Northern Trust Corp (NTRS) — Q2 2021 Earnings Call Transcript

Thank you, Stephanie. Good morning, everyone, and welcome to Northern Trust Corporation's Second Quarter 2021 Earnings Conference Call. Joining me on our call this morning are Mike O'Grady, our Chairman and CEO; Jason Tyler, our Chief Financial Officer; Lauren Allnutt, our Controller; and Briar Rose from our Investor Relations team. Our second quarter earnings press release and financial trends report 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 21 call is being webcast live on northerntrust.com. The only authorized rebroadcast of this call is the replay that will be available on our website through August 18. 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 2020 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. During today's question-and-answer session, please limit your initial query to one question and one related follow-up. This will allow us to move through the queue and enable as many people as possible the opportunity to ask questions as time permits. Thank you again for joining us today. Let me turn the call over to Mike O'Grady.

Thank you, Mark. Let me join in welcoming everyone to our second quarter 2021 earnings call. During the second quarter, we continued to successfully execute on our growth strategies across each of our businesses. In our Wealth Management business, our goals-driven approach and last year's launch of the Northern Trust Institute continue to resonate with our clients, further increasing client satisfaction levels. Our digital Navigate The Now campaign, which we introduced last year, is successfully generating new contacts and leads, creating more opportunity. Uncertainty in tax law changes has also contributed to new business momentum. Earlier in the quarter, we announced the launch of our Tax Policy Resource Center, an extension of the Northern Trust Institute. Within Asset Management, we continue to see momentum in our liquidity products as well as strong growth in our FlexShares ETFs and ESG strategies. We continue to focus on expanding sustainable investment solutions and earlier this month, announced the launch of the Quality Low Volatility Low Carbon World Strategy, an actively managed strategy focusing on high-quality, low-volatility stocks, while maintaining a low carbon footprint relative to the MSCI World Index. We also introduced the Northern Trust ESG Vector Score, which measures financially relevant ESG-related criteria that could impact the operating performance of publicly traded companies. Within our Asset Servicing business, we continue to see growth that was well diversified across regions, products, and client segments. Recent notable public wins include Fundsmith, Marks & Spencer Pension Trust, Martin Currie Investment Management, and Coal Pension Trustees Services Limited. We continue to invest and expand our asset servicing solutions as evidenced by finalizing our acquisition of Parilux Investment Technology, which underscores our commitment to the front office solutions business. The execution of our growth strategies, combined with favorable markets, resulted in 12% year-over-year growth in our trust fees, despite significant headwinds from money market fee waivers. Our expense growth of 8%, inclusive of a pension settlement charge, generated four points of positive fee operating leverage. The expense growth reflected new business as well as investments in both technology and our staff as we continue to build a diverse, engaged workforce with skills for the future. I also want to draw your attention to our latest corporate social responsibility report, which we published last week, marking a full decade of transparent, detailed CSR reporting about the company. The report details our progress towards creating long-term value for our clients, employees, shareholders, communities, and other key stakeholders. Moving into the second half of 2021 and beyond, we remain focused on continuing to effectively navigate the persistent low-interest rate environment, focusing on driving greater efficiencies as well as continuing to grow organically in a scalable and profitable manner. With respect to the public health environment, we continue to operate in what we call resiliency mode, which means we're focused on providing our clients continuity of service while the majority of our employees worldwide are working remotely. However, during the third quarter, we expect to see more of our staff returning to their respective locations. Our return to office plans are being driven first by robust health and safety protocols specific to each location and second, by business function needs and timelines. Finally, I want to express my sincere appreciation for our employees whose commitment, expertise and professionalism continues to be exceptional. Now let me turn the call to Jason to review our financial results in greater detail for the quarter.

Thank you, Mike. Let me join Mark and Mike in welcoming you to our second quarter 2021 earnings call. Let's dive into the financial results for the quarter, starting on Page 2. This morning, we reported second quarter net income of $368.1 million. Earnings per share were $1.72, and our return on common equity was 13.7%. This quarter's results included a $17.6 million pension settlement charge within the employee benefits expense category. As you can see on the bottom of Page 2, equity markets performed well during the quarter. Recall that a significant portion of our trust fees are based on quarter lag or month lag asset levels, and both the S&P 500 and EAFE Local had strong sequential performance based on those calculations. As shown on this page, average 1-month and 3-month LIBOR rates were stable during the quarter with only modest declines. The U.S. dollar was weaker on a year-over-year basis, which had a favorable impact on our reported revenue but was unfavorable to our expenses. Let's move to Page 3 and review our financial highlights of the second quarter. Year-over-year, revenue was up 5%, with noninterest income up 10% and net interest income down 9%. Expenses increased 8%, while net income was up 18%. In the sequential comparison, revenue and expense were both flat. While net income, taking our credit provision and taxes into account, was down 2%. The provision for credit losses reflected a release of $27 million in reserves in the current quarter compared to a provision of $66 million in the prior year and a release of $30 million in the prior quarter. Return on average common equity was 13.7% for the quarter, up from 12.2% a year ago and consistent with the prior quarter. Assets under custody and administration of $15.7 trillion grew 30% from a year ago and 6% sequentially. Assets under custody of $12.2 trillion grew 32% from a year ago and 6% sequentially. Assets under management were $1.5 trillion, up 22% from a year ago and 6% sequentially. Now let's look at results in greater detail, starting with revenue on Page 4. Trust investment and other servicing fees, representing the largest component of our revenue, totaled $1.1 billion and were up 12% from last year and up 1% sequentially. Foreign exchange trading income was $71 million in the quarter, down 1% year-over-year and down 10% sequentially. The sequential decline was driven by lower client volumes as well as lower volatility. The remaining components of noninterest income totaled $99 million in the quarter, down 3% from one year ago and down 2% sequentially. Within this, securities commissions and trading income were flat with the prior year and down 5% sequentially. The sequential performance was driven by lower trading within our core brokerage business, partially offset by higher transition management revenue. Other operating income totaled $54 million and was down 4% from one year ago and down 1% sequentially. Net interest income, which I'll discuss in more detail later, was $344 million in the second quarter, down 9% from one year ago and down 1% sequentially. Let's look at the components of our trust and investment fees on Page 5. For our Corporate & Institutional Services business, fees totaled $612 million and were up 8% year-over-year and down 1% sequentially. Favorable currency translation benefited total C&IS fees on a year-over-year basis by approximately 3 points. Custody and fund administration fees were $455 million and up 21% year-over-year and up 2% on a sequential basis. Both the year-over-year and sequential increases were driven by favorable markets and new business with a year-over-year comparison also benefiting from currency translation. Assets under custody and administration for C&IS clients were $14.8 trillion at quarter-end, up 30% year-over-year and up 6% sequentially. Both the year-over-year and sequential growth were driven by favorable markets and new business with currency translation also as a benefit in the year-over-year comparison. Investment management fees in C&IS of $101 million were down 22% year-over-year and down 13% sequentially. Higher money market fund fee waivers were the key driver of both declines, partially offset by favorable markets and new business. Fee waivers in C&IS totaled $50 million in the second quarter compared to $28 million in the prior quarter. Assets under management for C&IS were $1.2 trillion, up 22% year-over-year and up 7% sequentially. The growth from the prior year was driven by favorable markets, client flows, and favorable currency translation. The sequential growth was driven by favorable markets and net flows. Securities lending fees were $19 million, down 29% year-over-year and up 7% sequentially. The year-over-year decline was primarily driven by lower spreads, partially offset by higher volumes. While the sequential performance was driven by higher spreads and volumes. Average collateral levels were up 19% year-over-year and up 3% sequentially. Moving to our Wealth Management business. Trust investment and other servicing fees were $464 million and were up 17% compared to the prior year and up 5% from the prior quarter. Fee waivers in Wealth Management totaled $29.2 million in the current quarter compared to $22.2 million in the prior quarter. Across the regions, both the year-over-year and sequential growth were impacted by favorable markets and new business, partially offset by higher fee waivers. Within Global Family Office, the favorable impact of markets and new business were offset by higher fee waivers. Assets under management for our Wealth Management clients were $371 billion at quarter-end, up 22% year-over-year and up 4% sequentially. The year-over-year growth was driven by favorable markets and client flows, while the sequential performance primarily reflected favorable markets. Moving to Page 6. Net interest income was $344 million in the quarter and was down 9% from the prior year. Earning assets averaged $142 billion in the quarter, up 13% versus the prior year. Average deposits were $128 billion and were up 15% versus the prior year, while loan balances averaged $36 billion and were up 2% compared to the prior year. The net interest margin was 0.97% in the quarter and was down 25 basis points from a year ago. The net interest margin decreased primarily due to lower average interest rates as well as a mix shift within the balance sheet. On a sequential quarter basis, net interest income declined 1%. Average earning assets and average deposits each increased 1% on a sequential basis, while average loan balances were up 6%. The net interest margin declined 3 basis points sequentially, primarily due to lower average rates. Turning to Page 7. Expenses were $1.1 billion in the second quarter and were 8% higher than the prior year and flat with the prior quarter. The current quarter included a $17.6 million pension settlement charge within the employee benefits category. This charge represented approximately 1.5 points of year-over-year and sequential growth. The year-over-year comparison for expenses was also unfavorably impacted by currency translation by approximately 2 points of growth. Compensation expense totaled $486 million and was up 6% compared to the prior year and was down 6% sequentially. The year-over-year growth was primarily driven by higher cash-based incentive accruals as well as higher salaries. The growth in salaries was primarily attributable to unfavorable currency translation. The sequential decline was primarily due to the prior quarter's equity incentives, including $32 million in expenses associated with retirement-eligible staff. Excluding the previously mentioned pension settlement charge, employee benefits expense was up 11% from one year ago and down 3% sequentially. The year-over-year increase was primarily related to higher medical expenses, while the sequential decline was due to lower payroll withholding, partially offset by higher medical expenses. Outside services expense was $218 million and was up 24% from a year ago and up 11% from the prior quarter. Revenue and business volume expenses accounted for nearly two-thirds of the year-over-year growth and nearly half of the sequential growth. The remaining growth within the category included higher technical services, consulting, and legal expenses, reflecting investment in the business as well as the timing of engagements. Equipment and software expense of $178 million was up 9% from one year ago and up 1% sequentially. The year-over-year growth reflected higher software support and amortization costs. Occupancy expense of $52 million was down 13% from one year ago and up 3% sequentially. The prior year included costs associated with our workplace real estate strategies. Other operating expenses of $68 million were down 21% from one year ago and down 6% sequentially. The year-over-year decline was driven by lower miscellaneous expenses, including account servicing activities, mutual fund co-administration costs, and supplemental compensation plan expenses. The sequential decline was due to lower miscellaneous expenses, partially offset by higher business promotion and staff-related costs. Turning to Page 8. Our capital ratios remained strong with our common equity Tier 1 ratio of 12% under the standardized approach, flat with the prior quarter. Our Tier 1 leverage ratio was 7.1%, up slightly from 6.9% in the prior quarter. During the second quarter, we repurchased 252,000 shares of common stock at a cost of $30 million. We also declared cash dividends of $0.70 per share, totaling $148 million to common stockholders. The current environment continues to demonstrate the importance of a strong capital base and liquidity profile to support our clients' needs. We continue to provide our clients with the exceptional service and solution expertise they've come to expect from us. Our competitive positioning across each of our businesses, Wealth Management, Asset Management, and Asset Servicing continues to resonate well in the marketplace. Thank you again for participating in Northern Trust's second-quarter earnings conference call today. Mike, Mark, Lauren and I would be happy to answer your questions. Stephanie, will you please open the line?

So maybe I'll start with expenses. I was hoping, Jason, you could unpack some of the trends both on the compensation and non-compensation side of the equation. And I guess on the compensation side, when we look at the sequential decline in compensation, almost all of that is really just kind of explained by the seasonal effects. So compensation is pretty well controlled, especially in the context of a better revenue environment. So how should we think about that for the rest of the year? Are there factors that would allow you guys to hold the line on expenses for the second half? And then similarly, on the non-comp side of things, things were a little bit higher than originally expected, and you previewed that at a conference a few weeks ago. But a similar line of question: how should we think about the jumping-off points for the non-comp side of the equation?

Yes. So let me take them in order. I think you hit the compensation side well, in that it was controlled. If you look at headcount in particular, Alex, that's flat for the second quarter in a row, which evidences how we've been managing through the announcements we made in January about what we were trying to do. Part of that is that we also look to reinvest some of that savings, which may play into the second part of your question, which I'll come to in a second. But in terms of looking forward for the rest of the year, part of what we did was go through that expense savings exercise. Earlier in the year, we talked about $40 million to $50 million, somewhere in that range of savings. We've gotten through that and executed that pretty well. At this point, I’m not saying that we're going to continue to see a downward trajectory. Now I think, frankly, the business growth and some of the investments we're making in the business might cause that to start to have more of a traditional feel going forward. So then if I come to the non-comp side. And I think the area you're probably looking at is probably outside services. We've got there’s a $20 million increase sequentially there, and we did talk about that. I did reference that that line item was going to be higher than anticipated. And so it probably makes sense for me to unpack that a little bit for the group. The way we've been thinking about it is to separate that outside services category into two categories. First, there are a lot of business-related expenses that are in there. And so it's sub-custody, third-party advisory, brokerage clearing, market data. Those are line items that are going to trend with the growth of the business, and about half of the growth that we see sequentially is related to that business growth. You can kind of even test that—if that’s half of the $20 million, say it's about $10 million, compare that to the fact that we saw about $40 million in trust fee growth excluding waivers. And that’s not bad. You should expect that when we've got that kind of lift on trust fees; you'd expect there to be some increase coming in these business-related growth exercises. The second big category is a lot of our technology costs are within that outside services line. We've had a very consistent goal of strengthening the foundation of technology, improving data architecture, and our client experience. Since we're doing well on those headcount exercises and the markets are up, we want to be deliberate and say we're going to reinvest some of that savings back into technology. That accounts for about half of that increase. Now to your question, how should we think about it going forward? All that tech investment is not going to continue to grow at $10 million a quarter. The components of outside services that relate to technology should actually be flat over the next few quarters. We've got some engagements-- we had with consulting firms and others front-load the activities there. And at this point, we're thinking that component should be flat.

Great. That's super helpful. And then maybe I could squeeze another follow-up just around capital return dynamics. The buyback was a little bit late this quarter. Obviously, you guys continue to have very strong capital ratios. And we've seen your peers talk about the willingness to sort of go even a little bit below their internal incentive management targets because the balance sheets have ballooned as much as they did. How does that inform at all your appetite for share repurchases? I know you guys kind of think about yourselves relative to peers and that sort of construct as opposed to the absolute sort of vacuum. But given the backdrop for share repurchases for State Street and BK, curious how you're thinking about yourselves?

Yes. No, we acknowledge a lot of firms have talked about aggressive share repurchase. To us, share repurchase is tied to a lot of factors as we think about how to deploy earnings. If we keep capital levels roughly level, we've got to consider dividends, which you consider those kind of predictable, then you're managing to two other factors: capital required to support RWA growth; and then lastly, share repurchase. If you look at-- we actually looked at the last five years pre-pandemic, and dividends are interesting. They're consistently about one-third of net income. Think about the other two-thirds split between supporting our RWA growth and share repurchase. Over those five years coming into the pandemic, RWA wasn’t changing significantly. The increase that we saw related to RWA growth is just about 15%, and that leaves about 50% of our earnings that were redeployed to share repurchase. Since the start of the health crisis, though, the relationship between repurchase and retention has actually flipped. Dividends are still roughly one-third, maybe a little higher. The rise in loans and securities that you see on the balance sheet has led to an increase in RWA. So, about half the earnings have been redeployed in the form of retention to maintain capital levels. That left about 15% for repurchase. That's the overall narrative of where we've gotten to where we are. Now that is not to say that we wouldn't change our capital levels or that the change in RWA is a long-term phenomenon. We could easily see lower RWA levels in a lot of different scenarios that we could predict. But that at least explains what happened in the five years pre-pandemic and the trends you saw there, and then how things have changed amidst the health crisis and how our share repurchases are like relative to what you saw coming pre-pandemic.

So a question on just rate impact in general. Flat rates from here or better, do we finally see the signs of NIM, NII, and fee waivers bottoming out? Or is there another level to think about as non-operating deposits might start declining? Just curious to get your thoughts and the cadence from here.

Yes. High level, I think the band at this point has narrowed a lot. There’s still runoff in the securities portfolio. We’re two-thirds of the way through the runoff there, and we’re still losing about 40 basis points. But if we think about the impact of what that’s doing, it’s not as significant as it once was. And then another component is people, obviously, you’ve seen IOER up. One thing to note there is people see we’ve got about $35 billion in cash, but we only have about $13 billion, $14 billion, $15 billion at the Fed. That translates to $1.5 million or $2 million a quarter; it’s not that much in terms of lift. LIBOR continues to be a big impact, and you actually saw LIBOR come down a little bit; it went from 12 basis points to 10 over the quarter. All those things together or, at least at this point, we’re not talking about $5 million and $10 million, $15 million moves, we’re talking about $1 million, $2 million, $3 million moves a quarter, and they’re offsetting each other largely. So I think we’re in a band where the volumes across the portfolio are going to be the driver of what happens in net interest income.

Okay. I appreciate that. I wonder if you could just expand or just comment on the fixed versus floating rate mix of both your debt and in the securities portfolio? I’m just curious if you’re thinking about locking in either side as rates have moved yet again lower.

No, it wouldn’t cause us—the recent moves wouldn’t cause us to make a change. We’re constantly looking out at the market and just thinking broadly about how we feel about it. So we did have duration step out a little bit. It went from 2.5 to 2.6, maybe 2.6, maybe 2.7, somewhere in that range. But that’s more reflective of the longer journey we’ve been on, extending the securities portfolio. We’re conscious to not try and chase return by doing anything inconsistent with what we’ve talked about strategically. The strategy we discussed at ALCO has been to get about where we are right now in duration and in mix. So no significant changes that I would want to forecast coming up.

Can I follow up on the money market mutual fund waiver fees? Now that there’s been a slight increase in rates in the reverse repo area, where many of the money market mutual funds are now engaged with the Federal Reserve, do you sense that your money market mutual fund waiver fees could actually decline sequentially? Some of your peers have pointed that out.

Yes, I think they will. Unless we get a significant change in the short end of the yield curve, what happened in mid-June was helpful for waivers. If you think about the math of it—first of all, I can tell you where we were; we peaked at a run rate of $80 million to $85 million a quarter. That’s where we were in early June, and now as we sit today, the run rate is more like $70 million a quarter. That run rate changed pretty quickly after the Fed actions around June 16 or whatever it was. That said, there’s not much—I don’t think there’s that much more that’s going to come in terms of run rate. At this point, because the money market mutual funds are so short, probably 40% of them on average have 30 days or less in duration in the portfolio, so they’ve already turned over and reinvested. The run rate I gave you is reflective of the post-IOER and overnight repo facility changes. But yes, there is a benefit that came from Fed actions in mid-June.

Very good. And then as a follow-up. You’ve talked a little bit about your reserves at the Fed. I think on your balance sheet, your total deposits at banks, all central banks are around $54 billion. If that’s the right number? Can you tell me what’s the more normal number once we get into maybe a more normal environment at some point in the future? Are you—what would be a lower number that you’d be comfortable with?

Well, I’m not sure it’s lower. It’s interesting—we talk a lot about this, what is—if we layer in the overall deposits; on average deposits are—forget about just what’s at the Fed. But just in general, what’s driving the asset level is the liability side. If we're at $125 billion, $130 billion, how much is that a post-pandemic normal? It’s just too hard to tell. Clients are, right now, they’ve held on to liquidity longer than what we would have anticipated. That $35 billion in cash, the other $20 billion-ish that’s in other currencies at other central banks, it’s all driven by the deposit base. It’s held in there pretty flat for a while now in that kind of $120 billion, $130 billion level.

Jason, curious about the loan growth. So that was pretty robust this quarter and actually the end of the period was higher than the average. It certainly suggests it was steady through the quarter. Can you maybe give some color around what's driving the loan growth? And also the decline in the loan yield, was that simply a function of LIBOR? Or was there some mix that was contributing to that as well?

So the loan growth, I’d put it in two buckets. One is there’s been an ongoing for the last several months, for this year and maybe even leading up to it, an initiative, a desire, a deliberate level of activity with clients to explain to them, we like the types of loans that we do, but we’re willing to do more of them with those clients. I’ve talked about being perceived as more of a reluctant lender. We’ve been talking to clients saying we’ll do more, and I think that’s been a continued lift to our loan portfolio, particularly relative to what we’ve seen in the rest of the industry. Now that said, there’s also a chunk of it that’s probably more episodic. We’ve talked about the spikiness in the deposits that can come from particularly GFO clients or very large asset owners. There’s an element there that we would view as episodic and spiky, and that’s leading to both a big part of the increase that you mentioned and also is a driver of the yield. But back to the fact that we did see LIBOR come down a couple of basis points; that obviously is also going to have an impact on the loan portfolio as a whole.

Got it. Okay. And then thinking about organic growth in the quarter, you guys had signaled recently that things were starting to pick back up after being on hold with the pandemic and all of the disruption. So how did organic growth come in this quarter? When you think about organic growth, particularly on the Wealth Management side, do you typically use metrics that are consistent for Wealth Management like net new assets in order to gauge that growth? And is there any chance that we’ll be getting some disclosure, maybe some formal disclosure around those metrics at any point so we can have a better, clearer sense of how this business is growing?

Well, we feel like we’re giving revenue numbers by region and also splitting out the family office business. So we can come back to the disclosure element if you’d like, but just maybe start sequentially with your questions. The organic growth across the company was good, and it was strong in Corporate & Institutional Services for the quarter. We look at that very much year-over-year. It’s very difficult to try and unpack that on a sequential basis. But the C&IS business has had strong new business growth and that’s coming to fruition; it’s being onboarded, and we’re seeing good organic lift in the business. Then Wealth, as you can see, it’s benefiting a lot; it’s more exposed to market growth. So that’s been more of a help. But there’s also been good year-over-year growth in the Wealth Management business as well. I’ll also call out and looking at the numbers a little deeper that a portion of the growth sequentially in Wealth came from what we think were nonrecurring items. We have those items in C&IS and we call those out, but we also have those in the Wealth Management business. So that can be trust and state settlements; it can be how we account for alternatives. Coming out of the income statement, not a huge amount, but you could call it $3 million, $4 million of the lift that we had was nonrecurring in nature. Overall, it was a very strong organic growth quarter for the enterprise.

Mike, your opening comment, you mentioned the digital strategy and some changes that you made and how that’s helping out right now. That’s a very high-level comment, and it's appreciated. But can you connect that to some more concrete metrics on how it’s actually impacting the results that we’re seeing and maybe how it will impact the results ahead?

With digital, Mike, there’s a number of ways to look at it. To start with the reference in my opening comments, particularly in Wealth Management, a lot of this is, as I’ve talked previously about switching from a new business generation model that has historically been primarily either in-person or on the phone to being more digital. When I talked about the Navigate Now campaign, that was essentially a driven online digital campaign. The key to it was how do we generate more opportunities from that, so leads from that. Both what was online were supported then with some more traditional media through advertisements. That generated thousands of leads for us at a high level, which then have been worked through to get to the leads that fit our profile and then could be followed up in a more traditional way. Another point that I referred to is the Tax Policy Resource Center, which is part of the Northern Trust Institute. While we talk a lot about that being our knowledge base that we leverage for our clients, it’s also a significant new business generation asset. The key reason why that’s also digital is when we launched that center, which is essentially online, it has generated significant new leads. Since its launch, we’ve had over 250,000 views of that. That gives us the data to follow up with those that are going to the center. That doesn’t mean that all of those will be good leads, but it’s the funnel you then work down to being ultimately new clients. When I mentioned digital, that was the reference on that front. More broadly, with what we're doing with digitalizing our entire business, that’s much broader regarding our technological capabilities that drive both new capabilities for clients and efficiencies for our business model.

On that last point, when you talk about efficiencies for the business model, is there any way you can size the potential, your aspirational targets, lowering unit costs, improving the expense relationship? Any context you can put around that?

Yes. As you know, and you highlighted it there, there’s a number of financial metrics, but one we’ve looked to, which is the expenses to trust fees. We’ve continued to drive that down over time. At a high level financial perspective, that’s where you’re going to see it come through. Just to try to make that more tangible, one of our big investments in Asset Servicing is in our matrix platform. That first focus is on transfer agency. That will provide a much better experience for our clients’ clients because we’re doing that on behalf of asset manager clients. But also, that is going to yield significant efficiencies for us. Essentially, that’s the first funding mechanism for the business plan to make that investment. The other, of course, is generating new business because of those capabilities.

With regards to the outlook, Jason, I was hoping you could speak to what's driving. Is this some of the increased loan appetite in the current environment? I know you talked about really strong growth and demand across your client base. But I was hoping you could provide just some context around how much of seasonality or factors that maybe drove the step up given some of the tax seasonality? And just the implications for the NII trajectory in the back half? Whether there’s a sufficient offset to the securities yield headwind that you had cited earlier in your remarks?

Not a lot—there’s not a lot of seasonality on the loan side for us at all. Some on the deposits, but not on the loans. What I was talking about earlier is there may be a layer less about seasonality, but more about just the spikiness of how some of our very, very large clients will sometimes come to us and say, we want to borrow a very large dollar amount to either avoid selling a large asset, or to avoid the public sale of large assets, and we’re happy. Those are extremely high-quality loans and are meaningful to clients to help on their liquidity needs. You can also imagine pricing on them isn’t something that’s driving incredible increases in net interest income either. I don't think that—I think it probably sticks out more in volume levels than it will in net interest income levels over time.

Got it. And just for my follow-up also on NII. I was hoping to get a sense as to how you're thinking about managing some of the excess liquidity that is parked at the Fed? You saw a very healthy step-up not surprisingly sequentially. And the securities growth has been relatively tepid as excess reserves have continued to expand. I want to get a sense as to whether you have sufficient excess liquidity or buffer? Some of those incremental funds back into securities?

Yes. We’ve got a lot of—we’ve got plenty of room right now if we wanted to move from whether it’s HQLA to non-HQLA, whether we wanted to increase the balance sheet size if clients were the driver there and saying we wanted to do significant increases. Again, we haven’t—we’re not incredibly receptive to the phone calls from organizations we don’t work with saying, ‘Can we park $10 billion, $5 billion on the balance sheet?’ We’ve always talked about the balance sheet being there for our clients and being a strategic resource for us to engage with them. But at this point, we feel like we’ve got a lot of flexibility. You look at Tier 1 leverage of 7.1, and that gives an indication in and of itself of tens of billions of dollars of room that we could have to bring on additional assets.

I had a couple of questions on some of the initiatives that you’ve announced recently, in particular, the European ETF launch and the alternative asset servicing digitization initiative. Maybe you can give us a sense as to how we should be thinking about the rollout, the timing, and the impact? Is it likely to come through earnings in the next couple of years? Or is this a client acquisition over time type of initiative?

I’d headline both as long-term, strategically important, but short term, not needle moving from the income statement perspective. Take, for example, the European ETF; we’ve got $160 billion in AUM in overall assets, mostly in Europe related to ESG. We’ve got a nice business in Europe regarding ESG and fund launches. That’s a good example of us thinking about what's important for our clients and working with the Asset Management business to determine what they can do to provide incremental resources for clients long term. If you think about the size of $1.5 trillion in assets in AUM in the Asset Management business, that’s not something we think is going to be a needle mover to that $1.5 trillion, but also it’s strategically really important.

Betsy, to address the other one, it fits into my comments on digitalization and the fact that the first driver often is the efficiencies that we get from it. What we announced on the alternative asset side is the ability to use machine learning to capture all the data for alternative assets and digitize them, if you will, so that then they can be processed much more efficiently through the entire process. That will benefit us on the efficiency and productivity side.

Okay. And then just separately, obviously, equity markets are up nicely. We're hearing a lot of pension plans looking to get frozen and put into the hands of OCIO providers. I know you're involved in that business. Could you give us a sense of how you believe you're positioned for what seems like a wave of opportunity here?

You're right. We're in that business, and in a good way. If you think about particularly North America pension plans, our OCIO business was leading in that space. It falls into our sweet spot. We’ve got very good expertise and a sophisticated client base. Flip side to it is you get a lot of clients who, as they derisk and do other things with their portfolios, can that sometimes work against you? I don’t think about it as a big wave that’s going to move the needle much on $4 billion in fees, but it’s a very strategically important business for us.

I would just add, Betsy, because we do believe we’re particularly well-positioned for that trend, because in addition to what Jason said, if you think about our business model, you have the OCIO practice and that Jason talked about, but also we have relationships through Wealth Management and through the family office part of that as well, where we have exposure and connections into a number of foundations that might not be as large as some of the biggest that you read about but are going through the same decision-making of whether they want to just outsource the investment activity there. We think that will continue, and we think we cover it as broadly as anybody.

Okay. All right. And then just one squeeze-in question on the dividend. I know we talked earlier about the buyback, but should we be expecting any changes to the dividend going forward?

If you look over the last few years, particularly pre-2020, which is kind of a goofy year, our dividend is pretty consistently 30% to 50% of net income. It’s been very consistent. If you look at where this quarter falls, it falls right in the middle of that 30% to 50% range. So nothing there that would raise a flag up or down, and we think it’s very attractive. Interestingly, I think something people don’t do a lot, we look at dividends relative to RWA, which is an interesting way to combine thinking about payout ratio with returns. As we look at our peers, and you can pick your own, both in terms of that level of that payout ratio on a percent basis relative to earnings, the consistency of it, and how it is relative to RWA, we score really well on those different lenses.

Just a follow-up on that point on capital further. I just want to make sure I clear that. It seems like you're focusing as much on just maintaining capital ratios with that balancing act you mentioned on RWA versus the combined shareholder return. So I know you guys don’t give us formal targets, but I think historically, I might have thought you might have lived relative to where others are. Is this a little bit of a difference? Maybe it’s post pandemic, or maybe you want to keep some aside for inorganic opportunities? Just wondering how we think about how Northern Trust thinks about your absolute capital in that regard? I understand the mix of usage has changed, but coming back to just where you want to live on absolute levels.

Sure. Ken, it’s Mike. I think you hit on the key factors and how those change over time. To your point, you said while the pandemic and how you may feel about that, that criteria is the operating environment. So we’re always looking at that operating environment, determining where we think we need to be. The second, I would say, is certainly from a regulatory perspective. Again, feel very good about where we are there, but that’s another lens to make sure that we think we’re in the right place vis-à-vis all the ratios and the whole CCAR process and everything. The third, as you mentioned, is instead, I’ll call it absolute, the relative capital ratios, which we know that is a part of the considerations clients have when they think about a financial partner and a partner that they need to trust not just today to be around and be strong but be around for a very long time. That’s part of the pitch, if you will, Ken, that Northern Trust has been around and will be around through all types of environments and we have amongst all the capabilities but also the financial strength and capitalization. So that’s why that criteria is important. To your point, that can change over time as our peers move their capital levels up and down.

It just would seem to me that you've got plenty of capacity on all of those factors, plus room for balance sheet growth, plus room for buybacks, but it just seems like the mix of the buyback has become a smaller proportion, obviously, as we saw this quarter?

Yes, it did. As Jason went through, we’ve just gone through in the last six quarters a meaningful increase in RWA. It’s largely intentional, as Jason talked about, we saw the opportunity to really support clients and to get prospects that would not just be credit clients but broader relationships. We saw that as a better opportunity at that time to redeploy in the business and RWA went up, as he said, more in the six quarters than it did in the five previous years in a meaningful way. Does that stay the same going forward? Yes, obviously, we don’t know. Generally speaking, these things tend to change over time.

That's very fair. And just one question on the deposit growth, which has remained stickier as you guys have mentioned. Are you comfortable housing it all on balance sheet, even though you're getting relatively low returns in the low rate environment? Or do you contemplate trying to move some of it off into off-balance sheet vehicles?

We can start in that instance with what's best for clients. We’ve got $280 billion in a money market fund family. The performance there is good. It’s a very attractive set of money market mutual funds. At the same time, some clients really like the saying we want to be on the balance sheet. Some of it is geographic—obviously, in the U.S., there’s much more prevalence to use funds while some of our European clients like to use the balance sheet more. We’re in a good position where we’ve got room on both sides, really good attractive offerings on both sides. Don’t need to nudge clients one way or another for us. That said, we sometimes look in different operating environments. We can think about pricing. We can think about the value proposition that we can offer clients in one platform versus another. We can have conversations and do things, but not in a position at this point to have to nudge. Again, that 7.1% in this environment where all bank balance sheets are inflated gives us a lot of room to be able to just lead with what makes the most sense for large sophisticated depositors.

Just let me go back into the capital question since that—the buybacks and dividends have caught everybody’s attention. Following up on your comment, you do watch versus peers and I understand you’re focused on the risk-weighted assets, so that would imply that you’re focused on the CET1 ratio versus peers. Is it a gap? What is the gap that you’re trying to maintain above peers? Is it 100 basis points? Is it 50? Can you give us some sense of as we think about how to in the constructs of your balance sheet, whatever assumptions we make, what is it that we should be keeping in mind?

Yes, there’s no gap in particular, and that’s not even—I also wouldn’t say that’s the only ratio that we look at, CET1. We’re looking at—we’ve talked about Tier 1 leverage a few times just this morning on this call. There are other things that we look at as well in terms of balance sheet strength and credit quality and other factors, and how all that—duration and what exposures look like across different asset classes that we invest in. There are a lot of ways to litmus test that. At the same time, we’ve also mentioned and Mike just walked through the framework a few minutes ago. We’re thinking not just about the relative but at an absolute level where we want to be, thinking about what the regulatory environment is like. I always remind people that we’re not just making this decision unilaterally. We have good engaged conversations with our Board around this topic and where we might want to take the balance sheet strategically. I know it’s tempting to look and say, okay, well, what’s the floor and where are you going? There are so many factors that we’re looking at. The reinvestment opportunity set looks like. If we’ve got opportunities to let RWA grow in ways that we think are building future earnings, some people can miss that RWA growth isn’t just a drag. It should give a sense that there’s potential future earnings that are expected. We’re still trying to grow earnings. Looking at dividends and share repurchase can sometimes pull the narrative toward thinking about those things as the better way to redeploy earnings. Still, RWA growth is reflective in some ways over the long run of the base of business we have. It’s not to say RWA is going to continue; it could come down. Even mentioning the loan growth we’ve talked about has caused a significant increase in RWA at this period. If that goes away in a year, then RWA would come down. There are so many factors that when we sit around the table and talk about where we want to go with the redeployment of earnings; we’ve got to predict not just where things are, but where things are going in each of these elements. But it’s certainly broader than thinking about a specific gap on CET1.

Okay. Great. And one more on the overall expenses. You told us that the other operating expenses—you expect the trajectory to be. Are you seeing any other impact from an inflationary standpoint? Any color on that given the big talk in the environment about inflation? What are you able to do to offset that?

I think we missed the operative word there. Are we looking to see any changes in—what did you say to that?

From the rise in inflation, are you seeing any inflation creep impacting your expenses, Jason? And if so, how are you—what are you being able to do to offset that?

Thanks for clarifying, and then just another component of the question. The comments we made earlier weren't on other expenses. It was on outside services, just to make sure everybody understands what we were talking about in detail there. The inflation is showing up in different areas. Every firm is dealing with talent issues, and the pressure is there. We certainly see that and experience it, talking at management levels about how to address it and the inflation we see across the business in different areas as well. Some of it is unit cost, but some of it is just the increased cost of doing business. We talked about the significant increase in technology-oriented expenses that we’re having. In some ways, that’s an inflation cost on the business. It’s not just a unit price in inflation, but it's inflation in the overall cost of doing business. So it’s showing up in different ways across the organization.

Yes. I would just add, Vivek, if you think about it in a manufacturing context, to Jason’s point, we’re seeing inflation on the cost side in several ways. In a manufacturing context, your question would be whether you can pass that on to the end consumer. That’s not the way our operating model is set up. That said, if you think about how we’re pricing what we do, a lot of it relates to the asset level. So to the extent that inflation is going through to AUM and AUC levels, you're capturing some of it there. To the extent that you believe inflation is on the horizon as well, you would expect interest rates to go up as well, and we know where we are on rates and what the impact would be to the extent those increase.

Most of my questions have been asked and answered, but maybe just to come back on the seasonal expenses in the second half. You gave us the color on the outside service expense. Typically, you see a seasonal bump in equipment and software expense; that’s been pretty reliable at least over the last three years. So if you could just maybe comment on whether we expect to see that similar dynamic? And then in other expenses, just—I don’t know if I missed it, but the Northern Trust Open is going to be a factor for Q3.

Thanks for bringing up the equipment and software; I probably should have referenced that earlier. Yes, there’s likely to be an increase there as we think about what’s happening over the remainder of the year. It’s not one or two areas that I could point you to, but you’re right, there are some dynamics where it tends to tick up. Some of the expenses that we—some of the capital expenses we put in place you start to see depreciation come up there. It’s in a lot of different line items. There should be a tick-up there—a normal-ish or maybe even slightly above that increase in equipment and software. As for the Northern Trust Open, it will be in the third quarter.

Yes. And Brian, this is Mark. You can look at the business promotional line, although that's not all, but there's seasonality to it. If you look at 2017 through 2019, there was about a $16 million to $17 million step-up from the second to third quarter. So that’s probably a decent way to think about it.