Morgan Stanley (MS) — Q1 2017 Earnings Call Transcript

Good morning. This is Sharon Yeshaya, Head of Investor Relations. During today’s presentation, we will refer to our earnings release and financial supplement, copies of which are available at morganstanley.com. Today’s presentation may include forward-looking statements that are subject to risks and uncertainties that may cause actual results to differ materially. Please refer to our notices regarding forward-looking statements and non-GAAP measures that appear in the earnings release. This presentation may not be duplicated or reproduced without our consent. I will now turn the call over to Chairman and Chief Executive Officer, James Gorman.

Thank you, Sharon. Good morning, everyone, and thank you for joining us. At the beginning of 2016, we laid out several strategic priorities that we aim to achieve in 2017. The most important of which was to generate an ROE within the range of 9% to 11%. Other priorities included achieving a wealth management pre-tax margin of 23% to 25%, delivering on project streamline, and improving results across our fixed income division. These priorities were contingent upon modest revenue growth, a continuation of our capital distribution plan, and the absence of any outsized litigation expenses or penalties. 2017 has started well, we remain focused and continued to demonstrate strong expense discipline. Wealth management recorded a pre-tax margin well within our target range, and the fixed income division delivered revenues meaningfully north of our $1 billion average quarterly goal. These public markers, combined with continued strength in investment banking, leadership in equities, and improved returns in investment management all contributed to one of the strongest quarters in recent history. The net impact of these efforts was an ROE north of 10%, again well within the range related to 12 months ago. We’re pleased to see the results of the many difficult decisions and business growth initiatives best prove as we begin 2017. In addition, in the first quarter, the Federal Reserve announced that it did not object to our resubmitted 2016 capital plan. Separately, along with all our peers, we recently submitted our capital plan for the 2017 CCAR cycle. Strong capital return remains a critical element of our future success. All of that said, we live in uncertain times. You are all aware of the political and geopolitical uncertainties that exist on the domestic front as well as abroad. How this will impact markets during the rest of the year is too early to predict. We will remain nimble should the macro environment change materially. Notwithstanding these risks, given our business model and leading positions in several franchises, we expect to continue to deliver appropriate returns in the absence of a major disruption. In addition to the obvious uncertainties, there are two notable policy areas that could meaningfully affect us in a positive way in the next several years: first, the potential for a reduction of the domestic corporate tax rate. Almost all of our wealth management business and a significant part of our institutional securities businesses are based in the United States; secondly, the perspective regulatory changes. At the very least, it is hard to imagine the regulatory burden increasing from this point forward, and some of the policy proposals being floated make good common sense. Given Morgan Stanley’s very strong capital and liquidity position, potential modifications could substantially impact us over the coming years. I am sure we'll talk a lot more about this at the rest of this call and in subsequent quarters. I will now turn over to Jon to discuss this particular quarter in greater detail.

Thank you, James, and good morning. Results in the first quarter were strong, aided by an active new cycle, improved sentiment, and solid economic data. Firm revenues of $9.7 billion were up 8% compared to Q4. In the first quarter, CBT was $2.8 billion, EPS was $1, and ROE was 10.7%. Our performance was buoyed by typical first quarter seasonality as well as momentum following the U.S. elections. Importantly, we produced results characteristic of constructive markets, and we controlled expenses, highlighting the operating leverage in our business. Our efficiency ratio improved to 71% this quarter. I will spend a minute on our expenses and project streamline before turning to the businesses. Compared to the fourth quarter, non-interest expenses of $6.9 billion were up approximately $160 million or 2%. This increase was driven by higher compensation expenses, which rose 9% sequentially due to higher revenues and the impact of mark-to-market on our deferred compensation plans across the firm. Non-compensation expenses were down approximately $220 million or 8% quarter-over-quarter. Recall that Q4 included elevated seasonal expenses and a provision in connection with the tax reporting issue. Given the fourth quarter seasonality, the year-over-year comparison may be more relevant when trying to understand the impact of project streamline. Year-over-year revenues were up $2 billion while non-compensation expenses increased by only $100 million over the same period. These results demonstrate our operating leverage and discipline. We remain well on our way to executing roughly 200 expense initiatives that we identified as part of project streamline. This includes the use of robotic process automation to consolidate our technology support, rationalizing our North American data centers into modern and environmentally sound centers that now host high-density technologies, and introducing a cloud-based procurement platform that uses more straight-through processing and payments, informing more intelligent purchasing decisions. We also continue to implement the workforce strategy we shared with you last year. During the remainder of 2017, our focus will be on completing the remaining initiatives and, more importantly, on keeping these costs permanently out of the expense base. Now to the businesses. Our Institutional Securities franchise performed well in Q1. Our businesses built on Q4 momentum and produced strong results with total net revenue of $5.2 billion, up 12% quarter-over-quarter. Non-compensation expenses were $1.6 billion for the quarter, down 7% sequentially, driven by lower seasonal expenses, partially offset by higher execution-related costs. Compensation expenses were $1.9 billion, reflecting an ISG compensation to net revenue ratio of approximately 36%, consistent with our target of maintaining a ratio at or below 37%. In Investment Banking, we generated $1.4 billion in revenues, which is an 11% increase over the fourth quarter. The increase was driven by strong underwriting results across both debt and equity, partially offset by a decline in advisory revenues. Advisory revenues for the quarter were $496 million, down 21% compared to a very strong fourth quarter. Clients remain engaged and interested in discussing strategic transactions, and pipelines are healthy. Turning to underwriting, continued investor optimism combined with stable capital markets characterized by low volatility and tighter credit spreads, translated into strong underwriting activity in the first quarter. While equity volumes are still well below peak levels, Q1 represented a more constructive new issue market with low overall volatility and fewer specific risk events. Against this backdrop and with a strong pipeline coming into the new year, equity underwriting revenues were $390 million, up 73% compared to the fourth quarter. We expect activity levels to remain healthy, although upcoming events such as European elections and continued policy uncertainty may affect issuance windows. Fixed income underwriting revenues increased 26% sequentially to $531 million, driven by strength in investment grade bond and high yield financing issuance in an attractive credit environment. Our sales and trading business performed well as constructive market conditions witnessed in the fourth quarter carried into the first quarter. Revenue increased 10% on a sequential basis to $3.5 billion. In equities, we were number one in the U.S. and expect to retain our number one global position. Despite a decline in volumes, first quarter revenues were $2 billion, up 3% compared to the fourth quarter. Results were driven by strength in both derivatives and cash equities in a more stable trading environment. The first quarter results underscore the importance of our product breadth and geographic diversity. We saw strength in Europe and continued stability in the Americas, which was partially offset by weaker results in Asia. Despite various economic and political challenges, we remain committed to our global footprint. Fixed income revenues in the first quarter were $1.7 billion, up 17% compared to a strong fourth quarter. A constructive trading environment and an uptick in client activity, variability in interest rate expectations, and a favorable credit environment contributed to these results. In our credit businesses, we saw continuation of the increased market volumes that followed the U.S. elections. Steady client activity and favorable market conditions across products drove strong performance. In particular, our securitized product business performed well, driven by spread tightening and strong demand. Our macro businesses witnessed a sequential decrease in revenues. While our rates business benefited from increased client activity related to repricing of interest rate expectations in the U.S., this was partially offset by a decline in foreign exchange. After a challenging environment in Q1 2016, this quarter marks the fourth consecutive quarter with revenues in excess of our $1 billion target. The results have increased our confidence as the business has experienced good momentum, reinforcing that it is critically and credibly sized. Average trading VaR for the period was $44 million, up versus a historically low level of $39 million last quarter. As we have discussed, the derisking of our balance sheet over the last several quarters has provided us with significant capacity to prudently raise VaR to support accretive client opportunities. In the first quarter, we saw both strong client demand and pockets of volatility, contributing to an increase in both spot and average trading VaR. Now turning to Wealth Management. In the first quarter, we reported record revenues of $4.1 billion, representing a 2% sequential increase. The CBT margin at 24% was the highest since the Smith Barney acquisition and fell firmly within our 2017 target range. Importantly, the drivers of this business are healthy. We witnessed increased fee-based asset flows, additional lending, better client engagement, and eliminated FA attrition. Client assets reached $2.2 trillion, a record high, reflecting rising domestic and global equity industries. Fee-based assets increased 6% to $927 billion, including net asset flows of $19 billion. This represents the highest fee-based asset flows since Q4 2014. Asset Management revenues were flat sequentially. Higher asset levels and positive flows were largely offset by the effect of fewer calendar days in the quarter. Net interest income was up modestly. The benefit of higher rates and loan balances in the first quarter was partially offset by the impact of lower prepayment amortization in the fourth quarter. Year-over-year, we have seen strong net interest income growth of 20% and we remain confident with the net interest income guidance we provided in February. We are positioned to continue to benefit from higher rates and lending growth. Bank lending balances were up $1 billion quarter-over-quarter. Transaction revenues of $823 million were up 6% from Q4 2016. Higher mark-to-market gains on our deferred compensation plans had a meaningful impact on the sequential increase. Additionally, we witnessed a recovery in the underwriting calendar, especially in structured projects as issuers capitalize on increased retail demand for new issue products. Total expenses were flat versus Q4 as seasonally lower business development expenses were partially offset by higher compensation expenses. The compensation ratio of 57% was negatively impacted by seasonality and the impact of mark-to-market on our deferred compensation plans. Looking forward, we remain optimistic about the outlook for this business. The steady increase in fee-based assets positions us well to build our annuitized revenues. We continue to invest in our digital capabilities, which over time will encourage asset aggregation and increase FA and client engagement. We look forward to sharing more with you on this topic later this quarter. Finally, we are confident in the attractiveness of our platform and the opportunities that afford us to recruit and retain talent as the landscape continues to favor scale players. Investment management saw stable asset management fees and better investment results. Total net revenues were $609 million, up 22% quarter-over-quarter. AUM grew to $421 billion in the quarter. Market appreciation in equities and fixed income and positive flows in alternative products contributed to a modest uptick versus Q4 2016. Asset management fees for the quarter were stable at $517 million. Investment revenues were $98 million, up $122 million compared to the fourth quarter, which was adversely impacted by the sales and markdowns of non-strategic third-party LP investments. Overall, expenses were up 7% quarter-over-quarter, primarily driven by compensation expenses attributable to higher carried interest. Turning to the balance sheet, total spot assets increased to $832 billion. As I mentioned earlier in the year, we had the capital capacity to increase our balance sheet if the client opportunities and returns justify the usage. Pro forma fully phased-in Basel III advanced RWAs are expected to be approximately $360 billion, down $10 billion from the fourth quarter, driven by lower operational risk RWAs. The reduction in RWAs contributed to a 70 basis point increase in our pro forma fully phased-in Basel III advanced common equity Tier 1 ratio of 16.6%, bringing it more in line with our pro forma fully phased-in Basel III standardized common equity Tier 1 ratio. As the two ratios have almost converged, we will be disclosing both going forward. Our pro forma fully phased-in supplementary leverage ratio for the quarter increased to 6.4%. During the first quarter, we repurchased approximately $750 million of common stock or approximately 17 million shares, and our Board declared a $0.20 dividend per share. Our tax rate in the first quarter was 29%. This includes a $112 million tax benefit attributable to the employee share-based payment accounting change adopted in January. This accounting change is permanent and will impact our quarterly and annual effective tax rate. Given our stock vesting schedule, the most meaningful impact will occur in the first quarter of each year when restricted stock units convert into common stock. If our stock appreciates over the vesting period, we will have a benefit, and if our stock depreciates between the grant and vesting date, we will have an expense. This change, along with the variability of our geographic mix of business, will make the tax rate somewhat more volatile. We expect our tax rate for the remainder of the year to be in the 32% to 33% range. As James said in the opening, the strong results this quarter provide support that our strategy is working. The post-election momentum continued into 2017 and provided a healthy backdrop for most of our businesses. Our M&A and underwriting pipelines remain healthy, and macro events should continue to provide opportunities for our trading businesses. Our wealth business is performing well and has several tailwinds that have begun to materialize. Our investment management businesses have seen flows stabilize and better investing performance. However, questions around the timing and achievability of the new administration’s policy initiatives resulted in more sporadic client activity towards the end of the first quarter. This was consistent with a broader theme that began to crystallize in late March. The contrast between the strength of the global economy and the unease around U.S. policy outcomes and potential geopolitical threats. We’re conscious that uncertainty can weigh on market mentality and activity levels. With that, we will open up the line to questions.

So really encouraging to see the securities business put up another good quarter. And so now that it seems like it’s pretty hard to argue, it’s not very much unstable footing, the restructuring worked out very, very well with that really repositioning. What are you focused on from here, when you think about the potential for less hostile regulatory environment? Where that might provide opportunities versus how your franchise is positioned, how should we think about that going forward? And how do you balance the idea of potentially getting better returns in that business versus returning capital to shareholders? Could you help us how you're thinking about that?

Brendan, I would need quite a bit of detail to fully address that topic. I'll refrain for now, as it will probably lead into many of the questions we'll tackle during this call. To start with the business, our main focus is on achieving results for the entire year rather than just one quarter. We are pleased with how the quarter unfolded, and I believe the team excelled in navigating the inconsistent environment. As Jon mentioned, the latter part of March presented greater challenges than the beginning of the quarter. So, our priority is to continue executing and effectively managing expenses while maintaining or increasing our market share where possible. Secondly, we are dedicated to substantially and progressively returning capital in the coming years. If we sustain our earnings growth at this pace, there’s no reason we shouldn't be able to continue those efforts, including retiring shares. We're keen on controlling our share count. The combination of increasing dividends and further buybacks is crucial for enhancing our return on equity performance. These factors are significant since they impact the denominator. We recently submitted our 2017 plan, and successfully resubmitting the 2016 plan was vital. Over the last four or five years, we have made consistent increases in dividends and capital. I think it's fair to say we're satisfied with this trend. I won't disclose our specific request, but discussions with the Federal Reserve will take place until we receive results. We retained a significant amount of earnings last year and aim to continue enhancing our capital returns. On the regulatory front, there are many variables at play. Regarding fiscal policy, particularly the corporate tax rate, we have a sizable business primarily in the U.S., so any potential changes in the corporate tax rate would benefit Morgan Stanley. It seems likely there will be some adjustments, whether this year or next, although I anticipate they may be more modest than some have suggested. Anything below 30% appears likely and would be advantageous. On the regulatory side, opinions suggest that while the U.S. financial system is healthier than before the crisis, the current capital and regulatory burdens could be re-evaluated, which is acknowledged even by those at the Federal Reserve. While it's premature to predict specific regulatory changes, a straightforward improvement could involve banks submitting their CCAR plans and receiving feedback before stating their capital requests. This would eliminate uncertainty surrounding available capital. If Morgan Stanley had done this last year, it could have resulted in an additional $2 billion in capital to manage with our board. I see a strong case for moving many regulatory programs to a biennial schedule. After six to seven years, the systems established within banks have made them much more predictable. With respect to CCAR and resolution planning processes, I question the value of an annual cycle, which is costly and time-intensive, as the response time for submissions spans several months. We may delve into more specifics during the call, but I believe there are concrete adjustments that can lessen expenses and time commitments without compromising the regulatory rigor essential for a robust banking system. For fully capitalized banks, which we consider ourselves to be, this creates an opportunity to return surplus capital to shareholders.

That’s very helpful and thorough. I know it was a broad question, but thanks for that, James. It seems there is some momentum behind the SLR and potential for changes. While I'm not asking you to predict what might change with that calculation, if we do see SLR relief, how do you feel about the growth potential for your PV business? Do you think this could also provide a positive impact on the equities business, considering the non-box approach?

I don’t want to be evasive, Brennan. But I also don’t want to presume. I think there are too many contingencies in there, if this and if that, then what would happen. I think it's fair to say the denominator in SLR clearly should be adjusted. And I think there has been a lot of discussions in the White House, in Treasury, and across the various regulatory bodies about that. And making it, A: more consistent with the Europeans. I think there is also an argument, by the way, bringing the ratio, which is currently 5% of capital to the growth that balance sheet to the European level, I suppose 3%. So there are some pretty significant differences between different jurisdictions. And I think harmonizing those makes sense. I think you will see an adjustment to the denominator, the total balance sheet under what I suspect will be the ultimate new SLR rules. But I don’t want to predict, and I'm pretty sure Jon doesn’t either, on how that might affect our equities business and what that implies about our prime, so it’s a little early for that. We have a terrific equities business. We think our PB is the best on the street, and obviously, that’s a source of focus and growth for the firm.

I have a quick question regarding your recent performance. It seems you lost some ground but didn't give up much market share when you reduced your workforce by 25%. Since then, you've gained back some of that market share. What strategies have you been implementing? Do you believe this positive momentum in market share can be sustained?

Listen, we're been very pleased with the performance in that business, as you said. We had it, went through a major restructuring. We’re now generating significantly more revenues than we had before that restructuring with lower expenses and fewer people. So the operating leverage in that business has been very good. Our market share and momentum in that business have been good. And I think we feel confident that we will continue to be relevant to our clients, support other ISG businesses. And the ultimate results will really be a function of the markets. In a growing market, we would expect to participate in that growth. And in a shrinking market, it becomes more challenging, and we would try to defend our positions.

Maybe just a follow-up on the regulatory question. Seems like everything is moving your way except where there have been some discussions about new Glass-Steagall would look like. If it’s similar to the ring fencing in the UK, is that something that concerns? Or how do you think about that as your wild card?

I get a little concerned when somebody tells me everything is moving our way. We have a lot of years where everything has not been moving our way. So it’s nice that something is moving our way, and I’ll leave it at that. I heard one of my peers say every time he hears about 21st-century Glass-Steagall, he asks everybody around what the heck does that mean. I’m not sure what it means, maybe there’s a ring fencing along that sort of Vickers rule in the UK. Again, we have a very different business model from the universal banks, but we do have a significant deposit business. And I am comfortable, on a global competitive basis, that the more pure investment bank models would be least affected by that kind of structure or holding company structure with so-called ring fences around them. But it’s a little early. I don’t really want to guess. I mean, I think there is and should be zero appetite for reshooting Glass-Steagall itself, obviously. And happy to see that that seems to be the prevailing view. But whether we move to this ring fence model, I’m pretty confident we can deal with that here at Morgan Stanley. But I don’t want to predict whether we get them on our own.

Maybe I’ll try a little bit more color on the FIG business, and obviously the great growth over the last four quarters. I guess I’d like to get towards, and I appreciate you don’t want to spell-out business-by-business underneath the covers. But maybe how diversified across products has the growth been, what your biggest business? Or how do you would define your identity? I think it’s been great, we’re just looking for more color.

The best way to describe it is to look at the quarter-over-quarter results and the macro backdrop we were operating under. We had strong performance in the Americas, particularly in our credit businesses, with a favorable environment marked by tightening spreads and activity levels, including securitized products and the credit complex more broadly. On the macro side, given the situation with the Fed and the uncertainty surrounding it, we observed increased activity. Our rates business was stronger during the quarter; however, this was offset by our FX business, which, despite being smaller for us, was negatively affected by low volatility and reduced client engagement. Our commodities sector, which is also smaller for us now, performed well in a stable environment, resulting in a reasonable amount of hedging activity and client engagement. Overall, it was a good quarter for our businesses, with strength across all products except for FX.

That actually helps a lot, defined on the product that level. Geographically, do you have a stronger weighting in the Americas, or is it reasonably globally diverse?

Definitely, the global footprint is important. But basically, in all of our ISG businesses, the Americas would be the biggest contributor. You see our revenue breakdowns; I know as a firm and the supplement we have about 70% of our revenues coming, give or take, from the Americas. But we do have a strong footprint in both EMEA and Asia, and so we had good performance across the board.

So want to kick things off with a question on CCAR in the capital stack, your CET1 ratio is clearly very strong. As we await the results for the upcoming CCAR exam, historically, leverage has tended to be a bit more constraining for you guys. And with the inclusion of the SLR in this upcoming test and also given the latest preferred issuance you announced, I was hoping you could just shed some light on how the introduction of the SLR constraint actually informs your thinking in terms of excess capital; and how we should expect you to manage the capital stack going forward, whether we should see some incremental preferred issuance from here.

Sure. In the beginning of 2016, we indicated that we had enough capital for our business mix and risk profile. Over the year, we accumulated capital and have begun reinvesting some of it back into the business. We saw growth in our balance sheet in the first quarter, marking the first time we've done that in a while, driven by strong client engagement and appealing return opportunities. CCAR remains our primary constraint concerning capital. As you noted, our leverage ratio has been at its lowest point post-stress for the past two years. The SLR is new this year, and while the models are not very clear, we will await the results in June. We've generally faced more constraints around leverage compared to risk-weighted asset ratios since we have significantly reduced risk, especially in our fixed income business. Leverage continues to be the constraint. Regarding your last point on the capital stack, we completed a preferred issuance that has been a cost-effective contributor. We will need to monitor our results and market conditions going forward to determine how we will manage that stack.

I would like to add something regarding the constraints and the way the supplemental leverage ratio will be applied, which all relies on the current CCAR methodology remaining unchanged. To address some practical solutions for CCAR, consider this: banks are required to assume they will conduct buybacks for nine quarters after entering a billable scenario. For us, the buyback last year was $3.5 billion, and over nine quarters, that amounts to about $7.7 billion. Essentially, you would be carrying $7.7 billion, while in theory, continuing to pay out to shareholders for nine quarters following a billable scenario. This situation not only seems unlikely, but there's a straightforward resolution. The board could send a letter or grant the Federal Reserve authority to eliminate the buyback program immediately upon entering such a scenario, which would be a simple solution. I recognize the reasoning behind maintaining banks’ dividend programs as some banks retained their dividends during past crises to show strength. However, no bank’s board would continue to buy back stock while their capital is being eroded. This situation inherently creates significant capital access challenges within these institutions before addressing which constraining leverage ratio comes into play. Pragmatic and sensible fixes like this could make the system more transparent and realistic in its operation, and I hope the new administration considers these aspects. This is essential to ensure the U.S. financial system functions on par with financial systems globally.

It’s interesting because Trula Velez had advocated for some practical changes as part of his stress capital buffer approach. He also noted some proposed changes back in September, including the desire to include surcharges in the CCAR exam. I would like to hear your thoughts on whether you believe some of these changes he outlined were sensible, especially since he is no longer in that position, and it's unclear if any of those changes will actually be implemented.

I don’t want to speak for former governor Trula. Obviously, I read the speech and had this discussion many times. So I think that change in the second one was the balance sheets grow during times of financial stress. I don’t know how you have balance sheet growth and unless you do an acquisition. So again, it is clearly illogical to have balance sheet growth during a time of financial stress. The assets would depreciate in value, and institutions will be shrinking, not growing. So those two things, the buyback and balance sheet growth, drove up the capital levels. When you took those out, I guess the view in that speech was you would simply replace that with a buffer. Well, to me, that’s just whether it’s balance sheet growth and holding buyback or buffer is kind of irrelevant. But the objective would seem to be in that case simply add a buffer of capital to the institutions. My question is why, why do they need that? If they're capitalized at the level where the global institutions are capitalized and some, it appears to me that would be a perfectly proven place to start with. So I'm a big fan of commoditizing the buyback and the balance sheet growth. I'm not a big fan of taking that off the table, but simply replacing with a buffer. I don’t think that makes good sense.

I think Steve one of the big challenges with all these questions is we just don’t know, and there is no new guidance for 2018. We haven’t gotten our 2017 results back; governor Trula did give a speech, but he is no longer in that seat, and that seat is currently vacant. And until it gets filled, then we get some more guidance, it's really just speculation at this point.

So we’ve talked a lot about capital, and I appreciate all the views on regulatory things that might change ahead or would make sense to change. I guess the question that I have been now that is what kind of visibility might there be to reducing excess capital over time, quite apart from regulatory change, which is, of course, hard to forecast at this point. Maybe you could give us some sense for the outlook in terms of further reduction in ISG’s capital consumption. Just from runoff over the medium term of legacy positions like long-dated derivatives. I couldn’t help, but notice, but you had a $3 billion reduction in ISG’s allocated equity during the quarter?

You observed our new capital allocation for the year. We allocate once and maintain it throughout the current year. We continued to reduce the risks on the balance sheet this year, particularly in fixed income, and as a result, we've decreased capital in that area. As I mentioned earlier, we have the capacity to grow that business if the client opportunities and returns are favorable. We now view the sales and trading business as a single entity and are directing resources accordingly to optimize across the various internal products within that sector. This quarter, we raised our investment in the balance sheet related to the sales and trading business. While we continue to see reductions in long-dated positions, it's not significant at this time and doesn't play a major role in managing the business.

I have a follow-up question regarding what James mentioned earlier about the CCAR. The proposal from Congress to change the CCAR to every other year is intriguing. I understand the potential cost savings you're referring to, but is that truly the case? Would you still need to keep a substantial infrastructure and personnel in place, as well as maintain the necessary systems, likely even operating some in parallel over time? Do the savings from reducing the frequency to every other year really amount to that much? Additionally, have you considered how the savings from this change would compare to the potential reductions you could achieve from a significant decrease in Volcker risk reporting? How do the two compare in terms of cost savings?

Let me start-off with, forget about what the cost savings are, and just say what is the intended benefit of the CCAR process to determine if an institution has sufficient capital and the stability of the scenario. And if it has been sufficiently robust in testing its processes, its risk management, anticipating risks and arriving that conclusions. And it’s a qualitative and quantitative aspect of it. My point is that it is an enormous task. In our case, it’s something like 25,000 pages, I think, Jon, we submit on an annual basis. And it takes an enormous effort by our regulators to digest; there are many, many meetings between the regulators and management; there are horizontal review teams across all of the Federal Reserve. And then eventually reporters produced pinning on whether you passed the quantitative and the qualitative by how much and various feedback relating to quantitative and qualitative. And then you resubmit again some months later. I just think the amount of time it takes to process all this information to meaningfully act on it, then the next annual submission appears very rapidly. So as a practical matter for an exercise of this rigor and substance, I think there would just be more value added in having people digest it for a year and have really proper thoughtful responses over the longer time frame. Does it reduce the cost to the organization? Of course, it's just the time management from myself down through to the heads of risk, audit, finance, compliance, legal, all down through the organizations and the whole CCAR. And yes, it’s a huge effort internally and with external consultants in the preparation of the 25,000-plus pages. Is that the primary driver of this? No, in my opinion, the primary driver should not be expense driven; it should be outcome driven. What is the right outcome to achieve the best result, which the regulators and frankly, taxpayers and the institutions and the shareholders want. And I think a more thoughtful outcome would be every other year, given the magnitude of it. So that's really my focus. It's not about money saved; does it have the additional outcome that expenses would come down and distraction for an organization? Sure. But that's not the objective. We all want a healthy and very safe and sound financial system; nobody is pushing against that. I think more time to digest changes and adjust to them for institutions of this complexity on a two-year cycle would just make good common sense.

Jon, my question goes to the net interest income, I know you talked a bit about it. But I'm a little confused still on the sequential trends, particularly as it relates to the cost of funds, which intuitively would have seemed to have moved higher given rate hikes, both in December and recently. So can you just help me understand what's occurring there?

Sure. I think if you're looking at the asset sensitivity or the net interest income in our wealth business, which is generally where most of the asset sensitivity is, a couple of things. We've grown that line item quite aggressively over the last several years, over $2 billion in the last four years, including $500 million of growth last year. What I said in February is that we still expect to generate good growth in net interest income, albeit at a slightly slower pace. And we still feel good about the guidance that we've given you. What we've seen now that we've been through three, I guess rate hikes in the last year and change is that the model data has been higher than what's actually happened in terms of the deposit base. And we still think that roughly the 50% data that we've been using is the right, is a reasonable estimate going forward. But again, it's a model, and we haven't really seen that many rate hikes over a long period of time, particularly given money market reform and digital products in terms of deposit behavior. So at this point, we still think it's a reasonably good estimate. But our performance in wealth NII is strong, and we still feel confident that we can grow that business, because of the lending products that we're offering to our clients as well as the benefit of the forward curve this year and the potential for future rate hikes.

But specifically understanding that maybe the deposit data isn't as high as you’ve anticipated. How would that reconcile with the actual decline in interest expense that you saw in Wealth Management, sequentially? Was it a change in liability structure, or I mean I guess I'm just surprised that that number went down, given that rates went up twice over that time frame?

You're referring to the $91 to $85?

Correct.

The $6 million is a minor figure to monitor. I believe that the liability stack remains fairly consistent from one quarter to the next.

I was wondering if you could talk about the equities business; it was fairly resilient year-over-year. Just a little more color on that. And then obviously one of the drags was in prime, and you mentioned higher funding costs. Maybe just so I question, but I thought there be, maybe an offset where your funding cost go up where you can pass that along to the clients as well. So just talk about that, but then more broadly speaking, the fact that the revolver is quite resilient versus a fairly solid year-ago level.

Sure. As you said, this is a very resilient business for us. We're number one in the world. We've got a very full-service platform in providing intellectual capital for our clients globally, and the business has performed quite well. We did see a pick up in cash and derivatives this quarter; PB was stable quarter-to-quarter. If you look at year-over-year, from the press release, we did see higher funding costs, but that’s really a function of the increased liquidity that we’ve carried across the entire firm. And we allocate liquidity to those businesses, so that sort of that dynamic there; but again, we're number one; we feel very good about our position; our performance was very strong, particularly in Europe this quarter; it's global; we’ve got a good product set and we feel very good about our position and our continued momentum there.

I have two questions on Wealth Management; could you talk about lending growth? Because to me it seems to slow markedly. Do you think you will meet the targets you set out in the February presentation on the lending side, and where we're on penetration? And then separately just the non-compensation in Wealth Management, which was pretty low. I think you mentioned seasonal, but I mean its still looking good year-on-year. Is that something that level could be sustained? Thank you.

On the second point regarding non-comps, we have been actively managing non-comps across the firm. Wealth Management has performed well in this area over the past few years, increasing margins from below 10% to the current 24%. The transition from the fourth quarter to the first quarter makes for a challenging comparison regarding non-comp expenses due to seasonality and some marketing and business expenses in wealth, but we are maintaining strong expense discipline in that sector, and we expect this to continue. Regarding our targets, I remain confident in the guidance we provided in February, especially since we anticipated two rate increases, one mid-year and another at the year's end. We saw one rate increase in March earlier than expected, and the data has been somewhat better than we anticipated. Therefore, my confidence in that guidance for net interest income (NII) remains robust. Lending growth in wealth products has been positive. While we expect mortgage lending to slow due to the rising rate environment, we are generally on track to meet our lending targets and achieve the NII growth we expect.

Maybe another one in equities here, we’re starting to get a number of questions on MiFID II as it moves closer. So being the leader in equities, it would be just great to get some perspective on what you’re hearing from clients and how you’re preparing for it. And ultimately, do you think this kind of a risk for the business or do you see an opportunity for Morgan Stanley to take more market share?

So just generally on MiFID II, as you would expect, we have been preparing for quite some time for the implementation in the beginning of 2018. There are operational and implementation requirements and costs that go with that, and we budgeted for that; it’s mostly around IT and systems. And we expect to be in compliance in the beginning of ’18 when the new rule comes into effect. In terms of the impact, clearly when you have a change, there is probably the potential, certainly early on, for disruption as people adjust to the new rule. In terms of how that affects market structure longer term and whether people start trading with fewer counterparties or not, I think it’s too early to tell. But again, we are number one in the world in this business, and we would expect to maintain that position. And if there is an opportunity for people to consolidate their trading counterparties, we would expect to be part of that benefit.

Just a quick follow-up here, securities-based loans begin to get some attention recently. I guess just maybe seeing a little bit more scrutiny and obviously, it’s been a nice product for Morgan Stanley. It seems like a nice natural product for your clients. I am just curious if there is any change in how you’re thinking about that product specifically within the overall bank mix?

No. Again, I think as you highlighted, it’s been a good product and an important product for our clients. It’s part of our full-service product offering. Our clients like the products if it helps to manage their liquidity. It’s actually reasonably easy and efficient application process. And if you look at the rates relative to other products like HELOC and unsecured, it’s an attractive rate for our clients. So it’s a good product for the clients. From our perspective, it’s highly collateralized. The weighted average LTV on the product is a little over 40%. It’s really not a credit risk issue; the risk is really around operational risks of fraud. And we haven’t really seen any material losses in that business. So again, we feel good; it’s floating rate; it’s a nice product for us to offer, and it’s a product that our clients like.

I guess just following up on the question on MiFID, what’s going on in Europe. Jon, you mentioned Brexit as being a potential catalyst for volatility. Could you provide a little more color on that given the announcement this week of June elections? And does that increase your view that there could be a greater level of volatility in the second quarter into the third quarter than you might have previously assumed?

In terms of Brexit, I don’t recall stating that there would be increased volatility due to it. However, we, like all our peer firms, have been planning for Brexit for quite some time. We have an extensive network of offices and licenses across the EU 27, which gives us several options that will be viable once the ultimate outcome is clear. We've had a presence in Europe for 50 years; it’s a significant market for us, and we remain dedicated to supporting our clients, whether from London or elsewhere. I’m not certain the election changes anything, and it certainly doesn’t alter our analysis. It represents another risk event for people to focus on. However, I don’t think it will change much of our work until the election occurs and negotiations progress; it’s difficult to predict what the final market structure and outlook will be.

I would like some clarification on the high interest rates and their impact. You mentioned the potential you're looking at, but are you detecting any need to increase deposit rates? If not at this time, how do you foresee this evolving in the future? Additionally, at what point would you expect that to shift to possibly addressing a third or 50% of the increased interest rates?

As I mentioned, Andrew, the deposit pricing; our deposit pricing hasn’t changed dramatically here, so the actual beta has been lower than the model beta. And I said we continue to model about a 50% beta, and we think that's a reasonable expectation. But ultimately, we'll have to see what happens around customer behavior and competitive dynamics, and see how it plays out over time.

I have a couple of quick questions regarding Wealth Management. Firstly, can you provide your perspective on the strong trends we’ve observed? Given the recent delays from the DOL and the possibility of some consequences, how is your team positioned? Are you noticing any impacts in either direction? Secondly, I noticed there was a slight dip in deposits this quarter. Have you addressed this already? If not, could you explain what might have caused this decline compared to the underlying long-term growth we've been experiencing?

So on DOL, we've been very consistent in saying that we want to provide our clients choice, and we will continue to do that with compliance solutions if DOL goes into effect. And we're prepared if it does to go into effect to be compliant. We've had good momentum broadly in the business. And some of the secular changes and secular flows that we've seen continue around fee-based assets and just benefits accruing to scale players. So I think all of that momentum is playing well in our system, in our network. It probably has had a chilling effect on recruiting; attrition has been low. We are in an attractive place to work, and we've seen some good opportunities to bring in talent so that’s all been positive from that perspective. And we'll ultimately have to see if DOL gets implemented, delayed again, or ultimately, I guess shelved. On the second question, Michael, the BDP seasonality. So it's obviously not a particularly large move, but one of the comments I made about client engagement, one of the ways that we gauge that metric, is around what people are doing with their cash. So every quarter, people receive dividends and interest. In periods of volatility around certainty, we've seen BDP balances grow, if people keep it in cash or take it out of the system. What we saw that quarter is significant investments and the dividend and interest going back into the market. We've seen some seasonality where that happens in the first quarter, both the combination of people putting that money to work, but also cap season. So nothing alarming and real stability in our deposit base.