DBRS: STT Sec Lending Outperforms, New Business Drive Improved 2Q14 NI; Higher Compliance Costs Loom

Summary:
• Operating net income available to common shareholders was up 6% YoY to $603 million, reflecting strong core servicing and management fees, and securities finance outperformance, partially offset by higher expenses.
• With higher than expected regulatory compliance costs, FY14 positive operating leverage will be difficult to achieve absent higher short-term interest rates and higher FX volatility.
• DBRS rates State Street Corporation Issuer & Senior Debt at AA (low) with a Stable trend.

DBRS, Inc. (DBRS) views State Street Corporation’s (State Street or the Company) 2Q14 results as good reflecting above-peer revenue growth, especially within securities finance, client re-risking, and solid net new business in both custody and asset management. Moreover, management noted that the new business pipeline is stronger than it has been for a while. Nonetheless, expenses increased year-on-year (YoY), as regulatory compliance expenses have increased at a much higher rate than originally expected. As a result of higher expenses, historically low foreign exchange volatility, and net interest revenue (NIR) pressure, DBRS does not anticipate that State Street will deliver positive operating leverage for FY14.

Revenues benefited from strong core servicing and management fees, and securities finance outperformance. Indeed, securities finance revenues increased 12% YoY even with declines at the other trust banks, as the Company’s newer enhanced custody business continues to drive growth. Moreover, NIR was up modestly sequentially, reflecting significant client deposit growth.

Operating expenses totaled $1.8 billion, an increase of 4% from 2Q13. The Company originally expected regulatory compliance costs to increase $30 million to $40 million from FY13 levels in FY14, but now believes they will be significantly higher. Management provided new expense guidance saying that 3Q14 operating expenses should increase by $20 million from 2Q14 levels and remain at that level in 4Q14. This implies FY14 operating expense growth of approximately 5.7%, which is higher than the operating revenue growth guidance of 3% to 5%. In order to achieve positive operating leverage, State Street would need higher market driven revenues, especially more foreign exchange volatility and higher short term interest rates.

During the quarter, the Company won new asset servicing mandates of $250 billion, while attracting $18 billion of net new assets under management (AUM), which was the highest level of new flows since 3Q12. Overall, State Street’s assets under custody reached a record $21.7 trillion, while AUM was also a record at $2.5 trillion.

Higher levels of deposits, solid earnings generation, and incremental improvement in the Company’s securities portfolio related to buying more high quality liquid assets to meet regulatory requirements, all contributed to the maintenance of the Company’s strong balance sheet. Significant balance sheet growth primarily from excess client deposits did pressure State Street’s supplementary leverage ratio during the quarter. However, at an estimated 6.1% at the holding company, the ratio remains the highest among the trust banks. DBRS continues to believe that State Street remains well positioned to meet all regulatory requirements.

DBRS rates State Street Corporation Issuer & Senior Debt at AA (low) with a Stable trend.

Note:
All figures are in U.S. dollars unless otherwise noted.