State Street Q3 2021 Earnings Call Transcript

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Provided by Quartr
October 17, 2021

Key Takeaways

  • Q3 EPS of $1.96 rose 35% year-over-year, driven by 9% fee revenue growth, improved net interest income, and disciplined expenses leading to about 7 points of operating leverage and a 29% pretax margin.
  • Assets under custody and administration reached a record $43.3 trillion with $1.7 trillion in Q3 new wins, lifting the pipeline to $2.7 trillion in orders yet to be installed and positioning fee revenue growth ahead of pricing headwinds.
  • State Street announced the intended acquisition of Brown Brothers Harriman Investor Services, aiming to become the top global asset servicer by AUC, enhance geographic coverage, and create long-term shareholder value.
  • To finance the BBH deal, State Street completed a $1.9 billion common stock offering, suspended share repurchases until Q2 2022, and raised its quarterly dividend by 10%, maintaining capital returns in line with medium-term targets.
  • For full-year 2021, fee revenue is guided to grow ~5% with servicing fees up 7.5–8.5%, Q4 net interest income of $475–490 million, and expenses ex-notables up 1–1.25%, supporting further margin and operating leverage expansion.
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Earnings Conference Call
State Street Q3 2021
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Operator

Good morning, and welcome to State Street Corporation's Q3 2021 earnings conference call and webcast. Today's discussion is being broadcasted live on State Street's website at investor.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 authorized broadcast of this call will be housed on the State Street website. Now I would like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street.

Ilene Bieler
Ilene Bieler
Global Head of Investor Relations at State Street

Good morning. Thank you all for joining us. On our call today, our CEO, Ronald O'Hanley, will speak first, then Eric Aboaf, our CFO, will take you through our Q3 2021 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 yourself to two questions and then re-queue. Before we get started, I'd like to remind you that today's presentation will include results presented on a basis that excludes or adjusts one or more items from GAAP. Reconciliations of these non-GAAP measures to the most directly comparable GAAP or regulatory measure are available in the appendix to our slide presentation. Today's presentation will contain forward-looking statements.

Ilene Bieler
Ilene Bieler
Global Head of Investor Relations at State Street

Actual results may differ materially from those statements due to a variety of important factors, such as those factors referenced in our discussion today and in our SEC filings, including the risk factors in our 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 Ron.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Thank you, Ilene, and good morning, everyone. Earlier this morning, we released our Q3 results, which reflect continued strong performance across our enterprise. Before I discuss our Q3 financial results, I want to acknowledge our employees for their ongoing achievements in supporting our clients in generating the performance and momentum we are now seeing across the franchise. Thanks to their hard work and execution, we are now seeing measurable progress in our financial results, even as we invest in our business for the future. We continue to successfully execute against our strategic objective of being an enterprise outsource solutions provider across the front, middle, and back office, and a leading asset manager. This is just the beginning.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

We are encouraged by the opportunities we see within our industry, our sales wins, the momentum in our pipeline, and what this means for our ability to drive future growth in 2022 and achieve our recently enhanced medium-term financial targets. We are encouraged by the trajectory of our organic profile, as demonstrated by our year-to-date business wins. For example, on a year-to-date basis, we have delivered the strongest AUCA wins in the company's history, while AUCA won, but not yet installed, stood at $2.7 trillion at quarter-end. At Global Advisors, our ETF franchise crossed $1 trillion of AUM this year, with year-to-date SPDR flows on track for a record year and already surpassing the full-year 2020 flows. Global Advisors' financial performance continues to strengthen, with pre-tax margin expanding to 36% in Q3.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

I also want to take a moment to note the intended acquisition of Brown Brothers Harriman Investor Services, which we announced in the Q3. We are excited by the opportunities this transaction presents. It is a strong demonstration of our confidence in the industry, our investment servicing business, and our overall strategy. The transaction is also financially compelling as it will enhance State Street's financial profile, and importantly, it will create long-term value for our shareholders. From a strategic perspective, this combination will strengthen our competitive positioning and market leadership and deepen geographic coverage, with State Street becoming the number one provider of asset servicing globally by assets under custody. Further, the accompanying talent will build on State Street's already strong expertise and better position us for growth. The compelling nature of the deal has enabled us to raise our medium-term pre-tax margin target.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Turning to slide three, I'll review our Q3 highlights. Q3 EPS was 196, up 35% year-over-year. We delivered about 7 percentage points of positive operating leverage this quarter and generated a strong improvement in State Street's Q3 pre-tax margin, which increased by about 5 percentage points year-over-year to over 29%. This year-over-year improvement was driven by solid fee revenue growth, good organic results, and higher NII supported by robust loan growth, leading to a strong total revenue performance. Meanwhile, our focus on expense discipline continued to drive earnings growth as expenses remained well contained. Relative to the year-ago period, quarterly total fee revenue increased 9% as we delivered broad-based improvement across all fee revenue lines.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Servicing and management fees increased 7% and 10% year-over-year respectively, we delivered solid results within our markets businesses despite a continued moderation of FX market volatility. Even with 9% year-over-year total fee revenue growth, expenses were well controlled, increasing just 1% over the same period, though expenses were flat year-over-year, excluding notable items, as our productivity improvements continued to yield results. AUCA increased to a record $43.3 trillion at quarter-end, with new asset servicing wins increasing to $1.7 trillion for the quarter, including a large Alpha mandate with Legal & General, which was announced in July. As a result, AUCA won, but not yet installed, increased to $2.7 trillion at quarter-end, as I noted a moment ago.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Including the Legal & General mandate, we reported three new Alpha client wins in the Q3, taking the total number of Alpha clients to 18 at quarter-end. At Charles River, annual recurring revenue increased 12% year-over-year to $239 million. I am pleased with its business performance and how it continues to propel our Alpha strategy. At Global Advisors, assets under management totaled $3.9 trillion at quarter-end, and management fees increased to a record $526 million in the Q3, benefiting from higher average equity market levels and continued inflows to our ETF franchise, where we continue to innovate. For example, in recent years, we have been expanding our actively managed ETF capabilities. And through three quarters this year, we have the most successful active ETF in the U.S. in terms of asset growth with the SPDR Blackstone Senior Loan ETF.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

By quarter-end, this fund had gathered $5.5 billion in flows in 2021 and had AUM of $7.7 billion. We also made an addition to our actively managed fixed income ETF range in the Q3 with the launch of the SPDR Loomis Sayles Opportunistic Bond ETF. Turning to our balance sheet and capital, we completed a $1.9 billion common stock offering related to the proposed acquisition of BBH Investor Services in the Q3. Also related to the transaction, we suspended common share repurchases in the Q3 and currently expect to reinstate common share repurchases during the Q2 of next year. We increased our quarterly common stock dividend by 10% in the Q3. Capital return remains a key part of our medium-term targets, we recognize its importance to our shareholders.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

We believe that the BBH Investor Services acquisition is a financially compelling use of our capital, and that it will deliver earnings accretion and value creation for our shareholders over time. With that, let me turn it over to Eric to take you through the quarter in more detail.

Eric Aboaf
Vice Chairman and CFO at State Street

Thank you, Ron. Good morning, everyone. I'll begin my review of our Q3 results on slide four. We reported GAAP EPS of $1.96, or $2 excluding the impact of notable items. On the left panel of the slide, you can see that we delivered strong revenue growth year-over-year across every line item. Controlled expenses. We delivered significant pre-tax margin expansion, all of which drove strong earnings growth. In fact, expenses were down year-on-year, excluding notable items and the headwinds from currency translation, which you can see at the bottom of the slide. This was another strong quarter where we were able to demonstrate the progress we are making in delivering on both our strategic priorities and our medium-term targets. Turning to slide five, you'll see our business volume growth. Period end AUCA increased 18% year-on-year to a record $43.3 trillion.

Eric Aboaf
Vice Chairman and CFO at State Street

The year-on-year increase was largely driven by higher market levels, net new business growth, and client flows. At Global Advisors, AUM increased 23% year-on-year to $3.9 trillion. The year-on-year increase was primarily driven by higher market levels coupled with net inflows. Quarter-on-quarter, both AUCA and AUM were relatively flat given relatively stable domestic market levels. Turning to slide six, you can see another quarter of strong business momentum. Q3 servicing fees increased 7% year-on-year. The increase reflects higher average equity market levels, good client activity inflows, and positive net new business. These items were only partially offset by normal pricing headwinds and about a percentage point of impact from some divestiture activity.

Eric Aboaf
Vice Chairman and CFO at State Street

On a sequential basis, servicing fees were flat as favorable equity markets and client activity were offset by about a percentage point of currency translation from the US dollar appreciation. AUCA wins totaled roughly $1.7 trillion in the Q3, which gets us to a record of over $3 trillion of new AUCA wins year-to-date. We continue to estimate that we need at least $1.5 trillion in gross AUCA wins annually in order to offset typical client attrition and normal pricing headwinds. Given the strong wins we've garnered year-to-date, we have already more than doubled that this year. At quarter-end, AUCA won but not yet installed amounted to $2.7 trillion. I would also note that the unique Alpha value proposition represents a large proportion, which reflects our competitive strength as the only front to back office offering from a single provider.

Eric Aboaf
Vice Chairman and CFO at State Street

I will remind you that installations typically incur in phases and over time, deals will vary by fee and product mix. As we've discussed previously, we would expect current won but yet to be installed AUCA to be converted over the coming 12 to 24-month time period with about half of the annualized revenue benefit through 2022 and about half in 2023. We continue to be pleased with our pipeline, and our robust wins this quarter further showcases the broad-based geographic and multi-segment momentum of our business and will help drive net new business revenue growth in 2022. Turning to slide seven. Q3 management fees reached a record $526 million, up 10% year-on-year, and were up 4% quarter-on-quarter, resulting in a record investment management pre-tax margin of about 36%.

Eric Aboaf
Vice Chairman and CFO at State Street

Both the year-over-year and quarter-over-quarter management fee results primarily benefited from higher average equity market levels and strong ETF flows. These year-over-year benefits were only partially offset by the impact of the previously reported idiosyncratic institutional asset, client asset reallocation, and money market fee waivers. Notably, we previously estimated that gross money market fee waivers on our management fees could be approximately $20 million-$25 million per quarter. As a result of the recent improvement in short-term rates, we now expect they will be modestly lower at around $20 million in the Q4, assuming current forward rates. Lastly, as you will recall, we have taken a number of actions to deliver growth in our long-term institutional and ETF franchises, and we continue to have strong momentum and year-to-date results, as you can see on the bottom right of the slide.

Eric Aboaf
Vice Chairman and CFO at State Street

Turning to slide eight, let me discuss the other important fee revenue lines in more detail. Within FX trading services, we are pleased that we continue to generate strong client volumes, which remained above pre-pandemic levels in the Q3. Relative to the Q3 of 2020, FX revenue increased 3% year-on-year, reflecting higher direct sales and trading revenue and indirect volumes, partially offset by lower FX volatility. FX revenue was down 2% quarter-on-quarter, largely driven by seasonally lower client volumes and spreads. Moving to securities finance, Q3 fees increased 26% year-on-year, mainly reflecting higher client securities loan balances and spreads, as well as business wins and Enhanced Custody. On a sequential basis, fees were down 3% quarter-on-quarter, mainly as a result of lower agency balances. Finally, Q3 software and processing fees increased 15% year-on-year, but were 8% lower quarter-on-quarter, largely driven by CRD, which I'll turn to next.

Eric Aboaf
Vice Chairman and CFO at State Street

Moving to slide nine, I'd like to highlight our CRD and Alpha performance. We delivered strong standalone CRD results in the quarter with a year-on-year revenue growth of 22%. We saw growth across all three categories of CRD revenues, on-premise, professional services, and software-enabled. The more durable SaaS and professional services revenues continued to grow nicely and were up 18% year-on-year. Record new quarterly bookings of $28 million and a healthy revenue backlog of $105 million also demonstrate the continued business momentum that we're seeing in CRD, supported by the Alpha value proposition. On the bottom right of the slide, we show some of the Q3 highlights from our State Street Alpha mandates. We reported three new Alpha mandates during the Q3 as the value proposition continues to resonate well with clients.

Eric Aboaf
Vice Chairman and CFO at State Street

Notably, since inception through Q3, we now have seven of 18 total Alpha client mandates that are live. As a testament to our ongoing commitment and investment to further building out our Alpha value proposition, we've also acquired Mercatus, a premier front and middle office solutions and data management provider for private market managers. In connection with the acquisition, we launched Alpha for Private Markets, which will extend our end-to-end data platform offering for alternatives. Turning to slide 10. Q3 NII increased 2% year-on-year, mainly driven by higher loan balances, growth in the investment portfolio, and more deposits, as well as the absence of the previously disclosed Q3 2020 true up, partially offset by lower investment portfolio yields due to the low rate environment.

Eric Aboaf
Vice Chairman and CFO at State Street

Relative to the Q2, NII came in 4% higher, primarily as a result of higher loan balances and a larger investment portfolio, as well as higher short-term rates, all of which was partially offset by ongoing compression of yields. I would also note that we saw a larger than usual slowdown in premium amortization in the quarter due to some tactical rotation of the MBS portfolio, which accounted for about a third of the sequential quarter improvement and something we wouldn't expect to repeat in the Q4. On the right of the slide, we show our average balance sheet during the Q3. Notably, total average deposits decreased by $9 billion in the Q3 or a decrease of roughly 4% quarter-on-quarter, reflecting the active management of non-operational deposits. We also put more of our surplus balance sheet cash to work.

Eric Aboaf
Vice Chairman and CFO at State Street

We added approximately $3 billion quarter-on-quarter to our investment portfolio. We also increased our average loan balances quarter-on-quarter to $32 billion in response to the good client demand. Turning to slide 11. Q3 expenses excluding notable items were flat year-over-year, as productivity savings for the quarter continued to more than offset targeted business investments, typical expense headwinds, and $10 million-$20 million of higher than expected revenue-related quarterly costs. Compared to the Q3 of last year, on a line item basis excluding notables, compensation employee benefits was down 1%, driven by higher salary deferrals and lower headcount, partially offset by higher medical benefit costs as claims begin to normalize. Information systems and communications were up 3% due to continued investment in infrastructure in our technology estate, partially offset by our savings programs.

Eric Aboaf
Vice Chairman and CFO at State Street

Transaction processing was up 8%, primarily driven by higher revenue-related expenses associated with sub-custody volumes and market-data-costs. Occupancy was down 6%, reflecting benefits from our footprint optimization efforts. Other expenses were down 5%, primarily driven by lower asset management sub-advisory fees and the timing of some marketing costs. Relative to the Q2, expenses excluding notable items were down primarily driven by the currency translation of the strong U.S. dollar and lower headcount. Overall, we are pleased with our continued ability to demonstrate productivity and expense discipline while driving high single-digit fee revenue growth year-over-year. When combined together, we delivered a solid pre-tax margin of nearly 30% and generated a robust operating leverage of about 7 percentage points year-over-year. Moving to slide 12, on the right of the slide, we show our capital highlights.

Eric Aboaf
Vice Chairman and CFO at State Street

As Ron mentioned earlier, to finance a proposed acquisition of Brown Brothers Investor Services business, we completed a $1.9 billion common offering this quarter. Also, in conjunction with the transaction, we did not repurchase any stock during the Q3 and intend to temporarily suspend repurchases before resuming them during the Q2 of 2022. Lastly, we still increased our quarterly dividend by 10% and returned a total of $179 million to shareholders in the Q3 in the form of dividends paid. To the left of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios. As you can see, we continue to navigate the operating environment with strong capital levels, with or without the recent equity raise relative to our requirements. As of the Q3, our standardized CET1 ratio improved by roughly 230 basis points quarter-on-quarter to 13.5%.

Eric Aboaf
Vice Chairman and CFO at State Street

The improvement was primarily driven by the issuance of $1.9 billion of common stock related to the proposed acquisition of Brown Brothers Harriman Investor Services and higher retained earnings. We also managed down our RWAs. Our Tier 1 leverage ratio also improved quarter-on-quarter by a little over 100 basis points to 6.3%, primarily driven by the issuance of the common stock, a decrease in the balance sheet size as we actively reduced some excess deposits, and higher retained earnings. Post-closing of the Brown Brothers Harriman Investor Services acquisition, we expect both capital ratios to be at the lower end of our target ranges. Turning to slide 13, in summary, I'm pleased with our quarterly performance, which demonstrates continued business momentum on our top line and productivity and engineering across our operating model.

Eric Aboaf
Vice Chairman and CFO at State Street

Total fee revenue was up 9% year-over-year, continuing the momentum we saw last quarter, reflecting growth in all businesses, with management fees reaching a record level this quarter. Our expenses remained effectively flat, excluding the impact of notable items as a result of our productivity efforts, notwithstanding higher revenue-related costs mentioned earlier. As a result, we delivered about 7 percentage points of operating leverage year-on-year, and were able to drive pre-tax margin and ROE closer to our recently enhanced medium-term targets, even in this low-rate environment. I'd like to update our outlook. With just Q1 left in the year, I would like to provide our current thinking regarding the full-year outlook. At a macro level, our rate outlook broadly aligns to the current forward rate curve.

Eric Aboaf
Vice Chairman and CFO at State Street

We're also assuming global equity markets levels will be flat to the Q3 average for the rest of the year, as well as continued normalization of FX market volatility. In terms of the full year outlook, we expect overall fee revenue to be up 5% year-over-year, with servicing fees expected to be up 7.5%-8.5% year-over-year. You will recall that at the beginning of the year, our guide was for total fee revenue to be flat to up 2%. This continues to be a meaningful increase over our earlier expectations. We increased this due to both higher equity markets and our net new business performance. Regarding NII, we had a small rebound in the short-end market rates and some movement in the longer end of the curve as well.

Eric Aboaf
Vice Chairman and CFO at State Street

We now expect NII in the range of $475 million-$490 million next quarter, which is a meaningful improvement from the range we provided last quarter. This assumes rates do not deteriorate and premium amortization continues to trend favorably. As I mentioned earlier, we would not expect the same episodic slowdown in amortization that we saw in the Q3 to repeat in 4Q. Turning to expenses, we remain confident in our ability to effectively manage core operating costs while onboarding new clients and investing in the business. Given the strong revenue performance this year and the healthy pipeline in front of us, we now see the need to both invest in our staff and in our business, as well as covering some revenue-related costs.

Eric Aboaf
Vice Chairman and CFO at State Street

We thus expect full-year expenses, ex notables, to be up 1%-1.25% year-over-year, which means a sequential quarter increase into the Q4. This is the equivalent of full-year expenses being flat, adjusted for the currency translation headwind, this would put us in a position to drive solid full-year margin expansion and operating leverage in spite of the double-digit year-on-year decline in NII. On taxes, we now expect that full-year 2021 tax rate will be towards the lower end of our range of 17%-19%. With that, let me hand the call back to Ron.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Thanks, Eric. To conclude our prepared remarks, we had a strong Q3 and continued to demonstrate measurable progress towards achieving our medium-term financial targets, including our recently increased pre-tax margin target. As we look ahead, we need to both appropriately recognize staff for a strong year and proactively invest in our business as we see growth accelerate. These strategic investments will include the Alpha platform and private markets expansion in particular, as well as State Street Digital to drive future growth. As we stand here today and make these business investments for the next stage of growth, we have confidence that we will be able to do so while also delivering positive operating leverage and expanding our pre-tax margin each year through our medium-term horizon, aided by the strong momentum we are seeing across our businesses. With that, operator, we can now open the call for questions.

Operator

As a reminder, to ask a question, simply press star then the number one on your telephone keypad. Again, that is star one to ask a question. Our first question is from Alex Blostein with Goldman Sachs. Please go ahead.

Alex Blostein
Alex Blostein
Analyst at Goldman Sachs

Hey, guys. Good morning. Thanks for taking the question. Maybe we can start with a question around asset management. I'm not sure if you can answer, but I'll give it a shot. We obviously continue to see market speculation surrounding strategic alternatives to SSGA. We've seen that in the past as well. Ron, you've been very vocal about sort of the secular changes in the asset management industry that are sort of supporting your growth strategy on the servicing fee side, and a lot of that just emphasizes scale. I guess with that in mind, do you think SSGA has enough scale to succeed in the marketplace today? If there are sort of strategic alternatives that you're considering, do you need to remain a majority shareholder of any asset management kind of entity?

Alex Blostein
Alex Blostein
Analyst at Goldman Sachs

If minority or a JV structure would make more sense, are the capital rules just too onerous and the obstacles too high to ultimately get anything done here?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Well, Alex, thanks. You've said a mouthful there. I'll begin this by saying that we like the business, and we particularly like our business. Its performance has continued to improve. It's now at least at average, if not above average in terms of the market, and continues to grow in what are secularly growing areas. If you think about the ETF business, particularly fixed income, ETFs, et cetera. We think the business is an attractive business. It's a business that helps us strategically from a portfolio perspective. For many years now, it's been a bit of a laboratory for us to test out different things. It gives us an insight into the rest of the marketplace. Our overriding goal would be to continue to participate in the business assuming that we continue to believe that we can improve performance.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

I'm not going to comment on speculation other than say that it's speculation. If we have something to talk about, we'll certainly come to you.

Alex Blostein
Alex Blostein
Analyst at Goldman Sachs

Got it. Fair enough. Eric Aboaf, maybe one follow-up for you just on the servicing fee side. Obviously, really nice momentum in terms of wins. Servicing fees are flattish quarter-over-quarter and even taking into account some of the currency headwinds. It sounds like a lot of it is just timing with next kind of 12-24 months. Hopefully, we'll see the benefit of the revenues on the yet-to-be-installed business. Can you help us frame and sort of size the revenue pool attached to the $2.7 trillion on yet to be installed? Within that, maybe hit on the pricing dynamics as well. I think in your comments that you continue to see kind of normal pricing headwinds in the business. I think it's been kind of in a 2%-3% range long-term.

Alex Blostein
Alex Blostein
Analyst at Goldman Sachs

Is that sort of the headwind we're still talking about or has that changed? Thanks.

Eric Aboaf
Vice Chairman and CFO at State Street

Alex, thanks for the question. Let me answer them maybe in reverse order. I think we continue to see the normalized pricing headwinds in the marketplace. We feel they're well controlled. We feel like they're understandable, they're logical, and that headwind is back down to about 2%, which is the historical norm. A lot of that is how we go to market, how we engage with clients, how we now have added more feature functionality to our offering. Alpha is a big part of that, of course. The duration of some of these deals will, I think, help reinforce that over time. We are very pleased, I think, as you could expect with the wins this quarter, last quarter, or the Q1 for that matter. They're certainly in the range of the fee rates that we have for the company.

Eric Aboaf
Vice Chairman and CFO at State Street

I think we don't feel comfortable going into individual deals or individual quarters on that. They are in that range that you broadly see on average. That gives us confidence that as this business get installed, it's going to have a meaningful impact to revenues. We've been clear we need about $1.5 trillion+ of AUCA wins. We need that at the current or around the fee rates that we have. It creates the right amount of gross revenue wins as well, which then get implemented over time. That's why we put that benchmark out there. What I would say is while I think we've had until this year a couple lighter years in terms of sales, we need to continue the momentum we've been building.

Eric Aboaf
Vice Chairman and CFO at State Street

Part of the reason we reference the pipeline is we feel comfortable with the pipeline, and we see maybe not another $3.2 trillion of AUCA wins, but at least substantial wins embedded in the pipeline for us to continue this momentum into next year.

Alex Blostein
Alex Blostein
Analyst at Goldman Sachs

Great. Appreciate all that. Thanks.

Operator

Our next question is from Brennan Hawken with UBS. Please go ahead. Mr. Hawken, your line is open.

Brennan Hawken
Brennan Hawken
Analyst at UBS

Sorry, was on mute. Thanks for taking my question. I'd like to start maybe with BBH. Could you talk about what you would expect the impact of that acquisition could do to your asset sensitivity and how the inclusion or pro forma balance sheet would be sensitive to 100 basis point shift in rates? Also to help contextualize investors, Eric, you had discussed on the M&A call that the cost savings assumption is conservative. What's a historical range for the right way to think about expenses for these types of deals? Thanks.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure. Let me start on the deposit side and then we'll link into the other part of the P&L. Obviously it's early with Brown Brothers Harriman Investor Services. We've now gotten our regulatory filings in. We're obviously working through the closing process and are continuing to target a year-end close. In terms of asset sensitivity, I think it's a little early to model it too finely. I think I would say is that the asset sensitivity of the book is probably in the range of what we have at State Street, just because it's similar asset management-oriented clients. They have similar expectations of deposits and deposit pricing, I think you'd get similar betas and adjustments overall. I think what's different, Brennan, and constructive here is because of the Brown Brothers Harriman sweep program, we have more flexibility than usual to either bring in deposits at attractive rates.

Eric Aboaf
Vice Chairman and CFO at State Street

That could, in a way, enhance our asset sensitivity, though you'd have to model that in. It could let us protect the size of the balance sheet and the leverage ratio constraints that we have, which also let us adjust the amount of preferred securities that we need to run the business. I'd say overall, it's probably in the same ballpark, but with an ability through the rate cycle to either add deposits in NII or to manage leverage. I think that's a constructive program and a new functionality that they bring to us and one that will continue. In terms of the expense guide, I did say I was hopeful it'd be a bit on the conservative side. I think the expense guide was for a reduction of about 25%, so I think on the lower-end of what we've achieved before.

Eric Aboaf
Vice Chairman and CFO at State Street

It's hard to compare to past deals too forcefully because every deal is different. We need to bring this business on and I've said in the past, we've not always finished what we've started and made sure that all the integration happens and all the functionality that we bring in from an acquisition gets fully integrated and created in our own offering. I think that's why it's been at the lower-end of our expense savings targets. We'll see. I think it's early. I think we'll certainly give guidance as to some of those cost estimates in January, and we'll certainly keep you posted. We stand by the guidance and as the CFO, I'm hopeful we certainly want to meet those. I always like to exceed where I can, but I think it's a little early to lean too far.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Hey, Brennan, it's Ron.

Brennan Hawken
Brennan Hawken
Analyst at UBS

Hi.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

What I would just add to that is we've emphasized about this acquisition. It is about capabilities and geographic reach and talent. As we think about the synergies here, we're thinking about them as combined synergies, if you will. There's instances where there's just some better capabilities that exist over at Brown Brothers.

Brennan Hawken
Brennan Hawken
Analyst at UBS

Great. Thanks for all that color. For my second question, Eric, when you provided the color on the Q4 expense expectation, you made a reference to some needs to invest and whatnot. I know it's probably early. You're probably just starting to work on the budget for 2022. Cost inflation is very much on the minds of investors. We hear about it broadly. One of your competitors at a recent conference raised the point that there would probably be some upward expense pressure in 2022. Should we begin to prepare for a bit of a lift? Is it appropriate maybe to use the Q4 as the jumping off point and then adjust for seasonality and then think about that into next year? Is there just some general guiding principles you could provide to help people level set on 2022?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Brennan, let me start on that, okay? We are definitely seeing instances where there is some cost pressure. It's untrue to say that it's across the board. Certain types of employees, for example, in the technology area, as you'd expect, because there we're not just competing with other custody banks, we're competing with technology firms. We are definitely seeing that. We also continue to see productivity improvements in our business. We're engineering them in. We do see an ability to offset some, if not all, that. We're just going to be careful about how we proceed forward. We don't want to under-invest in key staff. We also think that as we see performance, we can pay for performance and do it through the incentive line. It's something we're watching out for.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

There are particular areas where we are seeing the need to raise the fixed cost of talent, but we're not seeing an overwhelming kind of thing yet. Eric, you probably want to add something.

Eric Aboaf
Vice Chairman and CFO at State Street

Yeah. Brennan, I'd add to that. You go through the line items of expenses. Ron covered the salary comp incentives, and obviously we have a little pressure there, but we also have a little more attrition. I think everyone's seeing that. We need to net that out as we go into next year. I think you see a little bit of a creep on the tech side, obviously some of those costs and transactional costs. But again, we have our engineering programs to offset some of that. And while it means there's more work to do, there's always more work to do. That's just how it plays out.

Eric Aboaf
Vice Chairman and CFO at State Street

I think if you step back and you say, what are the guiding principles that we use as we go into our budget process, which has just really started and full swing in November and then comes through in December, it's really about how do we continue to make healthy or solid progress in expanding margin each year? How do we do that with positive operating leverage? You've heard me say before, we don't like to live on the edge and be too hopeful of an equity market tailwind or something of that sort. I think you've got to think of it as a commitment to progressing towards our medium-term targets and progressing at pace where we can make progress each year. You've seen us, notwithstanding the interest rate headwinds this year, we're making progress this year towards those targets.

Eric Aboaf
Vice Chairman and CFO at State Street

We're proud of that, and we feel like we need to continue that.

Brennan Hawken
Brennan Hawken
Analyst at UBS

Thanks for all that color.

Operator

Your next question is from Betsy Graseck with Morgan Stanley.

Betsy Graseck
Betsy Graseck
Analyst at Morgan Stanley

Hi, good morning.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Hi, Betsy.

Betsy Graseck
Betsy Graseck
Analyst at Morgan Stanley

Okay. Two questions. One, I think on the expense side, one of the reasons why there's so many questions here is that there had been a period where State Street had a tougher time delivering positive operating leverage. Then more recently, you've had very good success. When I hear the point about, hey, we're going to be reinvesting a bit for future growth, I'm just wondering, is this a message we should take that the investment spend was a bit under-invested over the past year and a half, and now we're going to ramp back up to "normal"? Is this more of a temporary, we've got some things, specific opportunities that we need to invest in. We can't tell you how many quarters it's going to take, but it's more of a specific opportunity.

Betsy Graseck
Betsy Graseck
Analyst at Morgan Stanley

The positive operating leverage we've been used to seeing recently will persist once we get through this period. I guess that's part of the reason why there's so many questions on expenses. If we could frame it like that, would there be any more color you could share with us? Thanks.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Hi, Betsy. It's Ron. We certainly have not been under-investing in our business. Whether it's inorganic or organic, obviously it was Charles River, more recently, Brown Brothers on an inorganic basis. As we've tried to emphasize quarter-over-quarter, every time we talked about us keeping expenses flat or even down, that that's been done by a fairly aggressive engineering effort to bring down BAU expenses while also continuing to invest in the business, particularly in the technology area. In terms of future investments, we just see the momentum building in areas where we've already started to invest and there's opportunity to invest more and accelerate growth. The three areas that we highlighted were, one, just continuing to invest in Alpha and kind of bring more and more of that to market quicker. Second is private markets.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Third is the whole digital space where we're seeing a lot of activity there. That's a combination of both supporting our clients in their digital kinds of ventures and also continuing to go to the next stage of digitization of our own business. That's what we're talking about there. Again, I would underscore what I said at the end of my prepared remarks, that we will do so with a commitment to positive operating leverage and continued margin expansion over the short-to-medium term.

Betsy Graseck
Betsy Graseck
Analyst at Morgan Stanley

That's great color. Those three threads, those are top of our list too, in terms of revenue generating growth potential over the next three-five years. That seems like it makes a lot of sense to be investing for that. Maybe a little bit more quarterly-oriented kind of question, but just on the loan growth that you saw in the quarter, just want to get a sense as to key drivers of that growth and should we think that it was specific to this quarter or there's a demand there that we'll likely see that kind of growth continue as we look into next year? Thanks.

Eric Aboaf
Vice Chairman and CFO at State Street

Betsy, it's Eric. It's a little bit of both, actually. We saw higher than usual opportunities this quarter. I think, sequentially, our loan balances were up. We're talking $3 billion. That's quite a bit on a $30 billion base of loans. A little bit of that was some discretionary lending we do, and then some of it was literally higher demand from private equity capital call financing. As the alternatives markets continues to boom. Some of our classic fund finance clients were looking for some support and so forth. I think it was a higher than usual quarterly print. I think year-on-year, what we're seeing is some confidence that we can grow this loan book in the low double digits, which is nice.

Eric Aboaf
Vice Chairman and CFO at State Street

The one thing we are conscious of, though, is with loans comes RWA, and so what we're always doing in background is optimizing the Risk-Weighted Asset and the returns mix of those loans to make sure that in some cases we add, in other cases we self-fund by optimizing other positions. That'll be part of how we think about it going forward. We do think of lending as an opportunity for us to drive NII in the coming quarters and years.

Betsy Graseck
Betsy Graseck
Analyst at Morgan Stanley

Thanks, Eric.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure.

Operator

Your next question is from Glenn Schorr with Evercore ISI.

Glenn Schorr
Glenn Schorr
Analyst at Evercore ISI

Hello there. Wonder if you could expand on the NII discussion. Just talk about what you think are non-operating excess deposits right now, and how you think they behave. How do you model them behaving in a modestly rising world, say, as we go into next year? Thanks.

Eric Aboaf
Vice Chairman and CFO at State Street

Yeah, Glenn, it's a really good and hard question because there's not an easy answer to them. I think we clearly have, like others have had, some amount of excess deposits flow in. What I would say, though, is if you go back, call it two years, you can ask the question, is that the typical deposits, and is all the increase excess? I'd say that's not true. What we've had over the last two years is very significant growth in our AUCAs. With AUCAs, clients need to leave a certain amount of cash with us to handle the transaction volumes. A good bit of the increase that we've seen over the last couple of years is on the core deposit side. There is, though, some, as you've seen, that is excess, and we've pulled off I think a reasonable amount this quarter.

Eric Aboaf
Vice Chairman and CFO at State Street

We don't necessarily want to push down deposits too far because we do want to be there for our clients. If you go with that context to, I think, the next part of your question, which is what happens in either tighter monetary policy with a slower expansion of the Fed's balance sheet or rising rates, does that reverse the course of deposits? I think it will eventually, I think it'll be a while. It'll be a two-three-year process for that to happen. Part of the reason I say that is the Fed continues even under a tapering, to expand its balance sheet. They're just expanding it less is what the talk is all about. It's not about actually stopping the expansion of its balance sheet.

Eric Aboaf
Vice Chairman and CFO at State Street

As the Fed continues to expand its balance sheet and then signal rising rates, I think we're probably going to be in an environment of having healthy deposit levels, which effectively mean they're core. Partly driven by the AUCA need and partly driven by just the surplus of cash in the system, and rising rates, which I think would be positive to certainly our balance sheet and NII and to other banks as well.

Glenn Schorr
Glenn Schorr
Analyst at Evercore ISI

I appreciate that. I wonder if you could just expand a little bit more on your thoughts. You mentioned private markets as one of the key growth areas. You're one of the pioneers on the custody side of that. What does Mercatus do for you, and what can and can't you do right now for the expanding world of private markets? Thanks.

Eric Aboaf
Vice Chairman and CFO at State Street

Yeah. Private markets is a broad area, which is why I think we see some opportunities. If you recall, there's hedge fund activity in private markets. There is classic private equity. There's more fixed income kind of loan-oriented private markets. There's real estate. It's in each of those areas where there's not one investment we need to make, but a series as we pick our spots and pick our spots not only across each of those products, but make some choices geographically as well. What Mercatus brings is a set of front-end functionality that we can use to support our private equity and other private market clients. Functionality around reporting to LPs, reporting to their own partnership. That's the front end that I think we value. With that comes a set of data feeds and communication that's quite valuable.

Eric Aboaf
Vice Chairman and CFO at State Street

If you think about that is directly plugged into the historical custodial operation that we provide and why we're so excited about it.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Yeah, Glenn, what I would add to this, that market is still largely a insourced market. This isn't about slugging it out with competitors in a race to the bottom on fees. It's to be able to demonstrate a better offering than what these institutions are doing for themselves. The stakes are going up for them, in terms of data reporting, particularly in ESG reporting. It's not just that investors are demanding it, but in some cases, particularly outside the U.S. and Europe, you're seeing reporting requirements being imposed not just on public companies, but on private companies. Investors want to know what's in their portfolio, including their private portfolio. Mercatus helps us do that, and this will all be a further impetus to drive this to a more outsourced model.

Glenn Schorr
Glenn Schorr
Analyst at Evercore ISI

Thank you for all that. Appreciate it.

Operator

Your next question is from Ken Usdin with Jefferies.

Ken Usdin
Ken Usdin
Analyst at Jefferies

Thanks. Good morning. Hey, Eric, just wanted a couple of cleanups here. You said that the premium AUM was improved, but you've called it episodic. Just wanted to understand, what was that premium AUM number in the Q3 so we can understand? I think you said it would continue to improve, just want to understand what the delta was this quarter?

Eric Aboaf
Vice Chairman and CFO at State Street

Yeah. I think the best way to describe it, Ken, is remember every quarter we get some headwind from the compression in underlying yields in the portfolio. What offsets that is less and less premium amortization, which comes through as a negative, but it's a smaller negative each quarter. This past quarter, I said about a third of the $20 million improvement was from, I'll describe as an excess reduction in premium amortization. That's the piece we don't expect to repeat. We do, as I said, continue to expect some marginal headwinds in the underlying portfolio yields. We do expect some ongoing reduction in premium amortization, not just at that same level. Then we've also been pleased with some of what we've been able to do on the balance sheet asset side around lending and the investment portfolio.

Eric Aboaf
Vice Chairman and CFO at State Street

That's why we took our range up, but we're a little conscious that the Q4 print. We gave a range purposely. We don't think the Q3 print's necessarily a perfect indicator of that. All that said, I think we're pleased with the direction that NII has taken over the last couple quarters. We think that sets us up for the future as well.

Ken Usdin
Ken Usdin
Analyst at Jefferies

You have a number to give us versus the $157 in the Q2?

Eric Aboaf
Vice Chairman and CFO at State Street

I think you'll have to help me. I think in the Q2, we had NII of $467, in the Q3 $487. I think the range I gave you was $475-$490 for Q4. That's total NII. I think what I'm trying to message is there are pieces below the surface, and we could get into a great amount of detail, but that's kind of where the net falls out.

Ken Usdin
Ken Usdin
Analyst at Jefferies

Okay. On money market fee waivers, can you tell us what the money market fee waivers in asset management were in the Q3?

Eric Aboaf
Vice Chairman and CFO at State Street

Sure. In the Q3, the money market fee waivers were about $19 million. Back in the Q2, they were close to $25 million. That's why we thought at current levels of front-end rates, which have stabilized, we said that Q4 is likely to be around the $19 million-$20 million that we just saw.

Ken Usdin
Ken Usdin
Analyst at Jefferies

What about the other fee waivers that were $21 million in the Q2? Do you have what that was in the third?

Eric Aboaf
Vice Chairman and CFO at State Street

I think we're focused. The biggest driver of money market fee waivers in our systems for GA, for our Global Advisors business, that's the one we've spent the most time tracking, I think is material and dominates. I think that's the area to focus on.

Ken Usdin
Ken Usdin
Analyst at Jefferies

Okay. Thanks a lot, Eric.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure.

Operator

Your next question is from Brian Bedell with Deutsche Bank.

Brian Bedell
Brian Bedell
Analyst at Deutsche Bank

Great. Thanks. Good morning, folks. First one is just on the asset servicing side. Eric, if you can maybe just sort of maybe give us a view on that step-up of asset servicing fee growth at legacy State Street, not including Brown Brothers, in 2022 and 2023, given that the new wins have been so strong and you're running at more than double the pace required to offset the pricing headwinds. I guess the short question here is, should we expect a step-up in organic growth of asset servicing in 2022 and again in 2023, given that pipeline, and not factoring in any kind of, or ignoring the market side of it.

Eric Aboaf
Vice Chairman and CFO at State Street

Brian, it's Eric. I think it's a little early to get out and start to forecast 2022 and 2023. I think what I was trying to signal is we're very pleased with our sales performance this year, what we've been able to book, and that clearly is going to be part of the components of delivering growth in 2022 and 2023. I would say, and I've said this before, we need to earn our keep every quarter by continuing to drive sales and wins. You saw that in the Q1. We had $343 million of AUCA wins. We're very pleased with that. We're pleased again with the Q2, with the Q3. We need to keep at it because if you step back, remember, a portion of every year's wins gets implemented in that particular year. It's something like a third.

Eric Aboaf
Vice Chairman and CFO at State Street

About two-thirds of a year's wins typically gets reported in the following calendar year, and then you still have some, it's probably like a sixth, in the year after that. We're in a business where what we sell, we then start to implement, and then we need to keep up that progress. That's what drives growth. I'd say we're on a good trajectory. We're pleased with this year's successes, and we'd like to continue to be successful, and we expect to be given our pipeline, but it's still early to forecast actual growth for next year and the year after.

Brian Bedell
Brian Bedell
Analyst at Deutsche Bank

Yeah. Okay. That's fair enough. Ron, just back on SSGA. Obviously, you made a good case for the growth in that business longer-term. As you just think of strategically State Street as a whole, obviously you've been the clear and away leader in the core asset servicing business, and you continue to enhance that lead with CRD and BBH, and other investments for organically growing it. As you think about State Street longer-term, maybe would you prefer to be more of a pure play on that leadership position, or would you prefer to have the balance of the asset management business within that? I guess also, is it really critical that you need SSGA for preferential capital treatment for going through the Fed stressed uncertain?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Well, Brian, if you think about our portfolio of businesses, we're far and away the narrowest of both the U.S. and the total GSIB population. We're pretty focused to begin with. If you think about those two broad businesses, because I would put markets underneath our investment servicing business because it's really there to support that business. If you think about those two businesses, they fall under that single purpose of helping institutional investors achieve better outcomes. We start out from a position of being very focused, and then we ask ourselves all the time. First, are we satisfied with our performance? Second, are we the right owner for these businesses?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

At this point, as we look at it, we think and believe that given the performance, given the somewhat symbiotic relationship between the two businesses, that having this participation in that business is actually enhancing. As you note, it certainly is helpful from a capital perspective. I mean relative to our investment servicing and related activities, it's a capital-light business. When you add it all together, we like the business. We recognize that you as shareholders can take care of diversification. It's not up to us to diversify for you. We have to make sure that as owners of these businesses, that we're good owners and we can continue to grow the business. We are looking at this all the time.

Brian Bedell
Brian Bedell
Analyst at Deutsche Bank

That's great color. Thank you.

Operator

Your next question is from James Mitchell with Seaport Research.

James Mitchell
James Mitchell
Analyst at Seaport Research

Hey, good morning. Maybe just on the security servicing side. Outside of one-off large outflows like the BlackRock biz, can you speak to your efforts to reduce client attrition and kind of get that $1.5 trillion bogey of annual gross outflows down to really start to enhance the net growth from that side of the equation?

Eric Aboaf
Vice Chairman and CFO at State Street

James, it's Eric. Let me start. There's a long history here in serving our clients, serving them well. Being incredibly focused on what they need. That's what both creates sales and sales opportunities because we've said over time, something like two-thirds, three-quarters of our sales come from our existing clients. The other side of that coin is staying close to our clients, understanding their needs, being there when they add funds or when they consider other options is also a big part of what we do. Now, sometimes our clients are involved in M&A, and we need to rebid what we've got. We have very active programs when that happens. That's part of the industry.

Eric Aboaf
Vice Chairman and CFO at State Street

We've got a set of client NPS, net promoter score work that we do that we've expanded over the last two years to now take on a very large portion of our clients. That provides real-time feedback to us from the C-suite on down to the operational portions of our clients. It's our coverage program. I think you saw us back in June describe how we do coverage with our global client division, our premium, our preferred. Each one of them is geared towards making sure that we're staying close and supporting our clients and making sure they're as satisfied as can be. Those are some of the elements, and I'd say it's deep in our culture and something we work on. That said, you've got to keep, if we want to grow and deliver core growth like we've done the last few quarters.

Eric Aboaf
Vice Chairman and CFO at State Street

We've been able to drive core growth which we're very pleased with. We got to keep expanding and selling both to existing and to new clients, and you've seen us do that successfully. On the other side, I think we feel quite good about our retention rates, and that's always an area of intense effort, and I'd say this year has been successful as well.

James Mitchell
James Mitchell
Analyst at Seaport Research

Okay. That's helpful. Maybe just the second question on enhanced custody. If I'm reading the balance sheet correctly, it seems like you've had very significant growth there. Is there any constraints on growing that business from a balance sheet capital perspective? How do we think about what's driving the growth and the outlook for that over the next year or two?

Eric Aboaf
Vice Chairman and CFO at State Street

Sure. James, it's Eric again. I think for all of our balance sheet businesses, we always need to be careful about how much they consume in risk-weighted assets versus the earnings and the opportunities that they can provide us. We do that certainly on a standalone basis because you've got to look at every asset on the balance sheet, whether it's lending asset for our loan book, for example, or securities finance business or enhanced custody business or FX business. You also have to think about it within the context of the client relationship because there's always a give and take. For a client that may not borrow very much, were they to do more securities finance or enhanced custody, that can be a reasonable mix and a way to serve them, but to serve them with decent returns.

Eric Aboaf
Vice Chairman and CFO at State Street

I'd say there's certainly room in these businesses, but I think what we are doing is going into the end of the year as we close the Brown Brothers acquisition. We are being a bit disciplined about our risk-weighted asset position because we want to close that deal, and we want to land within our capital ratios. I think while you've seen some very heady growth in the last couple of quarters, just in the next one-two-quarters, I think you'll continue to see some discipline. You've seen a little bit of that on the quarter-on-quarter balance sheet in some of the areas like securities finance. You can imagine we'll do that going into the beginning of next year.

Eric Aboaf
Vice Chairman and CFO at State Street

What I would say is I think the franchise, as we continue to grow the fee portion of the revenue base, manage our expenses, we can continue to put more capital to work over time, but sometimes there'll be some ebbs and flows, and I think I've given you a little bit of an indication where we see some of those.

James Mitchell
James Mitchell
Analyst at Seaport Research

Okay, great. Thanks.

Operator

Your next question is from Steven Chubak with Wolfe Research.

Steven Chubak
Steven Chubak
Analyst at Wolfe Research

Hi, good morning. Eric, I wanted to start off just discussing some comments you made actually a bit ago at the BAB conference. You talked about the servicing fee growth algorithm, and you framed it based on expectations around new store and same-store sales growth, pricing pressures, what have you. I was hoping you could maybe just update us on how your thinking has evolved with regards to that algorithm. Whether it's strengthened just given the improved outcomes that we're seeing in terms of new business wins, at least relative to what you've seen historically.

Eric Aboaf
Vice Chairman and CFO at State Street

Steve, I think the algorithm that you're referring to that I've described and we've described as a company is that servicing fee growth comes from a mix of equity market tailwinds, client activity inflows, net new business, which can either be positive as it has been the last couple of quarters, neutral or negative, and then pricing headwinds. It's that four-part structure. The way I'd update that is to say that the structure is still there and I think been fortified. The different areas move around a bit. Equity market tailwinds, we've seen very strong equity market tailwinds this year. I don't think we're going to see that every year. We'd like to see flat to up equity markets. You can imagine that part of the tailwind was very positive this year, which we're pleased with.

Eric Aboaf
Vice Chairman and CFO at State Street

The way we monetize that is we didn't take our expenses up with equity market uptick. The second one is client flows and activities. I think a couple of years back, this was a positive by a couple points. I think a year or two ago, as we saw outflows from package products in both, especially in the U.S., as mutual funds were on the wane and we saw less inflows in Europe. I think we felt less confident in client activity inflows as a tailwind. I think that's actually rebounded nicely this year. We expect that to continue given the current market dynamics. Net new business, as you referenced, I think we've got a strong year here in terms of wins. That'll now start to get implemented next year and the year after. That takes time, but we're pleased with the backlog.

Eric Aboaf
Vice Chairman and CFO at State Street

Pricing, I think, as I said, I think on the first question this morning, has been well controlled, and we just work on that intensely every day. I think the structure is intact. Every year will bring a little different mix and different elements of that framework.

Steven Chubak
Steven Chubak
Analyst at Wolfe Research

Thanks for that color, Eric. Just for my follow-up. I know you provided some helpful color on the BBH rate sensitivity, additional flex from having the off-balance-sheet suite option. I was just curious how the improving rate backdrop, just taking the forward curve, informs your willingness to onboard more than the $10 billion of deposits which you disclosed at the time of the deal. Just speak to the relative attractiveness of onboarding a larger percentage of deposits versus maybe other forms of capital return like buybacks and dividend increase.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure. Let me open up the aperture a little bit. Remember, the core of our capital constraint is around CET1, our common equity Tier 1 ratio, which is really a risk-weighted asset-based measure, not a leverage ratio measure. On the leverage ratio, we just need to be kind of within bounds. The decision on deposits and NII within reason is really around what rate levels we're sitting at. I think the way to think about deposits is when prevailing short rates, call it Fed funds, is at the current levels, near zero. You're not incented to have deposits on the balance sheet. That break-even tends to flip at around two or three rate hikes, around 75 basis points of Fed funds. You start to be in a more neutral position.

Eric Aboaf
Vice Chairman and CFO at State Street

At 100 basis points of Fed funds you start to be the right way around where you'd prefer the deposits on the balance sheet. It's somewhere in that area, call it two, three rate hikes from now, where we begin to seriously thinking about the benefit of adding more deposits instead of holding them off. I think that the question that the decision criteria that we'll get to is where are prevailing rates in the Q1 and the Q2 and the Q3 next year. At that point, we'll make some conscious decisions and trade off additional NII, which we'd like to bring in because it helps with our margin and our EPS. We'll just have to be careful about the balance sheet size. You've seen us manage the balance sheet size you saw this quarter.

Eric Aboaf
Vice Chairman and CFO at State Street

In fact, it's not like we know where to judiciously manage the balance sheet. I think we'll continue to do that while bringing on deposits and serving our clients as best we can.

Steven Chubak
Steven Chubak
Analyst at Wolfe Research

That's great color, Eric. Thanks so much for taking my questions.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure.

Operator

Your next question is from Gerard Cassidy with RBC.

Gerard Cassidy
Gerard Cassidy
Analyst at RBC

Good morning, Ron. Good morning, Eric.

Eric Aboaf
Vice Chairman and CFO at State Street

Hi, Gerard.

Gerard Cassidy
Gerard Cassidy
Analyst at RBC

Eric, can you share with us when you guys look at your asset under custody wins, can you break it out geographically? Also, are the wins coming from competitors or are they coming from just companies that were doing it internally and now have chosen to go with somebody like yourself? How do the numbers in this quarter look compared to the prior couple of years? Is there shifts going on in either of those two dynamics?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Yeah, Gerard, maybe I'll begin and Eric will add in color. If you look at this quarter, the standout obviously from an AUCA was Legal & General. Mostly U.K., but there's an American element to that also. In that case, it was for the most part a new client to us. We had a nominal existing relationship to it. It's an alpha-driven mandate, lots of activities will be coming our way over time. If you look at the prior quarter, again, the standout there would have been Invesco, which was more of a U.S.-based global client where we had an existing relationship.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

On the servicing side, we are consolidating much of that and expanding into the middle and front office. I would say that what we've seen over the past couple of years in terms of the Alpha-related kinds of wins, it's been nicely mixed geographically. As importantly, there's been more new client wins than we would've expected from the beginning. It's enabled us to drive new client growth and what's incumbent upon us then is to make sure that Obviously, if it's a new client, they've got the traditional servicing business with somebody else. What we are doing strategically is we'll have a discussion on Alpha, we'll win the Alpha, and then say, "Now we want to move the servicing business over." In terms of the core wins, I would say that there's been a little bit of a cycle here.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Eric will correct me if I'm getting this wrong. If you go back a couple, three years ago, EMEA was relatively light relative to the U.S., and we've seen actually over the past couple years, a lot of activity in EMEA. It's not so much that it's been less U.S., it's just been more activity in EMEA. That's had a lot to do with changing out and rebuilding a sales force and things like that had been done in the U.S., hadn't quite been done until more recently in EMEA. What we like is it's nicely mixed. More recently, we're starting to see some activity in Asia Pacific, and we're really excited about Brown Brothers because of the truly leading position that they have in Japan that we'll be able to leverage to spur even more growth there.

Gerard Cassidy
Gerard Cassidy
Analyst at RBC

Thank you. Very good. As a follow-up question, I apologize if you guys have addressed this already. In the revenue growth of servicing fees and management fees, 7% for servicing on a year-over-year basis, 10% for management. You mentioned that client flows, new business growth, higher-market-levels contributed to this growth. How much of that growth was attributed to the higher-market-levels?

Eric Aboaf
Vice Chairman and CFO at State Street

Gerard, it's Eric. It varies by business. On servicing fees, a large proportion of the up 7% was driven by the equity markets tailwind. A smaller proportion from client flows and net new business. In the other direction, you have the usual smaller amount of pricing headwinds, and we also called out a little bit of divestiture activity. It's kind of two-thirds, one-third. What I think I'm particularly pleased with is we're able to hold expenses flat notwithstanding that, and that's not been our history here as we've managed. On the management fee side, it was just the way that business tends to be priced. The market tailwinds tend to come in and are a very important part of the tailwind. We also had, I think, very nice net new business performance on the revenue side. You see it in flows.

Eric Aboaf
Vice Chairman and CFO at State Street

We also counted in revenues. You saw there us taking up our margin in the asset management business. While we're creating the environment for either an equity market tailwind or a flow tailwind in asset management, we're also managing the other side of the P&L, and that's been quite remunerative for us this quarter and pleasing.

Gerard Cassidy
Gerard Cassidy
Analyst at RBC

Very good. Thank you. Eric, we all are looking forward to seeing you at the BancAnalysts Association of Boston conference in about three weeks. We'll see you then. Thank you.

Eric Aboaf
Vice Chairman and CFO at State Street

See you shortly.

Operator

Your next question is from Robert Wildhack with Autonomous Research.

Robert Wildhack
Analyst at Autonomous Research

Good morning, guys. Just one more on the expense side. You highlighted some productivity savings this quarter, and that's been a trend recently. How much more is there left to do on the productivity side, and how much do you think that can continue to serve as an offset to any increases in other expenses going forward?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Yeah, Rob. Service productivity is hard work. We have been at it now for a couple of years, and despite the progress that we see, we actually see more opportunities. It's not as easy as just like in manufacturing, just substitute a people-driven assembly line with a bunch of robots. It's really activity by activity. Substituting AIs, substituting other kinds of automation, trying to eliminate reconciliations. We're making progress against that, and we see the opportunity to do more. We see this as it requires work, ongoing work and ongoing engineering, but we see opportunities over the next several years to continue to do more and more of this.

Eric Aboaf
Vice Chairman and CFO at State Street

Rob, it's Eric. I'd just add, as we adjust our outlook a little bit, part of that was just year-end incentives. We need to reward really strong performance. We also talked about starting to leg into investments, and we like to invest behind the revenue, not ahead of the revenue, but behind the revenue, and that's what we're doing. One of those investments, to be honest, is engineering work, right? Development work to actually automate processes, simplify processes, and so forth. Part of what we're doing, even into the Q4, is beginning some of that work so that several quarters from now, a year from now, two years from now, there's actually an engineering benefit. That's where it comes together as well. As Ron says, it takes real hard work, and it gets done in phases.

Robert Wildhack
Analyst at Autonomous Research

Got it. Thank you for that.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure.

Operator

Your next question is from Vivek Juneja with J.P. Morgan.

Vivek Juneja
Vivek Juneja
Analyst at J.P. Morgan

Hi Ron, hi Eric. Couple of questions for you folks on BBH acquisition. I remember you saying on the announcement of the call something about earn-out. Can you talk a little bit about is this additional payment over and above the purchase price? Or is it something else for the partners who would have presumably gotten a part of that purchase price in cash that you're getting, or can you give us some color on that? What's the driver of that? What is it tied to? Over what time period?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Yeah, Vivek. There's not an extra contingent payment here. Let's put that aside. What we have put in place, and as we talked about expected accretion here. We have put in place an incentive plan that's quite broad-based. Basically, it's a success-based pool with the factors being client onboarding and retention, as well as staff retention. Everybody, well, all of senior management, fairly deep into the BBH management participates in that. There's targets out there in terms of client retention. There's targets out there in terms of desired staff retention. It was really meant to align BBH people around what we're aligned about, which is growing our client base and keeping our best talent.

Eric Aboaf
Vice Chairman and CFO at State Street

Vivek, it's Eric. You'll see those costs in the acquisition restructuring line. We're purposely bounding it but including it in our financials. They're modest. They're what you'd expect us or any other acquirer to do in a deal. Given the combination, there's a real benefit in the execution here.

Vivek Juneja
Vivek Juneja
Analyst at J.P. Morgan

Okay, great. Another one on BBH, Eric, maybe this is more for you. The BBH sweep program that you mentioned previously too, how much of those deposits, how much of that sweep is at risk with banks who would not want to renew it because of capital constraints? How much of that would you need to take on and if you couldn't, what's the alternative to that?

Eric Aboaf
Vice Chairman and CFO at State Street

Yeah, Vivek. As part of our diligence, we looked at every part of this acquisition. How the revenues come together and there's a lot of share wallet opportunity, expenses, how it comes together. Certainly the sweep program. The sweep program is modest when it comes to the bank counterparties. It's not enormous for any one bank provider. I think the top 10 bank providers are important, but if you think about what swept away, I think we said about $60 billion-$70 billion is swept away today across 10 large banks. You're not talking about a real capacity constraint. We've actually engaged with each of those bank counterparties, most of whom we know extremely well and who we do business with, right? We often do business with those counterparties on the sub-custody side or in terms of other arrangements.

Eric Aboaf
Vice Chairman and CFO at State Street

There's a bidirectional set of relationships that we have. We don't see a lot of risk at this point and see more of an opportunity to actually sweep a little more, sweep a little less. What I would say is the core of the sweep's in U.S. dollar. I don't need to be patriotic to say that the U.S. dollar is an extremely valuable deposit and cash currency. They're certainly valuable to U.S. and global banks. I think we've got a good program set up, and we see it continuing with some upside optionality for us.

Vivek Juneja
Vivek Juneja
Analyst at J.P. Morgan

Okay. Thank you.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure.

Operator

Your next question is from Mike Mayo with Wells Fargo.

Mike Mayo
Mike Mayo
Analyst at Wells Fargo

Hi. If you can provide more color on your phrase, business investment for the next phase of growth. That sounds like something more significant than simply tweaking budgets going into year-end or anything like that. When you talk about this next phase of growth, I know you talked about Alpha, private markets, the digital space, but if you maybe just give more color on the overall tech strategy and the tech budget. How much are you looking to increase the tech budget from where it is now? How much of that is to change the bank? Which areas of tech are you investing, such as the cloud or other areas? Thanks.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Well, Mike, it's Ron. As I said earlier, we've been investing all along through this most recent period, these last several years. As Eric has noted, we've invested behind our revenue growth. The gates in our investment have not been necessarily opportunities. It's been, what can we do to fund this growth off of our BAU spending? Second, where and how is the growth coming in? In terms of what we're investing in, it really isn't changing much other than from a balance perspective. I would say that much of the investment that you've seen over the past several years, if you think about the whole resilience area, the whole, I mean, this is imposed on all of us. Resilience area, the cyber area would probably fall under the BAU or run the bank. State Street Alpha has certainly been a change the bank kind of thing.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

I think we would anticipate a little bit of a mix shift from run to change, in terms of total amounts. Really, it's not going to be a kind of peanut butter thing where everybody gets a little something here for their pet project. It really is about those things where we see it positioning us for meaningful growth, meaningful additional growth. We explain why, but that would be Alpha Private Markets and State Street Digital kind of primarily. What I would add to that would be continuing to selectively invest in Global Advisors. I mean, the investments we've made there in the past, particularly, for example, in the active ETF space, the investments we've made in European ETFs and in low-cost ETFs, all of which are growing and we're gathering disproportionate share on those spaces. That's how we think about it.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

You shouldn't expect us to be throwing a lot of money at things that we don't know anything about or that are new to us. It's about things that we've already established can give us growth, and that with a little more investment, we expect to be able to accelerate that growth.

Mike Mayo
Mike Mayo
Analyst at Wells Fargo

Okay. Don't spread around the peanut butter too much. When you look at it by function, like I know this predates you, Ron, when you talk about the cloud or the back office, and you talk about digitizing your operations, how are you looking at the cloud today in terms of public, private? How much of the workload has shifted? Where are you in that thought process, and how much does that play as part of your transformation?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

I mean, Mike, we've been very active in the cloud, and we've, I think, talked about this in other contexts. I'll use an example, what we're doing in Charles River and Alpha which is an entirely Right from the beginning when we said we were going to be open architecture and interoperable, that by definition meant that it had to be cloud-based. We have quite aggressively gone to the cloud. We've talked about our partnership which was one of the first in this whole security services area with Microsoft and their Azure products. That is very much a part of it, and we think about it as being, how can we I mean, certainly there's a cost element to it, but it's also about how do we advance the business strategically and grow revenues.

Mike Mayo
Mike Mayo
Analyst at Wells Fargo

All right. Thank you.

Operator

Our final question is from Rajiv Bhatia with Morningstar.

Rajiv Bhatia
Rajiv Bhatia
Analyst at Morningstar

Good morning. Just one quick question from me. There's some headlines that hedge fund flows are pretty strong. Can you comment on your alternative fund administration business and what kind of growth you're seeing there?

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Yeah. Why don't I begin and Eric Aboaf will pick up, Rajiv Bhatia. You're right. Hedge fund flows have been strong and going back to Mike Mayo's effort, that would be another example of where we've invested fairly significantly in new technology there. In this case, using an outside provider. We're enjoying the benefits of those flows. I think that we expect to see more and more flows into alternatives of all types. There's a further push to see this, if you will, go into smaller accounts and the so-called democratization of it. We want to be positioned for that.

Eric Aboaf
Vice Chairman and CFO at State Street

Rajiv, it's Eric. I'd just add the private markets, the hedge funds, they're all attractive asset classes for us. Year-on-year, we saw 7% growth this year across the servicing fee franchise. In the private markets, you're seeing 2, 3 percentage point higher growth than the average for the company. That's one of the reasons why over the last year or two and certainly going into the Q4 next year, we're investing more in private markets because we see those opportunities and that adds to the growth trajectory of the company.

Rajiv Bhatia
Rajiv Bhatia
Analyst at Morningstar

Got it. Thanks.

Eric Aboaf
Vice Chairman and CFO at State Street

Sure.

Operator

We have no further questions at this time. I'll turn the call back over to our presenters.

Ronald O'Hanley
Ronald O'Hanley
Chairman and CEO at State Street

Well, thanks to all on the call for joining us, and we look forward to speaking with you further. Thanks very much.

Executives
    • Ilene Bieler
      Ilene Bieler
      Global Head of Investor Relations
    • Ronald O'Hanley
      Ronald O'Hanley
      Chairman and CEO
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