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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good day, everyone, and welcome to the Northern Trust Corporation Second Quarter 2018 Earnings Conference Call. Today's call is being recorded.
At this time, I would like to turn the call over to Director of Investor Relations, Mark Bette, for opening remarks and introductions. Please go ahead, sir.
Thank you, Jonathan. Good morning, everyone, and welcome to Northern Trust Corporation's Second Quarter 2018 Earnings Conference Call. Joining me on our call this morning are Biff Bowman, our Chief Financial Officer; Aileen Blake, our Controller; and Kelly Lernihan from our Investor Relations team. For those of you who did not receive our second quarter earnings press release and Financial Trends Report via e-mail this morning, they are both available on our website at northerntrust.com. Also on our website, you will find our quarterly earnings review presentation, which we will use to guide today's conference call.
This July 18 call is being webcast live at northerntrust.com. The only authorized rebroadcast of this call is the replay that will be available on our website through August 15. Northern Trust disclaims any continuing accuracy of the information provided in this call after today. Now, for our safe harbor statement. What we say during today's conference call may include forward-looking statements, which are Northern Trust's current estimates and expectations of future events or future results. Actual results, of course, could differ materially from those expressed or implied by these statements because the realization of those results is subject to many risks and uncertainties that are difficult to predict. I urge you to read our 2017 annual report on Form 10-K and other reports filed with the Securities and Exchange Commission for detailed information about factors that could affect actual results. [Operator Instructions].
Thank you again for joining us today. Let me turn the call over to Biff Bowman.
Good morning, everyone. Let me join Mark in welcoming you to our second quarter 2018 earnings conference call. Starting on Page 2 of our quarterly earnings review presentation. This morning, we reported second quarter net income of $390.4 million. Earnings per share were $1.68 and our return on common equity was 16.5%. As noted on the second page of our earnings release, this quarter's results included $6.6 million of severance-related and restructuring charges. The quarter also included $22.1 million in fee revenue and $21.8 million in expense related to our acquisition of UBS Asset Management's fund administration units in Luxembourg and Switzerland, which closed at the beginning of the fourth quarter of 2017. Included in the $21.8 million in expense was $2.6 million relating to integration activity.
Before going through our results in detail, I would like to comment on some macro factors impacting our business during the quarter. Equity markets had a mixed impact for us during the quarter. End-of-period markets were favorable on a year-over-year basis with the S&P 500 and MSCI EAFE Indices increasing 12.2% and 3.3%, respectively. On a sequential basis, both indices increased with the S&P 500 up 2.9% and the EAFE up about 2.5%. Average daily markets for these indices were slightly lower on a sequential basis. As you will recall, some of our fees are also are based on lagged pricing. And in the prior quarter, the S&P 500 was down 1.2% while the EAFE was down 5.1%. The markets were also lower for some of our month-lagged pricing.
Short-term interest rates continued to increase during the quarter driven by a rate hike from the Federal Reserve. Currency rates influenced a translation of non-U.S. currencies to the U.S. dollar and, therefore, impact client assets and certain revenues and expenses. Both the British pound and euro ended the quarter up 2% versus the prior year as compared to the U.S. dollar, favorably impacting revenue, but negatively impacting expense. On a sequential basis, the British pound and euro declined 6% and 5%, respectively, compared to the U.S. dollar. The sequential changes had an unfavorable impact to revenue and a favorable impact to expense.
Let's move to Page 3 and review the financial highlights of the second quarter. Year-over-year, revenue increased 14% with noninterest income up 12% and net interest income up 21%. Expenses increased 6% from last year. The provision for credit losses was $1.5 million versus a credit of $7 million 1 year ago. Net income was 46% higher year-over-year. In the sequential comparison, revenue was up 2% with noninterest income flat and net interest income up 8%. Expenses were essentially flat compared to the prior quarter. Net income was 2% higher sequentially. Return on average common equity was at 16.5% for the quarter, up from 11.6% 1 year ago and up from 16% in the prior quarter.
Assets under custody and administration of $10.7 trillion increased 15% compared to 1 year ago and decreased slightly on a sequential basis. Included in assets under custody/administration is $575 billion relating to the acquisition of UBS Asset Management's fund administration units in Luxembourg and Switzerland.
Assets under custody of $8.1 trillion increased 10% compared to 1 year ago and were flat on a sequential basis. The year-over-year growth was driven by favorable market impacts and new business. On a sequential basis, the benefits from favorable markets and new business were offset by unfavorable moves in currency exchange rates.
Assets under management were $1.1 trillion, up 12% year-over-year and down 1% on a sequential basis. The year-over-year increase was driven by favorable markets and new business flows while, sequentially, the decline was primarily relating to lower end-of-period securities lending collateral levels as well as unfavorable moves in currency exchange rates.
Let's look at the results in greater detail, starting with revenue on Page 4. Second quarter revenue on a fully taxable equivalent basis was $1.5 billion, up 14% from last year and up 2% sequentially. Excluding the acquisition, revenue was up 12% from last year. The favorable translation impact of changes in currency rates benefited year-over-year revenue growth by approximately 0.5%.
Trust, investment and other servicing fees represent the largest component of our revenue and were $943 million in the second quarter, up 11% year-over-year and up 1% from the prior quarter. Excluding the UBS acquisition, fees were up 9% on a year-over-year basis.
Foreign exchange trading income was $79 million in the second quarter, up 58% year-over-year and flat sequentially. The year-over-year increase was primarily due to higher client volumes and increased foreign exchange swap activity in our Treasury department. Volatility, as measured by the G7 Index, was down both on a year-over-year and sequential basis.
Other noninterest income was $71 million in the second quarter, down 13% compared to 1 year ago and down 6% sequentially. The year-over-year decline was primarily due to nonrecurring net hedge gains recognized in the prior year and a decline in the current quarter relating to the valuation of existing swap agreements related to Visa Inc.'s Class B common shares. The Visa swap evaluations were also the key contributor of the sequential decline.
Net interest income, which I will discuss in more detail later, was $423 million in the second quarter, increasing 21% year-over-year and 8% sequentially.
Let's look at the components of our trust and investment fees on Page 5. For our Corporate & Institutional Services business, fees totaled $552 million in the second quarter, up 13% year-over-year and up 1% on a sequential basis. The quarter included $22.1 million in fees relating to the acquisition of UBS Asset Management's fund administration units in Luxembourg and Switzerland. Excluding these fees, C&IS fees were up 9% compared to the prior year. The favorable translation impact of changes in currency rates benefited year-over-year C&IS fees by approximately 1%.
Custody and fund administration fees, the largest component of C&IS fees, were $377 million, up 15% compared to the prior year and up 1% sequentially. This line does include the UBS acquisition-related fees. Excluding these fees, custody and fund administration fees were up 8% compared to the prior year. The year-over-year growth was driven by new business, favorable currency translation and markets. The sequential increase was primarily driven by new business, partially offset by unfavorable currency translation and lower markets.
Assets under custody/administration for C&IS clients were $10.1 trillion at quarter-end, up 16% year-over-year and down 1% sequentially. These results include $575 billion relating to the UBS fund administration acquisition. Year-over-year, excluding the acquisition, the increases primarily reflect favorable markets and new business. Sequentially, the benefit of markets and new business were offset by unfavorable movements in foreign exchange rates. Recall that lagged market values factor into the quarter's fees with both quarter-lagged and month-lagged markets impacting our C&IS custody and fund administration fees.
Investment management fees in C&IS of $113 million in the second quarter were up 14% year-over-year and up 3% sequentially. The year-over-year and sequential growth were both impacted by new business as well as a change to gross revenue presentation for certain clients. Markets had a favorable impact to the year-over-year growth, but had an unfavorable impact on a sequential basis. There was a corresponding increase to third-party advisor cost in outside services expense as a result of the change to gross revenue presentation.
Assets under management for C&IS clients were $862 billion, up 13% year-over-year and down 2% sequentially. Favorable market impacts and net new business were the drivers of the year-over-year growth, while the sequential decline was driven by a lower level of end-of-period securities lending collateral as well as unfavorable movements in foreign exchange rates.
Securities lending fees were $30 million in the second quarter, up 23% year-over-year and 16% sequentially. On a year-over-year basis, higher volumes were partially offset by lower spreads. For the sequential comparison, higher spreads were the primary driver of growth. Securities lending collateral was $174 billion at quarter-end and averaged $184 billion across the quarter. Average collateral levels increased 38% year-over-year and 1% sequentially.
Other fees in C&IS were $32 million in the second quarter, down 10% year-over-year and 7% sequentially. The year-over-year decline reflects lower sub-advisor fees. The income associated with sub-advisor fees has an associated lower expense in outside service category. This decline in sub-advisor fees is consistent with the prior 2 quarters when we discontinued the service offering. The sequential decline was primarily attributable to seasonally higher benefit payment fees in the first quarter of each year.
Moving to our Wealth Management business. Trust, investment and other servicing fees were $391 million in the second quarter, up 8% year-over-year and down 1% sequentially. Within Wealth Management, the Global Family Office business fees increased 11% year-over-year and 1% sequentially. The year-over-year growth was driven by new business and favorable markets while the sequential performance was driven by new business, partially offset by unfavorable markets. Within the regions, the year-over-year growth was driven by favorable markets, higher fees resulting from the adoption of the new revenue recognition standard and new business. Sequential performance was impacted by unfavorable month-lagged markets. Assets under management for Wealth Management clients were $287 billion at quarter-end, up 8% year-over-year and down slightly sequentially.
Moving to Page 6. Net interest income was $423 million in the second quarter, up 21% year-over-year. Earning assets averaged $114 billion in the second quarter, up 4% versus last year. Total deposits averaged $96 billion and were down 1% year-over-year. Interest-bearing deposits increased 1% from 1 year ago to $74 billion. This growth was offset by a 9% decline in noninterest-bearing deposits, which averaged $21 billion during the second quarter. Loan balances averaged $32 billion in the second quarter and were down 5% compared to 1 year ago. The net interest margin was 1.48% in the second quarter and was up 20 basis points from a year ago. The improvement in net interest margin compared to the prior year primarily reflects the impact of higher short-term interest rates, partially offset by a balance sheet mix shift. On a sequential quarter basis, net interest income was up $30 million or 8%. Average earning assets declined 1% sequentially driven by decreases in deposits, partially offset by higher short-term borrowing. On a sequential basis, the net interest margin increased 10 basis points, primarily driven by the benefit of higher short-term interest rates as well as lower premium amortization.
You will recall that premium amortization totaled $19 million in the first quarter as we shifted our remaining life assumption estimation methodology. That change will lead to a more consistent quarterly amount that we expect to be within the $10 million to $12 million range going forward. The prior quarter's results included a onetime $7 million true-up adjustment to align the remaining amortization. The current quarter reflects the new methodology with premium amortization at the lower end of the $10 million to $12 million range.
Looking at the currency mix of our balance sheet for the second quarter, U.S. dollar deposits represented 69% of our total deposits. This compared to 71% 1 year ago and is unchanged from the prior quarter.
Turning to Page 7. Expenses were $997 million in the second quarter and were 6% higher than the prior year and up slightly on a sequential basis. As previously mentioned, the current quarter included $21.8 million in expenses associated with the UBS acquisition. The current quarter also included $6.6 million in expense associated with severance and other charges. For comparison purposes, note that 1 year ago, our results included severance and other charges of $22.8 million while the prior quarter included $8.6 million. Excluding both the UBS acquisition and called out expense items, expense for the current quarter was 6% higher than a year ago. Excluding charges in both the current and prior quarter, expenses was up slightly.
Now, keeping to total noninterest expense, I would like to break down the year-over-year growth further. Starting with the adjusted 6% year-over-year increase, approximately 0.5 point of growth was from the unfavorable translation impact of changes in currency rates, primarily the British pound and the euro. Excluding currency impact therefore, our year-over-year expense growth rate was approximately 5.5%.
With respect to the remaining increase in year-over-year expense growth, the following items were key drivers within the category, compensation was higher driven by increased incentive compensation and this year's base pay adjustments, which were effective in April. The impact of staff growth on salaries was more than offset by staff actions and our ongoing location strategy efforts. Benefits were higher primarily due to an increase in retirement plan expenses, medical cost and higher payroll tax withholding compared to the prior year. Outside service costs were higher, driven primarily by higher third-party advisor fees, sub-custodian costs and technical services, partially offset by lower consulting and sub-advisor costs.
There was a corresponding increase to trust, investment and servicing fees as a result of the higher third-party advisor fees due to the change to gross revenue presentation. Equipment and software expense was up year-over-year due to higher software amortization costs. Occupancy-related costs were higher compared to the prior year, primarily due to accelerated depreciation related to a previously announced facility exit in one of our Chicago locations. Other operating expenses were lower than the prior year, primarily driven by a lower level of charges associated with accounting -- account servicing activities, lower FDIC costs and lower staff relocation expense, partially offset by higher business promotion costs.
Shifting to the sequential expense view. Excluding the expense charges in both the current and prior quarter, expenses were up slightly. Compensation expense declined sequentially primarily reflecting lower expenses related to long-term performance-based incentive compensation resulting from higher charges recorded in the prior quarter associated with incentive grants to retirement-eligible employees. This quarter's compensation included $11 million in expense associated with retirement-eligible staff versus $32 million in the prior quarter. Partially offsetting the decline from equity-based compensation were higher accruals for cash-based incentives and the impact of base pay adjustments, which were effective April 1. The impact of the base pay adjustments on salaries was partially offset by staff actions and our ongoing location strategy efforts.
Outside service costs were up sequentially primarily relating to higher levels of third-party advisor fees, technical service, consulting cost and sub-custody expense. Equipment and software expenses were higher sequentially primarily due to increased software amortization and software support costs. Other operating expense increased from the prior period primarily due to higher business promotional spend and staff-related costs, partially offset by lower FDIC and other miscellaneous expenses within the category.
Staff levels increased approximately 4% year-over-year and less than 1% sequentially. Approximately 1/2 of the year-over-year staff growth was the impact of the UBS acquisition. The remainder of the growth was all attributable to staff increases in lower-cost locations which include India, Manila, Limerick, Ireland and Tempe, Arizona, partially offset by reductions in our higher-cost locations.
Turning to Page 8. As we have discussed on previous calls, through our Value for Spend initiative, we are realigning our expense base with the goal of realizing $250 million in expense run rate savings by 2020. Concurrently, we are betting a sustainable expense management approach. We expect these efforts to slow our expense growth to be more closely aligned with our organic fee growth. Our second quarter results reflect approximately $23 million in expense savings, reducing the year-over-year expense growth rate by approximately 2.5 points. This would equate to approximately $92 million on an annualized basis against the $250 million goal.
I'd like to highlight a few examples of our progress to-date for you. We continue enhancing productivity by leveraging automation technologies such as robotics to increase efficiency of existing processes within our fund accounting and transfer agency businesses and we have optimized the organization of technology and operations to streamline processes and decision-making, enhance productivity and more closely align these functions within our clients' needs. We continue to cultivate a healthy pipeline of opportunities.
Turning to Page 9. A key focus has been on sustainably enhancing profitability and returns. This slide reflects the progress we have made in recent years to improve the expense-to-fee ratio, pretax margin and, ultimately, our return on equity. The ratio of expenses to fees is a particularly important measure of our progress as it addresses what we can most directly control. Reducing this measure from where it was previously, as high as 131% in 2011, to the levels we see today is a key contributor to the improvement in our pretax margin and, ultimately, our return on equity.
Turning to Page 10. Our capital ratios remained strong with Common Equity Tier 1 ratio of 13.2% under the advanced approach and 12.4% under the standardized approach. The supplementary leverage ratio of the corporation was 6.8% and at the bank was 6.2%, both of which exceed the 3% requirement to become -- that became applicable to Northern Trust effective at the start of the year. With respect to the liquidity coverage ratio, Northern Trust is above the 100% minimum requirement that became effective at the start of 2017. As Northern Trust progresses through fully phased-in Basel III implementation, there could be additional enhancements to our models and further guidance from the regulators on the implementation of the final rule, which could change the calculation of our regulatory ratios under the final Basel III rules.
In the second quarter, we repurchased 1.8 million shares of common stock at a cost of $191 million. As we announced in June, our 2018 capital plan received no objection from the Federal Reserve. In it, we requested authority to increase our quarterly common dividend 31% to $0.55 per share. Yesterday, our Board of Directors formally approved the planned dividend increase. The capital plan also provides the flexibility to repurchase up to $1 billion of common stock. The timing and amount of shares repurchased will depend on various factors, including but not limited to Northern Trust's business plans, financial performance, other investment opportunities and general market conditions, including share price.
In closing, Northern Trust continued to deliver solid financial results in the quarter, growing earnings per share 50% over the prior year and achieving return on average common equity of 16.5%. Our assets under custody/administration and assets under management were up 15% and 12%, respectively, versus the prior year. Importantly, as we seek to drive profitable growth, we delivered positive operating leverage and positive fee operating leverage both on a year-over-year and a sequential basis. On an organic basis, our fee and expense growth rates were better aligned.
Profitability continues to be strong in each of our businesses. Our Wealth Management business grew pretax income by 16% versus 1 year ago while improving the pretax margin from 39% to 41%. Our C&IS business similarly drove strong year-over-year performance with pretax income growing 41% and the pretax margin improving from 28% to 33%. Both businesses delivered strong year-over-year operating and fee operating leverage.
This year's THE NORTHERN TRUST will again kick off the FedExCup Playoffs August 21 through 26 at Ridgewood Country Club in Paramus, New Jersey. THE NORTHERN TRUST Tournament remains a strategic asset for us as we continue to grow our business in the Northeast and, in particular, the greater New York area. Last year's business promotion expense increased approximately $17 million sequentially in the third quarter and we would expect a similar trend this year.
Thank you again for participating in Northern Trust's second quarter earnings conference call today. Mark and I would be happy to answer your questions. Jonathan, please open the line.
[Operator Instructions]. Our first question comes from Brian Bedell with Deutsche Bank.
Maybe just to start out with the balance sheet and just look at sort of the growth maybe on a year-over-year basis. The deposit levels have come down a little bit on a year-over-year basis. Maybe if you can just talk about sort of what you're seeing on deposit behavior in the Wealth Management segment and -- versus your C&IS segment and think about how we should think about balance sheet growth going forward given you certainly have a lot of capacity -- capital capacity. And then, your use of borrowed funds as well does -- have doubled on a year-over-year basis, so maybe just talk about the strategy behind that as well.
Okay. I'll start with question one around the balance sheet and the growth and I'll focus first on the Wealth Management deposits. We have seen that level come down a bit. I think it's -- there are a couple of factors that we would highlight there.
First is, obviously, we've moved into an increasing rate environment. And those clients, particularly our clients at the higher end of the wealth spectrum, have an array of opportunities to invest their cash. It could be on our balance sheet and we do what we can to provide competitive pricing and opportunity on our balance sheet, but they also may be looking at cash funds and/or other investments to deploy their cash. So when we've seen that -- over the span of a year, we've seen those balances move. Most of those, more than half, about 2/3 have moved somewhere inside of The Northern Trust into either cash funds or other products and capabilities where we've seen those move internally.
The second thing on the deposit side which we see sequentially in the second quarter is we do see some sequential moves for tax purposes and that's -- we've seen that seasonally in the past. So on the Wealth deposits, while we've seen some of that come down on the Wealth side, it's really the deployment of that and, in some cases, that just moved from balance sheet to other funds at The Northern Trust. Some, approximately 1/3 or so as we described it, could have moved to other products somewhere outside of The Northern.
We remain competitive. We track our peer set closely and do what we can to ensure that our pricing remains competitive to attract and pay on those wealth deposits because they're very valuable deposits as you know.
On the institutional side, I would say that those deposit balances can demonstrate a little more volatility based on, A, our growth profile. We grow and they go up, but those are large sophisticated asset owners who may deploy those assets into the market at any time -- an opportune time. A meaningful portion are very operational in nature, but we can see some movement in that from quarter-to-quarter and year-over-year.
The pricing on those, the competitive nature of the pricing on those, we have fewer competitors than we do in the Wealth, but it's a little less transparent. So we monitor and have dialogues with our clients and do what we can to price those deposits appropriately. As you might imagine, some clients are on pre-negotiated rates and some are on standard rate cards. And again, we monitor that closely. We're competitive in the world in deposits and we will be in both spaces and continue to be competitive.
I think, generally, the growth on our balance sheet that we've seen over time has just been the success of our business growth strategy. You've seen high single to low double-digit growth rates in our firm and fees and that generally manifest itself in, over time, a growing balance sheet.
Short-term funds.
And then short-term borrowed funds, the second part of that, I would say what we do -- because of our strong capital levels, we have the ability to do some discretionary leveraging, which does produce incremental net interest income for our shareholders. And given our financial strength and the leverage or lack of leverage constraints that we have as you see in our results, it's allowed us to utilize that. It can have the added benefit, the borrowed funds, of helping the LCR as we manage that so it does add to that. Those borrowed funds where we typically borrow can have the added benefit of helping out on the LCR as well.
That's super helpful. And maybe just a follow-up, just the organic growth, we've had -- obviously had some headwinds on the FX side and the market returns were mixed on a sequential basis, but if we look at the actual AUM in Wealth Management, if you can just talk about your general organic growth in Wealth Management maybe in the second quarter versus, say, to the first quarter and a year-over-year basis?
Yes. I'll start maybe -- well, I'll talk the whole firm first. The organic growth rate, which we fairly consistently have been talking about in fees, has been -- we've talked about in the mid-single digits. Let's call it the 4% to 5% range. We, again, had a quarter where we were in that range, we saw.
Specifically to Wealth, we did see some slowing of the organic growth rate in Wealth from first to second quarter and, again, that was impacted less by gross new business than it was by flows. And the flows, if we think about it, can have things like tax payments in the first quarter when -- early second quarter, excuse me, on tax day and/or deployment of that cash and/or investment in the markets and/or potentially even loan pay downs as second homes or other items have become less tax-attractive. Those combined could create some flow pressures on values and AUM inside of our portfolios, but generally, the gross new business portion of that organic growth continue to be very strong in the business.
Our next question comes from Michael Carrier with Bank of America Merrill Lynch.
Maybe just one more on the net interest revenue outlook. Just how should we be thinking about it for the rest of the year in terms of balance sheet growth given that it doesn't seem like maybe there's a lot of demand, but you're able to use the short-term funding? And then, if we do get another rate hike, what's the expectations in terms of that flowing through either to the NIM?
Yes. So we obviously don't give guidance, but if I look at the impacts of a future hike, what I would say is the first thing we've got to look at is the asset side of the balance sheet for us. And I would say you can see that we remain asset-sensitive. We are heavily impacted by short-term rates, 1-month LIBOR primarily and three months LIBOR moving. So if those move up with a rate hike, which they would likely, the asset sensitivity remains in the balance sheet as you can see via a relatively low duration. So I think the asset side still has sensitivity to rate moves.
Then we go to the important factor, which is what happens with the liability pricing in that. And what I would just say there is we're doing our best to be both disciplined in our pricing on the liability side, but we also need to be competitive. So we have to be both. And you have a view on what the competition is doing and others do. We monitor them as well and we remain competitive. It's important for us to be competitive in that landscape. I think we want to be a disciplined firm. I think you can see that in our betas and others, but we also have to be competitive. Our clients expect and deserve competitive rates and we will be mindful of the market when we do that.
So the betas haven't reached one. So they are expensive to at least the NIM. And then the second part of your question was on the balance sheet side. That's a reflection of our new business opportunities and some of the nuances of where our clients are either deploying cash or elsewhere. So I'm certainly not going to be able to give you a projection on that, but I did give you some of our thinking on how we think the asset and liability side could move.
Got it, okay. And just as a follow-up, on the FX -- on the trading income, you mentioned the swaps again this quarter. Just, I don't know if you mentioned the magnitude, but just wanted to get some color because we saw the activity. But maybe like -- I know it's volatile [indiscernible] lumpy in the quarter.
Yes. So you're right. So if we looked at our FX total of $78 million, $79 million, approximately $18 million of that was from the treasury swap. But remember, as we said last quarter -- and that was largely swapping dollars into euros, and that drove a positive FX variance. As you might imagine, that actually hurt or suppressed net interest income to the tune of about $14 million. So the trade produced $18 million of FX at the expense, if you will, of $14 million of NII. That trade, if you look at sort of a euro-dollar swap kind of curve or something like that, you can see that spread has narrowed some. So it is possible that in the quarter, if that maintains, you could see some redistribution between FX, that $18 million in NII in the quarter. We'll provide better color later in the quarter as we see that unfold. So I would say that's generally what we've seen on the FX trade. Our core FX supporting our clients was actually up 20% year-over-year when we look at what we would consider our traditional FX support of our asset servicing business as well. So good trends in both of those components.
Our next question comes from Alex Blostein with Goldman Sachs.
So a question on expenses for you guys. So I heard your $92 million of annualized kind of run rate expenses [indiscernible] $250 million in 2Q. I think that's up from $55 million last quarter. So I guess, can you walk us through the pace of realizations for the remaining of this year and how we should be thinking about it for 2019? And I guess, secondly, as I think about it, I guess, sort of the jumping off point for expenses, backing out severance, it looks like you guys are around $990 million for this quarter. Other than the Northern Open, is there anything else we need to be mindful of as we think about 3Q expenses specifically?
So I'll take those in two parts, right? The first is on Value for Spend and the run rate. Alex, the answer on that is we continue to have a really strong pipeline of opportunities to get after, and we're getting after it as fast as we can. So the pacing of that, you did see some acceleration in there. And the team here remains focused on getting after it as fast as we can. I know we have talked about it being fairly evenly distributed over three years. We're going as fast as we can. And if we exceed that expectation, we're happy. But we also are getting after some of the things that have the quickest and -- I won't say easy because none of them were easy, but the fastest return. But we continue to look at an array of opportunities. So we think and are committed to that $250 million. So can't give you much more on that front. In terms of the third quarter, we gave you the Northern Trust Open. I would say the only other item in the quarter is we have actually some modest decline in equity incentives from, I think, we had 11 in this quarter, Mark...
That's right.
And then we should see some modest decline in the equity incentives as they ratchet down during the course of the year. I'd say other than that, it would be nothing that you wouldn't jump off. And your run rate of jumping off at $991 million was $990 million, $991 million is reasonable.
Got it, great. And then just as a quick follow-up on cost but slightly on the cost. Credit, not a huge deal, obviously, but we've seen you guys put up a negative provision for many quarters. The first time it turned positive. Obviously, credit remains quite benign. So maybe just kind of what's going on there would be helpful.
Yes. So we had one credit that we had a specific reserve for that drove it, one individual credit. So we would not see any trends unique, and credit quality remains at a very strong and positive levels. And that's about all I could say that we have very, very strong credit quality right now in the cycle.
Our next question comes from Ken Usdin with Jefferies.
Just one more question on the expense growth rate. So you showed on the slide 6% year-over-year growth, and I believe that would also be inclusive of the change in accounting presentation.
Yes.
So I'm just trying to understand if you adjust for that change in FX translation what you really saw as the underlying core growth rate in expenses on a year-over-year basis?
Yes. Ken, let me walk you through that real quick, if I could. I think that's a good question. If we took the charges out of the second quarter from last year and the charges out of this quarter, we think the expense growth rate would have been closer to 8%. I would take two points of that out for UBS is attributable to UBS. Currency is about 0.5 point. And then revenue recognition or net to gross presentation, however you want to call it, is about another point of that. And that point is also offset by some of our...
On the fee side...
No, while it's offset on the fee side, it's what we got out of in our GFS business.
Subadvisory.
Excuse me, subadvisory, thank you. So if you do that walk, Ken, you go from 8% down to about 4.5% as a core expense growth rate in our expenses. So that [indiscernible] rev rec or subadvisory, yes.
Okay, got it. And that's all right. And then that's a -- well, we'll see what happens going forward to your points about the comp comparisons, but Northern Trust and the comps [indiscernible] those are year-over-year things that were already in there, right? So it's really just about how the business grows in terms of that rate of growth from here?
Yes.
That's right.
That's right.
Okay, perfect. Great. And then just a question on just core business and wins and such. Obviously, the markets were down, so -- and it looked like the global piece was more of a negative in terms of the AUC, unless I look at the global assets under custody. Can you just talk us through just what type of win quarter it was in terms of new assets put on? And any updates on your just kind of underlying growth pipeline will be great.
Yes, we continue across both businesses to see a strong new business opportunities, and we highlight some of those with press releases, very strong. In the AUC piece, particularly the sequential comparator, the currency was really a pretty meaningful driver of what was flattish sequential. It was, I think, about two points of a currency impact. As you remember, we have a fairly significant global custody asset mix of our AUC, so we have a lot in other currencies. I think about 65% is in dollars but 35% isn't. And so the currency impact was pretty meaningful. So I know you asked about the new business trends, but in the AUC specifically, I would say that the currency was a meaningful driver. It more than offset market and new business uplifts in the quarter. We continue to have a significant pipelines and healthy, healthy growth opportunities in both businesses.
Our next question comes from Marty Mosby with Vining Sparks.
So you know where I'm heading. If you look at your NII number, it only represents 28% of your revenues, but it actually generates about 82% of your bottom line pretax profit. So it's a pretty important portion of what you manage. We've got the data now that show that look, interest-bearing deposits rates haven't increased precipitously. You may get a little bit more as we think you will get elasticity from here forward, so you'll get that low curve. DDAs have been relatively sticky, so there's not like they're running off in big portions. And yet, we still have $25 billion sitting in cash, and we got a duration on our securities portfolio that's probably about a year and a half. So at some point in the cycle, we need to defend against the next cycle, which is when rates come down and which that 82% of our profits get squeezed. So I just wanted to kind of put that back out there again and see how you're thinking about that now [indiscernible] what timing of that you might be looking at.
Yes, thank you, Marty. Well, what I would say is all of the points you made are factors that we contemplate in our ALCO committee. And we meet regularly, and we think about duration management. We think about liquidity management. We think about credit and quality in the portfolio. We have active and regular dialogues. And I'm certainly mindful of your views on those, and we continue to have active debates about what we should be doing to that portion of the balance sheet on a regular basis. So appreciate your comments.
And you've been continuing to roll the expenses relative to your core business -- core fees down. So where you were -- expenses are still 6% higher, but that is significantly better than what we've seen in the past. The efforts that you have should continue to push that ratio closer to 100%, I would expect, over the next couple of years. So that's the other piece of the initiative that really does create a lot of leverage to the income statement.
Yes. We're internally very focused on that measure because we think the majority of our expenses -- the majority, not all, but the majority of our expenses are tied to generating trust fees. So we think it's a very prudent measure. It's not a perfect measure, but it's a very prudent pressure to look at operating leverage in our business and performance leverage in our business, and we continue to drive that down. If you did the calculation in our Wealth Management business, you will see it's actually sub that 100%, and you see that manifest in 41% pretax margin in that business. But there's still opportunity left in there, and we talked about that a little bit in our Value for Spend options, our opportunities, and we're committed to continue to focus on that and drive it to the best levels we can.
That's been impressive improvement, so appreciate that. And that other leverage piece we have on the balance sheet with 3% yields out there in the marketplace, there's a lot of income that can still be kind of garnered through this process and yet still derisk and not risk the balance sheet anymore.
Thank you, Marty.
Our next question comes from Brennan Hawken with UBS.
Apologize if you hit on this before. I don't think you did. Any update on the -- I think you've previously called it the $5 billion to $6 billion of nonoperating balances [indiscernible] interest-bearing deposits.
Yes, and we haven't commented on it. We continue to have regular dialogues with those because those are typically large clients that are associated with our GFS business, our Global Fund Services business. And we have regular dialogues. It has remained at that level for 4 to 5 quarters now, so we think that at least a pretty meaningful portion of that is there for operational or other liquidity needs. We haven't seen that move. It could. We talked about that. So I can't predict. But in our regular dialogues with our relationship people and the owners of those balances, they continue to seem to need them there for liquidity and/or other strategic investment purposes. So they're ready to go. So we've -- we haven't seen that change now for 4 quarters.
Okay, that's encouraging. And then thinking about -- I believe you said that 69% or so of the deposits are not in U.S. dollar. Are you still mostly pound oriented? Can you remind us of that mix? And then how should we think about -- from what we hear, expectations are pretty good for an August rate hike from the BOE. How should we think about that? How should we think about expectations for beta given that the Bank of England is still in very much the early stages of raising rates?
Yes. So to clarify, 69% of our deposits are in dollars. I think you said aren't...
Yes, sorry, sorry. I got it backwards.
Yes. 69% are in dollars. So the 31% that aren't, I think, pound is our largest next balance 12%...
About 12%.
Of ours, and then euro would be next. But to your specific question then around the BOE rate rise, look, our clients that are -- that we have that have pound balances, we would benefit from another hike from the BOE. Our betas are not one there. Again, as I said earlier, we have clients in all currencies that are on what I would say more negotiated rates, and then we've got some that are on standard rate cards. The standard rate card's betas would be more preestablished. And then the majority that are on select rates, we would -- are on standard rates, excuse me, would be able to affect the beta through the cycle. Still coming off of a pretty low base. So if it behaves like it has in the U.S., there should be some opportunity there for expansion.
Our next question comes from Geoffrey Elliott with Autonomous Research.
You've now have been above the top end of the 10% to 15% ROE range for a couple of quarters. Can you give us an update on what you're thinking there given lower taxes? And we seem to be in a bit of a higher rate environment when you were kind of down at the lower end or even below the lower end of the range a few years ago.
Yes, so we don't have any change or nothing that we would comment on as of today. But we continue to look at this, and we'll keep you posted. I think, the one item that you pointed out in there that we look at is a truly secular change is if the tax rate is changed. So that will certainly be one of the important factors as we consider that range that we will contemplate. And a quick example would be, in this quarter, you can do this calculation, but effectively, it added about 1.7 points of ROE. So ex that, we would have been at the very high end of our existing 10% to 15% range. But as I said, we'll keep you posted as we look at that.
What's kind of held you back from changing that sooner? I guess, we're kind of 7 months post tax reform now, and the tax impact at least is fairly mechanical. So what stops you coming straight out and adding 1.7 points or whatever the number is to that range?
I think, Geoff, your comment assumes that all of those dollars flow through. The competitive landscape didn't change. The people didn't choose to price that away. We're six months into the tax reform here [indiscernible] perspective. And our view is we certainly wanted to observe how the tax reform was absorbed into the economy and to our clients and to our P&L before we raise to make those changes because you don't know exactly how it would end up flowing through financial statements until you looked at the competitive landscape. We're taking that time to observe that, absorb it and observe it, and then have the right strategic dialogues with all of our key constituents.
Our next question comes from Vivek Juneja with JPMorgan.
Couple of questions. So I want to go back to the short-term borrowings leverage question. I guess, try and look -- try a different tack. How much more leverage can you add here? How much more room do you have?
Well, that's a complicated question in this sense as some of that borrowing that we do is, I will say, dry powder that we want available for liquidity purposes and others. So we don't always necessarily want to tap that fully because we like it available for other reasons in the marketplace. The second is as you might imagine, that is -- it has somewhat constrained the NIM. It is producing incremental NII, which I know is valuable. But we do look at the overall balance of that and then we do also look at leverage ratio and others, which we're not terribly tight on, as you say, but we do evaluate all those factors when we look at the amount of discretionary leveraging we choose to do.
And would you say you still can bump this up a little bit further?
Our ratios would allow it, but we have to put it into the calculus that I just gave you where we're looking a whole series of factors, like liquidity and other items. So we can move it around and contemplate that from quarter-to-quarter.
Okay. It's completely a different question. Technology investments, can you give us an update on where you are in that trajectory of investing? Because I know you've been trying to automate and digitize. And where are you? And any color, any details on that?
Yes. So we continue to have significant investment in the business. This is a technologically intensive and capital intensive from that perspective business. I think we published in our K. We spent somewhere around $2.5 billion on both CapEx and expenditure on a rolling 3-year kind of program. So I think we've given about $2.5 billion from '17 through '19 that we would contemplate in terms of technology spending and/or expense associated with that. And that's meaningful against our revenue base. It's meaningful against the competitive landscape in which we operate. And we think that our technology efforts are certainly competitive and we hope, in many cases, leading the competition. But I know it's a primary focus and discussion point amongst our board and our management team.
Our next question comes from Mike Mayo with Wells Fargo Securities.
I just wanted to confirm one more time the way you look at core revenue growth and core expense growth year-over-year. What I think I heard you say is that a core -- and we can get rid of the accounting impact, the FX, the UBS deal. Core revenues were up 12% year-over-year and core expense was up 4% year-over-year. Is that right? Or do you want to change my assumption there?
No, you're pretty close. I would say, Mike, we would probably look at core revenue was up if I exclude any year-over-year currency or the acquisition would be up mid-11%, so 11% -- a little over 11%. And you're right on, on expenses. So that's what we would look at core revenue and core expenses sort of 11% and 4.5%, something like that.
All right, so I think you're going to win the award for greatest operating leverage for the quarter, measured that way. But how should we think about that going ahead? Should we think of some of these expense being lumpy? Or you don't get 700 basis points of positive operating leverage 1 quarter with -- I assume, without having not as good of operating leverage in future quarters. You did mention the $17 million of marketing in the third quarter, so I guess, that will impact that though, I guess, you still have that comp year-over-year. So I mean, what kind of operating leverage are you looking for, for this year and on a go-forward basis?
Well, there's obviously both the revenue and expense component to that. So it depends on how markets perform and rate lifts and others. But I know that we're focused on driving operating leverage into the franchise and particularly fee operating leverage into the franchise. So if we look at that, our fees grew somewhere adjusted around 7% if we stripped out all of that noise versus that 4.5%. So we still were driving 2.5 to 3 points of fee leverage. That is a very important focus. And then the second thing I would say is -- Mike is, we're very focused on organic leverage. So the rate we can organically grow our fees versus the rate that our expenses grow organically. So if our expense growth rate was 4.5%, some of those were inorganic factors in there. So that growth rate would've been lower. And if our fees were, as I've told you, somewhere in that 4% to 5% range, we're getting to that organic fee leverage -- I think we wrote in the script as well. So organic fee leverage, fee operating leverage and total operating leverage remain commonly held discussions around here in terms of focus.
And to be clear, so that 7% year-over-year fee growth excludes the UBS impact? And if it doesn't, what is the growth year-over-year excluding UBS?
So excluded.
That does exclude it. And excluded -- I took currency and I took the acquisition out of our fee numbers, and that's where you get it.
And how is UBS doing in terms of retention, cross-sell, kind of the metrics that you guys had internally? Is it above, in line, below?
Yes, it's exceeded expectations to date in terms of revenue growth and performance.
Yes. And the one thing, Mike, I would add is the AUA related to the UBS that we called out was $575 billion, which is down sequentially from $607 million, and that was really a currency factor there. So not a lost business this year or anything like that. So everything is going along really well.
Substantially from the acquisition though.
Yes.
Our next question comes from Gerard Cassidy with RBC.
Sticking with the comments on M&A, can you give us your outlook for opportunities? Obviously, the UBS transaction sounds like it's going well. You guys have done a number of deals over the years. Is there anything that you see in the horizon that could look interesting to you, whether it's in a different product line or just enhances an existing product line?
If you look at some announcements that were public, we closed, what I will call, the CTEC technology, Omnium technology acquisition in the quarter. We talked about an investment in Lumint and others. What we've done is found opportunities, I think, to partner with or work aside or acquire some products and capabilities to get to market quicker and to, I think, create some speed and solutions for our clients. So rather than a large acquisition, that's where we have over the last twos quarters focused more of our energy and some of our capital is those types of moves. We obviously stay attuned to the market. And should opportunities come up, we pay attention and we get the people that call on us that give us those advices, but I'd say what you've seen in the public domain is more of a targeted smaller acquisitions or investments in products and capabilities or technologies that I think help can move us forward.
Very good. And then just going into the organic side, over the years, you've obviously grown organically the private wealth business by expanding into different geographies outside the home base in Chicago. Can you give us an update on what your thinking over the next 12 to 18 months of potential organic expansion of the private wealth, personal wealth business geographically?
Yes, so we are absolutely continuing to look at anywhere where we -- there's a high opportunity set for wealth markets there, pockets along the East Coast where we're -- there's high net worth opportunities where we're underpenetrated. What I would highlight for you though in that strategy is that we don't always need to have a physical location there. There are some markets where virtual teams have covered that, and we've had tremendous success in certain cities where we actually cover them with virtual teams and have been successful with that approach. So we feel pretty good about our coverage in the wealth space, but we will continue to look at those opportunities if we have a geographical gap. But I think we're pretty excited with our model to be able to close that.
Our next question comes from Brian Kleinhanzl with KBW.
Just real quick on the new business wins. I know you don't want to quantify the numbers. But can you at least directionally say if it's up or down quarter-on-quarter?
Our new -- we don't -- I mean on a year-over-year basis, I would say yes. I mean, I don't know especially when you think about the institutional business quarter-on-quarter. There was a positive impact on the fees, I would say. The actual new business that's recognized can be lumpy from quarter-to-quarter. But there was sequential benefits as well as year-over-year benefits from new business.
And just as you look out for the organic revenue growth, I mean, when you look out at the asset servicing, what's the driver of this organic growth that you're seeing? Is it coming from client switching from other providers? Is it really just the new phase of outsourcing you're seeing picking up? I mean, can you help us give a better understanding of where it's coming from?
Yes, sure. Good question. I would say, we have seen a lot of it in our institutional side has been with asset servicing -- excuse me, asset manager clients providing asset servicing to asset manager clients. And to your point, some of that has been their drive to look at their cost structures in a difficult environment. And so opportunities for middle, back office and/or other places where they can outsource or partner with somebody has driven some of that. Look, many of -- if you're with the right managers, they also have growth. So we get some distributed growth as well. I think that's particularly true in our hedge fund services space, where we've had the opportunity and good fortune to partner with some partners, some clients who've been very successful in growing their own books and therefore our organic growth goes with them as they either launch new funds or grow their AUM themselves. And then geographies, I would add.
We've had great growth as we talked about in Australia, but we've had great growth in other regions of the world. The Netherlands has had terrific success. We opened an office in Seoul, South Korea, and other parts of the world. So geographical, it's some distributed growth by partnering with the right folks. And then the macroeconomic environment is causing some folks to look at outsourcing and/or other opportunities. And that's driven a lot of our C&IS growth. You're right, in the more traditional pension space, that's more of a takeaway game. We do very well in that takeaway game, but there's probably not a lot of new defined benefit plans being open for instance, so it's really a market share kind of gain there, which we continue to do well in.
Ladies and gentlemen, this concludes today's teleconference. You may now disconnect.