- --------------------------------------------------------------------------------
FINANCIAL REVIEW
- --------------------------------------------------------------------------------
This section provides management's discussion and analysis of State Street's
consolidated results of operation for the three years ended December 31, 1998,
and its financial condition at year-end 1998. It should be read in conjunction
with the Consolidated Financial Statements and Supplemental Financial Data.
State Street is a leading specialist in serving institutional investors
worldwide. Among the services State Street provides customers are:
[bullet] Custody, accounting, daily pricing and administration
[bullet] Foreign exchange, cash management and securities lending
[bullet] Investment management
[bullet] Information and trading
[bullet] Banking services
- --------------------------------------------------------------------------------
RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------
SUMMARY
- --------------------------------------------------------------------------------
In 1998, State Street's earnings per diluted share were $2.66, up 15% from the
outstanding performance of 1997. Total revenue of $2.8 billion increased 18%
from the previous year. Revenue growth was driven by growth in fiduciary
compensation, net interest revenue and foreign exchange revenue. Net income was
$436 million, up 15%. Return on stockholders' equity was 20.2%. With these
strong results, the Corporation performed well against its financial goals.
[bar chart begins]
Diluted Earnings Per Share
Dollars
94 1.32
95 1.47
96 1.78
97 2.32
98 2.66
[bar chart ends]
State Street's primary financial goal is to achieve sustainable real
(inflation-adjusted) growth in earnings per share. Over the last 15 years,
earnings per diluted share increased at a 16% compound annual growth rate. State
Street's two supporting financial goals are related to revenue growth and return
on stockholders' equity. The revenue goal, to repeat the strong revenue growth
of the 1980s in the 1990s, requires 12.5% real (inflation-adjusted) growth, or
approximately a 15% nominal compound annual growth rate. For the decade to date,
nominal revenue has increased at a 17% compound annual growth rate. Return on
stockholders' equity was 20.2% for 1998, exceeding State Street's goal of 18%.
This was State Street's twenty-first consecutive year of double-digit earnings
per share growth. State Street's consistent financial performance demonstrates
successful execution of its strategic plan to build value for its stockholders,
in part by continuing to invest in technology, new products and services, and
expansion into new markets.
Growth in revenue is integral to State Street's consistent financial
performance. In 1998, approximately 80% of State Street's increase in revenue
came from existing customers, and the remaining 20% came from new customers.
Revenue growth was driven by customers' expanding needs, arising in part from
the continuation of long-term, global trends: aging of the world's population,
pressures on pay-as-you-go pension systems, increasing cross-border investing,
and the growing complexity of investment strategies. Management has positioned
State Street to benefit from these trends.
Some environmental factors favorably affected State Street's performance in
1998. Securities values were generally higher than in 1997. Currency markets
were active and volatile. U.S. mutual funds experienced continued strong cash
inflows.
State Street achieved strong sales success in 1998. Given the level of new
business signed and the continuation of the long-term trends driving demand for
the services State Street provides, management is optimistic about State
Street's long-term prospects. Management remains confident that execution of its
strategic business plan will continue to create value for stockholders.
REVENUE
- --------------------------------------------------------------------------------
State Street specializes in providing services and investment management for
institutional investors worldwide, and focuses on customer relationships.
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14 State Street Corporation 1998 Annual Report
This focus results in high customer retention and recurring revenue.
State Street offers a wide range of products and services to customers with
varied and complex needs. Customers continue to increase the number of State
Street products they use. The Corporation's 1,000 largest customers used an
average of 5.8 products in 1998, up from 5.5 in 1997.
State Street classifies revenue received for services as either fee revenue or
net interest revenue, according to the service provided. Management focuses on
increasing total revenue. In 1998, total revenue grew 18%, to $2.8 billion.
[bar chart begins]
Total Revenue
Dollars in billions, taxable equivalent
Total Fiduciary Compensation
Other Fee Revenue
Net Interest Revenue
[PLOT POINTS TO BE PROVIDED BY CLIENT]
94 1.4
95 1.6
96 1.9
97 2.3
98 2.8
[bar chart ends]
FEE REVENUE
In 1998, fee revenue, which accounted for 72% of total revenue, was $2.0
billion, up $324 million, or 19%, from 1997 due to new business both from
existing customers and new customers, and due to customer growth.
Fee revenue growth came from fiduciary compensation, up $252 million; foreign
exchange trading revenue, up $44 million; and servicing and processing fees, up
$18 million.
- --------------------------------------------------------------------------------
FEE REVENUE Change
(Dollars in millions) 1998 1997 1996 97-98
- --------------------------------------------------------------------------------
Fiduciary compensation:
Services for Institutional
Investors ................... $ 1,024 $ 861 $ 711 19%
Investment Management .......... 480 391 307 23
------- ------- -------
Total ................. 1,504 1,252 1,018 20
Foreign exchange trading ............ 289 245 126 18
Servicing and processing ............ 177 159 125 12
Other ............................... 27 17 33 55
------- ------- -------
Total fee revenue ..... $ 1,997 $ 1,673 $ 1,302 19
======= ======= =======
- --------------------------------------------------------------------------------
Fiduciary Compensation
Fiduciary compensation, up 20% in 1998, is the largest component of fee revenue.
Fiduciary compensation is derived from accounting, custody, daily pricing,
information services, securities lending, trusteeship services and investment
management.
Fees recorded in fiduciary compensation are a function of the mix and volume of
assets under custody and assets under management, securities positions held,
portfolio transactions, and securities on loan. If equity values worldwide were
to increase or decrease 10%, State Street estimates that this, by itself, would
cause approximately a 2% change in total revenue. If bond values were to change
by 10%, State Street would anticipate less than a 1% change in total revenue.
The following sections discuss the factors contributing to growth in fiduciary
compensation, presented by market segment. State Street's customers use other
complementary services that are recorded in other revenue categories, such as
foreign exchange trading revenue and net interest revenue.
Services for Institutional Investors. In 1998, fiduciary compensation for
Services for Institutional Investors was $1.0 billion, up 19% from 1997.
Services for Institutional Investors revenue increasingly reflects customers'
use of services other than basic custody, such as mutual fund accounting and
administration, services for offshore mutual funds, securities lending,
performance and analytics, and compliance monitoring.
Mutual Funds. State Street is the largest mutual fund custodian and accounting
agent in the United States. State Street provides custody services for 42% of
registered U.S. mutual funds. State Street is distinct from many other mutual
fund service providers because customers make extensive use of a number of
related services in addition to custody, including accounting and daily pricing.
The Corporation provides fund accounting and valuation services for more than
five times the assets serviced by the next largest accounting service provider.
State Street is responsible for calculating 27% of the U.S. mutual fund prices
that appear daily in The Wall Street Journal. Services such as fund accounting
and administration, accounting for multiple classes of shares, master/feeder
accounting, and services for offshore funds and local funds in locations outside
the United States contribute to fiduciary compensation. Shareholder services are
provided through an affiliate, Boston Financial Data Services, Inc.
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15
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FINANCIAL REVIEW
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[bar chart begins]
Mutual Fund Complexes
94 227
95 238
96 243
97 247
98 253
[bar chart ends]
[bar chart begins]
Market Share of U.S.
Pension Assets
Percent of market
94 17
95 21
96 22
97 24
98 24
Source: Money Market Directory data
[bar chart ends]
[bar chart begins]
Assets Under Custody for
Non-U.S. Customers
Dollars in billions
94 102
95 152
96 202
97 266
98 362
[bar chart ends]
A long-term revenue driver is the number of mutual fund complexes, or mutual
fund families, the Corporation services. Once a mutual fund complex becomes a
customer, that complex is likely to select State Street to provide more
services, service more funds, or both. In addition, State Street benefits from
the growth of its customers. At year-end 1998, 253 mutual fund complexes used
State Street's services, up from 247 a year ago.
In 1998, revenue growth from servicing mutual funds came primarily from new
business, both from existing customers and new customers. Increased revenue from
accounting and custody reflected growth in assets and additional mutual funds.
Revenue from servicing offshore funds and from mutual fund administration
continued to increase.
In 1998, total mutual fund assets under custody increased 26%. The total number
of funds serviced increased by 340, or 10%, to 3,661. There were 583 new funds
serviced, 500 from existing customers and 83 from new customers, partially
offset by 243 funds no longer serviced due primarily to mergers and
consolidations of funds. The number of offshore funds serviced was up 14% from a
year ago and offshore assets increased 41%. Assets under administration were up
21%.
U.S. Pension, Insurance and Other Investment Pools. State Street provides
custody, portfolio accounting, securities lending, information and other related
services for retirement plans and other financial asset portfolios of
corporations, public funds, investment managers, non-profit organizations,
unions and others. The Corporation provides products and services, such as
performance and analytics, global reporting, and compliance monitoring, that
these institutional customers require to meet their changing needs. In 1998,
revenue growth was driven by new business and securities lending.
State Street has a leading share of the market for servicing U.S. tax-exempt
assets for corporate and public pension funds. Over the past five years, State
Street's market share has grown from 17% to 24%.
Customers Outside the United States. State Street is committed to expanding
globally by serving the global needs of both its U.S. and non-U.S. domiciled
customers. Revenue growth in 1998 from customers outside the United States was
driven primarily by new business, including business gained by an acquisition.
In 1998, assets under custody for these customers totaled $362 billion, an
increase of 36% from 1997, with strong growth in Europe, Canada and Japan. Over
the last five years, assets under custody for these customers have increased at
a compound annual growth rate of 32%.
Investment Management. Fiduciary compensation for Investment Management was $480
million, up 23% from 1997.
State Street provides an extensive range of investment management services,
including investment management for corporations, public funds and other
institutional investors; administration and investment services for defined
contribution and other employee benefit programs; and investment management and
other financial services for high-net-worth individuals. These services are
offered through State Street Global Advisors ("SSgA[RegTM]"). In the United
States, SSgA is the largest manager of tax-exempt assets, the third-largest
manager of defined contribution plan assets and the third-largest manager of
total assets. Globally, SSgA is the seventh-largest manager of total assets.
SSgA offers a broad array of investment strategies, including passive, enhanced
and active management using quantitative and fundamental methods for both global
equities and global fixed income. Fees are based
- --------------------------------------------------------------------------------
16 State Street Corporation 1998 Annual Report
on the investment strategy, the amount of the investment, and the customer's
total State Street relationship.
[bar chart begins]
Assets Under Management
Dollars in billions
94 161
95 227
96 292
97 390
98 485
[bar chart ends]
In 1998, the increase in revenue from investment management for institutional
investors reflected new business installed, additional contributions from
existing customers and higher values of U.S. equities. Revenue growth was driven
principally by customers' use of passive equity strategies and fixed income
strategies, including short-term investments.
Revenue from providing participant services to defined contribution and other
employee benefit programs grew as a result of an acquisition, new business and
growth in existing business. The number of defined contribution plan
participants served increased to 2.6 million from 2.4 million in 1997.
Assets Under Custody and Management. The amounts of assets under custody and
management indicate the relative size of various markets served and, as adjusted
for market-value changes, serve as proxies for business growth. However, changes
in asset levels do not necessarily result in proportional changes in revenue,
due to the many services that are priced on factors other than asset size and
State Street's relationship pricing for customers who use multiple services.
Market value changes had a positive impact on the value of assets under custody
in 1998. The U.S. equity market, as measured by the total return of the S&P 500
index, increased 29%, while the broader market, as measured by the Wilshire
5000, increased 23%. U.S. bond markets, as measured by the Lehman Brothers
Aggregate Bond index, increased 9%. International equity markets, as measured in
U.S. dollars by the Morgan Stanley EAFE index, increased 20%.
At year-end 1998, total assets under custody increased $909 billion, or 23%, to
$4.8 trillion, from 1997.
- ----------------------------------------------------------------------------------------------------------
ASSETS UNDER CUSTODY AND MANAGEMENT Compound
AS OF DECEMBER 31, Growth
Change Rate
(Dollars in billions) 1998 1997 1996 1995 1994 1993 97-98 93-98
- ----------------------------------------------------------------------------------------------------------
ASSETS UNDER CUSTODY
Customers in the U.S.:
Mutual funds ................. $ 2,144 $ 1,705 $ 1,281 $ 1,001 $ 788 $ 796 26% 22%
Pensions, insurance and
other investment pools ..... 2,306 1,932 1,459 1,125 838 798 19 24
Customers outside the U.S. ..... 362 266 202 152 102 90 36 32
------- ------- ------- ------- ------- ------
Total .................... $ 4,812 $ 3,903 $ 2,942 $ 2,278 $ 1,728 $ 1,684 23 23
======= ======= ======= ======= ======= =======
ASSETS UNDER MANAGEMENT
Equities:
Passive ...................... $ 237 $ 168 $ 119 $ 83 $ 55 $ 48 41 38
Active ....................... 34 26 20 18 14 11 31 25
Employer securities ............ 59 51 39 34 18 17 16 28
Fixed income ................... 32 28 24 19 12 11 14 24
Money market ................... 123 117 90 73 62 55 5 17
------- ------- ------- ------- ------- ------
Total .................... $ 485 $ 390 $ 292 $ 227 $ 161 $ 142 24 28
======= ======= ======= ======= ======= =======
- ----------------------------------------------------------------------------------------------------------
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17
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FINANCIAL REVIEW
- --------------------------------------------------------------------------------
Approximately 55% of these assets under custody were equities, 27% were fixed
income instruments, and 18% were short-term instruments. Non-U.S. securities
comprised 12% of total assets under custody, with emerging markets securities
comprising less than 1%.
At year-end 1998, assets under management increased $95 billion to $485 billion,
or 24%, from 1997. Non-U.S. securities comprised 21% of total securities, with
emerging markets securities comprising 1%.
Foreign Exchange Trading
In 1998, foreign exchange trading revenue rose 18%, to $289 million. Major
currencies were slightly more volatile than in 1997. Currency volatility in both
1998 and 1997 was significantly greater than in 1996. The dollar volume of
customer trades was up 29% from 1997.
Development of a comprehensive range of foreign exchange services to meet the
needs of institutional investors helped State Street earn the number two ranking
for "Best FX Service Overall" in a 1998 worldwide survey of global foreign
exchange providers conducted by Global Investor magazine.
[bar chart begins]
Investment Managers Using
Foreign Exchange Services
94 405
95 499
96 575
97 625
98 698
[bar chart ends]
In 1998, the number of investment managers using State Street's foreign exchange
services increased to 698, from 625 a year ago, and many existing relationships
expanded. A contributor to new foreign exchange business is State Street Global
Link,(SM) an integrated, electronic platform that includes unique research and
trade execution capabilities.
Servicing and Processing
Servicing and processing revenue includes fees from brokerage services, software
licensing and maintenance, loans, investment banking, and trade banking.
Servicing and processing revenue of $177 million was up 12% from 1997. Fees from
brokerage services and investment banking products drove revenue growth.
Servicing and processing revenue in 1997 included revenue from a non-strategic
business sold in June of that year.
Other Fee Revenue
Other fee revenue includes gains and losses on sales of investment securities,
leased equipment, and other assets; gains and losses on currency translation;
trading account profits and losses; profit or loss from joint ventures; and
amortization of investments in tax-advantaged financings. In 1998, other fee
revenue grew $10 million, principally due to gains on sales of investment
securities.
NET INTEREST REVENUE
Net interest revenue is the amount of interest received on interest-earning
assets less the interest paid on interest-bearing liabilities. In this
discussion, net interest revenue is expressed on a fully taxable-equivalent
basis to adjust for the tax-exempt status of revenue earned on certain
investment securities and loans.
- --------------------------------------------------------------------------------
NET INTEREST REVENUE
(Dollars in millions; Change
taxable equivalent) 1998 1997 1996 97-98
- --------------------------------------------------------------------------------
Interest revenue ............... $ 2,237 $ 1,755 $ 1,443
Taxable equivalent
adjustment .................. 40 44 37
------- ------- -------
2,277 1,799 1,480
Interest expense ............... 1,492 1,114 892
------- ------- -------
Net interest revenue ..... $ 785 $ 685 $ 588 15%
======= ======= =======
- --------------------------------------------------------------------------------
Taxable-equivalent net interest revenue in 1998 was $785 million, up $100
million, or 15%, over 1997. This growth was primarily due to an increase in
customer liabilities.
In serving institutional investors worldwide, State Street provides short-term
funds management, deposit services and repurchase agreements for cash positions
associated with customers' investment activities. The revenue associated with
deposit services and repurchase agreements, as well as from lending and lease
financing activities, is recorded as net interest revenue.
In 1998, State Street continued to expand globally, installing new customers and
benefiting from existing customers' growth, activity, and use of additional
services. These customers, in conjunction with their world-wide investment
activities, increased their level of deposits and securities sold under
repurchase agreements.
- --------------------------------------------------------------------------------
18 State Street Corporation 1998 Annual Report
Customer funds from these sources increased $8.8 billion and funded most of the
growth in average interest-earning assets, which increased $10.0 billion, or
32%, to $41.4 billion. Loans increased $996 million, or 19%, from last year, due
to growth in commercial loans, securities settlement advances and lease
financing.
Net interest margin, which is defined as taxable-equivalent net interest revenue
as a percent of average interest-earning assets, declined from 2.18% in 1997 to
1.90% in 1998, due to balance sheet growth in short-term money market
instruments and a flatter U.S. yield curve.
[bar chart begins]
Customer Liabilities
Average dollars in billions
Noninterest-
Bearing Deposits
Repurchase Agreements
Non-U.S. Deposits
94 17.1
95 19.7
96 22.8
97 27.5
98 36.3
[bar chart ends]
OPERATING EXPENSES
- --------------------------------------------------------------------------------
In 1998, operating expenses were $2.1 billion, up 19% from 1997. Expenses
increased as a result of investments for future growth, particularly people and
technology to support business volumes, product-line expansion through
development and acquisition, non-U.S. expansion, Year 2000 preparations, the
euro conversion, and other strategic business initiatives.
Installation of new business and existing customers' growth resulted in greater
business volume. Total assets under custody increased 23% and the volume of
securities transactions was up 16%. Assets under management were up 24%.
- --------------------------------------------------------------------------------
OPERATING EXPENSES
Change
(Dollars in millions) 1998 1997 1996 97-98
- --------------------------------------------------------------------------------
Salaries and employee benefits ...... $ 1,175 $ 973 $ 775 21%
Information systems
and communications ............... 241 185 158 30
Transaction processing services ..... 196 184 164 7
Occupancy .......................... 164 132 111 25
Other ............................... 292 260 190 12
------- ------- -------
Total operating expenses ...... $ 2,068 $ 1,734 $ 1,398 19
======= ======= =======
- --------------------------------------------------------------------------------
Salaries and employee benefits, the largest component of expense, was $1.2
billion, up 21% from 1997 due to additional staff supporting business growth.
The total number of employees at year end was 16,816, an increase of 18% from
year-end 1997. Approximately one-fourth of the staff growth was due to
acquisitions and the transfer of staff from a customer that outsourced
accounting and administration services to State Street.
Information systems and communications expense was $241 million, up 30%,
reflecting expansion of business capacity through information technology,
including processing and storage capacity, servers, and software. These
resources are necessary to support the increased volume and complexity of
business serviced, global expansion, and introduction of new products and
services. Transaction processing services are volume-related and include
external contract services, subcustodian fees and fees related to securities
settlement. This expense category was $196 million, up 7%.
Occupancy expense increased 25%, to $164 million, primarily due to growth in
existing locations and new space to support geographic expansion.
Other expenses include professional services, advertising, sales promotion and
other expenses. In 1998, other expenses were $292 million, up 12%, due to
increased use of professional services, including outsourced software
development, and advertising and sales promotion.
INCOME TAXES
- --------------------------------------------------------------------------------
Income tax expense was $221 million in 1998, compared to $184 million in 1997.
In 1998, the effective tax rate was 33.6%, up from 32.6% in 1997. The higher
effective tax rate for 1998 was primarily attributable to the increase in fully
taxable income, which was partially offset by higher tax credits and other
initiatives to minimize income tax expense worldwide.
ACQUISITIONS, ALLIANCES
AND DIVESTITURE
- --------------------------------------------------------------------------------
State Street makes acquisitions for strategic purposes. Acquisitions and
alliances enhance established capabilities by adding new products or services,
expanding geographic reach, or selectively expanding market share. State Street
is actively involved in reviewing and assessing various business opportunities
related to this strategy. In addition, State Street continuously reviews current
business operations to determine the applicability of these businesses to State
Street's core mission.
During 1998, State Street completed several acquisitions and alliances.
In February, State Street completed the acquisition of Bank of Scotland's unit
trust trustee business in the United Kingdom. This business complements State
Street's established expertise in accounting and fund administration, providing
a foundation on which State Street is building a full-service trustee,
accounting, and
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19
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FINANCIAL REVIEW
- --------------------------------------------------------------------------------
fund administration operation for the United Kingdom's collective investment
fund market.
In April, State Street acquired the remaining 50% partnership interest in
Wellspring Resources LLC, a provider of total benefits outsourcing.
State Street established several strategic alliances in 1998. These included
alliances with Nedcor Bank Limited, to meet the global and domestic service
requirements of institutional investors in South Africa, and Italy's Mediolanum,
an insurance and mutual fund group, to form a joint venture targeting defined
contribution-type pension plans.
In addition, in December, the Corporation sold a non-strategic business
servicing unclaimed property.
YEAR-2000 READINESS DISCLOSURE
- --------------------------------------------------------------------------------
Resolution 2000 Program Scope and Oversight. The approaching Year 2000 presents
companies in all industries with many challenges to ensure Year-2000 readiness
of their 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 developed a
comprehensive program, Resolution 2000, to address the related issues.
This program covers six major areas of Year-2000 readiness: information
technology 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 ("IT")
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 include office equipment such as fax machines. Facilities is
the embedded technology used throughout State Street's offices; for example, in
the uninterrupted power supply, fire alarms, security, and heating and
air-conditioning systems. Third-party suppliers refers to all external parties,
including vendors, service providers, subcustodian banks, counterparties,
business partners and customers, that have the potential to affect State
Street's ability to deliver Year-2000 ready products and services.
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 professional
technical 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, in conjunction with its consultant, in applying
the Resolution 2000 program to the core application software area. Using this
methodology, there is a phased approach followed that includes identifying and
validating an inventory of potentially date-sensitive items; assigning a
business risk rating to each item; assessing the Year-2000 readiness status of
each item; taking corrective action to renovate, replace, retire, upgrade or
outsource to achieve Year-2000 readiness; validating Year-2000 readiness 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. The methodology and phased approach are
being applied to all other areas of the Resolution 2000 program in performing
similar activities.
A central program management office, global Year-2000 readiness teams and a
corporate oversight structure support the Resolution 2000 program. Program
updates, progress reports and critical matters are regularly communicated to
senior management and to the Board of Directors.
The Resolution 2000 program activities are incorporated into State Street's
corporate risk-management functions. In addition, these program activities are
subject to reviews, which include internal audits and regulatory examinations
performed by the Federal Reserve Bank.
State Street has delayed certain IT projects unrelated to Year-2000 readiness
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.
State of Readiness. At December 31, 1998, State Street had completed the
inventory, risk assessments and Year-2000 readiness assessment work. Both
implementation of corrective actions required to achieve Year-2000 readiness,
and regression and internal testing to validate Year-2000 readiness, were
nearing completion. External testing with key industry organizations, such as
the Federal Reserve Bank, Depository Trust Corporation and Society for Worldwide
Inter-bank Financial Telecommunications (SWIFT), commenced in the third quarter
of 1998, with all tests to date successfully completed. External testing
- --------------------------------------------------------------------------------
20 State Street Corporation 1998 Annual Report
with subcustodians began in the fourth quarter of 1998 and customer testing will
begin in the first quarter of 1999.
Progress as of December 31, 1998 is as follows:
- --------------------------------------------------------------------------------
Regression
Testing and Internal
Production Year-2000
Correction Implementation Testing
- --------------------------------------------------------------------------------
IT infrastructure ............... 95% 95% 90%
Global data networks ............ 100 95 100
Core application software ....... 95 90 75
Business area
supported applications ........ 90 70 80
Facilities ...................... 55 55 55
- --------------------------------------------------------------------------------
State Street considers the IT infrastructure work remaining, consisting of
internal Year-2000 testing and production implementation of certain
third-party-provided system software products used in the client server
environments, to be mission critical. A portion of the core application software
work remaining, primarily the internal testing to validate the Year-2000
readiness, is also considered mission critical. State Street currently
anticipates that implementation of corrective actions required to achieve
Year-2000 readiness and internal testing to validate Year-2000 readiness will be
completed for internal mission-critical systems by March 31, 1999, with
remaining systems complete by June 30, 1999. External testing will be a focus in
the first half of 1999 and is expected to be completed 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 is expected to be completed in the
third quarter of 1999.
Progress at December 31, 1998, related to third-party suppliers, the readiness
of which could affect State Street's ability to deliver Year-2000 ready products
and services, is as follows:
Internal communications with vendors to obtain information on the Year-2000
readiness status of the products and services provided to State Street has been
completed. State Street has substantially completed development of remediation
contingency plans for those products and services that are considered high-risk.
Key vendors were asked to present updates to State Street on their Year-2000
readiness programs and related progress. Year-2000 readiness assessments of key
vendors have been completed and the current and future focus has turned to
implementation of remediation and business-resumption contingency planning.
Year-2000 readiness has been incorporated into State Street's existing due
diligence procedures performed with business partners and counterparties.
Year-2000 assessments of business partners have been completed and the focus has
turned to implementation of remediation and business-resumption contingency
planning. Year-2000 counterparty assessments are substantially complete.
Year-2000 readiness has been incorporated into the existing due diligence
procedures for State Street's subcustodian bank network. In addition,
questionnaires have been sent to the subcustodians focusing on the adequacy of
their Year-2000 readiness programs 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
complete. Year-2000 readiness testing began with subcustodians in the fourth
quarter of 1998 and is anticipated to be completed in the third quarter of 1999.
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 the Corporation failed to be Year-2000 ready, as
compared to its competitors, there could be an adverse effect on State Street's
business. In addition, since the Corporation and its subsidiaries are regulated
by federal, state and local banking authorities, and securities regulators,
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. State Street works with various third parties, including
customers, vendors and intermediaries. Failure of any key third party to be
Year-2000 ready could adversely affect State Street's business.
Contingency Plans. State Street cannot control the success of the Year-2000
readiness program of each third-party supplier. In instances where the risk of
Year-2000 readiness failure is high and there is potential for State Street not
providing or not receiving a compliant product, or if scheduled delivery is
beyond an acceptable date, the Corporation will adopt business-resumption
contingency plans. To mitigate the effects of its significant customers',
suppliers' or vendors' potential failure to remediate a Year-2000 issue in a
timely manner, State Street would take reasonable contingency actions. These may
include using alternative sources of supplies or services, manual workarounds,
or other 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
business contingency plans in place by the second quarter of 1999. If it becomes
necessary for
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21
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FINANCIAL REVIEW
- --------------------------------------------------------------------------------
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. 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 December 31, 1998, cumulative program expenditures were $72
million, of which $49 million was incurred during 1998. Such costs are expensed
as incurred and include approximately 400 full-time staff and consultants,
equipment, and other expenses.
EUROPEAN ECONOMIC AND
MONETARY UNION
- --------------------------------------------------------------------------------
On January 1, 1999, eleven member countries participating in the European
Economic and Monetary Union (EMU) adopted a common currency, the euro, and
established fixed conversion rates between their existing sovereign currencies
and the euro. For three years the participating countries can perform financial
transactions in either the euro or their original local currencies, resulting in
a fixed exchange rate among the participating countries. State Street's
information systems and business operations have been modified to service
customer accounting and other needs resulting from this currency adoption. In
1996, State Street began preparations to modify its information systems and
business operations in order to implement conversion to the euro. The conversion
effort was a major corporate focus in 1998, involving a dedicated EMU project
management office and an executive steering group.
The costs associated with the implementation and redenomination to the euro are
not expected to be material. While the adoption of the euro is expected to
affect trading volumes and deposit account balances within Europe throughout
1999, and while it is anticipated that new opportunities may arise from the
monetary union, management does not expect the impact of the euro to have a
material effect on State Street's financial condition.
COMPARISON OF 1997 VERSUS 1996
- --------------------------------------------------------------------------------
In 1997, diluted earnings per share increased 30% to $2.32. Total revenue
increased 24% and return on stockholders' equity was 20.6%, up from 18.1% in
1996.
This strong performance exceeded all financial goals and historical trends.
Revenue grew in all businesses and was driven by new business worldwide,
including new relationships and existing customers' use of additional products
and services. A generally favorable business environment, including the
continued expansion of cross-border investing, contributed to revenue growth as
well.
LINES OF BUSINESS
- --------------------------------------------------------------------------------
State Street reports three lines of business: Services for Institutional
Investors, Investment Management and Commercial Lending. The operating results
of these lines of business are not necessarily comparable with other companies.
Revenue and expenses are directly charged or allocated to the lines of business
through algorithm-based management information systems. State Street prices on
total customer relationships and other factors; therefore, revenues may not
necessarily reflect market pricing on products within the business lines in the
same way as they would for separate legal entities. Assets and liabilities are
allocated according to rules that support management's strategic and tactical
goals. Capital is allocated based on risk-weighted assets employed and
management's judgment. The capital allocations may not be representative of the
capital that might be required if these lines of business were independent
business entities.
In the following table, certain previously reported line of business information
has been restated to conform to the current method of presentation.
The following is a summary of the lines of business operating results for the years ended December 31:
- -----------------------------------------------------------------------------------------------------------------------------------
LINES OF BUSINESS Services for Institutional Investors Investment Management Commercial Lending
------------------------------------ ------------------------ -----------------------
(Dollars in millions; taxable equivalent) 1998 1997 1996 1998 1997 1996 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------------
Fee revenue:
Fiduciary compensation ............... $1,024 $ 861 $ 711 $ 480 $ 391 $ 307 $ $ $
Foreign exchange trading ............. 289 245 126
Other ................................ 109 105 103 34 17 11 61 54 44
------ ------ ------ ----- ----- ----- ----- ----- ----
Total fee revenue ................. 1,422 1,211 940 514 408 318 61 54 44
Net interest revenue .................... 551 485 419 44 34 23 173 150 138
------ ------ ------ ----- ----- ----- ----- ----- ----
Total revenue ..................... 1,973 1,696 1,359 558 442 341 234 204 182
Operating expense ....................... 1,503 1,294 1,043 461 347 268 104 93 87
------ ------ ------ ----- ----- ----- ----- ----- ----
Income before income taxes ........ $ 470 $ 402 $ 316 $ 97 $ 95 $ 73 $ 130 $ 111 $ 95
====== ====== ====== ===== ===== ===== ===== ===== ====
Pre-tax margin .......................... 24% 24% 23% 17% 21% 21% 56% 54% 52%
Average assets (billions) ............... $ 40.2 $ 30.6 $ 25.7 $ .9 $ .8 $ .6 $ 4.6 $ 4.0 $3.2
- -----------------------------------------------------------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
22 State Street Corporation 1998 Annual Report
[pie chart begins]
Total Revenue
Services for Institutional Investors 71%
Investment Management 20%
Commercial Lending 9%
[pie chart ends]
SERVICES FOR
INSTITUTIONAL INVESTORS
Services for Institutional Investors includes accounting, custody, daily pricing
and information services for investment portfolios. Customers around the world
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 State Street services, including foreign exchange, cash management,
securities lending, fund administration, recordkeeping, banking 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 1998.
Revenue increased to $2.0 billion, up 16% from $1.7 billion in 1997. The $278
million increase in revenue was driven by expanding relationships with customers
who are growing and using more services, the installation of new business, and
higher equity values.
Fee revenue was up $212 million, or 18%, due to growth in fiduciary compensation
and foreign exchange trading revenue. Fiduciary compensation, up 19%, reflected
substantial revenue increases from accounting, custody and other services for
mutual funds, U.S. pension plans and customers outside the United States.
Foreign exchange trading revenue grew 18% from a year ago due to growth in the
volume of customer trades, the level of currency volatility and the increased
use of State Street Global Link.
Net interest revenue, up 14%, reflected the results of investing customer
deposits and other short-term funds in interest-earning assets. In 1998,
customer funds, including non-U.S. deposits, repurchase agreements and
noninterest-bearing deposits, grew substantially.
Operating expenses were $1.5 billion, 16% higher than in 1997, supporting
business growth, investments for future growth and acquisitions.
In 1998, income before income taxes was $470 million, an increase of $68
million, or 17%, from 1997. The pre-tax margin was 24%.
INVESTMENT MANAGEMENT
State Street manages financial assets worldwide for both institutions and
individuals and provides related services, including participant services for
defined contribution and other employee benefit programs, and brokerage
services. Investment management offers 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
1998.
Revenue grew 26%, to $558 million, due to growth across all businesses.
Operating expenses increased $114 million, or 33%, to $461 million, reflecting
investment in additional staff, systems and office space to expand the product
line and broaden State Street's global reach; and the acquisition of the
remaining 50% partnership interest in Wellspring Resources LLC.
In 1998, income before income taxes was $97 million, an increase of $2 million,
or 2%, from 1997. Pre-tax margin was 17%.
COMMERCIAL LENDING
Reported in this line of business are lending activities and other banking
services for regional middle-market companies, companies in selected industries
and institutional investor customers. Other banking services include cash
management and deposit services. Revenue from this line of business comprised 9%
of State Street's total revenue for 1998.
Revenue grew to $234 million, up 15%, from $204 million in 1997, due primarily
to increased loans and leases, and increased fee revenue. Lease financing,
international trade finance, and loans to businesses in the northeastern United
States and specialty industries nationwide all grew. Increased revenue came from
gains on the sale of leased equipment and lending activity.
In 1998, credit quality remained strong. The provision for loan losses was $17
million, up from $16 million a year ago, supporting growth in loans outstanding.
The provision for loan losses and the credit experience of State Street for the
three years ended December 31, 1998 is shown in Note D to the Consolidated
Financial Statements on page 36.
Operating expenses increased $11 million, or 12%, to $104 million.
In 1998, income before income taxes was $130 million, an increase of $19
million, or 17%, from 1997. Pre-tax margin was 56%.
- --------------------------------------------------------------------------------
23
- --------------------------------------------------------------------------------
FINANCIAL REVIEW
- --------------------------------------------------------------------------------
FINANCIAL GOALS AND FACTORS
THAT MAY AFFECT THEM
- --------------------------------------------------------------------------------
State Street's primary financial goal is sustainable real growth in earnings per
share. The Corporation has two supporting goals, one for total revenue growth
and one for return on common stockholders' equity (ROE). The revenue goal is a
12.5% real, or inflation-adjusted, compound annual growth rate of revenue for
the decade of the 1990s. This translates to approximately a 15% nominal compound
annual growth rate. The ROE goal is 18%.
State Street considers these to be financial goals, not projections or
forward-looking statements. However, the discussion in this Financial Review,
and in other portions of this Annual Report, does contain statements that are
considered "forward-looking statements" within the meaning of the federal
securities laws. 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. The Corporation's financial
goals and such forward-looking statements involve certain risks and
uncertainties, including the issues and factors listed below and factors further
described in conjunction with the forward-looking information, which could cause
actual results to differ materially. The following issues and factors should be
carefully considered. The Corporation assumes no obligation for updating any
such forward-looking information.
Based on evaluation of the following factors, management is currently optimistic
about the Corporation's long-term prospects.
Cross-border investing. Increases in cross-border investing by customers
worldwide benefit State Street's revenue. Future revenue may increase or
decrease depending upon the extent of increases or decreases in 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 in 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, as discussed on page 15.
Dynamics of markets served. Changes in markets served, including the growth rate
of U.S. mutual funds, the pace of debt issuance, outsourcing decisions, and
mergers, acquisitions and consolidations among customers and 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 volatile currencies and changes in monetary
policy, and social and political instability, could affect results of
operations.
Interest rates. Market interest rate levels, the shape of the yield curve and
the direction of interest rate changes affect net interest revenue as well as
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 reprice 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. In general,
State Street benefits from currency volatility.
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. State Street believes that uncertainties
resulting from the Year 2000 issues could have an impact on new business for
1999 such that customers and potential customers of State Street will be less
inclined in the second half of 1999 to consider changing their business
relationships.
Business mix. Changes in business mix, including the mix of U.S. and non-U.S.
business, may 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.
There are risks inherent in this process. These include rapid technological
change in the industry, the Corporation's ability to access technical and other
information from customers, and the significant and ongoing investments required
to bring new services to market in a timely fashion at competitive prices.
Further, there is risk that competitors may introduce services that could
replace or provide lower-cost alternatives to State Street's services.
- --------------------------------------------------------------------------------
24 State Street Corporation 1998 Annual Report
State Street uses appropriate trademark, trade secret, copyright and other
proprietary rights procedures to protect its technology, and has applied for a
limited number of patents in connection with certain software programs. The
Corporation believes that patent protection is not a significant competitive
factor and that State Street's success depends primarily upon the technical
expertise and creative abilities of its employees and the ability of the
Corporation to continue to develop, enhance and market its innovative business
processes and systems. However, in the event a third-party asserts a claim of
infringement of its proprietary rights, obtained through patents or otherwise,
against the Corporation, State Street may be required to spend significant
resources to defend against such claims, develop a non-infringing program or
process, or obtain a license to the infringed process.
Year-2000 modifications. The costs and projected completion dates for State
Street's Year-2000 program are estimates. Factors that may cause material
differences include the availability and cost of systems and other personnel,
non-compliance of third-party providers, and similar uncertainties. If necessary
modifications and conversions are not completed in time, the Year-2000 issue
could affect State Street's performance.
Acquisitions and alliances. Acquisitions of complementary businesses and
technologies, and development of 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.
European Economic and Monetary Union. The move to a common currency could affect
foreign exchange volumes and the level of deposits denominated in the euro or
the legacy currencies.
- --------------------------------------------------------------------------------
FINANCIAL CONDITION
- --------------------------------------------------------------------------------
BALANCE SHEET
- --------------------------------------------------------------------------------
State Street provides deposit and other balance sheet services to its customers,
who are primarily institutional investors. These customers, in executing their
worldwide investment activities, require short-term investment vehicles and
deposit accounts. These short-term deposits and other customer funds comprise
the majority of State Street's liabilities. State Street's business mix results
in a distinctive composition of its balance sheet, which affects the
Corporation's approach to managing interest rate sensitivity, liquidity and
credit risk.
[pie chart begins]
Average Liabilities and Equity
Customer Funds with Interest 74%
Customer Funds without Interest 14%
Debt and Equity 7%
Other Noninterest-Bearing 5%
[pie chart ends]
LIABILITIES
The growth in State Street's balance sheet is primarily driven by growth in
liabilities. State Street uses its excess balance sheet capacity to support
customers' transactions and short-term investment strategies. State Street's
objectives and customers' needs determine the volume, mix and currencies of the
liabilities.
Average interest-bearing liabilities increased $8.7 billion, or 33%, in 1998.
The most significant growth in liabilities occurred in securities sold under
repurchase agreements, used primarily by mutual fund customers; and in non-U.S.
time, call and transaction deposits, used by both non-U.S. and U.S. customers.
Non-U.S. deposits grew 29%, to $16.3 billion; 38% of this balance consists of
transaction account balances, which have lower interest rates than other
interest-bearing sources of funds. Securities sold under repurchase agreements
increased 44%, to an average of $13.8 billion for the year. Long-term debt
increased, reflecting the issuance in May 1998 of $150 million of floating-rate
capital securities to provide cost-effective funding for corporate growth.
Noninterest-bearing deposits grew $966 million, or 18%. Customers use
noninterest-bearing deposit accounts for transaction settlements and to
compensate State Street for services.
ASSETS
State Street's assets consist primarily of short-term money market assets and
investment securities, which are generally more marketable than other types of
assets. Investment securities, principally classified as available-for-sale,
primarily include U.S. Treasury and Agency securities, highly-rated municipal
securities, asset-backed securities, and non-U.S. government bonds.
Interest-bearing deposits with banks are short-term, multi-currency instruments
invested with major U.S. and non-U.S. banks.
Average interest-earning assets increased $10 billion, or 32%, in 1998.
Securities purchased under resale agreement grew $6.5 billion, or 100%, from
1997. Additional
- --------------------------------------------------------------------------------
25
- --------------------------------------------------------------------------------
FINANCIAL REVIEW
- --------------------------------------------------------------------------------
customer funds, as well as maturing funds from the investment portfolio, were
primarily placed in short-term money market instruments due to the compression
of market spreads as the U.S. Treasury yield curve continued to flatten during
the year. Total investment securities fell $403 million, or 4%, from 1997.
Interest-bearing deposits with banks increased 32% from 1997, to $11.3 billion.
Total loans and leases increased 19%, to $6.3 billion.
[pie chart begins]
Average Assets
Money Market and Investments 77%
Loans 14%
Other Assets 7%
Cash 2%
[pie chart ends]
During 1998, the loan portfolio, consisting of commercial loans, securities
settlement advances and lease financing, comprised 14% of State Street's assets.
This was down from 15% in 1997. Approximately one-third of the loan portfolio
supports the liquidity needs of institutional investors in their investing and
settlement activity.
FAIR VALUE OF
FINANCIAL INSTRUMENTS
The short-maturity structure of State Street's assets and liabilities results in
the fair value of its financial instruments equating to or closely approximating
their balance sheet value. See Note U to the Consolidated Financial Statements,
page 45, for further discussion.
FURTHER INFORMATION
Further quantitative information on State Street's assets and liabilities is
furnished in the Supplemental Financial Data on pages 50-51 and Notes C-H to the
Consolidated Financial Statements, pages 36-38.
LIQUIDITY AND CAPITAL
- --------------------------------------------------------------------------------
LIQUIDITY
The primary objective of State Street's liquidity management is to ensure that
the Corporation 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 payment 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. When liquidity is
measured by the ratio of liquid assets to total assets, State Street ranks among
the highest 10% of U.S. bank holding companies. At December 31, 1998, the
Corporation's liquid assets were 80% of total assets.
State Street endeavors to maintain high ratings on its debt, as measured by
independent credit rating agencies. This ensures minimum borrowing costs and
enhances State Street's liquidity by ensuring the largest possible market for
the Corporation's debt. State Street's senior debt is rated AA- by Standard &
Poor's, A1 by Moody's Investors Service and AA by Fitch IBCA. State Street
Bank's long-term certificate of deposit ratings are AA by Standard & Poor's, Aa2
by Moody's Investors Service and AA+ by Fitch IBCA.
The Consolidated Statement of Cash Flows on page 32 provides additional
information.
CAPITAL
State Street's objective is to maintain a strong capital base in order to
provide financial flexibility for its business needs, including funding
corporate growth and supporting customers' cash management needs.
As a state chartered bank and member of the Federal Reserve System, State Street
Bank and Trust Company, 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 State Street 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%, State Street Bank's Tier 1 risk-based
capital ratio significantly exceeds the regulatory minimum of 4% and is among
the highest for U.S. banks. State Street's Tier 1 risk-based capital ratio of
14.1% is likewise among the highest for U.S. bank holding companies. See Note K
to the Consolidated Financial Statements, on page 40, for further information.
In May 1998, State Street issued $150 million of 30-year, floating-rate capital
securities, redeemable at the option of State Street in ten years. See Note H to
the Consolidated Financial Statements, on page 37, for further information.
The Board of Directors has authorized the purchase of State Street common stock
for use in employee benefit programs and for general corporate purposes. State
Street purchased 1.7 million shares in 1998. As of December 31, 1998, an
additional 3.3 million shares may be purchased within the stock purchase
program. See Note I to the Consolidated Financial Statements, on page 38, for
further information.
- --------------------------------------------------------------------------------
26 State Street Corporation 1998 Annual Report
- --------------------------------------------------------------------------------
DIVIDENDS AND COMMON STOCK
Market Price
---------------------------------------------
Dividends End of
Quarters Declared Low High Quarter
- --------------------------------------------------------------------------------
1997:
First .............. $.10 $31 5/16 $42 1/16 $34 11/16
Second ............. .11 33 1/4 54 1/4 46 1/4
Third .............. .11 46 5/8 61 9/16 60 15/16
Fourth ............. .12 51 3/8 63 11/16 58 3/16
1998:
First .............. .12 49 5/8 70 3/8 68 1/16
Second ............. .13 64 9/16 74 5/16 69 1/2
Third .............. .13 48 1/2 73 3/16 54 9/16
Fourth ............. .14 47 7/8 72 3/4 70 1/8
- --------------------------------------------------------------------------------
Consistent earnings growth has enabled State Street to increase its quarterly
dividend twice each year since 1978. Over the last fifteen years, the dividend
has grown at a 16% compound annual growth rate.
[bar chart begins]
Dividends Per Share
Dollars
1984 .06
1996 .38
1997 .44
1998 .52
[bar chart ends]
There were 6,457 stockholders of record at December 31, 1998.
RISK MANAGEMENT
- --------------------------------------------------------------------------------
In providing services for institutional investors globally, State Street must
manage and control certain inherent risks. These include counterparty risk,
credit risk, fiduciary risk, operations and settlement risk, and market risk.
Risk management is an integral part of State Street's business activities and is
centrally organized with close ties to the business units. This structure allows
for corporate risk management across the business areas while individual line
areas remain responsible for risk management in their units.
Risk management emphasizes establishing specific authorization levels and
limits. Exposure levels are reviewed and modified as required by changing
conditions. Business-risk concentration analysis includes specific industry
lending concentrations, country limits, and individual counterparty limits. In
managing country risk, State Street considers a variety of issues, including
those related to credit quality, asset concentration, liquidity and transfer
risk.
Credit risk results from the possibility that a loss may occur if a counterparty
becomes unable to meet the terms of a contract. State Street has policies and
procedures to monitor and manage all aspects of credit risk. These include a
comprehensive credit-review and approval process that involves the assignment of
risk ratings to all loans and off-balance sheet credit exposures. Rigorous
credit approval processes cover traditional credit facilities, foreign exchange,
placements, credit-enhancement services, securities lending and
securities-clearing facilities.
Fiduciary risk is the risk of financial loss as a consequence of breaching a
fiduciary duty to a customer. Business units are responsible for operating
within the rules and regulations applicable to their businesses, including any
corporate guidelines. The Corporate Fiduciary Review Committee and the
Compliance Committee work with the business units to oversee adherence to
corporate standards.
State Street is a large servicer and manager of financial assets on a global
scale, so management of operations and settlement risk is an integral part of
the management process throughout the Corporation. State Street focuses on
payment-system risk management, overdraft monitoring and control, and global
securities clearing and settlement. In addition to specific authorization levels
and limits, operating risk is minimized by automation, standardized operating
procedures and insurance.
MARKET RISK: FOREIGN EXCHANGE AND
INTEREST RATE SENSITIVITY
State Street engages in trading and investment activities to serve customers'
investment and trading needs, contribute to overall corporate earnings, and
enhance liquidity. In the conduct of these activities, the Corporation is
subject to, and assumes, market risk. Market risk is the risk of an adverse
financial impact from changes in market prices, such as interest rates and
foreign exchange rates. The level of risk State Street assumes is a function of
the Corporation's overall objectives and liquidity needs, customer requirements,
and market volatility.
State Street manages its overall market risk through a comprehensive risk
management framework that includes a market risk management group that reports
independently to senior management. Market risk from foreign exchange and
trading activities is controlled through established limits on aggregate and net
open positions, sensitivity to changes in interest rates, and concentrations.
These limits are supplemented by stop-loss thresholds. The Corporation uses a
variety of risk
- --------------------------------------------------------------------------------
27
- --------------------------------------------------------------------------------
FINANCIAL REVIEW
- --------------------------------------------------------------------------------
management tools and techniques, including value at risk, to measure, monitor
and control market risk. All limits and measurement techniques are reviewed and
adjusted as necessary on a regular basis by business managers, the market risk
management group and senior management.
State Street uses foreign exchange contracts and a variety of financial
derivative instruments to support customers' needs, conduct trading activities,
and manage its interest rate and currency risk. These activities are designed to
create trading revenue or hedge net interest revenue. In addition, the
Corporation provides services related to derivative instruments in its role as
both a manager and servicer of financial assets.
State Street's customers use derivatives to manage the financial risks
associated with their investment goals and business activities. With the growth
of cross-border investing, customers have an increasing need for foreign
exchange forward contracts to convert currency for international investment and
to manage the currency risk in international investment portfolios. As an active
participant in the foreign exchange markets, State Street provides foreign
exchange contracts and over-the-counter options in support of these customer
needs.
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 December 31, 1998, the notional amount of these derivative instruments was
$140 billion, of which $137 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 uses a sophisticated risk management system, known as RiskBooktrademark
from Askari, Inc., to estimate value at risk daily for all material trading
positions. The Corporation has adopted standards for estimating value at risk,
and maintains capital for market risk, 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 greater than 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 uses a simulation approach based on observed
changes in interest rates and foreign exchange rates and takes into account the
resulting diversification benefits provided from the mix of the Corporation's
trading positions.
Like all quantitative measures, value at risk is subject to certain limitations
and assumptions inherent to the methodology. State Street's methodology gives
equal weight to all market rate observations regardless of how recently the
market rates were observed. The estimate is calculated using static portfolios
consisting of positions held at the end of the trading day. 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 AS OF DECEMBER 31,
(Dollars in millions) Average Maximum Minimum
- --------------------------------------------------------------------------------
1998:
Foreign exchange contracts ... $ 1.0 $ 2.7 $ .3
Interest rate contracts ...... .3 2.3
1997:
Foreign exchange contracts ... .6 1.7 .2
Interest rate contracts ...... .1 .3
- --------------------------------------------------------------------------------
State Street compares actual daily profit and losses from trading activities to
estimated one-day value at risk. During 1998, State Street experienced foreign
exchange trading losses in excess of its end of day value at risk estimate on
one occasion.
Non-Trading Activities: Currency Risk
State Street had approximately $15 billion of non-U.S. dollar denominated
non-trading assets as of December 31, 1998, which were primarily funded by
non-U.S. dollar denominated deposits. State Street's non-U.S. dollar denominated
non-trading assets consisted of 45 non-U.S. currencies. Approximately 90% of
these assets were in 15 major currencies. Since non-trading assets are generally
invested in the same currency in which the initial deposits are received, the
risk associated with changes to currency exchange rates is minimal. To the
extent that deposits are not reinvested in the same currency, the resulting net
currency positions are managed as part of the trading risk as discussed above.
In general, the maturities of these non-trading assets and liabilities are short
term. To the extent duration mismatches exist, they are managed as part of State
Street's consolidated asset/liability management activities and the related
market risk is included in the following non-trading interest rate sensitivity
disclosure.
Non-Trading Activities:
Interest Rate Sensitivity
The objective of interest rate sensitivity management is to provide sustainable
net interest revenue under various economic environments and to protect asset
values from adverse effects of changes in interest rates. State Street
- --------------------------------------------------------------------------------
28 State Street Corporation 1998 Annual Report
manages the structure of interest-earning assets and interest-bearing
liabilities by adjusting the mix, yields, and maturity or repricing
characteristics, based on market conditions. Since interest-bearing sources of
funds are predominantly short-term, State Street maintains a generally
short-term structure for its interest-earning assets, including money market
assets, investments and loans. Off-balance sheet financial instruments,
including interest rate swaps, are used minimally as part of overall asset and
liability management to augment State Street's management of interest rate
exposure. State Street uses three tools for measuring interest rate risk:
simulation, duration, and gap analysis.
Key assumptions in the simulation, duration and gap models include the timing of
cash flows, maturities and repricing of financial instruments, changes in market
conditions, loan volumes and pricing, capital planning, and deposit sensitivity.
These assumptions are inherently uncertain and as a result, the models cannot
precisely estimate net interest revenue or precisely predict the impact of
changes in interest rates on net interest revenue and economic value. Actual
results may differ from simulated results due to the timing, magnitude and
frequency of interest rate changes and changes in market conditions and
management strategies, among other factors.
Simulation models facilitate the evaluation of the potential range of net
interest revenue under "most likely" and alternative interest rate scenarios.
Based upon results of the simulation model as of December 31, 1998, which
reflects asset sensitivity beyond three months, the Corporation would expect an
increase in net interest revenue of $9 million over the following 12 months for
an immediate 100 basis points increase in interest rates. Conversely, if
interest rates immediately decreased by 100 basis points, the Corporation would
expect an $18 million decrease in net interest revenue.
Duration measures the change in the economic value of assets and liabilities for
given changes in interest rates. Based upon the results of the duration model as
of December 31, 1998, which indicates a close-to-neutral position, the
Corporation would expect an increase in the economic value of assets net of
liabilities of $12 million, or 0.03% of assets, as a result of an immediate
increase in interest rates of 100 basis points. In the event of an immediate
decrease of 100 basis points to interest rates, there is an expected decrease of
$15 million, or 0.03% of assets, to the economic value of assets net of
liabilities.
The third measure of interest rate risk, gap analysis, is the difference in
asset and liability repricing on a cumulative basis within a specified
timeframe. As of year-end 1998, interest-bearing liabilities reprice faster than
interest-earning assets over the next 12 months, as has been typical for State
Street. If all other variables remained constant, in the short term, falling
interest rates would lead to net interest revenue that is higher than it would
otherwise have been; rising rates would lead to lower net interest revenue.
Other important determinants of net interest revenue are rate levels, balance
sheet growth and mix, and interest rate spreads.
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INTEREST SENSITIVITY POSITION AT DECEMBER 31, 1998 Interest Sensitivity Period in Months
----------------------------------------------------------------
(Dollars in millions) Balance 0 to 3 4 to 6 7 to 12 13 to 24 over 24
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Interest-earning assets:
Interest-bearing deposits with banks ..................... $ 12,085 $ 10,086 $ 1,778 $ 221 $ $
Other money market assets (1) ............................ 10,641 10,641
Investment securities .................................... 9,737 2,184 937 1,884 2,954 1,778
Loans .................................................... 5,019 3,174 193 166 43 1,443
-------- -------- ------- ------- ------ ------
Total interest-earning assets ......................... 37,482 26,085 2,908 2,271 2,997 3,221
-------- -------- ------- ------- ------ ------
Interest-bearing liabilities:
Domestic deposits ........................................ 2,520 2,324 3 8 1 184
Non-U.S. deposits ........................................ 16,633 16,624 9
Federal funds purchased and repurchase agreements ........ 13,477 13,361 116
Other interest-bearing liabilities ....................... 1,352 578 774
-------- -------- ------- ------- ------ ------
Total interest-bearing liabilities .................... 33,982 32,887 128 8 1 958
-------- -------- ------- ------- ------ ------
(6,802) 2,780 2,263 2,996 2,263
Interest rate swaps, net .................................... 407 (20) (34) (33) (320)
-------- ------- ------- ------ ------
Interest rate sensitivity position .......................... (6,395) 2,760 2,229 2,963 1,943
Cumulative interest rate sensitivity position ............... (6,395) (3,635) (1,406) 1,557 3,500
Cumulative gap percentage (2) .............................. (15)% (8)% (3)% 4% 8%
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(1) Includes adjustments to normalize the one-day position and for earnings credits
(2) Cumulative interest rate sensitivity position as a percent of total average earning assets
NEW ACCOUNTING DEVELOPMENTS
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Information related to new accounting developments appears in Note A to the
Consolidated Financial Statements on page 34.
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