Anthony G. Ostler - State Street Corp. Joseph L. Hooley - State Street Corp. Eric W. Aboaf - State Street Corp..

Glenn Schorr - Evercore Group LLC Alexander Blostein - Goldman Sachs & Co. LLC Ken Usdin - Jefferies LLC Elizabeth Lynn Graseck - Morgan Stanley & Co. LLC Brian Bedell - Deutsche Bank Securities, Inc. Brennan Hawken - UBS Securities LLC James Mitchell - The Buckingham Research Group, Inc.

Michael Carrier - Bank of America Merrill Lynch Geoffrey Elliott - Autonomous Research LLP.

Good morning and welcome to State Street Corporation's Second Quarter of 2017 Earnings Conference Call and Webcast. Today's discussion is being broadcast live on State Street's website at investors.statestreet.com. This conference call is also being recorded for replay. State Street's conference call is copyrighted and all rights are reserved.

This call may not be recorded for rebroadcast or distribution, 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 State Street website. Now, I would like to introduce Anthony Ostler at State Street..

Thanks, Victoria. Good morning and thank you all for joining us. On our call today, our Chairman and CEO, Jay Hooley, will speak first. Then, Eric Aboaf, our CFO, will take you through our second quarter 2017 earnings slide presentation, which is available for download in the Investor Relations section of our website, investors.statestreet.com.

Afterwards, we'll be happy to take questions. During the Q&A, please limit your questions to two questions and then re-queue. 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 measures are available in the appendix to our 2Q 2017 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 2017 slide presentation under the heading Forward-Looking Statements, and in our SEC filings including the Risk Factors section of our 2016 Form 10-K.

Our forward-looking statements speak only as of today, and we disclaim any obligation to update them even if our views change. Now, let me turn it over to Jay..

Thanks, Anthony. Good morning, everyone. We're pleased with our second quarter results, delivering a record level of quarterly earnings per share that reflect continued strength in global equity markets, as well as momentum in our asset management and asset servicing business.

We also, for the first time, exceeded $31 trillion in assets under custody and administration this quarter, fueled by a combination of new business activity and higher equity markets. In June, we celebrated our 225th anniversary. We're proud to be in a rare category of companies whose success is measured not in years or decades, but in centuries.

We've been able to achieve this success by focusing on our clients and on key markets, while delivering new solutions to address our clients' needs. We continue to invest and obtain long-term benefits from Beacon, which is core to the next phase of advancing State Street.

We're making progress in digitizing our operations and providing new capabilities and information advantages to our clients. We continue to prioritize returning capital to our shareholders.

In June, our Board of Directors approved a $1.4 billion common stock purchase program following the Federal Reserve's review of our capital plan under its 2017 CCAR process. Our 2017 capital plan also includes an increase of approximately 11% and our quarterly common stock dividend to $0.42 per share starting in the third quarter of 2017.

Now turning to slide number four. I'd like to review our progress on our strategic priorities and some key achievements this quarter.

We continued to deliver broad-based growth from our core franchise, with new asset servicing wins of approximately $135 billion for the quarter and our highest levels of assets under custody and administration at quarter end with growth of 12% from the second quarter 2016.

Our total new business yet to be installed at quarter end was $370 billion, and our pipeline of new business opportunities remains robust. SSGA finished the quarter with $2.61 trillion in assets under management, a 13% increase from 2Q 2016.

The majority of the growth from 2Q 2016 was driven by market appreciation, and 5% of the increase was from the acquired GE Asset Management business, which continues to support growth, including the win of the GE Alstom UK business.

We completed the integration of the acquired GE Asset Management business in the second quarter, which had already turned accretive ahead of schedule in the first quarter. I'm also pleased to say that momentum in our Global Markets business continues.

Our FX business, with its distinctive research and breadth of trading platforms, increased its ranking significantly according to Euromoney 2017 FX survey, as we were rated fifth with real money managers and hedge funds globally and that's up from seventh and 11th place, respectively, the year earlier.

This increase in market share is reflected in the 13% growth in FX trading revenue from 2Q 2016. Beacon continues to advance with our investments in technology, next-generation platforms, enhancements to operational performance and connectivity across the enterprise and through the delivery of innovative solutions and insights to our clients.

Eric will provide you some more detail on the progress that we're making with Beacon in a few minutes. We remain focused on providing clients with innovative solutions to address regulatory risk and analytic requirements, their investment needs and supporting the achievement of their growth objectives.

Some examples of the benefits of our ongoing investments include solutions for regulatory reporting, risk analytics and collateral management and the broadening and deepening of our OCIO capabilities with the acquisition of GE Asset Management operations.

We've also developed our Market Entry Solutions, which is an integrated value-added service that leverages our global presence and expertise to assist our clients with their global growth strategies.

Our mission is to provide clients with information insight, access and partnership to support their global product development and distribution ambitions.

So, in closing, we remain focused on achieving our financial goals as reflected by our year-over-year quarterly positive fee operating leverage of approximately 190 basis points and total operating leverage of over 270 basis points.

This resulted in improving our pre-tax operating margin to over 33% for 2Q 2017 and helped us increase EPS 14% from 2Q 2016 and 18% in the first six months compared to 2016, while generating a return on equity of approximately 14% for the quarter and 12% in the first six months of 2017. All of these are on an operating basis.

I'd now like to turn the call over to Eric, who'll cover the financials and then we'll open the call to your questions..

Thank you, Jay, and good morning everyone. Please turn to slide 5 where I will start my review of our operating-basis results for second quarter 2017. EPS for 2Q 2017 increased to $1.67 per share, up 14% from 2Q 2016.

2Q 2017 results reflected continued momentum in fee revenue, driven by higher equity markets, new business wins and positive client flows, as well as growth within our markets businesses. 2Q 2017 results also reflected higher NII as a result of the rising interest rate environment, disciplined liability pricing and improved liability mix.

We delivered approximately 2 percentage points of positive fee operating leverage and achieved a pre-tax margin of over 33%, up almost 2 percentage points. And importantly, ROE also improved to over 13%, up 1.4 percentage points. Now let me turn to slide six to briefly review growth of two key drivers.

First, AUCA increased to record levels of $31 trillion, up 12% from 2Q 2016. Growth was driven by a combination of market appreciation and net new business and client flows. AUCA growth translated into strong revenue increases across our three geographies and spanned a broad range of products and client segments.

As compared to 1Q 2017, both AUCA and revenues were up nicely. Second, at State Street Global Advisors, AUM increased 13% from 2Q 2016, driven by market appreciation and the impact of the acquired GE Asset Management operations and positive ETF flows, which were partially offset by continuing institutional net outflows.

Please turn to slide 7 where I will focus on 2Q 2017 fee revenue results, which were up 9% relative to 2Q 2016. You'll also find detail in the appendix for the sequential quarter comparison. Servicing fees increased 4%, primarily due to higher global equity markets, new business installations and client activity on a year-over-year basis.

While our wins were broad-based, we saw particular strength in EMEA, alternatives and middle-office outsourcing for asset managers. Management fees increased 38%, reflecting the contribution of the acquired GE Asset Management business and higher global equity markets on a year-over-year basis.

On a sequential quarter basis, both servicing and management fees demonstrated solid growth, increasing 3 percentage points and 4 percentage points, respectively. Trading services increased relative to 2Q 2016, primarily reflecting gains in market share and increased activity in emerging markets, offset in part by lower volatility.

Securities finance revenue increased from 2Q 2016, reflecting continued strength in enhanced custody. Processing fees and other revenue decreased from 2Q 2016, primarily reflecting unfavorable foreign exchange swap costs, which are primarily in NII this year.

As a reminder, 1Q 2017 processing and other revenue included a $30 million gain related to the sale of BFDS/IFDS. Moving to slide 8, NIM was up 16 basis points from 2Q 2016, and NII was up 13% on a relatively flat balance sheet.

Strength in NII was the result of higher market interest rates in the U.S., disciplined liability pricing and our continued focus on improving our liability mix, partially offset by a smaller investment portfolio. On a sequential basis, 2Q 2017 NII benefited from higher market rates as well as lower levels of wholesale CD funding.

NIM was up 10 basis points sequentially, a portion of which was non-recurring, so we expect closer to a 3 to 5 basis point uptick in the third quarter, given the June Fed rate increase. Interest-bearing client deposit pay has remained relatively low, within a 20% to 25% range.

And even with our disciplined pricing, we did see our deposits tick up sequentially, as clients continue to look for outlets for their U.S. dollar cash. Now I will turn to slide 9 to review second quarter expenses.

2Q 2017 expenses increased 7% in total from 2Q 2016, with approximately 3 percentage points of that increase related to the $51 million of expenses associated with the acquired GE Asset Management business.

Excluding those acquisition-related expenses, compensation, employee benefits increased from the year-ago quarter, primarily reflecting increased cost to support new business, incentive compensation and merit increases and regulatory initiatives, partially offset by Beacon savings.

Information systems, transaction processing and occupancy costs increased modestly year-over-year and in line with new business and planned investments.

Other expenses increased, primarily reflecting the costs associated with the acquired GE Asset Management business and higher regulatory and insurance expenses, partially offset by lower legal-related costs.

2Q 2017 GAAP results also included a pre-tax $62 million charge related to the restructuring associated with Beacon, which will provide benefits within the next five to six quarters. As compared to 1Q 2017, expenses decreased 5 percentage points, reflecting the 1Q 2017 seasonal deferred incentive compensation expense.

Excluding this seasonal impact, sequential expenses increased 3 percentage points, reflecting net new business, merit increases and the timing of incentive compensation awards, partially offset by savings related to State Street Beacon.

Let me now move to slides 10 and 11 to review our progress on State Street Beacon, as well as highlight the range of initiatives that enhance the client experience and increase operational efficiencies. Starting on slide 10, you can see four tangible benefits that are improving the client experience.

First, we are leveraging our global scale to improve the speed and efficiency of key services, transaction processing, fund accounting and fund administration. Each of these three services has a detailed set of metrics that we track, a subset of which you can see on the right side of the slide.

In particular, we are seeing strong benefits as we roll out and clients adopt our new technologies and tools. Second, we are upgrading our core platform architecture, integrating with new technologies and investing in IT capabilities. Third, we have made good progress expanding Beacon across the organization.

Earlier this year, we launched effectiveness and efficiency initiatives in the corporate function and in SSGA, while we also centralized our procurement and real estate processes.

Lastly, on the revenue side, we expect the development of innovative client business solutions, such as our recently-launched SEC Modernization product to result in incremental revenue, some of which we are already seeing in our sales pipeline.

Turning to slide 11; Beacon remains on track to achieve $550 million in targeted program savings, including at least $140 million in 2017. On the left side of the slide, we show the year-over-year growth benefits and investment expense related to Beacon.

You can see on the bottom row our previously-disclosed 2016 net savings, as well as our 2017 guidance to achieve at least $140 million. Each quarter, we carefully pace the level of investments to consider multiyear initiatives, support immediate opportunities and calibrate this to the external environment.

The net benefit varies each quarter, and in 2Q 2017, we recognized approximately $25 million in year-over-year net expense savings. On the right side of the slide, we have broken out the growth savings by major categories that I just described.

Approximately 70% of the projected growth savings in 2017 is a result of leveraging our scale and dispersing resources across our global platform. The balance comes from improving our technology and expanding Beacon deeper into the organization. Each year, the mix of benefits will change up or down as we identify opportunities for improvement.

Now let's turn to slide 12 to review our balance sheet and capital position. We continue to maintain a high-quality balance sheet, including an investment portfolio with a well-structured and diversified mix of securities. Our capital and liquidity position remains strong.

We repurchased $227 million of common stock in 2Q 2017, which completed our repurchase under our program announced in July of 2016. Our new capital actions announced just last month continue to demonstrate our commitment to return capital to shareholders through share repurchases and higher dividends.

While we were relatively pleased with our CCAR results, we are obviously digesting the detail as are other banks. We will carefully operate and optimize under the current rule. And of course, we are monitoring for potential developments. Let me briefly update you on LCR reporting requirements. We will begin to report our quarterly average LCR in August.

On an average daily basis for 2Q 2017, our LCR is above the 100% standard as you'd expect. Moving to slide 13, I'll update you on where we stand regarding our financial outlook. In summary, we are very pleased with the year-to-date progress against our original 2017 outlook.

Importantly, in 2Q 2017, we saw good revenue momentum; we continued to deliver a good operating leverage and our pre-tax margin expanded nicely. We remain focused on returning capital to shareholders, prudently managing expenses and executing on State Street Beacon, while driving growth in our core franchise.

So based on the strong year-to-date results, let me provide an update to our 2017 outlook relative to 2016. First, we now expect fee revenue growth for the full year to be in the 6% to 7% range, assuming the present favorable market conditions continue to prevail throughout the remainder of the year and the U.S.

dollar remains stable relative to major currencies. Second, we expect fee operating leverage to be towards the upper end of the 100 basis point to 200 basis point range that we communicated in January. On the expense front, we will continue to calibrate expenses against the revenue backdrop, but also in light of client installation requirements.

Third, due to strong year-to-date NII performance, we expect 2017 NII to be within a range of $2.43 billion to $2.45 billion or an increase of approximately 12% to 13% from 2016 levels. Lastly, we continue to expect our tax rate to be at the lower end of the 30% to 32% target we communicated in January.

Let me briefly touch on third quarter 2017 before turning the call back to Jay. We expect trading services revenue to be muted as activity usually slows in the summer, while securities finance revenue should decrease from the elevated seasonal levels experienced in 2Q.

We expect NII to increase in 3Q 2017 due to the Fed's most recent move at the end of June, but not at the same magnitude as we saw from 1Q to 2Q. In summary, we believe we are well positioned to achieve these full-year 2017 financial objectives. Now, let me turn the call back to Jay..

Thanks, Eric. Victoria, we now like you to open the call to questions..

Certainly. Your first question comes from the line of Glenn Schorr with Evercore ISI..

Hi, how are you?.

Good morning..

So the fee growth is great, even if you ex-out the GE acquisition. So it feels like there's a little bit better leverage to equity markets than the whole 10%, 2% rule of old.

But I don't know if you could help with how much of that is just emerging market versus developed market growth and the fee differential there? I don't know if you've ever shared with us what the fee differential is, but good to see, nonetheless..

Glenn, it's Eric. Good question and let me give you the summary. It's really all of those elements, right? So you remember equity markets are up nicely in the low teens. Bond markets on the other hand are actually flat to down. In some cases, hedge funds markets, private equity are kind of mixed.

So you kind of have to factor all that as you think about the AUCA growth. I think what we did see was actually a nice mix, both on the AUCA front in terms of growth and on the fee – services fee area in terms of growth. We saw a nice mix of some support from market appreciation, some nice contributions from flows.

We've seen flows broadly distributed this quarter and this – for the first half of the year across Europe, U.S. mutual funds, ETFs, right, all those are flowing in positively given our clients and the market. And then net new business has been good. You see we continue to have wins in the marketplace.

We still have a pipeline that we've been carrying that's $350 billion, $370 billion, $375 billion over the last couple of quarters, and that's getting implemented literally month-by-month. So it's really a combination of all the factors you described..

And is there a large fee differential EM versus developed markets? Or does that get bundled into a global client all-in fee?.

More and more it's bundled as a global client, right? We have clients that operate around the world. The fee discussions capture all their businesses.

You have some differential between lower-volume emerging markets, but even those are more typically in the – are quite advanced economies these days, slightly different fee levels at bonds versus equities, ETFs versus mutual funds. I mean, there's a dispersion but I don't think it's as dramatic as it once was..

Appreciate that. The last little one on balance sheet, you alluded to but I look for a little more color. The rate paid on non-U.S. deposits went negative from positive, small numbers but went negative from positive, yet those deposits actually still grow.

I'm just curious if you can give us a little more color on what drives that? Obviously, that's what you're talking about on your pricing discipline..

Yes. I think the – probably the best page to take a look at for folks is the supplemental information package, the page 13 where you see the average interest-earning balance sheet. I think you saw a couple of things.

I think the international deposits, remember, have a component of swaps that are tagged against those that feature into NII, and so that's why you see the lumpiness from quarter-to-quarter.

We actually pushed our international deposit pricing down a bp or two, just given the – our need to earn appropriate returns internationally, and also because we continue to see a nice inflow and willingness, almost the need from our clients to leave balances with us. They're doing that in euros, in sterling, in yen. They're doing that in dollars.

And so, we've got high demand on, I think, for clients to leave cash with banks. They're – a lot of that, they're steering towards us, and we obviously have a limited capability to accept too much of that given the leverage ratio constraints that we need to keep in mind..

All right. Thank you for all that, Eric..

Sure..

Your next question comes from the line of Alex Blostein with Goldman Sachs..

Hey, guys. Good morning. A couple of questions, I guess, in some of the buckets that they were particularly strong this quarter, and wanted to start, I guess, with the security lending. So nice uplift, it feel like seasonality has been softening over the last couple of years.

So maybe, as you look at the sequential change, can you help us understand kind of what was the seasonal uplift this time around versus more kind of normal growth? And then, I guess, the more important question is, enhanced custody obviously continues to contribute here.

Where do you guys still see the runway in that business, which, I guess, continues to be pretty strong?.

Yeah. Alex, it's Eric. Let me start. I think, as you described, seasonality and traditional SEC lending a little lighter than it's been historically, but we've still seen a decent amount of seasonality. Part of that just might be where we are in the market cycle. Part of that is there's the usual dividend activity and so forth that you'd expect.

On the enhanced custody side, I think, there we're actually seeing a continued pattern beyond seasonality of growth in revenues. Part of that is, we're serving more clients. Part of that is, we're going a little deeper with select clients. And so that – on – and that business was really a mix of both seasonality and growth on a year-over-year basis.

And so, I think, you can kind of take a look at the year-on-year comparisons. That's a good proxy for a growth of the two businesses. The quarterly uptick, a little more seasonal. But we also have to remember, right, there's volatility in these businesses, they ebb and flow.

And so, with a very strong quarter, we're quite pleased, but it will move up and down, and I think we all need to factor that in..

Sure. And then, just as far as some of the excitement around capital relief on the back of the treasury white paper.

I'm sure you guys got a bunch of question on that, but with Tier 1 leverage being obviously the more binding constraint for you guys in CCAR, what is the latest that you guys hear in terms of the ratio being augmented to kind of calibrate closer to what SLR could potentially change to or just making broader adjustments to CCAR that would alleviate against some of the pressure points there.

And I guess, if any of those things do happen, how should we think about the kind of newfound capital that you guys could either grow the balance sheet or return to shareholders?.

Let me start that one, Alex. This is Jay. The – I thought the treasury report I'm sure everybody's gone through it by now was a pretty balanced report with regard to ways to recalibrate and fine-tune some of the Dodd-Frank and Volcker legislations. So, I think, it was a good framework.

And hopefully, once we get some of these appointments with the Fed and other agencies, they'll start to attack that. For us, we have a pretty narrow set of concerns and issues. The most prominent one is the one you mentioned, which is the drag that excess deposits have on the leverage ratio.

And that is prominent, not only in that report, but in all the conversations that I have with regulators. Everybody, I would say, acknowledges that, that was an unintended consequence of the regulations. So I think there's a real desire to fix it. The fix, the conversation around a fix is kind of two dimensional.

One way to adjust the excess deposit issue for the trust banks would be simply to rescale the leverage ratio and that's one of the conversations out there so that you'd give the custody banks a little bit more headroom to accept these deposits.

And at the same time, put in place some kind of a provision so that in a crisis or in a market event that we get relief from the leverage ratio. So that's one kind of conversation, which would tend to just deal with the trust bank issues of the leverage ratio.

And then the broader thought out there is to reduce the denominator of the leverage ratio to accommodate central bank deposits, and that's, remember, that Bank of England took that approach in their leverage ratio. I'd say, and obviously that would treat not only the trust banks but the other, the rest of the banking industry as well.

Those are the two paths that are being discussed. I think it's going to depend on, again, new appointments and getting people in place and figuring out what the best way to deal with it is. But I have very high confidence.

I can't tell you when that the issue will be addressed because I think it's acknowledged in all circles that it was an unintended consequence of the regulations. With regard to the broader regulatory reform agenda, as I say, our needs, our issues are narrow.

I think more broadly though if we get to extended cycles on the resolution and recovery plan, if in CCAR, they held the balance sheet flat, all that would be additive to not only the cost of complying with regulation, but as you rightly mentioned, freeing up capital within State Street. Eric, I don't know if you'd add anything to that..

Yes, I think we're quite pleased to just see some balanced discussions and reports coming out of Washington. We think even Governor Tarullo, as he wound up his tenure, I think was supportive of some of these changes, which are really in the bucket of unintended consequences that have come through. Jay covered several of them.

Another one is on the Volcker rule.

The Volcker rule in an unintended way captures the seeding of new mutual funds and other types of investments that an asset manager has and if that asset manager is held within a bank environment like our SSGA business, it's kind of, you're guilty until proven innocent that it's not propped trading when in fact, all you're doing is seeding a new investment or a new mutual fund.

So we're optimistic that at multiple levels, there is an evolution here. We're certainly engaging with folks at multiple levels just to help articulate how to move the pendulum in a prudent way that gets us to where we should be..

Got it. Great. Appreciate you guys taking the questions..

Yes..

Your next question comes from the line of Ken Usdin with Jefferies..

Hi. Good morning, guys. First question just on the operating fee leverage guidance, you're still calling for 100 to 200, and it looks like inclusive of SGA, it's more like more like 320s through the first half.

So can you just talk us through, either what do you expect to change in that relationship in the second half? Or are you just continuing to have a conservative guide given always the uncertainty of the environment?.

Ken, it's Eric. The answer is really the second part of that, of your question, which is we've got to be conservative, right. A year-and-a-half ago, no one thought the equity markets would swoon like they did, and that is always a risk notwithstanding the indices like VIX and so forth, are at all-time's low.

But we know when things feel good is when you should be vigilant. I think we're also just trying to be conscious that as we have revenues, we also have an installation pipeline, as we have new wins that we're carrying that pipeline through.

And part of what you're seeing us do is we actually have to start to onboard new clients, put people against that build-out infrastructure and technology to plug them in. And so, part of what we are trying to signal is, we absolutely will calibrate operating leverage in the 100 to 200 basis point range.

We'd certainly – we've hinted that – or more than hinted, we'd like to be towards the upper end there, but we're mindful that, that the installation of those clients, especially those global clients who are particularly complex and have a broader set of offerings, take some energy and some spending. So we'll be disciplined here.

I think we're very pleased with the first half, but we don't have any interest in resting on our laurels. And we know we need to maintain a pattern, a consistent pattern of positive operating leverage..

Got it. Okay. And then secondly, if I could just dive one depth further into the liability cost side. Can you just help us go that extra mile on the U.S. deposit cost? You mentioned the wholesale funding. How much of that was a helper from 50 basis points to go to 38%? And then on that non-U.S.

side, can you help us understand the delta in the hedge, the $25 million last quarter, and what that went to this quarter? Thanks again, Eric..

Yeah. Let me do this at a couple levels to help answer your questions. So first, if you think about the 10 basis point uptick that we saw, I'd say 4 or 5 basis points of that this quarter was really market levels floating up, deposits which re-prices the asset side of the balance sheet, offset with disciplined pricing across both the U.S.

and the international jurisdictions. So we saw good performance there. We then saw couple basis point tick down from, as we rolled off some of those wholesale CDs that I mentioned. And then there was a couple of basis points just from market dislocations. We saw the swap costs were a little lower this quarter than previously.

That moves around with markets. It moves around with which currencies we're swapping. And so we had a little more of a tailwind than we would have expected. So those are the combinations. I think if you had decomposed the deposits, on a tactical basis, total U.S. deposit costs were down 12 basis points.

The underlying is that the CDs drove actually a bit more than that, kind of 15 basis point, 16 basis point roll down, and U. S. deposit costs were up by just four. And when you compare that to a 25 basis points move of the Fed, that's a 20% deposit beta, which is kind of the zone we've been in. We've been signaling 20% to 25%.

I think it's coming at the lower end of our range. On the international deposits, I did say earlier the underlying international deposits actually fell by a basis point in terms of cost.

The rest of the movement is in the swap, the furnishing swap costs, which we've actually enumerated in the footnotes of page 13 back there if you want to just do the math..

Perfect, yes. Thanks for the color, Eric..

The next question comes from the line of Betsy Graseck with Morgan Stanley..

Hi. Good morning..

Hi, Betsy, go ahead..

Can you hear me?.

Yes..

All right, great. I just had a couple of follow-up questions. One was on, Eric, the LCR. You mentioned that starting in August regulatory reports are going to require that you disclose the LCR ratio in a composition, Eric.

Could you just give us a sense as to what you've done to manage your position going into this announcement? And how you think about managing it as you're going to be disclosing this on a quarterly basis? And what you would recommend folks like us think about or look at as the numbers come out?.

Sure. I think the demand on the LCR has certainly predated me. The team two, almost three years ago when the LCR kind of came of age and got finalized did a couple of things to drive compliance. First, we added some deposits to our underlying balance sheet, right, and some of that was in the form of wholesale CDs.

And we did that because we needed that term structured that extended beyond the 30 days, 60 days, 90 days that you want to be at. I think secondly, the team then did some very good work to itemize their deposits and create clarity on which ones were operating versus excess and actually balance – rebalance that mix.

And you saw the reduction almost two years ago, deposits of about $20 billion, $25 billion. And that was really driving out excess deposits but actually keeping or actually increasing over time those operating transactional deposit balances.

And then what you've seen us do over time is we've continued that mix improvement, right, under the surface so that their operating deposits continue to trend upward. And that's given us the luxury to actually work down some of those wholesale CDs.

So I think there has been a program in place here over a two to three-year timeframe to actually prepare. I think we feel like we've now been operating under the LCR rules for kind of three years, but the last year has been really on a BAU basis. And so I don't think it's going to change a lot of our management going forward. Those are the rules.

The rules are the rules, and they're there for a good reason and we'll operate within them..

So is there anything left in non-operating to wind down here?.

Nothing that's terribly significant. There's always a little bit, and there's always an ongoing optimization that you do. We have a decent-sized alternatives accounting and fund administration business. That's with financial counterparties like hedge funds or private equity. And the Fed has deemed that as a 100% access. So we don't think that's right.

We don't think the model support that, but – so we need to keep some amount of access for those clients and we'll do that. But there's no big step change that we expect. And in truth, the best thing to do from an LCR management standpoint is now to operate with a healthy LCR.

But you don't want it to be neither too thin, nor to rich, right? If it's too rich, you're leaving money on the table and you can redeploy that into lending or securities. If it's too light, you're scraping by. And so I think there's a nice middle ground that we'd want to operate in..

Okay, great. And then just lastly, on the guidance that you have for the NII for the full year, obviously part of that uplift is this quarter, and it looks like there's a bit of an uplift also from 3Q, 4Q, but maybe at a slower pace than 2Q's uplift.

And my question is that just a function of being a little bit more conservative on the cost of funding given that some of the benefit this quarter came from what looks like swap market activity that maybe you're baking into the base case..

Yeah, I think the – that's the right way to think about it. We had a nice uptick from 4Q to 1Q, another nice uptick 1Q to 2Q.

But I think the – you can't bank on a full 10 basis point sequential uptick, again even with the Fed, the rate rise, we think the underlying core in that 10 might have been 5 basis points, 6 basis points depending on how you count.

Given that we have a little more of that now, we expect 2Q to 3Q uptick to be closer to 3 basis points to 5 basis points because some of it's already in the run rate. And that after that, we have to wait and see. There's been a lot of talk about deposit betas, where they'll go, when will begin to flow it upwards. That hasn't happened.

We've had nice stability in our deposit betas. We've had nice stability in our deposit base, but I don't think any of us with bankers want to get out ahead of ourselves and predict what – exactly what they'll look like in 4Q and then into next year just yet..

Okay. Super. Thank you so much. Really appreciate the color..

Yeah..

The next question comes from the line of Brian Bedell with Deutsche Bank..

Great. Thanks for taking my questions. Let me just circle back on the NII outlook.

What are your assumptions for – specifically for the rate backdrop in the second half in terms of Fed hikes and the tenure? And then I assume that you're still assuming like around a 25% deposit beta in the second half as well?.

Brian, it's Eric. That's about right. So we've been at the 20% to 25% right now. We think that for this June hike, we'll be around that level, but you never know for sure. We expect the June rate hike to come through, and then potentially a December hike. But since it's so late in the year, that really won't have much of an effect on 4Q.

So that's our interest rate forecast. I guess, what I would say is, if you step back, so far, deposits have performed well, I think, in this rising rate environment.

I think part of that is that we remix the quality of the deposits and pushed out a lot of that access two years ago, and then we've been managing carefully over the last year to support that. And then partly because the deposits from the custody banks I think actually respond in a decent way.

If you think about it, there's a hierarchy of response in deposits across different sectors, right? We all know that in retail, you have quite low deposit betas, and that's been shown for cycle after cycle.

I think at the other book end in the corporate sector where you get corporate treasurers, they're actually quite willing to shop their money, especially because they keep them for cash management and earnings credit. They'll move that around. They are borrowing from banks, and they're quid pro quo sometimes is, hey, you've got to pay up on deposits.

So I think the corporate sector and even high net worth tends to have a higher betas. And we're in the middle as a custody bank, right? We're doing with end-of-day cash, asset managers and pension funds who want to cover their transaction flows, who aren't really tempted to drawdown lines, right? That's not something that they look to do.

And so I think the custody banks are in this middle ground between retail and corporate, and that's part of the reason why our deposits have responded well through the first couple rate hikes..

Okay. That's great way to characterize it. And then my follow-up question, also sticking with the balance sheet.

If you can talk a little bit in more detail about the repurchase agreement financing that you've been doing? Specifically, I'm looking at the securities purchased under resale agreement line that revenue went from $46 million to $69 million in NII.

It's about a third or so of your Q-on-Q NII increase and I think over half of your year-on-year NII increase.

Can you just talk about how that business is going? How sustainable that is? What are you doing exactly to see that pretty remarkable improvement in revenue?.

Yes. So that's the – we detailed that well in the footnote. That's the support of our clients in the FICC repo program. That's a clearinghouse for repo. We arranged those repo trades with clients. These are clients who have surplus cash.

What they want is, they want to leave that cash but they want to get securities as collateral, right? So they're looking for a collateralized deposit in effect. We can effectively help them process that through the FICC clearinghouse. The FICC clearinghouse does well over $1 trillion of repo.

And you see that we're facilitating on the order of $30 billion, $35 billion for clients. So, this is just part of the support that we have for asset managers and other types of custodial clients. It has been in place for a number of years and we're there facilitating in the marketplace in ways that they appreciate..

Are you growing it based on client adoption of using that service that you're providing? Or do you think more of the growth is driven from the Fed hikes?.

The growth is just – the volumes are relatively stable. They're up a smidge, but it's – we do this as an accommodation as part of our business model. The rates are typically reverse repo rates, so those are just floating up in line with market reversed repo rates, general collateral..

Great. Thanks for taking the questions..

Sure..

Your next question comes from the line of Brennan Hawken with UBS..

Good morning. Thanks for taking the questions. Just a quick one on – again, on deposits. Sorry, it's the topic du jour here..

Popular..

Yeah, yeah, big focus, very active here this quarter. And when we think about non-operating deposits, could you just maybe update your outlook for those? And how fast you might think they could run off in this environment? How much might be like baseline operating need the business as usual type of balance? Thanks..

Yeah, Brennan, it's Eric. That's a – it's a fair question, but it's one where it's hard to answer definitively, right, because we are in a new environment. That said, you've seen – we've seen some kind of a gentle volatility around the levels that we're at, $42 billion, $43 billion, $44 billion, or $45 billion of non interest-bearing deposits.

You've seen it tick up. It's ticked down. Year-over-year, it's flattish actually and quarter-over-quarter, it's down $2 billion. And the question we're wrestling with, are we beginning to see, and we probably are some transition from non interest-bearing to interest-bearing.

But that's been predicted by our treasurers and every other treasurer on The Street. It feels like since the first rate hike, right. And so the $2 billion move, which is less than 5% of the non-interest bearing deposits this quarter, actually is less than what we expected. And so I think there will be some transition over the coming quarters.

It's hard to predict how much it is, but it's all factored into our deposit betas. Remember, you're moving from effectively zero interest-bearing into what might be a stated rate. A stated rate for us as a bank is in the 10 to 15 basis points relative to a 25 basis point Fed hike that quarter. That's actually all factored into our deposit betas.

And in fact, the way we characterize that is our deposit betas for interest-bearing deposits are 20% to 25%. When you factor in all the non interest-bearing deposits, those that are not moving and those that are maybe beginning to transition, the deposit beta in aggregate for total deposits is more like 15%. So it's factored in.

I think we expect it to trend downwards, and we're certainly prepared and it's part of our overall outlook..

Got it. That's great. Thank you and your overall outlook actually, I think, includes some reduction in the interest-earning assets, 0% to 5% for the year. When we look at the 2Q balances versus in 4Q average, we're already down about 3% and I think 3.5% roughly.

So is that right to imply that you guys expect the pace of decline in interest-earning assets to moderate here in the back half of the year? Thanks..

Brennan, if you can tell me when what will happen with surplus cash in the system, I can give you an answer to that. I think we continue just to see clients look for outlets for their cash, right? That's been happening ever since money market reform. The clients naturally come to their custodial bank to do that and they're doing that around the world.

So the balance sheet is down, like you say, a couple of percent year-to-date. If we can hold that level, that would be good. If we can trend down a little more, that obviously gives us the room in the leverage ratio.

But at the end of the day, we need to balance both how we want to ideally operate the balance sheet with being responsive to our clients because that's who we're here for..

Great. Thanks so much for the color..

Sure..

Your next question comes from the line of Jim Mitchell with Buckingham Research..

Hey, good morning, guys. A quick question on CCAR. It seemed like you guys were hit by OCI as you moved quite a bit to held to maturity, some of the higher-quality securities to held to maturity didn't offset the potential losses, I guess, elsewhere.

Is that going to change the way you approach it going forward, or do you stick with the plan as you have it now?.

Jim, it's Eric. Let me give you a little perspective. I think overall, we were pleased with CCAR in the sense that we wanted to take the dividend up 11%. We wanted to return $1.4 billion of capital through buybacks and the review proved supportive of that. So I think we were pleased.

I did say in my call text that we continue to look for transparency and try to understand the models because it's multiple models at the Fed. There are credit models that we were trying to make sure we understand.

There are PPNR models, right, and sort of different levels of PPNR for different banks and then for different banks within the same kind of cluster or same category. And then like you say, there's the OCI models, which seem to move and create a larger stress than we expected.

I think the first part of our reaction to CCAR is always just to manage our business and balance sheet carefully, right. And I say that in two ways. One is you're always trying to do your best with earnings. You give some of that back to shareholders, but some of that accretes on the balance sheet and you see our capital is up year-to-date.

The second part of that is we're always trying to manage the balance sheet in a tight way. We talked about deposits and the balance sheet being tighter year-to-date. And part of that is because we want to run with a leverage ratio that's got the right levels. And you see that in 4Q 2016 on page 12 of our earnings deck, our leverage ratio was 6.5%.

We're now at 7%. And what is that? That's actually the earnings accretion into the capital count as well as the tighter balance sheet, which has gotten us there. So just over the first six months of the year, we got 50 basis points more cushion when it comes to a step off. So that's where we're at.

After that, we're always going to look at the models and ask questions around are there refinements that we could make on our mix of assets, mix of securities, et cetera. But I think you can expect us and every bank to be doing that..

Right. Okay, well, thanks. And any update on the timing and impact from the movement of the custody assets to BlackRock? Thanks..

Yes, Jim, this is Jay. No, no update. Sometime in 2018, probably an elongated transition would be my best guess..

Okay, great. Thanks, guys..

Your next question comes from the line of Mike Carrier with Bank of America Merrill Lynch..

Hi. Thanks guys. First question, just on the foreign exchange and the trading; you guys had a good quarter definitely versus peers and I know the platform is a bit different.

But just what was maybe environmental driven versus strategically? It seems like there's more of a focus on growing that business than there has been, and so just over the next year or two years, where do you see that opportunity on that side of the business?.

Sure, Mike, I'll start that. This is Jay. As you point out, we do have a different foreign exchange franchise than some of our peers and that it's pretty broad-based and it's supported by some pretty intriguing research. So I would say that we compete at a different level with regard to foreign exchange.

I referenced in my comment, the Euromoney survey, I don't know if you're familiar with that, but it's the – kind of the go-to survey in the industry. And we moved up by quite a few paces – places in that survey, which to me means market share gain. And I think we've got a broad foreign-exchange offering.

We added a number of new clients this quarter, which is not unusual. We to continue to add new clients. Environmentally, I'd say the global and EM trade helps. But I would say generally, gaining share, which has driven higher volumes, a little help by EM, and just broad-based participation across all aspects of the foreign exchange market..

And Mike, it's Eric. I'd just add that the market share gains and kind of deepening our relationship with individual clients is what drives the kind of sustained year-on-year performance. The piece that's a little more volatile is whether you've got the flows going into EM and in to Europe and Asia like you did this quarter.

I think that was a nice uptick, but that's not always going to happen. And so what we found is having a broad-based franchise, because that's what we are. We're well distributed around the world with these global clients, actually is the way to build this business sustainably over years and years..

Okay. That's helpful. And then, just a quick follow-up. On the asset management side, just given the outflows this quarter, I don't know if you can put some perspective on it in terms of just kind of industry trends and some of the pressures that we're seeing there, maybe on the equity side.

But in terms of the – some of the other maybe buckets like alternatives, can you just – what was maybe some one-offs versus how do you see that business growing going forward?.

Yes. Let me start out, Mike. I'll just decompose a little bit the flows and then make a few comments and invite Eric to make comments he wants. We had the flows of $28 billion, $22 billion of that was kind of institutional low-revenue outflows, the ETF story which is one that we've been focused on.

The quarter was a little bit unkind to domestic equities and therefore, we saw almost $10 billion in outflows of our big spike, S&P 500 fund. Take that out, we had $5 billion in inflows. So I would say, if I step back, we weren't thrilled with the quarter. We thought it was a little disappointing.

Over the last four quarters, our ETF flows have been at $56 billion net inflows. So a little softer on the ETF side, a little bit of it in environmental. We are – we continue to invest in distribution as well as new product introductions.

We introduced nine new products in the second quarter, some in the smart beta space, which we think is an attractive and natural space for us. European ETF sales were good. It's a smaller market, but we really punched above our weight in Europe. So I would say that's kind of the broad-based commentary.

The only other thing I would reference is if you look at the SSGA franchise, very global institutional ETF on a retail basis. We're focused on the ETF marketplace and also broadly solutions. And I referenced that we completed the GE Asset Management acquisition, which gives us a prominent position in the outsourced CIO marketplace.

We were able to add some incremental business from GE, the Alstom business, and I think that just builds a little momentum in the outsourced pension space. We're also doing pretty well on the outsourced – or the solutions for retail 401 (k)s, target date funds. So I'd say, my summary would be not a particularly great quarter for SSGA.

I think the trends are intact. Our focus on ETFs and solutions would be my summary..

And Mike, it's Eric, I'd just add. This is an attractive business for us. ETFs have good price realization relative to the overall price yield in asset management, and that's what's actually been supporting the revenues.

And so incumbent upon us to predict – to continue to invest and make sure those investments bear fruit in ETFs, because not only in the U.S.

but around the world, they're here to stay, we have to do is just pick our spots and make sure we do that in areas like smart beta or high-yield fixed income that are more fragmented where we feel like we can build share and the scale at pace to earn good returns..

Okay, thanks a lot..

Your next question comes from the line of Geoffrey Elliott..

Good morning. Thank you for taking the question. I know you touched on this before, but the enhanced custody business really feels like it's becoming a pretty meaningful driver of securities finance.

So, can you elaborate a bit on how meaningful that is in terms of the overall securities finance contribution and the growth and where you'd like to get it to?.

Sure. I'll start that, Geoffrey. You are right to pick up on that. We've seen steady and consistent growth in our enhanced custody business. I think this quarter it approached 50% of the overall revenues. And as I say, that's been steadily climbing.

And I think it's a business that plays right into some of the capital constraints that traditional prime brokers have. And as our clients take on enhanced custody, they tend to deepen relationships over time, pretty stable, pretty steady. So I would see that business continuing to gain share in the credit intermediation space for funds.

Some of that is in the kind of the long, short type portfolio is probably where it's most prominent. But good business, I think we were a clear innovator four or five years ago and we're now reaping the benefits of that investment..

And apart from the traditional prime brokers, is there any other competition there?.

No, I'd say that's the typical competition. It's – you see funds diversifying their credit exposure, which is how we pick up business, new funds being created. No, it's mostly the prime brokers are the other alternative..

Thank you..

There are no further questions. I'd like to turn the call back over to Jay for any closing remarks..

Thanks, Victoria, and thanks everybody for participating this morning. We look forward to getting together after the third quarter to report our third quarter earnings. Thank you..

Again, thank you for your participation. This concludes today's call. You may now disconnect..