Good day, and welcome to the Northern Trust second quarter 2022 earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jennifer Childe. Please go ahead.
Thank you, Kevin. Good morning, everyone, and welcome to Northern Trust Corporation second quarter 2022 earnings conference call. Joining me on our call this morning are Mike O'Grady, our Chairman and CEO, Jason Tyler, our Chief Financial Officer, Lauren Allnutt, our Controller, and Mark Bette and Briar Rose from our investor relations team. Our second quarter earnings press release and financial trends report are both available on our website at northerntrust.com. Also on our website, you will find our quarterly earnings review presentation, which we will use to guide today's conference call. This July 20 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 August 17. Northern Trust disclaims any continuing accuracy of the information provided in this call after today.
Please refer to our Safe Harbor Statement regarding forward-looking statements on page 11 of the accompanying presentation, which will apply to our commentary on this call. During today's question and answer session, please limit your initial query to one question and one related follow-up. This will allow us to move through the queue and enable as many people as possible the opportunity to ask questions as time permits. Thank you again for joining us today. Let me turn the call over to Mike O'Grady.
Thank you, Jennifer. Let me join in welcoming you to our second quarter 2022 earnings call. We generated solid results in what turned out to be a more volatile and uncertain market and macroeconomic backdrop than we've experienced in some time. New business momentum continued to be strong and our capital position remains robust. Revenue increased 12%, EPS grew 8%, and we delivered a return on average common equity of 15.7%. Second quarter results benefited significantly from higher interest rates and the elimination of money market fee waivers related to low rates. The weaker equity and fixed income markets began to impact our fees and client levels, and due to the lag in our billing cycle, this impact will continue in the third quarter. We saw a 7% sequential decline in average deposits. However, these were largely non-operational in nature.
Our clients continue to see us as a valuable partner for the liquidity needs. Our expenses increased 9% compared to the prior year, reflecting inflationary impacts across our cost base, particularly within our compensation and equipment and software lines. Despite this inflationary pressure, we achieved three points of positive operating leverage in the second quarter. In wealth management, we continue to see healthy levels of engagement with new and existing clients. Growth within our Global Family Office was particularly strong. In asset management, consistent positive flows into our FlexShares ETF complex helped to partially offset equity market headwinds and broad-based liquidity outflows in our institutional channel. At $21 billion, our FlexShares assets under management were up 13% year-over-year. We also saw strong growth in our alternatives offerings in the quarter.
Notably, we were recognized by Asia Asset Management's 2022 Best of the Best awards as the winner of the best ESG manager in Asia, best factor investing manager in APAC, as well as the best application of ESG. Our asset servicing business continued to see positive new business momentum, and the pipeline remains robust. Notable wins announced in the quarter including Wilmington Trust and UK-based International Biotechnology Trust. Our integrated trading solutions capability continues to be an area of strength. We also continue to see strong interest in our investment data science product suite. In closing, as we navigate these volatile and uncertain times, we remain laser-focused on serving our clients, generating profitable long-term growth, and delivering value to our stakeholders.
Before turning it over to Jason to review our financial results in greater detail, I would like to note that we plan to publish our 2021 sustainability report in the next few days. I'm very proud of the progress we've made in our sustainability journey and serving as a force for change. Highlights for the report include our commitment to be net zero by 2050, a summary of our community support initiatives, and the launch of a more holistic business diversity program. I'll now turn the call over to Jason.
Thank you, Mike. Let me join Jennifer and Mike in welcoming you to our second quarter 2022 earnings call. Let's dive into the financial results of the quarter starting on page 2. This morning, we reported second quarter net income of $396.2 million. Earnings per share were $1.86, and our return on average common equity was 15.7%. Results for the quarter included a $20.3 million pension settlement charge within the employee benefits expense category. Also, recall from last year, we implemented accounting reclassifications to certain fees at the beginning of the year, which will continue to impact the year-over-year comparisons as noted on this page. Our effective tax rate was 26.7%, which compared to 24.3% in the prior year and 23.8% in the prior quarter.
The increase is largely related to our international earnings mix, including reserves for uncertain tax positions. We now expect our effective tax rate to be approximately 24%-25% on a go-forward basis. Let's move to page 3 and review the financial highlights of the quarter. Year-over-year, revenue was up 12% and expenses increased 9%. Net income was up 8%. In a sequential comparison, revenue was up 3% and expenses were up 1%, while net income increased 2%. The strengthening of the U.S. dollar resulted in a reduction in our year-over-year revenue and expense growth rates of approximately 2%, and a reduction in the sequential growth rates of approximately 1%. The provision for credit losses was $4.5 million in the quarter.
Return on average common equity was 15.7% for the quarter, up from 13.7% a year ago and up from 14.2% in the prior quarter. Let's look at the results in greater detail, starting with revenue on page four. Trust, investment, and other servicing fees, representing the largest component of our revenue, totaled $1.1 billion and were up 6% from last year and down 2% sequentially. All other remaining non-interest income declined 2% from both the prior year and the prior quarter. Net interest income, which I'll discuss in more detail later, was $470 million and was up 37% from one year ago and up 21% sequentially. Let's look at the components of our trust and investment fees on page five.
For our asset servicing business, fees totaled $643 million and were up 5% year-over-year and down 3% sequentially. Custody and fund administration fees were $434 million, down 5% year-over-year and down 4% sequentially. The year-over-year decline was primarily driven by unfavorable currency translation, partially offset by new business. The sequential decline was driven by unfavorable currency translation as well as unfavorable markets. Assets under custody and administration for asset servicing clients were $12.8 trillion at quarter end, down 13% year-over-year and down 12% sequentially. Both the year-over-year and sequential declines were primarily driven by unfavorable markets and unfavorable currency translation. Investment management fees and asset servicing of $148 million were up 47% year-over-year and up 1% sequentially.
The year-over-year performance was driven primarily by lower money market mutual fund fee waivers and the previously mentioned accounting reclassification, partially offset by client outflows. Sequentially, the increase is primarily due to lower fee waivers, partially offset by client outflows and unfavorable markets. There were no fee waivers relating to low interest rates in the second quarter results compared to $28 million in the prior quarter and $50 million in the prior year quarter. Assets under management for asset servicing clients were $950 billion, down 19% year-over-year and down 13% sequentially. Both declines were driven by unfavorable markets, client outflows, and unfavorable currency translation. Securities lending fees were $22 million, up 11% year-over-year and up 14% sequentially as wider spreads offset the impact of lower volumes.
Average securities lending collateral levels were down 7% year-over-year and down 5% sequentially. Other trust fees were $39 million, up 7% compared to the prior year and down 11% sequentially. The sequential decline was primarily driven by higher seasonal benefit payment services fees in the prior quarter. Moving to our wealth management business. Trust, investment, and other servicing fees were $501 million and were up 8% compared to the prior year and down 1% from the prior quarter. There were no fee waivers in relation to low interest rates in the current quarter compared to $23 million in the prior quarter and $29 million in the prior year quarter. Within the regions, the year-over-year growth was driven by lower money market mutual fund fee waivers and new business.
For the sequential performance, the decline within the regions was primarily driven by unfavorable markets, partially offset by lower fee waivers. Within Global Family Office, the year-over-year growth was driven by lower fee waivers, new business, and favorable markets. The sequential increase is mainly related to lower fee waivers, partially offset by unfavorable markets. Assets under management for our wealth management clients were $353 billion at quarter end, down 5% year-over-year and down 11% on a sequential basis. The year-over-year decline was driven by unfavorable markets, partially offset by client flows. The sequential decline was driven by unfavorable markets and client outflows. Moving to page 6. Net interest income was $470 million in the quarter and was up 37% from the prior year.
Earning assets averaged $140 billion in the quarter, down 1% versus the prior year. Average deposits were $129 billion and were up 1% versus the prior year, while loan balances averaged $41 billion and were up 12% compared to the prior year. On a sequential quarter basis, net interest income grew 21%. Average earning assets and average deposits both declined 7%, while average loan balances were up 3%. The net interest margin was 1.35% in the quarter, up 38 basis points from a year ago and up 30 basis points from the prior quarter.
The increases from the prior year and prior quarter were both driven primarily by higher average interest rates, the favorable balance sheet mix, and $7 million in non-recurring interest received from certain non-accrual loans. Turning to page seven. Expenses were $1.2 billion in the second quarter and were 9% higher than the prior year and 1% higher than the prior quarter. The current quarter's expenses included a $20.3 million pension settlement charge within the employee benefits category, while the prior year quarter included a pension settlement charge of $17.6 million. Also included in the quarter is the impact of the previously mentioned accounting reclassification, which increased other operating expense by $10.4 million compared to the prior year. Excluding these impacts, expenses were up 8% versus the prior year and flat sequentially.
Compensation expense was up 12% compared to the prior year and was down 3% sequentially. The year-over-year growth was primarily driven by higher salaries as well as higher cash-based incentives. The sequential decrease is primarily due to the prior quarter's equity incentives, including $49 million in expense associated with retirement-eligible staff, partially offset by higher salaries. Both the year-over-year and sequential comparisons benefited by favorable currency translation. Excluding the previously mentioned settlement charges, employee benefits expense was down 1% compared to the prior year and down 5% from the prior quarter. Outside services expense was $213 million and was down 2% from a year ago and flat sequentially. The year-over-year decline was primarily driven by lower third-party advisor and technical services costs, partially offset by higher consulting expenses.
Equipment and software expense of $204 million was up 14% from one year ago and 5% sequentially. The year-over-year and sequential growth were both primarily driven by higher software costs due to continued investments in technology as well as higher amortization. Occupancy expense of $51 million was down 2% from a year ago and flat sequentially. Other operating expense of $90 million was up 33% from a year ago and up 13% sequentially. The year-over-year increase was driven by the previously mentioned accounting reclassification and higher business promotion and other miscellaneous expense, partially offset by lower supplemental compensation plan expense. The sequential performance was primarily due to higher business promotion and staff-related expense. Turning to page 8.
Our capital ratios remain strong, with our common equity Tier 1 ratio of 10.5% under the standardized approach down from the prior quarter's 11.4%. Our Tier 1 leverage ratio was 6.7%, up from 6.5% in the prior quarter. An increase in net unrealized losses on the available-for-sale securities portfolio was a primary factor in this quarter's decline in capital ratios. Accumulated other comprehensive income at the end of the current quarter was a loss of $1.5 billion, with the loss in the second quarter totaling approximately $600 million. During the quarter, we declared cash dividends of $0.70 per share, totaling $148 million to common stockholders. As announced yesterday, our board of directors approved an increase in our third quarter dividend to $0.75 per share.
The current environment continues to demonstrate the importance of a strong capital base and liquid balance sheet to both weather the uncertain economic conditions and to support our clients' needs. We remain laser-focused on providing exceptional client service while executing on our strategic priorities to grow the franchise and create long-term value to our shareholders. Before we open it up to questions, I'd like to take a moment to thank Mark Bette, who's transitioning from heading Investor Relations to his new role as CFO for our Shared Services group. Mark, thank you for your leadership, your partnership, and your unwavering commitment to serving our analyst and investor community over the past six years. I know I speak for all of us when I say we've learned so much from your insights and perspective. Thank you. With that, please open the line for questions.
Ladies and gentlemen, if you would like to ask a question, please signal by pressing star one on your telephone keypad. As a reminder, please limit yourselves to one question and one follow-up to allow all participants the opportunity to signal for questions. Again, please press star one to ask a question. The first question today comes from Alex Blostein of Goldman Sachs.
Morning, Alex.
Hey, Jason. Good morning, everybody. I'd like to echo your prior comments for Mark as well. It was great working with you. Good luck in your next role. Maybe to start with a, you know, NII-related questions that I'm sure you guys had expected, given, you know, given the theme of the quarter. You've spoken in the past about deposit outflows, about a month ago. It seems like they have continued a little bit in June. Maybe help us unpack sort of the sources of where you guys seeing some of the deposit outflows, the mix between interest-bearing and non-interest-bearing, any comments on kind of how the things are standing so far in the third quarter and any sort of broader commentary you might have around where deposit levels could ultimately drop.
Sure. I'll give you some thoughts, but don't hesitate if you want us to touch on a different component of it. First of all, just taking a longer-term perspective, deposits have been strong since the beginning of the pandemic, including relative to peers in the industry. The institutional channel has declined in the last few months, but it appears that we may have peaked later. If you go back to the beginning of the pandemic, our deposits are still up meaningfully. We started the pandemic at about $90 billion, and you see now we're around $130 billion. Going forward, the strategy is very consistent, remain focused on retail and operational institutional deposits. The retail deposits are effectively all operational.
Our second quarter deposit volumes are down 6.5%, but let's, I wanna unpack where those sub-channels came from. First of all, more than half of that decline was in non-operational financial deposits. Generally, that is the most rate-sensitive channel by far. It's also the fastest declining category for us. It was down over 11%. The second fastest category of decline was actually other non-operational deposits, which declined about 5%. If you focus on the wealth channel and the institutional deposits that are operational, the decline was just 3%. Another dynamic to think about is that within that period, we had tax payments, and so you'd expect some decline alone just coming from that.
I think that just highlights the focus on the fact that the vast majority of the decline has come in non-operational. I think you wanted to get a sense of where we are in the quarter, even at this point. Deposits have been down from the average of second quarter, but they seem to be leveling off. The decline that we saw in second quarter was actually largely just in the month of May, and since then, deposits have stabilized at about $120 billion. That's a lot, but I'll stop there, but that should hopefully give you a good sense of how deposits have been trending.
Great. Is it fair to assume that the outflows that you guys have seen, albeit smaller outflows so far in the third quarter, are also non-operational? Is there a way to frame what you guys think the total size of non-operational deposits, kind of bucket is, and how much of that could ultimately still leave?
I'll answer the first, which is just what we've seen so far this quarter, 85% of that has been non-operational. There's strong continuing of that theme that those deposits are non-operational. We haven't talked externally about the mix of operational and non-operational deposits. You know, we can think about that and whether in future quarters we'd wanna do it. I think that's a lot for you guys to be able to work from at this point.
This is Mark. As a reminder, the non-operational deposits wouldn't all be at risk. I mean, we had, you know, plenty of them before the pandemic. That is where we've seen the flows, the movement so far.
Gotcha. All right. Thanks. I'll hop back in the queue.
Thanks, Alex.
We can go to Steven Chubak of Wolfe Research.
Hey, good morning.
Good morning.
Wanted to start off with a question on the NIM outlook. Just looking at last rate cycle, your NIM peaked somewhere in the low 160s. I saw a nice uplift this quarter. With loans composing a similar percentage of the balance sheet today versus last cycle, you have the benefit of higher terminal Fed funds, higher non-US rates contributing as well. Is it reasonable to expect higher NIMs this cycle? Any way you could help us frame how you think about peak NIM potential given some of those tailwinds?
Sure. One, you're absolutely right. If you go back to mid-2019, even if you look inside 2019, we were over 160 in the middle of that year. You're highlighting the right things to look on mix. There's no reason we shouldn't achieve or frankly surpass that level. The only caveat would be if you saw a very significant change in the yield curve, but we're not anticipating that, so no reason why we couldn't achieve or surpass that one-sixty-ish level. Then just as you're thinking about the starting point, though, we gave you that number about it was $6 million or $7 million in interest income that came from recovery of those non-accrual loans. The starting point should be not one. It's a little nit, but it shouldn't be 135.
Think about it more at 1.33, 1.32. Then betas is another thing that'd be helpful maybe to give you just so you can work the models better. For second quarter, betas are right at 25%. As we're looking into third quarter, the betas could be twice that, but not 100%. We're still seeing attractive increase. I'm glad you asked about that because we've hit on deposit levels and then NIM. We're trying to give you both volumes and betas so that at least gives you the building blocks to work from as you're thinking about modeling NII going forward.
Thanks for that color, Jason. Just for my follow-up on capital, you've noted in the past that you want to run with capital levels that are consistent with your G-SIB peers despite the lower reg requirements. Given some of the AOCI volatility that we've seen, as well as the strong loan growth, which has certainly consumed some capital of late, was hoping you could provide some updated thoughts on how you're thinking about target CET1 whether that 10%-11% range is something you're comfortable running at, and just how it informs your appetite to potentially accelerate buybacks, especially if other categories like lending potentially begin to slow in a rising rate backdrop.
You're right in that we just competitively, we like to have a strong position relative to the GSIB peers. I always say when clients are depositing $100,000, those deposits are insured usually by the FDIC. When they're depositing $100 million or $1 billion, they're effectively lending money to us, and we wanna reflect that our balance sheet is strong. We look at that closely. We look at the CET1 is important, which you highlighted, but also the leverage ratio. Looking at those in conjunction, we look good on a relative basis. Obviously, plenty of room relative to any regulatory limits. We'll continue to look at where things are competitively, and we'll also continue to look at what opportunities we have in the returns on buyback versus what opportunities we're seeing.
The loan growth we had, we were very deliberate in looking at what the returns on that growth are. We also talked about the spikiness of loan volume and other activity. Even right now, currency markets moving aggressively has an impact on FX positions, which has an impact on what our RWA looks like. All these things come into play. In general, we feel good about the capital levels. You've got to also note we have historically been in a higher range.
That's great. Best of luck, Mark, in the new role, and thanks so much for taking my questions.
Thanks, Steven.
The next question comes from Glenn Schorr of Evercore.
Hi, Glenn.
Hi. Hello there. In the quarter, obviously the operating leverage is welcome, but we know what's coming with the lag deposit pricing and lower fees. I wonder if you could give us any thoughts on expenses on a go-forward basis. I know on any given quarter you'll have ups and downs, but just your thoughts on, you know, the jumping off point for expenses and then the possibility of operating leverage on the full year. I know it's a moving boat right now. Thanks.
Sure. Well, you're right that it's hard to look in a quarter. In this year, it's even hard to think too aggressively about operating leverage for the full year. If you think about what's happening and the influence of rates, it has a big impact on net interest income. That's coming over time. It comes over quarters. The impact on expenses is happening more quickly. We can't get too excited about the net interest income coming, but we've got to stay focused on expenses. Let me walk through a little bit on the expense side and just give you a couple of highlights, and if you want us to drill in farther, we can. First, and it relates to inflation, let's talk about compensation.
For the quarter, just a couple comments, and I'll give you a bullet point or two on third quarter. The base pay adjustment came into play in third quarter in full, and that's in and of itself $20 million lift quarter over quarter. It's usually half that amount. Headcount was higher, and we also had some off-cycle adjustments which brought in another, call it $10 million. Currency helped significantly, call it $5-$10 million. But a big component is the cash is cash-based incentive accrual. I think sometimes people forget, as we do better, even in a category like NII, we're gonna have higher CBI accrual coming along with it. That's something that's really important to think about.
The second category on expenses that I'll call out is equipment and software because that was a $10 million lift just quarter-over-quarter. We mentioned it in the last conference that we were gonna have about a $5 million lift in amortization alone. That's coming through. We'll have another sequential lift going into third quarter. The other component that we experienced in second quarter, in addition to the increase in amortization, is just software rental and support costs are higher. Some of that is inflationary. Some of it is just our consumption is higher. But we are, at this point, anticipating another similar rise. Just looking into third quarter, you'd see a similar step-up potentially from second to third quarter than what we experienced in first to second quarter.
Those are the two big categories within expenses that I'd call out at this point.
Okay. That is definitely helpful. I appreciate it. Maybe just a quick follow-up to the previous convo on deposits and NII. Just curious, it might be a timing thing. You made the point, obviously, that, you know, your investment portfolio turns over time, so you get the NIM benefit of higher rates over time. Can you grow NIM from here in the near term if betas are doubling? Just curious how to think about that in the short term.
Yeah. Definitely. You know, the power of rates going up on where we are. If you look at just the way the balance sheet's naturally positioned, loans are high, probably 75-ish% floating. Even a big chunk of the securities portfolio reprices within a year. Obviously, the cash position is short. The asset side is significantly floating. Even if we give up just half the increase on the deposit side, we still have plenty of room to grow NIM and NII significantly in a rising rate environment, even from here.
Awesome. Thank you for that. Appreciate it.
Sure.
The next question comes from Mike Mayo of Wells Fargo Securities.
Hi, Mike.
Hi. Part of your NII guide, I guess, higher, but you're, I guess, not telling us how much higher, 'cause you tell us your sensitivity to lower stock markets, the impact on fees, but you're not giving us the NII guide. I guess you're giving us some building blocks. One component is loan growth, and it's up 12% year-over-year. One reason some investors hold Northern stock is because it's perceived as a safe haven during a recession. Your loan losses tend to be, you know, a fraction of the industry. My question to you is, what are you seeing in the loan growth, especially among your retail customers? How much appetite do you have to expand that?
Are you noticing some more competition because some of your peers are mentioning this more, vocally about being a growth area? Does Northern experience recession if we were to have one because the clients are such high-end? Thanks.
Sure. A few things there. On loan growth, the rate should definitely slow relative to what we experienced over the last two years. The last two years, that growth was highly initiative-driven. We had a plan to communicate more with our clients, tell them that we wanted to be there more in their journey of investing more in their businesses. We wanted to be, being a liquidity provider isn't just taking deposits, it's also creating loan opportunities for clients when they need it. The growth has been very largely in that type of channel, and the quality and our appetite has not changed at all. We were extremely deliberate in saying our appetite from a credit quality perspective was not changing.
If you look at some of the even numbers around credit quality at this point and, you know, nothing's changed. All of the increases we had this quarter were in the inherent reserves, not specific reserves. We actually had net recoveries again, a small amount. All early signs are very good. That gets into your last question was, which is do we have a recession and do we have loan issues in a recession? You know, we don't wanna proclaim victory before something like that happens, but at this point, all the indicators look good, and we haven't changed our appetite in what we brought on.
I'm going to ask one more really big picture question. Maybe this is for you, Mike. You know, one concern about going into a recession is the negative wealth effect. Since you deal with the highest-end customers, especially the family offices and like, what's the behavior of your customers after such a decline in their personal net worth? Thanks.
You're exactly right, Mike, that portion of our client base does have different dynamics to it. We're coming off of a time period where as we know, not only did we see asset values increase significantly, but also, as we've talked about in previous calls, you know, the opportunity to monetize assets, if you will, meaning sell businesses or real estate or whatever it may be, also was at a very high level. You know, that dynamic clearly has changed, as we've seen. You see it in the sense of, you know, market activity as far as IPOs and things like that going down.
As much as there's still plenty of private equity, you know, capital that's out there and looking to do transactions, you know, valuations are lower and that changes their attitude about whether now is the right time to sell that business. That said, you know, the position that a lot of these clients are in is that they've had a high level of liquidity. So when they see, you know, the markets go down, you know, they are in a position to be very long-term investors. So we see a lot of those clients actually, you know, deploying capital into the markets at this point. You know, so investing that liquidity that they've raised in the previous phase.
Now, as you move forward from that, you know, beyond having no idea, you know, where markets go, et cetera. Just to your point on the wealth effect, you know, there's no doubt that our business benefits when the overall wealth is, you know, increasing and accumulating and markets are robust. That is a better environment for us. We think that it's more resistant on the downside of it, as well, but all the same, it's at a lower level than when things are so good. Hopefully that addresses your macro question.
All right. Thank you.
Thank you.
The next question comes from Michael Brown of KBW.
Hi, good morning.
How are you, Bill.
Good. Thanks for taking my questions. So the AUCA decline was a bit greater than we were expecting this quarter and above some of your peers on a sequential basis. Can you just expand on some of those key drivers? I mean, you called out that you had some wins inter-quarter, but was there any material, you know, lost business, or was it truly just FX and markets that hit the AUCA levels this quarter?
Mike, just to confirm, did you say AUCA?
Correct.
Assets under custody administration. Okay. Yep. Yep. I can take it and you add anything you'd like, Mark, but nothing significant from a flow perspective to call out. If I look at it just mathematically, currency translation was a 2.5% hit and market levels another 8%. The vast majority of the movement you see was in those two factors. The core business, nothing to note from a flow perspective.
Okay, that's helpful. Thank you, Jason. Just as a follow-up, one of your peers talked about a plan to reprice certain aspects of their servicing business, and they talked about areas that are experiencing greater wage pressure and capacity constraints. Just curious, is this a dynamic that you guys are seeing? Is there any opportunities to reprice your business higher, as you think about, you know, the coming, you know, quarters or year with the, you know, inflation pressures that you and the industry are experiencing?
Why don't I take that, Michael? I would say that we tend to approach the client relationships a little bit different, I think, than some of our competitors. What I mean by that is, on an ongoing basis, we look to make sure that we have a, I'll call it balanced relationship or one that is generating value for, you know, both the client and ourselves. There are a lot of dynamics to the relationships that we have with our clients, meaning that we're providing a lot of services that we're paid a fee for. There's a lot of other activity, whether it's balances or FX and things like that we're doing, that the nature of the compensation, you know, the revenues are different. It's always kind of shifting.
Sometimes it can, you know, go more or less to one side with particular clients, and we like to be in dialogue with them. That doesn't always involve a change in the fee, you know, up or down. It can be a change in, you know, the level of activity that we're doing with them, you know, that they do leave more balances with us or do other things. It's just a different approach, and I would say less programmatic about, you know, going out at a particular time and, you know, looking to necessarily increase fees. As we know, just over time, because the asset levels have gone up, that's why there is, you know, a bit more pressure on the fee side of the equation to come down over time.
You know, when you have periods like this with inflation, I think you do see less of that activity because all the players are in the same position. A client or prospect going out to, you know, put their business out to bid, so to speak, is less likely to get aggressive bids by, you know, multiple parties in this type of environment than they would in others. I would say there's no doubt that, as you can see, you know, we're feeling the impact of inflation on the expense side. We get a benefit in the sense of interest rates are higher.
That's a little bit of a, you know, a hedge, if you will, that's built into our financials, and then just something that we look at over longer periods of time.
Okay, thanks. Very interesting perspectives, Mike. Appreciate it.
Sure.
The next question is from Brennan Hawken of UBS.
Morning, Brennan.
Good morning. Good morning. Thanks for taking my questions. I'd also like to say congrats to Mark. You know, it's been a real pleasure working together. Always helpful to talk to you and wish you the best of luck.
Thanks. Appreciate it.
You got it. Sure. Curious, you guys gave a lot of color on the non-operating deposits, and you know the runoff and kind of comparing that to how the operating deposits look. It was clear that the deposits were under pressure, but you know the NIM looks really good this quarter. What I'm hoping to understand, and maybe you could give us a bit of a comparison. Can you help us frame what the spreads look like for non-operating deposits versus operating deposits? I think that might help when we try and frame not just what mechanically the deposits might, and the balances might look like, but really how that might actually triangulate to NII.
Yep. Yeah, absolutely. One, just a couple of things at a high level, then I'll dig in a little bit.
You know, I mentioned, I think before, probably 75% of the loans repriced within 90 days, and even the securities portfolio, about a third of those are floating. Then the cash portfolio obviously is very short. Those are the three big categories. It's interesting because in non-operational deposits, and that's why I specifically separated the financial versus the non-financial, the most extreme case of something where you have to stay liquid with the deposit is a non-operational financial services channel deposit. You really can't invest that long. That stays effectively overnight. It largely, there are exceptions, but largely.
That's part of the reason why if you see our deposits come down, I talked about the fact that they were largely non-operational, and that's why you saw the decline on the earning assets come largely from our cash position. You can see what the yields are in the cash positions. If you think about the cost on the non-operational deposits, again, highly rate sensitive. In many instances, those clients are saying it's Fed funds minus something. It's tight. Those spreads are tight. If you work toward operational deposits, those are ones that by nature, you know you're able to invest longer.
There's a component of it that you have to keep liquid, you have to maintain liquidity for, but generally, that's what's gonna be represented in the longer duration of the securities portfolio. In today's environment, those are repricing, and we're waiting anxiously for those to mature. It just gives you a sense that those spreads are actually likely gonna increase over time. Those clients tend to be transaction accounts. They tend to be less spread sensitive, and we've got opportunity to invest them longer. That's why we keep emphasizing this distinction between the operational, non-operational or transactional, non-transactional because the economics underneath them are very, very different.
Right. Okay. That's really important, and thanks for laying that out, Jason. Sounds like there's a big difference between the economics. I guess my follow-up would be on beta. You talked about the beta increasing in the third quarter. Number one, that's a third quarter beta commentary, the roughly 50%, not cumulative, right? We would be not necessarily looking to get the whole cumulative up to 50. Does that increase in beta also contemplate the reduction in these far more rate sensitive non-operating deposits running off? And maybe how much are those non-operating, more rate sensitive deposits pressing that beta higher? Are they the largest contributor? And as they continue to run off, will that help to contain continued increases in beta?
Sorry, it's a multi-parter.
That is multi-part. Let me give you a couple thoughts, but don't hesitate. We wanna be helpful as you guys are thinking this through, so don't hesitate to clarify anything. Let me try to work backwards. I may not get all the way back to the beginning. Yes, to the extent that the non-operational deposits are the ones that continue to run off faster, that insulates betas a little bit. Then secondly, as we provided some commentary on what betas look like in the third quarter, yes, that is incremental within the quarter, but that's us leaning in in the spirit of trying to be helpful to uncertainty.
A lot of what we're doing is just trying to hold on to those deposits, those operational deposits because we feel they're so volatile. We're not starting from, we want our betas to be 50%, and we'll see what deposits hold in. We're talking with clients telling them we wanna be the liquidity partner for them. We're gonna, in large ways, at this point in the cycle, we're gonna follow what we see out there to make sure that for those valuable operational deposits, we maintain deposit levels.
Okay. The third quarter beta of 50, that's just a third quarter, not a cumulative, right?
Yes. Yeah. Again, that's.
Okay
a lot of uncertainty in what that's gonna look like. That's less factual, it's less tangible, and it's more just our forecasting of what we think is gonna happen based on what we think is gonna happen with the yield curve and what we think is gonna happen in the market.
The last component. I know, and I apologize it was so many parts, but the last component is, does the 50%, like, is that based on the current mix of operational, non-operational, you know, financial, non-financial? Is it based on the current mix, or as that non-operating piece winds down, does that ease the upward pressure on the beta? You know what I mean? It could allow for some better beta outcomes than you're thinking.
Yeah. That 50% is overall based on what we currently see and project the mix to be.
Thanks for that, Jason.
It's reflective.
Appreciate the color.
Yeah, sure.
The next question is from Brian Bedell of Deutsche Bank.
Great.
Morning, Brian.
Good morning. Thanks very much. I also echo all my comments for Mark as well. It's been great working with you, so also best of luck.
Thank you.
I think Brennan got my multi-parts on the deposit betas as well. I'll move over to expenses. The only other two categories, again, you know, Jason, thanks so much for the granular color there. The only other two categories I just wanted to get a comment on was the typical seasonal lift that we see in outside services in the second half of the year, whether you think that's likely to repeat as it has in the past. Then on the other expense line, you know, in lieu of having the Golf Open, I know you've wanted to reallocate those expenses to marketing initiatives.
Is that also a second half event like the Northern Open was, or have you done those over the course of the year, so we shouldn't see as much of a spike up?
All right. So on outside services, let me start. Yes, there tends to be a second half lift there. We don't expect it to be that dramatic at this point. In this quarter, it was. We actually remember, a lot of the expenses there are actually volume related, and so it's related to your. You've got market data, you know, and other transaction-related services. There are other items that are very volume related, and frankly, some of it's market level related. So that's something to just keep in mind that can dominate the seasonality component of that line item.
In the second quarter, volumes were down slightly, and that was fully offset by a little bit higher consumption level in consulting and legal. As we go into third quarter, those two dynamics are probably still at play, and we'll see which ones, as we get further into the quarter, which one wins out. On marketing related, Mike, you wanna talk about that for me?
Sure. Just on the marketing, Brian, there. Yes, we're spending that, if you will, throughout the year, so there's no seasonality, you know, major seasonality like you had with the golf tournament. As we've talked about before, it's less about, you know, one particular area and more just doing, you know, marketing within the three businesses.
Yeah. That's great color. Thanks. Maybe, Mike, if I could just follow up on alternatives. I think you mentioned that in your prepared remarks briefly. If you could just characterize what you're seeing from your wealth client base in terms of demand for illiquid products, both private equity, private credit, impact funds, and to what extent you've added those products onto your platform. Clearly it's a great way to retain clients given their interest in that. Maybe just also share if you think that can also have a revenue impact for Northern Trust, even if you're not managing them, but rather you know having them on your shelf, so to speak.
You described it well as far as our approach there, which is we wanna be able to provide the, you know, the full set of alternatives for our clients, and yet provide the added value, if you will, of certain particular funds that we can offer for them, and then funds that we manage on our own or through vehicles on our own. Within wealth management, you know, for the platform, you know, you kind of hit on some of the areas that are of greatest interest right now, like private credit. It's a much broader set than maybe it was years ago as to alternatives. When somebody says alternatives, you know, it used to mean was that, you know, hedge funds or PE.
Now it's a much, you know, broader set of the types of products that they would have there. Then also, my comment around the growth was particularly related to 50 South Capital, which is, you know, within asset management where we offer funds of funds. There again, we've seen strong interest on the part of our clients to have that type of more diversified exposure to alternatives. You're right. It has the benefit, you know, certainly from a return perspective for our clients, but from our perspective, it is something that has a more attractive financial profile for us, and one that further cements the relationship that we have.
We expect, although there's always, you know, ups and downs, and volatility, you know, with the various categories, but longer term still, that alternatives will be an area of growth.
Good. That's great color. Thank you.
Sure.
Next question comes from Ken Usdin of Jefferies.
Morning, Ken.
Hey, good morning, guys. Thanks. Just one more follow-up on the earning asset side. You know, just given rising rates and the OCI, just can you talk us through about where your securities portfolio duration is and what you're seeing on incremental pickups of, you know, new pickups, you know, relative to the roll-off on the back end, and just how you're thinking about mixing the portfolio and protecting OCI from here? Thank you.
Sure. Couple thoughts.
Duration overall is down to about 2.6 from 2.7. Secondly, just, from a reinvestment perspective, that fact alone indicates we've been going a little shorter. As we're reinvesting maturities that are maturing, we're leaving that powder dry effectively for the time being, given a couple of dynamics. One, just the significant volatility in the markets, and then secondly, anticipating higher rates. We've very much been not reinvesting longer on the curve at this point. What was the second part?
The second part was then just related to capital in the earlier question.
Oh, yeah.
Just about OCI, have you been moving things from AFS to HTM? Or are you rethinking at all how, and into your prior point about changing duration, how you protect incremental AFS from here? I guess, you know, just how would you expect the existing AFS OCI to kind of return back into capital over time? So just all things related to AOCI management.
Sure. Couple thoughts there. One is we did move about $7 billion from AFS to HTM, and we did that post-quarter close, actually. The future impact is that should protect about half of the exposure we have had on from an OCI perspective. Then in terms of return, it should be about 3.5 years total for us to recoup. You know, it may be a little bit longer to recoup that, but it gives you an overall general sense of what the trajectory looks like.
Okay. Got it. Thanks a lot, Jason.
Sure.
Our next question comes from Betsy Graseck of Morgan Stanley.
Hi.
Hi.
Good morning.
Morning.
Hi. Okay, just want to make sure you can hear me. A couple of questions. One, a little nitpicky, but on the average balance sheets, I think you show, you know, what the yields are obviously by asset class. I'm just wondering, repo yields went up. It looks like our repurchase agreements went up about two percentage points Q on Q, and I wanted to make sure I understood that.
Yeah, Betsy, part of that. This is Mark. Part of that was. There's a footnote, I think, on our reports that kind of talk about a netting change that we made and those yields. I think it's both on the asset side and the liability side. The yields would have been, for instance, on the asset side, just trying to find that line, which is reported as 231. I think it would have been around 70, I believe. But there is, so it was really driven by this kind of gross to net change, both on the asset and liability side.
Okay. Any details there we can do offline. The second question is just, you know, as we look at the 10-Q analysis regarding rate sensitivity and impact of 100 basis point parallel shift versus what we got this quarter, obviously this quarter was a much bigger benefit than what the 10-Q would suggest. I just want to make sure I understand the differences of what the assumptions are in the 10-Q that we see versus, you know, what happened in the real world.
Yeah. I mean, I guess one thing I would say is in the Q, it's a modeled process, and it does look at the forward curve, and it's really a shock, you know, a movement away from the forward curve. I know that I think from beginning of the quarter to the end of the quarter, there was a move from the forward curve, but probably not in the same magnitude of how it would have been, you know, modeled within the Q.
Yeah.
It's a directional guide. I mean, the base case is what is not there, which is what the forecast is with the forward curve. I don't know if that helps, Betsy.
Timing matters a lot, too. I mean, we came into the quarter with some lift from where rates were prior, and then we also had mix was another benefit of probably eight basis points alone just by higher mix in the balance sheet. There are other dynamics that came into play. You know, frankly, you know, back to when you're doing those shock scenarios, you're making assumptions around beta, you're making assumptions around a bunch of different things, but it's not. In reality, it just doesn't always play out that way. The beta is at 25% for us, we're low. We also had movements in other currencies, and so a lot of things at play that led to the increase in NIM.
Okay. Just lastly, I know at the beginning of the call you mentioned that, you know, non-operational deposit outflows, you know, look like they've stabilized. I guess my question is how do you feel your non-operational deposit depositors are behaving? In other words, you know, we're about to get another 75 basis points next week. Do you feel that they are optimizing for, you know, higher over this next six months already? Or do you feel like they optimize each time, you know, the Fed's moving? In other words, I'm wondering if we should be expecting another outflow as, you know, the Fed continues to jack up rates here.
I think that channel of depositors disproportionately relative to others have relationships at multiple institutions, and cash doesn't have a long-term commitment on it, and they're able to seek yield when it's important to them. I'm glad you asked the question because I don't want the interpretation to be that we don't want non-operational deposits. Oftentimes, those deposits are tied to broader relationships. Sometimes we do want those deposits for various reasons. The reason that we're highlighting the distinction is just the economics and the behavior of those deposits is very different. As you think about where NII is going, it's important to understand and appreciate those differences.
Yep. Okay. Thanks so much for the color.
Sure.
Our next question is from Vivek Juneja of JP Morgan.
Hi. Thanks for taking my question. One is, how much benefit did you have to expenses from FX translation, Jason?
This is Mark. On a year-over-year basis, it was about 2%, and on a sequential basis, it was about 1%. That's for total expense.
Right. Most of that would show up in which lines?
Most in comp and benefits. It would be, you know, as I look at it, probably.
A little in equipment and software as well.
Yeah, equipment and software. You're probably looking at, you know, just like our expense base, I guess maybe two-thirds of that probably being within comp and benefits.
Okay. A completely different question. Asset servicing assets under management fell 19% linked quarter, much more than, you know, overall wealth management AUM was down much less. 19% seems like a lot. Any color on that? It seems more than what markets dropped.
Sure. Yeah. We had outflows in the money market mutual fund business, and so that business has grown significantly since pre-pandemic, but declined in the quarter from a flow perspective.
Okay. All right. Thank you.
Sure.
The next question is from Jeff Harte of Piper Sandler.
Good morning, Jeff.
Hey, good morning, guys. Excuse me. One question left for me. How do you expect funding costs on non-US interest-bearing deposits to move with the ECB hiking? I'm just trying to think, could we see some near-term pressure on NIM or NII as ECB goes from, you know, negative through the zero bound to something higher than 25 basis points?
Higher beta. I'm glad you brought that up. For clients where they have potentially been in negative rates, we're expecting betas to be higher. This is clients to say, "We understand that we were negative, but when do we get out?" That's the one channel where we expect that to be aggressive. Mark, anything to add there?
I was just going to mention that the size of that. The euro deposits for us is a little bit over 5%-6% of our total deposits. That's just, you know, something to keep in mind from an order of magnitude perspective.
Okay. I mean, any guess to how much higher betas might be there? I get that it would be purely a guess, I suppose, but...
Yeah, it's just super hard to tell. Sometimes rates are, you know, part of larger pricing and relationship considerations. We would just expect at this point in the curve for those betas to be quite high. Again, not, you know. It's 6% of the total. It's not tremendous an impact, but I don't think it's crazy to assume, and again, I'm just speculating, say 75%-100%. I don't think it changes the dynamics of the outcome significantly on NII, but it's. When we say significantly higher, it's not 55 versus 50, it's more like 75, 100 is a safer way to model it.
Okay. Thank you.
Sure.
Next question is from Alex Blostein of Goldman Sachs.
Hey, guys. Thanks for taking
Welcome back.
Hello again. Thanks for taking the follow-up. I wanted just to get your perspective, maybe top of the house view on operating leverage. Over the years, we've kind of gotten accustomed to thinking about operating expenses as a percentage of fees, and obviously quarter to quarter, you know, that will move around. You guys gave some explicit guidance, I guess, for a couple of line items. Really just kind of want to zoom out and think about in an environment we're in today where the markets are a little choppier, I guess, to say the least, and inflation is rising, where, what is the new normal for that expense to fee ratio over the next, say, you know, a year or two, right?
Clearly, you guys are highlighting that some of the higher NII will show up in comp with respect to, I guess, incentive-based compensation. That will, I guess, also pressure that expense-to-fee ratio. Helping me just kind of think through that is like if we lived in a 105, but we're now thinking like 110 plus, and are there any expense initiatives that you guys are starting to contemplate beyond 2022? It feels like the budgeting for this year has sort of left the station, but any incremental thoughts there will be helpful.
Sure. Alex, it's Mike. The way that we're thinking about it is that as you pointed out, a number of factors on both the revenue side and on the expense side that we wanna be in the range for a pre-tax margin of kind of that, you know, low- to mid-30s%. That's the type of range that gets us at the higher end of our ROE target as well. That's what we're shooting for. You're exactly right. We're also looking at that expense to trust fee ratio, which has a different set of dynamics to it and has more pressure on it when you have markets going down and inflation. That's not a reason to say that we're not focused on trying to keep that in the range that we've been in.
That is kind of the, you know, whether it's, you know, 105, you know, plus or minus around that's where we're trying to keep it. Because our view is that over time, that's a, you know, a better, more stable, level or measure of our profitability, you know, for the business. That's what we're looking to do. As far as I, you know, looking at expenses, you know, again, always trying to be focused on that. I would say, even though you said, you know, the train has left the station, you know, for this year, you know, we are very much focused on getting productivity in all the businesses, but particularly in the asset servicing business.
You know, those initiatives were very much in place at the beginning of the year, and we're executing on those. You know, as we do next year, you know, there'll be a new set of initiatives around how we get greater scale and efficiency in the company, but particularly in that business.
Great. Very helpful. Thanks, Mike.
Sure.
The next question is from Gerard Cassidy of RBC.
Hi, Gerard.
Hi, Mike. Hi, Jason. You guys may have touched on this, and I apologize if you did and I missed it on your call. Obviously you're talking a lot about betas with deposits, with rates going higher. Have you guys been able to map out or build models to see what impact, you know, the full-blown quantitative tightening will have on deposit flows at your organization? You figure they're going to reach, what, $95 million or $95 billion a month coming up soon here, and we really haven't gone through this before. We're in uncharted territory. How do you guys approach that?
We have modeled it. We've looked back to see what correlation there is. I have to say the takeaway is it's not. Our client base just doesn't. It's not granular enough to say that there's strong correlation between what the modeling spits out. You think about a $130 billion deposit base. We have clients that have $10 million, $50 million, $100 million, $200 million. Some super large institutional or even wealth or even Global Family Office clients will be over, sometimes over $1 billion. It's just. It's very spiky, and it's hard to throw a correlation out publicly at what those models spit out.
I think the one thing I think it's instructive to think through is that a lot of our clients think about cash as an asset allocation output. One of the things to think about as you're predicting where even core operational transactional deposits will look like is what are overall asset levels and what are market levels. Because our clients consistently think about liquidity as an asset allocation tool and probably less affected in a predictive way by what's happening at the macro level by the Fed.
Very good. Thank you. As a follow-up, granted the market conditions are very unsettling today and a lot of disruption going on out there, but there's also probably opportunities to pick up maybe some businesses at discounted prices relative to where it was maybe a year to 2 years ago. Northern, over the years, has done acquisitions. Mike, can you give us some color of, you know, allocating capital? Should something come up for sale that really makes sense, is that something you guys could consider in the next 12-18 months?
Gerard, you're right. Historically, you know, the company has been opportunistic and having the ability to add core capabilities during times like this. You know, that you know, attitude or approach hasn't changed. I wouldn't say that we're out you know, looking to take advantage of the environment per se. I would say it's more, you know, a similar strategic focus, which is growing the business organically. Then over time, if there are opportunities to accelerate that through acquisitions, then we consider it.
Great. Thank you. Mark, good luck in the next run. Good working with you. Thank you.
Thanks, Gerard. Appreciate it.
We can go back to Vivek Juneja of JP Morgan.
Hi. Thanks for taking a follow-up question. Going back to capital, Jason, I hear your comment on, you know, competitively, you wanna be ahead of your peers. You know, is there a level below which you would not want to see your CET1 go, especially given there's still uncertainty in the markets and volatility? What do you intend to do to not let it go below that?
We've got a lot of different guardrails around how we think about what to do. We obviously, you know, we have not been, you know, share repurchase is the first thing to do. Conversely, you saw us increase our dividend at this point. I think that tells you that we're not desperately trying to increase levels from here. We feel fine. Again, we've got plenty of room from a regulatory perspective, and we feel good how we look on a competitive basis. We've always said it's a combination of different factors. We have very good conversations with our board about how we wanna position capital levels. We feel good where we are, and always want to, at the same time, take advantage of any opportunities in the market to grow the business.
Sometimes that means just what we did with loans a couple of years ago. We made a big investment there from a capital perspective in the form of higher RWA exposure. It's just a good example of how we're balancing different factors at any given point in an economic cycle. The absolute levels is an important, but it's just one of those factors.
Thank you. Mark, I was remiss. Thank you for, you know, it was great working with you, and good luck in your new role.
Thanks, Vivek. Appreciate it.
We can come to Mike Mayo of Wells Fargo Securities.
How are you, Mike?
Hi. Yeah. As we tweak or update our earnings models, I'm just looking at page 38 of your proxy, and I'm looking at your peer group. You do have a lot of banks in this peer group, but the two most comparable banks seem to have tax rates that are 500 basis points below what you have. I think you're in the range of 25%, and those other two trust banks are closer to 20% or below, give or take. The question is, we always talk about pre-tax margins. What about after-tax margins? What can you do, Jason, to better manage your taxes, which is one of the biggest expenses at the firm? You'll love this question, Mike.
You know, would you under what circumstances would you consider a move away from Chicago, like Citadel, to the extent that that could help your taxes? Thanks.
Two very different questions. I'll hit the first one. You're absolutely right, taxes, tax rate matters. I'll give you a sense of how we are relative to others. First, you know, a high percentage of our income is from wealth management, and that's predominantly a domestic business which comes with a higher tax rate. Two, even within the domestic exposures, we're in Illinois, California, New York. We're in high tax states. Then a lot of our. We've got less benefits from tax credit investments. Another dynamic is we've got less income from tax-exempt income. More of a nuanced but important factor is there are limitations on U.S. foreign tax credits. That's actually increasing in our difference relative to our peers.
Those are at least a half dozen things that get to the vast majority of the reason why there's a difference. Going forward, there are things that we can look at and try and implement to try and get that tax rate down. We're not just resting on that as a fait accompli. It's something that we wanna work on over time.
Mike, I would say, you know, we're a global company that is headquartered in Chicago. Proud to be headquartered in Chicago. Like other important decisions, you know, we look at it from a stakeholder perspective. You know, you highlight one, you know, which is, I'll say the tax rate, but more broadly, you know, the financial implications of being headquartered anywhere. That is absolutely a relevant consideration and one that we're, you know, looking at all the time. You have other stakeholders that are critical to that. You know, certainly where our clients are and where we need to be to serve them. Also, you know, equally important is all of our partners, meaning our employees. It needs to be, you know, a great place to live.
We are very focused on, you know, not just monitoring that over time and determining if it's a great place to live, but I would say, actively being a part of the community to address the challenges and make Chicago an even better city to live in and to have our headquarters.
Thank you.
Sure.
Ladies and gentlemen, that concludes today's question and answer session. I would like to turn the call back to Mark Bette for any additional or closing remarks.
I think we're all good. Thanks everyone for joining us. Appreciate it, and we'll talk to you next quarter.
Congratulations, Mark, on a great run.
Thanks.
Congratulations on the promotion.
Thanks, everyone.
Thanks, everybody.
Ladies and gentlemen, that concludes today's conference call. We thank you for your participation. You may now disconnect.