Northern Trust - Q3 2020

Transcript

Operator (participant)

Good day, everyone, and thanks for standing by. Welcome to today's Northern Trust third quarter 2020 earnings call. A quick reminder that today's program is being recorded, and at this time, I'd like to turn the floor over to Mr. Mark Beatty, Director of Investor Relations. Please go ahead, sir.

Mark Beatty (Director of Investor Relations)

Thank you, Greg. Good morning, everyone, and welcome to Northern Trust Corporation's third quarter 2020 earnings conference call. Joining me on our call this morning are Michael O'Grady, our Chairman and CEO, Jason Tyler, our Chief Financial Officer, Lauren Allnutt, our Controller, and Kelly Lernihan from our Investor Relations team. Our third 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 October 21st call is being webcast live on northerntrust.com. The only authorized rebroadcast of this call is the replay that will be made available on our website through November eighteenth. 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 2019 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 Michael O'Grady.

Michael O'Grady (CEO)

Thank you, Mark. Let me join and welcome you to our third quarter 2020 earnings call. Amid the ongoing public health crisis, I hope you and your families are healthy and well. At Northern Trust, we continue to operate in what we call resiliency mode, which means we're focused on providing our clients continuity of service, while over 90% of our employees worldwide are working remotely. In this environment, we have adapted to a new normal as to how we serve and communicate with our clients. Though challenging, the transition across each of our businesses has been effective. Within wealth management, earlier this year, we introduced the Northern Trust Institute, the embodiment of the intellectual capital of our wealth management business, drawn from our experience serving the most affluent individuals and families in the world.

It combines and integrates the best thinking of our firm across 34 practices, including areas such as investments, fiduciary, banking, planning, family business, philanthropy, and governance. We have also published a number of insights and research pieces covering timely topics in the current environment, including family governance, philanthropy, commercial real estate investing, and the upcoming U.S. election. Lastly, we've been very encouraged by the client and prospect participation in our digital Navigate the Now campaign, which is driving more engagement. Our asset management business has seen considerable market share gains during 2020 within our liquidity products, which have strategically been positioned over time. We've also experienced recent success in our active and indexed fixed income and tax-advantaged equity products. We manage nearly $100 billion in assets globally under ESG mandates, where our strong capabilities position us for future growth in this space.

Within asset servicing, as we've mentioned previously, we did see a deferral in implementation activity from the end of the first quarter and into the most recent quarter. However, the pipeline is strong and opportunities have increased as clients and prospects have adapted and become more comfortable operating in the current virtual environment. Recent notable public wins include Driehaus Capital Management and Federated Mutual Insurance Company in the U.S., Marks and Spencer Pension Trust in the U.K., Hannover Re, a European-based insurer, and Azimut Limited for its funds in the Middle East. We continually develop our solution-based services to support the needs of our clients, with two recent examples being enhancements to our ESG analytics capabilities to support our clients' oversight, risk, and exposures, and the launch of dynamic valuation and reporting tools for asset owners using our innovative Front Office Solutions product.

We also continue to build our positioning in the outsourcing space, most notably in outsourced foreign exchange and trade execution. Finally, we just recently published our latest corporate social responsibility report, detailing our progress toward reducing our greenhouse gas emissions, enhancing our diversity, equity, and inclusion strategy, and launching client-focused ESG tools and investment vehicles, as I previously mentioned. As we move forward in the current and persistent low interest rate environment, we will accelerate our focus in two areas. First, we will continue to drive greater efficiencies with a focus on technology solutions to drive productivity gains. Second, from a growth perspective, we're focused on doing more with our existing client base and also bringing on new clients to allow us to continue to grow organically in a scalable, profitable manner.

Finally, I want to express my sincere appreciation for our staff, whose commitment, expertise, and professionalism throughout these extraordinary times has been exceptional. Now, let me turn the call to Jason to review our financial results for the quarter.

Jason Tyler (CFO)

Thank you, Mike. Let me join Mark and Mike in welcoming you to our third quarter 2020 earnings call. Before I start, I would also like to take a brief moment to recognize all those affected by this ongoing crisis, especially those working on the front lines. Our thoughts are with you, and we hope you and your loved ones remain safe and healthy. Now let's dive into the financial results of the quarter, starting on page two. This morning, we reported third quarter net income of $294.5 million. Earnings per share were $1.32 a share, and our return on average common equity was 10.5%. The quarter included a $43.4 million pre-tax charge related to a corporate action processing error.

The issue was identified internally by our corporate actions team, and to put the impacted clients in the same position as they would have been if the error had not occurred, we executed open market transactions, which resulted in a loss. As you can see on the bottom of page two, equity markets, particularly domestic U.S. 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. It's worth noting that on a year-over-year basis, the EAFE Local index remains negative, which creates an unfavorable impact to our fees compared to the prior year. As shown on this page, average one-month and three-month LIBOR rates continued to decline during the quarter.

Let's move on to page three and review the financial highlights of the third quarter. Year-over-year, revenue was down 3%, with non-interest income up 3% and net interest income down 21%. Expenses increased 6%. The provision for credit losses was $500,000 in the current quarter. Net income was down 23%. In a sequential comparison, revenue declined 1%, with non-interest income up 2% and net interest income down 11.4%. Expenses increased 6%, and net income declined 6%. Return on average common equity was 10.5% for the quarter, down from 14.9% a year ago and 12.2% in the prior quarter. Assets under custody and administration, $13.1 trillion, grew 13% from a year ago and increased 8% on a sequential basis.

Assets under custody of $10.1 trillion grew 16% from a year ago and increased 9% on a sequential basis. Assets under management were $1.3 trillion, up 9% from a year ago and up 4% on a sequential basis. Let's look at the results in greater detail, starting with revenue on page four. Third quarter revenue on a fully taxable equivalent basis was $1.5 billion, down 3% compared to last year and down 1% sequentially. Trust, investment, and other servicing fees, representing the largest component of our revenue, totaled $1 billion and were up 3% from last year and 4% sequentially. Foreign exchange trading income was $62 million in the quarter, up 3% year-over-year and down 14% sequentially.

The increase compared to a year ago was primarily driven by higher volatility, while the sequential decline was impacted by lower volumes and lower volatility. The remaining components of non-interest income totaled $91 million in the quarter, up 7% compared to one year ago and down 10% sequentially. Securities, commissions, and trading income decreased 10% compared to a year ago and was down 22% sequentially. Both year-over-year and sequential declines were primarily due to lower interest rate swap activity and referral fees. Other operating income increased 19% compared to the prior year and was down 5% sequentially. The increase compared to the prior year was driven by higher income related to a bank-owned life insurance program, as well as higher miscellaneous income, primarily associated with a market value increase in the supplemental compensation plans.

This higher income resulted in a related increase within the other operating expenses. The sequential performance was impacted by a lower market value adjustment for seed capital investment relative to the prior quarter, partially offset by lower Visa swap expense. Net interest income, which I'll discuss in more detail later, was $336 million in the third quarter, down 21% from a year ago and down 11.4% sequentially. Let's look at components of our trust and investment fees on page five. For our Corporate & Institutional Services business, fees totaled $585 million in third quarter and were up 4% year-over-year and up 3% sequentially.

Custody and fund administration fees, the largest component of C&IS fees, were $395 million, and up 1% year-over-year and up 5% on a sequential basis. Year-over-year performance was primarily driven by favorable currency translation and new business, partially offset by unfavorable markets. The sequential increase was primarily driven by favorable currency translation as well as favorable markets. Assets under custody and administration for C&IS clients were $12.3 trillion at quarter end, up 13% year-over-year and up 8% sequentially. Both the year-over-year and sequential increases were attributable to new business, favorable markets, and favorable currency translation. Investment management fees in C&IS of $137 million in the third quarter were up 19% year-over-year and up 7% sequentially....

The year-over-year growth was primarily driven by strong flows within our money market funds. The sequential increase was primarily driven by the impact of favorable markets. This quarter's results included $0.9 million in money market fund fee waivers within our C&IS investment management fees. Assets under management for C&IS were $993 billion, up 10% year-over-year and up 4% 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 currency translation. Securities lending fees were $20 million in the quarter, down 2% year-over-year and down 28% sequentially. The year-over-year decline was primarily driven by lower spreads and lower volumes, while the sequential decline was primarily driven by lower spreads.

Average collateral levels declined 5% year-over-year, but were up 1% sequentially. Moving to our wealth management business, trust, investment, and other servicing fees were $419 million in the third quarter and were up 1% compared to the prior year and up 6% sequentially. Both the year-over-year and sequential performance were impacted by favorable markets, partially offset by money market fund fee waivers. Within our wealth management business, fee waivers totaled $4.4 million in the quarter. Assets under management for our wealth management clients were $319 billion at quarter end, up 6% year-over-year and up 5% sequentially. The year-over-year growth was driven by favorable markets and net flows, while the sequential increase was primarily driven by favorable markets. Moving to page six.

Net interest income was $336 million in the third quarter and was down 21% from the prior year. Earning assets averaged $129 billion in the quarter, up 23% versus the prior year. Average deposits were $113 billion and were up 27% versus the prior year. The net interest margin was 1.03% in the quarter and was down 58 basis points from a year ago. The net interest margin decreased primarily due to lower short-term interest rates, as well as mix shift within the balance sheet. On a sequential quarter basis, net interest income was down 11.4%. Average earning assets increased 3% on a sequential basis, while average deposits were up 2%.

The net interest margin declined 19 basis points, primarily due to declining asset yields as securities and loans repriced to lower interest rates. Turning to page seven. Expenses were $1.1 billion in the third quarter and were 6% higher than both the prior year and prior quarter. Expenses during the quarter included the previously mentioned $43.4 million dollar charge. Excluding the charge, expenses were up 1% on both a year-over-year and sequential basis. Compensation expense totaled $462 million, and it was up 1% compared to one year ago and flat sequentially. The year-over-year growth was driven by higher salary expense due to staff growth, base pay adjustments, and unfavorable currency translation, partially offset by lower incentives. On a sequential basis, higher salaries driven by unfavorable currency translation and staff growth were mostly offset by lower incentives.

Employee benefits of $97 million was up 11% from one year ago and up 8% sequentially. The year-over-year increase was primarily related to higher pension expense. The sequential increase was primarily driven by higher medical costs. Outside services expense of $186 million was down 4% on a year-over-year basis and up 5% sequentially. The year-over-year decline was driven by lower costs across a number of categories, including technical services, consulting, third-party advisory fees, and data processing, partially offset by higher subcustody expense and brokerage clearing costs. The sequential increase was due to higher technical services costs, third-party advisory fees, consulting, and subcustody-related costs. Equipment and software expense of $171 million was up 13% from a year ago and up 4% sequentially. The year-over-year growth reflected higher depreciation and amortization, as well as software support costs.

The sequential increase was driven by increases in software support and equipment maintenance costs. Occupancy expense of $52 million decreased 2% from one year ago and was down 14% sequentially. Both declines were related to lower costs associated with executing workplace real estate strategies. Other operating expense of $127 million was up 38% from one year ago and up 48% sequentially. Results for the quarter included the previously mentioned $43.4 million charge. Excluding the charge, the category declined 9% compared to one year ago and was down 3% sequentially. The year-over-year comparison was impacted by lower expense related to business travel, partially offset by higher mutual fund co-administration fees, as well as higher costs associated with supplemental compensation plan expense within staff-related expense.

The sequential comparison was impacted by higher costs associated with the Northern Trust-sponsored golf tournament, offset by lower other miscellaneous expenses within the category. Turning to page eight, our capital ratios remain strong, with our Common Equity Tier 1 ratio of 13.4% under the standardized approach and 13.9% under the advanced approach, both unchanged from the prior quarter. Our Tier 1 leverage ratio was 7.7% under both the standardized and advanced approaches. During the third quarter, we declared cash dividends of $0.70 per share, totaling $148 million to common stockholders. It's times like these that show the importance of a strong capital base and liquidity profile that support our clients' activities, and we continue to provide our clients with the exceptional service and solution expertise they've come to expect.

Our competitive positioning in wealth management, asset management, and asset servicing continues to resonate well in the marketplace. Thank you again for participating in Northern Trust third quarter earnings conference call today. Mike, Mark, Lauren, and I would be happy to answer your questions. Operator, please open the line.

Operator (participant)

Absolutely. And ladies and gentlemen, if you do have any questions, please signal by pressing star one on your telephone keypad. If you would just make sure you have your mute function turned off so we can receive that signal. We'd also ask that you, limit yourselves to one question and a related follow-up. Once again, folks, that is star one for any questions at this time. And first, from Jefferies, we have Ken Usdin.

Jason Tyler (CFO)

Hi, Ken.

Ken Usdin (Managing Director of Equity Research)

But thanks. Hey, thanks. Good morning, guys. Just want to follow up on the whole side of rates. So, good news that NII was down better than the original guide, and I was just wondering if you can update us on what your thoughts are as far as the outlook for NII, and at what point do you expect NII to get close to, you know, just flattening out? You know, is that sometime early in two thousand and twenty-one, or how can you help us think through that? Thank you.

Jason Tyler (CFO)

Yeah, it's first of all, I think it's important for people to realize that there are components of the securities portfolio that are longer dated, and there are securities we bought in seventeen, eighteen, nineteen that aren't going to mature for another two, three, four, or five years. And so it's going to take a long time to get this whole portfolio repriced. That said, at this point, 75% of overall earning assets have been repriced on the new yield curve. And if you were to break it down even a little bit farther from that, you can look and see that, you know, effectively all of the floating rate assets have been repriced, 80% of the loan book has been repriced, and about 50% of the securities book has been repriced.

And so I think the best way to think about it, from what you can see, is that from here, about 1%-2% of the overall earning asset base is going to reprice every quarter. And so we've gotten through most of it. And if you think about how aggressively we had to get through, going from the first quarter, where everything was on the prior book, to then in the second quarter and now this third quarter movement, we've got the vast majority of it done. That's why we think the flattening. We're at that point now. It's just trickles from here, but it's not going to be 100% flat for a long time as those longer-dated securities play through it.

Ken Usdin (Managing Director of Equity Research)

Okay. And I guess just, you know, relative to your prior comments, I just want to give you the opportunity to level set us on what your expectation would be, you know, for 4Q NII versus 3Q.

Jason Tyler (CFO)

Yeah, I appreciate that, and I do think that. First I'll answer the question. The way we look at it now, and it comes back to that dynamic of about 2% repricing, you could say it's going to be down 2%, give or take a point. And I think that's what you should expect from the math at this point. That said, now that we're at the point where so much of the book has been repriced, the movement in NII from here is going to be driven more by what happens in the business and more by what happens in loans and what happens in the deposit book and how that stays on. And frankly, our confidence level in reinvesting that into not just cash at central banks, but into higher-yielding assets.

From here, it's going to be much more business driven.

Ken Usdin (Managing Director of Equity Research)

Okay. Thanks, Jason.

Jason Tyler (CFO)

Thanks, Ken. Sure.

Operator (participant)

And we have, Glenn Schorr with Evercore.

Jason Tyler (CFO)

Hey, Glenn.

Glenn Schorr (Senior Managing Director and Senior Research Analyst)

Hello there. Thanks. So definitely not the norm for you guys, but I, you know, I think everyone has a little bit higher sensitivity to issues like this these days. So I was going to ask, just for a little more color on the corporate action item. Was this a manual issue? What have you done to rectify, and have there been MRAs outstanding related to this? I think that some of the Q&A back and forth pre-call was about that, so I figured we'd just address it. Thanks.

Jason Tyler (CFO)

Sure. I appreciate, Glenn. So, first of all, I just want to provide a little bit of context on this group for people that don't know it well and how an item like this occurs. I think it's important to understand, with $13 trillion in assets under custody or administration, the security services group is processing literally millions of transactions a year. We got errors in the group on a consistent basis, and they total somewhere between $5 million, $10 million a quarter on average. That's typically what we experience there, and they're accounted for consistently in the other operating expense line on the income statement that you see. So the event itself is not unusual, it's the dollar amount.

If we focus on that a little bit, you think over the last 10 years, we've actually never had a loss cumulatively in a quarter to even get to $20 million. If you look back even on the years, we've never had a full year that amounts to this level of a loss. Interestingly, this quarter in and of itself, from a volume perspective of losses, it was light. Even the other items added up to a less than normal level, you know, it was at the bottom end of that kind of $5 million-$10 million range, and so then if you ask, you know, what have we done? You know, you can imagine, you know, the first thing we do is unpack the situation.

Once we're confident that there's been a mistake, we did everything we needed to do in order to make our clients whole. We did that, and then at that point, we look at the processes, identify ways to improve even a process we felt strongly about, but we identified ways to strengthen it. We put those in place, and at this point, we move on. From an MRA perspective, you know, we wouldn't be able to, you know, to talk about that at this point if it were even, if that had even been surfaced. But obviously, we, you know, we took this very seriously. This is not, and I think it's important to note, this isn't, this is not out of the normal course of servicing $13 trillion in assets in terms of the event.

It was really the fact that we had a very large exposure within it that was unusual.

Glenn Schorr (Senior Managing Director and Senior Research Analyst)

Okay, cool. Maybe I do a follow-up on something related to the balance sheet. Hi, Jason. The other securities line is up 30% year-on-year, and it's almost the biggest part of earning assets now. The footnote talked about community development and investment, but could you just expand a little bit more on that because it's such a larger part and it's growing more? What benefit do you get from that? What kind of yield pickup, and should we expect to see more of that? Thanks so much.

Jason Tyler (CFO)

Sure. Just before you, before you go on, you Glenn, I want to make sure we answer your question really specifically. So you're talking about the increase in the securities portfolio to kind of $56 billion-$58 billion. Is that where you're looking?

Mark Beatty (Director of Investor Relations)

Yeah, I think most of that growth came on that other securities line. So if we address-

Jason Tyler (CFO)

Yeah.

Mark Beatty (Director of Investor Relations)

If we address the growth in securities year-over-year, I think that'll...

Jason Tyler (CFO)

Yeah. So, you know, in general, the group... Go ahead. Were you going to add a clarification, Glenn, or?

Glenn Schorr (Senior Managing Director and Senior Research Analyst)

Nope, nope, you got it. The other line-

Got it.

in the securities line on the balance sheet. Thanks.

Jason Tyler (CFO)

So in general, the treasury group is always looking for opportunities to lean out a little bit from just cash when we feel confident. And there'll be types of investments that are short term, where it's not cash, but they're items where we pick up a little bit of yield. And so it could be short term JGBs, it could be other short-term instruments where we pick up a little bit of cash, a little bit of yield without taking too much incremental exposure. And so they've been looking at that in different ways.

Part of it, I think we talked last time about the fact that part of this NII journey is going to be not just the size of the balance sheet, but when we felt confident that we could step out of central banks. So as the treasury group's looking to do that, they're looking for not just these traditional, what are we going to do with two-year, three-year, four-year securities or mortgage backs, but other items that can stay short, but still pick up a little bit in yield. So that's not necessarily something you should see as a longer-term trend. It's something that as we did this initial step out, we saw opportunity.

Glenn Schorr (Senior Managing Director and Senior Research Analyst)

Oh, great. Thanks so much. Appreciate it.

Jason Tyler (CFO)

Sure.

Operator (participant)

Next question will come from Alex Blostein with Goldman Sachs.

Alex Blostein (Managing Director)

Hi. Hey, guys. Thanks. Good morning. So maybe just a quick clarification on NII first. So, you know, hear you on the kind of 1%-2% decline in NII from here as the securities book reprice. Does that include any mitigation efforts to offset the roll-off from loan dynamics? Or, or that's really kind of like a gross number, and then there are things you could do to help mitigate the remaining pressure albeit it's obviously somewhat small, which could get you to more of a kind of flattish NII from here?

Jason Tyler (CFO)

The answer is, it's very much just looking organically at the amount of, that's in the book. That doesn't include any other strategic items. That's just the math of what's rolling off from here. That said, I do want to caution people, even though net interest income is down significantly, obviously, we're not going to be looking to have dramatic changes in our strategy or our risk profile to think about, quote, unquote, "offsetting the decline in rates," and we're constantly thinking about optimizing the investment book, and we continue to do that. No change in our risk appetite at all, but the 1%-2% a quarter is very much just the math of what exists in the book right now, absent any other things that we would be...

You shouldn't be thinking that's exactly what's going to happen over time. There are other things we're thinking about in terms of the securities portfolio, other things we can do with the balance sheet, but those were things we were contemplating before rates came down, frankly.

Alex Blostein (Managing Director)

Got it. That's very clear. Thanks for that. My bigger picture question kind of revolves around fees, and this has obviously been a pretty volatile year with respect to both markets and new business and volumes, et cetera. Maybe help us level set what has been the organic fee growth in the business, maybe kind of over the last twelve months. You know, given your comments around strong pipeline and sort of the building momentum in C&IS, maybe help frame what that kind of organic fee growth could look like over the next 12 months. And then specifically, I was hoping you guys could also hit on the Global Family Office business. That revenue has been kind of flattish for the last four quarters, despite a pretty significant growth in assets.

I know there's a little bit of lag there, but still feels like the fees are lagging, lagging the asset base. So, I kind of bigger picture question, but if you guys could hit on all that, that would be awesome. Thanks.

Jason Tyler (CFO)

Sure. So if I start on C&IS, I think that we'd separate it into two different buckets there, interestingly. One is that there has been significant growth that's come in the investment management fee line, and that's come from very good collaboration between the asset management business and C&IS, and a lot of work we did in the last couple of years, setting up the liquidity business to be able to take on assets. So I'm going to do this at the corporate level, but a lot of these assets apply to C&IS. But if you go back to last year, or to the beginning of this year, the liquidity business had $215 billion in AUM, and now we're close to $285 billion, $290 billion.

Very significant growth, bigger than what's happened in the industry. So that's led to good organic growth in the business as a result of good collaboration. Again, not 100% of that is in the C&IS business, but the vast majority of it is. The other aspects of C&IS, as you just get to the traditional custody and other asset servicing type activities, interestingly, the organic growth this quarter was not great. It was positive, but it wasn't great. They do feel stronger about the pipeline that they have, the one not funded business. Part of that is a result of the fact that there were a lot of prospects that we won that delayed implementation, partially because of COVID, but still very high confidence level that's going to be onboarded in fourth quarter or first quarter.

And so we see good opportunity set to bring on that business in the next couple of quarters. That said, the growth in the money market mutual fund business. It's been great, but it has flattened out at this point, and so it's good diversification in the business to sometimes get growth coming from the investment management side, and sometimes from the other.

Michael O'Grady (CEO)

This is Mike. I'm going to pick up for Jason while he gets a chance to get a sip of water, Alex. So I think importantly, longer term, that, again, we continue to see the opportunity to grow at a higher organic growth rate. Having said that, as we've always said, it's critical that that's profitable growth for us, and so that we're doing it in a way that is coming with operating leverage and fee operating leverage. Now, with the change in the rate environment, you know, that dramatically impacts your ability in the short term to get the operating leverage. And so as a result, you know, it makes it focuses us on ensuring that that growth does not come with the requirement for significant resources.

So looking at the expense side of the equation and just making sure that we keep those in line in this type of environment, and that the growth is high quality, scalable growth for us. So that's on the asset servicing side, and Jason mentioned asset management. Just to close off on wealth management, you know, again, as you mentioned, this has been an unusual year, and so we've had to shift our sales and new business strategy as a result, and I would say that I'm very optimistic on the long-term prospects for that, but it has in this, you know, interim period, you know, has caused some additional volatility in the normal sales pattern that we would have.

So long term, you know, very positive, but to your point, you know, there's some bumpiness that we've had this year that we haven't had in previous years.

Alex Blostein (Managing Director)

Mm-hmm.

Mark Beatty (Director of Investor Relations)

Alex, this is Mark, and I could comment on the GFO asset growth. I think you're seeing the growth of stuff up in the second quarter. Can't get into a lot of the specifics there, but that type of client, that type of segment for us, those clients can move pretty large, concentrated asset holdings onto our custody platform, and that's what the majority of the increase was in the second quarter. There's not necessarily a corresponding noticeable increase in fees, with that, just because of the nature of the holding, single holding that we might be having on our platform, for those clients.

Alex Blostein (Managing Director)

Great. Thanks, everybody, for tackling all that. Thanks.

Jason Tyler (CFO)

Thanks, Alex.

Operator (participant)

Next up from Morgan Stanley, we have Betsy Graseck.

Betsy Graseck (Large Cap Banks Analyst and Global Head of Banks and Diversified Finance Research)

Hi, good morning. I had a couple questions. You know, on the capital ratios, I know you, you know, typically sit with a pretty nice cushion above your regulatory minimums and above, you know, what your management buffers might add it to it. Obviously, in this period with no buybacks, it's capital ratio is improving even further. Could you give us a sense as to how you're thinking about utilizing that excess capital, you know, in the event that there's the suspension on buybacks continues, is there anything that you might wanna discuss about how you could be using that capital outside of buybacks? You know, we've seen some acquisitions in the space recently on the asset management side, and wanted to get your sense on that, if there's anything to do there. That's the first part of the question.

Thanks.

Jason Tyler (CFO)

Good. All right, I'll try it and see if I get my voice back. The good news is that Mike and I talk about this a lot, so if I don't, we'll definitely be on the same page on it. So, you know, I'm gonna start with, and you've heard me talk about this a little bit, Betsy, but I think there's four components to how firms. To at least how we think about how we deploy capital and what capital levels we maintain. The first is we have very good, genuine discussions with our board about it, and that's not to say that there's any tension there. There's not at all.

We're completely aligned, but we also wanna make sure that we're not being presumptuous in saying where we want capital levels to be, without having good conversations with them, so that it really does truthfully start with that discussion, and then secondly, we think about capital on an absolute basis. We wanna have good cushion relative to where we need to be from a regulatory perspective. The third is we look very closely, frankly, out the side view mirror, and we look at things on a relative basis. When we talk to clients and prospects, they care, and we wanna be able to reflect. It's part of our overall value proposition that we've got strong capital levels, and we have to be able to evidence that on a relative basis.

And the fourth, maybe most instructively, given the fact that the stock price has come down, is thinking about things on a returns basis. And so we think about that deployment of capital, not just, do we, do we take capital up or down, but what types of returns are we getting for it? And there, we have to compare what returns are we getting by investing in our own stock effectively. And that has to do a lot with where we think things are from a price-to-book perspective, and, and how it's trading and what we think. And secondly, what opportunities do we have to reinvest organically in the business? And then third, we're looking at what examples there are where we can invest or non-organically outside.

And so we've talked about the fact that we're very open, and I'd say particularly in the wealth management space, where it is difficult to have organic growth. We feel very strong about the franchise, and we feel like our ability to maintain a high-quality client base is very strong if we were to bring that in.

Betsy Graseck (Large Cap Banks Analyst and Global Head of Banks and Diversified Finance Research)

When you're talking about wealth management, you're talking about teams, firms, portfolios. Is there any nuance to that?

Jason Tyler (CFO)

Yeah. You know, the teams I think is harder. I think those tend to be, first of all, you know, culturally, it's not super consistent for us to do something like that for various reasons. I'm happy to talk about it a little bit more. I think firms where you've got more of a sense of scale that's been there, but they're maybe not at the scale that we are, and we can bring that in. And we think about our different groups almost as large teams.

We think about the offices we have, the $320 billion in assets. You split that between the offices we have, and you know, you have a team of, you know, one, two, three billion, so something of, you know, that size or 10 bi- you know, up to $8 billion is kind of a couple of teams from our lens. Extracting a team out of another firm is not something that we have tended to do.

And so thinking about an organization, an established organization with a client base, but with a leadership that hasn't been able to develop a succession plan in place, or they think it just might be better to go to the infrastructure of a larger organization, and you think about the scale we represent at that asset level, we can be a good solution for firms that don't have that succession planning in place.

Betsy Graseck (Large Cap Banks Analyst and Global Head of Banks and Diversified Finance Research)

Okay, and what I'm hearing in your answer is, wealth management over asset management. Is that fair?

Jason Tyler (CFO)

To the extent there are opportunities in asset management, it's a little bit more nuanced. We've done some things there, quietly, more small, that have been extremely consistent with our strategic desire to do more intermediary distribution. And, you know, that. So we look closely at those as well. I think the distinction might be probably a little bit of a higher bar right now to do something in size at the asset servicing side of the business.

Betsy Graseck (Large Cap Banks Analyst and Global Head of Banks and Diversified Finance Research)

Got it. And then what if the Fed does lift the restrictions on buybacks? Maybe you could give us a sense as to how you're thinking about, you know, how you would manage the capital in that scenario, in terms of the pace that you might start buybacks back up at, and how quickly you wanna get back down to, you know, the capital ratios that you, you think are most efficient for your business model.

Jason Tyler (CFO)

I can-

Michael O'Grady (CEO)

Yeah, I'll, so Betsy, I think Jason laid out the framework, so I won't go into that, but that is the framework that we would apply, you know, should the Fed lift the restrictions. And, you know, we'll see. But, you know, prior to the pandemic, you know, we were repurchasing our shares. And so, you know, it depends on that, you know, broader environment that we would lay over with the regulatory constraints.

So, you know, I would hope that to the extent that the Fed removes the restrictions, that's also an indication that the environment is relatively favorable, which will put us back in a position similar to at the beginning of the year, where we were both able to and were repurchasing our stock.

Betsy Graseck (Large Cap Banks Analyst and Global Head of Banks and Diversified Finance Research)

Okay, got it. Thank you.

Michael O'Grady (CEO)

Sure.

Operator (participant)

Next question will come from Mike Carrier with Bank of America.

Michael O'Grady (CEO)

Mike.

Mike Carrier (Senior Research Analyst)

Hi, good morning. Thanks for taking the questions. First, you guys have been focused on, you know, both investing in the business, but also doing a good job on, on driving efficiencies and operating leverage. The longer we're operating, you know, in this work from home backdrop, I'm just curious if you've found additional areas of potential efficiencies, whether it's in real estate, you know, or other areas, that could drive that longer term?

Mark Beatty (Director of Investor Relations)

We, you know, this environment has been very. Obviously, it's made everybody take a step back and think about that. We have, frankly, there are things that we're accelerating the business. I mentioned super quickly in the opening comments that we're on a, a real estate strategy journey right now. We looked deeply at that just a couple of months ago, kind of in the midst of this, to say, how does the healthcare crisis influence that strategy? There are elements of it that it accelerates, and there are consolidations we were thinking about that, frankly, we're saying, "We can do that faster." Then there are other things that we were not considering before, that this endeavor makes us consider.

You know, I tell people kind of jokingly, you know, a year ago, I did not know how many sq ft we had off the top of my head, and now I do. I know where they are, and I know how much we're paying per sq ft. So we're talking about that element a lot, to try and think about what does real estate look like in the future, not just domestically, but internationally. There are a lot of creative things we can do to try and be more efficient and try and leverage the technology that we've invested in into our partners, in order to decrease reliance on sq ft, frankly. That also leads to areas of saying how we become more resilient, how do we think about resiliency with our workforce overall?

We've had to make them more technologically equipped in order to be resilient, and that adds flexibility as well, obviously, in very creative other ways, the way we think about resiliency centers and other things like that.

Mike Carrier (Senior Research Analyst)

Okay, that's helpful. And then, Jason, you mentioned in the past that loan demand, you know, will be a key driver, you know, to NII going forward. And we've seen fairly divergent trends, you know, across the industry. You know, it's still, you know, fairly weak in loan demand, but pockets of strength within the wealth area. So just wanting to get an update on your front, you know, in terms of the demand that you're seeing, you know, across the business.

Jason Tyler (CFO)

Yeah, you can't see it from the financial statements, but, you know, loans are actually a tick up within September, even. And that surprised us. You know, when you go back ninety days ago, we. I think everyone felt like we were gonna see balance sheets come down. We thought liquidity. We thought cash was gonna come down, deposits were gonna come down, we thought loans were gonna come down. But, you know, our balance sheet on average was up in the quarter, and even there, it's not just that clients are holding more deposits, but loans were held in.

And so I it does seem like there some of the loan demand we have is coming from clients that are saying they want to be ready to do things to be more active if they see opportunities come up. It's unclear whether or not that'll actually happen, whether or not the opportunity come, or whether or not they'll actually pull the trigger on it. But that's certainly been the case, that they've held in terms of loan volume. And we've been talking recently about the fact that liquidity, in general, is a big component of what we do with our clients. And so if you think about liquidity more broadly, as clients wanting to find safe, high quality places to park their cash and short-term assets, they view our balance sheet as strong.

And we've talked about the fact that our money market mutual funds, very strong investment performance, they're at size. Our treasury funds are $80 billion-$90 billion, and so various appealing places, even for very large institutional investors to invest. And then on the other side, clients know that as they've worked with us, we understand their asset composition well, and so we can be a thoughtful lender in terms of how to structure things in the most efficient way for them.

Mike Carrier (Senior Research Analyst)

Great, thanks a lot.

Jason Tyler (CFO)

Sure.

Operator (participant)

Moving on from Deutsche Bank, we have Brian Bedell.

Brian Bedell (Director)

Great.

Jason Tyler (CFO)

Hi, Brian.

Brian Bedell (Director)

Thanks very much. Hi, good morning. Just a couple of quick questions, just get those out of the way. Just if you could comment on the typical seasonality that we see in uptick in expenses that we typically see in the fourth quarter, in conjunction with the Golf Open, which added some expense in 3Q. And also the exit rate for money market fee waivers in September, just to get a sense of sort of where we're running rate into for 4Q on that.

Jason Tyler (CFO)

Sure. Mike, do you want to do the first?... Yeah.

Michael O'Grady (CEO)

So the first was on the seasonality in the, in the Northern Trust?

Brian Bedell (Director)

No, just in general on expense, I think-

Michael O'Grady (CEO)

Oh, no. In expenses in general.

Jason Tyler (CFO)

For fourth quarter except-

Yeah, sure.

Yep.

Michael O'Grady (CEO)

So there are components of expenses in fourth quarter that we should actually clarify, 'cause I think third quarter, in some ways, is not an ideal run rate for some of them. And so maybe we just walk through it a little bit. First of all, you know, take benefits, for example. You know, you see the trend that took place, but, you know, but part of it is the fact that medical has gone, and it's not an enormous line, but it's had an enormous jump from second quarter. And so medical in second quarter was something like $17.5 million, it went up to $26 million in third quarter. That's closer to a typical run rate, but could still see some tweak up from there.

And so, so I think that's, that's just something to keep in mind, that as our partners exited effectively doing normal things in their own healthcare maintenance, that's coming back online, and it's had a surprisingly large level of volatility from my perspective, frankly. And then outside services is another one where we believe we could see a similar step up in fourth quarter to what we saw in third quarter. There's a lot of business volume-related costs within that category that are likely to increase, and we're still running at relatively low levels of cost when you think about things like consulting, legal, technical services that dial down, and we're doing everything we can to tamp those down, but that could come back up. And then equipment and software.

On a year-to-date basis, equipment and software costs are up 11%. You know, that's likely close to where we're gonna land for the full year of 2020. The category where the expenses are expected to have high levels, higher levels of growth this year, as the fact we've invested in the business, we've got higher depreciation and amortization costs. We've called that out. D&A is something like two-thirds of that line in general. And so that's kind of in the soup. It's hard to tamp that down as aggressively. And then I'll talk about occupancy. You know, I mentioned it a little bit. There's gonna be volatility there. We're gonna make some investments, frankly, in occupancy to try and get our longer-term run rate down a little bit.

And so you're gonna see that line item bounce around a little bit. And so in general, I'd say it's less about seasonality of run rate and in expenses, and it's more about two things. One is, how do we get back to undoing the COVID-related influences on expenses? And second, what are the investments we're gonna make to try and decrease our run rate in the long run?

Brian Bedell (Director)

Yeah. Does that put that on the money market fee waiver trajectory at the end of the 3Q?

Jason Tyler (CFO)

Yeah, thanks. So let me, I'll do a couple of comments there. One is, you know, as you could pick it up from the opening comments, we're right at $5 million only in the third quarter. Now, the reality is there's, you know, of the, you know, the $300 billion in money market mutual fund assets we have, that is relatively stable at this point, but rates are moving around a lot. So you've got to assume that rates and volumes stay the same, but third quarter was $5 million. As we sit today, the run rate on a quarterly basis is about $11.5 million, as we sit today. The team thinks we could have waivers in the fourth quarter, $20-$25 million.

Exiting the year, so as a launch point, coming into 2021, could be $25 million-$35 million. And just to give you a sense of, you know, what does that mean? I think it's super important to remember the fact that if you go back to the beginning of this year, when we were $215 billion in assets, you know, the overall revenue run rate was much lower than what it is right now. And so now you go up to $290 billion, and the run rate's over $400 million in revenue.

We're talking about the fact that we have a decent amount of waivers, but from a much higher revenue base, and so the story there is kind of mixed in some ways.

Brian Bedell (Director)

That's, that's super helpful. And then, Mike, maybe on just ESG, you mentioned that at the outset, the ESG analytic service that you have started. Maybe if you could just talk about where you are on the growth path of that, and are you rolling it out to all of your asset servicing clients and how's the take-up? And then also on the wealth management side, are you seeing more demand from your wealth clients for investing in ESG product that you have and sort of the organic growth outlook in the investment management side for your ESG products?

Michael O'Grady (CEO)

So, Brian, the reason why I did mention it up front is because ESG does run across the company and each of our businesses, and you started to highlight it there, but let me go back through a little bit, you know, first of all, just from an investing perspective, to your point, you know, we are seeing more and more demand from our clients, you know, both institutional, but to your point, on the wealth side, including our GFO clients, in ESG investment product and investment strategies, so as a result, we've as you would expect with our business model, we've looked to fulfill those demands with ESG products from our asset management group.

And as I mentioned, over $100 billion at this point, but, I would say still in the early days, of that trend and of the growth opportunity, for us there. And then, you know, more broadly, in thinking about our institutional clients, particularly, you know, asset owner clients, you know, they're being held to a higher standard as well as to how they're investing, and, from an ESG perspective. And as a result, they need the analytics around that. So I talked about the capabilities that we rolled out, and, to your point, I would say, you know, early days on that, because I think this is a, you know, very long-term trend.

Brian Bedell (Director)

Great. That's super helpful. Thank you.

Michael O'Grady (CEO)

Sure.

Operator (participant)

Next, we have Vivek Juneja from JPMorgan.

Michael O'Grady (CEO)

Hi, Vivek.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Hi, Mike. Hi, Jason, and Mark. Let me. I just want to follow up on the operating error. I know you've had those for years, and I know. I recognize it's one item, but large amounts do get a lot of attention. You, I'm sure, are aware of what's happened to another to a G-SIB, when the amount got much larger, similar to their business. They do have those kinds of errors. And I know you've been. What do you plan to do to automate more of these processes so that you have less of these errors? Since we've heard you talk about trying to do stuff where you need less reconciliation, less checking.

So Mike, what do you need to do to step up to limit these and hope that, you know, something like this doesn't get even to be a larger amount in the future?

Michael O'Grady (CEO)

Sure, Vivek. So as Jason mentioned, you know, this is the nature of our businesses, you know, in that part of the business, is processing, transactions, you know, for our clients, broadly speaking. And there are certain aspects of that that have been automated and were automated, you know, years ago. And that's, you know, what you would expect, is find the areas that lend themselves to automation. You get the benefit of both efficiency, but also, you know, dramatic, reduction in risk, from incurring errors. And so, you know, that's, that's the longer term path that, you know, we've been on for, and, you know, I'd say the industry as well, for some time period.

And then you have other aspects of what we do that don't lend themselves as much to automation because of the, you know, idiosyncratic nature of, the particular transactions. So in this case, you know, corporate actions where, you know, certain aspects of corporate actions are very straightforward, and so, you know, they've already been automated or, or portions of them have been automated, but other parts where it's still difficult because of the, the lack of, you know, homogeneity of the transactions themselves. With that said, you know, we have... This area, even though it's, you know, primarily manual, you know, with some level of automation, it's an area that gets a lot of attention from a procedures and control perspective.

And frankly, as much as there have been errors, you know, in the past, it's been very well controlled. So think about it as, you know, higher inherent risk as we see it, but with procedures and controls that we've been able to, you know, manage and mitigate the risk that comes with that. That's not to say that we haven't been on a path of trying to add in additional workflow tools and automate additional things that we can. We've been investing, broadly speaking, in our security services area significantly for years to modernize the technology in there, in that area.

So, you know, it's on a path, and then you have a, you know, situation like this that occurs that certainly brings more attention to it, but it wasn't attention that we felt as though, you know, "Boy, we've ignored this area." Rather, we've controlled it, and we've tried to improve it, but it requires, you know, additional procedures and controls, and as we go forward, more modernization and automation as well.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Understood. Thanks. A quick one for Jason, a take, a minor one. Jason, the CIS fees, you mentioned year-on-year benefit from FX translation. Could you give us the number ex FX translation?

Jason Tyler (CFO)

2%.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

2% growth ex FX translation. Okay.

Mark Beatty (Director of Investor Relations)

I mean, just to clarify, this is Mark. On the custody and fund services line, that's where most of the currency impact would be, and that impact was about a 2% benefit on a year-over-year basis.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Okay. So that means that-

Mark Beatty (Director of Investor Relations)

And that line, I should also add, even though you didn't ask, that is the area that we saw the EAFE Local is down on a year-over-year basis. So that was actually a drag for that line, markets were, because that line, as we've talked about before, is probably, you know, two to one more based on EAFE Local than I would say what domestic indices are doing.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Okay, great. Yeah, I did notice that you mentioned that, markets were down, and I was wondering which ones, so I'm glad you clarified that one. But is that and are you highlighting that because the fee rate is higher on that market? Because I didn't think EAFE was over 50% of your revenues.

Mark Beatty (Director of Investor Relations)

No, just to try and give you a sense of, you know, the importance, as you try and predict asset levels, you're trying to just appreciate the influence of inflows local within the C&IS trust fee base, as opposed to wealth, that's much more exclusively driven by just domestic, the domestic indices.

Vivek Juneja (Managing Director and Senior Equity Research Analyst)

Sorry, okay, I'll clarify that with Jason with Mark offline. Thanks. Thank you.

Operator (participant)

Moving on, we have, Brennan Hawken with UBS.

Michael O'Grady (CEO)

Hi, Brennan.

Brennan Hawken (Senior Analyst of Equity Research)

Hey, good morning. Thanks for taking my questions. Just to actually sort of following up on that line of questioning from Vivek. When we look at the trends in AUC/A growth in C&IS versus revenue, it looks like, at least the way all of us, you know, knuckleheads from the outside model you, there was some fee rate pressure. I know that it doesn't always translate that way to how you run the business and how you strike, you know, the deals and the contracts and the way all the pricing works. But could you maybe provide some color in helping us understand, you know, what might have caused some of those dynamics? Are those sustainable? You know, what was behind that?

Just to help us inform as we sit there and think about our modeling and where to go from here.

Jason Tyler (CFO)

Yeah, understood. I think more and more frankly, there's going to be less connectivity between the asset level and revenue levels. And, you know, a lot of the negotiations that take place, we're thinking about trying to include a more holistic approach to the relationship, which might be what we're doing with the firm, with investment management, what we're doing with Integrated Trading Solutions, what we might be doing from an IO perspective, how we're handling cash and sweep. And so I know it's super frustrating to not be able to just use that row on a model to predict the revenue, but more and more, the reality is it's just disconnected in terms of the way the business actually prices these relationships. Mark spent a lot of time thinking about this, too. Mark, you add your thoughts. Right.

Mark Beatty (Director of Investor Relations)

I mean, part of it, I would also say, is fee structure. And as we've talked about before, 35%-40% of those asset servicing fees in C&IS are not directly linked to assets. So in an environment where assets are rising, that factor alone would probably put the fees at a lower growth rate. And then, more importantly, and it gets a little bit to what Jason was saying, is mix of business. And even within the actual asset servicing fee category, a very large domestic U.S. custody mandate, large assets, maybe not a large fee. A fund administration mandate could come with much less assets, and the fees are significantly higher.

So there is a mix that's at play, too, besides the timing, which we've talked about before, end of period versus, you know, earning over a quarter. But hopefully, that helps. It's a tough one to unpack, we understand, to the point that Jason mentioned.

Brennan Hawken (Senior Analyst of Equity Research)

Okay, so just... That's all fair, and I totally appreciate that. But to the point of, can you give some color to the point of the third quarter as a jumping off point then? Like, were trends that you saw in the quarter then, you know, reasonably sustainable? Was there some sort of noise that might have caused that divergence to look a little wider? Just to help us kind of any help you can give on that front as we think about it?

Mark Beatty (Director of Investor Relations)

Yeah, well. A couple thoughts. One is that in the spirit of, you know, the business does have some compression, just to get to your specific point earlier, as you asked a question. I want to make sure we come back to it and address it specifically. And those fee compressions are going to be honored, whether or not we're in a COVID environment or not. I actually think, though, that doesn't have as much of an influence on the dynamic that you're realizing, which is that there's a disconnect between the growth in asset levels and the growth of trust fees. Then in the short run, you can have flows into and out of the business that are going to be reported on...

The assets are going to be reported on where they are at the end of the period, and the revenue is going to be reported based on where they were, you know, a prior period, the period before that, maybe average. So it's very misleading to try and do the math on short-term, to try and get a sense of what the fee realization rates look like on a business on an incremental basis. Even the business that's being added, if it's very large pieces of business, it could be at extremely low fee rates. But if it's more middle-market activity, it could be much higher. So the business mix itself will have an influence there, but much less on the ultimate profitability.

Brennan Hawken (Senior Analyst of Equity Research)

Okay. Thanks for your patience with that one. My second question is around just trying to get at the processing error again. I think Mike, you might have made some comment about this, but I just wanted to kind of explore it. I think you said that you all are continuing to review those processes, see opportunities for automation, you know, control and process review, which is, of course, ongoing, but maybe-

You know, an event or a loss like this might sharpen pencils, so to speak. Will this have some kind of impact, do you think, on investment in the near term or some of the expense lines as you guys look to maybe shift or invest in some automation, hire some additional staff for that effort or what have you? Or is it more operational focus rather than the potential for investment?

Michael O'Grady (CEO)

So, Brennan, I would say it's some of both. So certainly there are the operational aspects which I talked about. And just to be clear, you know, we've done the full scrub on this incident already and have changed the procedures already and changed the controls already, in that area. And, you know, from a resource perspective, it was not a question of, you know, insufficient resources in the area that resulted in the error. All the same, you know, we're trying to ensure that that isn't the case at any point going forward as well, so whatever resources. But that's not something that would result in, you know, a change in our financials, if you will, or expense run rate. And then on investments, to your point there, you know, the...

It will - the incident in and of itself doesn't change our investment plan. But the broader environment, without a doubt, you're always, we are always, you know, impacted by the situation that we're in, and as a result, prioritizing our investments. So there's - the opportunities we have to invest, you know, far outstretch what we would, you know, deploy in a given year. And as a result, you have to determine, okay, how do you prioritize those? And do you focus on productivity, you know, investments for productivity, investments for risk management, investments for innovation, and growth? And so, you know, that's a process we go through every year and ongoing.

And I would say in the environment that we're in now, we have to ensure that yes we have the operational resiliency and levels of automation to ensure that going forward. And then second, I would say productivity. We have to make sure that we're investing the technology dollars in a way to get the productivity improvements we think we need in this environment to be able to drive scalable growth.

Brennan Hawken (Senior Analyst of Equity Research)

Great. Thank you.

Michael O'Grady (CEO)

Sure.

Operator (participant)

Next from Seaport Global, we have Jim Mitchell.

Mark Beatty (Director of Investor Relations)

Hi, Jim. Jim, you might be on mute. Jim, can you-

Jim Mitchell (Senior Equity Analyst)

Can you hear me?

Mark Beatty (Director of Investor Relations)

Yeah, I can hear you now.

Jim Mitchell (Senior Equity Analyst)

Can you hear me?

Mark Beatty (Director of Investor Relations)

Yes.

Jim Mitchell (Senior Equity Analyst)

Okay, sorry about that. So maybe just to follow up on deposits. It seems like non-interest-bearing deposits for you guys grew pretty nicely, both on an average and period-end basis, where your peers saw declines. And it seems like that helped you, I guess, outperform on NII a little bit. So just, is there anything unusual in the non-interest-bearing side? Is that something you're trying to grow, or is that just, you know, the episodic gives and takes?

Mark Beatty (Director of Investor Relations)

I mean, I maybe, you know, I'd put it a little bit in between. I mean, first of all, I actually think it's good for people to realize the reason we did better than we anticipated with NII, frankly, a little bit less around the size of deposits. That certainly played a factor, but I come back to the fact that we were able to turn on non-cash and loans held in better. But then to your specific question about the growth in that category, hard for us to comment on what the industry's experiencing, but we go back to the theme that we talk about liquidity a lot with our clients, and they tend to comment to us that they view our balance sheet as very strong.

We try to position it that way, and so we're happy to be a liquidity partner for our clients there. And I do think that has an influence on where they tend to park their short-term assets.

Jim Mitchell (Senior Equity Analyst)

Okay. That's fair. And then maybe for Mike, you mentioned it upfront that you're trying to do more with current clients. What any examples you can give us in terms of what you see as the biggest opportunity set to do more with your current clients?

Michael O'Grady (CEO)

So first of all, I'd say within the businesses, there's definitely the opportunity and one we're pursuing to do more, particularly, I would say, with asset managers. So just thinking about, you know, our approach to the market, you know, from a whole office perspective, it's not just, you know, back office or middle office, but also what we can do on the front office. So I mentioned, for example, Integrated Trading Solutions or, you know, essentially outsourced trading for those institutions. You know, that's doing more with those clients. So it's using, you know, really our position of strength, which is in the back and the middle office, to be able to do more in the front office for them.

So that's on that side, and I could use, I'll say, other examples within the businesses, but also I want to add, though, and highlight, it's also across the businesses, and so it's a concerted effort to say, you know, if we have a, let's say, an administration client, fund administration client, are we providing wealth management to the executives?

You know, of that firm, or if we have a corporate client where, you know, we are the asset servicer for their pension plans, you know, can we provide a wealth management solution or program, what we would call firm to firm, you know, for their executive group, so it's those types of cross-business opportunities that, you know, historically, we've done very well with these, but I would say it's more because of the culture and, and the way that we operate, and we're trying to be, you know, more purposeful and disciplined about how we do that.

Jim Mitchell (Senior Equity Analyst)

Okay, great. Thanks for the thought.

Michael O'Grady (CEO)

Sure.

Operator (participant)

All right, we'll move on to Steven Chubak with Wolfe Research.

Mark Beatty (Director of Investor Relations)

Steve?

Steven Chubak (Managing Director)

Hi, good morning. So wanted to start off with a question on just some of the NII comments. And, specifically, I was hoping you could help us think about the incremental capacity that you have currently to remix some of those excess reserves into securities. And just as we think about modeling the securities yields, where are you in reinvesting today versus the 130 basis points on the back book?

Mark Beatty (Director of Investor Relations)

You know, the capacity is a trickier one because it depends on, you know, how quickly the deposits come in, and sometimes we have to let deposits season in order to get proper treatment for those, and get the confidence level that they're going to stick around so that we know we can take more duration risk with those. The reality is, the size of the deposit base doesn't necessarily correlate exactly to what we can think about in terms of non-cash reinvestment opportunities. In terms of the opportunities on where we are investing at the time, there is more of a distinction there, frankly.

We did step away from just central bank deposits once we started to feel that the balance sheet was more stable. And frankly, I think this is something people have missed. Part of the reason that I think all banks were even going to the point of why were share repurchases suspended? Banks wanted to be there for their clients, if in case there was significant loan demand, and in case there was very significant demand to place deposits where, and we wanted to make sure that regulatory ratios were going to be adequate. And given the fact that we've got such a large custody base, we wanted to make sure that if those assets started to come toward the balance sheet, we were going to feel good about it.

And so we were patient on that. But the more we realized that there was stability from a client perspective, the other components of the regulatory environment were there and more stable, we could take a step away, and what we did in third quarter was really incremental in size and in asset class. But if you think about eventually, the things we can start to move more toward longer-dated securities, we can start to move more toward CLOs, more toward MBS. Now, unfortunately, in a typical environment, you might see more of a 50 basis point, 70 basis point differential between the non-HQLA portfolio and the HQLA portfolio. That's compressed, and it's more like a 30 basis point differential at this point.

There are other things that we can do and explore based on what the opportunity set is, given the risk and return framework of the different securities that we feel comfortable in. But that should at least give you a little bit of a framework on how we think about it and a little bit of the dynamics from a quantitative perspective as well.

Steven Chubak (Managing Director)

Got it. Okay, that's helpful color. And then just thinking about the expense outlook, you know, looking out to 2021, I just wanted to better understand, you know, how we should be thinking about the expense growth trajectory. You know, NII is expected to decline about low double digits, you know, assuming versus the current run rate, things are relatively stable. But fee income growth, potentially growing, you know, mid-single digits, at least on an organic basis. And just wondering, is there room to do better on costs, where expense growth actually lags some of the organic fee growth to help dampen some of those pressures? Or how are you thinking about it in terms of the general internal philosophy?

Mark Beatty (Director of Investor Relations)

Well, we still consider ourselves a growth firm, and we're investing for growth. And you know, things even like the growth in the money market mutual funds, it takes investment upfront to get the cutoff times right and to get investments done with portals. It takes also expense growth on an incremental basis when you think about the administration fees that we pay to some of the on some of the processing side. And so I think that's a good example of just thinking we think about things more from an operating leverage perspective. And to the extent that we have good operating leverage in the business, then we're going to feel okay about the expense growth. Otherwise, we have to be extraordinarily disciplined about it.

And so let me just break it down into three different levels of how, you know, to your question, how do we think about it? Three different levels. One is total operating leverage, two, trust fee operating leverage, and three, organic trust fee operating leverage. Now, on the first, with this total operating leverage, that's including a very declining component of revenue, which is NII. And so it's gonna be very difficult, and I don't think it's a very pure test right now, given the unpredictability and the disconnect of that line item from the rest of the business, to think about that as the one we'd want you to to focus on. The other end of the spectrum is organic trust fee leverage. Unfortunately, there, that's not a GAAP number.

And so we can give you some components of how we think about it, but we can't really ask you to track that and just trust us that it's going to what we're expecting. And so let's focus in the middle on trust fee leverage. And there, I think that's probably the best from what you can see, and from what we think about, that's probably the way to focus our discussion and track how we're doing. But those three elements, and certainly trust fees, operating leverage, a very big one for us as we think about the expense trajectory next year, it's incredibly front of mind for us. Again, we went through the entire re-plan. We did the re-plan on expenses, we did it on capital, we did it on strategy.

As we go into 2021, the trust fee leverage is gonna be a key item to make sure we're doing and exhibiting the discipline we should, given the net interest income environment that we're in. We're giving up $300 million. If you extrapolate what we've done so far this year and put that kind of on a run rate, and you're talking about hundreds of millions of dollars that we've given up in NII, and we're not gonna ignore that. We've got to be more disciplined and have a high sense of urgency about doing what we can to get the expenses as lean as possible, given the environment we're in.

Steven Chubak (Managing Director)

Thanks for that context. And just two quick modeling questions, if I may. One is just how we should be thinking about the jumping off point for other income, given there's a lot of noise in the quarter, as we just look out in 4Q and heading into 2021. And then just on the fee waivers, just to clarify quickly, $5 million was the impact this quarter, but it still sounds like your expectation is somewhere in the range of $25 million-$35 million per quarter headwind exiting this year. Is that right?

Jason Tyler (CFO)

Yes. Yes, that's right. Yeah. Again, this is, and I thought about mentioning it earlier, but I want to make sure we're giving you guys everything we can. The. If you think about, call it $300 billion dollar base of business and say, you know, say $200 billion of it is somewhere in flow for waivers. And the different funds jump into waiver mode at different levels. But if you look at where the overnight repo, for example, is right now, and if you look at NIF Treasury, if you look at the Treasury products, and those are the biggest products we have. And this is all that. You got to imagine that over 50% of the assets are 30 days or less.

At $90 billion, roughly, you're talking about $9 million per basis point. I, you know, I cringe giving you guys numbers that have such volatility in them, but just think about how much of a dynamic that is. If that fund, if that strategy comes down literally a single basis point, it influences run rate by almost $10 million a year. The numbers you quoted are right, but I think it's important for everybody to track the overnight repo market, track 30-day Treasuries, track 6 months, track 12 months, to get a better sense intra-quarter of what that number might be looking like.

Mark Beatty (Director of Investor Relations)

On the other operating income, this is Mark. It certainly has volatility, so I can appreciate the difficulty modeling it. If you looked at averages over the last, you know, year and a half or so, you're probably looking at something in the, you know, mid to upper forty range. This quarter, we did have some benefit from the supplemental compensation plans that sit within that line that were a little bit outsized versus what they've normally been. So, you're probably a little high this quarter, and if you looked at the average, like I said, mid to upper forties.

Steven Chubak (Managing Director)

Perfect. Thanks for clarifying that. Appreciate you taking my questions.

Jason Tyler (CFO)

Sure. Thanks.

Operator (participant)

Moving on, we have Mike Mayo with Wells Fargo Securities.

Mike Mayo (Managing Director and Head of U.S. Large-Cap Bank Research)

Hi. So it looks like you have best-in-class fee growth, led by best-in-class wealth and asset management growth. But I still need help on the disconnect between the growth and the assets under custody, which are up twice the pace of peer, year-over-year, up 16%, and the custody fee line, which is up only half as much, and then you said timing is part of it, but if you look at the last twelve months, your assets under custody is up twice as much, and your related fees are about in line, so it just seems like outside AUC growth relative to the fees, and I know you said some of the AUC is not tied to fees. That's fine, but it still doesn't seem to explain everything that's going on there.

So either there's something else in there, or you're really fighting based on price, or I'm just missing something. Thanks.

Mark Beatty (Director of Investor Relations)

So let me address this. That business, the vast majority of AUC in wealth is GFO. And the reason for that is, you know, that's where the outsized portion of clients that might not manage here, but that want to use us as a custodian, it's kind of a hybrid business between the wealth business and the institutional business. And so when you look at the AUC number there, vast majority GFO. That client base is very, very spiky.

You get a small number of clients that can literally have billions or tens of billions of dollars of assets coming in from an AUC perspective, and that's not going to influence how we think about the pricing on the overall relationship. We think about the relationship very holistically, and if a client has it could be mega liquidity events from a small number of clients, that'll move that line item, that AUC number dramatically without influencing fees.

Mike Mayo (Managing Director and Head of U.S. Large-Cap Bank Research)

What, what's happening with those super high net worth customers then? What are they doing? What have you seen recently?

Mark Beatty (Director of Investor Relations)

Yeah. So a lot of times they'll have a large sale. It could be, you know, life event, it could be, you know, business sale, you know-

Jason Tyler (CFO)

Single stock.

Mark Beatty (Director of Investor Relations)

Single stock exposure that they're dealing with. They'll ask us to custody those assets for a period of time until they decide where to put those funds to work. And so, you know, our goal is to work. First of all, be that provider so that we can be a best-in-class custodian for them, and then introduce the other advisors, managers, to do what we can to also be a manager and a financial advisor. We might do manager selection for them. We might become an OCIO provider. They might put some of those assets into- they might move those assets from where they are into our liquidity funds. They might ask us to do tax-advantaged equity investing, where we're very tax conscious. They might do a more aggressive ESG mandate.

But the custodying in that business, especially if it's a mandate of that size, is gonna obviously significantly change the denominator, but in the short run, it's not going to change the numerator, which is the fees we're getting off of those assets.

Mike Mayo (Managing Director and Head of U.S. Large-Cap Bank Research)

Okay, and I want just one follow-up. So just the gist behind the question was pricing competition in the servicing business. Is it getting worse, better? You know, how do you think about competing? I mean, sometimes it might make sense to take lower prices because of the scalability.

Mark Beatty (Director of Investor Relations)

Yeah. The, you know, in general, the conversations are, you know, you know, have been hopefully starting to be, you know, more about what is your capability set? What does resiliency look like? How did you handle the crisis? What are you able to do to help us from either investment operations outsourcing? Mike hinted earlier at Integrated Trading Solutions. And so all those things in the long run should be helpful in moving away and just like the asset management business, moving away from just talking about investment performance, here, moving away from just talking about pricing and more value added. In the short run, there were concessions that we agreed to, as we do every year, and those played through early in the year.

And so, but in the longer run, we're hoping that these conversations more about capabilities and about service quality are gonna reduce those, the frequency of and severity of the pricing discussions. But we're always going to have-

Mike Mayo (Managing Director and Head of U.S. Large-Cap Bank Research)

Sorry. Sorry, the word concession, the word concessions kind of sticks out in my mind. So is there a magnitude of the concessions, and do they come back or they just. How does that work?

Mark Beatty (Director of Investor Relations)

I think it still comes back to the 1.5%-2% a year of kind of price compression.

Mike Mayo (Managing Director and Head of U.S. Large-Cap Bank Research)

Yeah.

Mark Beatty (Director of Investor Relations)

So, you know, the word concession maybe is a little different, but repricing, that's just the kind of thing that we've seen pretty consistently, and I don't know, Jason, if the business is talking about that picking up or accelerating at all.

Jason Tyler (CFO)

Yeah. And Mike, I would just add, so where you have large relationships that are good, but those client relationships have grown, meaning the assets have grown, just like we talked about, when their fees are tied to, you know, a basis point on those assets that we're either custodying, administrating, you know, whatever it may be, you know, they tend to then go up over time, and then the client looks at it and says, "Hey, you know what? I'd like to take a look at the pricing on this because your fees have gone up, because our assets have gone up, and yet, you know, from a work perspective, you know, you may be doing more, but not as much as our asset growth." And so that's the exercise.

If you're not able to come to an agreement, then, you know, a client can say, "We're going to take it out for rebid." And then that process, then as a result, they're likely to get, you know, more aggressive pricing on it. Now, again, we try to minimize when it, you know, has to go through that full process, but I think that's, you know, the nature for, you know, very large, institutions like that. I would also say on new business, just to be clear, you know, price is a factor, of course, and we lose business on pricing at times. So it's not as though we price to win.

You know, we price to win at a profitable margin for us, and, you know, have models to be able to determine what are the resources required, and therefore, you know, where can we price it? And if we can't get there, you know, with either where we think it is, you know, or you just find out through a process, you know, you lost, and the reason why you lost is your pricing, you know, was not aggressive enough relative to who they ultimately picked.

Mike Mayo (Managing Director and Head of U.S. Large-Cap Bank Research)

Thank you.

Jason Tyler (CFO)

Sure.

Operator (participant)

Next, we have Gerard Cassidy with RBC.

Michael O'Grady (CEO)

Hey, Gerard.

Gerard Cassidy (Managing Director)

Good morning, everyone. I got a big picture question, and be able to answer, but we'll give it a try. Your balance sheet and your deposits, in fact, Jason, you mentioned it, I think, in the earlier question. Everyone was surprised at the order, so it's got some good. What do you think normal is, or the size of your deposit base? You mentioned customers had much more liquidity today because of certain, and we all know that. But with balance sheet now $7 trillion, what do you think your normal size would be? And do you have any or maybe you're at it, and it'll stay at these. And you may actually get there. Is it 22, 23? Any thoughts?

Michael O'Grady (CEO)

Gerard, it's Mike. Well, why don't I just first just clarify, your question is around, you know, as you started it, you know, bigger picture question, but with all these factors going on, what is your expectation for a normal, the normal size, I'll call it, for the balance sheet? Is that what you're getting at?

Gerard Cassidy (Managing Director)

Yes. Yes, that's correct.

Michael O'Grady (CEO)

Okay. Okay, let me make one comment, and then, since you led in with big picture, that allows me to answer it without all the detail that Jason can provide. But, you know, I would say, as much as you might say, "Boy, there's been a lot of monetary policy, you know, across the globe," and that has elevated the size of your balance sheet. And so would you expect that to kind of come out of the system and see your balance sheet go back down? So do you have, you know, quote, unquote, "excess deposits" right now? You know, my perspective on it is, you know, we're into a very long-term period for this type of monetary policy.

And so, you know, I don't know how to define normal, but as far as, you know, the liquidity that our clients have right now and what they're doing with it, be it on our balance sheet, in the funds, I think there's gonna be a lot of liquidity in the marketplace for some time period. Now, it ebbs and flows, you know, as far as our client and our balance sheet and funds, but just in general, I think the water level is higher, and I think it'll remain higher, you know, for some time period. Jason, I don't know if you want to add.

Jason Tyler (CFO)

I think the only thing just to maybe bookend it is that, you know, that if you go back a year ago, deposits were kind of mid-80s billions. And if you think about, you know, when you look at where deposits are today in the 110s, and so I would use those as the bookends, but I think Mike's comments reflect it's probably near the higher end of that bookend.

Gerard Cassidy (Managing Director)

Very good. And then just to come back to the processing error, that you've been very good at explaining what happened. You mentioned that processing errors occur all the time, and, you know, do millions of processing and processings every year, of course. Was the actual whatever the execution was, was it upsized execution relative to your normal processing services caused an outsized cost? And then second, was it, once the execution happened, take a couple of days to figure it out?

Michael O'Grady (CEO)

Yeah, so Gerard, again, just because your line's cutting in and out a little bit, but I think I have the question. The first one, you're trying to get your arms around the size of the loss, and the two things I would say, you know, one is that, you know, it was a large corporate action. So size-wise, in the marketplace, it was a large corporate action, and our clients were, you know, active in that particular corporate action. So that was one aspect of the size. It was large for the market. It wasn't necessarily, you know, any larger for us vis-a-vis anybody else. It just happened to be a large corporate action.

Then second, as far as, you know, a timing perspective, the error, just to be clear, was identified within minutes of having been made. And so it's not, and then it was ultimately, you know, remediated as soon as we could practically do it. So we did not carry a risk position, I'll call it, for an extended time period that just got worse because we thought markets were gonna change or anything like that. You know, it was obviously, you know, unfortunate situation. We're very disappointed about it, but we look to, you know, mitigate the potential costs as soon as practical, and we were able to do that.

Gerard Cassidy (Managing Director)

Very good, Mike. Thank you.

Michael O'Grady (CEO)

Sure.

Operator (participant)

And moving on, we have Rob Wildhack with Autonomous Research. Rob?

Rob Wildhack (Director and Equity Research Analyst of Consumer Finance, Fintech, and Payments)

Good morning, guys. Mike, you've started to touch on it a little bit in the last third of the call here, and in the past, you've emphasized scalability. In your upfront remarks today, you emphasized tech solutions. So I was hoping you could give us an update on the progress you've made here on these priorities and where you think are the best opportunities to, you know, increase scalability and up your tech solutions going forward.

Michael O'Grady (CEO)

So I think that, Rob, the expectation would be that I would say, you know, it's all in our asset servicing business and, you know, the processes and operations around that, which is certainly from a dollar perspective, that's the largest opportunity. And it's one, as you mentioned, you know, we've been pursuing that, and the point here is we'll only continue to do it. If you did say, you know, within 2020 and everything that's happened, you know, has that affected the pace? I would say it has. And some of it is, you know, I would say the, you know, fortunate circumstances of seeing the model operate differently and seeing new opportunities for scalability within the business model. So, you know, more remote work is definitely, you know, a part of that.

You know, frankly, managing the processes is different in a remote environment than it is in a facilities in-person based model. So we've had to adapt, and as we've acknowledged, you know, there have been changes and risks that come with that, but also I'm saying there, there's also some opportunity where we see to get more scalability. Then the other aspect of my response was going to be that in areas where it's already relatively scalable, so for example, in wealth management, as that business becomes more digital, that becomes even more scalable as well. You know, the point being that...

Again, we've seen an acceleration of that in this environment as well, because as much as we will always offer, you know, the highest level of service for our clients, you know, and that's our market positioning, you know, that's a differentiator for it. You know, the nature of that has changed over time and has only accelerated. You know, being more specific, you know, clients need to and want to be able to do more things on their own, you know, through you know mobile or other digital devices, and that's great, you know, so instead of necessarily calling someone here to get something done, you know, they can just go to their phone and get it done.

Well, that changes the scalability of that activity, because they can, you know, we can have as much volume of that as you can imagine, but it doesn't increase the resources or certainly at the same rate. So, we see it, as I say, kind of across the company, and it's just a matter of continuing to execute.

Rob Wildhack (Director and Equity Research Analyst of Consumer Finance, Fintech, and Payments)

Okay, that's great. Thanks, man.

Michael O'Grady (CEO)

Sure.

Operator (participant)

All right, and moving on, we'll take our final question from Brian Kleinhanzl with KBW.

Mark Beatty (Director of Investor Relations)

Brian?

Brian Kleinhanzl (Managing Director of Large-Cap Banks Research)

Hey, thanks, guys. Yeah, I just have one quick question at this point. When you think about the pipeline, I know it's a mix of different clients that are in there and different services that you're onboarding, but when you think about the onboarding process underneath this, you know, operating environment that you have to work with today, how much longer is the onboarding process, just so we can think about how to lag these revenues in this current environment versus what it would have been previously? Thanks.

Michael O'Grady (CEO)

Sure. So as Jason mentioned, you know, we did have a you know call it deferral in the transitions, you know, particularly in the second quarter, and then it picked back up, transitions picked back up in the third quarter, particularly towards the end of the quarter. And yet he's also said, you know, we have a high level of business that has been won, but needs to be transitioned. And, you know, you, you've identified one of the aspects of how that has changed the you know cadence or sequencing of those transitions, because some of them are much easier to do in a virtual environment. So if you think about, I'll call it you know custody-type mandates, there's a lot of activity that's required, but that happens or can happen.

A lot of it, frankly, it was already, you know, I would call it very digital or could be done virtually. Whereas if you think about broader, IOO, you know, investment office outsourcing mandates, those are more difficult to do. They involve more people. And so when those people are, you know, remote, whether they're the, you know, the clients or ours or there's some, you know, requirement for us to be hiring people to be able to take on that business, that does take longer to implement and to get transitioned. And then there's all types of mandates, I would say, that are in between there.

And we're moving on them, you know, so you heard some of the fund administration wins that we've had in the 40 Act space, which has been great, but it does take a little bit longer given the nature of that activity that you're taking on.

Brian Kleinhanzl (Managing Director of Large-Cap Banks Research)

Okay.

Mark Beatty (Director of Investor Relations)

Operator, any other questions?

Operator (participant)

No, sir. That was the final question. That does conclude our Q&A session, so I'll turn the floor back to you for any additional or closing remarks, sir.

Mark Beatty (Director of Investor Relations)

Thanks, everyone, for joining us. We'll talk to you in ninety days.

Operator (participant)

All right. And everyone, that does conclude our call again for today. We do thank you for joining us. You may now disconnect.