Fitch: Litigation Accrual Impacts State Street's 1Q15 Earnings

State Street Corporation's (STT) first quarter 2015 earnings of $377 million were down relative to the sequential quarter due in part to litigation accrual of $150 million due to issues surrounding foreign exchange (FX) practices. These earnings equated to a 7.9% return on average common equity, which according to Fitch Ratings, is below long-term expectations.

Relative to the year-ago quarter earnings increased by 6% due in large part to higher revenue generated from FX trading amid higher FX volatility during the quarter. Additionally the company's securities finance revenue improved relative to the year-ago quarter, which helped offset the continued decline in net interest revenue.

As such, STT's fully tax equivalent net interest margin (NIM) declined to 1.06% in 1Q15 down from 1.09% in the sequential quarter and 1.30% in the year-ago quarter. Fitch would expect the NIM to continue to grind down -- at least until short-term interest rates eventually rise.

Expenses modestly increased relative to both the sequential and year-ago quarters. Nevertheless Fitch continues to believe STT's focus on efficiency and keeping expense growth lower than revenue growth generally remains intact.

While STT's revenues may be slightly volatile depending on the performance of market based revenue (FX trading and securities finance revenue), the growth in expenses appears to be relatively inline with revenue growth in servicing fees and management fees. Should market based remain strong, Fitch would expect STT to begin to deliver some strong operating leverage on a go forward basis. This should help boost the company's return on average common equity (ROE) to its long-term averages and closer to Fitch estimate of STT's cost of equity assumption of approximately 12%.

STT's balance sheet modestly expanded in 1Q15 as the company continues to accumulate deposits. This growth in deposits has generally been placed with other banks or at the Federal Reserve. This quarter, however, STT modestly increased its repurchase agreement portfolio to handle some of its excess liquidity.

While Fitch believes this deposit growth helps to keep STT's balance sheet very liquid, it also has an adverse impact on the company's Enhanced Supplementary Leverage Ratio (SLR), which on a fully phased-in basis is effective in January 2018. Due in part to the deposit growth, the fully phased-in SLR at the operating company remained constant at 4.8%, currently below the 6% requirement in 2018, and the SLR at the holding company declined to 4.9%, slightly below the 5.0% requirement in 2018.

Fitch believes STT will continue to pursue avenues to move some client deposits away from STT or its balance sheet in order to help the company reach compliance with the SLR.

In Fitch's view STT's capital position remains good, particularly given Fitch's view of the comparatively low-risk nature of the balance sheet. As of 1Q15, STT's fully phased-in Basel III Common Equity Tier 1 (CET1) ratio under the advanced approaches was 11.5%, unchanged from the prior quarter, and under the standardized approach was 9.9%, up one basis point from the prior quarter. Fitch notes that the standardized approach will likely remain STT's binding constraint ratio.

Additional information is available at www.fitchratings.com

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