STATE STREET CORP quarterly report, Q2 FY2014

State Street Corporation — Q2 2014 Form 10-Q

Reporting period: Three and six months ended June 30, 2014; comparisons are with the corresponding 2013 periods unless noted. State Street provides investment servicing and investment management to institutional clients. At quarter-end, assets under custody and administration were $28.40 trillion and assets under management were $2.48 trillion. Financial statements are unaudited and were reviewed, not audited, by the independent accounting firm.

Financial results and position

Metric	Q2 2014	Q2 2013	Six months 2014	Six months 2013
Total revenue	$2.598bn	$2.560bn	$5.083bn	$4.995bn
Net income	$622m	$579m	$985m	$1.043bn
Net income available to common shareholders	$602m	$571m	$958m	$1.026bn
Diluted EPS	$1.38	$1.24	$2.19	$2.22
Total expenses	$1.850bn	$1.798bn	$3.878bn	$3.624bn
Income before tax	$746m	$762m	$1.201bn	$1.371bn
Net interest revenue	$561m	$596m	$1.116bn	$1.172bn

Q2 revenue rose 1%, while net income rose 7% and diluted EPS rose 11%. For the first half, revenue rose 2%, but net income fell 6% and diluted EPS fell 1%.
Q2 pretax margin was 29%, versus 30% a year earlier; first-half pretax margin was 24%, versus 27%. Q2 return on average common equity was 11.9%, versus 11.3%; first-half return was 9.6%, versus 10.2%.
Q2 fee revenue increased 3% to $2.039bn. Servicing fees rose 7%, management fees 8%, and securities finance 12%; trading services fell 14%, including foreign exchange trading down 16%. Stronger markets, net new servicing business and a weaker U.S. dollar supported fee growth; lower currency volatility and electronic trading volumes weighed on trading revenue.
Fully taxable-equivalent net interest margin fell to 1.17% from 1.42% in Q2 and to 1.23% from 1.40% for the first half. Management cited lower yields and elevated client deposits placed partly at low-yielding central banks.
At June 30, total assets were $282.32bn, deposits $218.83bn, total shareholders’ equity $21.70bn, and long-term debt $9.04bn. Total assets increased from $243.29bn at year-end 2013; deposits rose from $182.27bn.
Reported asset liquidity was $120.77bn, including $98.39bn of interest-bearing bank deposits. Parent-company net liquid assets were $3.83bn, down from $4.42bn at year-end. Management considered consolidated liquidity sufficient for commitments and business needs.
First-half operating cash flow was $446m, versus cash used of $1.761bn in 2013. Investing activities used $34.478bn, principally reflecting a $34.129bn increase in interest-bearing bank deposits; financing provided $37.059bn. Cash and due from banks increased $3.027bn to $6.247bn.
Basel III advanced-approach ratios at June 30 were 12.8% tier 1 common, 14.1% tier 1, 16.1% total risk-based capital and 6.9% tier 1 leverage. The preliminary estimated standardized-approach tier 1 common ratio was 11.3%. Ratios across periods are not directly comparable because calculation methods changed.

Material changes and management outlook

Expenses increased 3% in Q2 and 7% in the first half. Compensation and benefits rose 7% and 9%, respectively, due to staffing for new business, incentive compensation, merit increases, foreign exchange effects and regulatory compliance costs. First-half compensation included $76m of severance.
Management expected approximately $130m of additional 2014 pretax savings from its Business Operations and IT Transformation program. It projected annualized savings of approximately $575m–$625m versus 2010 expenses by year-end 2014, with the full effect expected in 2015; these are program estimates, not a company-wide expense or earnings forecast.
State Street secured an estimated $250bn of new servicing assets in Q2; $89bn was installed by June 30 and the remainder was expected to be installed in the rest of 2014. It reported $243bn of awarded servicing assets awaiting installation. SSgA recorded approximately $15bn of Q2 net new managed business, while approximately $6bn awarded but not installed was excluded from reported assets under management.
The company repurchased approximately 6.3m shares for $410m in Q2 under a program authorizing up to $1.70bn through March 31, 2015; $1.29bn remained at quarter-end. It declared a $0.30-per-share quarterly common dividend. First-half repurchases totaled approximately $830m.
State Street began reporting regulatory capital under Basel III advanced approaches in Q2. It also issued $742m net proceeds from Series D preferred stock in Q1. Management stated that the company and its bank subsidiary exceeded applicable regulatory capital requirements.

Risks, contingencies and unusual items

Interest-rate sensitivity, client-deposit levels and pricing, investment yields, market volatility and regulatory liquidity requirements may affect future net interest revenue, margins and liquidity. A modeled immediate 100-basis-point rate increase implied a 16.5% increase in next-12-month net interest revenue versus baseline; a 100-basis-point decrease implied a 12.4% decline. These are model estimates based on assumptions, not forecasts.
The portfolio included approximately $5.10bn of collateralized loan obligation investments. The company said future interpretation of the Volcker Rule could require divestiture; a sale at a discount could materially affect results or financial condition, though management did not consider a forced sale before recovery likely.
Loans and leases, net of allowance, were $16.77bn, up from $13.46bn at year-end. Senior secured bank loans were $1.32bn and internally rated speculative; the allowance for loan losses was $32m. Management expected to increase participation in these loan syndications.
Off-balance-sheet commitments to extend credit were $23.15bn. Indemnified securities on loan totaled $363.06bn, supported by $377.26bn of collateral held as agent; these gross figures are not recorded as company assets and liabilities.
Legal and regulatory matters included indirect foreign-exchange pricing litigation and government inquiries, securities-lending litigation, and transition-management matters. Aggregate legal and regulatory accruals, net of anticipated insurance recoveries, were approximately $51m. The company disclosed a proposed $60m shareholder-class settlement and $10m settlement of two retirement-plan actions, subject to court approval; related accruals plus anticipated insurance were stated to be sufficient. In January 2014, it paid a £22.9m ($37.8m) U.K. regulatory fine concerning transition-management charges; separate U.S. investigations continued.
In August 2014, regulators informed State Street and other large banking organizations of shortcomings in their 2013 resolution plans. The company warned that failure to satisfy regulators in its 2015 plan could lead to stricter capital, leverage or liquidity requirements, growth or activity restrictions, or divestitures.
Management identified regulatory compliance, operational and cyber risks, litigation, client withdrawals, market disruption, counterparty credit, model risk and execution of the transformation program as important uncertainties. Disclosure controls were assessed as effective at June 30, 2014.

Investor verification priorities

Confirm subsequent installation and revenue contribution of the $243bn servicing pipeline and the awarded SSgA assets not yet installed.
Track fee growth against continuing weakness in foreign-exchange and electronic trading, and monitor net interest margin under changing rates and deposit levels.
Assess whether expense growth, severance, regulatory costs and transformation savings align with management’s stated program expectations.
Review Basel III standardized and advanced-approach capital ratios as regulatory methods phase in; do not treat the reported periods as directly comparable.
Follow the status, accrual adequacy and potential financial or reputational effects of foreign-exchange claims, proposed settlements and regulatory investigations.
Monitor liquidity and funding exposures, loan growth and credit quality, securities-lending indemnities, and potential Volcker Rule treatment of CLO holdings.