client reasons?

That is correct, Mike, and again, we have a range built in there as you can imagine because we don't have a crystal ball in exactly how much they're going to decline, but we do have a decline built in there.

All right. Thank you.

The next question will come from a line of Alex Blostein with Goldman Sachs.

Thanks. Good morning, everybody. Question for you on expenses. Maybe there's a couple moving pieces obviously, but help us understand how we should think about in dollar terms for the back half of the year, given the fact that second quarter expense growth was a little bit, 20 basis points year-over-year versus the revenue growth, which is obviously below your 200 basis points. I get the fact that on a year-to-date basis, you guys are still looking pretty good. I'm curious to see where is there flexibility in the model on the expense front into the back half of the year to help you achieve that 200 basis points plus?

Sure. The short answer is it really does depend upon a handful of important factors. One is of course the overall level of net new business that we add in the second half of the year that will directly tie to the level of expense that we need to add to service, that additional revenue. That would be one. Second, as I mentioned earlier we do have work underway on the existing regulatory initiatives to look to replace outside consulting expenses with full-time staff to the extent of possible. Our success rate there will be a key factor.

Then lastly, importantly we are looking at some additional expense actions literally as we speak. I would expect to be in a position to provide a more public update at our Q3 earnings call, but we are looking at some additional expense actions to see what else can be done to improve the overall productivity level, beyond the regulatory pieces that I mentioned.

Okay, that's helpful. I guess the comments you guys are making around replacing consultants with full-time staff, when you go through the analysis on how much you're spending on consultants versus how much it would cost to bring in full-time headcount, what's the net benefit to pretax earnings from doing so?

I'd really prefer not to try to give you a specific number at this point. Again, fair to say that we do have some of that benefit built into our overall second half of the year expectations, but I'd rather not disaggregate a specific number from our overall thinking.

Okay. Thanks so much.

Jim Mitchell, Buckingham Research.

Good morning. Just a quick follow-up, and sorry to beat a dead horse on the balance sheet, but ABS was down $7 billion period end. That's a pretty significant increase versus the $2 billion a quarter that you've been doing in the prior year. Are we getting closer to the end of the rebalancing for the LCR, or is there still a lot more to do on the ABS side? I'm just trying to get a sense of is the NIM compression going to start to be slow a little bit if that is done?

Jim, it's Mike. First, at this point I expect that it is unlikely that we would have another material transaction that would shrink the ABS portfolio along the lines of what we did in Q2. I think that's unlikely to happen in the second half of the year, but as I mentioned, this optimization work is going to go on for a while. I wouldn't at this point foreclose the additional actions for example in 2016 along those lines. Again remember, we've got these longer term objectives. It's not just a 2015 objective. We've got these longer term objectives strengthening our overall capital ratios and reducing the mark-to-market sensitivities that impact CCAR. As part of our overall ROE improvement, both of those objectives are important, and really are somewhat separate from the near-term needs for LCR compliance.

Right, but can you give us any help on timing and amount of additional mix shift?

Again, Jim, I think that the mix shift will continue for several quarters. Again importantly, that is factored into the NIR range that we gave you in our prepared remarks.

Okay. Then maybe just a quick follow-up with the guidelines from the Fed. They said SLR will not be part of the next CCAR. Does that take some of the pressure off in terms of it gives you more time to think about how potentially higher interest rates affects deposits, and takes the pressure off on the preferred side? Can you give it another year to see how things progress, or do you still have to still build in a glide path?

Jim, you're absolutely right that it was helpful to us, probably helpful to others as well, that the NPR that was released around the 2016 CCAR indicated that SLR would not be part of the process of this year. That is in fact helpful. I would point out though that tier 1 leverage was our [binding] constraint at this past CCAR, and that remains an important consideration for the next CCAR. It certainly means that it's still very important that we pay attention to the non-operational deposits as it relates to the capital for next year and any potential pref issuance in particular.

Okay, thanks.

Adam Beatty, Bank of America.

Thank you and good morning. Question on the pipeline and backlog in asset servicing, it looks like the backlog of work to be installed came down somewhat in the quarter. Does that create a natural bias for higher servicing revenue subject, of course, to markets in currencies, and also looks like the win rate ticked down a little bit. Do expect that to normalize higher? Thank you.

Sure, let me pick that one up. This is Jay. On the pipeline more broadly, nothing really has changed. It's robust. It's diverse. There's activity. Over the last six weeks, I've been in all continents and visited 15 different offices, and there's a lot of activity, activity that I think is stimulated by constrained environments, compliance, and regulatory. Pipelines are solid.

For the quarter, we committed, I think it was, $143 billion in assets. That was a little low relative to what we've been running. Probably the last couple of years we've been in the $200 billion to $300 billion range. I wouldn't read into it. I think it's just some of the stuff is timing. No read-through there.

With regard to the beginning of your question, we've got $174 billion, I think that sounds right, of assets that of committed, that have not yet installed. I'm looking around the table. I think that's about where we've been historically. The relationship between pipeline, the funnel, what we win, and how we implement seems pretty steady. I'd say that in the $174 billion and in the $143 billion, there aren't big lumpy two-year implementations, which will delay revenues, so we should expect a pretty steady stream of service fee revenue that would trickle out of those three factors

Adam, it's Mike. The only other thing I would add is you'll note that our [GS] revenue was strong in the quarter, relative to both Q1 as well as a year ago. Certainly we've gotten good contribution. We got good contribution in Q2 from the net new business piece of it.

Thank you. I appreciate that, guys. Also on the asset management, in terms of some of the redemptions, in past we've heard a couple times this quarter about international and sovereign clients maybe having some liquidity needs based on lower commodity prices. What's your outlook on that, given where things are right now, and given what you're hearing from your clients? Is there a potential for an additional draw-down there, or is that pretty much over in Europe? Thanks.

I think if you look at oil prices as probably maybe the biggest single driver of that, I don't know what your outlook for crude is, but it feels to me like this was an adjustment from over $100 a barrel, $50 a barrel, as opposed to month in time adjustment. I wouldn't expect there would be big additional outflows. I don't know. I think it's unlikely oil will go lower, and therefore it feels more like a one-time adjustment versus something that we're going to see every quarter.

Got it. That makes sense. Thank you, Jay.

Brennan Hawken, UBS.

Hi, guys. First question on FX, revenues looked light versus peers, and I don't know whether there's a connection here, but we saw the FX revenues come in the bit light. Then we continue to see these FX charges ratchet and the discussions ongoing. Is it possible that there's a connection there?

No connection at all, Brennan. If you look at, we track as you'd expect, pretty closely the indirect FX, the direct FX, the platform FX, and all pretty steady as she goes. It's hard to make any judgment on a quarter. Back at Investor Day, I don't know if you recall this, but we showed our FX performance in absolute terms versus the near and peers, both electronic and directly traded. It's quite a bit higher than on an actual basis.

I think if you stretch back over a couple two or three quarters and look at trends, you would see our FX performance is as good as if not better than the peers. Nothing really in the quarter, and certainly no connection between these litigation discussions, which are historical, and our customers understand that have had no influence on indirect FX, which is where if it had influence, it would have influence.

Okay. Thanks for that, Jay. Then maybe a bit more of a broad or strategic question on expenses, certainly this is not easy times for large financial services companies and GSIBs, but you could argue that higher regulatory expense pressure is not really environmental. Now it's just part of the new operating landscape, rather than being a transient factor.

I know you referenced that you're looking to do a few things later in the year. Clearly, that's not lost on you, but I sense from conversations with investors that there's increasing frustration on a lack of push on the expense front. The revenue is what it is. Expense is a bit more in your control. Why is it? Can you help us understand why there hasn't been more movement on the expense front?

Yes, let me start that one, and then Mike can maybe jump in. First off, I agree with your point of view that the regulatory compliance is a structural shift. I think most firms are trying to deal with the immediacy, and then the ongoing nature of not only how do you comply with these things, but how do you comply with these things in a highly automated way, which is the way we would look at anything at State Street. We've got a combination of addressing that with manpower, consultants, individuals, but ultimately want to apply technology and drive down the cost of complying, not only for ourselves but as a service to our customers.

Let me just introduce another front which is maybe what the comment that Mike made a few cycles ago. We went through the five-year IT and ops transformation plan, and I think it set us up nicely. You've heard me talk about the fact that we've had great core discipline around core systems. We haven't drifted to multiple systems, and we've taken those common systems and improved the processes. We've leveraged work sites, China, Poland, (inaudible) we continue to do that. There's an ongoing opportunity now that we've moved in that direction to continue to apply technology to replace labor.

Part of what has underpinned the last year have been regulatory and compliance costs offset by some of the operational improvements that we're making which is really applying technology to reduce labor. There's much more opportunity to do more there, so what we're thinking about is a way to accelerate some of that activity, to do more with systems, to accelerate the minimization of the labor content and the work output, if I can say it that way. We view that and we have view that as something that's ongoing because we don't believe, one, that the regulatory compliance pressure lets up, and we don't know when the top line environment gets better.

The thing we can control is the expenses. In the background, we've been continuing to invest in technology to improve our operational efficiency, but the question is can we do more? Can we accelerate some of that activity, if that helps.

Very helpful. Thanks a lot, Jay.

Our last question will come from the line of Geoffrey Elliott with Autonomous Research.

Thank you for taking the question. Starting with some of the regulatory type issues that have been going on with BSA, AML, and then with the [Wells] notice that you received, I think, relating to lobbying and around the pensions business, are those having any impact on growth and revenue generation as you have to focus a bit more internally, rather than externally, and going out and winning new business?

Yes, fair question, Geoffrey I would say no pretty directly. The AML/BSA activity, we were criticized for not having the level of process that the regulators expected and wanted us to have. We've been at this for 18 months. It's a pretty segregated activity that we are conducting, country by country, business by business. It's pretty contained. It's got project plans. It's managed separately from the business line, so I really don't think that is going to hinder our ability to grow the revenue line.

On the [Wells] notice reference, which again is a pre-2012 reference to acquisition of pension retirement plans using consultants, again, we are working through that. We've got a different point of view than others on that. It hasn't, and shouldn't, affect any revenue generation.

Great. Thank you. Then just a quick follow-up on something you said earlier. You mention the GSIB buffers as a factor that feeds into the workaround on operational deposits. Is the goal there to come down from 150 bips to 100 bips? If so, how much do you need to do to get yourself into the lower bucket?

Geoffrey, it's Mike. There are a number of different nuances with the final rule that just came out on Monday, so I think it's a little bit early to give you a specific number. It's not lost to us that the increased excess deposits over the last couple of years is the single biggest factor driving our GSIB surcharge up. Therefore, it increases what was already a priority. It increases the importance of reducing those.

Now again, some of that will happen from our actions. We think some of that will happen naturally as market interest rates rise, but it does increase the importance of that work. I think that's the most important thing (inaudible) at this point. I think that 150 basis point GSIB surcharge by itself is manageable, but again, number one, we would obviously like to reduce the piece that's related to excess deposits, and it's just more of an incentive to get that accomplished.

Just to be clear for everybody on the call, it's our expectation that if we do that then the 150 or whatever it is, is [varied]. They'll be a calibration of that, so there is some motivation incentive to drive deposits down.

Great. Thank you very much.

Thank you.

Thank you, and that was our final question. I'll turn the conference call back over to management for closing remarks.

Yes, Holly, just a quick thanks to everybody for their attention. We look forward to speaking with you after the third quarter. Thanks.

Once again, we'd like to thank you for your participation on today's State Street conference call. You may now disconnect.