Bank Of New York Mellon Corp (BK) — Q3 2022 Earnings Call Transcript

Thank you, operator. Good morning, everyone, and welcome to our third quarter 2022 earnings call. As always, we will reference our financial highlights presentation, which can be found on the Investor Relations page of our website at bnymellon.com. I'm joined by Robin Vince, President and Chief Executive Officer; and Emily Portney, our CFO. Robin will make introductory remarks, and Emily will then take you through the earnings presentation. Following their prepared remarks, there will be a Q&A session. Before we begin, please note that our remarks include forward-looking statements and non-GAAP measures. Information about these statements and non-GAAP measures are available in the earnings press release, financial supplement, and financial highlights presentation, all available on the Investor Relations page of our website. Forward-looking statements made on this call speak only as of today, October 17, 2022, and will not be updated. With that, I will turn it over to Robin.

Thank you, Marius, and thank you, everyone, for joining us this morning. Having formally taken over as CEO a little over a month ago, it is a tremendous honor to usher in a new chapter for this great institution. After spending a significant portion of the past few months engaging with clients, regulators, employees, and other business leaders, I'm excited about our exceptional client franchise, our central role in global financial markets, and the opportunity that lies ahead. Now, as a new CEO and considering the current environment and it being the time of year when budgets and strategic plans are helpfully debated and brought together, naturally, I'm using this opportunity to take a particularly close look at our priorities. While I'm still reviewing everything, it's apparent to me that while we've made good progress in a number of areas over the last couple of years, there are also clearly opportunities to further enhance BNY Mellon's performance for our clients and shareholders alike. First, I see exciting growth opportunities and numerous examples of innovation like Pershing X, the reimagining of our collateral and custody platforms, digital assets, and real-time payments that we need to continue to invest in and execute on with great discipline and urgency. Second, we're not just reviewing the top line. We are also closely examining our cost base and margins. I'm questioning how we do things, and I'm of the view that our margins should be better in some areas. For example, we talked to you about improving our pretax margin in security services to 30% over the medium term. More broadly, we are also going to be looking for efficiency opportunities as we drive our operating model transformation and will be very determined to see them through. And third, while we have been providing more holistic solutions to clients, we believe that our unique collection of businesses is better placed to deliver, and we have the potential to do a lot more. I touched on this in the last earnings call, but I continue to believe that the opportunity to deliver the whole firm through a more unified One BNY Mellon is meaningful. As we continue to work through and bottom out all of these opportunities in the coming months, we will be regularly providing you with progress updates along the way. Moving on to the quarter, I'll start with some broader perspectives before I run through a few financial highlights and then I'll turn it over to Emily to review our financial results in more detail. As you are aware, during the quarter, we continued to see high levels of volatility across both global equity and fixed income markets persistently high inflation, driving increased expectations for significant rapid rate increases by central banks in developed countries, a strengthening U.S. dollar, and a complex geopolitical landscape. We also began to see some government intervention, for example, Japan stepping into the FX market to manage their currency. This was particularly on display in the UK, where in the last few weeks, there has been extraordinary volatility in the gilt market as a result of the UK government's spending and taxation plans. This led to a series of actions by the Bank of England, including delaying their QT plans, announcing a gilt purchase program, and a liquidity facility aimed at stabilizing the market. Our business model as a core provider touching so much of the financial system gives us a terrific vantage point on what's going on in markets. For example, our data shows that building up throughout the quarter and heading into quarter end, the market was extremely short euros to levels not seen in quite a few years. We've seen international holders selling U.S. treasuries, and more broadly, it's clear that market liquidity continues to be challenged in some markets, more so than in others. As we sit here today, most markets have continued to function in a relatively orderly fashion, trades are settling, and failed and overdrafts are at fairly normal levels. But clearly, risks are elevated, and the system feels more fragile than it was a few months ago. While the environment is quite uncertain, our platform of trust and innovation is very much in demand by our clients. As their cost pressures rise, we are seeing a lot of interest in engaging with us to review operating models. The scale of our platforms should allow us to lower operating costs for our clients, enabling them to focus on their core strengths. Turning to our performance in the quarter and referring to Page 2 of our financial highlights presentation. We reported EPS of $0.39 on $4.3 billion of revenue and a return on tangible common equity of 7%. These results were impacted by a goodwill impairment charge that Emily will discuss in more detail shortly. Excluding the impact of notable items, EPS was $1.21, up 11% year-over-year, and our return on tangible common equity was 22%. Revenue grew 6% year-over-year, a testament to the diversity and resiliency of our business model. This performance reflected the benefit of higher interest rates as well as continued strength in client volumes and balances across our Securities Services and Market and Wealth Services segments. While investment in Wealth Management was naturally more affected by the continued decline in global market values, particularly in Investment Management, the business delivered positive net inflows in the quarter and continued to deliver solid investment performance for our clients. Touching on a few business highlights, Asset Servicing continued to deliver solid top-line results, and our sales momentum remains strong with wins and mandates up from a strong 2021, and yet to be installed AUCA meaningfully higher than last quarter. In ETFs, we continue to see strong net inflows, and the total number of funds serviced is up almost 10% from the beginning of the year. We're also seeing strong momentum and traction in the alt space and have an active pipeline across credit, private equity, and real estate. We were pleased to announce that Aviva Investors, a large European-based global asset manager, recently appointed us to provide a fully integrated operating model for certain front office support services as well as middle and back office activities, allowing them to focus on delivering an exceptional client experience powered, in no small part, by the scale and capabilities of our platform. Finally, following the formation of our digital assets unit in 2021, we are now live with our digital asset custody platform in the U.S. We continue to see significant institutional demand for resilient, scalable financial infrastructure built to accommodate both traditional and digital assets. We see digital asset custody as an important foundational capability for the future of financial markets as blockchain technology allows for tokenization of all kinds of assets and currencies. Just to be clear, we did not invest in this space just for the purpose of custodying crypto. We see this as the beginning of a much broader journey. Pershing had a solid and resilient quarter, benefiting from its diverse revenue mix that includes not only market-based fees but also transaction fees, balance-based fees, subscription fees, and net interest revenue with many of these income streams playing well in the current environment. We also gathered a strong $45 billion of net new assets in the quarter, and the pipeline remains healthy, boding well for flows in the months ahead. Pershing X reached another milestone through an equity investment and partnership with Conquest Planning, a fintech, which uses AI and powerful analytics tools to help advisers improve their efficiency and create highly customizable financial plans for their clients. X's minimum viable product remains on track to launch in the fourth quarter. Our client engagement, together with the product design input, is helping us to accelerate and enhance the delivery of an exciting end-to-end digital experience for advisers. Clearance and Collateral Management delivered strong growth on the back of higher U.S. clearance volumes as market volatility continues to drive secondary trading activity in U.S. treasuries. In fact, in September, settlement volumes were the highest they've been since March of 2020. We also saw growth in margin-related services, reflecting the industry-leading work that the team is doing to help our clients comply with uncleared margin rules in derivatives trading. Treasury Services achieved a number of wins this quarter as we continue to bring innovative new solutions to the market. We were awarded a contract for white-labeled trade processing for a major U.S. bank. We sponsored our first supply chain financing program for a major investment-grade corporate client and we were awarded and will be managing payroll and digital asset transfers for a major digital asset client. Recognizing our momentum in this business, we were named 2022 Global Transaction Bank of the Year. We're also proud to have been recognized with additional awards for our work to transform the real-time and digital payment space and optimize trade finance payments by leveraging emerging technologies. Let me conclude with a note of humility about the uncertainty that we're all witnessing in markets these days. None of us can predict the exact path of markets and the economic conditions from here, and the level of uncertainty is greater than many have become used to. As a firm, we are positioning ourselves conservatively in this environment and recognize that the strength and stability of our platform is important for the uninterrupted functioning of a significant part of global capital markets. We're proud of this role and the service that we deliver to our clients around the world. With that, I'll hand it over to Emily for the more detailed review of our financial performance in the quarter.

Thank you, Robin, and good morning, everyone. As I walk you through the details of our results for the quarter, all comparisons will be on a year-over-year basis unless I specify otherwise. Starting on Page 3, total revenues increased by 6% to $4.3 billion in the third quarter. Fee revenue was down 1% as the benefit of lower money market fee waivers and organic growth across our Securities Services and Market and Wealth Services segment was offset by the impact of lower market values across equity and fixed income markets and the unfavorable impact of the stronger U.S. dollar. Firm-wide assets under custody and administration of $42.2 trillion decreased by 7%. The impact of lower market values and currency headwinds was tempered by continued growth from new and existing clients. Assets under management of $1.8 trillion decreased by 23%, also reflecting lower market values and the unfavorable impact of the stronger U.S. dollar, partially offset by cumulative net inflows. Investment and other revenue was $117 million in the quarter. This included a $37 million gain on the sale of our HedgeMark subsidiary. Through a minority equity stake in the combined company, we will continue participating in their growth and our clients will certainly benefit from a robust suite of managed account solutions. Net interest revenue increased by 44%, primarily reflecting higher interest rates. Reported expenses were up 26%. This included a $680 million impairment of goodwill associated with our investment management reporting units, which was driven by lower market values and a higher discount rate. While having impacted our earnings for the quarter, this impairment represented a non-cash charge and did not affect the firm's liquidity position, tangible common equity, or regulatory capital ratios. Excluding notable items, expenses were up 4%. Provision for credit losses was a benefit of $30 million, primarily reflecting reserve releases related to cash balances and exposure to Russia as well as a modest benefit from our commercial real estate portfolio. Our effective tax rate was 38.4% or 19.5%, excluding notable items. Reported EPS was $0.39; and pretax margin was 15%; and return on tangible common equity was 7%. Excluding the impact of notable items, EPS was $1.21; pretax margin was 31%; and return on tangible common equity was 22%. Now on to capital and liquidity on Page 4. Our consolidated Tier 1 leverage ratio was 5.4%, up 19 basis points sequentially, reflecting the benefit of lower average assets, partially offset by a decrease in Tier 1 capital. The sharp increase in interest rates, especially in the last weeks of the quarter, resulted in an increase of the unrealized loss on our available-for-sale securities portfolio of approximately $900 million after tax during the quarter. We distributed approximately $300 million of earnings to our shareholders through common stock dividends. As I mentioned earlier, the goodwill impairment did not affect our regulatory capital ratio. Our CET1 ratio was flat sequentially at 10%. Finally, our LCR was 116%, up five percentage points sequentially. Turning to our net interest revenue and balance sheet trends on Page 5, which I'll also talk about in sequential terms. Net interest revenue of $926 million was up 12% sequentially. This increase primarily reflects higher interest rates on interest-earning assets, partially offset by higher funding expense. Average deposit balances decreased 7%. The strengthening of the U.S. dollar contributed approximately one percentage point to this decline. Overall, this is largely consistent with our previously expressed expectation for the trajectory of deposit balances through the remainder of the year amid continuously rising interest rates as well as typical seasonal declines in deposit balances in the third quarter, while non-interest-bearing deposit balances continue to hold up better than we had previously expected. Average interest-earning assets decreased by 5%. Underneath that, cash and reverse repo declined by 10%; loan balances decreased by 1%; and our securities portfolio balances were down 2%. Moving on to expenses on Page 6. Expenses for the quarter were $3.7 billion on a reported basis. Excluding notable items, expenses of $3 billion were down 1% quarter-over-quarter and up 4% year-over-year. This year-over-year increase reflects investments net of efficiency saves, higher revenue-related expenses, including higher distribution expenses related to the abatement of fee waivers, as well as the impact of inflation, partially offset by the benefit of the stronger U.S. dollar. A few additional details regarding noteworthy year-over-year expense variances. Distribution and servicing expense was up 16%, driven by higher distribution costs associated with money market funds. Business development expenses increased as travel and entertainment expense continued to normalize off a low base last year. Lastly, the change in other expenses reflects litigation expenses in the prior year. Turning to Page 7 for a closer look at our business segments. Securities Services reported total revenue of $2.1 billion, an increase of 13% compared to the prior year. Fee revenue was up 1% and net interest revenue increased by 54%, driven by higher interest rates, partially offset by lower deposit balances. As I discuss the performance of our Securities Services and Market and Wealth Services segment, I will focus my comments on investment services fees for each line of business, which you can find in our financial supplement. In Asset Servicing, investment services fees were down 3%, and as growth from abating money market fee waivers, high client activity, and net new business was more than offset by the impact of lower market values and the strengthening of the U.S. dollar. We continue seeing healthy organic growth from both new and existing clients, and our sales momentum continues with wins year-to-date up meaningfully compared to an already strong 2021. In Issuer Services, Investment service fees were up 2%, primarily reflecting the reduction of money market fee waivers, partially offset by previously disclosed lost business in Corporate Trust in the prior year and lower fees from depository receipts programs for Russian issuers. Next, Market and Wealth Services on Page 8. Market and Wealth Services reported total revenue of $1.4 billion, up 17% compared to the prior year. Fee revenue increased 11% and net interest revenue was up 34%, reflecting higher interest rates and higher loan balances, partially offset by lower deposit balances. In Pershing, investment services fees were up 16%. The positive impact of lower money market fee waivers and higher client activity was partially offset by the impact of previously disclosed lost business in the second half of last year and lower market levels. Net new assets were $45 billion in the quarter. On an annualized basis, this translates into a 9% growth rate, highlighting a strong quarter of inflows for both new and existing clients, especially in this current environment. An average active clearing accounts increased by 3% year-on-year. In Treasury Services, investment services fees were up 3%, driven by lower money market fee waivers, new business, and slightly higher payment volumes, partially offset by higher earnings credits for our clients on the back of higher interest rates. Pending clearance and collateral management, investment services fees were up 5%, primarily reflecting higher U.S. government clearance volumes driven by continued demand for U.S. treasury securities due to elevated volatility amid a rapidly evolving monetary policy backdrop. Now turning to Investment and Wealth Management on Page 9. Investment and Wealth Management reported total revenue of $862 million, down 16%. Fee revenue was also down 16% and net interest revenue was up 21%, reflecting higher interest rates and higher loan balances. As I mentioned earlier, assets under management of $1.8 trillion decreased by 23% year-on-year. The decrease primarily reflects lower market values and the unfavorable impact of the stronger U.S. dollar, as about 40% of our AUM are denominated in foreign currencies, partially offset by cumulative net inflows. As it relates to flows in the quarter, we saw $23 billion of net inflows into long-term products and $2 billion of net outflows from cash. In Investment Management, revenue was down 20%, primarily reflecting lower market values and the unfavorable impact of the stronger U.S. dollar, as well as changes in the AUM mix, partially offset by lower fee waivers. Robin mentioned the extraordinary volatility in the U.K. government bond market earlier. This has caused some significant challenges for U.K. pension scheme over the past few weeks. As a manager of liability-driven investment strategies, Insight has been working closely with our clients to maintain the appropriate hedging levels in their portfolios. I'd like to note that as an agent between our LDI clients and their market counterparties, we have no balance sheet exposure. In Wealth Management, revenue was down 7% as the decline in fee revenue resulting from lower market values was partially offset by higher net interest revenue reflecting higher interest rates. Client assets of $256 billion were down 17% year-over-year, primarily driven by lower market values. Page 10 shows the results of the other segments. As always, I'd like to close with a few comments on our outlook for the remainder of the year as we see it today, acknowledging the heightened uncertainty about the macroeconomic environment and continued market volatility. Based on current market-implied interest rates, we now expect net interest revenue for the full year to be up approximately 30% compared to 2021, as we expect another quarter of sequential NIR growth. Given the continued decline in equity and fixed income markets as well as the continued strengthening of the U.S. dollar, we now expect fee revenue for the full year to be down slightly compared to 2021, assuming equity and fixed income values as well as currency stay at the levels where they ended the third quarter. We continue to expect expenses, excluding notable items for the full year to be within the range of up 5% to 5.5% that we had guided you throughout the year. That being said, we are intensely focused on disciplined expense management and are working hard to drive this towards the bottom half of that range, and we still expect an effective tax rate between 19.5% and 20% in the fourth quarter. I'll note that we continue to manage to a Tier 1 leverage ratio target of 5.5% as well as a CET1 ratio target of 10%. As we think about the right timing for a resumption of buybacks in the coming months, we will continue to be prudent and consider capital levels, the expected trajectory of deposit balances at AOCI, as well as the economic outlook at that time.

I appreciate your comments about acting as an agent in the LDI cases in the UK. I wonder if we could get a little more of the ins and outs, the impact to both BK and clients because Insight has been a great acquisition that produced a lot of flows for you in the past. I'm curious about the impact in the quarter and whether you get more collateral when clients have lower balances and what you think clients are going to do with this business going forward?

Good morning, Glenn, and thanks for the question. Obviously, this topic has been in the news a lot over the course of the past few weeks. Let's maybe just start by stepping back and remember what LDI actually stands for and what it is. So it's liability-driven investing and the principle at work, as I think you know, but let me just recap it, is really the investment approach that ensures that the assets ultimately are moving more in line with the value of the liabilities. We think that principle, which has been very important to the pension space over time, is an important one, and it's going to be something that we would expect to continue. These strategies have been employed for many years. They've been extensively embraced by the pension regulators in the UK and then the consultants who advise our pension clients in the space. The second thing I'd say is that, more broadly, higher interest rates have actually served to improve the funding positions of most pension funds because the value of the liabilities has decreased by more than the decreases in their gilt holdings. That has been a net positive in terms of contributing to the pension funds' funding status. Clearly, as you pointed out, the speed and magnitude of the rise in the UK government bond yields has been unprecedented and certainly has created challenges in the market due to the speed and magnitude of everything that's been going on. That's created issues, including liquidity issues, for many of these pension funds, as they've had to sell gilts and mobilize other forms of liquidity in order to meet the margin calls on derivatives. They are the principal on the derivatives. This has clearly put a strain on the markets. The sheer size of the pension market versus the UK gilt market shows the degree of impact that they can have, and it's highlighted some operational challenges. If you think about the two-day settlement of margin versus the time to liquidate assets across the wider asset pools, that's been exacerbated by some operational providers. We actually don't provide direct operational support to Insight. That's done by a third-party. Clearly, people are raising additional liquidity, which makes a lot of sense. We’ve been pleased with Insight's performance. They've been focused on building collateral buffers throughout the year, and this prudence has been helpful in protecting client portfolios. Insight has also been, over time, working on a strategy that they call integrated solutions, which is really encouraging pension funds to look across all types of assets they have, so that they see the whole and not just the individual pieces. We think that integrated approach, which they've advocated for, has been a good solution in this particular crisis. We actually believe that net-net, our solution is being strengthened in the market. Insight's reputation has done quite well. In fact, they are turning away new business as they’ve benefited from a flight to quality. Clearly, a situation that's still evolving. Today's market looks a little better following some of the news at the end of last week and over the weekend, but we're watching it very closely.

I appreciate all the information. I keep track of everything, and it seems like there were no significant issues with the balance sheet as there were no major client outflows. However, I'm uncertain about why they would be declining new business. Are clients planning to use this service less in the future or relying on less leverage? I'm interested in your forecast. I believe it was a strong source of inflows previously, and I'm eager to hear your thoughts moving forward.

Yes. The reason we've been turning away some new business is because we want to protect the interests of our existing clients. Taking on more problematic situations and there are some in the market which have less funding and liquidity available to them and then bringing them into our franchise, having to deal with that problem, didn't seem like the smartest thing to do, and wouldn't be in the interest of our existing clients who have been with Insight all along. More broadly, we do expect to continue to get incoming phone calls given some of the differentiated nature of how Insight has performed through this, and we view that to be positive for the franchise. I actually view that as something of a tailwind because these types of reputational events in the market can certainly sift out some of the different players.

I noticed that the AUCA declined just about 2% quarter-over-quarter. This would be less than we'd expect given the market backdrop here. You talked about the strong sales momentum and recent wins. So how much did organic growth contribute this quarter, if you could kind of quantify that? And when did that come in, in the quarter?

It's Emily, I'll take that. The AUCA trends speak to the diversity of the franchise overall. Firm-wide AUCA was down about 7%. That was based on lower security services AUCA of about 11%, but tempered by growth in Market and Wealth Services, led by Clearance and Collateral Management. If you want to drill down a bit more into Security Services and what you're seeing there, about the 11% decline, about 13% of that was due to lower market values as well as the strengthening U.S. dollar, partially offset by about 2% of net new business.

If I heard your comments correctly on the share buybacks, it sounds like it's really dependent on the capital levels. Did I understand that correctly, that it's still possible that you could be in the market for buybacks this quarter if the capital levels perform as expected?

As I said in my prepared remarks, it's very important that everyone understands we're going to continue to be prudent with respect to buybacks. This is natural given the continued volatility we see across the markets and the uncertain macroeconomic environment. We also want to be above our internal target for our capital ratios before we consider resuming buybacks. So, it is true that when we think about capital distribution, our approach hasn't changed, whether it's this quarter or next quarter; it's always going to be informed by the rate trajectory, the corresponding impact on AOCI, the size of our balance sheet, market conditions, and our forward outlook. But beyond the near term, we have a business model that allows a meaningful amount of return of our capital to shareholders, pending the sale of Alcentra as well as over time, as rates do move in a different direction that AOCI will be pulling back to par, and that will free up meaningful capital levels.

I wanted to start off with a question on the operating margin. While the operating backdrop remains highly uncertain, the last Fed tightening cycle saw the Company generating mid-30s operating margins fairly consistently. I wanted to get your perspective on whether you see a credible path to getting back to those types of operating margins? What are some of the drivers that could potentially help you close the gap here?

Sure, Steven. I'll just start by reminding you, when we announced our re-segmentation in December last year, both Emily and I commented on the fact that we were driving towards a 30%-plus margin in our Securities Services segment, which, as you know, is not where we have been. And we said at the time that would be made up of a variety of different components, including top-line organic growth, the rate cycle, and then a focus on the bottom line. That's how I think about the strategy for the whole firm. We're laser-focused on executing our growth investments, including projects like Pershing X, and real-time payments. However, we also have to be good stewards of expenses, and although we've made significant investments in resiliency over the past four to five years, I believe there's still room for us to invest in efficiency-related technology.

We are, as Robin said, intensely focused on our forward expense trajectory. In the budget cycle that we've just kicked off, we're actually doubling down on a rubric that we've used historically, but mostly just for tech, and now we're applying that across the entire company. We'll stratify all of our expenses across three buckets. The first is really structural or run the bank. The second is change the bank, and we're drilling into that category to be very clear about whether investments are for growth, transformation, or ongoing regulatory obligations. Lastly, the third bucket is revenue-related, which rises with top-line growth.