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State Street Q2 2023 Earnings Call Transcript


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Participants

Corporate Executives

  • Ilene Fiszel Bieler
    Global Head of Investor Relations
  • Ronald P. O'Hanley
    Chairman and Chief Executive Officer
  • Eric Aboaf
    Vice Chairman and Chief Financial Officer

Analysts

Presentation

Operator

Good morning, and welcome to State Street Corporation's Second Quarter 2023 Earnings Conference Call and Webcast. Today's discussion is being broadcast live on State Street's website at investors@statestreet.com. This conference call is also being recorded for replay. State Street's conference call is copyrighted and all rights are reserved. This call may not be recorded for rebroadcast or distribution in whole or in part without the expressed written authorization from State Street Corporation. The only authorized broadcast of this call will be housed on the State Street's website.

Now I would now like to introduce Ilene Fiszel Bieler, Global Head of Investor Relations at State Street. Please proceed.

Ilene Fiszel Bieler
Global Head of Investor Relations at State Street

Good morning, and thank you all for joining us. On our call today, our CEO, Ron O'Hanley will speak first. Then Eric Aboaf, our CFO, will take you through our second quarter 2023 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 requeue.

Before we get started, I would 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, also available in the IR section of our website.

In addition, today's presentation will contain forward-looking statements. Actual results may differ materially from those statements due to a variety of important factors such as those factors referenced in our discussion today 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 P. O'Hanley
Chairman and Chief Executive Officer at State Street

Thank you, Ilene, and good morning, everyone. Earlier today, we released our second quarter financial results. Relative to the significant volatility experienced by investors in the first quarter, market conditions in 2Q were more subdued and global financial market performance was varied. Global equities generated positive returns for the third consecutive quarter as investors saw continued strength in developed equity markets, but weakness in emerging markets.

Fixed income market sell as investors had to contend was still elevated levels of inflation and further Central Bank rate hikes including the federal reserve raising interest rates above 5% for the first time since 2007. The second quarter was also characterized by falling currency market volatility, which created headwinds for our foreign exchange business.

Turning to Slide 3 of our investor presentation, I will review our second quarter highlights before Eric takes you through the quarter in more detail. Beginning with our financial performance, second quarter ROE was 13% and pre-tax margin expanded by 1.2 percentage points year-over-year to 29.5%. Relative to the year ago period, 2Q EPS increased by 14% to $2.17 supported by our common share repurchases, significantly higher NII, strong front office software and data revenue growth, and an increase in securities finance revenue. Our results also benefited from the release of an allowance related to the support of a U.S. financial institution as well as an accounting adoption. Taken together, these factors more than offset headwinds in some of our other fee based businesses and the impact of higher than desired year-over-year expense growth.

Turning to our business momentum. In Q1, I highlighted that by strengthening our implementation capabilities, we have line of sight into a meaningful amount of client onboarding this year. We began to realize the benefits of this plan and onboarded $1.2 trillion of AUC/A during the second quarter, primarily driven by State Street Alpha underscoring the power of the alpha value proposition to our investment services strategy and long-term growth. As a result, our AUC/A installation backlog declined to $2.4 trillion, while total AUC/A increased by 5% quarter-over quarter to $39.6 trillion both at quarter end and in part as a result of this new business.

We also recorded over $140 billion of asset servicing wins in the second quarter largely driven by strong sales in the desirable asset owner, official Institutions and alternatives client segments. Our sales pipeline grew and we expect substantial onboardings in the coming quarters. We continue to advance and broaden our enterprise outsource solutions strategy across our clients' front, middle and back office activities as demonstrated by the expansion of Alpha's capabilities to ETFs, which we announced in 2Q. For the past 30 years, State Street has continuously innovated to support what has become a $10 trillion ETF market.

Today, State Street is the largest ETF administrator in the world with more than 2,700 ETFs serviced in 13 countries. That long cycle of innovation continues as State Street Alpha now supports the entire ETF lifecycle. By integrating CRD's front office products with State Street's industry-leading ETF servicing capabilities, Alpha now provides a centralized platform for ETF issuers across the entire ETF lifecycle, including portfolio management, trading and compliance to enable the growth across a variety of ETF strategies and increase speed to market.

Turning to front office, software and data business. Our overall CRD pipeline is strong. In the second quarter, we converted a meaningful number of on-prem CRD clients to recurring SaaS revenue which when coupled with new SaaS client implementations increased annual recurring revenue by 12% relative to the year ago period. In addition, Charles River Wealth Management Solution continues to resonate with clients and drove a significant increase in on-prem revenues this quarter. Year-to-date, CRD's wealth driven revenue has more than doubled as compared to the first half of 2022 and we remain on-track to grow CRD's wealth revenue this year.

At the State Street Global Advisors, quarter end assets under management totaled $3.8 trillion supported by higher period end market levels and $38 billion of net inflows from all three business lines, ETF, cash and institutional. Our SPDR ETF business gathered $27 billion of net inflows in the second quarter, including $20 billion of net inflows into SPY, the industry's largest ETF. We also delivered a solid performance in our U.S. low-cost ETF segment, which gathered $7 billion of net inflows in the quarter continuing to gain market share. Our cash business gathered a solid $10 billion of net inflows in the second quarter as our U.S. government money market funds benefited from the attractiveness of the cash asset class in the higher rate environment.

Turning to our financial condition. State Street's balance sheet, liquidity and capital positions remain strong. Our CET1 ratio was a strong a 11.8% at quarter end, well above our regulatory minimum. The ongoing capital generation of our business coupled with effective balance sheet management and our strong capital position has enabled us to deliver against our goal of returning significant capital to our shareholders. In 2Q, we returned approximately $1.3 billion of capital buying back more than $1 billion of our common shares and declaring over $200 million of common stock dividends. This means cumulatively over the last three quarter to the end of June, we have returned approximately $4.4 billion of capital to our shareholders through a combination of share repurchases and common stock dividends.

The strength of our balance sheet was also highlighted with the release of the federal reserve's annual CCAR stress test results in June following which we announced our intention for the third year in a low to increase State Street's common stock dividend by 10% in the third quarter subject to consideration and approval by our Board of Directors. It remains our intention to continue common share repurchases under our existing authorization for up to $4.5 billion in 2023 subject to market conditions and other factors.

To conclude, financial market conditions in the second quarter were mixed. Although global equities recorded another sequential quarter of growth there was weakness in emerging markets and we witnessed a negative impact of persistent inflation and further Central Bank rate hikes on fixed income markets. Meanwhile, both equity and currency volatility continued to decline. Despite this varied backdrop, we achieved a number of positive outcomes in the second quarter, including meaningfully reducing our asset servicing backlog, further developing our Alpha capabilities, continuing to record new asset servicing wins, driving strong growth in front office software and data revenue, and gathering solid net inflows at Global Advisors.

And while we reached double-digit year-over-year EPS growth supported by our capital management and the higher interest rate environment, our results were below our potential. First, while we achieved sequential fee revenue growth in areas of our business this quarter, we need to demonstrate that fee growth every quarter especially as NII -- we need to demonstrate that feed growth every quarter especially as NII is no longer a tailwind. And second, we are highly focused on controlling our expense base. We have a well established track record of reengineering our processes and transforming our operations in order to improve our efficiency and realized productivity growth. We plan to utilize additional tactical expense levers at our disposal in addition to our ongoing structural productivity efforts in order to support our financial performance for the benefit of our shareholders.

Now let me hand the call over to Eric who will take you through the quarter in more detail.

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Thank you, Ron, and good morning, everyone. I'll begin my review of our second quarter results on Slide 4. We reported EPS of $2.17 for the quarter, an increase of 14% relative to the second quarter a year ago. As you can see on the left panel of the slide, revenue grew by 5% year-on-year, driven by the expansion in our front office solutions area where we're an industry leader, continued momentum in securities finance business as well as strong growth in net interest income. This growth enabled us to offset some of the headwinds we saw in other fee areas given the relatively mixed macroeconomic backdrop.

We also had the benefit of an accounting change for tax credit investments, which simplifies our reporting going forward. While our overall year-on-year fee growth was less than we would have liked to deliver, we did see sequential quarter revenue momentum and a step up in the sales pipeline, which we expect to build upon in the coming quarters and which I'll discuss later in today's presentation. As we drive growth, we continue to prudently invest in the business while remaining focused on managing costs given the current operating environment and we stand ready to further intervene on expenses should the softness in the global environment persist.

Turning now to Slide 5. We saw period end AUC/A increase by 4% on a year-on-year basis and 5% sequentially. Year-on-year, the increase in AUC/A was already driven by higher period end equity market levels and client net inflows. Quarter-on-quarter AUC/A increased as a result of the significant $1 trillion Alpha installation and a higher period end market levels. At Global Advisors, we saw similar positive dynamics play out in the quarter. Period end AUM increased 9% year-on-year and 5% sequentially. The year-on-year increase in AUM was largely driven by higher period end market levels. Quarter-on-quarter the increase in AUM was also due to higher period end market levels as well as strong sequential net inflows.

Turning to Slide 6. On the left side of the page, you'll see second quarter total servicing fees down 3% year-on-year as net-new business in the quarter was more than offset by lower client activity and adjustments largely due to lower custody and transaction volume and better than usual pricing headwinds. Positive year-on-year equity markets were offset by the negative impact of fixed income markets. Sequentially, total servicing fees were up 3%, primarily as a result of higher average market levels and net new business, slightly offset by better than usual pricing headwinds this quarter.

We had a more constructive market environment relative to the first quarter as well as a significant onboarding of $1.2 trillion of AUC/A related to an Alpha client in the asset manager of client segment, which comes at a modest fee rate, but which services are expected to be added in the coming years. Within the servicing fees, back office servicing fees were generally consistent with total servicing fees and largely driven by the factors I just described. Middle office services performance was meaningfully more positive for the quarter. On a year-on year basis, fees were up 3%, primarily reflecting net new business and up 10% sequentially, largely driven by the installation that I just mentioned.

On the bottom panel of this page, we've again included some sales performance indicators, which highlight the business momentum we saw in the quarter. While total AUC/A wins in the second quarter were not as robust in volume terms, client engagement remained healthy and we saw wins across strategic segments, including mandates and asset owners, official Institutions and alternatives, which are key growth areas for us as we previously mentioned. The wins including those in the Alternatives segment which are more complex as service come with above average fee rates. We've also seen a healthy uptick in our pipeline this quarter.

Turning to Slide 7. Second quarter management fees were $461 million, down 6% year-on-year, primarily reflecting the impact of net outflows from prior periods, a of certain management fees into NII as previously described and some pricing headwinds, partially offset by higher average market levels. Quarter-on-quarter management fees were up 1% as a result of higher market levels and cash net inflows. As you can see on the bottom right of the slide, our investment management franchise remains well positioned with very strong and broad based business momentum across each of our three lines of business.

In ETFs, we saw very strong net inflows of $27 billion into SPY and our sector suite of ETFs as well as our SPDR portfolio low-cost suite. In our institutional business, we saw net inflows with continued momentum in our well-established index fixed income and defined contribution franchises. Across our cash franchise, we continue to see strong demand for our money market funds. We recorded net inflows of $10 billion.

Turning to Slide 8. Relative to the period a year ago, second quarter FX trading services revenue was down 8% year-on-year and 11% sequentially, primarily reflecting lower client FX volumes and lower industry FX volatility. Relative to the period a year ago, both volumes and volatility were more muted as the start of the war in Europe last year caused unusually high FX trading activity in the first half of 2022. Many clients were also risk off during the debt ceiling discussions in April and May with a rebound in June and client volumes following its resolution.

Altogether, 2Q is needed. We are optimistic about 3Q, but it's hard to predict. Securities finance performed well in the second quarter with revenues up 9% year-on-year, driven by higher agency spreads. Sequentially, revenues were up 7%, again mainly driven by higher agency spreads, as well as higher prime services or enhanced custody revenues from deeper client engagement and specials activity, partially offset by lower balances.

Moving onto software and processing fees. Second quarter software and processing fees were up 18% year-on-year and 34% sequentially, primarily driven by higher front office software and data revenue associated with CRD, which I will turn to shortly. Lending fees for the quarter were down 5% year-on-year, primarily due to changes in product mix, but up 5% sequentially, mainly driven by strong client demand for lines of credit. Finally, other fee revenue increased $101 million year-on-year, primarily due to a tax credit investment accounting change and the absence of negative market related adjustments. This includes the impact of the new accounting adoption.

Moving to Slide 9, you'll see on the left panel that front office software and data revenue increased 29% year-on-year, primarily as a result of higher on-premise renewals and continued growth in our more durable software enabled and professional services revenue as we continue to convert and implement more clients over to our SaaS environment. About 60% of our clients are now on our SaaS platform. Sequentially, front office software and data revenue was up nearly 50%. About two-thirds of this uptick was driven by wealth management mandates that are becoming an increasingly important growth segment for us. Our sales pipeline continues to grow and remained strong for our Charles River Development front office solutions products.

Turning to some of the other Alpha business metrics on the right panel. We were pleased we had three more Alpha mandates go live, which brings our total live Alpha clients to 15. And as I previously mentioned, we installed a significant portion of assets related to Alpha this quarter. We expect to provide more services related to these assets in the future helping us increase the share of our clients' wallet.

Now turning to Slide 10. Second quarter NII increased 18% year-on-year, but declined 10% sequentially to $691 million. The year-on-year increase was largely due to higher short-term rates, an increase in long-term rates and proactive balance sheet positioning, partially offset by lower average deposits. Sequentially, the decline in NII performance was primarily driven by our continued rotation of non-interest bearing deposit balances and rate pressure in the U.S. back book, partially offset by higher short-term market rates from international Central Bank hikes.

On the right side of the slide, we show our average balance sheet during the second quarter. Average deposits declined 2% quarter-on-quarter in line with industry total deposit trends, which also fell by 2% in the second quarter and reflect client preferences to shift from cash to other products during periods of rising rates. Our operational deposits as a percentage of total deposits remained consistent at approximately 75%. Our global floating rate loan book provides upside at this stage in the cycle and our investment portfolio positioning provides a tailwind as long rates roll-through. We now also have the opportunity to selectively add some duration across the curve as we see good entry points, which could enhance NII over time.

Sequentially, U.S. dollar client deposit betas were 100% during the second quarter leading again to some sequential NII compression. We are now at the point in the U.S. rate cycle where we expect to adjust back book pricing to accommodate our larger clients, but do so in a disciplined manner and usually as part of a broader relationship discussion of balancing trade for fee opportunities. Foreign currency deposit betas for the quarter continued to be much lower in the 45% to 50% range.

We've also included a new slide in the appendix, Page 16, that shows our NII trends over the past few rate cycles. I think it will be-- it will put the larger NII increases and decreases in context, which are driven by many factors, including changes in interest rates, the pacing of hikes, deposit levels and mix, Fed balance sheet changes, as well as equity markets. You can see from that page that our recent quarters have come with a much higher than usual level of NII and we're now normalizing to a more typical level of NII that is inherent in our business activities.

Turning to Slide 11. Second quarter expenses excluding notable items increased 6% year-on year. Sequentially, excluding seasonal expenses, second quarter expenses increased just over 1% as we actively managed the expenses and continued our productivity and optimization savings effort, all while carefully investing in strategic elements of the company including Alpha, private markets, technology and operations, automation. On a line-by-line basis year-on year, compensation and employee benefits increased 7%, primarily driven by salary increases associated with the wage inflation and higher headcount attributable primarily to operational staff for growth areas, technology staff insourcing and lower than-expected attrition rates.

Sequentially, however, we have managed headcount to be flat. Information systems and communications expenses increased 3% mainly due to higher technology and infrastructure investments, partially offset by benefits from ongoing optimization efforts, insourcing and credits related to vendor savings initiatives. Transaction processing decreased 2% mainly reflecting lower sub custody costs from vendor credits. Occupancy increased 7% as we relocated our headquarters building temporarily resulting in overlapping cost and other expenses were up 7% mainly reflecting higher professional fees.

Moving to Slide 12. On the left side of the slide, we show the evolution of our CET1 and Tier 1 leverage ratios followed by our capital trends on the right side of the slide. As you can see, we continue to navigate our operating environment with very strong capital levels, which remain well above both our internal targets and regulatory minimums.

As of quarter end, our standardized CET1 ratio of 11.8% was down 30 basis points quarter-on-quarter, largely driven by the continuation of our share repurchases and modestly higher RWA, partially offset by retained earnings. Our LCR for State Street Corporation was flat quarter-on-quarter at 108% and decreased 4 percentage points quarter-on-quarter, but still quite high at 120% for State Street Bank and Trust. We're also very happy with our performance in this year's CCAR with the calculated stress capital buffer well above the 2.5% minimum resulting in a continued preliminary SCB at the floor. This demonstrates we have one of the strongest balance sheets in the industry.

In keeping with our results, in June, we announced the planned 10% increase for our 3Q '23 quarterly common stock dividend subject to board approval and it remains our intention to continue common share repurchases under our current authorization of up to a total of $4.5 billion in 2023 subject to market conditions and other factors. We plan another $1 billion buyback in third quarter. Lastly, we are quite pleased to return roughly $1.3 billion to shareholders in the second quarter '23 consisting of just over $1 billion of common share repurchases and over $200 million in common stock dividends.

Turning to Slide 13, which provides a summary of our second quarter results. While there is certainly still work to do, we're pleased with the durability of our business this quarter against the mixed and divergent backdrop, robust expansion of our front office solutions area and continued momentum in securities finance as well as strong growth in net interest income enabled us to offset some of the headwinds we saw on the other fee areas highlighting the resiliency of the franchise.

Next, I'd like to provide our current thinking regarding our third quarter. At a macro level, while we know that rate expectations have been moving, our rate outlook is broadly in line with the current forwards, which suggest that the Fed, the ECB and BOE will all continue to hike in 3Q to varying degrees. In terms of average equity markets, we currently expect U.S. equity markets to be up about 5% quarter-on-quarter as we're expecting equity markets to remain flat from now to quarter end and we expect international equity markets to be flattish on average.

Regarding fee revenue in 3Q, on a sequential quarter basis, we expect overall fee revenue to be down approximately 1% to 1.5% with servicing fees down 1% to 2% as the below average fee repricing headwinds we saw this past quarter is expected to normalize in 3Q. This will also include a revenue headwind from the previously disclosed client exit. We expect management fees to be up around 0.5% to 1.5%. We expect front office software and data quarter-on-quarter to be down 7% as we do not expect the level of on-premise renewals in 3Q that we saw this quarter.

We expect the other fee revenue line to come in around $30 million to $35 million in 3Q, which is higher than prior years, but down post the accounting change impact in 2Q. Regarding NII, after three double digit sequential increases in NII last year, we now expect NII to decrease 12% to 18% on a sequential quarter basis, driven by lower deposit levels and continued rotation as rate hikes continue into 3Q. Our outlook assumes that average non-interest bearing deposits decline by approximately $5 billion from 2Q to 3Q.

As we look forward to 4Q, we do expect to see some moderation to the amount of deposit rotation as we work through most of our back book and most central banks begin to pause. With that context, we expect that 4Q's NII decline to be much less, somewhere in the range of down 2% to 6% versus 3Q and we expect NII to then stabilize around those levels, but it will depend on market conditions and our expectation is that 4Q declines in non-interest bearing deposits will be smaller as well likely in the down $2 billion to $3 billion range versus 3Q.

Turning to expenses. We remain focused on controlling costs in this environment and we expect to take action in 3Q to bend the cost curve. As such, we expect that expenses will be down 0.5% to 1% on a sequential quarter basis and intend to continue to actively manage expenses. As always, this is on an ex-notables basis and we're keeping an eye on the FDIC assessment, which could be a 3Q notable item. And as I noted previously, given the accounting changes we adopted this quarter, we expect our effective tax rate to be between 21% and 22% for third quarter.

With that, let me hand the call back to Ron.

Ronald P. O'Hanley
Chairman and Chief Executive Officer at State Street

Thanks, Eric. Operator, we can now open the call for questions.

Questions and Answers

Operator

[Operator Instructions] Our first question comes from Brennan Hawken from UBS. Your line is now open.

Brennan Hawken
Analyst at UBS Securities, LLC (U.S.)

Good morning. Thanks for taking my questions. Eric, I'd like to sort of double click on some of the comments that you made about deposits. So you talked about back book pricing in the U.S. dollar book. Does that mean that we should be thinking about the potential for betas to exceed 100% here when that starts to work through? And what kind of magnitude do you think that could reach? And could you also help me understand the euro because when I look in the financial supplement in the breakout by currency, it looks like the euro deposit costs were up about low 40s bps quarter-over-quarter which seems like a beta that's a good deal higher than the 50% you referenced? I know there's some swap noise. So maybe that's what it is, but could you maybe flesh that out a bit for me?

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Brennan, sure. Let me start on the betas that we saw and particularly on the U.S. book, because we're at a period in the interest rate cycle where we've now had multiple 50 basis points moved. It's been a very strong signal to our clients that rates are much, much higher, much more quickly and much more visibly. And at the same time, they now have -- because of the highly inverted yield curve, they have real substitute alternatives that they used to not have in the past, whether it's treasuries, whether it's money market, whether it's repo. There is a range of what they can invest in. And what we've found is that our larger clients and we primarily have large sophisticated clients are quite active and thinking about their alternatives and that has been accelerated by the swiftness of this cycle and the place that we've come to and the speed.

If we think about the U.S. deposit betas, they were In the 80% to 90% range last couple of quarters. This quarter, we saw 100% and yes, we expect next quarter will be well over 100%. And what's driving that is really a catch up in the back book. We have clients coming to us as you'd expect, just like it happens with retail deposits or for retail banks, but we have sophisticated large clients coming back and saying, look, some of our lower transactional rate levels or mid-tier rate levels are something that they'd like us to adjust. And in a way what I think has played out is that while spreads widen for us on the deposit book for some period of time, we're now seeing a convergence back to where they would have been. And that's coming through.

And so what we have in the cycle is actually a number of quarters of below 100% betas, then we get to 100% beta. And then we are going to have a quarter where betas are well above that 100% level and it's really a catch up in the back book and that's what's playing through. It is what is beginning to drive this higher reduction in NII this quarter, the 10% quarter-on-quarter that you saw in my outlook. We are expecting 12% to 18% reduction in NII this coming quarter. And if you peel that apart, some of that is the continued rotation out of non-interest bearing, but some of it and a good part of it is this catch up in the back book that's playing through.

We do think that over time, we've seen the bulk of that and that, that will begin to moderate. And I'm certainly happy to go into that and some of our perspectives as we drill down deeply into our areas, but that's the context. On your other question on euros, we should probably follow up. I think we see betas quarter-on-quarter of about 50%, but we should probably just follow up offline because I think that's deep in the supplement and probably do that with you and the IR team.

Brennan Hawken
Analyst at UBS Securities, LLC (U.S.)

Okay. No problem. And then another question, just quickly on fee revenue. You flagged that the large client migration is going to be part of the outlook. Is the -- how much of that will be impacting the third quarter delta and then how much will be -- how should we be thinking about the timeframe for whatever is left and when that would end up playing out?

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Yeah. I think the broader context as you recall, Brennan, is that we disclosed that large client de-conversion was going to happen over multiple years. We announced it well over a year ago and we described it in our K at about 1.7% of fee revenue. So you can calculate that through. I think in our fourth quarter earnings call in January, I described that we had seen about $20 million on a run rate come out, but I'll -- I can reconfirm that. This In the next quarter, this coming third quarter, we'll see about $20 million come out sequentially. And then in the fourth quarter, there is an another piece of about another $15 million that will come out as well. And then after that, it's several more quarters before we see the later and final instalments, but that's incorporated into our guide.

Brennan Hawken
Analyst at UBS Securities, LLC (U.S.)

Okay. Thanks for taking my questions.

Operator

Your next question comes from Alex Blostein from Goldman Sachs. Please go ahead.

Alexander Blostein
Analyst at Goldman Sachs & Co. (U.S.)

Hey. Good morning guys. So just maybe staying on the deposit question for another minute. Why do you guys think this catch up happening now so sort of late in the cycle? We've obviously been in a higher rate environment for well over a year. So curious if you can provide more color on particular customer segments in the U.S. that's driving that and sort of the discussions around that. And then maybe as you sort of think about the end state for U.S. interest bearing deposits, I think you're at 3.5% or so today. The cumulative beta on that is I think is around 70% relative to the Fed funds rate. Should we think of that approaching between, I don't know, 85%, 90%, kind of how do you think about where that deposit price in the U.S. will stabilize?

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Alex, it's a good question. I mean, we're clearly navigating and living through an interest rate environment that we've not seen in two decades, right? You've got to go back pre-crisis before you see 5% prevailing rates. I think if you also think about how swiftly we've gotten to where we are that's why we created -- we put some of this information back on Page 16 in our materials.

You see this cycle has moved twice as far in terms of the uptick in rates in half the time of the last cycle. And so what plays out as that happens is that we always have clients that as rates move up, they begin discussing with us and engaging with us on what would be appropriate, maybe putting in place multiple balanced years, having discussions about their expectations we negotiate and so forth. And you could imagine large client discussions occur over three, six, sometimes even nine month periods.

And so if you kind of turn back the clock and say, when did some of those discussions occur, some of them early ones may have started second quarter of last year, third quarter of last year, fourth quarter of last year because there was also a perspective among our clients and us for that matter that rates might continue to 5%, but they might have gone to 4% or 3%, which would have put us and our clients in a different position from a NIM and NII and rate setting perspective. So I think it's really the speed of this that has played out on one hand.

And on the other, the inverted yield curve gets clients and the prevalence of the money funds and treasuries and so forth give clients an alternative, right, that's more vivid I'd say than in some of the past cycles. And so that's the kind of client behavior. What we have seen is that if you decompose our book, some of this activity is in the non-interest bearing deposits, which have come down and some of it is in the interest bearing back book because some clients with non-interest bearing deposits come to us and say, look, can you make them now interest bearing at a certain rate. And what we've seen is some real segmentation of that book.

As an example, the average account in non-interest bearing, there's about 30,000 accounts. The average accounts barely over $1 million. What you can do and some of the analytic work we've done is separate out the higher balanced non-interest bearing clients and client accounts for the lower balanced ones. Not surprisingly, the higher balanced accounts are down year-over-year in balanced terms by 70%, right? The large number of smaller accounts are down by 15%. And so this is where -- what we're starting to work through is the, what I'll describe as the burn down. How much of the larger deposits in non-interest bearing have migrated to interest bearing, right, at what rate?

And our perspective is that we are now working through I'll describe as a catch up on the back book. Some of that is non-interest bearing deposits moving into interest bearing and some of that is interest bearing being priced up. And as we think about it, we think that the peak of that catch up will play out in third quarter as we scan the deposit types, the larger, more sophisticated clients versus the smaller clients. And that's why we expect both the catch up to continue into the third quarter and likely peak in the third quarter and then begin to moderate in the fourth quarter and to burn down.

Alexander Blostein
Analyst at Goldman Sachs & Co. (U.S.)

Got it. And then like just the end game in terms of what you ultimately think U.S. deposit cost is going to look like relative to kind of the 3.5% and the Fed funds at 5%?

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

I think it's -- I've not calculated it directly on a cost versus rate basis, on a NIM basis, but I guess, we could back into it if it would be helpful to you. As we think about the long range view of NII on our book, I've given some guidance for 3Q NII, for 4Q NII. I think our instinct is that NII will settle in this $550 million to $600 million range per quarter. And if it's helpful, we can try to calculate that back into a spread on assets or a spread or cost of funds on deposits and follow-up with you.

Alexander Blostein
Analyst at Goldman Sachs & Co. (U.S.)

I got you. That's helpful. Thanks. And my bigger picture question for you guys and to Ron as well as is I think you mentioned productivity efforts in light of the fact that NII has clearly become a bigger headwind over the next several quarters. And you guided servicing fees down in the third quarter. So as you think about measuring those productivities, are you solving for overall pre-tax margin stability? Are you solving for kind of fee margin stability? So like ex NII, how should we think about sort of measuring the productivity efforts in light of a more challenging revenue backdrop?

Ronald P. O'Hanley
Chairman and Chief Executive Officer at State Street

Alex, I mean, where we start with is, I mean, because what you're describing is outcomes of the productivity efforts where we've -- and these are not new. These are ongoing. We really start with how do we create more scale in our business, how do we Increase speed, lower error rates, increase client satisfaction, take out manual interventions. So the measures that we're using would be the traditional productivity measures and this has been underway now for several years. You've been seeing the results in our -- and we've been able to manage cost certainly relative to others. But in terms of how we think about the business going forward, particularly given that NII is no longer a tailwind in terms of an outcome basis, we really have been developing the operating leverage. I think is the key outcome we're managing to, if that's the question you're asking.

Alexander Blostein
Analyst at Goldman Sachs & Co. (U.S.)

Yeah, sort of the operating lines. Got it. All right. Thank you very much.

Ronald P. O'Hanley
Chairman and Chief Executive Officer at State Street

Thanks.

Operator

Your next question comes from Rob Wildhack from Autonomous Research. Your line is now open.

Rob Wildhack
Analyst at Bernstein Autonomous

Good morning, guys. Just trying to ask about the asset side and the securities book quickly. Decent uplift in yield again plus 21 basis points. Can you give us some color or some numbers around the front book, back book difference there and how much repricing can sort of assist NII going forward?

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Rob, it's Eric. There is a good bit of tailwind that comes from the front book, back book. I think this on a kind of year-on-year basis, long rates were quite constructive from a year-on-year NII standpoint. The long rate tailwind year-on year was In the $100 million basis. So it's quite substantial. On a quarter-on-quarter, the long rate tailwind is closer to $15 million, $20 million. So it's not in substantial. And I think as we see some steepness in the curve come back or I guess, I'll describe the lessened version. We've got some -- we've got abilities to leg into duration or curve positions or in some cases some amount of convexity where we find it helpful.

From a rate standpoint, like you said, average rates on the investment portfolio in aggregate was 270 basis points or so. The run off is a good bit below that kind of in the 180 basis point range. So 90 basis points, 100 basis points south of that. And the roll on that occurs is well above that 270 basis point average, it's closer to 410 basis points or more. So you've got a nice tailwind there that's playing through. We also have a tailwind on short rates for international currencies. So that's helpful and then we are -- we continue to invest and think about opportunities cross currency from a basis standpoint, so forth. And we've got some latitude to do that as well given our global balance sheet.

Rob Wildhack
Analyst at Bernstein Autonomous

Thanks, Eric. And then one more, just on the operational deposits. If I use the numbers on the Page 10, operational -- or excuse me, overall deposits are down and operational deposits are down as a percentage of the mix. Conceptually, what would be driving that? I guess, I'm confused as to why operational deposits would be down year-over-year more than non-operational deposits.

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Yeah. I think there's a little bit of -- I look at that data and I think you've got roughly similar movements in operational and non-operational deposits. I think what's happening in this part of the cycle is as deposits or I'll say as cash for our clients is more valuable, right, they are selectively thinking about how much cash do I absolutely must keep in their deposit -- in their custodial accounts. And if you think about it, they make that decision in I think it's more than 100,000 different accounts themselves, right? It's a very large and disparate set of decisions and sub decisions by 100,000 plus fund managers and many, many fund board.

And so they're trying to see, hey, can I edge it down and that's why at this point in the cycle, you see total deposits drift down, but also operational. What they end up needing to trade off and the reason why it will level off over time is that they need a certain amount of deposits, so they don't overdraw. They -- fund managers really hate the overdraw at the end of day. And then there's also a governor where we gauge with our clients on intraday and make sure that they have enough cash to cover their transactional flow and throughput.

But we're just at the period where in the core custody accounts, you've got this drift downwards where they're trying to optimize without going too far and that's what you're seeing. But this is expected. We expect the operational deposits to stay comfortably in this kind of 75% range and it's a part of the kind of custodial operations, which is what makes them so sticky, right. because they need to be there for the very significant daily, hourly and minute by minute transactional flows that we are processing on their behalf so that they aren't over drawing.

Rob Wildhack
Analyst at Bernstein Autonomous

Okay. Thanks, Eric.

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Sure.

Operator

Your next question comes from Glenn Schorr from Evercore. Please go ahead.

Glenn Schorr
Analyst at Evercore ISI

Thanks, Eric. Maybe just the different attempts at the deposit discussion. So I get clients wanting more yields, I have what treasuries do. We all did. But is there any point where the client profitability discussion has teeth, like are they able to move 100% of non-operating deposits that they want, like what discussions you're having with them about doing more with State Street in areas like FX, lending Alpha? But maybe you could update us on what you're doing to try to help impact what seems like you can't impact the deposit side? So is there anything else you can do?

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Yeah. Let me start there, Glenn and I think Ron will play in as well because a number of us have these engaging conversations with clients. I think from a burn down standpoint, let me first take it from that angle is if you think about our $200 billion of deposits, we've got deposits at a number of different price tiers and we have kind of very large sophisticated clients and then kind of that large tail of small and mid sized clients. Of the $200 billion, we think there's about $50 billion that we've been very focused on and continue to be focused on. So about a quarter of our total deposits are with these clients that as we've talked about the last couple of questions, there has been a real catch-up on the back book.

I describe that because of that $50 billion, which is either very low priced or zero priced for our larger and more sophisticated clients where we have these engaging and balance of trade discussions, right? We've got about $25 billion that's behind us where largely we've repriced those deposits. We've had those discussions and some of those have come with some balance of trade improvements or some commitments on stability, on fees and those are behind us. Included in the outlook that I provide beyond the $25 billion and there's another $15 billion that's underway right now, that's included in my third quarter outlook, right? So that gets us to $35 billion, almost $40 billion of the $50 billion.

And then there's a trail that we'll still have. And so I think from a client discussion and negotiation standpoint, the third quarter we expect to be the peak. I think what you'll find is that each of these questions on deposits, certainly rates goes through pricing committee from a balance sheet management standpoint, but very quickly those go to the most senior client executives and all the way up to our C-Suite because those are large. They're very large and that's where we engage. And I think what you'll see over time is some of that will come back through FX revenues and lending revenues and the absence of fee rate reductions in the future, right, on one hand.

And on the other hand, some of what we do here is also work with clients on expanding the range of what we do for them when it comes to managing their cash, right? I think some of the reason you're seeing the uptick in cash with -- and our asset management because some of those clients say, look, I'd like to be in a cash money market sweep until we've been doing that. You see our repo business continues to do very, very well. it's actually an add to -- it's a stabilizer to NII or and add to NII on a year-on-year basis in stabilizing. And it's a stable source of NII income quarter-on-quarter because we've been able to shift some of the client cash to those areas. So there's some offsets as well there, but that's a bit of a start.

Ronald P. O'Hanley
Chairman and Chief Executive Officer at State Street

Yeah. Glenn, what I would add to what Eric said is that the -- if you think about over the last four or five years, our focus on pricing has been -- initially was on fee pricing and kind of addressing, if not combating the fee compression and really working that in an institutional way and in a very high skilled way and escalating those or elevating those decisions way above where they used to be. Deposits for -- up until this rate cycle really weren't part of that because I mean there were times that we would just assume not to have the deposits.

We've now integrated that as Eric implied into that discussion, but also included a full share of wallet analysis and the part of this is recognizing that these institutions are very large. And when you have a pricing discussion and putting that in air quotes, it really depends on what it is. And what we have worked to avoid is to not have a series of unilateral discussions without understanding and making sure that at the highest levels of our clients, they understand the impact of this. And just reminding them that you have the fee you have because of this assumption on other services that we're going to provide you or some assumption on deposits and those conversations are actually starting to work well.

It's cost change of process for us, another change process for us. But more importantly it's changed the way how we're engaging and at what level we're engaging with these clients. And so more to go there, but we also think it's a skill that now developed will help us through various kinds of cycles going forward.

Glenn Schorr
Analyst at Evercore ISI

Thanks for all that color.

Operator

Your next question comes from Steven Chubak from Wolfe Research. Please proceed.

Sharon Leung
Analyst at Wolfe Research

Hi. Good morning. This is actually Sharon Leung filling in for Steven. Just on the deposits, outside of the rotation out of NIB, can you talk about the overall trajectory of total deposits particularly because it looks like more recent liquidity drawdown has come out of our RPE instead of deposits? I just wanted to get your thoughts on the expectations for the trajectory on deposits from here in the context of QT, Treasury issuance, etc.

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Yeah, it's Eric. It's hard to really gauge the deposit changes outright. I think we're a little more focused on the net interest -- I'm sorry, the non-interest bearing deposits where we've signaled another $5 billion likely outflow this coming quarter. That's less of an outflow than in the second quarter. So you're starting to see some of the burn down that I've described. In the external environment, I think from the H8 reports as banks, we've seen about a 2% sequential fall in deposits. For the trust banks, we tend to have more deposits coming in when deposits in the bank system increase and we have somewhat more coming out when deposits in the bank system come out and probably it's just the absolute sophistication of our clients.

So we expect to a downtick in deposits again next quarter, but it's just been a little more focused on the non-interest bearing because that's where it makes a big difference. I think there is always some movement in interest bearing deposits, especially at the higher rate tier because what we're finding increasingly as we get to a little more of this is we expect to get to a time stabilization or at least low more of a balance with our clients. Now what they're going to do is it's heartfelt to move and underlying operating deposits that actually has to cover the hundreds, thousands, in some case of tens of thousands of transactions that are flowing through their particular account, but sometimes move they'll thin margin deposits to a treasury. And so we might lose 10 basis points on something and they'll pickup 10 basis points on treasuries. So there is some of that that's going on and I think in truth that's not as dominant driver of our NII at this point.

Sharon Leung
Analyst at Wolfe Research

Thanks for that. And then as a follow-up, just on some of the updated capital rules that are coming. I understand you probably won't be able to give much color because we haven't seen a proposal yet. But just in terms of like expected ways you might be able to mitigate some of that impact and which businesses might be more impacted for you guys?

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

Yeah. I mean, there is -- obviously we're like many waiting to see more from the rules. The last time we saw Basel III endgame draft from either the U.S. or international regulators was several years back. So I think we expect some higher capital requirements. It's just hard to tell how much. We do think there will be effects on different parts of our businesses. So the new rules will come with an operational capital charge that probably will be relatively hard to influence because we actually want to build our fee driven businesses. And so those I think will just come with the capital requirement that's -- that will be an add.

There'll be some reduction on the lending books. So that will be helpful. And then I think in particular while the fundamental review of the trading book will affect the universal banks potentially in a negative way, for us, the sec [Phonetic] finance business will tend to be a positive, will be in a positive territory where capital requirements will be less. Well, it no longer need to hold capital to indemnify treasuries. So they'll finally become economically more rational in the safer areas, right, as they should be. They should obviously -- capital needs to be held for the riskier activities, but we don't traffic in the riskier areas.

And I think that in some ways that will give us an opportunity to grow those areas that are quite aligned with our client base like sec finance and actually deploy capital more actively. And so I think there will be a mix of impacts we're going to see as it comes through, but I like many we're considering what's the common, we'll react accordingly as it does.

Sharon Leung
Analyst at Wolfe Research

Great. Thank you.

Operator

Your next question comes from Brian Bedell from Deutsche Bank. Please proceed.

Brian Bedell
Analyst at Deutsche Bank Securities

Great. Thanks for taking my question. Ron, I guess, I wanted to come back to your comments on basically the overall revenue per client if I can sort of summarize it that way. Obviously, there are different components of how clients, the asset servicing clients pay for the business and there are many different ways aside from the core fees that they can do that. So as you think about that across the client base, I know you have looked at this more holistically across clients over many, many years. But with the deposit beta going up, is that sort of revenue per client going down or do you think you're able to actually be able to improve the fee rate given that they aren't paying as much on the compensating balances?

Ronald P. O'Hanley
Chairman and Chief Executive Officer at State Street

Brian, it's a good question. And what I was referring to and what you're referring to is what I would call how we think about this tactically client by client, but I also want to come back to the strategic elements of this also. In terms of -- there's no one answer for any particular client, because if you think about it in the core back office business, you've got custody fund accounting. And there is a pricing element to that along typically with associated deposits in more and more instances obviously. A client might have a middle office assignment with us where we're doing -- we are their back office and obviously, going all the way to Alpha. And then there's the question of are we doing FX and securities finance with them. Obviously, FX is a function of are they -- to the advocation to use FX and increasingly most managers do. Securities finance, it's manager by manager. So the reason why I think it's tactical, there's a holistic conversation that needs to occur here and it's important on both sides, ours included to lay out for the client that remember all we did for you over the past few years to get you through whatever fee challenges they were having.

That was predicated on X and X might be an assumed deposit level. It might be on an assumed FX level. X isn't playing out. We need to have a conversation on this and that could in cases lead to more fees or it could -- and the more typical outcome is that -- or hey, we're not doing this with you let's try and do that or even there these set of funds over here that we've never talked about, whatever the Cayman Islands or something and let's see if we can move those. I mean, the deposit situation is a challenge. The conversations it brings are opportunities. And there are real opportunities of senior people intimately involved in these because we don't get a lot of reduce on them. This is at the moment to be doing it. So we think it's a way to -- I mean, the again kind of NII outflow is a significant headwind, but we think it's an opportunity to mitigate some of it.

The strategic side of this, Brian, is I don't want to lose, right, because going back to the acquisition of Charles River, the launch of Alpha, all the development that we've been doing, we're now seeing onboarding happening there. With the typical onboarding journey tends to be the lower fee complicated kind of middle office stuff starts first and then there's follow-on services and it's making sure that we are implementing -- addressing and implementing those follow-on services as fast as possible.

So when we talked earlier and talked about the onboarding, talked about that we were able to move little over $1 trillion into to be onboarded to onboard it, what we'll follow there is other services and increase kind of the revenue per asset per -- I mean, that's the way Alpha works and that's the way Alpha is going to play out, which is why notwithstanding the short-term issues that Eric has raised in terms of we've got this client transition, we're actually quite optimistic over the, what I would call the short to medium-term as we look into 2024 about the revenue picture.

Brian Bedell
Analyst at Deutsche Bank Securities

That's great color. And then maybe just on the expense side, Eric, you mentioned the expense levers. Are they more tactical in nature or do you see -- you have an ability to re-engineer -- continue to re-engineer the cost base. You've already done a great job in reducing costs structurally over the last several years. I don't know if we're like mostly through that and when you do have the cost saves, you reinvest them in growth initiatives or is there and ability to sort of reduce the overall cost structure?

Ronald P. O'Hanley
Chairman and Chief Executive Officer at State Street

Brian, let me address that first and then Eric will come in. So we are definitely not through this. And by that I mean when we started on this journey a couple of years ago, we obviously addressed, call it, what you want the lower hanging fruit, the kinds of things that we could get out without a lot of technology investment, without a lot of reengineering. But there is more to do and we're making a lot of progress on it. We've got people in place now on both the operations reengineering and on the technology side that are working this through.

The way this is played through in our results, you've seen what our expenses have been, but we've also been able to Invest more in the businesses than we otherwise would. And we think that, that journey as more to go and you'll see that and we'll report on that quarter-after-quarter. What we also talked about though is that there is some tactical things that we can do and should do just given that kind of outlook that we've described to you. And those would be less about reengineering and more about how do we think about short-term things like incentives and those things.

Eric Aboaf
Vice Chairman and Chief Financial Officer at State Street

And just to round that out, we've got a pay for performance. So when we have larger -- we deliver larger sales, we'll pay for that. When it's a little lighter as you saw, we will rain that in and that's part of the execution mindset we have. We've also just given some of the evolution on salary increases and that we've all worked through over the last couple quarters over the last year. We also feel like it's time where we have enough staff and so we've put in place a hiring freeze because we need to contain our staffing costs and we need to make sure as we re-engineer, we actually redeploy our folks to say new business areas or to our growth areas and actually pair down others. And the way to do that in a more emphatic way tactically, right, is to be particularly disciplined on hiring and freeze that or just limit it. And so given the short-term performance, we're doing that as well, which gives you a sense for our willingness to bend the cost curve.

Brian Bedell
Analyst at Deutsche Bank Securities

That's great color. Thanks very much, Ron and Eric.

Operator

There are no further questions at this time. I would like to turn the call back over to Ron O'Hanley for closing remarks.

Ronald P. O'Hanley
Chairman and Chief Executive Officer at State Street

Well, thanks, operator, and thanks to all on the call for joining us.

Operator

[Operator Closing Remarks]

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