Eric Aboaf
Executive Vice President and Chief Financial Officer at State Street
Thank you, Ron, and good afternoon, everyone. I'll begin my review of our second quarter results on Slide 4. We reported EPS of $1.91 or $1.94 excluding acquisition and restructuring costs as detailed on the panel on the right side of the slide. As Ron noted earlier, the operating environment in the second quarter remained challenging, largely characterized by continued market volatility related to macroeconomic events and continued geopolitical uncertainties.
As you can see on the left panel of the slide, strong growth in both net interest income and FX trading enabled us to partially offset significant headwinds from lower equity and fixed income markets in the quarter that impacted other fee areas. Also evidenced by today's results, our approach to expense management remains very disciplined and deliberate. On a year-on-year basis, second quarter expenses were down even as we experienced higher-than-expected wage increases and continue to thoughtfully invest in the franchise.
Lastly, you'll see that in the second quarter, we had a lower-than-expected tax rate. The bulk of the discrete tax items that contributed to our lower taxes were due to the reassessment of a deferred tax asset worth roughly $60 million. All things considered during the quarter, our business model demonstrated resilience against the challenging backdrop.
Turning to Slide 5. During the quarter, we saw period-end AUC/A decreased by 10% on a year-on-year basis and 8% sequentially. Amidst continued and uncertain economic conditions, the year-on-year change was largely driven by lower period end market levels across just about every equity and fixed income market around the world, partially offset by net new business and client flows. On a quarter-on-quarter -- the quarter-on-quarter decline was largely a result of the same lower period end market levels, as we've also started to see industry outflows from investment products as the risk off sentiment continues.
Similarly, at Global Advisors, quarter-end AUM decreased 11% year-on-year and 14%, sequentially. The year-on-year decline in AUM was also largely driven by lower period end market levels and institutional net outflows which was partially offset by positive net inflows in both our U.S. low-cost ETF complex and cash inflows in the quarter.
Turning to Slide 6. On the left side of the page, you'll see second quarter total servicing fees down 7% year-on-year, market levels, normal pricing headwinds, client activity and adjustments and the impact of currency translation, partially offset by net new business growth. Excluding the impact of currency translation, servicing fees were down only 4% year-on-year.
I'd also highlight that from a segment perspective, we continue to see excellent revenue growth in our alternative client segment, both year-on-year and quarter-on-quarter. Sequentially, total servicing fees were down 5%, primarily as a result of the same drivers, lower average equity and fixed income market levels, client activity and adjustments and the impact of currency translation, partially offset by positive net new business.
Within servicing fees, back office fees were down 7% year-on-year and 5% quarter-on-quarter, largely driven by the factors I just described. Middle Office Services was down 12% year-on-year and 8% quarter-on-quarter, primarily due to decreased client AUMs, driven by lower market levels and client transaction activity and adjustments. But we are seeing some compression in our legacy middle office book. It is an important component of our Alpha proposition when it connects to both the Front office and Back office and new wins generally come with contracts of 7 to 10 years. We continue to expect to see good growth over the medium term as evidenced by our large uninstalled middle office revenue backlog of more than $90 million, which I will talk more about in a moment.
Even against this challenging backdrop, we continue to be pleased with our Investment Services business momentum and robust pipeline. We recorded another strong quarter of new AUC/A wins worth $972 billion while AUC/A won, but yet to be installed amounted to $3.6 trillion at quarter end. As Ron mentioned earlier, during second quarter, we reported another new Alpha win, Allspring Global Investments taking the total number of Alpha clients to 20 and now have 12 implementations live.
Lastly, in response to industry inflationary cost pressures, we've undergone a comprehensive analysis of our pricing across all our product areas. The result of this analysis has led to the decision to begin to adjust our client pricing upwards in certain areas of servicing where the wage pressure is most acute and industry capacity is stretched. Ultimately, we believe these pricing changes will support the continued investment that allows us to best serve our clients.
Turning to Slide 7. Second quarter management fees were $490 million, down 3% year-on-year, primarily reflecting lower average equity and fixed income market levels, the impact of currency translation and a specific client repricing adjustment, partially offset by the elimination of money market fee waivers and the run rate impact of net ETF inflows. Management fees were down 6% quarter-on-quarter, largely due to equity and fixed income market headwinds, partially offset by the elimination of the same money market fee waivers.
As you can see on the bottom right of the slide, our franchise remains well positioned for growth. In ETFs, although we saw outflows in equity and commodities, we continue to see inflows into SPDR low cost and fixed income ETFs. In our Institutional Business, there's continued momentum in our target date franchise, notwithstanding outflows primarily from one large client with very low fee assets, which ultimately benefited the overall management fee rate this quarter.
Across our cash franchise, we again saw another quarter of strong net inflows, this time worth $15 billion in the quarter, contributing to market share gains.
On Slide 8, FX trading services had yet another strong quarter. Relative to a period a year ago, second quarter FX trading services revenue was up 16%, primarily driven by higher FX spreads, partially offset by lower client FX volumes. Quarter-on-quarter, FX trading services revenue was down 8% as the benefit of higher FX spreads was more than offset by lower client FX volumes too. Our second quarter securities finance revenues decreased slightly year-on-year, primarily driven by lower agency and enhanced custody balances due to lower markets, partially offset by higher spreads. Sequentially, revenues were up 11%, mainly reflecting higher spreads, partially offset by lower agency and enhanced custody balances.
Second quarter software and processing fees were down 11% year-on-year and 6% quarter-on-quarter, largely driven by lower Front office software and data revenue associated with CRD, which I'll turn to shortly. Finally, other fee revenues of negative $43 million in the second quarter declined both year-on-year and quarter-on-quarter. Both the year-on-year and quarter-on-quarter declines largely reflect negative market-related adjustments while the absence of prior period positive fair value adjustments on equity investments also contributed to the sequential decline.
While we saw pressure throughout the quarter, almost half of the $43 million came through in the second half of June.
Moving to Slide 9. Let me provide some details on the performance of our Front office software and data revenue in the second quarter on the left panel of this slide. As a reminder, CRD represents the majority of these revenues, but we also include Alpha Data Services, Alpha Data Platform and Mercatus revenues since they are part of our Front office offering. On both a year-on-year and quarter-on-quarter basis, Front office software revenue declined as expected, primarily driven by the absence of several on-premise renewals in the prior periods as well as some episodic fees when compared to the prior year quarter, partially offset by higher software-enabled SaaS revenue.
It is important to note, however, that the more durable and recurring software-enabled and professional services revenues have continued to grow nicely with a year-on-year growth of 15%, demonstrating success in deploying our cloud-based SaaS platform environment to more clients.
Turning to some of the softer metrics enabled by CRD and Alpha on the right panel, you'll see that our annual recurring revenue has grown 20% year-on-year as we convert more clients to SaaS, which we expect will create a stickier and more profitable business model.
As for the middle office, we continue to have an extremely healthy backlog of uninstalled revenue worth $92 million, which is almost twice the prior year. Lastly, we are pleased to have announced another Alpha mandate win this quarter. We're also excited to have expanded an existing Alpha relationship this quarter, winning approximately $300 billion of new back office assets to custody from an asset owner client. This provides another proof point that our Alpha value proposition is working as we're gaining more of the wallet share over time.
Turning to Slide 10. Second quarter NII increased 25% year-on-year, primarily reflecting the impact of higher interest rates and continued growth in loan balances. Relative to the first quarter, NII was up 15%. The sequential increase was largely driven by the improvement in both short and long end rates, which benefited our yields, together with continued growth in loan balances, partially offset by lower investment portfolio balances.
On the right side of the slide, we show our average balance sheet during the quarter. Average deposits were down 6% year-on-year and 2% quarter-on-quarter, primarily related to the impact from currency translation and dollar strengthening, which accounted for almost half of the year-on-year decline and 2/3 of the sequential decline. The investment portfolio is now down modestly, and we have almost 60% of our securities now in held to maturity. We're pleased that our balance sheet is well positioned to recognize this interest rate and NII tailwinds and also protect OCI.
Turning to Slide 11. Second quarter expenses, excluding notable items, decreased 1% year-on-year or increased 2% adjusted for currency translation. In response to the revenue environment, we have been proactively managing our expenses, including lowering our incentive compensation, in addition to carefully executing on our continued productivity savings efforts which generated approximately $60 million in year-on-year gross saves or approximately $150 million year-to-date. These savings enabled us to continue to self-fund the good portion of the 4% to 6% higher wage rates we're facing and the targeted investments in the business, including the Alpha product, technology infrastructure and broader automation.
Compared to 2Q '21, compensation employee benefits was down 3% as lower incentive compensation, the impact of currency translation were partially offset by salary merit increases associated with wages and inflationary pressure and higher contractor spend. Excluding currency translation, compensation and employee benefits would have been up 1%.
Information systems and communications expenses was down 2%, primarily due to the episodic credits related to vendor pricing optimization and infrastructure rationalization. Occupancy was down 4% due largely to currency translation. And other expenses were up 18%, primarily reflecting higher recoverable client-related expenses, which are offset in fee revenue, professional fees and travel costs.
On a quarter-on-quarter basis, expenses were down due to seasonal expenses in the first quarter. Headcount increased quarter-on-quarter as we continue to in-source some strategic technology functions from vendors as well as support growth in Alpha. Overall, in light of the current macroeconomic environment, we have had pretty healthy pretax margin for the quarter at approximately 29%, excluding notable items, supported by active expense management and strong NII growth.
Moving to Slide 12. On the right side of the slide, we show our capital highlights. We are quite pleased to report CET1 of 12.9%, up 100 basis points happy with our performance under this year's CCAR with a calculated stress capital buffer well above the 2.5% minimum, resulting in a preliminary SCB at the floor. As a result, in June, we announced the planned 10% increase to our 3Q '22 quarterly common stock dividend, subject to Board approval, and it remains our intention to again begin our existing common share repurchase program in the fourth quarter in an amount reflecting market conditions at the time.
To the left of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios. As you can see this quarter, even against the backdrop of a challenging operating environment, we drove stronger and higher capital levels. During the second quarter, we completed several of the previously announced RWA optimization actions across our trading, lending and investment portfolios, reducing RWA $12 billion quarter-on-quarter. We also shifted about $20 billion of AFS securities to HTM. As a result, we limited AOCI from the investment portfolio to under $500 million or 40 basis points of CET1, even with a roughly 60 basis point upward interest rate move across the two and five-year part of the curve.
You'll see a larger AOCI move in the GAAP books, but much of that is ratio hedged and offset by the appreciating dollar effect on RWA with an offsetting goodwill and intangibles as well. Given that we have now significantly reduced the OCI risk to interest rate shocks by 75%, we are now comfortable operating somewhat below our standard target ranges for both CET1 and Tier 1 leverage ratios.
Turning to Slide 13. We provide a summary of our second quarter results. Despite the continued volatile market environment, I am pleased with our quarterly performance, which demonstrates the strength of our business model. The current macroeconomic environment and persistent geopolitical uncertainties, notwithstanding, our strong growth in both net interest income and FX trading services enabled us to partially offset significant headwinds from both equity and fixed income markets highlighting the resiliency of our franchise. And our expenses remained well controlled, demonstrating the progress we are making in improving our operating model.
Now turning to outlook. We would like to provide our current thinking regarding the third quarter. At a macro level, while market rate expectations have been volatile, our current interest rate outlook is broadly in line with the current forward which suggests the year-end Fed funds rate of 3.5%. We expect other major international central banks to continue raising rates, with the ECB expected to start increasing rates in third quarter. The current spot level of global equity markets would imply that average equity markets in 3Q would be down 7% to 8% quarter-on-quarter, and U.S. Dollar appreciation to be about 1 percentage point of headwind to revenues and tailwind to expenses, which will be included in our guide.
Now in terms of the third quarter of 2022 and on a standalone State Street basis. Given the implied declines in average Global Markets, we expect total fee revenue to be down about 2% on a sequential basis. And we expect both servicing fees and management fees to be down 4% quarter-on-quarter, driven by weaker market levels.
Turning to NII. Following 1 of the strongest sequential increases in the NII for many years in 2Q, we expect to deliver further growth with NII expected to increase 5% to 9% quarter-on-quarter, driven by the tailwind from Central Bank rate hikes. This outlook includes our expectation for some initial deposit outflow and rotation in 3Q. And for the full year, on a stand-alone State Street basis, we expect NII to increase 24% to 27%, which is significantly better than our prior full year guide of 18% to 20%.
Next, we expect total expenses, excluding notable items, to increase just under 1% quarter-on-quarter, driven by inflationary pressures on wages as we continue to target productivity initiatives and execute against our strategy with a deep focus on expense discipline. This focus enable us to drive positive total operating leverage, excluding notable items for the full year.
Lastly, we would expect our 3Q tax rate to be approximately 20% for the quarter.
And with that, let me turn the call back to Ron.
