- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
------------------------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
[_] 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. 0-5108
STATE STREET CORPORATION
(Exact name of registrant as specified in its charter)
COMMONWEALTH OF MASSACHUSETTS 04-2456637
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
225 Franklin Street 02110
Boston, Massachusetts (Zip Code)
(Address of principal
executive office)
617-786-3000
(Registrant's telephone number, including area code)
------------------------------
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 [_]
The number of shares of the Registrant's Common Stock outstanding on October
31, 1998 was 160,500,971.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
STATE STREET CORPORATION
TABLE OF CONTENTS
PAGE
-----
PART I. FINANCIAL INFORMATION
Item 1.Financial Statements
Consolidated Statements of Income....................................... 1-2
Consolidated Statement of Condition..................................... 3
Consolidated Statement of Cash Flows.................................... 4
Consolidated Statement of Changes in Stockholders' Equity............... 5
Notes to Consolidated Financial Statements.............................. 6-12
Independent Accountants' Review Report.................................. 13
Item 2.Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................. 14-23
Item 3.Quantitative and Qualitative Disclosure About Market Risk........ 24
PART II. OTHER INFORMATION
Item 6.Exhibits and Reports on Form 8-K................................. 24
Signatures.............................................................. 25
Exhibits
PART I. ITEM 1.
FINANCIAL STATEMENTS
CONSOLIDATED STATEMENT OF INCOME - STATE STREET CORPORATION (UNAUDITED)
- --------------------------------------------------------------------------------
(Dollars in millions, except per share data) Three months ended
September 30, 1998 1997
- ----------------------------------------------------------------------------------
FEE REVENUE
Fiduciary compensation............................................ $ 379 $ 324
Foreign exchange trading.......................................... 73 74
Servicing and processing.......................................... 48 37
Other............................................................. 11 7
------- -------
Total fee revenue............................................. 511 442
NET INTEREST REVENUE
Interest revenue.................................................. 602 452
Interest expense.................................................. 415 288
------- -------
Net interest revenue.......................................... 187 164
Provision for loan losses......................................... 4 5
------- -------
Net interest revenue after provision for loan losses.......... 183 159
------- -------
TOTAL REVENUE................................................. 694 601
OPERATING EXPENSES
Salaries and employee benefits.................................... 297 250
Transaction processing services................................... 49 48
Equipment......................................................... 57 42
Occupancy......................................................... 39 30
Other............................................................. 86 81
------- -------
Total operating expenses...................................... 528 451
------- -------
Income before income taxes.................................... 166 150
Income taxes...................................................... 55 49
------- -------
NET INCOME.................................................... $ 111 $ 101
======= =======
EARNINGS PER SHARE
Basic........................................................... $ .69 $ .63
Diluted......................................................... .68 .62
AVERAGE SHARES OUTSTANDING (in thousands)
Basic........................................................... 161,145 160,369
Diluted......................................................... 163,922 163,849
CASH DIVIDENDS DECLARED PER SHARE................................. $ .13 $ .11
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
1
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
CONSOLIDATED STATEMENT OF INCOME - STATE STREET CORPORATION (UNAUDITED)
- --------------------------------------------------------------------------------
(Dollars in millions, except per share data) Nine months ended
September 30, 1998 1997
- ----------------------------------------------------------------------------------
FEE REVENUE
Fiduciary compensation............................................ $ 1,106 $ 918
Foreign exchange trading.......................................... 215 170
Servicing and processing.......................................... 127 116
Other............................................................. 19 16
------- -------
Total fee revenue............................................. 1,467 1,220
NET INTEREST REVENUE
Interest revenue.................................................. 1,649 1,275
Interest expense.................................................. 1,104 807
------- -------
Net interest revenue.......................................... 545 468
Provision for loan losses......................................... 13 11
------- -------
Net interest revenue after provision for loan losses.......... 532 457
------- -------
TOTAL REVENUE................................................. 1,999 1,677
OPERATING EXPENSES
Salaries and employee benefits.................................... 857 704
Transaction processing services................................... 146 138
Equipment......................................................... 157 118
Occupancy......................................................... 107 87
Other............................................................. 242 213
------- -------
Total operating expenses...................................... 1,509 1,260
------- -------
Income before income taxes.................................... 490 417
Income taxes...................................................... 165 137
------- -------
NET INCOME.................................................... $ 325 $ 280
======= =======
EARNINGS PER SHARE
Basic........................................................... $ 2.02 $ 1.74
Diluted......................................................... 1.98 1.71
AVERAGE SHARES OUTSTANDING (in thousands)
Basic........................................................... 161,080 160,716
Diluted......................................................... 164,069 163,716
CASH DIVIDENDS DECLARED PER SHARE................................. $ .38 $ .32
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
2
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
CONSOLIDATED STATEMENT OF CONDITION - STATE STREET CORPORATION
- --------------------------------------------------------------------------------
SEPTEMBER 30, December 31,
(Dollars in millions) 1998 1997
- ------------------------------------------------------------------------------
(UNAUDITED)
ASSETS
Cash and due from banks............................ $ 2,110 $ 2,411
Interest-bearing deposits with banks............... 12,289 10,080
Securities purchased under resale agreements and
securities borrowed............................... 15,320 5,544
Federal funds sold................................. 847 621
Trading account assets............................. 310 205
Investment securities (principally available-for-
sale)............................................. 9,657 10,375
Loans (less allowance of $83 and $83).............. 6,270 5,479
Premises and equipment............................. 684 500
Customers' acceptance liability.................... 49 45
Accrued income receivable.......................... 597 566
Other assets....................................... 2,474 2,149
------- -------
TOTAL ASSETS................................... $50,607 $37,975
======= =======
LIABILITIES
Deposits:
Non-interest-bearing............................... $ 7,563 $ 7,785
Interest-bearing:
Domestic......................................... 2,398 2,374
Non-U.S. ........................................ 17,954 14,719
------- -------
Total deposits................................. 27,915 24,878
Securities sold under repurchase agreements........ 15,562 7,409
Federal funds purchased............................ 327 189
Other short-term borrowings........................ 808 609
Notes payable...................................... 44
Acceptances outstanding............................ 49 45
Accrued taxes and other expenses................... 884 831
Other liabilities.................................. 1,922 1,201
Long-term debt..................................... 922 774
------- -------
TOTAL LIABILITIES.............................. 48,389 35,980
STOCKHOLDERS' EQUITY
Preferred stock, no par: authorized 3,500,000;
issued none.......................................
Common stock, $1 par: authorized 250,000,000;
issued 167,225,000 and 167,223,000................ 167 167
Surplus............................................ 65 102
Retained earnings.................................. 2,184 1,920
Net unrealized gains............................... 23 11
Treasury stock, at cost (6,704,000 and 6,387,000
shares)........................................... (221) (205)
------- -------
TOTAL STOCKHOLDERS' EQUITY..................... 2,218 1,995
------- -------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY..... $50,607 $37,975
======= =======
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
3
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
CONSOLIDATED STATEMENT OF CASH FLOWS - STATE STREET CORPORATION (UNAUDITED)
- --------------------------------------------------------------------------------
(Dollars in millions) Nine months ended September 30, 1998 1997
- --------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net Income................................................... $ 325 $ 280
Non-cash charges for depreciation, amortization, provision
for loan losses and deferred income taxes................... 274 171
-------- -------
Net income adjusted for non-cash charges................... 599 451
Adjustments to reconcile to net cash (used) provided by
operating activities:
Securities gains, net...................................... (6) (1)
Net change in:
Trading account assets................................... (105) 149
Other, net............................................... 207 (11)
-------- -------
NET CASH PROVIDED BY OPERATING ACTIVITIES.............. 695 588
-------- -------
INVESTING ACTIVITIES
Payments for purchases of:
Available-for-sale securities.............................. (5,166) (3,999)
Held-to-maturity securities................................ (1,993) (661)
Lease financing assets..................................... (738) (882)
Premises and equipment..................................... (200) (84)
Proceeds from:
Maturities of available-for-sale securities................ 5,418 2,675
Maturities of held-to-maturity securities.................. 1,704 640
Sales of available-for-sale securities..................... 755 277
Principal collected from lease financing................... 63 49
Net payments for:
Interest-bearing deposits with banks....................... (2,209) (1,261)
Federal funds sold, resale agreements and securities
borrowed.................................................. (10,002) (569)
Loans...................................................... (556) (416)
-------- -------
NET CASH USED BY INVESTING ACTIVITIES.................. (12,924) (4,231)
-------- -------
FINANCING ACTIVITIES
Proceeds from issuance of:
Long-term debt............................................. 149 300
Non-recourse debt for lease financing...................... 524 687
Notes payable.............................................. 1
Treasury stock............................................. 17 8
Payments for:
Maturities of notes payable................................ (44)
Non-recourse debt for lease financing...................... (95) (78)
Long-term debt............................................. (1) (1)
Cash dividends............................................. (61) (51)
Purchase of common stock................................... (88) (99)
Net proceeds from:
Deposits................................................... 3,037 2,592
Short-term borrowings...................................... 8,490 171
-------- -------
NET CASH PROVIDED BY FINANCING ACTIVITIES.............. 11,928 3,530
-------- -------
NET DECREASE........................................... (301) (113)
Cash and due from banks at beginning of period............... 2,411 1,623
-------- -------
CASH AND DUE FROM BANKS AT END OF PERIOD............... $ 2,110 $ 1,510
======== =======
SUPPLEMENTAL DISCLOSURE
Interest paid.............................................. $ 1,091 $ 810
Income taxes paid.......................................... 94 61
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
4
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY - STATE STREET
CORPORATION (UNAUDITED)
- --------------------------------------------------------------------------------
(Dollars in millions, except per share data) Nine months ended September 30,
1998 1997
- -------------------------------------------------------------------------------
COMMON STOCK
Balance at beginning of period..................... $ 167 $ 84
Stock dividend, two-for-one split.................. 83
------ ------
Balance at end of period......................... 167 167
------ ------
SURPLUS
Balance at beginning of period..................... 102 105
Treasury stock issued.............................. (37) (8)
------ ------
Balance at end of period......................... 65 97
------ ------
RETAINED EARNINGS
Balance at beginning of period..................... 1,920 1,694
Net Income......................................... 325 $325 280 $280
Stock dividend, two-for-one split.................. (83)
Cash dividends declared ($.38 and $.32 per share).. (61) (51)
------ ------
Balance at end of period......................... 2,184 1,840
------ ------
NET UNREALIZED GAINS (LOSSES)--OTHER COMPREHENSIVE
INCOME
Balance at beginning of period..................... 11 12
Foreign currency translation....................... 3 3 (7) (7)
Change in net unrealized holdings on available-for-
sale securities................................... 9 9 6 6
------ ---- ------ ----
12 (1)
---- ----
Balance at end of period......................... 23 11
------ ------
Comprehensive Income............................... $337 $279
==== ====
TREASURY STOCK, AT COST
Balance at beginning of period..................... (205) (120)
Common stock acquired (1,500,000 and 2,359,200
shares)........................................... (88) (99)
Treasury stock issued (1,536,373 and 430,262
shares)........................................... 72 20
------ ------
Balance at end of period......................... (221) (199)
------ ------
TOTAL STOCKHOLDERS' EQUITY....................... $2,218 $1,916
====== ======
- --------------------------------------------------------------------------------
The accompanying notes are an integral part of these financial statements.
5
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - STATE STREET CORPORATION
(UNAUDITED)
NOTE A--BASIS OF PRESENTATION
State Street Corporation ("State Street" or the "Corporation") is a
financial services corporation that provides banking, global custody,
investment management, administration and securities processing services to
both U.S. and non-U.S. customers. State Street reports three lines of
business. Services for Institutional Investors include accounting, custody,
daily pricing, administration, foreign exchange, cash management and
information services to support institutional investors and for large
portfolios of investment assets. Investment Management provides an extensive
array of services for managing financial assets worldwide for both
institutional and individual investors as well as recordkeeping and investment
services for defined contribution plans. Commercial Lending activities include
loans and other banking services for regional middle-market companies,
selected industries nationwide, broker/dealers, leasing and international
trade finance.
The consolidated financial statements include the accounts of State Street
and its subsidiaries, including its principal subsidiary, State Street Bank
and Trust Company ("State Street Bank"). The preparation of financial
statements requires management to make estimates and assumptions that affect
the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates. All significant intercompany
balances and transactions have been eliminated upon consolidation. The results
of operations of businesses purchased are included from the date of
acquisition. Investments in affiliates owned less than 50% are accounted for
by the equity method. Certain previously reported amounts have been
reclassified to conform to the current method of presentation.
For the Consolidated Statement of Cash Flows, State Street has defined cash
equivalents as those amounts included in the Consolidated Statement of
Condition caption, "Cash and due from banks".
Effective January 1, 1998, State Street adopted SFAS No. 130, "Reporting
Comprehensive Income" which establishes standards for reporting comprehensive
income. Disclosures required by SFAS No. 130 are presented in the Statement of
Changes in Stockholders' Equity and Note E to the Consolidated Financial
Statements.
In 1997, SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information" was issued. This statement establishes standards for
reporting information about operating segments in annual and interim financial
statements. This statement is effective for annual periods beginning after
December 15, 1997, and for interim periods beginning after December 15, 1998.
State Street will adopt the new disclosures required by SFAS No. 131 for the
year ending December 31, 1998. State Street does not expect its current
disclosures to change significantly under SFAS No. 131.
Statement of Position 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" was issued in March 1998. State Street
will adopt this standard effective January 1, 1999. Management is currently
evaluating the impact of this statement.
On June 16, 1998, SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities" was issued. This statement requires companies to record
the fair value of derivatives on the balance sheet as assets or liabilities.
Fair market valuation adjustments for derivatives meeting hedge criteria will
be recorded in either other comprehensive income in Shareholders' Equity or
through earnings in the Statement of Income, depending on their
classification. Derivatives used for trading purposes will continue to be
marked to market through earnings. This statement is effective for State
Street beginning January 1, 2000. Management is currently evaluating the
impact of this statement.
In the opinion of management, all adjustments consisting of normal recurring
accruals, which are necessary for a fair presentation of the financial
position of State Street and subsidiaries at September 30, 1998 and
6
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - STATE STREET CORPORATION
(UNAUDITED)
NOTE A--BASIS OF PRESENTATION (CONTINUED)
December 31, 1997, and its cash flows and consolidated results of its
operations for the three and nine months ended September 30, 1998 and 1997,
have been made. These statements should be read in conjunction with the
financial statements and other information included in State Street's latest
annual report on form 10-K.
NOTE B--INVESTMENT SECURITIES
Available-for-sale securities are recorded at fair value and held-to
maturity securities are recorded at amortized cost. Investment securities
consisted of the following as of the dates indicated:
- -----------------------------------------------------------------------------------
SEPTEMBER 30, 1998 DECEMBER 31, 1997
-------------------------- --------------------------
UNREALIZED UNREALIZED
------------ FAIR ------------ FAIR
(Dollars in millions) COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
- -----------------------------------------------------------------------------------
Available for sale:
U.S. Treasury and
Federal agencies...... $3,870 $21 $ 1 $3,890 $4,906 $15 $ 2 $4,919
State and political
subdivisions.......... 1,724 18 4 1,738 1,647 17 7 1,657
Asset-backed securi-
ties.................. 1,341 2 1 1,342 1,673 1 1 1,673
Collateralized mortgage
obligations........... 723 1 1 723 574 1 4 571
Other investments...... 776 13 2 787 654 9 1 662
------ --- --- ------ ------ --- --- ------
Total.................. $8,434 $55 $ 9 $8,480 $9,454 $43 $15 $9,482
====== === === ====== ====== === === ======
Held to maturity:
U.S. Treasury and
Federal agencies...... $1,177 $ 6 $1,183 $ 893 $ 1 $ 1 $ 893
====== === === ====== ====== === === ======
- -------------------------------------------------------------------------------
During the nine months ended September 30, 1998, there were gross gains of
$7.4 million and gross losses of less than $1 million realized on the sales of
$755 million of available-for-sale securities. During the nine months ended
September 30, 1997, there were gross gains of $1.3 million and gross losses of
less than $1 million realized on the sales of $277 million of available-for-
sale securities.
NOTE C--ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level believed adequate by
management to absorb estimated probable credit losses. Management's periodic
evaluation of the adequacy of the allowance for loan losses is based on State
Street's past loan loss experience, known and inherent risks in the portfolio,
current economic conditions and adverse situations that may affect the
borrowers' ability to repay, timing of future payments, estimated value of any
underlying collateral, and the performance of individual credits in relation
to contract terms and other relevant factors. The provision for loan losses
charged to earnings is based upon management's judgment of the amount
necessary to maintain the allowance at a level adequate to absorb estimated
probable credit losses.
Changes in the allowance for loan losses were as follows:
- ------------------------------------------------------------------------------
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
(Dollars in millions) 1998 1997 1998 1997
- ------------------------------------------------------------------------------
Balance at beginning of
period........................ $ 93 $ 74 $ 83 $ 73
Provision for loan losses...... 4 5 13 11
Loan charge-offs............... (15) (1) (15) (7)
Recoveries..................... 1 1 2 2
--------- --------- --------- ---------
Balance at end of period..... $ 83 $ 79 $ 83 $ 79
========= ========= ========= =========
- -------------------------------------------------------------------------------
7
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - STATE STREET CORPORATION
(UNAUDITED)
NOTE D--REGULATORY MATTERS
The regulatory capital amounts and ratios were the following at September
30, 1998, and December 31, 1997:
- ------------------------------------------------------------------------------------------------
REGULATORY GUIDELINES(1) STATE STREET STATE STREET BANK
------------------------------ ---------------- ------------------
WELL
(Dollars in millions) MINIMUM CAPITALIZED 1998 1997 1998 1997
- ------------------------------------------------------------------------------------------------
Risk-based ratios:
Tier 1 capital........ 4% 6% 14.3% 13.7% 12.9% 12.2%
Total capital......... 8 10 14.6 13.8 13.4 12.5
Leverage ratio.......... 3 5 5.5 5.9 5.4 5.2
Tier 1 capital.......... $ 2,624 $ 2,259 $ 2,354 $ 1,996
Total capital........... 2,671 2,274 2,436 2,040
Risk-based assets:
On-balance sheet...... $13,892 $12,647 $ 13,722 $ 12,491
Off-balance sheet..... 4,273 3,825 4,273 3,825
Market-risk
equivalent(2)........ 184 184
------- ------- -------- --------
Total risk-based
assets............. $18,349 $16,472 $ 18,179 $ 16,316
======= ======= ======== ========
- -------------------------------------------------------------------------------
(1) The regulatory designation of "well capitalized" under prompt corrective
action regulations is not applicable to bank holding companies (State
Street). Regulation Y defines well capitalized for bank holding companies
(State Street) for the purpose of determining eligibility for a
streamlined review process for acquisition proposals. For such purposes,
qualifying as well capitalized requires a minimum Tier 1 risk-based
capital ratio of 6% and a minimum total risk-based capital ratio of 10%.
(2) Effective January 1, 1998, regulatory capital standards require the
addition of market risk equivalent assets to total risk-based assets.
- -------------------------------------------------------------------------------
NOTE E--STOCKHOLDERS' EQUITY
The components of other comprehensive income for the nine months ended
September 30 consisted of the following:
- ----------------------------------------------------------------------------------------
1998 1997
------------------------------- -------------------------------
PRETAX TAX (EXPENSE) NET OF TAX PRETAX TAX (EXPENSE) NET OF TAX
(Dollars in Millions) INCOME BENEFIT AMOUNT INCOME BENEFIT AMOUNT
- ----------------------------------------------------------------------------------------
Net unrealized gains
(losses) on:
Foreign currency
translation.......... $ 5 $(2) $ 3 $(11) $ 4 $(7)
Available-for-sale
securities held as of
period end........... 16 (7) 9 10 (4) 6
--- --- --- ---- --- ---
Other comprehensive
income............. $21 $(9) $12 $ (1) $ $(1)
=== === === ==== === ===
- -------------------------------------------------------------------------------
8
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - STATE STREET CORPORATION
(UNAUDITED)
NOTE E--STOCKHOLDERS' EQUITY (CONTINUED)
On September 17, 1998, the Board of Directors authorized a two million share
increase in its stock purchase program. As of September 30, 1998, 10.5 million
shares have been acquired under the stock purchase program. The expanded
program allows for the purchase of a further 3.5 million shares.
NOTE F--NET INTEREST REVENUE
Net interest revenue consisted of the following:
- ------------------------------------------------------------------------------
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------------------- -------------------
(Dollars in millions) 1998 1997 1998 1997
- ------------------------------------------------------------------------------
INTEREST REVENUE
Deposits with banks................... $ 145 112 $ 406 $ 297
Investment securities:
U.S. Treasury and Federal agencies.. 72 92 237 270
State and political subdivisions
(exempt from Federal tax).......... 20 19 59 58
Other investments................... 39 42 122 118
Loans................................. 104 90 294 248
Securities purchased under resale
agreements, securities borrowed and
Federal funds sold................... 219 95 524 278
Trading account assets................ 3 2 7 6
--------- --------- --------- ---------
Total interest revenue.............. 602 452 1,649 1,275
--------- --------- --------- ---------
INTEREST EXPENSE
Deposits.............................. 172 135 493 363
Other borrowings...................... 225 138 562 404
Long-term debt........................ 18 15 49 40
--------- --------- --------- ---------
Total interest expense.............. 415 288 1,104 807
--------- --------- --------- ---------
Net interest revenue................ $ 187 $ 164 $ 545 $ 468
========= ========= ========= =========
- --------------------------------------------------------------------------------
NOTE G--OPERATING EXPENSES--OTHER
The other category of operating expenses consisted of the following:
- ----------------------------------------------------------------------------------
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- -------------------
(Dollars in millions) 1998 1997 1998 1997
- ----------------------------------------------------------------------------------
Professional services................... $ 27 $ 24 $ 74 $ 61
Advertising and sales promotion......... 17 13 46 37
Postage, forms and supplies............. 7 6 23 20
Telecommunications...................... 9 7 26 20
Other................................... 26 31 73 75
--------- --------- --------- ---------
Total operating expenses--other....... $ 86 $ 81 $ 242 $ 213
========= ========= ========= =========
- --------------------------------------------------------------------------------
9
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - STATE STREET CORPORATION
(UNAUDITED)
NOTE H--INCOME TAXES
The provision for income taxes included in the Consolidated Statement of
Income is comprised of the following:
- --------------------------------------------------------------------------------
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- ---------------------
(Dollars in millions) 1998 1997 1998 1997
- --------------------------------------------------------------------------------
Current............................ $ 3 $ 34 $ 37 $ 58
Deferred........................... 52 15 128 79
--------- --------- --------- ----------
Total provision.................. $ 55 $ 49 $ 165 $ 137
========= ========= ========= ==========
Effective tax rate................. 33.2% 32.5% 33.6% 39.2%
========= ========= ========= ==========
- -------------------------------------------------------------------------------
NOTE I--EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings
per share:
- -----------------------------------------------------------------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -----------------
(Dollars in millions, except per share data;
shares in thousands) 1998 1997 1998 1997
- -----------------------------------------------------------------------------------
Net Income.................................. $ 111 $ 101 $ 325 $ 280
========= ========= ======== ========
Basic Average Shares........................ 161,145 160,369 161,080 160,715
Stock options and stock awards............ 1,948 2,421 2,120 1,916
7.75% convertible subordinated deben-
tures.................................... 829 1,059 869 1,085
--------- --------- -------- --------
Dilutive average shares................. 163,922 163,849 164,069 163,716
========= ========= ======== ========
Basic earnings per share.................... $ .69 $ .63 $ 2.02 $ 1.74
========= ========= ======== ========
Diluted earnings per share.................. $ .68 $ .62 $ 1.98 $ 1.71
========= ========= ======== ========
- -------------------------------------------------------------------------------
NOTE J--COMMITMENTS AND CONTINGENT LIABILITIES
State Street provides banking, global custody, investment management,
administration and securities processing services to both U.S. and non-U.S.
customers. Assets under custody and assets under management are held by State
Street in a fiduciary or custodial capacity and are not included in the
Consolidated Statement of Condition because such items are not assets of State
Street. Management conducts regular reviews of its responsibilities for these
services and considers the results in preparing its financial statements. In
the opinion of management, there are no contingent liabilities at September
30, 1998, that would have a material adverse effect on State Street's
financial position or results of operations.
State Street is subject to pending and threatened legal actions that arise
in the normal course of business. In the opinion of management, after
discussion with counsel, these actions can be successfully defended or
resolved without a material adverse effect on State Street's financial
position or results of operations.
10
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - STATE STREET CORPORATION
(UNAUDITED)
NOTE K--OFF-BALANCE SHEET FINANCIAL INSTRUMENTS, INCLUDING DERIVATIVES
State Street uses various off-balance sheet financial instruments, including
derivatives, to satisfy the financing and risk management needs of customers,
to manage interest rate and currency risk and to conduct trading activities.
In general terms, derivative instruments are contracts or agreements whose
value can be derived from interest rates, currency exchange rates and/or other
financial indices. Derivative instruments include forwards, futures, swaps,
options and other instruments with similar characteristics. The use of these
instruments generate fee, interest or trading revenue. Associated with these
instruments are market and credit risks that could expose State Street to
potential losses.
A table which summarizes the contractual or notional amounts of significant
derivative financial instruments held or issued by State Street is as follows:
- --------------------------------------------------------------------------------
SEPTEMBER 30, DECEMBER 31,
(Dollars in millions) 1998 1997
- --------------------------------------------------------------------------------
Trading:
Interest rate contracts:
Swap agreements.................................. $ 799 $ 1,015
Options and caps purchased....................... 34 38
Options and caps written......................... 179 186
Futures--short position.......................... 824 594
Options on futures purchased..................... 5
Options on futures written....................... 8
Foreign exchange contracts:
Forward, swap and spot........................... 141,075 91,742
Options purchased................................ 204 144
Options written.................................. 201 138
Balance Sheet Management:
Interest rate contracts:
Swap agreements.................................. 808 243
Options and caps purchased....................... 30 50
Foreign exchange contracts:
Forward, swap and spot........................... 44
- -------------------------------------------------------------------------------
11
PART I. ITEM 1.
FINANCIAL STATEMENTS (CONTINUED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - STATE STREET CORPORATION
(UNAUDITED)
NOTE K--OFF-BALANCE SHEET FINANCIAL INSTRUMENTS, INCLUDING DERIVATIVES
(CONTINUED)
A table which summarizes the fair value of financial instruments held or
issued for trading purposes is as follows:
- ---------------------------------------------------------------------------------
SEPTEMBER 30, 1998 DECEMBER 31, 1997
-------------------- ------------------
AVERAGE AVERAGE
FAIR FAIR FAIR FAIR
(Dollars in millions) VALUE VALUE VALUE VALUE
- ---------------------------------------------------------------------------------
Foreign exchange contracts:
Contracts in a receivable position..... $ 1,589 $ 1,232 $ 1,037 $ 1,064
Contracts in a payable position........ 1,583 1,221 1,036 1,087
Other financial instrument contracts:
Contracts in a receivable position..... 5 10 3 7
Contracts in a payable position........ 9 7 2 5
- -------------------------------------------------------------------------------
The preceding amounts have been reduced by offsetting balances with the
counterparty where a master netting agreement exists. Contracts in a
receivable position are shown in other assets on the balance sheet and
contracts in a payable position are shown in other liabilities.
Credit-related financial instruments include commitments to extend credit,
standby letters of credit, letters of credit and indemnified securities lent.
The maximum credit risk associated with credit-related financial instruments
is measured by the contractual amounts of these instruments. A summary of the
contractual amount of State Street's credit-related, off-balance sheet
financial instruments is as follows:
- --------------------------------------------------------------------------------
SEPTEMBER 30, DECEMBER 31,
(Dollars in millions) 1998 1997
- --------------------------------------------------------------------------------
Indemnified securities on loan....................... $70,590 $57,465
Loan commitments..................................... 8,764 7,294
Standby letters of credit............................ 1,710 1,821
Letters of credit.................................... 215 179
- -------------------------------------------------------------------------------
On behalf of its customers, State Street lends their securities to
creditworthy brokers and other institutions. In certain circumstances, State
Street may indemnify its customers for the fair market value of those
securities against a failure of the borrower to return such securities. State
Street requires the borrowers to provide collateral in an amount equal to or
in excess of 102% of the fair market value of the securities borrowed. The
borrowed securities are revalued daily to determine if additional collateral
is necessary. State Street held, as collateral, cash and U.S. Government
securities totaling $73 billion and $59 billion for indemnified securities on
loan at September 30, 1998 and December 31, 1997, respectively.
Loan and letter-of-credit commitments are subject to the same credit
policies and reviews as loans on the balance sheet. Collateral, both the
amount and nature, is obtained based upon management's assessment of the
credit risk. Approximately 70% of the loan commitments expire in one year or
less from the date of issue. Since many of the extensions of credit are
expected to expire without being drawn upon, the total commitment amounts do
not necessarily represent future cash requirements.
12
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
The Stockholders and Board of Directors
State Street Corporation
We have reviewed the accompanying consolidated statement of condition of
State Street Corporation (State Street) as of September 30, 1998, and the
related consolidated statements of income for the three-month and nine-month
periods ended September 30, 1998 and 1997, and the statements of cash flows
and changes in stockholders' equity for the nine-month periods ended September
30, 1998 and 1997. These financial statements are the responsibility of State
Street's management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data, and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, which will
be performed for the full year with the objective of expressing an opinion
regarding the financial statements taken as a whole. Accordingly, we do not
express such an opinion.
Based on our reviews, we are not aware of any material modifications that
should be made to the accompanying consolidated financial statements referred
to above for them to be in conformity with generally accepted accounting
principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated statement of condition of State Street Corporation
as of December 31, 1997 (presented herein), and the related consolidated
statements of income, cash flows and changes in stockholders' equity for the
year then ended (not presented herein), and in our report dated January 13,
1998, we expressed an unqualified opinion on those consolidated financial
statements.
ERNST & YOUNG LLP
Boston, Massachusetts
October 13, 1998
13
PART I. ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
SUMMARY
Earnings per share for the third quarter were $.68 on a diluted basis, an
increase of 10% from $.62 in the third quarter of 1997. Revenue grew 15%, from
$612 million to $704 million. Net income was $111 million, up from $101
million a year ago. Return on stockholders' equity was 20.0%.
CONDENSED INCOME STATEMENT--TAXABLE EQUIVALENT BASIS
- ---------------------------------------------------------------------------------------------------------
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------------ ------------------------------------
(Dollars in millions, except
per share data) 1998 1997 CHANGE % 1998 1997 CHANGE %
- ---------------------------------------------------------------------------------------------------------
Fee revenue:
Fiduciary compensation.... $ 379 $ 324 $ 55 17 $ 1,106 $918 $ 188 21
Foreign exchange trading.. 73 74 (1) (1) 215 170 45 26
Servicing and processing.. 48 37 11 28 127 116 11 9
Other..................... 11 7 4 74 19 16 3 21
-------- -------- -------- --------- --------- -------
Total fee revenue....... 511 442 69 16 1,467 1,220 247 20
Net interest revenue........ 197 175 22 13 575 502 73 15
Provision for loan losses... 4 5 (1) (20) 13 11 2 18
-------- -------- -------- --------- --------- -------
Total revenue........... 704 612 92 15 2,029 1,711 318 19
Operating expenses.......... 528 451 77 17 1,509 1,260 249 20
-------- -------- -------- --------- --------- -------
Income before taxes....... 176 161 15 10 520 451 69 16
Income taxes................ 55 49 6 13 165 137 28 20
Taxable equivalent
adjustment................. 10 11 (1) (1) 30 34 (4) (10)
-------- -------- -------- --------- --------- -------
Net income.............. $ 111 $ 101 $ 10 10 $ 325 $ 280 $ 45 16
======== ======== ======== ========= ========= =======
Earnings Per Share
Basic..................... $ .69 $ .63 $ .06 10 $ 2.02 $ 1.74 $ .28 16
Diluted................... .68 .62 .06 10 1.98 1.71 .27 16
- -------------------------------------------------------------------------------
(Percentage change based on dollars in thousands, except per share data)
TOTAL REVENUE
Total revenue for the quarter was $704 million, up $92 million, or 15%, from
a year ago. For the nine months ended September 30, 1998, total revenue was
$2.0 billion, up $318 million, or 19%, from 1997. Revenue for the third
quarter and the nine months ended September 30, 1998 increased due to growth
in both fee revenue and net interest revenue.
FEE REVENUE
Fee revenue in the third quarter of 1998 was $511 million, up 16% from a
year ago.
Fiduciary compensation, the largest component of fee revenue, is generated
by services for institutional investors and investment management. Fiduciary
compensation was $379 million for the quarter, up $55 million, or 17%, from a
year ago. This increase was driven by expanded and new customer relationships.
On a sequential quarter basis, fiduciary compensation was down slightly,
despite new business installed, due to declining securities market valuations.
14
PART I. ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
Services for institutional investors, which include accounting, custody,
recordkeeping and information services, reflected broad-based growth. Total
assets under custody at September 30, 1998, increased 15% from a year ago to
$4.3 trillion. Measured against second quarter, assets under custody declined
by $177 billion due to the impact of lower securities market valuations,
offset in part by new business.
Revenue from mutual funds reflected new business from new and existing
customers and asset growth. Total mutual fund assets under custody at
September 30, 1998, increased 14% with year-over-year growth in both U.S. and
non-U.S. assets. Assets for which State Street provides accounting services
increased 18%. Revenue from servicing offshore funds and from mutual fund
administration reflected strong growth.
Revenue from servicing U.S. pension plans increased primarily due to new
business reflecting growth in portfolio accounting and custody services.
Growth was dampened by decreased securities lending revenue.
Outside the United States, revenue growth was driven by additional business
from new and existing customers, including business gained through the
acquisition of a unit trust trusteeship business in the United Kingdom. Assets
under custody for non-U.S. customers at September 30, 1998, increased 13% from
a year ago.
Revenue from investment management reflected growth across all services--
investment management for institutional investors, recordkeeping and
investment services for defined contribution plans, and investment services
for high-net-worth individuals. Revenue from managing assets for institutional
investors was driven primarily by new relationships, additional contributions
from existing customers and higher securities values. Total assets managed
increased 11% from a year ago to $422 billion. Measured against second
quarter, assets under management were down $37 billion, or 8%, primarily due
to declining market values.
Foreign exchange trading revenue was $73 million in the quarter, down
slightly from a year ago. New business is attributable to State Street's on-
line research, trade execution and trade confirmation services, which are
encouraging existing customers to expand relationships and attracting new
customers. The volume of trades, as measured in dollars, increased 16% from a
year ago.
Servicing and processing fee revenue was $48 million in the quarter,
compared to $37 million a year ago. The increase is due to a higher level of
demand for brokerage services and software products.
For the nine months ended September 30, 1998, fee revenue was $1.5 billion,
up $247 million, or 20% from a year ago. Fiduciary compensation increased $188
million, or 21%. Foreign exchange trading revenue increased $45 million, or
26%, due to new business and active currency markets.
NET INTEREST REVENUE
Taxable equivalent net interest revenue for the third quarter was $197
million, up $22 million, or 13%, from a year ago due primarily to a $12
billion, or 38%, increase in average interest-earning assets. State Street
uses its balance sheet to support the cash management needs of institutional
investors. These customers, in conjunction with their worldwide investment
activities, made increased use of securities sold under repurchase agreements
and deposits, which were invested primarily in low-risk assets by
State Street. Strong growth in securities sold under repurchase agreements, up
$5.8 billion, and non-U.S. deposits, up $3.9 billion, contributed to the
revenue increase.
15
PART I. ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
Net interest margin declined by 38 basis points due to the narrower spread
of rates earned over rates paid, along with higher volumes of foreign deposits
and securities sold under repurchase agreements.
- --------------------------------------------------------------------------------
THREE MONTHS ENDED SEPTEMBER 30,
1998 1997
---------------- ----------------
AVERAGE AVERAGE
(Dollars in millions) BALANCE RATE BALANCE RATE
- --------------------------------------------------------------------------------
Interest-earning assets..................... $ 43,922 5.54% $ 31,899 5.76%
Interest-bearing liabilities................ 37,098 4.39 26,597 4.30
------ ------
Excess of rates earned over rates paid.... 1.15% 1.46%
====== ======
Net Interest Margin......................... 1.79% 2.17%
====== ======
- -------------------------------------------------------------------------------
For the nine months ended September 30, 1998, taxable equivalent net
interest revenue was $575 million, up $73 million, or 15%, from the same
period in 1997 due to a $9.3 billion, or 31%, increase in average interest-
earning assets. The growth in average interest-earning assets was driven
primarily by a $3.7 billion increase in non-U.S. deposits and a $3.5 billion
increase in securities sold under repurchase agreements.
OPERATING EXPENSES
Operating expenses for the quarter were $528 million, up $77 million, or
17%, from the third quarter of 1997, supporting business expansion and
investments in capabilities and capacity for future growth, and acquisitions.
Salaries and employee benefits in the quarter were $297 million, up $47
million, or 19%, due to increased staffing and acquisitions. The increases in
staffing and business growth contributed to the 34% increase in equipment
expense, which was $57 million for the quarter, and the 29% increase in
occupancy expense, which was $39 million for the quarter.
For the nine-month period ended September 30, 1998, operating expenses were
up $249 million, or 20%, due primarily to increased salaries and employee
benefits costs.
RESOLUTION 2000
Program Scope and Oversight. The approaching Year 2000 presents companies in
all industries with a myriad of challenges to ensure compliance of its
computer systems and processes. These challenges stem from a once-common
programming standard using two-digit years for date fields contained in
computer programs and related data. Commencing in 1996, State Street assessed
the impact of the upcoming Year 2000 on its operations and has developed a
comprehensive program, Resolution 2000, to address the related issues.
This program covers six major areas of Year-2000 compliance: Information
Technology ("IT") Infrastructure, Global Data Networks, Core Application
Software, Business Area Supported Applications, Facilities, and Third Party
Suppliers. Information Technology Infrastructure, Global Data Networks and
Core Application Software make up what is commonly referred to as Information
Technology Systems. More specifically, Information Technology Infrastructure
is the hardware and system software required to support the Core Application
Software, which consists of State Street's Custody, Accounting, Deposits,
Loans, Cash Management and Investment Management systems. Global Data Networks
consist of the wide and local area networks and telephone/PBX systems.
Business Area Supported Applications are those desktop applications developed
and supported by non-IT areas, and includes office equipment such as fax
machines. Facilities is the embedded technology used throughout State Street's
offices, for example uninterrupted power supply, fire alarms, security and
heating and air-conditioning systems. Third-Party Suppliers refers to all
external parties that have the potential to impact State Street's ability to
deliver compliant products and services, such as vendors, service providers,
subcustodian banks, counterparties business partners, and customers.
16
PART I. ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
State Street engaged a consulting firm at the onset of the Resolution 2000
program to assist in the area of program management, and to provide technical
professional resources to the program as required. This firm was selected for
its recognized leadership in management of large-scale information technology
programs and for its established methodology. This methodology forms the basis
for State Street's activities with its consultant in applying the Resolution
2000 program to the Core Application Software area. Under this program, there
is a phased approach followed with each element of the program which includes:
inventorying potentially date sensitive items; assigning a business risk
rating to each item; assessing the compliance status of each item; taking
corrective action to renovate, replace, retire, upgrade or outsource to
achieve compliance; validating compliance through several levels of testing
(regression, internal and external Year-2000 testing); and developing and
validating business resumption contingency plans for each critical business
function as required. All major areas of the Resolution 2000 program are
performing these activities.
A central program management office, global compliance teams, and a
corporate governance/oversight structure support the Resolution 2000 program.
Program updates, progress reports, and critical matters are regularly
communicated to senior management and the Board of Directors.
The Resolution 2000 program activities are incorporated into State Street's
corporate risk management functions. In addition, these activities are subject
to ongoing assurance reviews, which include internal audits, regulatory
examinations performed by the Federal Reserve, and compliance procedures
performed by external auditors in connection with third party reviews and
financial statement audits.
State of Readiness. At September 30, 1998, the inventorying, risk
assessments and compliance assessment work had been completed by State Street
and corrective actions and internal Year-2000 testing were well underway.
External testing with key industry organizations such as the Federal Reserve,
Depository Trust Corporation, and Society for Worldwide Interbank Financial
Telecommunications (SWIFT), had commenced with all tests to date successfully
completed. External testing with subcustodians will begin in the fourth
quarter of 1998 and customer testing will begin in the first quarter of 1999.
State Street currently anticipates that its Year-2000 compliance inventory,
assessment, correction and internal testing efforts which commenced at the
beginning of 1996 will be substantially completed by December 31, 1998 with
all internal testing being completed by March 31, 1999. External testing will
be a key focus in the first half of 1999 and is expected to be complete in the
third quarter of 1999. State Street's Year-2000 contingency planning program
is underway, leveraging the strength of State Street's business resumption
contingency plans. Year-2000 contingency plan development is expected to be
complete by the second quarter of 1999. Validation of these plans will be
completed in the third quarter of 1999.
Progress as of September 30, 1998 is as follows:
REGRESSION
TESTING AND INTERNAL
PRODUCTION YEAR-2000
CORRECTION IMPLEMENTATION TESTING
---------- -------------- ---------
IT Infrastructure....................... 95% 90% 90%
Global Data Networks.................... 95% 50% 95%
Core Application Software............... 90% 80% 50%
Business Area Supported Applications.... 70% 30% 45%
Facilities.............................. 85% 85% 70%
17
PART I. ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
Progress at September 30, 1998 related to the Third Party Suppliers, which
could impact State Street's ability to deliver compliant products and
services, is as follows:
Internal communications with vendors, to obtain information on the
compliance status of the products and services provided to State Street has
been completed. Key vendors have been asked to present updates to State
Street on their compliance programs and related progress. Eighty percent
have been assessed and necessary action plans are being developed for
issues identified in these assessments of key vendors. With respect to
those products and services that are considered high-risk, State Street has
substantially completed development of contingency remediation plans.
Year-2000 compliance has been incorporated into State Street's existing due
diligence procedures performed with business partner and counterparty
relationships. Year-2000 assessments of business partners has been
completed and the current and future focus has turned to implementation of
remediations and contingency planning. Year-2000 counterparty assessments
are substantially complete, in line with the recommendations of the Federal
Financial Institutions Examination Council (FFIEC).
Year-2000 compliance has been incorporated into the existing due diligence
for its subcustodian bank network. In addition, questionnaires have been
sent to the subcustodians focusing on the adequacy of its compliance
program and implementation plans, including testing with State Street.
Subcustodian contingency planning efforts aimed at identifying alternative
subcustodian banks in each of State Street's markets is near completion.
Test planning activities are currently underway, and live testing is
expected to begin in the Fourth Quarter 1998.
Certain IT projects have been delayed due to resources committed to the
Resolution 2000 program. The impact of these delays is not expected to have a
material adverse impact on State Street's financial condition or results from
operations.
Risks of Year-2000 Issues. State Street's businesses are substantially
dependent upon its data processing software and hardware systems, and upon its
ability to process information. If State Street failed to be Year-2000
compliant, as compared to its competitors; there could be an adverse effect on
State Street's business. In addition, since State Street is regulated by
various regulatory agencies of state and federal banking authorities, failure
to be Year-2000 compliant could subject State Street to formal supervisory or
enforcement actions, which could have an adverse impact on State Street's
business.
Contingency Plans. State Street cannot control the success of each third
party's Year-2000 compliance program. In instances where the risk of Year-2000
compliance failure is high and there is potential for not providing or not
receiving a compliant product, or if scheduled delivery is beyond an
acceptable date, State Street will adopt business contingency plans. To
mitigate the effects of its or significant customers' or supplier/vendors'
potential failure to remediate the Year-2000 issue in a timely manner, State
Street would take reasonable contingency actions, which may include
implementing alternatives, using manual workarounds and event management. The
ultimate goal in developing contingency plans is to have an uninterrupted flow
of information between State Street and third party providers in the Year 2000
and beyond. State Street expects to have contingency plans in place by the
second quarter of 1999. If it becomes necessary for State Street to take these
corrective actions, it is uncertain, until the contingency plans are
implemented, whether this would result in significant delays in business
operations or have a material adverse effect on State Street.
Costs. Annual Resolution 2000 program costs are absorbed within normal
spending levels. Management currently estimates the aggregate cost of the
Resolution 2000 Program to be less than 2% of total operating expenses for the
five-year period 1996-2000. As of September 30, 1998, cumulative program
expenditures were $69 million of which $14 million was incurred during the
third quarter. Such costs are expensed as incurred and include dedicated
staff, equipment, consultants, and other expenses.
18
PART I. ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
European Economic and Monetary Union
Effective January 1, 1999, eleven countries participating in the European
Economic and Monetary Union will adopt a common currency, the "Euro". State
Street has developed and is currently implementing a plan to service customer
accounting and other needs resulting from this currency adoption. State
Street's modification to its information systems and business operations to
implement the conversion to the Euro has been tested, and, management believes
the information systems and business operations are ready for January 1, 1999
adoption. If necessary, State Street would take appropriate contingency
actions if there were a failure in State Street's systems and business
operations relative to the Euro. Such contingency actions could include manual
intervention or increased staff time. If it becomes necessary for State Street
to take these corrective actions, it is uncertain, until the contingency plans
are implemented, whether this would result in significant business delays or
have a material adverse effect on State Street.
Management estimates that the costs to State Street associated with the
implementation and ultimate redenomination of the Euro will not be material.
The anticipation surrounding the adoption of the Euro has impacted foreign
exchange volumes within Europe and is expected to effect trading volumes
throughout 1999, offset by new opportunities which may arise from the monetary
union. As a result, management does not expect the impact of the Euro to have
a material impact on the financial condition of State Street.
TAXES
Taxes in the quarter were $55 million, up from $49 million a year ago. The
effective tax rate was 33.2%, up from 32.5% in the third quarter of 1997.
CREDIT QUALITY
At September 30, 1998, total loans were $6.3 billion. During the third
quarter, the allowance for loan losses decreased from $93 million to $83
million. The decrease was largely the result of the charge-off of a loan to a
single borrower during the third quarter. The potential for a loss for this
troubled credit was incorporated into prior period assessments of loan loss
allowance adequacy.
Overall, the portfolio continues to reflect the current credit environment.
During the quarter, net recoveries were $1 million. The provision for loan
losses charged against income was $4 million, consistent with the prior
quarter, and down slightly from the provision for the third quarter of 1997 of
$5 million.
LINES OF BUSINESS
Following is a summary of line of business operating results for the nine
months ended September 30:
- ------------------------------------------------------------------------------
SERVICES FOR
INSTITUTIONAL INVESTMENT COMMERCIAL
INVESTORS MANAGEMENT LENDING
-------------- ------------ ------------
Taxable equivalent basis
(Dollars in millions) 1998 1997 1998 1997 1998 1997
- ------------------------------------------------------------------------------
Fee revenue....................... $1,046 $ 881 $ 372 $ 297 $ 49 $ 42
Net interest revenue.............. 404 354 30 19 128 118
------ ------ ----- ----- ----- -----
Total revenue................... 1,450 1,235 402 316 177 160
Operating expenses................ 1,096 938 336 251 77 71
------ ------ ----- ----- ----- -----
Operating profit................ $ 354 $ 297 $ 66 $ 65 $ 100 $ 89
====== ====== ===== ===== ===== =====
Pretax margin..................... 24% 24% 16% 21% 56% 55%
Average assets (billions)......... $ 38.8 $ 30.0 $ .9 $ .7 $ 4.2 $ 3.7
- -------------------------------------------------------------------------------
19
PART I. ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
Services for Institutional Investors
Services for institutional investors include accounting, custody, daily
pricing and information services for large portfolios of investment assets.
Customers include mutual funds and other collective investment funds,
corporate and public pension plans, corporations, investment managers, non-
profit organizations, unions, and other holders of investment assets.
Institutional investors are offered other State Street services, including
foreign exchange, cash management, securities lending, fund administration,
recordkeeping, credit services, and deposit and short-term investment
facilities. These services support institutional investors in developing and
executing their strategies, enhancing their returns, and evaluating and
managing risk. Revenue from this line of business comprised 71% of State
Street's total revenue for the nine months ended September 30, 1998.
Revenue for the nine months ended September 30, 1998 increased to $1.5
billion, up $215 million, or 17%, from $1.2 billion in 1997. The $215 million
increase in revenue resulted from increased cross-border investment activity,
the installation of new business, and expanding relationships with customers
who are growing and using more services. Fee revenue was up 19%. This
reflected strong growth in revenue from accounting, custody and other services
for mutual funds, U.S. pension plans, and customers outside the U.S. Net
interest revenue, up 14%, reflected additional funding from customers in
conjunction with their worldwide investment activities.
Operating expenses for the nine months ended September 30, 1998 were $1.1
billion, 17% higher than a year ago, due to business growth, investments for
future growth and acquisitions. Operating profit was $354 million, an increase
of $57 million, or 19%, from a year ago and reflected strong business growth.
Investment Management
State Street manages financial assets worldwide for both institutions and
individuals and provides related services, including participant recordkeeping
for defined contribution plans. Investment management features a broad array
of services, including passive and active equity, money market, and fixed
income strategies. Revenue from this line of business comprised 20% of State
Street's total revenue for the first nine months of 1998.
Revenue grew 27% to $402 million for the nine months ended September 30,
1998 due to revenue growth across the product line. Operating expenses
increased 34% reflecting additional staff to support business growth and an
acquisition. Operating profit was $66 million, relatively unchanged from the
nine months ended September 30, 1997.
Commercial Lending
Reported in this line of business are loans and other banking services for
regional middle-market companies, for companies in selected industries
nationwide, for broker/dealers and for leasing and international trade
finance. Other banking services include cash management, leasing and
international trade finance. Revenue from this line of business comprised 9%
of State Street's total revenue for the first nine months of 1998.
Revenue grew to $177 million for the nine months ended September 30, 1998,
up $166 million or 11% from a year ago, due primarily to a 14% increase in
loans. Loans to New England businesses, specialty industries nationwide,
leases, and international trade finance all grew.
Operating expenses increased 8% for the nine months ended September 30,
1998, supporting business growth. Operating profit was $100 million, an
increase of $11 million, or 12% from 1997.
NEW ACCOUNTING DEVELOPMENTS
Information related to new accounting developments appears in Note A to the
Consolidated Financial Statements.
20
PART I. ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
CAPITAL AND LIQUIDITY
State Street's objective is to be well capitalized in order to provide
financial flexibility which facilitates funding corporate growth and other
business needs. Capital levels also support State Street customers' cash
management needs.
Capital
As a state chartered bank and member of the Federal Reserve System, State
Street Bank, State Street's principal subsidiary, is regulated by the Federal
Reserve Board which has established guidelines for minimum capital ratios.
State Street has developed internal capital-adequacy policies to ensure that
the Bank meets or exceeds the level required for the "well capitalized"
category, the highest of the Federal Reserve Board's five capital categories.
State Street's capital management emphasizes risk exposure rather than simple
asset levels. At 12.9%, the Bank's tier 1 risk-based capital ratio
significantly exceeds the regulatory minimum of 4%. See Note D to the
Consolidated Financial Statements for further information.
State Street purchased 1,010,000 shares of its stock during the third
quarter of 1998. As of September 30, 1998, an additional 3.5 million shares
may be purchased within the stock purchase program. See Note E to the
Consolidated Financial Statements for further information.
Liquidity
The primary objective of State Street's liquidity management is to ensure
that it has sufficient funds to meet its commitments and business needs,
including accommodating the transaction and cash management requirements of
its customers. Liquidity is provided by State Street's access to global debt
markets, its ability to gather additional deposits from its customers,
maturing short-term assets, the sale of securities and payments of loans.
Customer deposits and other funds provide a multi-currency, geographically
diverse source of liquidity.
State Street maintains a large portfolio of liquid assets. At September 30,
1998, State Street's liquid assets were 78% of total assets.
TRADING ACTIVITIES: FOREIGN EXCHANGE AND INTEREST RATE SENSITIVITY
As part of its trading activities, the Corporation assumes positions in both
the foreign exchange and interest rate markets by buying and selling cash
instruments and using financial derivatives, including forward foreign
exchange contracts, foreign exchange and interest rate options, and interest
rate swaps. As of September 30, 1998, the notional amount of these derivative
instruments was $144.2 billion, of which $141.1 billion was foreign exchange
forward contracts. Long and short foreign exchange forward positions are
closely matched to minimize currency and interest rate risk. All foreign
exchange contracts are valued daily at current market rates.
The corporation uses a variety of risk measurement and estimation techniques
including value at risk. Value at risk is an estimate of potential loss for a
given period of time within a stated statistical confidence interval. State
Street estimates value at risk daily for all material trading positions using
a methodology based on the distribution of historical market movements. The
Corporation has adopted standards for estimating value at risk, and monitors
capital in accordance with the Federal Reserve's Capital Adequacy Guidelines
for market risk. Value at risk is estimated for a 99% one-tail confidence
interval and an assumed one-day holding period using a historical observation
period of one year. A 99% one-tail confidence interval implies that daily
trading losses should not exceed the estimated value at risk more than 1% of
the time, or approximately three days out of the year. The methodology takes
into account observed correlations between interest rates and foreign exchange
rates, and the resulting diversification benefits provided from the mix of the
Corporation's trading positions.
21
PART I. ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
Like all quantitative measures, value at risk is subject to certain
limitations and assumptions inherent to the methodology. State Street's
methodology uses an assumption of normal distribution of market returns. The
estimate is calculated using static portfolios consisting of positions held at
the end of the trading day in Boston. Implicit in the estimate is the
assumption that no intraday action is taken by management during adverse
market movements. As a result, the methodology does not represent risk
associated with intraday changes in positions or intraday price volatility.
The following table presents State Street's market risk for its trading
activities as measured by its value at risk methodology:
VALUE AT RISK FOR SEPTEMBER 30, 1998
- --------------------------------------------------------------------------------
(Dollars in millions) AVERAGE MAXIMUM MINIMUM
- --------------------------------------------------------------------------------
Foreign exchange contracts.............................. $.8 $3.0 $.3
Interest rate contracts................................. .1 .3
- -------------------------------------------------------------------------------
State Street compares actual daily profit and losses from trading activities
to estimated one-day value at risk. During the third quarter of 1998, State
Street did not experience any foreign exchange trading loss in excess of its
end of day value at risk estimate.
FACTORS AFFECTING FUTURE RESULTS
From time to time, information provided by State Street, statements made by
its employees, or information included in its filings with the Securities and
Exchange Commission (including this Form 10-Q), may contain statements which
are not historic facts (so-called "forward looking statements"), including
statements about the Corporation's confidence and strategies and its
expectation about revenues and market growth, new technologies, services and
opportunities, and earnings. These statements may be identified by such
forward looking terminology as "expect", "look", "believe", "anticipate",
"may", "will", or similar statements or variations of such terms. These
forward-looking statements involve certain risks and uncertainties which could
cause actual results to differ materially. Factors that may cause such
differences include, but are not limited to, the factors discussed in this
section and elsewhere in this Form 10-Q. Each of these factors, and others,
are also discussed from time to time in the Corporation's other filings with
the Securities and Exchange Commission, including its report on Form 10-K.
Cross-border investing. Cross-border investing by customers worldwide
benefits State Street's revenue. Future revenue may increase or decrease
depending upon the extent of cross-border investments made by customers or
future customers.
Savings rate of individuals. State Street benefits from the savings of
individuals that are invested in mutual funds or defined contribution plans.
Changes in savings rates or investment styles may affect revenue.
Value of worldwide financial markets. As worldwide financial markets
increase or decrease in value, State Street's opportunities to invest and
service financial assets may change. Since a portion of the Corporation's fees
are based on the value of assets under custody and management, fluctuations in
worldwide securities market valuations will affect revenue.
Dynamics of markets served. Changes in markets served, including the growth
rate of U.S. mutual funds, the pace of debt issuance, outsourcing decisions,
mergers, acquisitions and consolidations among customers and
22
PART I. ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
(CONTINUED)
competitors can affect revenue. In general, State Street benefits from an
increase in the volume of financial market transactions serviced.
State Street provides services worldwide. Global and regional economic
factors and changes or potential changes in laws and regulations affecting the
Corporation's business, including changes in monetary policy, could also
affect results of operations.
Interest rates. Market interest rate levels, the shape of the yield curve
and the direction of interest rate changes affect both net interest revenue
and fiduciary compensation from securities lending. All else being equal, in
the short term State Street's net interest revenue benefits from falling
interest rates and is negatively affected by rising rates because interest-
bearing liabilities re-price sooner than interest-earning assets.
Volatility of currency markets. The degree of volatility in foreign exchange
rates can affect the amount of foreign exchange trading revenue.
Pace of pension reform. State Street expects to benefit from worldwide
pension reform that creates additional pools of assets that use custody and
related services and investment management services. The pace of pension
reform may affect the pace of revenue growth.
Pricing/competition. Future prices the Corporation is able to obtain for its
products may increase or decrease from current levels depending upon demand
for its products, its competitors' activities, and the introduction of new
products into the marketplace.
Pace of new business. The pace at which existing and new customers use
additional services and assign additional assets to State Street for
management or custody will affect future results.
Business mix. Changes in business mix, including the mix of U.S. and non-
U.S. business, will affect future results.
Rate of technological change. Technological change creates opportunities for
product differentiation and reduced costs, as well as the possibility of
increased expenses. State Street's financial performance depends in part on
its ability to develop and market new and innovative services and to adopt or
develop new technologies that differentiate State Street's products or provide
cost efficiencies.
Year-2000 modifications. The costs and projected completion date of State
Street's Resolution 2000 program are estimates. Factors that may cause
material differences in actual results include the availability and cost of
systems and personnel, non-compliance of third-party providers (including
customers), and similar uncertainties. State Street's businesses are
substantially dependent upon its data processing software and hardware systems
and upon its ability to process information on its customers' behalf. If the
Corporation were unable to process information as a result of the Year-2000
issues, despite State Street's efforts and its contingency planning, such a
failure could have a materially adverse effect on State Street's business, as
could Year-2000 problems experienced by others with whom the Corporation does
business.
Acquisitions and alliances. Acquisitions of complementary businesses and
technologies and strategic alliances are an active part of State Street's
overall business strategy, and the Corporation has completed several
acquisitions and alliances in recent years. However, there can be no assurance
that services, technologies, key personnel, and businesses of acquired
companies will be effectively assimilated into State Street's business or
service offerings or that alliances will be successful.
23
PART I. ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
See information under the caption "Trading Activities: Foreign Exchange and
Interest Rate Sensitivity" on page 21.
PART II--OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit Index
EXHIBIT NUMBER PAGE OF THIS REPORT
-------------- -------------------
12 Ratio of earnings to fixed charges....... 26
15 Letter regarding unaudited interim
financial information.................... 27
27 Financial data schedule.................. 28
(b) Reports on Form 8-K
A current report on Form 8-K/A dated September 17, 1998, was filed by the
Registrant on September 28, 1998 with the Securities and Exchange Commission
which reported that the Board of Directors authorized a two million share
increase in its stock purchase program.
24
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE
REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
State Street Corporation
Date: November 9, 1998
By: /s/ Ronald L. O'Kelley
----------------------------------
RONALD L. O'KELLEY
EXECUTIVE VICE PRESIDENT AND CHIEF
FINANCIAL OFFICER
Date: November 9, 1998
By: /s/ Rex S. Schuette
----------------------------------
REX S. SCHUETTE
SENIOR VICE PRESIDENT AND CHIEF
ACCOUNTING OFFICER
25