UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________________________________________
FORM 10-K
____________________________________________________________
x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2018
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File No. 001-36609
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NORTHERN TRUST CORPORATION
(Exact name of registrant as specified in its charter)
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Delaware | 36-2723087 |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
50 South La Salle Street | |
Chicago, Illinois | 60603 |
(Address of principal executive offices) | (Zip Code) |
Registrant’s telephone number, including area code: (312) 630-6000
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Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class | Name of Each Exchange On Which Registered |
Common Stock, $1.66 2/3 Par Value | The NASDAQ Stock Market LLC |
Depositary Shares, each representing 1/1000th interest in a share of Series C | |
Non-Cumulative Perpetual Preferred Stock | The NASDAQ Stock Market LLC |
Securities registered pursuant to Section 12(g) of the Act: None
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Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer | x | Accelerated filer | ¨ |
Non-accelerated filer | ¨ | Smaller reporting company | ¨ |
Emerging growth company | ¨ | ||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ¨ No x
The aggregate market value of the registrant’s common stock as of June 29, 2018 (the last business day of the registrant’s most recently completed second quarter), based upon the last sale price of the common stock at June 29, 2018 as reported by The NASDAQ Stock Market LLC, held by non-affiliates was approximately $22.8 billion. Determination of stock ownership by non-affiliates was made solely for the purpose of responding to this requirement and the registrant is not bound by this determination for any other purpose.
At January 31, 2019, 218,411,773 shares of common stock, $1.66 2/3 par value, were outstanding.
Portions of the registrant’s Proxy Statement for its 2019 Annual Meeting of Stockholders are incorporated by reference into Part III hereof.
NORTHERN TRUST CORPORATION
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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PART I
ITEM 1 – BUSINESS
Northern Trust Corporation
Northern Trust Corporation (Corporation) is a financial holding company that is a leading provider of wealth management, asset servicing, asset management and banking solutions to corporations, institutions, families and individuals. The Corporation conducts business through various U.S. and non-U.S. subsidiaries, including The Northern Trust Company (Bank). The Corporation was originally formed as a holding company for the Bank in 1971. The Corporation has a network of offices in 20 U.S. states and Washington, D.C., and across 23 locations in Canada, Europe, the Middle East and the Asia-Pacific region. At December 31, 2018, the Corporation had consolidated total assets of $132.2 billion and stockholders’ equity of $10.5 billion.
The Bank is an Illinois banking corporation headquartered in Chicago and the Corporation’s principal subsidiary. Founded in 1889, the Bank conducts its business through its U.S. operations and its various U.S. and non-U.S. branches and subsidiaries. At December 31, 2018, the Bank had consolidated assets of $131.7 billion and common bank equity capital of $9.6 billion.
The Corporation expects that the Bank will continue in the foreseeable future to be the major source of the Corporation’s consolidated assets, revenues, and net income. Except where the context otherwise requires, references to “Northern Trust,” “we,” “us,” “our” or similar terms mean Northern Trust Corporation and its subsidiaries on a consolidated basis.
Business Overview
Northern Trust focuses on managing and servicing client assets through its two client-focused reporting segments: Corporate & Institutional Services (C&IS) and Wealth Management. Asset management and related services are provided to C&IS and Wealth Management clients primarily by the Asset Management business. The revenue and expenses of Asset Management and certain other support functions are allocated fully to C&IS and Wealth Management. Northern Trust reports certain income and expense items not allocated to C&IS and Wealth Management in a third reporting segment, Treasury and Other.
CORPORATE & INSTITUTIONAL SERVICES
C&IS is a leading global provider of asset servicing and related services to corporate and public retirement funds, foundations, endowments, fund managers, insurance companies, sovereign wealth funds, and other institutional investors around the globe. Asset servicing and related services encompass a full range of capabilities including, but not limited to: custody; fund administration; investment operations outsourcing; investment management; investment risk and analytical services; employee benefit services; securities lending; foreign exchange; treasury management; brokerage services; transition management services; banking; and cash management. Client relationships are managed through the Bank and the Bank’s and the Corporation’s other subsidiaries, including support from locations in North America, Europe, the Middle East, and the Asia-Pacific region. At December 31, 2018, total C&IS assets under custody/administration, assets under custody, and assets under management were $9.49 trillion, $6.97 trillion, and $790.8 billion, respectively.
WEALTH MANAGEMENT
Wealth Management focuses on high-net-worth individuals and families, business owners, executives, professionals, retirees, and established privately-held businesses in its target markets. The business also includes the Global Family Office, which provides customized services to meet the complex financial needs of individuals and family offices in the United States and throughout the world with assets typically exceeding $200 million. In supporting these targeted segments, Wealth Management provides trust, investment management, custody, and philanthropic services; financial consulting; guardianship and estate administration; family business consulting; family financial education; brokerage services; and private and business banking.
Wealth Management is one of the largest providers of advisory services in the United States, with assets under custody/administration, assets under custody, and assets under management of $634.8 billion, $622.9 billion, and $278.6 billion, respectively, at December 31, 2018. Wealth Management services are delivered by multidisciplinary teams through a network of offices in 18 U.S. states and Washington, D.C., as well as offices in London, Guernsey, and Abu Dhabi.
ASSET MANAGEMENT
Asset Management, through the Corporation’s various subsidiaries, supports the C&IS and Wealth Management reporting segments by providing a broad range of asset management and related services and other products to clients around the world. Investment solutions are delivered through separately managed accounts, bank common and collective funds,
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registered investment companies, exchange traded funds, non-U.S. collective investment funds, and unregistered private investment funds. Asset Management’s capabilities include active and passive equity; active and passive fixed income; cash management; alternative asset classes (such as private equity and hedge funds of funds); and multi-manager advisory services and products. Asset Management’s activities also include overlay services and other risk management services. Asset Management operates internationally through subsidiaries and distribution arrangements and its revenue and expense are fully allocated to C&IS and Wealth Management. As discussed above, Northern Trust managed $1.07 trillion in assets as of December 31, 2018, including $790.8 billion for C&IS clients and $278.6 billion for Wealth Management clients.
Competition
Northern Trust faces intense competition in all aspects and areas of its business. Competition comes from both regulated and unregulated financial services organizations, whose products and services span the local, national, and global markets in which Northern Trust conducts operations. Our competitors include a broad range of financial institutions and service companies, including other custodial banks, deposit-taking institutions, asset management firms, benefits consultants, trust companies, investment banking firms, insurance companies, investment counseling firms, and various financial technology companies, including software providers and data services firms. As our businesses grow and markets evolve, we may encounter increasing and new forms of competition around the world.
Northern Trust’s principal business strategy is to provide quality financial services to targeted market segments in which it believes it has a competitive advantage and favorable growth prospects. As part of this strategy, Northern Trust seeks to deliver a level of service that distinguishes it from its competitors. In addition, Northern Trust emphasizes the development and growth of recurring sources of fee-based income. Northern Trust seeks to develop and expand its recurring fee-based revenue by identifying select markets with attractive growth characteristics and providing a high level of individualized service to clients in those markets. Northern Trust also seeks to preserve its asset quality through established credit review procedures and to maintain a conservative balance sheet.
Economic Conditions And Government Policies
The earnings of Northern Trust are affected by numerous external influences. Chief among these are general economic conditions, both domestic and international, and actions that governments and their central banks take in managing their economies. These general conditions affect all of Northern Trust’s businesses, as well as the quality, value, and profitability of their loan and investment portfolios.
The Board of Governors of the Federal Reserve System (Federal Reserve Board) implements monetary policy through its open market operations in United States Government securities, its setting of the discount rate at which member banks may borrow from Federal Reserve Banks, and its changes in the reserve requirements for deposits. The policies adopted by the Federal Reserve Board directly affect interest rates and therefore what banks earn on their loans and investments and what they pay on their savings and time deposits and other purchased funds.
Supervision And Regulation
Northern Trust is subject to extensive regulation under state and federal laws in the United States, as well as the applicable laws of each of the various jurisdictions outside the United States in which Northern Trust does business. The discussion below outlines significant elements of selected laws and regulations applicable to Northern Trust. Changes in these laws or regulations, or their application, cannot be predicted, but may have a material effect on Northern Trust’s businesses and results of operations.
FINANCIAL HOLDING COMPANY REGULATION
Under U.S. law, the Corporation is a bank holding company that has elected to be a financial holding company under the Bank Holding Company Act of 1956, as amended (BHCA). Consequently, the Corporation and its business activities throughout the world are subject to the supervision, examination, and regulation of the Federal Reserve Board. The BHCA and other federal laws subject bank and financial holding companies to particular restrictions on the types of activities in which they may engage and to a range of supervisory requirements, including enforcement actions for violations of laws and regulations. Supervision and regulation of bank holding companies, financial holding companies, and their subsidiaries are intended primarily for the protection of depositors and other clients of banking subsidiaries, the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (FDIC), and the banking system as a whole, not for the protection of stockholders or other nondepository creditors.
Under the BHCA, bank holding companies and their banking subsidiaries are generally limited to the business of banking and activities closely related or incidental to banking. As a financial holding company, the Corporation is permitted to engage in other activities that the Federal Reserve Board determines to be financial in nature, incidental to an activity that is financial in nature, or complementary to a financial activity and that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally, or to acquire shares of companies engaged
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in such activities. Activities defined to be financial in nature include: providing financial or investment advice; securities underwriting and dealing; insurance underwriting; and making merchant banking investments in commercial and financial companies, subject to significant limitations. They also include activities previously determined by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Corporation may not, however, directly or indirectly acquire the ownership or control of more than 5% of any class of voting shares, or substantially all of the assets, of a bank holding company or a bank, without the prior approval of the Federal Reserve Board.
In order to maintain the Corporation’s status as a financial holding company, the Bank, as the Corporation’s sole insured depository institution subsidiary, must remain “well-capitalized” and “well-managed” under applicable regulations, and must have received at least a “satisfactory” rating in its most recent examination under the Community Reinvestment Act (CRA). In addition, as a result of the amendment of the BHCA by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), as discussed further below, the Corporation must remain “well-capitalized” and “well-managed” in order to maintain its status as a financial holding company. Failure to meet one or more of these requirements would mean, depending on the requirements not met, that the Corporation could not undertake new activities, continue certain activities, or make acquisitions other than those permitted generally for bank holding companies.
SUBSIDIARY REGULATION
The Bank is a member of the Federal Reserve System, its eligible deposits are insured by the FDIC up to the maximum authorized limit, and it is subject to regulation by both these agencies. As an Illinois banking corporation, the Bank is also subject to Illinois state laws and regulations and to examination and supervision by the Division of Banking of the Illinois Department of Financial and Professional Regulation. The Bank is also registered as a transfer agent with the Federal Reserve Board and is therefore subject to the rules and regulations of the Federal Reserve Board in this area.
The Bank is registered provisionally as a swap dealer with the U.S. Commodity Futures Trading Commission (CFTC) under the Commodity Exchange Act and is a member of the National Futures Association (NFA). As a provisionally registered swap dealer, the Bank is subject to significant regulatory obligations regarding swap activity and the supervision, examination and enforcement powers of the CFTC, NFA, and other regulators. Certain of the Corporation’s other affiliates are registered with the CFTC as commodity trading advisors and commodity pool operators under the Commodity Exchange Act, are members of the NFA, and are subject to that act and the associated rules and regulations of the CFTC and NFA.
The Corporation’s nonbanking affiliates are all subject to examination by the Federal Reserve Board. Its broker-dealer subsidiary is registered with the U.S. Securities and Exchange Commission (SEC) as a broker-dealer and an investment adviser and is a member of the Financial Industry Regulatory Authority, subject to the rules and regulations of both of these bodies. The Corporation’s broker-dealer subsidiary also is registered with the SEC and Municipal Securities Rulemaking Board as a municipal securities dealer. Several subsidiaries of the Corporation are registered with the SEC under the Investment Advisers Act of 1940 and are subject to that act and the rules and regulations promulgated thereunder. Those subsidiaries also act as investment advisers to various mutual funds, exchange-traded funds and hedge funds of funds that are subject to regulation by the SEC under the Investment Company Act of 1940. Other subsidiaries are regulated by state regulators in various states.
FUNCTIONAL REGULATION
Federal banking law has established a system of federal and state supervision and regulation based on functional regulation, meaning that primary regulatory oversight for a particular activity generally resides with the federal or state regulator designated as having the principal responsibility for that activity. Banking is supervised by federal and state banking regulators, insurance by state insurance regulators, derivatives activities by the CFTC, and securities activities by the SEC and state securities regulators.
A significant component of the functional regulation relates to the application of federal securities laws and SEC oversight of some bank securities activities. Generally, banks may conduct securities activities without broker-dealer registration only if the activities fall within a set of activity-based exemptions designed to allow banks to conduct only those activities traditionally considered to be primarily banking or trust activities. Securities activities outside these exemptions, as a practical matter, need to be conducted by a registered broker-dealer affiliate. The Investment Advisers Act of 1940 requires the registration of any bank or separately identifiable division of the bank that acts as an investment adviser to a registered investment company.
Another component of the functional regulation relates to the application of federal commodity and derivatives laws and CFTC oversight of some bank commodity and derivatives activities, including swap-dealing activities.
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THE DODD-FRANK ACT, AS AMENDED
The Dodd-Frank Act has had a broad impact on the financial services industry, imposing significant new regulatory and compliance requirements, including the imposition of increased capital, leverage, and liquidity requirements, and numerous other provisions designed to improve supervision and oversight of, and strengthen safety and soundness within, the financial services sector. Additionally, the Dodd-Frank Act established a new framework of authority to conduct systemic risk oversight within the U.S. financial system to be distributed among new and existing federal regulatory agencies, including the U.S. Financial Stability Oversight Council, the Federal Reserve Board, and the FDIC. In May 2018, the U.S. Congress passed, and the President signed, the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Regulatory Relief Act”), which revised parts of the Dodd-Frank Act and directed the Federal Reserve Board and other federal regulators to revise parts of their regulations. The Federal Reserve Board has finalized or proposed some of the regulatory changes required by the Regulatory Relief Act, but other required changes remain to be finalized and/or proposed. The Corporation cannot predict what changes may occur to the Dodd-Frank Act as a result of the Regulatory Relief Act or the ultimate effect such changes would have on the Corporation. The following items provide a brief description of certain provisions of the Dodd-Frank Act, as amended, that currently are the most relevant to the Corporation and its subsidiaries, including the Bank.
Enhanced Prudential Standards. The Dodd-Frank Act imposed enhanced prudential requirements on U.S. bank holding companies with at least $50 billion in total consolidated assets, including the Corporation. The enhanced prudential standards include more stringent risk-based capital, leverage, liquidity, risk management, and stress testing requirements and single counterparty credit limits for large bank holding companies, including the Corporation. The Federal Reserve Board also has the discretion to require these large U.S. bank holding companies to limit their short-term debt, to issue contingent capital instruments, and to provide enhanced public disclosures. The Federal Reserve Board has issued final rules implementing enhanced prudential standards for more stringent risk-based capital, leverage, liquidity, risk management, stress testing requirements, and aggregate credit exposure limits. Under the final rules, the Corporation must submit annual capital plans to the Federal Reserve Board, be subject to supervisor-conducted periodic stress tests to evaluate capital adequacy in adverse economic conditions, conduct capital stress tests, implement enhanced risk management procedures, comply with a liquidity risk management framework (discussed below in “Liquidity Standards”) and aggregate credit exposure limits, conduct liquidity stress tests, and hold a buffer of liquid assets estimated to meet funding needs during a financial stress event. The Federal Reserve Board also has proposed rules that would implement early remediation requirements that are required to be established under section 166 of the Dodd-Frank Act.
The Regulatory Relief Act immediately increased the threshold for imposing enhanced prudential standards on U.S. bank holding companies from $50 billion to $100 billion in total consolidated assets. This threshold will further increase to $250 billion in November 2019 for all U.S. bank holding companies, but the Federal Reserve Board retains the ability to apply enhanced prudential standards to certain U.S. bank holding companies with between $100 billion and $250 billion in total consolidated assets. To implement this change, in October 2018, the Federal Reserve Board proposed creating risk-based categories of banking organizations, each of which would be subject to a tailored set of the enhanced prudential standards. The Federal Reserve Board has indicated that, assuming it finalizes the October 2018 proposal without further modification, the Corporation will be a Category II institution, which means that the Corporation would remain subject to the existing enhanced prudential standards described above, but would not be subject to the total loss-absorbing capacity requirement, capital surcharge, enhanced supplementary leverage ratio, or aggregate credit exposure limit that apply to U.S. bank holding companies that are global systemically important bank holding companies. As of the date of this report, the Federal Reserve Board has not finalized the October 2018 proposal and the Corporation cannot predict whether the October 2018 proposal will be finalized and whether such finalization would alter the way in which the enhanced prudential standards are applied to the Corporation.
Resolution Planning. As required by Section 165(d) of the Dodd-Frank Act, the Federal Reserve Board and the FDIC jointly issued a final rule that requires each U.S. bank holding company with at least $50 billion in total consolidated assets, including the Corporation, to submit periodically to regulators a resolution plan for such bank holding company’s rapid and orderly resolution in the event of material financial distress or failure. In addition, the FDIC issued a final rule (the “CIDI Resolution Plan Rule”) that requires insured depository institutions with more than $50 billion in total assets, including the Bank, to submit to the FDIC periodic plans for resolution in the event of such institution’s failure. The Regulatory Relief Act immediately raised the threshold for application of the resolution planning requirement to $100 billion, and this threshold will further increase to $250 billion in November 2019, although the Federal Reserve Board retains the ability to apply enhanced prudential standards to certain U.S. bank holding companies with between $100 billion and $250 billion in total consolidated assets. The Federal Reserve Board and the FDIC have indicated that in light of the Regulatory Relief Act, the agencies will publish proposals and solicit comment on revisions to the resolution planning requirements. Until such time as the Federal Reserve Board and FDIC propose and finalize changes to the resolution
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planning requirements, the Corporation and the Bank will be required to submit resolution plans pursuant to the existing rules; provided, however, that the agencies have indicated that the Corporation is not required to submit a Section 165(d) resolution plan before December 31, 2019 and the FDIC has indicated that the Bank is not required to submit an insured depository institution resolution plan before July 1, 2020.
On March 24, 2017, the Federal Reserve Board and the FDIC provided joint written feedback to the Corporation regarding the resolution plan submitted by the Corporation in December 2015 pursuant to Section 165(d) of the Dodd-Frank Act (the “2015 165(d) Plan”). The joint written feedback identified certain “shortcomings” in the Corporation’s 2015 165(d) Plan. While the identification of these shortcomings is different from a determination that the plan is not “credible”, the Corporation was required to address the shortcomings in a satisfactory manner in the Corporation’s resolution plan to be submitted to the Federal Reserve Board and the FDIC by December 31, 2017. This plan was submitted on December 19, 2017 (the “2017 165(d) Plan”). If the Federal Reserve Board and the FDIC jointly decide that the 2017 165(d) Plan fails to address the identified shortcomings in a satisfactory manner, then the Federal Reserve Board and the FDIC could jointly determine that the 2017 165(d) Plan is not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code. In the event of such a joint determination, the Corporation could be subject to more stringent capital, leverage or liquidity requirements, restrictions on growth, activities or operations, or be required to divest certain assets or operations. To date, no formal written feedback or guidance has been received regarding the 2017 165(d) Plan. In addition, on June 27, 2018, the Bank submitted its resolution plan (the “2018 CIDI Plan”) to the FDIC under the CIDI Resolution Plan Rule. To date, no formal written feedback or guidance has been received regarding the 2018 CIDI Plan.
Separately, the European Union Bank Recovery and Resolution Directive (BRRD), was adopted for European Union credit institutions, including certain of the Bank’s subsidiaries and branches, effective January 1, 2015. In accordance with applicable Prudential Regulation Authority (PRA) guidance, a recovery plan for Northern Trust Global Services Limited (since reincorporated as Northern Trust Global Services SE), a UK incorporated indirect subsidiary of the Bank, has been established and will be reviewed at least annually. PRA guidance also requires institutions to produce resolution planning information. In accordance with such guidance, a resolution pack for Northern Trust Global Services SE and the Bank’s London branch has been prepared and such information will be reviewed every two years.
The Corporation and the Bank have and will continue to focus management attention and substantial resources to meet U.S. and European regulatory expectations with respect to these resolution planning requirements.
Orderly Liquidation Authority. Under the Dodd-Frank Act, certain financial companies, such as the Corporation and certain of its covered subsidiaries, can be subjected to an orderly liquidation authority. For the orderly liquidation authority to apply, the U.S. Treasury Secretary, in consultation with the President of the United States, must make a determination, among other things, that the Corporation is in default or danger of default, the failure of the Corporation and its resolution under the U.S. Bankruptcy Code would have serious adverse effects on financial stability in the United States, no viable private sector alternative is available to prevent the default of the Corporation, and orderly liquidation authority proceedings would mitigate these adverse effects. This determination must be recommended by two-thirds of the FDIC Board of Directors and two-thirds of the Federal Reserve Board. Absent such actions, the Corporation, as a bank holding company, would remain subject to the U.S. Bankruptcy Code. If the Corporation were subject to orderly liquidation authority, the FDIC would be appointed as its receiver, which would give the FDIC considerable powers to resolve the Corporation, including: (1) the power to remove officers and directors and appoint new ones; (2) the power to assign assets and liabilities to a third party or bridge financial company without the need for creditor consent or prior court review; (3) the ability to differentiate among creditors, including by treating junior creditors better than senior creditors, subject to a minimum recovery right to receive at least what such senior creditors would have received in bankruptcy liquidation; and (4) broad powers to administer the claims process to determine distributions from the assets of the receivership to creditors not transferred to a third party or bridge financial institution.
The Volcker Rule. The Volcker Rule bans proprietary trading subject to exceptions for market-making, hedging, certain trading activities in U.S. and foreign sovereign debt, certain trading activities of non-U.S. banking entities trading outside the United States, and trading activities related to liquidity management. The Volcker Rule also maintains significant restrictions on sponsoring or investing in certain “covered funds,” such as hedge funds or private equity funds. A banking entity may “organize and offer” certain private funds only if certain requirements are satisfied. Moreover, a banking entity only may retain a limited ownership interest in such funds, and must monitor and track investments in such covered funds carefully to ensure that the ownership interest in the fund does not exceed regulatory thresholds. Generally, a banking entity that sponsors or invests in certain private funds is also restricted from providing credit or other support to the funds or permitting the funds to use the name of the bank. The Volcker Rule requires large banking entities, including the Corporation, to implement a detailed compliance program and, on an annual basis, requires the Chief Executive Officer of the banking entity to attest that the compliance program is reasonably designed to achieve compliance with the rule. Compliance with the Volcker Rule generally has been required since July 21, 2015. Northern Trust has conducted an
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enterprise-wide review of affected activities, taken steps to bring those activities into conformance, and has established an enterprise-wide compliance program to comply with the Volcker Rule.
In July 2018, the Federal Reserve Board and other federal regulatory agencies having oversight over the Volcker Rule proposed amendments to the rule. The notice of proposed rulemaking contains certain revisions to the Volcker Rule’s restrictions. Northern Trust is evaluating the proposal to determine the impact such proposal will have, if any, if it becomes effective, but as of the date of this report, no final rule amendments have been issued. The full impact of the Volcker Rule on Northern Trust ultimately will depend on the finalization of the July 2018 proposed amendments and further interpretation and guidance by the regulatory agencies responsible for its enforcement. Northern Trust is monitoring developments with respect to the Volcker Rule actively and will revise further its operations and compliance programs as appropriate or required.
Swaps and Other Derivatives. Title VII of the Dodd-Frank Act (Title VII) imposes a regulatory structure on the over-the-counter derivatives market, including requirements for clearing, exchange trading, capital, margin, trade reporting, and recordkeeping. Title VII also requires certain persons to register as a “major swap participant,” a “swap dealer,” a “major-security-based swap participant” or a “security-based swap dealer.” The CFTC has finalized most rules further defining these registrant categories, while the SEC continues to draft rules related to security-based swaps. The CFTC’s Title VII rules and regulations are applicable to the Bank’s activity as a swap dealer and include rules related to internal and external business conduct standards, reporting and recordkeeping, mandatory clearing for certain swaps, and trade documentation and confirmation requirements, and applied certain regulatory requirements to cross-border swap activities. In addition, the Federal Reserve Board has finalized regulations applicable to the Bank regarding mandatory posting and collection of margin by certain swap counterparties. The SEC’s rules related to security-based swaps are not currently applicable to the Bank’s swap dealing activity and the Bank’s current trading activity does not mandate its regulation as a security-based swap dealer. Northern Trust continues to monitor Title VII-related regulatory developments and will revise further its operations and/or swaps compliance program as appropriate or required.
Incentive Compensation Arrangements. The Dodd-Frank Act requires federal regulators to prescribe regulations or guidelines regarding incentive-based compensation practices at certain large financial institutions. No final rule has been issued to date.
HOLDING COMPANY SUPPORT UNDER THE FEDERAL DEPOSIT INSURANCE ACT
The Dodd-Frank Act amended the Federal Deposit Insurance Act (FDIA) to obligate the Federal Reserve Board to require bank holding companies, such as the Corporation, to serve as a source of financial strength for any subsidiary depository institution. The term “source of financial strength” is defined as the ability of a company to provide financial assistance to its insured depository institution subsidiaries in the event of financial distress at such subsidiaries. Under this requirement, the Corporation in the future could be required to provide financial assistance to the Bank should the Bank experience financial distress.
PAYMENT OF DIVIDENDS
The Corporation is a legal entity separate and distinct from its subsidiaries. The Corporation may pay dividends, repurchase stock, and make other capital distributions only in accordance with a capital plan that has been reviewed by the Federal Reserve Board and as to which the Federal Reserve Board has not objected. A significant source of funds for the Corporation is dividends from the Bank. As a result, the Corporation’s ability to pay dividends on its common stock will depend on the ability of the Bank to pay dividends to the Corporation in amounts sufficient to service its obligations and fund dividend payments. Dividend payments from the Bank are subject to Illinois law and to regulatory limitations, generally based on capital levels and current and retained earnings, imposed by various regulatory agencies with authority over the Bank. The ability of the Bank to pay dividends is also subject to regulatory restrictions if paying dividends would impair its profitability, financial condition or cash flow requirements.
Various federal and state statutory provisions limit the amount of dividends the Bank can pay to the Corporation without regulatory approval. Approval of the Federal Reserve Board is required for payment of any dividend by a state-chartered bank that is a member of the Federal Reserve System if the total of all dividends declared by the bank in any calendar year (including any prospective dividend) would exceed the total of its retained net income (as defined by regulatory agencies) for that year combined with its retained net income for the preceding two years. In addition, a state member bank may not pay a dividend in an amount greater than its “undivided profits,” as defined, without regulatory and stockholder approval.
The Bank is also prohibited under federal law from paying any dividends if the Bank is undercapitalized or if the payment of the dividends would cause the Bank to become undercapitalized. In addition, the federal regulatory agencies are authorized to prohibit a bank or bank holding company from engaging in an unsafe or unsound banking practice. The payment of dividends could, depending on the financial condition of the Bank, be deemed to constitute an unsafe or
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unsound practice. The Dodd-Frank Act and Basel III (as defined and discussed further below) impose additional restrictions on the ability of banking institutions to pay dividends.
CAPITAL PLANNING AND STRESS TESTING
The Corporation’s capital distributions are subject to Federal Reserve Board oversight. The major component of that oversight is the Federal Reserve Board’s Comprehensive Capital Analysis and Review (CCAR) exercise, implementing its capital plan rules. These rules require bank holding companies having $50 billion or more in total consolidated assets (including the Corporation) to submit annual capital plans to their respective Federal Reserve Bank. The Corporation also is required to collect and report certain related data on a quarterly basis to allow the Federal Reserve Board to monitor progress against the annual capital plans. The CCAR exercise is an intensive assessment of the capital adequacy of bank holding companies as well as of the processes used by certain bank holding companies to assess their capital needs. Through CCAR, the Federal Reserve Board assesses whether bank holding companies have robust, forward-looking capital planning processes that account for their unique risks and that permit continued operations during times of economic and financial stress. The Corporation and other affected bank holding companies may pay dividends, repurchase stock, and make other capital distributions only in accordance with a capital plan as to which the Federal Reserve Board has not objected. The Federal Reserve Board may object to a capital plan for a number of reasons, including if the capital plan does not show that the covered bank holding company will meet, for each quarter throughout the nine-quarter planning horizon covered by the capital plan, all minimum regulatory capital ratios under applicable capital rules as in effect for that quarter, as well as all minimum regulatory capital ratios on a pro forma basis under the base case and stressful scenarios. The capital plan rules also stipulate that a covered bank holding company may not make a capital distribution, unless after giving effect to the distribution, it will meet all minimum regulatory capital ratios.
On January 30, 2017, the Federal Reserve Board announced modifications to capital plan and stress testing rules. Under the modified final rules, the qualitative assessment of CCAR was removed for bank holding companies with total consolidated assets between $50 billion and $250 billion, irrespective of the amount of on-balance-sheet foreign exposure held by such bank holding companies. As a result, capital plans submitted by the Corporation currently are no longer subject to objection from the Federal Reserve Board on qualitative grounds. In lieu of the qualitative assessment of CCAR, the Corporation is subject to a horizontal capital review (HCR), focusing on specific areas of capital planning, conducted as part of the Federal Reserve Board’s normal supervisory process. Any supervisory findings resulting from the HCR are addressed through supervisory communications. Capital plans submitted by the Corporation remain subject to objection from the Federal Reserve Board on quantitative grounds.
The Corporation submitted its capital plan to the Federal Reserve Board in April 2018 as part of the Federal Reserve Board’s 2018 CCAR exercise, and the Federal Reserve Board did not object to the Corporation’s plan. The Corporation will submit its 2019 capital plan to the Federal Reserve Board by April 5, 2019. The Federal Reserve Board is expected to publish either its objection or non-objection to the 2019 capital plan and proposed capital actions, such as dividend payments and share repurchases, in mid-2019.
In addition to the CCAR stress testing requirements, Federal Reserve Board regulations include Dodd-Frank Act stress tests (DFAST). Under the DFAST regulations, the Corporation is required to undergo regulatory stress tests conducted by the Federal Reserve Board annually, and to conduct internal stress tests pursuant to regulatory requirements semi-annually. The Bank also is required to conduct its own annual internal stress test (although it is permitted to combine certain reporting and disclosure of its stress test results with the results of the Corporation). These requirements involve both company-run and supervisory-run testing of capital under various scenarios, including baseline, adverse and severely adverse scenarios provided by the appropriate banking regulator. Results from the Corporation’s and the Bank’s annual company-run stress tests are reported to the appropriate regulators and published. Northern Trust published the results of its company-run stress tests on June 21, 2018, and the results of its company-run mid-cycle stress tests on October 31, 2018.
In April 2018, the Federal Reserve Board proposed revisions to the CCAR exercise and DFAST regulations that would in part integrate the forward-looking stress test results with the non-stress capital requirements discussed below by using the results of the annual supervisory stress test to set specific buffer requirements above minimum capital requirements, which restrict capital distributions under the capital rule and establish a single approach to capital distribution limitations. The April 2018 proposal also would replace the 2.5% capital conservation buffer requirement with a stress capital buffer requirement and establish a stress leverage buffer requirement in addition to the minimum 4% Tier 1 leverage ratio requirement. Under the April 2018 proposal, an institution would be required to maintain capital ratios above its minimum plus its buffer requirements in order to avoid restrictions on its capital distributions and discretionary bonus payments. An institution would be bound by the most stringent distribution limitations, if any, as determined by its capital conservation buffer requirement, its stress leverage buffer requirement and, if applicable, its advanced approaches capital conservation buffer requirement and enhanced supplementary leverage ratio standard.
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The April 2018 proposal also would remove the stress testing assumption that an institution would make all planned capital distributions over the planning horizon, including any planned common stock dividends and repurchases of common stock. Instead, the stress buffer requirements would include only four quarters of planned common stock dividends in order to preserve the incentives for an institution to engage in disciplined, forward-looking dividend planning. Further, the April 2018 proposal would adjust the methodology used in the supervisory stress test to assume that the institution takes actions to maintain a constant level of assets, including loans, trading assets, and securities over the planning horizon and assume that the institution’s risk-weighted assets and leverage ratio denominator generally remain unchanged over the planning horizon. The April 2018 proposal also would remove the quantitative objection in CCAR and eliminate the 30 percent dividend payout ratio as a criterion for heightened scrutiny of an institution's capital plan. The Federal Reserve Board would retain the CCAR qualitative supervisory review and the ability to object to an institution’s capital plan on qualitative grounds based on the adequacy of the institution’s capital planning processes (qualitative objection) for institutions supervised by the Large Institution Supervision Coordination Committee and other large and complex institutions.
Separately, the Regulatory Relief Act immediately raised the threshold for application of DFAST regulations to $100 billion, and this threshold will further increase to $250 billion in November 2019. However, the Regulatory Relief Act did not directly affect the CCAR exercise. In its October 2018 proposal described above, the Federal Reserve Board proposed that the Corporation will be subject to the qualitative and quantitative assessments of the CCAR exercise and the DFAST regulations, but did not address the April 2018 proposal. As of the date of this filing, the Federal Reserve Board has not finalized the April 2018 or October 2018 proposals, and the Corporation cannot predict whether either proposal will be finalized and whether such finalization would alter the way in which the CCAR exercise and DFAST regulations are applied to the Corporation.
Additionally, on December 21, 2018, the Federal Reserve Board announced it will not incorporate the current expected credit losses methodology (CECL) from Accounting Standards Update No. 2016-13 into its supervisory stress tests until at least 2022 to reduce uncertainty, allow for better capital planning at affected firms, and allow the Federal Reserve Board to gather additional information on the impact of CECL. The Federal Reserve Board will still require banking organizations subject to company-run stress test requirements as part of the CCAR exercise to incorporate CECL into their internal stress testing processes beginning in 2020.
CAPITAL ADEQUACY REQUIREMENTS
The regulators view capital levels as important indicators of an institution’s financial soundness. As a general matter, FDIC-insured depository institutions and their holding companies (including the Bank and the Corporation) are required to maintain minimum capital relative to the amount and types of assets they hold. The final supervisory determination on an institution’s capital adequacy is based on the regulator’s assessment of numerous factors.
The risk-based capital guidelines that apply to the Corporation and the Bank are based upon the 2011 capital accord of the International Basel Committee on Banking Supervision (Basel Committee), a committee of central banks and bank supervisors, as implemented by the Federal Reserve Board (Basel III). The Basel III rules are currently being phased in, and will come into full effect by January 1, 2022.
To implement Basel III for bank holding companies, including the Corporation, the Federal Reserve Board established risk-based and leverage capital guidelines. The federal banking regulators also established risk-based and leverage capital guidelines that FDIC-insured depository institutions, such as the Bank, are required to meet. These regulations are generally similar to those established by the Federal Reserve Board for bank holding companies. The Bank’s risk-based and leverage capital ratios remained strong at December 31, 2018, and were well above the minimum regulatory requirements established by U.S. banking regulators.
Under the final Basel III rules, the Corporation is one of a small number of “core” banking organizations. The rules require core banking organizations to have rigorous processes for assessing overall capital adequacy in relation to their total risk profiles, and to disclose publicly certain information about their risk profiles and capital adequacy. In order to implement the capital rules, a core banking organization, such as the Corporation, is required to complete satisfactorily a parallel run, in which it calculates capital requirements under both the Basel III rules and previously effective regulations. The Corporation and the Bank completed their parallel runs in 2014 and are required to use the advanced approaches methodologies to calculate and disclose publicly their risk-based capital ratios.
Pursuant to the Federal Reserve Board’s implementation in the final Basel III rules of a provision of the Dodd-Frank Act, the Corporation is subject to a capital floor that is based on the Basel III standardized approach. The Corporation is therefore required to calculate its risk-based capital ratios under both the standardized and advanced approaches, and is subject to the more stringent of the risk-based capital ratios as calculated under the standardized approach and the advanced approach in the assessment of its capital adequacy.
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The risk-based and leverage capital ratios for the Corporation and the Bank, together with the regulatory minimum ratios and the ratios required for classification as “well-capitalized,” are provided in the following chart.
TABLE 1: RISK-BASED AND LEVERAGE CAPITAL RATIOS AS OF DECEMBER 31, 2018
COMMON EQUITY TIER 1 CAPITAL | TIER 1 CAPITAL | TOTAL CAPITAL | TIER 1 LEVERAGE | SUPPLEMENTARY LEVERAGE | ||||||||||||||
ADVANCED APPROACH | STANDARDIZED APPROACH | ADVANCED APPROACH | STANDARDIZED APPROACH | ADVANCED APPROACH | STANDARDIZED APPROACH | ADVANCED APPROACH | STANDARDIZED APPROACH | ADVANCED APPROACH | ||||||||||
Northern Trust Corporation | 13.7 | % | 12.9 | % | 15.0 | % | 14.1 | % | 16.9 | % | 16.1 | % | 8.0 | % | 8.0 | % | 7.0 | % |
The Northern Trust Company | 14.1 | % | 13.1 | % | 14.1 | % | 13.1 | % | 15.8 | % | 14.8 | % | 7.3 | % | 7.3 | % | 6.4 | % |
Minimum required ratio | 4.5 | % | 4.5 | % | 6.0 | % | 6.0 | % | 8.0 | % | 8.0 | % | 4.0 | % | 4.0 | % | 3.0 | % |
“Well-capitalized” minimum ratios, as applicable | ||||||||||||||||||
Northern Trust Corporation | N/A | N/A | 6.0 | % | 6.0 | % | 10.0 | % | 10.0 | % | N/A | N/A | N/A | |||||
The Northern Trust Company | 6.5 | % | 6.5 | % | 8.0 | % | 8.0 | % | 10.0 | % | 10.0 | % | 5.0 | % | 5.0 | % | 3.0 | % |
In addition to the above, as of January 1 2018, advanced approaches institutions, such as the Corporation and the Bank, must comply with a supplementary leverage ratio. Under the supplementary leverage ratio rule, advanced approaches institutions are subject to a minimum supplementary leverage ratio of 3.0%. Insured depository institutions that are advanced approaches institutions, such as the Bank, also are required to maintain at least a 3.0% supplementary leverage ratio to be considered “well-capitalized” under the rule. The supplementary leverage ratio differs from the leverage ratio in that the leverage ratio does not take into account certain off-balance-sheet assets and exposures that are reflected in the supplementary leverage ratio.
Basel III also introduced a capital conservation buffer, requiring banking organizations to hold a buffer of common equity Tier 1 capital above the minimum risk-based capital requirements. The minimum capital conservation buffer in 2018 was 1.875% and will increase to 2.5% for 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking organizations with a common equity Tier 1 ratio above the minimum but below the conservation buffer may face constraints on dividends, equity repurchases and compensation based on the amount of such shortfall. Basel III also introduced a “countercyclical buffer” of 0% to 2.5% of a banking organization’s total risk-weighted assets for advanced approaches banking organizations, such as the Corporation, which is intended to create a capital buffer for such banking organizations during expansionary economic phases in order to protect against declines in asset prices if credit conditions weaken. In general, the amount of the countercyclical capital buffer is a weighted average of the countercyclical capital buffer established in the various jurisdictions in which the banking organization has credit exposures. The U.S. countercyclical buffer is currently set at 0%, and the Federal Reserve Board has indicated that generally it will provide a 12-month phase-in of changes to the minimum required countercyclical buffer and use the notice and comment process to communicate proposed changes to the public. Certain other jurisdictions in which the Corporation has credit exposures currently have countercyclical buffers set at levels greater than 0%, slightly increasing the weighted average countercyclical buffer to which the Corporation is subject.
On December 21, 2018, the Federal Reserve Board adopted a final rule that will permit banking organizations, including the Corporation and the Bank, to elect to phase-in the day-one adverse effects of implementing CECL on regulatory capital calculations over a three-year period. The final rule will take effect April 1, 2019, although CECL is not required to be implemented by public companies until 2020.
As discussed above, in April 2018, the Federal Reserve Board proposed revisions to the Basel III rules that would in part integrate the forward-looking stress test results with the non-stress capital requirements discussed in this section. If implemented, the revisions would establish revised capital requirements for large banking organizations, such as the Corporation, that are institution-specific and risk-sensitive. The April 2018 proposal would also modify several assumptions in the CCAR exercise to align them better with an institution’s expected actions under stress. Separately, the Regulatory Relief Act directed the Federal Reserve Board to revise the Basel III rules to provide relief from the supplementary leverage ratio requirement for certain funds that are deposited with a central bank. Further, in October 2018, the Federal Reserve Board proposed changes to the applicability thresholds for regulatory capital and liquidity requirements for certain large U.S. banking organizations. At the same time, the Federal Reserve Board indicated that, assuming it finalizes the proposal without further modification, the Corporation will be a Category II institution, meaning
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that it will become subject to certain additional capital planning and liquidity reporting requirements. As of the date of this report, the Federal Reserve Board has not finalized the April 2018 or October 2018 proposals or proposed rules to implement the relief provided for in the Regulatory Relief Act. The Corporation cannot predict whether the April 2018 or October 2018 proposals will be finalized, whether and when the rules to implement the relief provided for in the Regulatory Relief Act will be proposed and finalized, and whether finalization of any proposal would alter the way in which the Basel III rules are applied to the Corporation and Bank.
LIQUIDITY STANDARDS
In addition to capital adequacy standards, Basel III introduced two quantitative liquidity standards: a liquidity coverage ratio (LCR) and a net stable funding ratio (NSFR). The LCR is intended to promote the short-term resilience of the liquidity risk profile of covered banking organizations, improve the banking industry’s ability to absorb shocks arising from financial and economic stress, and improve the measurement and management of liquidity risk. In September 2014, the U.S. banking agencies finalized rules to implement the LCR in the United States for large banking organizations, such as the Corporation and the Bank. Among other things, the finalized LCR rules require covered banking organizations, which include the Corporation and the Bank, to maintain an amount of high-quality liquid assets (HQLAs) equal to or greater than 100% of the banking organization’s total net cash outflows over a thirty-calendar-day standardized supervisory liquidity stress scenario. The LCR has been fully implemented since January 1, 2017. Northern Trust is required to calculate its LCR on a daily basis and disclose publicly certain LCR information on a quarterly basis.
The NSFR requires banking organizations to maintain a stable funding profile in relation to the composition of their assets and off-balance-sheet activities. More specifically, the NSFR requires that the ratio of available stable funding relative to the amount of required stable funding be equal to at least 100% on an ongoing basis. The Basel Committee finalized its NSFR rules in October 2014, which were to be implemented by the Federal Reserve Board as a minimum standard by January 1, 2018. The Federal Reserve Board issued a proposal on May 3, 2016 to implement the NSFR and revised aspects of that proposal in the two October 2018 proposals discussed above, but has not adopted a final rule.
The enhanced prudential standards (discussed above) specify certain liquidity risk management practices to be followed by covered large U.S. banks and bank holding companies, including the Corporation and the Bank. These practices include an independent review of liquidity risk management and the establishment of cash flow projections, a contingency funding plan, and liquidity risk limits. The Corporation’s Board of Directors (Board) also is required to establish and maintain a liquidity buffer of unencumbered HQLAs based on the results of internal liquidity stress testing. This liquidity buffer must be tailored to Northern Trust’s business risks and is in addition to other liquidity requirements, such as the LCR and NSFR discussed above. The enhanced prudential standards also establish requirements and responsibilities for the Board of Directors and its Business Risk Committee with respect to liquidity risk management. The enhanced prudential standards require Northern Trust to engage in liquidity stress testing under multiple stress scenarios and time horizons tailored to its specific products and risk profile. The Board of Directors has approved a liquidity management policy establishing the principles and guidelines for the Corporation to govern the processes and activities for the management of its liquidity position. Among other matters, this policy includes limits and thresholds related to the enhanced prudential standards liquidity buffer and the LCR.
PROMPT CORRECTIVE ACTION
The FDIC Improvement Act of 1991 requires the appropriate federal banking regulator to take “prompt corrective action” with respect to a depository institution if that institution does not meet certain capital adequacy standards. While these regulations apply only to banks, such as the Bank, the Federal Reserve Board is authorized to take appropriate action against a parent bank holding company, such as the Corporation, based on the under-capitalized status of any banking subsidiary. In certain instances, the Corporation would be required to guarantee the performance of the capital restoration plan for its under-capitalized banking subsidiary.
As noted above, the Federal Reserve Board has issued proposed rules to implement certain “early remediation requirements” applicable to U.S. bank holding companies with total consolidated assets of $50 billion or more as required under Section 166 of the Dodd-Frank Act. Similar to prompt corrective action, the early remediation requirements would require institutions subject to the proposal to take increasingly stringent corrective measures as the institution’s financial condition deteriorates. No final rule implementing Section 166 has been issued as of the date of this report, and the thresholds at which such a final rule would apply have been raised by the Regulatory Relief Act and may be subject to further rulemaking by the Federal Reserve Board.
RESTRICTIONS ON TRANSACTIONS WITH AFFILIATES AND INSIDERS
As an insured depository institution, the Bank is subject to restrictions which govern transactions between FDIC-insured banks and any affiliated entity, whether that entity is the Corporation, as the Bank’s parent holding company, a holding company affiliate of the Bank or a subsidiary of the Bank. Regulation W restrictions apply to certain “covered
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transactions,” including extensions of credit, issuance of guarantees, investments or asset purchases. In general, these restrictions require that any extensions of credit must be secured fully with qualifying collateral and are limited, as to any one of the Corporation or such nonbank affiliates, to 10% of the Bank’s capital stock and surplus, and, as to the Corporation and all such nonbank affiliates in the aggregate, to 20% of the Bank’s capital stock and surplus. These restrictions are also applied to transactions between the Bank and its financial subsidiaries. Furthermore, these transactions must be on terms and conditions that are, or in good faith would be, offered to nonaffiliated companies (i.e., at arm’s length).
The Dodd-Frank Act generally enhanced the restrictions on transactions with affiliates under Sections 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” to include credit exposures related to derivatives, repurchase agreements and securities lending arrangements, and an increase in the amount of time for which collateral requirements regarding covered credit transactions must be satisfied. The definition of “affiliate” was expanded to include any investment fund to which the Corporation or an affiliate serves as an investment adviser. The ability of the Federal Reserve Board to grant exemptions from these restrictions was also narrowed, including by requiring coordination with other bank regulators. In addition, the provision in Section 23A that had permitted the Bank to engage in covered transactions with a financial subsidiary of the Bank in an amount greater than 10% (but less than 20%) of the Bank’s capital and surplus has been eliminated.
The restrictions on loans to directors, executive officers, principal stockholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all federally insured institutions, including the Bank. These restrictions include, among others, limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans (including credit exposures related to derivatives, repurchase agreements and securities lending arrangements) to insiders and their related interests. These loans cannot exceed the institution’s total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions. The Dodd-Frank Act enhanced these restrictions and also imposed restrictions on the purchase or sale of assets between banking institutions and insiders.
ANTI-MONEY LAUNDERING, ANTI-TERRORISM LEGISLATION, AND OFFICE OF FOREIGN ASSETS CONTROL
The Corporation and certain of its subsidiaries are subject to the Bank Secrecy Act of 1970, as amended by the USA PATRIOT Act of 2001, which contains anti-money laundering (AML) and financial transparency provisions and requires implementation of regulations applicable to financial services companies, including, but not limited to, standards for conducting due diligence, verifying client identification, and monitoring client transactions and detecting and reporting suspicious activities. AML laws outside the U.S. contain similar requirements. The Corporation and its subsidiaries have implemented policies, procedures and internal controls that are designed to comply with all applicable AML laws and regulations. Compliance with applicable AML laws and related requirements is a common area of review for financial regulators, and the Corporation’s and its subsidiaries’ failure to comply with these requirements could result in fines, penalties, lawsuits, regulatory sanctions or difficulties in obtaining approvals, restrictions on their business activities or harm to their reputation.
In May 2016, the Financial Crimes Enforcement Network (FinCEN) issued a new rule that requires certain financial institutions, including the Bank, to obtain beneficial ownership information related to certain legal entity clients. Compliance with the new rule has been required since May 2018. As part of its AML compliance program, Northern Trust has implemented, and continues to maintain, processes and controls to comply with the new beneficial ownership information collection rule.
The U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) is responsible for requiring that U.S. entities do not engage in business with certain prohibited parties and jurisdictions, as defined by various executive orders and Acts of Congress. OFAC publishes lists of persons, organizations and countries suspected of aiding, harboring or engaging in terrorist acts, trafficking in narcotics, proliferating weapons of mass destruction or representing other threats to national security, known as Specially Designated Nationals and Blocked Persons. If the Corporation or the Bank finds a sanctioned name or jurisdiction on any transaction or account, the Corporation or the Bank must reject or block such account or transaction as required, and notify the appropriate authorities.
Many other countries have imposed similar laws and regulations that apply to the Corporation’s non-U.S. offices. The Corporation has established policies and procedures to comply with these laws and the related regulations in all relevant jurisdictions.
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DEPOSIT INSURANCE AND ASSESSMENTS
The Bank accepts deposits, and eligible deposits have the benefit of FDIC insurance up to the applicable limit. The current limit for FDIC insurance for deposit accounts is $250,000 for each depositor account. Under the FDIA, insurance of deposits may be terminated by the FDIC upon a finding that the insured depository institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by a bank’s federal regulatory agency. The FDIC’s Deposit Insurance Fund is funded by assessments on insured depository institutions. Certain liquid assets are excluded from the deposit insurance assessment base of custody banks that satisfy certain institutional eligibility criteria. This has the effect of reducing the amount of deposit insurance fund insurance premiums due from custody banks. In March 2016, the FDIC finalized a surcharge assessment on insured depository institutions with total consolidated assets of $10 billion or more, such as the Bank, in connection with the Dodd-Frank Act requirement to increase the Deposit Insurance Fund’s minimum reserve ratio from 1.15% to 1.35% without increasing the assessments of small insured depository institutions. This surcharge assessment remained in effect until September 30, 2018, when the reserve ratio reached 1.35%. On December 22, 2017, the Tax Cuts and Jobs Act was signed into law, placing new restrictions on insured depository institutions with total consolidated assets of $10 billion or more, such as the Bank, with respect to the deduction of all or a portion of all of their deposit insurance assessment payments as business expenses for federal taxation purposes. As a result of this tax law change, the Bank is no longer able to deduct its FDIC deposit insurance assessment payments.
FIDUCIARY RULE
The U.S. Department of Labor issued a final regulation and related prohibited transaction exemptions, effective June 2017, which significantly expanded the concept of “investment advice” for the purpose of determining fiduciary status to employee benefits plans, plan participants, and individual retirement account (IRA) owners under ERISA and the Internal Revenue Code (IRC). However, in June 2018, the U.S. Court of Appeals for the Fifth Circuit vacated the final regulation, and related prohibited transaction exemptions, and thus they are no longer in effect. In anticipation of the Fifth Circuit’s action, the Department of Labor issued guidance in May 2018 stating that, pending the issuance of further regulations, exemptions or administrative guidance, it will not pursue prohibited transaction claims against investment advice fiduciaries who are working diligently and in good faith to comply with the “impartial conduct standards” set forth in the vacated regulation for transactions that would have been exempted by the vacated prohibited transaction exemptions. The Corporation is operating under the Department of Labor’s May 2018 guidance pending further developments.
COMMUNITY REINVESTMENT ACT
The Bank is subject to the Community Reinvestment Act (CRA). The CRA and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service areas, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank’s record in meeting the needs of its service area when considering applications to establish branches, merger applications, and applications to acquire the assets and assume the liabilities of another bank. In October 2012, the Federal Reserve Board, the federal regulator responsible for monitoring the Bank’s CRA compliance, approved the designation of the Bank as a “wholesale bank.” As a result of this designation, the Bank fulfills its CRA obligations by making qualified investments for the purposes of community development, rather than retail CRA loans. Federal banking agencies are required to make public the rating of a bank’s performance under the CRA. The Bank received an “outstanding” CRA rating from the Federal Reserve Board in its most recent CRA examination.
PRIVACY AND SECURITY
Federal law establishes a minimum federal standard of financial privacy by, among other provisions, requiring financial institutions to adopt and disclose privacy policies with respect to consumer information and setting forth certain limitations on disclosure to third parties of consumer information. Regulations adopted under the federal law set standards for protecting the security, confidentiality and integrity of client information, and require notice of data breaches to regulators, and in some cases, to clients.
Most states, the European Union (EU) and other non-U.S. jurisdictions also have adopted their own statutes and/or regulations concerning financial privacy and security and requiring notification of data breaches. For example, a new European data protection framework - the General Data Protection Regulation (GDPR) - was adopted on April 8, 2016, and became effective in all European Economic Area (EEA) member states on May 25, 2018. GDPR is designed to harmonize data privacy laws across the EEA, to protect EEA citizens’ data privacy and to reshape the way organizations across the region approach data privacy. GDPR has extraterritorial effect as its scope includes all data controllers and processors outside the EEA whose processing activities relate to the offering of goods or services to, or monitoring the behavior of, EEA individuals. Organizations that violate certain provisions of GDPR could be fined up to €20 million or 4% of their annual global turnover (i.e., revenue) for the preceding fiscal year, whichever is greater.
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The Corporation has adopted and disseminated privacy policies, and communicates required information relating to financial privacy and data security, in accordance with applicable law.
CONSUMER LAWS AND REGULATIONS
The Corporation’s banking subsidiaries are subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with clients and monitor account activity when taking deposits, making loans to or engaging in other types of transactions with such clients. Failure to comply with these laws and regulations could lead to substantial penalties, operating restrictions and reputational damage to the financial institution. The Dodd-Frank Act established an independent Consumer Financial Protection Bureau (CFPB) within the Federal Reserve System. The CFPB was tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The creation of the CFPB by the Dodd-Frank Act has led to enhanced enforcement of consumer financial protection laws.
NON-U.S. REGULATION
Northern Trust is subject to the laws and regulatory authorities of the jurisdictions in which its non-U.S. branches and subsidiaries operate. For example, branches and subsidiaries conducting banking and asset servicing businesses in the United Kingdom are authorized to do so pursuant to the UK Financial Services and Markets Act 2000. They are authorized by the PRA or the Financial Conduct Authority (FCA) and regulated by the FCA and, in some instances, also the PRA. The PRA and FCA exercise broad supervisory and disciplinary powers that include the power to revoke temporarily or permanently authorization to conduct a regulated business upon breach of the relevant regulations, suspend registered employees, and impose censures and fines on both regulated businesses and their regulated employees.
Northern Trust’s European branches and subsidiaries are subject to the laws and regulatory authorities of the EU and the member states in which they are domiciled. Moreover, Northern Trust’s non-European branches and subsidiaries conducting financial services activities also may be within the scope of these laws, given that some EU laws apply to the wider EEA, which includes not only all EU member states but also the non-EU member states Iceland, Liechtenstein and Norway, and because of increasing extraterritorial effect of European legislation.
The following items provide a brief description of certain recently implemented and in-progress regulatory changes in the EU and UK relevant to the Corporation and its subsidiaries, in addition to the BRRD and GDPR discussed under “The Dodd-Frank Act – Resolution Planning” and “Privacy and Security,” respectively, above.
Revised Capital Requirements Directive and revised Capital Requirements Regulation. The EU Capital Requirements Directive of June 26, 2013 (CRD) and the EU Capital Requirements Regulation of June 26, 2013 (CRR) govern the legal framework for banking regulation in the EU, including, among other things, own fund requirements. On November 23, 2016, the EU Commission published a proposal for a revision of the CRD (CRD V) and the CRR (CRR II). Formal adoption of CRD V and CRR II by the EU Parliament and European Council has not yet occurred. Further, CRD V and CRR II currently contain mandates for the European Banking Authority (EBA) to produce a number of regulatory technical standards (RTS) and implementing technical standards (ITS), which remain under development.
Central Securities Depositories Regulation. On September 17, 2014, the EU Central Securities Depositories Regulation (CSDR) entered into force (subject to a number of transitional provisions). The CSDR aims principally to ensure that transactions between buyers and sellers of dematerialized securities are settled in a safe and timely manner by introducing common securities settlement standards across the EU. CSDR requires several “Level 2” (or implementing) measures in order for its provisions to take effect fully. A number of these “Level 2” measures were published in 2017. Most recently, on September 13, 2018, the EU Commission Delegated Regulation (EU) 2018/1229 supplementing the CSDR with regard to technical standards on settlement discipline was published in the EU’s Official Journal. The Delegated Regulation, which is expected to enter into force on September 14, 2020, sets out measures to prevent and address failed settlements and encourage settlement discipline by monitoring failed settlements, collecting and distributing cash penalties for failed settlements, and specifying the operational details of the buy-in process.
Securities Financing Transactions and Reuse of Collateral Regulation. On November 25, 2015, the EU adopted a regulation on securities financing transactions and reuse of collateral (SFTR) as part of its approach to addressing shadow banking. The regulation includes provisions for enhanced transparency and reporting of securities financing transactions. The SFTR entered into force on January 12, 2016, subject to certain transitional provisions. SFTR requires adoption of certain “Level 2” measures which are being finalized by relevant authorities.
UK Criminal Finances Act. On September 30, 2017, the UK Criminal Finances Act (CFA) entered into force. The CFA has extra-territorial effect, introducing certain new corporate criminal offenses in circumstances where a corporate entity or partnership (a “relevant body”) fails to prevent an “associated person” (broadly meaning an employee, agent or
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person who performs services for or on behalf of the relevant body) from criminally facilitating the evasion of tax, whether the tax evaded is owed (i) in the United Kingdom or (ii) in a foreign country if the relevant body has a nexus, or any conduct constituting part of the foreign tax evasion facilitation offence takes place, in the United Kingdom. These corporate offenses are strict liability offenses, such that in circumstances where an associated person of a relevant body criminally facilitates the evasion of tax and such relevant body has failed to prevent the associated person from committing such criminal facilitation of tax evasion, the relevant body will itself be guilty of a criminal offense carrying unlimited fines, unless it can show that it put in place reasonable prevention procedures (or by showing that it was not reasonable in all the circumstances to expect the relevant body to have any prevention procedures in place).
Benchmarks Regulation. On January 1, 2018, the EU Benchmarks Regulation (BMR) became applicable in all EU member states, subject to certain transitional provisions. The principal objectives of the BMR are to restore investor confidence in the accuracy, robustness and integrity of indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds, and the benchmark-setting process itself. The BMR aims to achieve these objectives by ensuring that benchmarks are not subject to conflicts of interest, are used appropriately, and reflect the actual market or economic reality they are intended to measure.
Market in Financial Instruments Directive. On January 3, 2018, the recast Market in Financial Instruments Directive (MiFID II) became applicable to investment services and activities in the EU. MiFID II, together with the Markets in Financial Instruments Regulation (MiFIR I), repealed and recast the Markets in Financial Instruments Directive (2004/39/EC) (MiFID). Going forward, MiFID II and MiFIR I form the EU legal framework governing the requirements applicable to investment firms, trading venues, data reporting service providers and third-country firms providing investment services or activities in the EU.
Money Market Funds Regulation. On June 30, 2017, an EU regulation on money market funds (MMFR) with a view of making money market funds more resistant to crises and market turbulence was published. Subject to certain transitional provisions, the MMFR became applicable on July 21, 2018 for new money market funds and January 21, 2019 for existing money market funds. It will impose detailed rules relating to the investment policies, risk management and other operational aspects of such funds. Further “Level 2” regulations containing the technical implementation of the MMFR were published in 2018. Technical guidelines to clarify how to comply with certain reporting obligations under MMFR remain under development.
European Deposit Insurance Scheme. On October 11, 2017, the EU Commission announced that it aims to complete all parts of the European Banking Union by 2018. This will require, among other things, the creation of a single European Deposit Insurance Scheme (EDIS), applying to deposit guarantee schemes (DGSs) in EU member states participating in the single supervisory mechanism (SSM) and credit institutions in those member states. The EDIS will not directly affect member states that are not participating in the SSM, such as the United Kingdom, meaning that the Financial Services Compensation Scheme (FSCS), the UK DGS, will not be subject to the EDIS. The EU Council and Parliament continue to consider the legislative proposal for the EDIS regulation, which was published by the EU Commission in November 2015. The EU Commission proposed changes to its approach to the EDIS in its October 2017 communication on completing the banking union but to date has not published any revisions to the text of the EDIS regulation to reflect these changes.
Fifth EU Money Laundering Directive. On July 9, 2018, the Fifth EU Money Laundering Directive (MLD5) entered into force. MLD5 must be transposed into local law by EU member states by January 10, 2020 and introduces the following key changes to the current EU AML regime: (i) EU member states must ensure that registers of ultimate beneficial owners of companies and other legal entities become accessible to the general public; (ii) the current AML regime is extended to additional service providers, such as electronic wallet providers, virtual currency exchange service providers, and art dealers, and further specifications regarding the scope of application of MLD5 with respect to tax advisors and estate agents are provided; (iii) the threshold for identifying holders of prepaid cards is lowered to €150; and (iv) EU member states will be required to implement enhanced due diligence measures to monitor suspicious transactions involving high-risk countries more strictly.
In addition to the above, the Bank’s and the Corporation’s subsidiary banks located outside the United States are subject to regulatory capital requirements in the jurisdictions in which they operate. As of December 31, 2018, each of our non-U.S. banking subsidiaries had capital ratios above their specified minimum requirements.
Staff
Northern Trust employed approximately 18,800 full-time equivalent staff members as of December 31, 2018.
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Available Information
Through the Corporation’s website at www.northerntrust.com, the Corporation makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all other reports and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (Exchange Act), as soon as reasonably practicable after it files such material with, or furnishes such material to, the SEC. The contents of the Corporation’s website, the website of the SEC or any other website referenced herein are not a part of this Annual Report on Form 10-K.
Statistical Disclosure by Bank Holding Companies
The following statistical disclosures, included in the “Supplemental Item – Selected Statistical and Supplemental Financial Data” section of this Annual Report on Form 10-K, are incorporated herein by reference.
• | Average Consolidated Balance Sheets with Analysis of Net Interest Income for the years ended December 31, 2018, 2017 and 2016. |
• | Changes in Net Interest Income for the years ended December 31, 2018 and 2017. |
• | Remaining Maturity and Average Yield of Debt Securities Held to Maturity and Available for Sale as of December 31, 2018. |
• | Remaining Maturity of Selected Loans and Leases as of December 31, 2018. |
• | Distribution of Non-U.S. Loans by Type as of December 31, 2018, 2017, 2016, 2015 and 2014. |
• | Allowance for Credit Losses Relating to Non-U.S. Operations for the years ended December 31, 2018, 2017, 2016, 2015 and 2014. |
• | Analysis of Allowance for Credit Losses for the years ended December 31, 2018, 2017, 2016, 2015 and 2014. |
• | Average Deposits by Type as of December 31, 2018, 2017 and 2016. |
• | Distribution of Non-U.S. Deposits by Type as of December 31, 2018, 2017 and 2016. |
• | Remaining Maturity of Time Deposits $100,000 or More as of December 31, 2018. |
• | Average Rates Paid on Interest-Related Deposits by Type for the years ended December 31, 2018, 2017 and 2016. |
• | Selected Average Assets and Liabilities Attributable to Non-U.S. Operations for the years ended December 31, 2018, 2017, 2016, 2015 and 2014. |
• | Percent of Non-U.S.-Related Average Assets and Liabilities to Total Consolidated Average Assets for the years ended December 31, 2018, 2017, 2016, 2015 and 2014. |
• | Non-U.S. Outstandings as of December 31, 2018, 2017 and 2016. |
• | Purchased Funds as of December 31, 2018, 2017 and 2016. |
The following statistical disclosures, included under Items 6, 7 and 8 of this Annual Report on Form 10-K, are incorporated herein by reference.
• | Item 6, “Selected Financial Data,” includes the Corporation’s consolidated return on average common equity, return on average assets, dividend payout ratio and ratio of average equity to average assets. |
• | The “Securities Portfolio” table (Item 7) provides the book values of investments in obligations of the U.S. government, states and political subdivisions, and other held to maturity and available for sale debt securities as of December 31, 2018, 2017 and 2016. |
• | The “Composition of Loan Portfolio” table (Item 7) provides loans and leases by type as of December 31, 2018, 2017, 2016, 2015 and 2014. |
• | The “Nonperforming Assets” table (Item 7) provides information about the Corporation’s nonaccrual, past due and restructured loans receivable as of December 31, 2018, 2017, 2016, 2015 and 2014. |
• | The “Commercial Real Estate Loans” table (Item 7) provides details of loan concentrations as of December 31, 2018 and 2017. |
• | The “Allocation of the Allowance for Credit Losses” table (Item 7) provides a breakdown of the allowance for credit losses by loan class and illustrates the proportion of each loan class to total loans. |
• | The “Allowance and Provision for Credit Losses” section (Item 7) provides a discussion of the factors which influenced management’s judgment in determining the provision for credit losses. |
• | Note 6, “Loans and Leases,” (Item 8) provides the Corporation’s forgone interest income on nonaccrual loans, as well as a description of the nature of non-U.S. loans as of December 31, 2018 and 2017. |
• | Note 1, “Summary of Significant Accounting Policies,” (Item 8) provides a discussion of Northern Trust’s policy for placing loans on non-accrual status. |
• | Further discussion of Northern Trust’s management of credit risk with respect to the provision and allowance for credit losses is provided in the following information that is incorporated herein by reference to the notes to the consolidated financial statements provided in Item 8, “Financial Statements and Supplementary Data.” |
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•Note 1, “Summary of Significant Accounting Policies”:
•H. Loans and Leases.
•I. Allowance for Credit Losses.
•L. Other Real Estate Owned (OREO).
•Note 6, “Loans and Leases.”
•Note 7, “Allowance for Credit Losses.”
•Note 8, “Concentrations of Credit Risk.”
•Note 28, “Off-Balance-Sheet Financial Instruments.”
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ITEM 1A - RISK FACTORS
In the normal course of our business activities, we are exposed to a variety of risks. The following discussion sets forth the risk factors that we have identified as being most significant to Northern Trust. Although we discuss these risk factors primarily in the context of their potential effects on our business, financial condition or results of operations, you should understand that these effects can have further negative implications such as: reducing the price of our common stock and other securities; reducing our capital, which can have regulatory and other consequences; affecting the confidence that clients and counterparties have in us, with a resulting negative effect on our ability to conduct and grow our businesses; and reducing the attractiveness of our securities to rating agencies and potential purchasers, which may affect adversely our ability to raise capital and secure other funding or the cost at which we are able to do so. Further, additional risks beyond those discussed below, elsewhere in this Annual Report on Form 10-K or in other of our reports filed with, or furnished to, the SEC also could affect us adversely. We cannot assure you that the risk factors herein or elsewhere in our other reports address all potential risks that we may face.
These risk factors also serve to describe factors which may cause our results to differ materially from those described in forward-looking statements included herein or in other documents or statements that make reference to this Annual Report on Form 10-K. Forward-looking statements and other factors that may affect future results are discussed under “Forward-Looking Statements” included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of this Annual Report on Form 10-K.
Market Risks
We are dependent on fee-based business for a majority of our revenues, which may be affected adversely by market volatility, a downturn in economic conditions, underperformance and/or negative trends in investment preferences.
Our principal operational focus is on fee-based business, which is distinct from commercial banking institutions that earn most of their revenues from loans and other traditional interest-generating products and services. Fees for many of our products and services are based on the market value of assets under management, custody or administration; the volume of transactions processed; securities lending volume and spreads; and fees for other services rendered, all of which may be impacted negatively by market volatility, a downturn in economic conditions, underperformance and/or negative trends in investment preferences. For example, downturns in equity markets and decreases in the value of debt-related investments resulting from market disruption, illiquidity or other factors historically have reduced the valuations of the assets we manage or service for others, which generally impacted our earnings negatively. Market volatility and/or weak economic conditions also may affect wealth creation, investment preferences, trading activities, and savings patterns, which impact demand for certain products and services that we provide.
Our earnings also may be affected by poor investment returns or changes in investment preferences driven by factors beyond market volatility or weak economic conditions. For example, poor investment performance in funds or client accounts that we manage or in investment products that we design or provide that is due to underperformance relative to our competitors or benchmarks could result in declines in the market values of portfolios that we manage and/or administer and may affect our ability to retain existing assets and to attract new clients or additional assets from existing clients. Further, broader changes in investment preferences that lead to less investment in mutual funds or other collective funds, such as the recent shift in investor preference to lower fee products, could impact our earnings negatively.
Changes in interest rates can affect our earnings negatively.
The direction and level of interest rates are important factors in our earnings. Although the Federal Reserve Board has raised the target Federal Funds rate range in recent years, interest rates generally remain low relative to historical levels. Low interest rate environments have had in the past, and may have in the future, a negative impact on our net interest margin, which is the difference between what we earn on our assets and the interest rates we pay for deposits and other sources of funding. Low interest rate environments also have historically had a negative impact on our fees earned on certain of our products. For example, in the past, we have from time to time waived certain fees associated with money market mutual funds due to short-term interest rate levels. While we did not implement any such fee waivers in 2018, we may do so in the future if short-term interest rate levels decline. Low net interest margins and fee waivers each negatively impact our earnings.
Conversely, a continued rise in interest rates also may affect us negatively. For example, we may be impacted negatively if such an increase were to cause: market volatility and downturns in equity markets, resulting in a decrease in the valuations of the assets we manage or service for others, which generally impact our earnings negatively; our clients to transfer funds into investments with higher rates of return, resulting in decreased deposit levels and higher fund or account redemptions; our borrowers to experience difficulties in making higher interest payments, resulting in increased credit costs, provisions for loan and lease losses and charge-offs; reduced bond and fixed income fund liquidity, resulting in lower
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performance, yield and fees; a decline in the value of securities held in our portfolio of investment securities, resulting in decreased levels of capital and liquidity; or higher funding costs.
Further, although we have policies and procedures in place to assess and mitigate potential impacts of interest rate risks, if our assumptions about any number of variables are incorrect, these policies and procedures to mitigate risk may be ineffective, which could impact earnings negatively.
Please see “Market Risk” in the “Risk Management” section included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of this Annual Report on Form 10-K for a more detailed discussion of interest rate and market risks we face.
Changes in the monetary and other policies of the various regulatory authorities or central banks of the United States, non-U.S. governments and international agencies may reduce our earnings and affect our growth prospects negatively.
The monetary and other policies of U.S. and international governments, agencies and regulatory bodies have a significant impact on interest rates and overall financial market performance. For example, the Federal Reserve Board regulates the supply of money and credit in the United States, and its policies determine in large part the level of interest rates and our cost of funds for lending and investing, which are important factors in our earnings. The actions of the Federal Reserve Board or other regulatory authorities also may reduce the value of financial instruments we hold. Further, their policies can affect our borrowers by increasing interest rates or making sources of funding less available, which may increase the risk that borrowers fail to repay their loans from us. Changes in monetary and other governmental policies are beyond our control and can be difficult to predict, and we cannot determine the ultimate effect that any such changes would have upon our business, financial condition or results of operations.
The ultimate impact on us of the United Kingdom’s referendum regarding whether to remain part of the European
Union remains uncertain.
In June 2016, United Kingdom (UK) voters approved a departure from the European Union (EU), commonly referred to as “Brexit.” In March 2017, the UK delivered a formal notice of withdrawal to the EU. The terms of the withdrawal are subject to a negotiation period expected to last at least two years from the withdrawal notification date and such negotiation period likely will be followed by additional negotiations between the EU and the UK concerning future relations between the parties. On December 8, 2018, the UK and EU jointly published the terms of a withdrawal agreement, which to date has failed to generate the support of the UK Parliament, and a non-binding statement on future relations. The ultimate impact of Brexit on the Corporation and the Bank remains uncertain and will depend on the final terms of withdrawal and the post-Brexit relationships between the UK and other EU nations. Further, such impact may be more pronounced if the withdrawal were to occur without a transition agreement in place between the UK and the EU. Brexit has contributed, and may continue to contribute, to market volatility, particularly the valuation of the Euro and British pound, and could have significant adverse effects on our businesses, financial condition and results of operations. Additionally, certain of our EU operations are conducted through subsidiaries located in the UK, leveraging the EU financial services “passport,” which permits activities throughout the single EU market without needing to obtain local authorizations. In conjunction with our Brexit-related preparations, and to mitigate the potential risk that our UK subsidiaries will be unable to retain their EU financial services “passports,” we have taken steps to implement certain changes to our organizational structure, including the establishment of an EU-domiciled credit institution in Luxembourg. We have incurred, and may in the future continue to incur, additional costs associated with such measures and unforeseen political, regulatory, or other developments related to Brexit, or operational issues associated with the organizational restructuring related thereto, also may result in additional costs and disruption to our EU banking business.
Uncertainty about the financial stability of various regions or countries across the globe, including the risk of defaults on sovereign debt and related stresses on financial markets, could have a significant adverse effect on our earnings.
Risks and concerns about the financial stability of various regions or countries across the globe could have a detrimental impact on economic and market conditions in these or other markets across the world. Foreign market and economic disruptions have affected, and may continue to affect, consumer confidence levels and spending, personal bankruptcy rates, levels of incurrence of and default on consumer debt, and home prices. Economic challenges faced in various foreign markets, including negative interest rates in some jurisdictions, and any disruptions related to such challenges, may impact our earnings negatively.
Declines in the value of securities held in our investment portfolio can affect us negatively.
Our investment securities portfolio represents a greater proportion, and our loan and lease portfolios represent a smaller proportion, of our total consolidated assets in comparison to many other financial institutions. The value of securities available for sale and held to maturity within our investment portfolio, which is generally determined based upon market
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values available from third-party sources, may fluctuate as a result of market volatility and economic or financial market conditions. For example, the global financial crisis of 2007-08 and resultant period of economic turmoil and financial market disruption affected negatively the liquidity and pricing of securities, generally, and asset-backed and auction rate securities, in particular. Declines in the value of securities held in our investment portfolio negatively impact our levels of capital and liquidity. Further, to the extent that we experience unrealized losses in our portfolio of investment securities from declines in securities values that management determines to be other than temporary, the book value of those securities will be adjusted to their estimated recovery value and we will recognize a charge to earnings in the quarter during which we make that determination. Although we have policies and procedures in place to assess and mitigate potential impacts of market risks, including hedging-related strategies, those policies and procedures are inherently limited because they cannot anticipate the existence or future development of currently unanticipated or unknown risks. Accordingly, we could suffer adverse effects as a result of our failure to anticipate and manage these risks properly.
Volatility levels and fluctuations in foreign currency exchange rates may affect our earnings.
We provide foreign exchange services to our clients, primarily in connection with our global custody business. Foreign currency volatility influences our foreign exchange trading income as does the level of client activity. Foreign currency volatility and changes in client activity may result in reduced foreign exchange trading income. Fluctuations in exchange rates may raise the potential for losses resulting from foreign currency trading positions, where aggregate obligations to purchase and sell a currency other than the U.S. dollar do not offset each other or offset each other in different time periods. We also are exposed to non-trading foreign currency risk as a result of our holdings of non-U.S. dollar denominated assets and liabilities, investments in non-U.S. subsidiaries, and future non-U.S. dollar denominated revenue and expense.
We have policies and procedures in place to assess and mitigate potential impacts of foreign exchange risks, including hedging-related strategies. Any failure or circumvention of our procedures to mitigate risk may impact earnings negatively. Please see “Market Risk” in the “Risk Management” section included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of this Annual Report on Form 10-K for a more detailed discussion of market risks we face.
Changes in a number of particular market conditions can affect our earnings negatively.
In past periods, reductions in the volatility of currency-trading markets, the level of cross-border investing activity, and the demand for borrowing securities or willingness to lend such securities have affected our earnings from activities such as foreign exchange trading and securities lending negatively. If these conditions occur in the future, our earnings from these activities may be affected negatively. In a few of our businesses, such as securities lending, our fee is calculated as a percentage of our client’s earnings, such that market and other factors that reduce our clients’ earnings from investments or trading activities also reduce our revenues. For example, the global financial crisis of 2007-08 and resultant period of economic turmoil and financial market disruption produced losses in some securities lending programs, reduced borrower demand and led some clients to withdraw from these programs. A return of these conditions in the future could result in additional withdrawals and decreased activity, which could impact our earnings negatively.
Operational Risks
Many types of operational risks can affect our earnings negatively.
We regularly assess and monitor operational risk in our businesses. Despite our efforts to assess and monitor operational risk, our risk management program may not be effective in all cases. Factors that can impact operations and expose us to risks varying in size, scale and scope include:
• | failures of technological systems or breaches of security measures, including, but not limited to, those resulting from cyber-attacks; |
• | human errors or omissions, including failures to comply with applicable laws or corporate policies and procedures; |
• | theft, fraud or misappropriation of assets, whether arising from the intentional actions of internal personnel or external third parties; |
• | defects or interruptions in computer or communications systems; |
• | breakdowns in processes, over-reliance on manual processes, which are inherently more prone to error than automated processes, breakdowns in internal controls or failures of the systems and facilities that support our operations; |
• | unsuccessful or difficult implementation of computer systems upgrades; |
• | defects in product design or delivery; |
• | difficulty in accurately pricing assets, which can be aggravated by market volatility and illiquidity and lack of reliable pricing from third-party vendors; |
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• | negative developments in relationships with key counterparties, third-party vendors, employees or associates in our day-to-day operations; and |
• | external events that are wholly or partially beyond our control, such as natural disasters, pandemics, computer viruses, geopolitical events, political unrest or acts of terrorism. |
While we have in place many controls and business continuity plans designed to address many of these factors, these plans may not operate successfully to mitigate these risks effectively. We also may fail to identify or fully understand the implications and risks associated with changes in the financial markets or our businesses—particularly as we expand our geographic footprint, product pipeline and client types—and consequently fail to enhance our controls and business continuity plans to address those changes in an adequate or timely fashion. If our controls and business continuity plans do not address the factors noted above and operate to mitigate the associated risks successfully, such factors may have a negative impact on our business, financial condition or results of operations. In addition, an important aspect of managing our operational risk is creating a risk culture in which all employees fully understand that there is risk in every aspect of our business and the importance of managing risk as it relates to their job functions. We continue to enhance our risk management program to support our risk culture, ensuring that it is sustainable and appropriate for our role as a major financial institution. Nonetheless, if we fail to provide the appropriate environment that sensitizes all of our employees to managing risk, our business could be impacted adversely.
Failures of our technological systems or breaches of our security measures, including, but not limited to, those resulting from cyber-attacks, may result in losses.
Any failure, interruption or breach in the security of our systems could severely disrupt our operations. Our systems involve the use of clients’ and our proprietary and confidential information, and security breaches, including cyber-attacks, could expose us to a risk of theft, loss or other misappropriation of this information. Our security measures may be breached due to the actions of outside parties, employee error, failure of our controls with respect to granting access to our systems, malfeasance or otherwise, and, as a result, an unauthorized party may obtain access to our or our clients’ proprietary and confidential information, resulting in theft, loss or other misappropriation of this information. Regulators globally are also introducing the potential for greater monetary fines on institutions that suffer from breaches leading to the theft, loss or other misappropriation of such information. For example, the General Data Protection Regulation (GDPR), which was adopted by the EU in 2016 and became effective in May 2018, establishes new requirements regarding the handling of personal information. Noncompliance with the GDPR may result in monetary penalties of up to 4% of worldwide revenue. The GDPR and other changes in laws or regulations associated with the enhanced protection of personal and other types of information could greatly increase the size of potential fines related to the protection of such information.
Information security risks for large financial institutions like us are significant in part because of the proliferation of new technologies to conduct financial transactions and the increased sophistication and activities of hackers, terrorists, organized crime and other external parties, including foreign state actors. If we fail to continue to upgrade our technology infrastructure to ensure effective cyber-security relative to the type, size and complexity of our operations, we could become more vulnerable to cyber-attack and, consequently, subject to significant regulatory penalties. Additionally, our computer, communications, data processing, networks, backup, business continuity or other operating, information or technology systems, including those that we outsource to other providers, may fail to operate properly or become disabled, overloaded or damaged as a result of a number of factors, including events that are wholly or partially beyond our control, which could have a negative effect on our ability to conduct our business activities.
The third parties with which we do business also are susceptible to the foregoing risks (including regarding the third parties with which they are similarly interconnected or on which they otherwise rely), and our or their business operations and activities may therefore be affected adversely, perhaps materially, by failures, terminations, errors or malfeasance by, or attacks or constraints on, one or more financial, technology, infrastructure or government institutions or intermediaries with whom we or they are interconnected or conduct business. In addition, our clients often use their own devices, such as computers, smart phones and tablets, to manage their accounts, which may heighten the risk of system failures, interruptions or security breaches.
In recent years, several financial services firms suffered successful cyber-attacks launched both domestically and from abroad, resulting in the disruption of services to clients, loss or misappropriation of sensitive or private information, and reputational harm. Although we have not to our knowledge suffered a material breach of our systems, we and our clients have been subject to cyber-attacks, and it is possible that we could suffer a material breach in the future. Because the techniques used to obtain unauthorized access, disable or degrade service or sabotage systems change frequently and often are not recognized until launched against a target, we may be unable to anticipate these techniques, to implement adequate preventative measures, or to address them until they are discovered. We expect to continue to face increasing cyber-threats,
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including computer viruses, ransomware and other malicious code, distributed denial of service attacks, phishing attacks, information security breaches or employee or contractor error or malfeasance that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our, our clients’ or other parties’ confidential, personal, proprietary or other information or otherwise disrupt, compromise or damage our or our clients’ or other parties’ business assets, operations and activities. Our status as a global financial institution and the nature of our client base may enhance the risk that we are targeted by such cyber-threats. If a breach of our security occurs, we could be the subject of legal claims or proceedings, including regulatory investigations and actions, the market perception of the effectiveness of our security measures could be harmed, our reputation could suffer and we could lose clients, each of which could have a negative effect on our business, financial condition and results of operations. A breach of our security also may affect adversely our ability to effect transactions, service our clients, manage our exposure to risk or expand our business. An event that results in the loss of information also may require us to reconstruct lost data or reimburse clients for data and credit monitoring services, which could be costly and have a negative impact on our business and reputation.
Further, even if not directed at us, attacks on financial or other institutions important to the overall functioning of the financial system or on our counterparties could affect, directly or indirectly, aspects of our business.
Errors, breakdowns in controls or other mistakes in the provision of services to clients or in carrying out transactions for our own account can subject us to liability, result in losses or have a negative effect on our earnings in other ways.
In our asset servicing, investment management, fiduciary administration and other business activities, we effect or process transactions for clients and for ourselves that involve very large amounts of money. Failure to manage or mitigate operational risks properly can have adverse consequences, and increased volatility in the financial markets may increase the magnitude of resulting losses. Given the high volume of transactions we process, errors that affect earnings may be repeated or compounded before they are discovered and corrected.
Our dependence on technology, and the need to update frequently our technology infrastructure, exposes us to risks that also can result in losses.
Our businesses depend on information technology infrastructure, both internal and external, to record and process, among other things, a large volume of increasingly complex transactions and other data, in many currencies, on a daily basis, across numerous and diverse markets and jurisdictions. Due to our dependence on technology and the important role it plays in our business operations, we must constantly improve and update our information technology infrastructure. Upgrading, replacing, and modernizing these systems can require significant resources and often involves implementation, integration and security risks that could cause financial, reputational and operational harm. Failure to ensure adequate review and consideration of critical business and regulatory issues prior to and during the introduction and deployment of key technological systems or failure to align operational capabilities adequately with evolving client commitments and expectations may have a negative impact on our results of operations. The failure to respond properly to and invest in changes and advancements in technology could limit our ability to attract and retain clients, prevent us from offering products and services comparable to those offered by our competitors, inhibit our ability to meet regulatory requirements or otherwise have a material adverse effect on our operations.
The systems and models we employ to analyze, monitor and mitigate risks, as well as for other business purposes, are
inherently limited, may be not be effective in all cases and, in any case, cannot eliminate all risks that we face.
We use various systems and models in analyzing and monitoring several risk categories, as well as for other business purposes. However, these systems and models are inherently limited because they involve techniques and judgments that cannot anticipate every economic and financial outcome in the markets in which we operate, nor can they anticipate the specifics and timing of such outcomes. Further, these systems and models may fail to quantify accurately the magnitude of the risks we face. Our measurement methodologies rely on many assumptions and historical analyses and correlations. These assumptions may be incorrect, and the historical correlations on which we rely may not continue to be relevant. Consequently, the measurements that we make may not adequately capture or express the true risk profiles of our businesses or provide accurate data for other business purposes, each of which ultimately could have a negative impact on our business, financial condition and results of operations. Errors in the underlying model or model assumptions, or inadequate model assumptions, could result in unanticipated and adverse consequences, including material loss or noncompliance with regulatory requirements or expectations.
A failure or circumvention of our controls and procedures could have a material adverse effect on our business, financial condition and results of operations.
We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain
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assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system will be met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, financial condition and results of operations. If we identify material weaknesses in our internal control over financial reporting or are otherwise required to restate our financial statements, we could be required to implement expensive and time-consuming remedial measures and could lose investor confidence in the accuracy and completeness of our financial reports. In addition, there are risks that individuals, either employees or contractors, consciously circumvent established control mechanisms by, for example, exceeding trading or investment management limitations, or committing fraud.
Failure of any of our third-party vendors to perform can result in losses.
Third-party vendors provide key components of our business operations such as data processing, recording and monitoring transactions, online banking interfaces and services, and network access. Our use of third-party vendors exposes us to the risk that such vendors may not comply with their servicing and other contractual obligations to us, including with respect to indemnification and information security, and to the risk that we may not satisfy applicable regulatory responsibilities regarding the management and oversight of third parties and outsourcing providers. While we have established risk management processes and continuity plans, any disruptions in service from a key vendor for any reason or poor performance of services could have a negative effect on our ability to deliver products and services to our clients and conduct our business. Replacing these third-party vendors or performing the tasks they perform for ourselves could create significant delay and expense.
We are subject to certain risks inherent in operating globally which may affect our business adversely.
In conducting our U.S. and non-U.S. business, we are subject to risks of loss from various unfavorable political, economic, legal or other developments, including social or political instability, changes in governmental policies or policies of central banks, expropriation, nationalization, confiscation of assets, price controls, capital controls, exchange controls, unfavorable tax rates and tax court rulings and changes in laws and regulations. Less mature and often less regulated business and investment environments heighten these risks in various emerging markets, in which we have been expanding our business activities. Our non-U.S. operations accounted for 34% of our revenue in 2018. Our non-U.S. businesses are subject to extensive regulation by various non-U.S. regulators, including governments, securities exchanges, central banks and other regulatory bodies in the jurisdictions in which those businesses operate. In many countries, the laws and regulations applicable to the financial services industry are uncertain and evolving and may be applied with extra scrutiny to foreign companies. Moreover, the regulatory and supervisory standards and expectations in one jurisdiction may not conform with standards or expectations in other jurisdictions. Even within a particular jurisdiction, the standards and expectations of multiple supervisory agencies exercising authority over our affairs may not be harmonized fully. Accordingly, it may be difficult for us to determine the exact requirements of local laws in every market or manage our relationships with multiple regulators in various jurisdictions. Our inability to remain in compliance with local laws in a particular market and manage our relationships with regulators could have an adverse effect not only on our businesses in that market but also on our reputation generally. The failure to mitigate properly such risks or the failure of our operating infrastructure to support such international activities could result in operational failures and regulatory fines or sanctions, which could affect our business and results of operations adversely.
We actively strive to optimize our geographic footprint. This optimization may occur by establishing operations in lower-cost locations or by outsourcing to third-party vendors in various jurisdictions. These efforts expose us to the risk that we may not maintain service quality, control or effective management within these operations. In addition, we are exposed to the relevant macroeconomic, political and similar risks generally involved in doing business in those jurisdictions. The increased elements of risk that arise from conducting certain operating processes in some jurisdictions could lead to an increase in reputational risk. During periods of transition, greater operational risk and client concern exist with respect to maintaining a high level of service delivery.
In addition, we are subject in our global operations to rules and regulations relating to corrupt and illegal payments and money laundering, laws relating to doing business with certain individuals, groups and countries, such as the U.S. Foreign Corrupt Practices Act, the USA PATRIOT Act, and the UK Bribery Act, and economic sanctions and embargo programs administered by the U.S. Office of Foreign Assets Control and similar agencies worldwide. While we have invested and continue to invest significant resources in training and in compliance monitoring, the geographic diversity of our operations, employees, clients and customers, as well as the vendors and other third parties with whom we deal, presents the risk that we may be found in violation of such rules, regulations, laws or programs and any such violation could subject us to significant penalties or affect our reputation adversely.
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Failure to control our costs and expenses adequately could affect our earnings negatively.
Our success in controlling the costs and expenses of our business operations also impacts operating results. Through various parts of our business strategy, we aim to produce efficiencies in operations that help reduce and control costs and expenses, including the costs of losses associated with operating risks attributable to servicing and managing financial assets. Failure to control these and other costs could affect our earnings negatively and reduce our competitive position. In October 2017, we announced our “Value for Spend” expense management initiative, through which we intend to realize $250 million in expense run-rate savings by 2020 through improved organizational alignment, process optimization and strategic sourcing. Although we have made progress toward achieving this level of expense run-rate savings, we cannot provide assurance that the overall “Value for Spend” initiative will be successful, nor can we predict its overall effect on our financial condition or results of operations.
Acts of terrorism, natural disasters, pandemics and global conflicts may have a negative impact on our business and operations.
Acts of terrorism, natural disasters, pandemics, global conflicts or other similar catastrophic events could have a negative impact on our business and operations. While we have in place business continuity plans, such events could still damage our facilities, disrupt or delay the normal operations of our business (including communications and technology), result in harm to or cause travel limitations on our employees, and have a similar impact on our clients, suppliers, third-party vendors and counterparties. These events also could impact the purchase of our products and services negatively to the extent that those acts or conflicts result in reduced capital markets activity, lower asset price levels, or disruptions in general economic activity in the United States or abroad, or in financial market settlement functions. In addition, war, terror attacks, political unrest, global conflicts, national and global efforts to combat terrorism and other potential military activities and outbreaks of hostilities may impact economic growth negatively, which could have an adverse effect on our business and operations, and may have other adverse effects on us in ways that we are unable to predict.
Credit Risks
Failure to evaluate accurately the prospects for repayment when we extend credit or maintain an adequate allowance for credit losses can result in losses or the need to make additional provisions for credit losses, both of which reduce our earnings.
We evaluate extensions of credit before we make them and then provide for credit risks based on our assessment of the credit losses inherent in our loan portfolio, including undrawn credit commitments. This process requires us to make difficult and complex judgments. Challenges associated with our credit risk assessments include identifying the proper factors to be used in assessments and accurately estimating the impacts of those factors. Allowances that prove to be inadequate may require us to realize increased provisions for credit losses or write down the value of certain assets on our balance sheet, which in turn would affect earnings negatively.
Market volatility and/or weak economic conditions can result in losses or the need for additional provisions for credit losses, both of which reduce our earnings.
Credit risk levels and our earnings also can be affected by market volatility and/or weakness in the economy in general and in the particular locales in which we extend credit, a deterioration in credit quality or a reduced demand for credit. Adverse changes in the financial performance or condition of our borrowers resulting from market volatility and/or weakened economic conditions could impact the borrowers’ abilities to repay outstanding loans, which could in turn impact our financial condition and results of operations negatively.
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The failure or perceived weakness of any of our significant counterparties could expose us to loss.
The financial markets are characterized by extensive interconnections among financial institutions, including banks, broker/dealers, collective investment funds and insurance companies. As a result of these interconnections, we and many of our clients have counterparty exposure to other financial institutions. This counterparty exposure presents risks to us and to our clients because the failure or perceived weakness of any of our counterparties has the potential to expose us to risk of loss. Instability in the financial markets has resulted historically in some financial institutions becoming less creditworthy. During such periods of instability, we are exposed to increased counterparty risks, both as principal and in our capacity as agent for our clients. Changes in market perception of the financial strength of particular financial institutions can occur rapidly, are often based upon a variety of factors and can be difficult to predict. In addition, the criteria for and manner of governmental support of financial institutions and other economically important sectors remain uncertain. Further, the consolidation of financial service firms and the failures of other financial institutions has in the past, and may in the future increase the concentration of our counterparty risk. These risks are heightened by the fact that our operating model relies on the use of unaffiliated sub-custodians to a greater degree than certain of our competitors that have banking operations in more jurisdictions than we do. We are not able to mitigate all of our and our clients’ counterparty credit risk. If a significant individual counterparty defaults on an obligation to us, we could incur financial losses that have a material and adverse effect on our business, financial condition and results of operations.
Changes in the method pursuant to which the London Interbank Offered Rate (LIBOR) or other interest rate benchmarks are determined could adversely impact our business and results of operations.
Many financial markets currently rely on interbank offered rates (each, an IBOR) as mutually agreed upon reference rates serving as the basis for the pricing and valuation of assets, trading positions, loans and other financial transactions. Following historical concerns about attempted manipulation of IBOR levels, as well as a potential lack of liquidity in the underlying activity that contributes to an IBOR setting, global regulators have signaled interest in replacing existing IBOR rates with alternative reference rates. While there are multiple IBORs, LIBOR is the most widely used interest rate benchmark in the world and serves as the reference rate for our floating-rate funding, certain of the products that we own or offer, various lending and securities transactions in which we are involved, and many derivatives that we use to manage our or our clients’ risk. LIBOR has been the subject of recent national and international regulatory guidance and proposals for reform. The United Kingdom Financial Conduct Authority, which regulates the process for establishing LIBOR, announced in July 2017 that it intends to stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. Such announcement indicates that the continuation of LIBOR on the current basis cannot be guaranteed after 2021. At this time, it is not possible to predict the effect that these developments, any discontinuance, modification or other reforms to LIBOR or any other interest rate benchmarks, or the establishment of alternative reference rates may have on LIBOR or other interest rate benchmarks. Any change in the availability or calculation of LIBOR or other interest rate benchmarks may affect adversely the cost or availability of floating-rate funding; the yield on loans or securities held by us; the amounts received and paid on derivative instruments we have entered into; the value of loans, securities, or derivative instruments held by us or our clients, which, in the case of assets held by our clients, could also negatively impact the amount of fees we earn in relation to such assets; the trading market for securities based on LIBOR or other benchmarks; the terms of new loans being made using different or modified reference rates; or our ability to use derivative instruments to manage risk effectively. Further, the potential transition away from the use of LIBOR or other interest rate benchmarks, or uncertainty related to any such potential transition, may cause us to recognize additional costs or experience operational disruptions, which may negatively impact our business, financial condition or results of operations.
Liquidity Risks
If we do not manage our liquidity effectively, our business could suffer.
Liquidity is essential for the operation of our business. Market conditions, unforeseen outflows of funds or other events could have a negative effect on our level or cost of funding, affecting our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund new business transactions at a reasonable cost and in a timely manner. If our access to stable and low-cost sources of funding, such as customer deposits, are reduced, we may need to use alternative funding, which could be more expensive or of limited availability. Further evolution in the regulatory requirements relating to liquidity and risk management also may impact us negatively. Additional regulations may impose more stringent liquidity requirements for large financial institutions, including the Corporation and the Bank. Given the overlap and complex interactions of these regulations with other regulatory changes, the full impact of the adopted and proposed regulations remains uncertain until their full implementation. For more information on these regulations and other regulatory changes, see “Supervision and Regulation-Liquidity Standards” in Item 1, “Business,” of
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this Annual Report on Form 10-K. Any substantial, unexpected or prolonged changes in the level or cost of liquidity could affect our business adversely.
If the Bank is unable to supply the Corporation with funds over time, the Corporation could be unable to meet its various obligations.
The Corporation is a legal entity separate and distinct from the Bank and the Corporation’s other subsidiaries. The Corporation relies on dividends paid to it by the Bank to meet its obligations and to pay dividends to stockholders of the Corporation. There are various legal limitations on the extent to which the Bank and the Corporation’s other subsidiaries can supply funds to the Corporation by dividend or otherwise. Dividend payments by the Bank to the Corporation in the future will require continued generation of earnings by the Bank and could require regulatory approval under certain circumstances. For more information on dividend restrictions, see “Supervision and Regulation-Payment of Dividends” in Item 1, “Business,” of this Annual Report on Form 10-K.
We may need to raise additional capital in the future, which may not be available to us or may only be available on unfavorable terms.
We may need to raise additional capital to provide sufficient resources to meet our business needs and commitments, to accommodate the transaction and cash management needs of our clients, to maintain our credit ratings in response to regulatory changes, including capital rules, or for other purposes. However, our ability to access the capital markets, if needed, will depend on a number of factors, including the state of the financial markets. Rising interest rates, disruptions in financial markets, negative perceptions of our business or our financial strength, or other factors may impact our ability to raise additional capital, if needed, on terms acceptable to us. Any diminished ability to raise additional capital, if needed, could subject us to liability, restrict our ability to grow, require us to take actions that would affect our earnings negatively or otherwise affect our business and our ability to implement our business plan, capital plan and strategic goals adversely.
Any downgrades in our credit ratings, or an actual or perceived reduction in our financial strength, could affect our borrowing costs, capital costs and liquidity adversely.
Rating agencies publish credit ratings and outlooks on our creditworthiness and that of our obligations or securities, including long-term debt, short-term borrowings, preferred stock and other securities. Our credit ratings are subject to ongoing review by the rating agencies and thus may change from time to time based on a number of factors, including our own financial strength, performance, prospects and operations as well as factors not under our control, such as rating-agency-specific criteria or frameworks for our industry or certain security types, which are subject to revision from time to time, and conditions affecting the financial services industry generally.
Downgrades in our credit ratings may affect our borrowing costs, our capital costs and our ability to raise capital and, in turn, our liquidity adversely. A failure to maintain an acceptable credit rating also may preclude us from being competitive in certain products. Additionally, our counterparties, as well as our clients, rely on our financial strength and stability and evaluate the risks of doing business with us. If we experience diminished financial strength or stability, actual or perceived, a decline in our stock price or a reduced credit rating, our counterparties may be less willing to enter into transactions, secured or unsecured, with us, our clients may reduce or place limits on the level of services we provide them or seek other service providers, or our prospective clients may select other service providers, all of which may have other adverse effects on our business.
The risk that we may be perceived as less creditworthy relative to other market participants is higher in a market environment in which the consolidation, and in some instances failure, of financial institutions, including major global financial institutions, could result in a smaller number of larger counterparties and competitors. If our counterparties perceive us to be a less viable counterparty, our ability to enter into financial transactions on terms acceptable to us or our clients, on our or our clients’ behalf, will be compromised materially. If our clients reduce their deposits with us or select other service providers for all or a portion of the services we provide to them, our revenues will decrease accordingly.
Our success with large, complex clients requires substantial liquidity.
A significant portion of our business involves providing certain services to large, complex clients, which, by their nature, require substantial liquidity. Our failure to manage successfully the liquidity and balance sheet issues attendant to this portion of our business may have a negative impact on our ability to meet client needs and grow.
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Regulatory and Legal Risks
Failure to comply with regulations can result in penalties and regulatory constraints that restrict our ability to grow or even conduct our business, or that reduce earnings.
Virtually every aspect of our business around the world is regulated, generally by governmental agencies that have broad supervisory powers and the ability to impose sanctions. In the United States, the Corporation, the Bank and many of the Corporation’s other subsidiaries are regulated heavily by bank regulatory agencies at the federal and state levels. These regulations cover a variety of matters ranging from required capital levels to prohibited activities. They are directed specifically at protecting depositors, the federal deposit insurance fund and the banking system as a whole, not our stockholders or other security holders. The Corporation and its subsidiaries also are regulated heavily by bank, securities and other regulators globally and subject to evolving laws and regulations regarding privacy and data protection, including the GDPR. Regulatory violations or the failure to meet formal or informal commitments made to regulators could generate penalties, require corrective actions that increase costs of conducting business, result in limitations on our ability to conduct business, restrict our ability to expand or impact our reputation adversely. Failure to obtain necessary approvals from regulatory agencies on a timely basis could affect proposed business opportunities and results of operations adversely. Similarly, changes in laws or failure to comply with new requirements or with future changes in laws or regulations may impact our results of operations and financial condition negatively.
The ongoing implementation of the Dodd-Frank Act, as amended by the Economic Growth, Regulatory Relief, and Consumer Protection Act, may have a material effect on our operations.
The Dodd-Frank Act became law in July 2010 and has had a significant impact on the regulatory and compliance structure in which we operate. In February 2017, an executive order was issued by the President (i) establishing core principles for regulating the U.S. financial system and (ii) instructing the U.S. Secretary of the Treasury to consult with heads of the member agencies of the U.S. Financial Stability Oversight Council and to issue reports that identify laws, regulations, and policies, including those implemented under the Dodd-Frank Act, that inhibit federal regulation of the U.S. financial system in a manner consistent with the core principles. The required reports were issued in 2017 and 2018, and further action may be taken in the future regarding the reports’ recommendations. In May 2018, Congress passed, and the President signed into law, the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), containing significant amendments to the Dodd-Frank Act and requiring the Federal Reserve Board and other regulatory agencies to adopt various implementing regulations. While some of the implementing regulations have been finalized, others remain subject to further regulatory action, and there remains uncertainty surrounding the manner in which certain of the existing provisions will be implemented by the various regulatory agencies. These legislative and regulatory changes may also require us to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements, and any further changes to or resulting from the Dodd-Frank Act and the EGRRCPA may impact the profitability of our business activities, require changes to certain of our business practices, or otherwise affect our business adversely.
Failure to address shortcomings identified by regulators in our 2015 resolution plan could result in restrictions or directives that restrict our ability to grow or even conduct our business.
Section 165(d) of the Dodd-Frank Act and implementing regulations jointly issued by the Federal Reserve Board and the FDIC require bank holding companies with at least $50 billion in assets, which includes the Corporation, to submit annually a resolution plan to the Federal Reserve Board and the FDIC detailing the bank holding company’s plan for rapid and orderly resolution in the event of material financial distress or failure. If the regulators jointly determine that our resolution plan is not “credible” or would not facilitate an orderly resolution under the U.S. Bankruptcy Code, the Corporation could be subject to more stringent capital, leverage or liquidity requirements, restrictions on growth, activities or operations, or be required to divest certain assets or operations. On March 24, 2017, the Federal Reserve Board and the FDIC jointly identified certain “shortcomings” in the resolution plan submitted by the Corporation in December 2015. While the identification of shortcomings is different from a determination that the plan is not credible, the Corporation was required to address satisfactorily the identified shortcomings in the Corporation’s resolution plan submitted to the Federal Reserve Board and the FDIC on December 19, 2017, with respect to which the Corporation has not yet received formal regulatory feedback. If the Federal Reserve Board and the FDIC jointly decide that the Corporation’s 2017 resolution plan fails to address the identified shortcomings in a satisfactory manner, then the Federal Reserve Board and the FDIC could jointly determine that the 2017 resolution plan is not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code, and could subject us to the measures described above.
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Changes by the U.S. and other governments to policies involving the financial services industry may heighten the challenges we face and make compliance with the evolving laws and regulations applicable to banks and other financial services companies more difficult and costly.
In the past several years, various regulatory bodies have demonstrated heightened enforcement scrutiny through many regulatory initiatives, including anti-money-laundering rules, anti-bribery laws, and loan-modification requirements. These and other regulatory requirements have increased compliance costs and regulatory risks and may lead to financial and reputational damage in the event of a violation. While we have programs in place, including policies, training and various forms of monitoring, designed to ensure compliance with legislative and regulatory requirements, these programs and policies may not always protect us from conduct by individual employees. Governments may take further actions to change significantly the way financial institutions are regulated, either through new legislation, new regulations, new applications of existing regulations or a combination of all of these methods. We cannot currently predict the impact, if any, of these changes to our business. Additionally, governments and regulators may take actions that increase intervention in the normal operation of our businesses and the businesses of our competitors in the financial services industry, and likely would involve additional legislative and regulatory requirements imposed on banks and other financial services companies. Any such actions could increase compliance costs and regulatory risks, lead to financial and reputational damage in the event of a violation, affect our ability to compete successfully, and also may impact the nature and level of competition in the industry in unpredictable ways. The full scope and impact of possible legislative or regulatory changes and the extent of regulatory activity is uncertain and difficult to predict.
We may be impacted adversely by claims or litigation, including claims or litigation relating to our fiduciary responsibilities.
Our businesses involve the risk that clients or others may sue us, claiming that we have failed to perform under a contract or otherwise failed to carry out a duty perceived to be owed to them. Our trust, custody and investment management businesses are particularly subject to this risk. This risk is heightened when we act as a fiduciary for our clients and may be further heightened during periods when credit, equity or other financial markets are deteriorating in value or are particularly volatile, or when clients or investors are experiencing losses. In addition, as a publicly-held company, we are subject to the risk of claims under the federal securities laws, and volatility in our stock price and those of other financial institutions increases this risk. Claims made or actions brought against us, whether founded or unfounded, may result in injunctions, settlements, damages, fines or penalties, which could have a material adverse effect on our financial condition or results of operations or require changes to our business. Even if we defend ourselves successfully, the cost of litigation is often substantial, and public reports regarding claims made against us may cause damage to our reputation among existing and prospective clients or negatively impact the confidence of counterparties, rating agencies and stockholders, consequently affecting our earnings negatively.
We may be impacted adversely by regulatory enforcement matters.
In the ordinary course of our business, we are subject to various regulatory, governmental and enforcement inquiries, investigations and subpoenas. These may be directed generally to participants in the businesses in which we are involved or may be directed specifically at us. In conjunction with enforcement matters, we may face claims for disgorgement, the imposition of civil and criminal penalties or the imposition of other remedial sanctions, any of which could have an adverse impact on us.
We may fail to set aside adequate reserves for, or otherwise underestimate our liability relating to, pending and threatened claims, with a negative effect on our earnings.
We estimate our potential liability for pending and threatened claims, and record reserves when appropriate pursuant to GAAP, by evaluating the facts of particular claims under current judicial decisions and legislative and regulatory interpretations. This process is inherently subject to risk, including the risks that a judge or jury could decide a case contrary to our evaluation of the law or the facts or that a court could change or modify existing law on a particular issue important to the case. Our earnings will be affected adversely to the extent that our reserves are not adequate.
If we fail to comply with legal standards, we could incur liability to our clients or lose clients, which could affect our earnings negatively.
Managing or servicing assets with reasonable prudence in accordance with the terms of governing documents and applicable laws is an important part of our business. Failure to comply with the terms of governing documents and applicable laws, manage adequately risks or manage appropriately the differing interests often involved in the exercise of fiduciary responsibilities may subject us to liability or cause client dissatisfaction, which may impact negatively our earnings and growth.
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Strategic Risks
If we do not execute strategic plans successfully, we will not grow as we have planned and our earnings growth will be impacted negatively.
Our growth depends upon successful, consistent execution of our business strategies. A failure to execute these strategies will impact growth negatively. A failure to grow organically or to integrate successfully an acquisition could have an adverse effect on our business. The challenges arising from generating organic growth or the integration of an acquired business may include preserving valuable relationships with employees, clients, suppliers and other business partners, delivering enhanced products and services, as well as combining accounting, data processing and internal control systems. To the extent we enter into transactions to acquire complementary businesses and/or technologies, we may not achieve the expected benefits of such transactions, which could result in increased costs, lowered revenues, ineffective deployment of capital, regulatory concerns, exit costs or diminished competitive position or reputation. These risks may be increased if the acquired company operates internationally or in a geographic location where we do not already have significant business operations.
Execution of our business strategies also may require certain regulatory approvals or consents, which may include approvals of the Federal Reserve Board and other domestic and non-U.S. regulatory authorities. These regulatory authorities may impose conditions on the activities or transactions contemplated by our business strategies which may impact negatively our ability to realize fully the expected benefits of certain opportunities. Further, acquisitions we announce may not be completed if we do not receive the required regulatory approvals, if regulatory approvals are significantly delayed or if other closing conditions are not satisfied.
Competition for our employees is intense, and we may not be able to attract and retain key personnel.
Our success depends, in large part, on our ability to attract new employees, retain and motivate our existing employees, and continue to compensate our employees competitively. Competition for the best employees in most activities in which we engage can be intense, and there can be no assurance that we will be successful in our efforts to recruit and retain key personnel. Factors that affect our ability to attract and retain talented and diverse employees include our compensation and benefits programs, our profitability and our reputation for rewarding and promoting qualified employees. Our ability to attract and retain key executives and other employees may be hindered as a result of existing and potential regulations applicable to incentive compensation and other aspects of our compensation programs. These regulations may not apply to some of our competitors and to other institutions with which we compete for talent. The unexpected loss of services of key personnel, both in businesses and corporate functions, could have a material adverse impact on our business because of their skills, knowledge of our markets, operations and clients, years of industry experience and, in some cases, the difficulty of promptly finding qualified replacement personnel. Similarly, the loss of key employees, either individually or as a group, could affect our clients’ perception of our abilities adversely.
We are subject to intense competition in all aspects of our businesses, which could have a negative effect on our ability to maintain satisfactory prices and grow our earnings.
We provide a broad range of financial products and services in highly competitive markets. We compete against large, well-capitalized, and geographically diverse companies that are capable of offering a wide array of financial products and services at competitive prices. In certain businesses, such as foreign exchange trading, electronic networks present a competitive challenge. Additionally, technological advances and the growth of internet-based commerce have made it possible for other types of institutions to offer a variety of products and services competitive with certain areas of our business. Many of these nontraditional service providers have fewer regulatory constraints and some have lower cost structures. The same may be said for competitors based in non-U.S. jurisdictions, where legal and regulatory environments may be more favorable than those applicable to the Corporation and the Bank as U.S.-domiciled financial institutions. These competitive pressures may have a negative effect on our earnings and ability to grow. Pricing pressures, as a result of the willingness of competitors to offer comparable or improved products or services at a lower price, also may result in a reduction in the price we can charge for our products and services, which could have, and in some cases has had, a negative effect on our ability to maintain or increase our profitability.
Damage to our reputation could have a direct and negative effect on our ability to compete, grow and generate revenue.
The failure to meet client expectations or fiduciary or other obligations, operational failures, litigation, regulatory actions or fines, the purported actions of our affiliates, vendors or other third parties with which we do business, the purported actions or statements of our employees or adverse publicity could materially and adversely affect our reputation as well as our ability to attract and retain clients or key employees. Damage to our reputation for delivery of a high level of service could undermine the confidence of clients and prospects in our ability to serve them and accordingly affect our earnings negatively. Damage to our reputation also could affect the confidence of rating agencies, regulators, stockholders and other
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parties in a wide range of transactions that are important to our business and the performance of our common stock. Failure to maintain our reputation ultimately would have an adverse effect on our ability to manage our balance sheet or grow our business. Actions by the financial services industry generally or by other members of or individuals in the financial services industry also could impact our reputation negatively. Further, whereas negative public opinion once was driven primarily by adverse news coverage in traditional media, the proliferation of social media channels utilized by us and third parties, as well as the personal use of social media by our employees and others, may increase the risk of negative publicity, including through the rapid dissemination of inaccurate, misleading or false information, which could harm our reputation or have other negative consequences.
We need to invest in innovation constantly, and the inability or failure to do so may affect our businesses and earnings negatively.
Our success in the competitive environment in which we operate requires consistent investment of capital and human resources in innovation, particularly in light of the current “FinTech” environment, in which financial institutions are investing significantly in evaluating new technologies, such as blockchain and other distributed ledger technologies, and developing potentially industry-changing new products, services and industry standards. Our investment is directed at generating new products and services, and adapting existing products and services to the evolving standards and demands of the marketplace. Among other things, investing in innovation helps us maintain a mix of products and services that keeps pace with our competitors and achieve acceptable margins. Our investment also focuses on enhancing the delivery of our products and services in order to compete successfully for new clients or gain additional business from existing clients, and includes investment in technological innovation as well. Effectively identifying gaps or weaknesses in our product offerings also is important to our success. Falling behind our competition in any of these areas could affect our business opportunities, growth and earnings adversely. There are substantial risks and uncertainties associated with innovation efforts, including an increased risk that new and emerging technologies may expose us to increased cybersecurity and other information technology threats. We must invest significant time and resources in developing and marketing new products and services, and expected timetables for the introduction and development of new products or services may not be achieved and price and profitability targets may not be met. Further, our revenues and costs may fluctuate because new products and services generally require start-up costs while corresponding revenues take time to develop or may not develop at all.
Failure to understand or appreciate fully the risks associated with development or delivery of new product and service offerings will affect our businesses and earnings negatively.
The success of our innovation efforts depends, in part, on the successful implementation of new product and service initiatives. Not only must we keep pace with competitors in the development of these new offerings, but we must accurately price them (as well as existing products) on a risk-adjusted basis and deliver them to clients effectively. Our identification of risks arising from new products and services, both in their design and implementation, and effective responses to those identified risks, including pricing, is key to the success of our efforts at innovation and investment in new product and service offerings.
Our success with large, complex clients requires an understanding of the market and legal, regulatory and accounting standards in various jurisdictions.
A significant portion of our business involves providing certain services to large, complex clients which require an understanding of the market and legal, regulatory and accounting standards in various jurisdictions. Any failure to understand, address or comply with those standards appropriately could affect our growth prospects or affect our reputation negatively. We identify and manage risk through our business strategies and plans and our risk management practices and controls. If we fail to identify and manage significant risks successfully, we could incur financial loss, suffer damage to our reputation that could restrict our ability to grow or conduct business profitably, or become subject to regulatory penalties or constraints that could limit some of our activities or make them significantly more expensive. In addition, our businesses and the markets in which we operate are continuously evolving. We may fail to understand fully the implications of changes in legal or regulatory requirements, our businesses or the financial markets or fail to enhance our risk framework to address those changes in a timely fashion. If our risk framework is ineffective, either because it fails to keep pace with changes in the financial markets, legal and regulatory requirements, our businesses, our counterparties, clients or service providers or for other reasons, we could incur losses, suffer reputational damage or find ourselves out of compliance with applicable regulatory or contractual mandates or expectations. These risks are magnified as client requirements become more complex and as our increasingly global business requires end-to-end management of operational and other processes across multiple time zones and many inter-related products and services.
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We may take actions to maintain client satisfaction that result in losses or reduced earnings.
We may take action or incur expenses in order to maintain client satisfaction or preserve the usefulness of investments or investment vehicles we manage in light of changes in security ratings, liquidity or valuation issues or other developments, even though we are not required to do so by law or the terms of governing instruments. The risk that we will decide to take actions to maintain client satisfaction that result in losses or reduced earnings is greater in periods when credit or equity markets are deteriorating in value or are particularly volatile and liquidity in markets is disrupted.
Other Risks
Changes in tax laws and interpretations and tax challenges may affect our earnings negatively.
Both U.S. and non-U.S. governments and tax authorities, including states and municipalities, from time to time issue new, or modify existing, tax laws and regulations. These authorities may also issue new, or modify existing, interpretations of those laws and regulations. These new laws, regulations or interpretations, and our actions taken in response to, or reliance upon, such changes in the tax laws may impact our tax position in a manner that affects our earnings negatively.
On December 22, 2017, the Tax Cuts and Jobs Act (H.R. 1) (the Act) was signed into law. The Act introduced a number of changes in then-existing tax law impacting businesses including, among other things, a reduction in the corporate income tax rate from 35% to 21%, disallowance of certain deductions that had previously been allowed, limitations on interest deductions, alteration of the expensing of capital expenditures, adoption of a territorial tax system, assessment of a repatriation tax or “toll-charge” on undistributed earnings and profits of U.S.-owned foreign corporations, and introduction of certain anti-base erosion provisions. In the fourth quarter of 2017, we recognized a net tax benefit of $53.1 million associated with the Act. In conjunction with the issuance by the IRS of additional guidance with respect to the Act and certain additional analyses conducted by the Corporation, we also recognized an additional $4.8 million of net income tax benefits in 2018 related to the Act. The ultimate impact of the Act on our financial condition and results of operations in 2018 and future years remains uncertain and may differ materially from our expectations due to the issuance of technical guidance regarding elements of the Act, changes in interpretations and assumptions we have made with respect to the Act, and changes to the competitive landscape in which we operate and other factors.
In the course of our business, we are sometimes subject to challenges from U.S. and non-U.S. tax authorities, including states and municipalities, regarding the amount of taxes due. These challenges may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions, all of which may require a greater provision for taxes or otherwise affect earnings negatively.
Changes in accounting standards may be difficult to predict and could have a material impact on our consolidated financial statements.
New accounting standards, changes to existing accounting standards, or changes in the interpretation of existing accounting standards by the Financial Accounting Standards Board, the International Accounting Standards Board, the SEC or bank regulatory agencies, or otherwise reflected in GAAP, potentially could have a material impact on our financial condition and results of operations. These changes are difficult to predict and in some cases we could be required to apply a new or revised standard retroactively, resulting in the revised treatment of certain transactions or activities, or even the restatement of consolidated financial statements for prior periods.
Our ability to return capital to stockholders is subject to the discretion of our Board of Directors and may be limited by U.S. banking laws and regulations, applicable provisions of Delaware law, or our failure to pay full and timely dividends on our preferred stock and the terms of our outstanding debt.
Holders of our common stock are entitled to receive only such dividends and other distributions of capital as our Board of Directors may declare out of funds legally available for such payments under Delaware law. Although we have declared cash dividends on shares of our common stock historically, we are not required to do so. In addition to the approval of our Board of Directors, our ability to take certain actions, including our ability to pay dividends, repurchase stock, and make other capital distributions, is dependent upon, among other things, their payment being made in accordance with a capital plan as to which the Federal Reserve Board has not objected. There can be no assurance that the Federal Reserve Board will not object to our future capital plans. In addition to imposing restrictions on our ability to return capital to stockholders, an objection by the Federal Reserve Board to a future capital plan would negatively impact our reputation and investor perceptions of us.
A significant source of funds for the Corporation is dividends from the Bank. As a result, our ability to pay dividends on the Corporation’s common stock will depend on the ability of the Bank to pay dividends to the Corporation. There are various legal limitations on the extent to which the Bank and the Corporation’s other subsidiaries can supply funds to the Corporation by dividend or otherwise. Dividend payments by the Bank to the Corporation in the future will require continued generation of earnings by the Bank and could require regulatory approval under certain circumstances. If the
30 2018 Annual Report | Northern Trust Corporation | ||
Bank is unable to pay dividends to the Corporation in the future, our ability to pay dividends on the Corporation’s common stock would be affected adversely.
Our ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, shares of our common stock or any of our shares that rank junior to our preferred stock as to the payment of dividends and/or the distribution of any assets on any liquidation, dissolution or winding-up of the Corporation also generally will be prohibited in the event that we do not declare and pay in full dividends on our Series C Non-Cumulative Perpetual Preferred Stock (Series C preferred stock) and Series D Non-Cumulative Perpetual Preferred Stock (Series D preferred stock). Further, in the future if we default on certain of our outstanding debt or elect to defer interest payments on our Floating Rate Capital Debt we will be prohibited from making dividend payments on our common stock until such payments have been brought current.
Any reduction or elimination of our common stock dividend, or even our failure to increase our common stock dividend along with our competitors, likely would have a negative effect on the market price of our common stock.
For more information on dividend restrictions, see “Supervision and Regulation-Payment of Dividends” in Item 1, “Business,” of this Annual Report on Form 10-K.
ITEM 1B – UNRESOLVED STAFF COMMENTS
None.
ITEM 2 – PROPERTIES
The executive offices of the Corporation and the Bank are located at 50 South La Salle Street in Chicago. This Bank-owned building is occupied by various divisions of Northern Trust’s businesses. Adjacent to this building are two office buildings in which the Bank leases space principally for corporate support functions. Financial services are provided by the Bank and other subsidiaries of the Corporation through a network of offices in 20 U.S. states and Washington, D.C., and across 23 locations in Canada, Europe, the Middle East and the Asia-Pacific region. The majority of those offices are leased. The Bank’s other primary U.S. operations are located in six facilities: a leased facility at 801 South Canal Street in Chicago; a leased facility at 231 South La Salle Street in Chicago; a leased facility in Tempe, Arizona; and three Bank-owned supplementary operations/data center buildings located in the western suburbs of Chicago. A majority of the Bank’s London-based staff is located at a leased facility at Canary Wharf in London. Additional support and operations activity originates from three facilities in Bangalore, two facilities in Limerick, as well as one facility in each of Manila and Pune, all of which are leased. The Bank and the Corporation’s other subsidiaries operate from various other facilities in North America, Europe, the Asia-Pacific region, and the Middle East, most of which are leased.
The Corporation believes that its owned and leased facilities are suitable and adequate for its business needs. For additional information relating to properties and lease commitments, refer to Note 9, “Buildings and Equipment” and Note 10, “Lease Commitments,” included under Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K and which information is incorporated herein by reference.
ITEM 3 – LEGAL PROCEEDINGS
The information presented under the caption “Legal Proceedings” in Note 25, “Contingent Liabilities,” included under Item 8, “Financial Statements and Supplementary Data,” of this Annual Report on Form 10-K is incorporated herein by reference.
2018 Annual Report | Northern Trust Corporation 31 | ||
ITEM 4 – MINE SAFETY DISCLOSURES
Not applicable.
32 2018 Annual Report | Northern Trust Corporation | ||
SUPPLEMENTAL ITEM – EXECUTIVE OFFICERS OF THE REGISTRANT
The following sets forth certain information with regard to each executive officer of the Corporation.
Michael G. O’Grady - Mr. O’Grady, age 53, joined Northern Trust in 2011 and has served as Chairman of the Board since January 2019, Chief Executive Officer since January 2018 and as President since January 2017. Prior to that, Mr. O’Grady served as Executive Vice President and President of Corporate & Institutional Services from 2014 to 2016 and as Chief Financial Officer from 2011 to 2014. Before joining Northern Trust, Mr. O’Grady served as a Managing Director in Bank of America Merrill Lynch’s Investment Banking Group.
Aileen B. Blake - Ms. Blake, age 51, joined Northern Trust in 2004 and has served as Executive Vice President and Controller since May 2017. Prior to that, Ms. Blake served as Executive Vice President and Director of Financial Planning and Strategy from February 2016 to May 2017 and as Head of Enterprise Productivity from 2011 to February 2016. She also previously served as Controller from 2004 to 2011.
S. Biff Bowman - Mr. Bowman, age 55, joined Northern Trust in 1985 and has served as Executive Vice President and Chief Financial Officer since 2014. Prior to that, Mr. Bowman served as Executive Vice President, Human Resources from 2012 to 2014. From 2010 to 2012, Mr. Bowman was the Head of Americas for Corporate & Institutional Services. From 2008 to 2010, he served as Executive Vice President, Corporate & Institutional Services for Europe, Middle East and Africa.
Robert P. Browne - Mr. Browne, age 53, joined Northern Trust in 2009 as Executive Vice President and Chief Investment Officer. Before joining Northern Trust, Mr. Browne served as Chief Investment Officer for Fixed Income and Proprietary Investments for ING Investment Management Holdings N.V. from 2004 to 2009.
Peter B. Cherecwich - Mr. Cherecwich, age 54, joined Northern Trust in 2007 and has served as Executive Vice President and President of Corporate & Institutional Services since February 2017. Prior to that, Mr. Cherecwich served as Executive Vice President and President of Global Fund Services from 2010 to 2017 and as Chief Operating Officer of Corporate & Institutional Services from 2008 to 2014. From 2007 to 2008, he served as Head of Institutional Strategy & Product Development. Before joining Northern Trust, Mr. Cherecwich served in several executive and operational roles at State Street Corporation.
Steven L. Fradkin - Mr. Fradkin, age 57, joined Northern Trust in 1985 and has served as Executive Vice President and President of Wealth Management since September 2014. Prior to that, Mr. Fradkin served as President of Corporate & Institutional Services from 2009 to 2014. He served as Chief Financial Officer from 2004 to 2009.
Wilson Leech - Mr. Leech, age 57, joined Northern Trust in 2004 and has served as Executive Vice President and Chief Risk Officer since February 2017. Prior to that Mr. Leech served as Executive Vice President, Corporate & Institutional Services for Europe, Middle East and Africa from 2010 to 2017 and as Head of Global Fund Services from 2005 to 2010. From 2004 to 2005, he served as Chief Financial Officer for Europe, Middle East and Africa and Asia Pacific. Before joining Northern Trust, Mr. Leech served in various operational and financial roles at State Street Corporation and the Royal Bank of Scotland.
Susan C. Levy - Ms. Levy, age 61, joined Northern Trust in 2014 and has served as Executive Vice President and General Counsel since that time and as Corporate Secretary since October 2018. Before joining Northern Trust, Ms. Levy served as Managing Partner of the law firm Jenner & Block from 2008 to 2014, where she was a partner since 1990.
Teresa A. Parker - Ms. Parker, age 58, joined Northern Trust in 1982 and has served as Executive Vice President and President of Corporate & Institutional Services for Europe, Middle East and Africa since June 2017. Prior to that, Ms. Parker served as Chief Operating Officer of Corporate & Institutional Services from 2014 to 2017. From 2009 to 2014, she served as Executive Vice President, Corporate & Institutional Services for Asia Pacific.
Thomas A. South - Mr. South, age 49, joined Northern Trust in 1999 and has served as Executive Vice President and Chief Information Officer since September 2018. Prior to that, Mr. South served as Chief Business Architect from 2014 to 2018 and as Chief Operating Officer for Operations & Technology from 2013 to 2014.
2018 Annual Report | Northern Trust Corporation 33 | ||
Joyce M. St. Clair - Ms. St. Clair, age 59, joined Northern Trust in 1992 and has served as Executive Vice President and Chief Human Resources Officer since July 2018. Prior to that, Ms. St. Clair served as Executive Vice President and Chief Capital Management Officer from 2015 to 2018, as President of Enterprise Operations from 2014 to 2015, as President of Operations & Technology from 2011 to 2014, and as Chief Risk Officer from 2007 to 2011.
Shundrawn A. Thomas - Mr. Thomas, age 45, joined Northern Trust in 2004 and has served as Executive Vice President and President of Asset Management since October 2017. Prior to that, Mr. Thomas served as Executive Vice President and Head of the Funds and Managed Accounts Group from 2014 to 2017 and as Head of the Exchange-Traded Funds Group from 2010 to 2014. He also previously served as President and Chief Executive Officer of Northern Trust Securities, Inc. from 2009 to 2010 and as Head of Corporate Strategy from 2006 to 2009.
All officers are appointed annually by the Board of Directors. Officers continue to hold office until their successors are duly elected or until their death, resignation or removal by the Board.
34 2018 Annual Report | Northern Trust Corporation | ||
PART II
ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is listed on The NASDAQ Stock Market LLC under the symbol “NTRS.” There were 1,805 shareholders of record as of January 31, 2019.
The following table shows certain information relating to the Corporation’s purchases of common stock for the three months ended December 31, 2018.
TABLE 2: PURCHASES OF COMMON STOCK IN THE FOURTH QUARTER OF 2018
PERIOD | TOTAL NUMBER OF SHARES PURCHASED | AVERAGE PRICE PAID PER SHARE | TOTAL NUMBER OF SHARES PURCHASED AS PART OF A PUBLICLY ANNOUNCED PLAN (1) | MAXIMUM NUMBER OF SHARES THAT MAY YET BE PURCHASED UNDER THE PLAN | |||||
October 1 - 31, 2018 | 797,315 | $ | 97.04 | 797,315 | 22,085,658 | ||||
November 1 - 30, 2018 | 545,459 | 96.25 | 545,459 | 21,540,199 | |||||
December 1 - 31, 2018 | 1,139,328 | 88.53 | 1,139,328 | 20,400,871 | |||||
Total (Fourth Quarter) | 2,482,102 | $ | 92.96 | 2,482,102 | 20,400,871 | ||||
(1) Repurchases were made pursuant to the repurchase program announced by the Corporation on July 17, 2018 under which the Corporation’s Board of Directors authorized the Corporation to repurchase up to 25.0 million shares of the Corporation's common stock. The repurchase program has no expiration date.
2018 Annual Report | Northern Trust Corporation 35 | ||
COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN
The graph below compares the cumulative total stockholder return on the Corporation’s common stock to the cumulative total return of the S&P 500 Index and the KBW Bank Index for the five fiscal years ended December 31, 2018. The cumulative total stockholder return assumes the investment of $100 in the Corporation’s common stock and in each index on December 31, 2013 and assumes reinvestment of dividends. The KBW Bank Index is a modified-capitalization-weighted index made up of 24 of the largest banking companies in the United States. The Corporation is included in the S&P 500 Index and the KBW Bank Index.
Total Return Assumes $100 Invested on
December 31, 2013 with Reinvestment of Dividends
DECEMBER 31, | ||||||||||||||||||
2013 | 2014 | 2015 | 2016 | 2017 | 2018 | |||||||||||||
Northern Trust | $ | 100 | $ | 111 | $ | 121 | $ | 153 | $ | 174 | $ | 149 | ||||||
S&P 500 | 100 | 114 | 115 | 129 | 157 | 150 | ||||||||||||
KBW Bank Index | 100 | 109 | 110 | 141 | 167 | 138 | ||||||||||||
36 2018 Annual Report | Northern Trust Corporation | ||
ITEM 6 – SELECTED FINANCIAL DATA
2018 | 2017 | 2016 | 2015 | 2014 | |||||||||||
FOR THE YEAR ENDED DECEMBER 31, | |||||||||||||||
CONDENSED STATEMENTS OF INCOME (In Millions) | |||||||||||||||
Noninterest Income | $ | 4,337.5 | $ | 3,946.1 | $ | 3,726.9 | $ | 3,632.5 | $ | 3,325.7 | |||||
Net Interest Income | 1,622.7 | 1,429.2 | 1,234.9 | 1,070.1 | 1,005.5 | ||||||||||
Total Revenue | $ | 5,960.2 | $ | 5,375.3 | $ | 4,961.8 | $ | 4,702.6 | $ | 4,331.2 | |||||
Provision for Credit Losses | (14.5 | ) | (28.0 | ) | (26.0 | ) | (43.0 | ) | 6.0 | ||||||
Noninterest Expense | 4,016.9 | 3,769.4 | 3,470.7 | 3,280.6 | 3,135.0 | ||||||||||
Income before Income Taxes | $ | 1,957.8 | $ | 1,633.9 | $ | 1,517.1 | $ | 1,465.0 | $ | 1,190.2 | |||||
Provision for Income Taxes | 401.4 | 434.9 | 484.6 | 491.2 | 378.4 | ||||||||||
Net Income | $ | 1,556.4 | $ | 1,199.0 | $ | 1,032.5 | $ | 973.8 | $ | 811.8 | |||||
Preferred Stock Dividends | 46.4 | 49.8 | 23.4 | 23.4 | 9.5 | ||||||||||
Net Income Applicable to Common Stock | $ | 1,510.0 | $ | 1,149.2 | $ | 1,009.1 | $ | 950.4 | $ | 802.3 | |||||
PER COMMON SHARE | |||||||||||||||
Net Income – Basic | $ | 6.68 | $ | 4.95 | $ | 4.35 | $ | 4.03 | $ | 3.34 | |||||
– Diluted | 6.64 | 4.92 | 4.32 | 3.99 | 3.32 | ||||||||||
Cash Dividends Declared Per Common Share | 1.94 | 1.60 | 1.48 | 1.41 | 1.30 | ||||||||||
Book Value – End of Period (EOP) | 43.95 | 41.28 | 38.88 | 36.27 | 34.54 | ||||||||||
Market Price – EOP | 83.59 | 99.89 | 89.05 | 72.09 | 67.40 | ||||||||||
SELECTED BALANCE SHEET DATA (In Millions) | |||||||||||||||
At Year End: | |||||||||||||||
Earning Assets | $ | 122,847.3 | $ | 129,656.6 | $ | 115,446.4 | $ | 106,848.9 | $ | 100,889.8 | |||||
Total Assets | 132,212.5 | 138,590.5 | 123,926.9 | 116,749.6 | 109,946.5 | ||||||||||
Deposits | 104,496.8 | 112,390.8 | 101,651.7 | 96,868.9 | 90,757.0 | ||||||||||
Senior Notes | 2,011.3 | 1,497.3 | 1,496.6 | 1,497.4 | 1,497.0 | ||||||||||
Long-Term Debt | 1,112.4 | 1,449.5 | 1,330.9 | 1,371.3 | 1,615.1 | ||||||||||
Stockholders’ Equity | 10,508.3 | 10,216.2 | 9,770.4 | 8,705.9 | 8,448.9 | ||||||||||
Average Balances: | |||||||||||||||
Earning Assets | $ | 113,731.0 | $ | 111,178.3 | $ | 107,037.6 | $ | 102,249.8 | $ | 95,947.5 | |||||
Total Assets | 122,946.6 | 119,607.4 | 115,570.3 | 110,715.1 | 104,083.5 | ||||||||||
Deposits | 95,103.1 | 96,504.8 | 93,613.9 | 90,768.0 | 84,656.6 | ||||||||||
Senior Notes | 1,704.0 | 1,496.9 | 1,496.6 | 1,497.2 | 1,661.2 | ||||||||||
Long-Term Debt | 1,296.8 | 1,519.4 | 1,392.4 | 1,426.4 | 1,654.9 | ||||||||||
Stockholders’ Equity | 10,228.9 | 9,980.6 | 9,085.3 | 8,624.5 | 8,166.5 | ||||||||||
CLIENT ASSETS (In Billions) | |||||||||||||||
Assets Under Custody/Administration | $ | 10,125.3 | $ | 10,722.6 | $ | 8,541.3 | $ | 7,797.0 | N/A | ||||||
Assets Under Custody | 7,593.9 | 8,084.6 | 6,720.5 | 6,072.1 | 5,968.8 | ||||||||||
Assets Under Management | 1,069.4 | 1,161.0 | 942.4 | 875.3 | 934.1 | ||||||||||
SELECTED RATIOS AND METRICS | |||||||||||||||
Financial Ratios and Metrics: | |||||||||||||||
Return on Average Common Equity | 16.2 | % | 12.6 | % | 11.9 | % | 11.5 | % | 10.0 | % | |||||
Return on Average Assets | 1.27 | 1.00 | 0.89 | 0.88 | 0.78 | ||||||||||
Dividend Payout Ratio | 29.2 | 32.5 | 34.3 | 35.3 | 39.2 | ||||||||||
Net Interest Margin (*) | 1.46 | 1.33 | 1.18 | 1.07 | 1.08 | ||||||||||
Average Stockholders’ Equity to Average Assets | 8.3 | 8.3 | 7.9 | 7.8 | 7.8 | ||||||||||
Capital Ratios: | DECEMBER 31, 2018 | DECEMBER 31, 2017 | DECEMBER 31, 2016 | DECEMBER 31, 2015 | DECEMBER 31, 2014 | |||||||||||||||
ADVANCED APPROACH | STANDARDIZED APPROACH(a) | ADVANCED APPROACH | STANDARDIZED APPROACH(a) | ADVANCED APPROACH | STANDARDIZED APPROACH(a) | ADVANCED APPROACH | STANDARDIZED APPROACH(a) | ADVANCED APPROACH | STANDARDIZED APPROACH(a) | |||||||||||
Common Equity Tier 1 | 13.7 | % | 12.9 | % | 13.5 | % | 12.6 | % | 12.4 | % | 11.8 | % | 11.9 | % | 10.8 | % | 12.4 | % | 12.5 | % |
Tier 1 | 15.0 | 14.1 | 14.8 | 13.8 | 13.7 | 12.9 | 12.5 | 11.4 | 13.2 | 13.3 | ||||||||||
Total | 16.9 | 16.1 | 16.7 | 15.8 | 15.1 | 14.5 | 14.2 | 13.2 | 15.0 | 15.5 | ||||||||||
Tier 1 Leverage | 8.0 | 8.0 | 7.8 | 7.8 | 8.0 | 8.0 | 7.5 | 7.5 | N/A | 7.8 | ||||||||||
Supplementary Leverage(b) | 7.0 | N/A | 6.8 | N/A | 6.8 | N/A | 6.2 | N/A | N/A | N/A | ||||||||||
(*) Net interest margin is presented on a fully taxable equivalent (FTE) basis, a non-generally-accepted-accounting-principle (GAAP) financial measure that facilitates the analysis of asset yields. The net interest margin on a GAAP basis and a reconciliation of net interest income on a GAAP basis to net interest income on an FTE basis are presented on page 88.
(a) In 2014, Standardized Approach risk-weighted assets were determined by Basel I requirements. Effective with the first quarter of 2015, risk-weighted assets are calculated in accordance with the Basel II Standardized Approach final rules.
(b) Effective with the first quarter of 2015, advanced approaches banking organizations must calculate and report their supplementary leverage ratio. Effective January 1, 2018, the Corporation and Bank are subject to a minimum supplementary leverage ratio of 3 percent.
2018 Annual Report | Northern Trust Corporation 37 | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
BUSINESS OVERVIEW
Northern Trust Corporation (the Corporation) is a financial holding company that is a leading provider of wealth management, asset servicing, asset management, and banking solutions to corporations, institutions, families and individuals. The Corporation focuses on managing and servicing client assets through its two client-focused reporting segments: Corporate & Institutional Services (C&IS) and Wealth Management. Asset management and related services are provided to C&IS and Wealth Management clients primarily by the Asset Management business.
The Corporation conducts business through various U.S. and non-U.S. subsidiaries, including The Northern Trust Company (the Bank). The Corporation was originally formed as a holding company for the Bank in 1971. The Corporation has a global presence with offices in 20 U.S. states and Washington, D.C., and across 23 locations in Canada, Europe, the Middle East and the Asia-Pacific region. Except where the context requires otherwise, the terms “Northern Trust,” “we,” “us,” “our” or similar terms refers to the Corporation and its subsidiaries on a consolidated basis.
FINANCIAL OVERVIEW
Net income in 2018 totaled $1.56 billion, up $357.4 million or 30%, from $1.20 billion in 2017. Earnings per diluted common share totaled $6.64 in 2018 compared to $4.92 in 2017. Return on average common equity improved to 16.2% in 2018 from 12.6% in 2017.
Revenue increased 11% to $5.96 billion in 2018 from $5.38 billion in the prior year, driven by a 9% increase in trust, investment and other servicing fees, a 14% increase in net interest income, and a 46% increase in foreign exchange trading income, partially offset by a 19% decline in other operating income.
Client assets under custody/administration (AUC/A) and under custody, a component of AUC/A, were each down 6%, as of December 31, 2018 as compared to December 31, 2017 levels. Client assets under management were down 8% as of December 31, 2018 as compared to December 31, 2017 levels. As of December 31, 2018, AUC/A decreased to $10.13 trillion from $10.72 trillion at December 31, 2017. As of December 31, 2018, client assets under custody decreased to $7.59 trillion from $8.08 trillion, and included $4.70 trillion of global custody assets, down 5% from $4.94 trillion at December 31, 2017. As of December 31, 2018, client assets under management decreased to $1.07 trillion from $1.16 trillion at December 31, 2017.
Trust, investment and other servicing fees, which represent the largest component of total revenue, increased 9% to $3.75 billion, from $3.43 billion in 2017, primarily due to favorable markets, revenue associated with the acquisition and integration of UBS Asset Management’s fund administration units in Luxembourg and Switzerland (the UBS acquisition), new business, a change in presentation of certain fees resulting from the adoption of the new revenue recognition standard, and the favorable impact of movements in foreign exchange rates.
Foreign exchange trading income of $307.2 million increased 46% from $209.9 million in 2017, primarily resulting from increased foreign exchange swap activity in Treasury and higher volatility.
Other operating income was $127.5 million in 2018, down 19% from $157.5 million in the prior year, primarily due to the impairment of a community development equity investment previously held at cost, expenses related to existing swap agreements related to Visa Inc. Class B common shares, and the net impact of various other operating income categories.
Net interest income on a fully taxable equivalent (FTE) basis in 2018 was $1.66 billion, an increase of $188.9 million, or 13%, from $1.48 billion in 2017, due to an increased net interest margin and higher levels of average earning assets. The net interest margin on an FTE basis increased to 1.46% in 2018 from 1.33% in 2017, primarily due to higher short-term interest rates.
The provision for credit losses in 2018 was a credit of $14.5 million, reflecting reductions in outstanding loans and undrawn loan commitments and standby letters of credit and improved credit quality across the portfolio. This was partially offset by increases in specific reserves primarily related to the commercial and institutional portfolio. The provision for credit losses in 2017 was a credit of $28.0 million, reflecting improvement in the credit quality of the Corporation’s loan portfolio and reductions in outstanding loans and undrawn loan commitments and standby letters of credit. Loans and leases as of December 31, 2018 totaled $32.5 billion, down slightly from $32.6 billion in 2017. Net charge-offs for the year ended December 31, 2018 were $1.1 million, down from $10.2 million in 2017. Nonperforming assets as of December 31, 2018 were $117.7 million, a decline from $155.3 million in 2017.
Noninterest expense totaled $4.02 billion in 2018, up $247.5 million, or 7%, from $3.77 billion in the prior year, reflecting increased compensation, outside services, equipment and software expense, and employee benefit expense, including higher third-party advisor costs due to a change in presentation resulting from the adoption of the new revenue
38 2018 Annual Report | Northern Trust Corporation | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
recognition standard and higher expenses associated with the UBS acquisition, partially offset by lower severance and related charges. The prior year also included a one-time employee cash bonus recorded in connection with the Tax Cuts and Jobs Act (TCJA).
The provision for income taxes in 2018 totaled $401.4 million, representing an effective tax rate of 20.5%. The provision for income taxes in 2017 totaled $434.9 million, representing an effective tax rate of 26.6%. The current year includes a net benefit to the tax provision primarily attributable to the reduction in the U.S. corporate income tax rate from 35% to 21% as a result of the TCJA enacted in the fourth quarter of 2017 as well as adjustments recorded in the current year associated with the implementation of the TCJA. Also in 2018, the Corporation recognized a tax benefit resulting from a change in accounting method regarding the timing of tax deductions for software-development related expenses. These decreases to the provision for income taxes in the current year were partially offset by tax accounting changes in 2018 brought about by the TCJA including the tax accounting associated with additional non-deductible expenses and a reduction in the income tax benefit derived from the vesting of restricted stock units and stock option exercises.
Northern Trust continued to maintain a strong capital position during 2018, with all capital ratios exceeding those required for classification as “well-capitalized” under federal bank regulatory capital requirements. Total stockholders’ equity was $10.5 billion at year-end, up 3% from $10.2 billion in 2017. During the year ended December 31, 2018, Northern Trust increased its quarterly common stock dividend to $0.55 per share and repurchased 9.0 million shares of common stock, returning $1.36 billion in capital to common stockholders, compared to $895.6 million in 2017.
CONSOLIDATED RESULTS OF OPERATIONS
Revenue
Northern Trust generates the majority of its revenue from noninterest income that primarily consists of trust, investment and other servicing fees. Net interest income comprises the remainder of revenue and consists of interest income generated by earning assets, net of interest expense on deposits and borrowed funds.
Revenue in 2018 was $5.96 billion, an increase of 11% from $5.38 billion in 2017. Noninterest income represented 73% of total revenue in 2018 and 2017, and totaled $4.34 billion, up 10% from $3.95 billion in 2017.
The current-year increase in noninterest income primarily reflected higher trust, investment and other servicing fees and foreign exchange trading income, partially offset by lower other operating income. Trust, investment and other servicing fees totaled $3.75 billion in 2018, up $319.3 million, or 9%, from $3.43 billion in 2017, primarily due to favorable markets, revenue associated with the UBS acquisition, new business, a change in presentation of certain fees resulting from the adoption of the new revenue recognition standard, and the favorable impact of movements in foreign exchange rates. Foreign exchange trading income in 2018 totaled $307.2 million, up $97.3 million, or 46%, compared with $209.9 million in 2017, primarily resulting from increased foreign exchange swap activity in Treasury and higher volatility. Other operating income was $127.5 million in 2018, down 19% from $157.5 million in the prior year, primarily due to the impairment of a community development equity investment previously held at cost, expenses related to existing swap agreements related to Visa Inc. Class B common shares, and the net impact of various other operating income categories.
Net interest income on an FTE basis in 2018 was $1.66 billion, an increase of $188.9 million, or 13%, from $1.48 billion in 2017, due to an increased net interest margin and higher levels of average earning assets. The net interest margin on an FTE basis increased to 1.46% in 2018 from 1.33% in 2017, primarily due to higher short-term interest rates. Average earning assets increased $2.6 billion, or 2%, in 2018, primarily reflecting higher levels of securities, partially offset by a decrease in loans and leases and short-term interest bearing deposits.
2018 Annual Report | Northern Trust Corporation 39 | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Additional information regarding Northern Trust’s revenue by type is provided below.
2018 TOTAL REVENUE OF $5.96 BILLION
n | 63% Trust, Investment and Other Servicing Fees | |
n | 27% Net Interest Income | |
n | 5% Foreign Exchange Trading Income | |
n | 5% Other Noninterest Income | |
Noninterest Income
The components of noninterest income, and a discussion of significant changes during 2018 and 2017, are provided below.
TABLE 3: NONINTEREST INCOME
FOR THE YEAR ENDED DECEMBER 31, | CHANGE | ||||||||||||
($ In Millions) | 2018 | 2017 | 2016 | 2018 / 2017 | 2017 / 2016 | ||||||||
Trust, Investment and Other Servicing Fees | $ | 3,753.7 | $ | 3,434.3 | $ | 3,108.1 | 9 | % | 10 | % | |||
Foreign Exchange Trading Income | 307.2 | 209.9 | 236.6 | 46 | (11 | ) | |||||||
Treasury Management Fees | 51.8 | 56.4 | 62.8 | (8 | ) | (10 | ) | ||||||
Security Commissions and Trading Income | 98.3 | 89.6 | 81.4 | 10 | 10 | ||||||||
Other Operating Income | 127.5 | 157.5 | 241.2 | (19 | ) | (35 | ) | ||||||
Investment Security Losses, net | (1.0 | ) | (1.6 | ) | (3.2 | ) | (33 | ) | (50 | ) | |||
Total Noninterest Income | $ | 4,337.5 | $ | 3,946.1 | $ | 3,726.9 | 10 | % | 6 | % | |||
Trust, Investment and Other Servicing Fees
Trust, investment and other servicing fees were $3.75 billion in 2018 compared with $3.43 billion in 2017. Trust, investment and other servicing fees are based primarily on the market value of assets held in custody, managed and serviced; the volume of transactions; securities lending volume and spreads; and fees for other services rendered. Certain market value calculations on which fees are based are performed on a monthly or quarterly basis in arrears. Based on an analysis of historical trends and current asset and product mix, management estimates that a 10% rise or fall in overall equity markets would cause a corresponding increase or decrease in Northern Trust’s trust, investment and other servicing fees of approximately 3% and in total revenue of approximately 2%. For a more detailed discussion of 2018 trust, investment and other servicing fees, refer to the “Reporting Segments and Related Information” section.
When considering the impact of markets on the Corporation’s results, the following tables present selected market indices and the percentage changes year over year.
TABLE 4: EQUITY MARKET INDICES
DAILY AVERAGES | YEAR-END | |||||||||||
2018 | 2017 | CHANGE | 2018 | 2017 | CHANGE | |||||||
S&P 500 | 2,746 | 2,448 | 12 | % | 2,507 | 2,674 | (6 | )% | ||||
MSCI EAFE (U.S. dollars) | 1,966 | 1,886 | 4 | 1,720 | 2,051 | (16 | ) | |||||
MSCI EAFE (local currency) | 1,125 | 1,105 | 2 | 1,008 | 1,164 | (13 | ) | |||||
40 2018 Annual Report | Northern Trust Corporation | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE 5: FIXED INCOME MARKET INDICES
AS OF DECEMBER 31, | ||||||
2018 | 2017 | CHANGE | ||||
Barclays Capital U.S. Aggregate Bond Index | 2,047 | 2,046 | — | % | ||
Barclays Capital Global Aggregate Bond Index | 479 | 485 | (1 | ) | ||
ASSETS UNDER CUSTODY/ADMINISTRATION AND ASSETS UNDER MANAGEMENT
AUC/A and assets under management form the primary drivers of our trust, investment and other servicing fees. For the purposes of disclosing AUC/A, to the extent that both custody and administration services are provided, the value of the assets is included only once. At December 31, 2018, AUC/A were $10.13 trillion, down 6% from $10.72 trillion at December 31, 2017. The decrease in AUC/A primarily reflected unfavorable markets, the unfavorable impact of movements in foreign exchange rates, and net outflows. Assets under custody, a component of AUC/A, were $7.59 trillion at December 31, 2018, down 6% from $8.08 trillion at December 31, 2017, and included $4.70 trillion of global custody assets, compared to $4.94 trillion at December 31, 2017. The decrease in assets under custody primarily reflected unfavorable markets, the unfavorable impact of movements in foreign exchange rates, and net outflows. Assets under management totaled $1.07 trillion, down 8% from $1.16 trillion at the end of 2017. The decrease primarily reflected unfavorable markets and net outflows.
AUC/A by reporting segment were as follows:
TABLE 6: ASSETS UNDER CUSTODY/ADMINISTRATION BY REPORTING SEGMENT
DECEMBER 31, | CHANGE | |||||||||||||||
($ In Billions) | 2018 | 2017 | 2016 | 2015 | 2018 /2017 | 2017 /2016 | ||||||||||
Corporate & Institutional | $ | 9,490.5 | $ | 10,066.8 | $ | 7,987.0 | $ | 7,279.7 | (6 | )% | 26 | % | ||||
Wealth Management | 634.8 | 655.8 | 554.3 | 517.3 | (3 | ) | 18 | |||||||||
Total Assets Under Custody/Administration | $ | 10,125.3 | $ | 10,722.6 | $ | 8,541.3 | $ | 7,797.0 | (6 | )% | 26 | % | ||||
Assets under custody by reporting segment were as follows:
TABLE 7: ASSETS UNDER CUSTODY BY REPORTING SEGMENT
DECEMBER 31, | CHANGE | FIVE-YEAR COMPOUND GROWTH RATE | |||||||||||||||||||
($ In Billions) | 2018 | 2017 | 2016 | 2015 | 2014 | 2018 /2017 | 2017 / 2016 | ||||||||||||||
Corporate & Institutional | $ | 6,971.0 | $ | 7,439.1 | $ | 6,176.9 | $ | 5,565.8 | $ | 5,453.1 | (6 | )% | 20 | % | 7 | % | |||||
Wealth Management | 622.9 | 645.5 | 543.6 | 506.3 | 515.7 | (4 | ) | 19 | 5 | ||||||||||||
Total Assets Under Custody | $ | 7,593.9 | $ | 8,084.6 | $ | 6,720.5 | $ | 6,072.1 | $ | 5,968.8 | (6 | )% | 20 | % | 6 | % | |||||
Assets under custody were invested as follows:
TABLE 8: ASSETS UNDER CUSTODY BY INVESTMENT TYPE
DECEMBER 31, | ||||||||||
2018 | 2017 | 2016 | 2015 | 2014 | ||||||
Equities | 45 | % | 47 | % | 46 | % | 44 | % | 45 | % |
Fixed Income Securities | 37 | 35 | 36 | 37 | 36 | |||||
Cash and Other Assets | 16 | 16 | 17 | 17 | 17 | |||||
Securities Lending Collateral | 2 | 2 | 1 | 2 | 2 | |||||
2018 Annual Report | Northern Trust Corporation 41 | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Assets under management by reporting segment were as follows:
TABLE 9: ASSETS UNDER MANAGEMENT BY REPORTING SEGMENT
DECEMBER 31, | CHANGE | FIVE-YEAR COMPOUND GROWTH RATE | |||||||||||||||||||
($ In Billions) | 2018 | 2017 | 2016 | 2015 | 2014 | 2018 / 2017 | 2017 / 2016 | ||||||||||||||
Corporate & Institutional | $ | 790.8 | $ | 871.2 | $ | 694.0 | $ | 648.0 | $ | 709.6 | (9 | )% | 26 | % | 4 | % | |||||
Wealth Management | 278.6 | 289.8 | 248.4 | 227.3 | 224.5 | (4 | ) | 17 | 5 | ||||||||||||
Total Assets Under Management | $ | 1,069.4 | $ | 1,161.0 | $ | 942.4 | $ | 875.3 | $ | 934.1 | (8 | )% | 23 | % | 4 | % | |||||
Assets under management were invested and managed as follows:
TABLE 10: ASSETS UNDER MANAGEMENT BY INVESTMENT TYPE
DECEMBER 31, | ||||||||||
2018 | 2017 | 2016 | 2015 | 2014 | ||||||
Equities | 50 | % | 51 | % | 51 | % | 51 | % | 52 | % |
Fixed Income Securities | 17 | 16 | 17 | 17 | 17 | |||||
Cash and Other Assets | 19 | 19 | 20 | 20 | 18 | |||||
Securities Lending Collateral | 14 | 14 | 12 | 12 | 13 | |||||
TABLE 11: ASSETS UNDER MANAGEMENT BY MANAGEMENT STYLE
DECEMBER 31, | ||||||||||
2018 | 2017 | 2016 | 2015 | 2014 | ||||||
Index | 49 | % | 46 | % | 47 | % | 47 | % | 49 | % |
Active | 38 | 41 | 40 | 40 | 39 | |||||
Multi-Manager | 5 | 5 | 5 | 4 | 6 | |||||
Other | 8 | 8 | 8 | 9 | 6 | |||||
Foreign Exchange Trading Income
Northern Trust provides foreign exchange services in the normal course of business as an integral part of its global custody services. Active management of currency positions, within conservative limits, also contributes to foreign exchange trading income. Foreign exchange trading income in 2018 totaled $307.2 million, up $97.3 million, or 46%, compared with $209.9 million in 2017, primarily resulting from increased foreign exchange swap activity in Treasury and higher volatility.
Treasury Management Fees
Treasury management fees, generated from cash and treasury management products and services provided to clients, totaled $51.8 million in 2018, down 8%, from $56.4 million in 2017, primarily due to an increase in the earnings credit rate applied to client balances.
Security Commissions and Trading Income
Security commissions and trading income is generated primarily from securities brokerage services provided by Northern Trust Securities, Inc., and totaled $98.3 million in 2018, up 10%, or $8.7 million, from $89.6 million in 2017, primarily due to higher core brokerage revenues and transition management revenues.
42 2018 Annual Report | Northern Trust Corporation | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Other Operating Income
The components of other operating income include:
TABLE 12: OTHER OPERATING INCOME
FOR THE YEAR ENDED DECEMBER 31, | CHANGE | ||||||||||||
($ In Millions) | 2018 | 2017 | 2016 | 2018 / 2017 | 2017 / 2016 | ||||||||
Loan Service Fees | $ | 48.9 | $ | 50.7 | $ | 56.6 | (4 | )% | (10 | )% | |||
Banking Service Fees | 46.4 | 48.6 | 50.6 | (5 | ) | (4 | ) | ||||||
Other Income | 32.2 | 58.2 | 134.0 | (44 | ) | (57 | ) | ||||||
Total Other Operating Income | $ | 127.5 | $ | 157.5 | $ | 241.2 | (19 | )% | (35 | )% | |||
Other income totaled $32.2 million in 2018, down $26.0 million or 44%, from $58.2 million in 2017, primarily due to the impairment of a community development equity investment previously held at cost, expenses related to existing swap agreements related to Visa Inc. Class B common shares, and the net impact of various other operating income categories.
Investment Security Losses, Net
Net investment security losses totaled $1.0 million and $1.6 million in 2018 and 2017, respectively. Losses in 2018 and 2017 include $0.5 million and $0.2 million of charges related to the other-than-temporary impairment (OTTI) of certain Community Reinvestment Act (CRA) eligible held-to-maturity securities, respectively.
NONINTEREST INCOME – 2017 COMPARED WITH 2016
Trust, investment and other servicing fees were $3.43 billion in 2017, up 10% from $3.11 billion in 2016, primarily due to favorable markets, new business, and revenue associated with the UBS acquisition. Foreign exchange trading income decreased 11% to $209.9 million in 2017 from $236.6 million in 2016, primarily resulting from lower volatility and client volumes in 2017.
Other operating income totaled $157.5 million in 2017, a decrease of 35% from $241.2 million in 2016. Other operating income in 2016 included a gain on the sale of 1.1 million Visa Inc. Class B common shares, net of a valuation adjustment to existing swap agreements, totaling $118.2 million, offset by impairment charges and a loss on sale related to the decision to exit a portion of a non-strategic loan and lease portfolio, as well as impairment charges related to the residual value of certain aircraft and rail cars of $18.9 million.
Net investment security losses totaled $1.6 million and $3.2 million in 2017 and 2016, respectively. Losses in 2017 and 2016 include $0.2 million and $3.7 million of charges related to the OTTI of certain CRA eligible held-to-maturity securities, respectively.
Net Interest Income
Net interest income stated on an FTE basis is a non-generally-accepted-accounting-principle (GAAP) financial measure that facilitates the analysis of asset yields. Management believes an FTE presentation provides a clearer indication of net interest margins for comparative purposes. When adjusted to an FTE basis, yields on taxable, nontaxable, and partially taxable assets are comparable; however, the adjustment to an FTE basis has no impact on net income. A reconciliation of net interest income on a GAAP basis to net interest income on an FTE basis is provided on page 88.
2018 Annual Report | Northern Trust Corporation 43 | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
An analysis of net interest income on an FTE basis, major balance sheet components impacting net interest income and related ratios are provided below.
TABLE 13: ANALYSIS OF NET INTEREST INCOME (FTE)
FOR THE YEAR ENDED DECEMBER 31, | CHANGE | ||||||||||||
($ In Millions) | 2018 | 2017 | 2016 | 2018 / 2017 | 2017 / 2016 | ||||||||
Interest Income – GAAP | $ | 2,321.4 | $ | 1,769.4 | $ | 1,416.9 | 31 | % | 25 | % | |||
FTE Adjustment | 41.2 | 45.8 | 25.1 | (10 | ) | 82 | |||||||
Interest Income – FTE | 2,362.6 | 1,815.2 | 1,442.0 | 30 | 26 | ||||||||
Interest Expense | 698.7 | 340.2 | 182.0 | 105 | 87 | ||||||||
Net Interest Income – FTE Adjusted | 1,663.9 | 1,475.0 | 1,260.0 | 13 | 17 | ||||||||
Net Interest Income – GAAP | 1,622.7 | 1,429.2 | 1,234.9 | 14 | 16 | ||||||||
AVERAGE BALANCE | |||||||||||||
Earning Assets | $ | 113,731.0 | $ | 111,178.3 | $ | 107,037.6 | 2 | % | 4 | % | |||
Interest-Related Funds | 88,638.4 | 83,422.0 | 76,886.0 | 6 | 9 | ||||||||
Net Noninterest-Related Funds | 25,092.6 | 27,756.3 | 30,151.6 | (10 | ) | (8 | ) | ||||||
CHANGE IN PERCENTAGE | |||||||||||||
AVERAGE RATE | |||||||||||||
Earning Assets | 2.08 | % | 1.63 | % | 1.35 | % | 0.45 | 0.28 | |||||
Interest-Related Funds | 0.79 | 0.41 | 0.24 | 0.38 | 0.17 | ||||||||
Interest Rate Spread | 1.29 | 1.22 | 1.11 | 0.07 | 0.11 | ||||||||
Total Source of Funds | 0.62 | 0.31 | 0.17 | 0.31 | 0.14 | ||||||||
Net Interest Margin – GAAP | 1.43 | % | 1.29 | % | 1.15 | % | 0.14 | 0.14 | |||||
Net Interest Margin – FTE | 1.46 | % | 1.33 | % | 1.18 | % | 0.13 | 0.15 | |||||
Refer to pages 168 and 169 for additional analysis of net interest income.
Net interest income is defined as the total of interest income and amortized fees on earning assets, less interest expense on deposits and borrowed funds, adjusted for the impact of interest-related hedging activity. Earning assets – including federal funds sold, securities purchased under agreements to resell, interest-bearing due from banks and interest-bearing deposits with banks, Federal Reserve and other central bank deposits, securities, and loans and leases – are financed by a large base of interest-bearing funds that include client deposits, short-term borrowings, senior notes and long-term debt. Earning assets also are funded by net noninterest-related funds, which include demand deposits, and stockholders’ equity, reduced by nonearning assets such as noninterest-bearing cash and due from banks, items in process of collection, and buildings and equipment. Net interest income is subject to variations in the level and mix of earning assets and interest-bearing funds and their relative sensitivity to interest rates. In addition, the levels of nonperforming assets and client compensating deposit balances used to pay for services impact net interest income.
Net interest income in 2018 was $1.62 billion, up $193.5 million, or 14%, from $1.43 billion in 2017. Net interest income on an FTE basis for 2018 was $1.66 billion, an increase of $188.9 million, or 13%, from $1.48 billion in 2017, due to an increased net interest margin and higher levels of average earning assets. Average earning assets increased $2.6 billion, or 2%, to $113.7 billion in 2018 from $111.2 billion in 2017. The net interest margin in 2018 was 1.43%, up from 1.29% in 2017. The net interest margin on an FTE basis in 2018 was 1.46%, up from 1.33% in 2017.
Growth in average earning assets primarily reflected higher levels of securities, partially offset by reductions in loans and leases and interest-bearing due from and deposits with banks. Securities, inclusive of Federal Reserve and Federal Home Loan Bank stock and certain community development investments which are classified in other assets in the consolidated balance sheets, averaged $50.3 billion, an increase of $5.6 billion, or 12%, from $44.7 billion in 2017. Loans and leases averaged $32.0 billion, a decrease of $1.6 billion, or 5%, from $33.6 billion in 2017. Interest-bearing due from and deposits with banks averaged $6.0 billion in 2018, down $1.1 billion, or 16%, from $7.1 billion in 2017.
The increase in average earning assets was primarily funded by higher levels of short-term borrowings and interest-bearing deposits, partially offset by reductions of demand and other noninterest-bearing deposits. Average short-term borrowings increased $4.1 billion, or 61%, to $10.8 billion in 2018 from $6.7 billion in 2017. Average interest-bearing deposits increased $1.2 billion, or 2%, to $74.6 billion in 2018 from $73.4 billion in 2017. Average demand and other noninterest-bearing deposits decreased $2.6 billion, or 11%, to $20.5 billion in 2018 from $23.1 billion in 2017.
44 2018 Annual Report | Northern Trust Corporation | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Stockholders’ equity averaged $10.2 billion in 2018, compared with $10.0 billion in 2017. The increase of $248.3 million, or 2%, was attributable to current-year earnings, partially offset by the repurchase of common stock pursuant to the Corporation’s share repurchase program and dividend declarations. During the year ended December 31, 2018, the Corporation increased its quarterly common stock dividend by 31% to $0.55 per share and repurchased 9.0 million shares, returning $1.4 billion in capital to common stockholders, compared to $895.6 million in 2017.
Under the Corporation’s 2018 Capital Plan, which was reviewed without objection by the Federal Reserve, the Corporation may repurchase up to $529.5 million of common stock after December 31, 2018, through June 2019.
For additional analysis of average balances and interest rate changes affecting net interest income, refer to the Average Balance Sheets with Analysis of Net Interest Income included in “Supplemental Item – Selected Statistical and Supplemental Financial Data.”
NET INTEREST INCOME – 2017 COMPARED WITH 2016
Net interest income on an FTE basis increased 17% to $1.48 billion in 2017 from $1.26 billion in 2016, reflecting higher levels of average earning assets and an increased net interest margin. Average earning assets increased $4.1 billion, or 4%, to $111.2 billion in 2017 from $107.0 billion in 2016, primarily reflecting higher levels of securities and short-term interest-bearing deposits, partially offset by reductions in loans and leases. The net interest margin on an FTE basis increased to 1.33% in 2017 from 1.18% in 2016, primarily due to an increase in short-term interest rates.
Stockholders’ equity averaged $10.0 billion in 2017, compared with $9.1 billion in 2016. The increase in 2017 was attributable to prior-year earnings, partially offset by the repurchase of common stock pursuant to the Corporation’s share repurchase program and dividend declarations.
Provision for Credit Losses
The provision for credit losses was a credit of $14.5 million in 2018 compared with a credit provision of $28.0 million in 2017, and a credit provision of $26.0 million in 2016. The current-year provision primarily reflected reductions in outstanding loans and undrawn loan commitments and standby letters of credit and improved credit quality across the portfolio. This was partially offset by increases in specific reserves primarily related to the commercial and institutional portfolio. Nonperforming assets at December 31, 2018 decreased 24% from the prior year-end. Residential real estate, commercial, commercial real estate, and non-U.S. loans accounted for 87%, 6%, 6%, and 1% respectively, of nonperforming loans and leases at December 31, 2018. For further discussion of the allowance and provision for credit losses for 2018, 2017, and 2016, refer to the “Asset Quality” section.
Noninterest Expense
Noninterest expense for 2018 totaled $4.02 billion, up $247.5 million, or 7%, from $3.77 billion in 2017, primarily reflecting increased compensation, outside services, equipment and software expense, and employee benefits expense. The current year included higher third-party advisor costs due to a change in presentation resulting from the adoption of the new revenue recognition standard and higher expenses associated with the UBS acquisition, partially offset by lower severance-related charges. The prior year also included a one-time employee cash bonus recorded in connection with the Tax Cuts and Jobs Act.
The components of noninterest expense and a discussion of significant changes during 2018 and 2017 are provided below.
TABLE 14: NONINTEREST EXPENSE
FOR THE YEAR ENDED DECEMBER 31, | CHANGE | ||||||||||||
($ In Millions) | 2018 | 2017 | 2016 | 2018 / 2017 | 2017 / 2016 | ||||||||
Compensation | $ | 1,806.9 | $ | 1,733.7 | $ | 1,541.1 | 4 | % | 13 | % | |||
Employee Benefits | 356.7 | 319.9 | 293.3 | 12 | 9 | ||||||||
Outside Services | 739.4 | 668.4 | 627.1 | 11 | 7 | ||||||||
Equipment and Software | 582.2 | 524.0 | 467.4 | 11 | 12 | ||||||||
Occupancy | 201.1 | 191.8 | 177.4 | 5 | 8 | ||||||||
Other Operating Expense | 330.6 | 331.6 | 364.4 | — | (9 | ) | |||||||
Total Noninterest Expense | $ | 4,016.9 | $ | 3,769.4 | $ | 3,470.7 | 7 | % | 9 | % | |||
Compensation
Compensation expense, the largest component of noninterest expense, totaled $1.81 billion in 2018, up $73.2 million, or 4%, compared to $1.73 billion in 2017, reflecting increases due to higher salary expense and higher cash-based incentive
2018 Annual Report | Northern Trust Corporation 45 | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
compensation, partially offset by lower severance-related charges and a one-time employee cash bonus recorded in the prior year in connection with the Tax Cuts and Jobs Act. The increase in salary expense was primarily driven by base pay adjustments. Staff on a full-time equivalent basis totaled approximately 18,800 at December 31, 2018, up 4% from approximately 18,100 at December 31, 2017.
Employee Benefits
Employee benefits expense totaled $356.7 million in 2018, up $36.8 million, or 12%, from $319.9 million in 2017 reflecting higher retirement plan expenses, medical expenses, and payroll taxes, partially offset by lower severance-related charges.
Outside Services
Outside services expense totaled $739.4 million in 2018, up $71.0 million, or 11%, from $668.4 million in 2017, primarily reflecting a change in presentation of third-party advisor costs resulting from the adoption of the new revenue recognition accounting standard, increased costs associated with the UBS acquisition, higher technical services costs, increased restructuring charges, and higher subcustodian expense, partially offset by lower consulting services. There is a corresponding increase to trust, investment, and other servicing fees as a result of the adoption of the new revenue recognition accounting standard.
Equipment and Software
Equipment and software expense, comprised of depreciation and amortization, rental, and maintenance costs, increased $58.2 million, or 11%, to $582.2 million in 2018 compared to $524.0 million in 2017, reflecting increased software amortization and higher software-related charges.
Occupancy
Occupancy expense totaled $201.1 million in 2018, up $9.3 million, or 5%, from $191.8 million in 2017, primarily reflecting accelerated depreciation expense related to a previously-announced facility exit.
Other Operating Expense
Other operating expense in 2018 totaled $330.6 million, down $1.0 million from $331.6 million in 2017. The components of other operating expense are as follows:
TABLE 15: OTHER OPERATING EXPENSE
FOR THE YEAR ENDED DECEMBER 31, | CHANGE | ||||||||||||
($ In Millions) | 2018 | 2017 | 2016 | 2018 / 2017 | 2017 / 2016 | ||||||||
Business Promotion | $ | 98.3 | $ | 95.4 | $ | 83.6 | 3 | % | 14 | % | |||
FDIC Insurance Premiums | 27.4 | 34.7 | 31.7 | (21 | ) | 9 | |||||||
Staff Related | 33.6 | 42.8 | 43.0 | (22 | ) | (1 | ) | ||||||
Other Intangibles Amortization | 17.4 | 11.4 | 8.8 | 52 | 30 | ||||||||
Other Expenses | 153.9 | 147.3 | 197.3 | 4 | (25 | ) | |||||||
Total Other Operating Expense | $ | 330.6 | $ | 331.6 | $ | 364.4 | — | % | (9 | )% | |||
Other operating expense in the current year compared to the prior year reflects lower staff-related expense and FDIC deposit protection expense from the prior-year, offset by higher intangibles amortization driven by the UBS acquisition and increased other expenses driven primarily by higher expense associated with account servicing activities.
NONINTEREST EXPENSE – 2017 COMPARED WITH 2016
Noninterest expense in 2017 totaled $3.77 billion, up 9% from $3.47 billion in 2016, primarily reflecting increased compensation, equipment and software expense, and outside services expense. Results for 2017 included higher severance-related charges, expenses associated with the UBS acquisition, and a one-time employee cash bonus. Results for 2016 included charges relating to certain securities lending litigation, contractual modifications associated with certain existing asset servicing clients, and severance and other personnel related charges.
Compensation expense increased 13% to $1.73 billion in 2017 from $1.54 billion in 2016, reflecting higher salary expense, performance-based incentive compensation, severance-related charges, a one-time employee cash bonus recorded in 2017, and expense associated with the UBS acquisition. The increase in salary expense was driven by staff growth and base-pay adjustments.
46 2018 Annual Report | Northern Trust Corporation | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Employee benefits expense totaled $319.9 million in 2017, up 9% from $293.3 million in 2016, reflecting increases in payroll taxes, medical expense, severance-related charges, expense associated with the UBS acquisition and payroll taxes on a one-time employee cash bonus recorded in 2017.
Outside services expense totaled $668.4 million in 2017, up 7% from $627.1 million in 2016, reflecting an increase in technical services, subcustodian expense, expense associated with the UBS acquisition, and severance-related charges.
Equipment and software expense increased 12% to $524.0 million in 2017 compared to $467.4 million in 2016, reflecting increased software amortization, software support costs, computer maintenance and rental costs, and expense associated with the UBS acquisition.
Occupancy expense for 2017 was $191.8 million, up 8% from $177.4 million in 2016, primarily reflecting accelerated depreciation expense related to a previously-announced facility exit, higher rent expense, and higher costs associated with the UBS acquisition.
Other operating expense totaled $331.6 million in 2017, down 9% from $364.4 million in 2016, primarily due to charges recorded in 2016 relating to certain securities lending litigation and contractual modifications associated with existing C&IS clients, partially offset by increases in expense in 2017 related to higher business promotion expense driven by increased costs associated with the Northern Trust-sponsored PGA TOUR golf tournament, and higher charges associated with account servicing activities, supplemental compensation plans, and costs associated with the UBS acquisition.
Provision for Income Taxes
Provisions for income tax and effective tax rates are impacted by levels of pre-tax income as well as nonrecurring items such as the resolution of tax matters and changes in income tax rates and tax laws. The 2018 provision for income taxes was $401.4 million, representing an effective rate of 20.5%. This compares with a provision for income taxes of $434.9 million and an effective rate of 26.6% in 2017.
The current year includes tax benefits primarily attributable to the reduction in the U.S. corporate income tax rate from 35% to 21% as a result of the TCJA enacted in the fourth quarter of 2017, a tax benefit recognized in 2018 resulting from a change in accounting method regarding the timing of tax deductions for software-related expenses, and adjustments recorded in the current year associated with the implementation of the TCJA as outlined below. These decreases to the provision for income taxes in the current year were partially offset by the impact of an increase in income before income taxes, tax accounting changes in 2018 brought about by the TCJA including the tax accounting associated with additional non-deductible expenses, and a reduction in the income tax benefit derived from the vesting of restricted stock units and stock option exercises. Also included in the 2017 tax provision were Federal and State research tax credits related to the Corporation’s technology spend between 2013 and 2016.
The TCJA was enacted on December 22, 2017, and reduced the U.S. federal corporate tax rate from 35% to 21%. It also required companies to pay a mandatory deemed repatriation tax on earnings of foreign subsidiaries that were previously tax deferred. At December 31, 2017, Northern Trust made a reasonable estimate as to the impact of the TCJA. During 2018, Northern Trust completed the related calculations and additional analyses associated with the implementation of the TCJA, resulting in a number of adjustments to the 2018 tax provision as follows:
TABLE 16: IMPACT OF TAX CUTS AND JOBS ACT
(In Millions) | 2018 | 2017 | ||||
Federal Taxes on Mandatory Deemed Repatriation | $ | (16.8 | ) | $ | 150.0 | |
Impact Related to Federal Deferred Taxes | 12.7 | (210.0 | ) | |||
Other Adjustments | (0.7 | ) | 6.9 | |||
Provision (Benefit) for Income Taxes | $ | (4.8 | ) | $ | (53.1 | ) |
Adjustments in the above table include a tax benefit of $16.8 million resulting from an adjustment to the Corporation’s 2017 income tax provision for mandatory deemed repatriation with respect to the pre-2018 earnings of its non-US subsidiaries, offset by a $12.7 million net provision associated with the repricing of deferred taxes.
The income tax provision of $434.9 million for 2017 represented an effective tax rate of 26.6%, and reflects reductions totaling $50.0 million related to certain non-U.S. subsidiaries whose earnings were reinvested indefinitely outside of the United States. As a result of the TCJA enacted in the fourth quarter of 2017, these earnings and the earnings from prior years which have been reinvested indefinitely outside of the United States are deemed to have been repatriated to the United States and subject to a repatriation tax. As of December 31, 2018, Northern Trust’s repatriation tax has been estimated to be $133.2 million.
2018 Annual Report | Northern Trust Corporation 47 | ||
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The 2016 income tax provision of $484.6 million represented an effective tax rate of 31.9%, and reflects reductions of $50.1 million related to certain non-U.S. subsidiaries whose earnings were reinvested indefinitely outside the United States.
REPORTING SEGMENTS AND RELATED INFORMATION
Northern Trust is organized around its two client-focused reporting segments: C&IS and Wealth Management. Asset management and related services are provided to C&IS and Wealth Management clients primarily by the Asset Management business. The revenue and expenses of Asset Management and certain other support functions are allocated fully to C&IS and Wealth Management. Income and expense associated with the Corporation’s and the Bank’s wholesale funding activities and investment portfolios, as well as certain corporate-based expense, executive level compensation, and certain nonrecurring items are not allocated to C&IS and Wealth Management, and are reported in Northern Trust’s third reporting segment, Treasury and Other, in the following pages.
C&IS and Wealth Management results are presented to promote a greater understanding of their financial performance. The information, presented on an internal management-reporting basis, is derived from internal accounting systems that support Northern Trust’s strategic objectives and management structure. Management has developed accounting systems to allocate revenue and expense related to each segment. These systems incorporate processes for allocating assets, liabilities and equity, and the applicable interest income and expense. Equity is allocated to the reporting segments based on a variety of factors including, but not limited to, risk, regulatory considerations, and internal metrics. Allocations of capital and certain corporate expense may not be representative of levels that would be required if the segments were independent entities. The accounting policies used for management reporting are consistent with those described in Note 1, “Summary of Significant Accounting Policies,” to the consolidated financial statements provided in Item 8, “Financial Statements and Supplementary Data.” Transfers of income and expense items are recorded at cost; there is no consolidated profit or loss on sales or transfers between reporting segments. Northern Trust’s presentations are not necessarily consistent with similar information for other financial institutions.
TABLE 17: CONSOLIDATED FINANCIAL INFORMATION
FOR THE YEAR ENDED DECEMBER 31, | CHANGE | ||||||||||||
($ In Millions) | 2018 | 2017 | 2016 | 2018 / 2017 | 2017 / 2016 | ||||||||
Noninterest Income | |||||||||||||
Trust, Investment and Other Servicing Fees | $ | 3,753.7 | $ | 3,434.3 | $ | 3,108.1 | 9 | % | 10 | % | |||
Foreign Exchange Trading Income | 307.2 | 209.9 | 236.6 | 46 | (11 | ) | |||||||
Other Noninterest Income | 276.6 | 301.9 | 382.2 | (8 | ) | (21 | ) | ||||||
Net Interest Income (Note) | 1,663.9 | 1,475.0 | 1,260.0 | 13 | 17 | ||||||||
Revenue (Note) | 6,001.4 | 5,421.1 | 4,986.9 | 11 | |||||||||