Fitch Affirms State Street Corporation at 'AA-'; Outlook Stable
KEY RATING DRIVERS
IDRS, VRS AND SENIOR DEBT
The affirmation of State Street's ratings is reflective of the company's stable operating performance, seasoning of risk management practices and procedures, and relatively conservative overall balance sheet posture. Additionally, Fitch believes that management's continued efforts to streamline the business will lead to more significant positive operating leverage in a higher short-term interest rate environment.
State Street's high ratings are supported by the company's strong business model that is characterized by high barriers to entry and sticky customer relationships. State Street's ratings are further bolstered by the company's good funding profile, consisting mainly of core custody deposits. These factors offset the comparatively weaker earnings performance for State Street due in large part to continued low short-term interest rates as well as some litigation charges.
State Street's overall earnings performance as measured by return on assets (ROA) and return on equity (ROE) has been challenged amid the protracted low interest rate environment of the past few years. The company's net interest margin (NIM) has continued to decline and now sits at 1.00% as of the second quarter of 2015 (2Q15). Fitch would expect the NIM to remain depressed until short-term interest rates are meaningfully higher.
Similar to the 1Q15, State Street's 2Q15 earnings were significantly impacted by litigation accruals regarding the company's indirect foreign exchange (FX) litigation matters. In 2Q15, State Street incurred a \\$250 million pre-tax litigation charge, or net \\$156 million after-tax charge. This compares to a \\$150 million both pre-tax and after-tax litigation charge in 1Q15.
State Street's 2Q15 earnings equated to an 8.3% ROE, which is slightly higher than the 7.7% ROE earned in 1Q15, but below the company's long-term averages. On an operating basis, which for comparison purposes excludes the notable charges described above, State Street earned a 12% ROE in 2Q15, up from a 10.4% ROE in the sequential quarter and flat from the ROE in the year-ago quarter. In Fitch's view, if not for the persistent litigation accruals, State Street's earnings performance would have been good.
Fitch believes that the operating results noted above are evidence that the company's expense control measures are beginning to gain some traction. State Street has done a relatively good job on expense initiatives by keeping compensation and benefits expense relatively flat while making significant investments in people and outside services due to various regulatory initiatives. Fitch believes that this has laid the groundwork for positive operating leverage in a higher short-term interest rate environment.
Fitch believes that with a meaningful interest rate increase, and the company continues to benefit from higher FX revenue, earnings could come closer to historical levels and returns on equity could be above Fitch's cost of equity assumption for the industry of 12% for an extended period.
Fitch believes that State Street is appropriately capitalized, given the agency's view of the company's relatively low-risk balance sheet. State Street's combined available-for-sale (AFS) and held-to-maturity (HTM) securities portfolio is considered to be relatively low risk and highly liquid. The majority of the portfolio is composed of U.S. agency securities, and 91% of the portfolio components carry an 'AAA' or 'AA' rating.
State Street's estimated common equity Tier I (CETI) under Basel III (Advanced Approach Fully Phased-In) was 11.4% at 2Q15. These capital ratios compare favourably with both U.S. and international peers, particularly in the context of the balance sheet noted above.
While the Basel III CET1 ratio is good, Fitch believes State Street's binding constraint capital ratio is the Enhanced Supplementary Leverage Ratio (SLR). Under the Advanced Approach on a Fully Phased-In Pro-Forma basis, the SLR was 5.1% at the parent company and 4.9% at the main operating bank as of 2Q15.
In order to achieve SLR compliance as well as to reduce the recently finalized Global Systemically Important Bank (GSIB) buffer of 150 basis points, Fitch expects State Street to aggressively reduce excess deposits. State Street has begun charging clients fees to hold deposits on balance sheet in some geographies, and Fitch would expect more of the same going forward.
SUPPORT RATING AND SUPPORT RATING FLOOR
In May of this year, Fitch downgraded the support ratings of State Street Bank & Trust Company (SSBT) and State Street Corporation (State Street) in line with Fitch's view of sovereign support. The Support Ratings (SR) and Support Rating Floors (SRF) reflect Fitch's view that senior creditors can no longer rely on receiving full extraordinary support from the sovereign in the event that State Street becomes non-viable.
In Fitch's view, implementation of the Dodd Frank Orderly Liquidation Authority legislation is now sufficiently progressed to provide a framework for resolving banks that is likely to require holding company senior creditors participating in losses, if necessary, instead of or ahead of the company receiving sovereign support.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
Subordinated debt and other hybrid capital issued by State Street and by various issuing vehicles are all notched down from State Street's or its bank subsidiaries' VRs in accordance with Fitch's assessment of each instrument's respective non-performance and relative loss severity risk profiles.
SUBSIDIARY AND AFFILIATED COMPANY
Fitch upgraded SSBT's long-term IDR to 'AA' from 'AA-' in May of 2015. The Outlooks on the long-term IDRs are Stable. The upgrade of SSBT's rating to a notch above the parent company's long-term IDR reflects the expected implementation of total loss absorbing capital (TLAC) requirements for U.S. Global Systemically Important Banks (G-SIBs).
The VRs remain equalized between State Street and its material operating subsidiaries, namely SSBT. The common VR of State Street and its operating companies reflects the correlated performance, or failure rate between State Street and these subsidiaries.
LONG- AND SHORT-TERM DEPOSITS
Fitch upgraded SSBT's long-term deposit ratings to 'AA+' in May 2015. The upgrade of SSBT's deposit ratings is based on the upgrade of their IDRs. Deposit ratings are one notch higher than senior debt reflecting the deposits' superior recovery prospects in case of default given depositor preference in the U.S.
HOLDING COMPANY
The VR of State Street are equalized with the VR of its operating company, SBBT, reflecting its role as a bank holding company, which is mandated in the U.S. to act as a source of strength for its bank subsidiary.
RATING SENSITIVITIES
IDRS, VRS AND SENIOR DEBT
Given that State Street's ratings are already near the top of Fitch's global rated bank universe, Fitch views limited potential for an upwards ratings momentum. .
Fitch believes that the main threat to State Street's business model and ratings would result from a large idiosyncratic technological or operational loss resulting in reputational damage that causes clients to flee the firm. State Street has been making significant investments in its technology systems over the past several years, which the agency believes helps to reduce the potential from some idiosyncratic losses.
Fitch does believe these risks have been well monitored and controlled, but also acknowledges that they are inherently difficult to predict and quantify. As such, a large occurrence would likely prompt Fitch to review ratings to determine if a negative rating action was appropriate.
SUPPORT RATING AND SUPPORT RATING FLOOR
Any upward revision to the SR and SRF would be contingent on a positive change in the U.S.'s propensity to support its banks. While not impossible, Fitch views this as highly unlikely.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
State Street's subordinated debt ratings are broadly sensitive to the same considerations that might affect State Street's VR.
SUBSIDIARY AND AFFILIATED COMPANIES
Given that SSBT's and State Street's VRs remain equalized, SSBT's ratings are broadly sensitive to the same considerations that might affect State Street's VR.
LONG- AND SHORT-TERM DEPOSITS
The ratings of long- and short-term deposits issued by State Street and its subsidiaries are primarily sensitive to any change in the State Street's IDR. This means that should a Long-term IDR be downgraded, deposit ratings could be similarly impacted.
HOLDING COMPANY
Fitch could notch the holding company's VR from the operating company's VR if holding company liquidity were to deteriorate, and raise concerns relative to the parent's ability to meet its obligations.
Fitch has affirmed the following ratings:
State Street Corporation
--Long-term IDR at 'AA-'; Outlook Stable;
--Short-term IDR at 'F1+';
--Support at '5';
--Support Rating Floor at 'NF';
--Viability rating at 'aa-';
--Junior subordinated debt at 'BBB+';
--Commercial paper at 'F1+';
--Preferred stock at 'BBB';
--Long-term senior debt at 'AA-';
--Long-term subordinated notes at 'A+'.
State Street Bank and Trust Company
--Long-term IDR at 'AA'; Outlook Stable;
--Short-term IDR at 'F1+';
--Support at '5';
--Support Rating Floor at 'NF';
--Viability rating at 'aa-';
--Short-term deposits at 'F1+';
--Long-term deposits at 'AA+';
--Long-term subordinated at 'A+'.
State Street Capital I
State Street Capital IV
--Trust Preferred Securities at 'BBB+'.
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