STATE STREET CORP quarterly report, Q3 FY2014

State Street Corporation — Q3 2014 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2014; comparisons are with the corresponding 2013 periods unless stated otherwise. State Street provides institutional investment servicing and investment management. Its September 30, 2014 scale included $28.47 trillion of assets under custody and administration (AUC) and $2.42 trillion of assets under management (AUM).

Financial results and position

Metric	Q3 2014	Q3 2013	Nine months 2014	Nine months 2013
Total revenue	$2.582 billion	$2.425 billion	$7.665 billion	$7.420 billion
Net income	$560 million	$540 million	$1.545 billion	$1.583 billion
Net income available to common shareholders	$542 million	$531 million	$1.500 billion	$1.557 billion
Diluted EPS	$1.26	$1.17	$3.45	$3.40
Total expenses	$1.892 billion	$1.722 billion	$5.770 billion	$5.346 billion
Net interest revenue (GAAP)	$570 million	$546 million	$1.686 billion	$1.718 billion
Net interest margin (fully taxable-equivalent)	1.12%	1.33%	1.19%	1.38%

Q3 revenue rose 6%, with fee revenue up 7%; nine-month revenue rose 3%. Q3 net income increased 4%, while nine-month net income fell 2%. Higher expenses—up 10% for Q3 and 8% year to date—outpaced revenue growth.
Q3 diluted EPS increased 8%; nine-month diluted EPS increased 1%, despite lower nine-month net income, partly reflecting fewer average diluted shares.
Q3 return on average common equity was 10.6%, versus 10.8% a year earlier; nine-month return was 10.0%, versus 10.4%. Reported pre-tax margin was 27% for Q3 (29% prior year) and 25% year to date (28% prior year).
Fee trends were mixed: Q3 servicing fees rose 8%, management fees 14%, securities finance 34%, and trading services 5%; processing fees and other revenue fell 70%. For the nine months, servicing fees rose 7%, management fees 11%, securities finance 17%, while trading services fell 8% and processing fees and other revenue fell 30%.
At September 30, total assets were $274.81 billion, deposits $207.97 billion, total shareholders’ equity $21.16 billion, and long-term debt $9.02 billion. Loans and leases, net of allowance, were $18.36 billion; allowance for loan losses was $34 million.
Nine-month cash flows were negative $964 million from operations and negative $23.91 billion from investing, offset by $25.80 billion provided by financing; cash and due from banks ended at $4.15 billion. Investing outflows largely reflected the $22.69 billion increase in interest-bearing bank deposits. Financing inflows included deposit growth.
Asset liquidity was $114.40 billion at quarter-end, including $86.95 billion of highly liquid short-term investments. Parent-company net liquid assets were $4.15 billion. Management considered overall liquidity sufficient for current commitments and client needs.
Regulatory capital ratios for State Street under the Basel III advanced approach were 12.8% tier 1 common, 14.2% tier 1, 16.2% total risk-based, and 6.4% tier 1 leverage. The estimated tier 1 common ratio under the standardized approach was 10.9%. Methodology changes mean period comparisons are not directly comparable; the bank and parent exceeded applicable requirements.

Material changes and management commentary

Q3 servicing and management fee gains reflected stronger equity markets, net new business and, for management fees, inflows and higher performance fees. AUC reached $28.47 trillion, up from $26.03 trillion at September 2013; AUM was $2.42 trillion, up from $2.24 trillion.
Higher client deposits supported Q3 net interest revenue, but low central-bank yields on a portion of those deposits weighed on margin. Q3 average interest-bearing deposits with banks were $63.16 billion, compared with $25.27 billion a year earlier. Nine-month net interest revenue declined 2%, as lower asset yields offset higher earning-asset levels and lower funding costs.
Expenses increased due to staffing for new business, merit increases, regulatory compliance, higher processing activity and other items. The Q3 “other” expense increase included a $70 million pre-tax legal accrual related to indirect foreign-exchange client claims and a charitable contribution; prior-year Lehman-related gains and recoveries also affected the comparison.
Management expected approximately $130 million of additional 2014 pre-tax savings from its Business Operations and Information Technology Transformation program. It projected $575 million to $625 million of annualized savings by the end of 2014 versus 2010 expenses, with the full effect expected in 2015; these are program estimates, not a forecast of total company expenses.
Management reported $302 billion of servicing business awarded in Q3, of which $173 billion had been installed by quarter-end. Approximately $250 billion of awarded servicing assets remained to be installed. SSgA recorded about $3 billion of Q3 net new business, with approximately $1 billion awarded but not installed.
Common-stock repurchases totaled approximately $410 million in Q3 and $1.24 billion in the first nine months. The quarterly common dividend was $0.30 per share; nine-month declared dividends were $0.86 per share. State Street issued Series D preferred stock in Q1, raising approximately $742 million net.

Outlook, risks and contingencies

No broad earnings or revenue guidance is provided in the supplied filing text. Management said net interest revenue and margin remain sensitive to global rates, deposit levels and mix, reinvestment yields, regulatory liquidity rules, and the remaining accretion on former conduit securities. It estimated about $427 million of future aggregate discount accretion from those securities, assuming they are held to maturity, with about half expected over the next four years.
State Street recorded a $70 million pre-tax ($53 million after-tax) accrual for an intended effort to resolve some, but not all, potential and outstanding indirect-FX claims. Government inquiries and civil actions remain; the company said settlements could exceed the accrual and additional claims may arise. Aggregate legal and regulatory accruals, net of anticipated insurance recoveries, were approximately $111 million.
The company was responding to DOJ and SEC subpoenas concerning solicitation of public retirement-plan servicing business, including use of consultants and lobbyists. It also disclosed continuing scrutiny and litigation across the FX industry relating to alleged benchmark manipulation, and an internal review of trader communications.
Other disclosed matters included shareholder and ERISA litigation, a California state-pension FX action, and transition-management investigations following a 2014 U.K. FCA settlement and fine of approximately $37.8 million. State Street said adverse outcomes in certain matters could materially affect period results or reputation, though it did not believe pending matters were likely to materially affect consolidated financial condition.
Important financial risks include interest-rate and market sensitivity, client-deposit outflows, counterparty and credit risk, regulatory change, operational and cyber risk, and execution of the transformation program. A 100-basis-point rate decline was estimated to reduce next-12-month net interest revenue by $313 million under an immediate shock scenario. A 200-basis-point rise produced estimated negative EVE sensitivity of $2.45 billion, or 14.0% of tier 1 and tier 2 capital.
Off-balance-sheet exposures included $24.15 billion of unfunded credit commitments and $340.24 billion of indemnified securities on loan, supported by collateral exceeding 100% of loaned securities’ fair value. The scale of these activities entails counterparty, collateral, liquidity and operational risks.
Approximately $4.82 billion of CLO investments raised potential Volcker Rule classification and divestiture risk. Management said it did not believe a sale before recovery in value was likely based on its assessment and the remaining conformance period.
State Street was identified as a global systemically important bank, with a 1% surcharge category then designated by the Financial Stability Board; U.S. implementation remained pending. Resolution-plan shortcomings identified by regulators could lead to stricter requirements or business restrictions if not satisfactorily addressed.
Quarterly comprehensive loss was $36 million despite $560 million of net income, primarily reflecting $591 million of after-tax foreign-currency translation losses and other comprehensive losses. Nine-month comprehensive income was $1.533 billion.

Investor verification priorities

Track whether awarded servicing and management assets are installed on schedule and translate into recurring fee revenue, and distinguish installed business from announced awards.
Assess the durability of fee growth against market levels, client flows, FX volumes and spreads, performance fees, securities-finance activity, and continuing declines in processing and other revenue.
Monitor expense growth, regulatory compliance costs, the $70 million FX accrual versus eventual settlements, and realized savings and implementation costs from the transformation program.
Review deposit stability and concentration, liquidity under stress, the effects of LCR/NSFR and leverage-rule implementation, and the substantial cash held at central banks at low yields.
Examine capital ratios under both advanced and standardized Basel III approaches and subsequent G-SIB and supplementary leverage requirements; current ratios use changing regulatory methodologies.
Follow FX, public-pension solicitation, transition-management and other litigation/investigations, including possible claims beyond recorded accruals and insurance recoveries.
Review loan growth and credit quality, particularly speculative-rated senior secured bank loans, and the adequacy of the $34 million loan-loss allowance.
Consider the effect of currency translation and interest-rate changes on comprehensive income, equity, portfolio values and reported capital.

The interim financial statements were reviewed, not audited; the independent accountant reported no material modifications needed for GAAP conformity. Management concluded disclosure controls were effective as of September 30, 2014.