DBRS: State Street’s 2Q Operating Earnings Down YoY; Solid Core Business Growth

Summary:
• Operating net income available to common shareholders of $569 million, a decline of 6% reflecting negative operating leverage and a higher tax rate.
• The core business continues to perform well with servicing fees up 4.1% sequentially and 2.9% YoY.
• 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) 2Q15 results as sound with solid servicing fee growth. While the Company did have revenue growth, operating expenses increased at a faster rate year-over-year (YoY), as regulatory and compliance costs continue to climb.

For the fourth consecutive quarter, the Company increased its legal accruals related to indirect foreign exchange trading, which in aggregate now totals $585 million. As disclosed in the 10-Q, settlement demands aggregate up to $925 million, but an agreement may be nearing, especially since financial terms have likely been agreed upon.

Assets under custody and administration were up modestly during the quarter and the Company had $143 billion of new servicing mandates in the quarter. Management once again characterized the pipeline as deep and diverse. Meanwhile, assets under management experienced $65 billion of net outflows, but the impact on net new business revenues was minimal, as much of the outflow was priced lower than the new business inflows. In 1H15, the Company launched 45 new products, including the second most successful ETF launched this year.

Operating revenues increased 2% YoY driven by relatively broad-based fee growth, although net interest revenue remains pressured from the low interest rate environment. Foreign exchange trading increased YoY on higher volumes and volatility, but was down sequentially after a particularly strong 1Q that benefited from higher volatility. Meanwhile, operating expenses increased 3% YoY, primarily from higher regulatory and compliance costs. Overall, State Street reported negative operating leverage YoY and will be hard pressed to achieve positive operating leverage for FY15 absent imminent rate hikes.

During the quarter, the Company undertook several balance sheet actions to optimize the balance sheet and help comply with upcoming regulatory requirements. Specifically, State Street’s high quality investment portfolio declined $11 billion to $101 billion with the decline primarily coming from asset-backed securities. Overall, the duration inched higher to 2.2 years, as did the percentage of fixed rate securities.

Just recently, the Federal Reserve indicated that using the most recently available data State Street would be required to have a surcharge of 1.5%, or 50 basis points higher than BNY Mellon, for systemically important banks, when the rule becomes fully effective on January 1, 2019. The primary driver of the surcharge is the high amount of custody deposits that are deemed non-operational and considered short-term wholesale funding. Between this rule and the supplementary leverage ratio, the Company noted they are highly incentivized to reduce excess deposits. Nonetheless, despite charging more for certain deposits, average deposits increased during the quarter.

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.