Exhibit 13.2
FINANCIAL REVIEW - State Street Boston Corporation
This section provides management's discussion and analysis of State Street's
consolidated results of operation for the three years ended December 31, 1996,
and its financial condition at year-end 1996. It should be read in conjunction
with the Financial Statements and Supplemental Financial Data.
State Street is the world's leading specialist in serving institutional
investors. Among the services State Street provides worldwide are:
O CUSTODY, ACCOUNTING, DAILY PRICING AND ADMINISTRATION O CUSTOMIZED FINANCIAL ANALYSES AND REPORTING
O CASH MANAGEMENT O FOREIGN EXCHANGE SERVICES
O ACTIVE AND INDEXED INVESTMENT MANAGEMENT O CREDIT SERVICES
Results of Operations
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SUMMARY
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In 1996, State Street achieved its nineteenth consecutive year of double-digit
earnings per share growth. It was an outstanding year: earnings per share
increased 21% to $3.56 on a fully diluted basis, revenue grew 19% to $1.9
billion and return on stockholders' equity was 18.1%. The Corporation exceeded
all its financial goals, continuing to execute its strategic plan to build value
for its stockholders.
State Street's primary financial goal is sustainable real earnings per share
growth. To accomplish this, management's primary focus is on revenue growth. In
1996, revenue grew in all businesses. This was driven by new business worldwide,
including both new relationships and additional services for existing customers;
the continued growth of existing customers; continued expansion in cross-border
investing from the United States; and a generally favorable business
environment.
In 1996, State Street began to reap the benefits of its previous investments in
technology as evidenced by the revenue growth rate exceeding the expense growth
rate.
EARNINGS PER SHARE
Fully diluted (dollars)
1992 ............................. 2.04
1993 ............................. 2.28
1994 ............................. 2.64
1995 ............................. 2.95
1996 ............................. 3.56
REVENUE
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State Street specializes in meeting the servicing and investment management
needs of institutional investors worldwide and focuses on customer
relationships. This results in high customer retention and recurring revenue
flows.
State Street offers a wide range of products and services to its sophisticated
customers. Services are priced based on each customer's business relationship.
The revenue received is classified as either fee revenue or net interest
revenue, depending on the services provided. Management focuses on total
revenue. In 1996, total revenue grew 19% to $1.9 billion, with a $183 million
increase in fee revenue and a $124 million increase in net interest revenue.
TOTAL REVENUE
(Dollars in billions)
1996 1995 1994 1993 1992
Fiduciary compensation ... 1,018.2 823.8 749.8 657.0 579.2
Other fee revenue ........ 283.5 295.3 267.5 208.6 164.3
Net Interest Revenue ..... 579.9 456.3 405.6 345.9 308.9
Total Revenue ............ 1,881.6 1,575.4 1,422.9 1,211.5 1,052.4
FEE REVENUE
In 1996, fee revenue accounted for 69% of total revenue and was $1.3 billion, up
$183 million, or 16%, over 1995 due to strong new business installations,
customer growth, and the expansion of the number of services used by existing
customers. Revenue from new business was particularly significant from
investment management, and from financial asset services for non-U.S. customers
and U.S. mutual funds.
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FEE REVENUE Change
(Dollars in millions) 1996 1995 1994 95-96
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Fiduciary compensation ... $ 1,018 $ 824 $ 750 24%
Foreign exchange trading . 126 141 114 (11)
Servicing and processing . 125 113 115 10
Other .................... 33 41 38 (20)
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Total fee revenue $ 1,302 $ 1,119 $ 1,017 16
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FIDUCIARY COMPENSATION
The major component of the 1996 fee revenue increase was fiduciary compensation,
which was up $194 million, or 24%. Fiduciary compensation, the largest component
of fee revenue, is derived from accounting, custody, information, investment
management, securities lending and trusteeship services.
Fees recorded in fiduciary compensation are a function of the volume and mix of
assets under custody and management, securities held, portfolio transactions,
and securities on loan. Fees increasingly reflect the use of value-added and
complex services, such as mutual fund administration, services for offshore
mutual funds, performance and analytics, and investment policy reporting. Due to
relationship pricing, fiduciary compensation may be a function of the use of
other services which are not recorded as fiduciary compensation, such as foreign
exchange and deposit services. Because of the large number of products used by
State Street's customers, the basic custody service provides less than 30% of
total fiduciary compensation. Portfolio transaction fees and securities lending
revenue each account for less than 10% of fiduciary compensation.
Because of the increasing number of services used by customers, revenue is
becoming less sensitive to price movements in securities markets. If equity
values worldwide were to increase or decrease 10%, State Street estimates that
this, by itself, would cause approximately a 1% change in total revenue. If bond
values were to change by 10%, less than a 1% change in total revenue would be
anticipated.
The following sections discuss businesses which contribute fiduciary
compensation and the factors driving fiduciary compensation growth. These
businesses also generate other forms of revenue, including net interest revenue,
which are discussed subsequently. The first two businesses are included in the
Financial Asset Services line of business; Investment Management is reported
separately. Many customers use both financial asset services and investment
management services.
MUTUAL FUND SERVICES. State Street is the largest custodian of mutual funds in
the United States, servicing 39% of registered mutual funds. State Street is
distinct from other mutual fund service providers in the extent to which it
provides a number of related services in addition to custody, including
accounting and daily pricing, which require meeting daily deadlines for
publication of fund prices. Shareholder services are provided through an
affiliate, Boston Financial Data Services. Services such as fund administration,
accounting for multiple classes of shares, master/feeder accounting, and
services for offshore funds and in-country funds from locations outside the
United States, add importantly to fiduciary compensation.
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 for one service for one fund, there is a greater probability that the
complex will select State Street to provide more services and to service more
funds. In addition, State Street benefits substantially from the growth of its
customers. At year-end, mutual fund complexes at State Street totaled 248,
continuing a long record of growth, despite the mergers of 24 existing and
potential customers during the year.
REALTIONSHIPS WITH MUTUAL FUND COMPLEXES
1992 ............................. 186
1993 ............................. 187
1994 ............................. 231
1995 ............................. 242
1996 ............................. 248
In 1996, about half the revenue growth from servicing mutual funds came from new
business, both from existing customers and new customers. Increased revenue from
accounting and custody reflected a 34% growth in average U.S. assets, 44% growth
in non-U.S. assets, additional mutual funds, and higher trading volume. Revenue
continued to increase rapidly from servicing offshore funds and expanding use of
mutual fund administration.
In 1996, the total number of funds serviced increased by 132, to 2,974. There
were 442 new funds, 389 from existing customers and 53 from new customers,
partially offset by 310 funds no longer serviced due to liquidations of funds
and consolidation among customers.
MASTER TRUST/MASTER CUSTODY/GLOBAL CUSTODY. State Street provides custody,
portfolio accounting, securities lending, information and other, related
services for retirement plans and other financial assets of corporations, public
funds, investment managers and non-profit organizations for both U.S. and
non-U.S. customers. Over time, the Corporation is providing increasingly complex
services to these institutional customers, such as performance and analytics,
global reporting, and compliance monitoring.
State Street is the largest servicer of U.S. tax-exempt assets for corporations
and public funds, a rank it has held since 1986. Over the past five years, its
market share has grown from 13% to 25%. In the United States, substantial
revenue growth in 1996 came from new customers and securities lending.
MARKET SHARE OF U.S. MASTER TRUST/MASTER CUSTODY
(Percent of market)
1992 ............................. 13
1993 ............................. 15
1994 ............................. 17
1995 ............................. 21
1996 ............................. 25
Source: Money Market Directory data
As part of its global expansion plan, State Street has built systems to deliver
tailored services to meet the needs of customers in their local markets. Assets
under custody for customers outside the United States have increased at a
compound annual rate of 31% since 1991. In 1996, assets for those customers
totaled $202 billion, an increase of 33% from 1995, with particularly rapid
growth in the Asia/Pacific region. Outside the United States, revenue grew
rapidly in 1996 due to new customers and additional business from existing
customers.
ASSETS UNDER CUSTODY FOR NON-U.S. CUSTOMERS
(Dollars in billions)
1992 ............................. 59
1993 ............................. 90
1994 ............................. 102
1995 ............................. 152
1996 ............................. 202
INVESTMENT MANAGEMENT. State Street invests the assets of corporations, public
and private institutions, and individuals and provides related benefits
outsourcing services. These services are offered through State Street Global
Advisors ("SSgA"). In the United States, State Street is ranked as the largest
manager of tax-exempt assets, the third largest manager of total assets, and the
third largest manager of defined contribution plan assets.
SSgA provides index, active quantitative, and traditional active strategies for
both equities and fixed income. Fees vary according to the strategies used and
the size of the investment.
In 1996, fiduciary compensation from institutional investment management grew
rapidly. Growth occurred across the investment product line, with over half of
the revenue increase from the management of non-U.S. equities. Assets under
management grew 29%; the compound annual growth rate since 1991 is 27%.
ASSETS UNDER MANAGEMENT
(Dollars in billions)
1992 ............................. 111
1993 ............................. 142
1994 ............................. 161
1995 ............................. 227
1996 ............................. 292
SSgA provides recordkeeping and other services attendant to its investment
management activities. In 1996, revenue from providing participant services to
defined contribution plans grew significantly as a result of new business and an
acquisition. The number of participants served increased to 2.0 million from 1.4
million in 1995.
ASSETS UNDER CUSTODY, TRUSTEESHIP AND MANAGEMENT. Assets under custody,
trusteeship and management serve to indicate the relative size of various
markets served and, in the context of market-value changes, as proxies for
business growth. There is not a direct correlation between assets serviced and
revenue, due to the wide range of services used by many of State Street's
customers and the declining percentage of revenue coming from asset-value-based
custody and accounting fees.
Overall, market value changes had a positive impact on the value of assets under
custody and management in 1996. The U.S. equity market, as measured by the S&P
500 index, increased 20%. U.S. bond markets, as measured by the Lehman Brothers
Aggregate Bond index, declined 3%. International equity markets, as measured in
dollars by the Morgan Stanley EAFE index, increased 4%.
In 1996, total assets under custody increased $664 billion, or 29%, to $2.9
trillion. Using broad assumptions, management estimates that approximately
one-third of the increase was due to the impact of higher securities market
values and two-thirds was due to customers' growth and new business.
At year-end, approximately 50% of assets under custody at State Street were
equities, 30% were short-term instruments and 20% were fixed income instruments.
Non-U.S. securities comprised 15% of total assets under custody.
In 1996, bonds under trusteeship increased $39 billion to $322 billion, up 14%,
due to additional trusteeship appointments and acquisitions.
Assets managed increased to $292 billion, up $65 billion, or 29%, from year-end
1995. State Street estimates that approximately one-third of the $65 billion
year-over-year increase was due to higher securities market values and
two-thirds due to additional contributions and new business. The $43 billion
increase in equities managed includes a $38 billion increase in
passively-managed equities.
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ASSETS UNDER CUSTODY, TRUSTEESHIP AND MANAGEMENT Compound
DECEMBER 31, Growth
Change Rate
(Assets in billions) 1996 1995 1994 1993 1992 1991 95-96 91-96
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ASSETS UNDER CUSTODY
Customers excluding mutual funds:
United States ........ ..... $ 1,459 $ 1,125 $ 838 $ 798 $ 674 $ 503 30% 24%
Non-U.S..................... 202 152 102 90 59 53 33 31
Mutual funds/collective
investment funds ........... 1,281 1,001 788 796 656 579 28 17
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Total .................... $ 2,942 $ 2,278 $ 1,728 $ 1,684 $ 1,389 $ 1,135 29 21
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BONDS UNDER TRUSTEESHIP
Corporate trust ............... $ 322 $ 283 $ 210 $ 201 $ 136 $ 132 14 20
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ASSETS UNDER MANAGEMENT
Equities ...................... $ 141 $ 98 $ 69 $ 59 $ 44 $ 39 44 29
Employer securities ........... 39 34 19 19 19 18 15 17
Fixed income .................. 23 22 12 12 11 10 5 18
Money market .................. 89 73 61 52 37 22 22 32
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Total .................... $ 292 $ 227 $ 161 $ 142 $ 111 $ 89 29 27
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FOREIGN EXCHANGE TRADING
State Street's foreign exchange activities focus on serving institutional
investors around the world. In the short-term, revenue is a function of market
volatility and the volume of transactions. A long-term driver of revenue is the
number of investment managers using the Corporation's foreign exchange trading
services. At year end, there were 575 such managers, including many who custody
their securities at State Street, and 65% of the 175 largest global money
managers in the world.
INVESTMENT MANAGERS USING FOREIGN EXCHANGE SERVICES
1992 ............................. 299
1993 ............................. 369
1994 ............................. 405
1995 ............................. 499
1996 ............................. 575
In 1996, foreign exchange trading revenue was $126 million, down $15 million
from 1995. Decreased market volatility resulted in lower revenue, although
transaction volumes were up 24% and the number of investment managers for whom
services were provided increased 15%.
SERVICING AND PROCESSING
Servicing and processing revenue includes fees from mortgage servicing, loans,
trade banking, investment banking, cash management, and brokerage services.
Servicing and processing revenue of $125 million was up 10% from 1995. The
increase was primarily due to higher volume of brokerage transactions, an
increase in loan fees and an acquisition, partially offset by the loss of
revenue from a non-strategic business that was sold.
OTHER FEE REVENUE
Other fee revenue includes gains and losses on sales of securities and other
assets, trading account profits, mortgage custody fees, leveraged leasing
residuals, and equity income from joint ventures. In 1996, other fee revenue
declined $8 million, or 20%, as the Corporation took $7 million less in gains on
the investment securities portfolio.
NET INTEREST REVENUE
In serving institutional investors worldwide, State Street provides repurchase
agreements and deposit services for the short-term cash associated with
customers' investment activities. The revenue from these services and from
lending are recorded as net interest revenue.
Net interest revenue is the amount of interest received on interest-earning
assets reduced by 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.
Taxable-equivalent net interest revenue in 1996 was $588 million, up $124
million, or 27%, over 1995. This increase in net interest revenue was driven by
balance sheet growth and a wider spread between interest rates earned and paid.
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NET INTEREST REVENUE - TAXABLE EQUIVALENT
Change
(Dollars in millions) 1996 1995 1994 95-96
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Interest revenue .......... $ 1,443 $ 1,336 $ 936
Taxable equivalent
adjustment ............. 37 35 25
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1,480 1,371 961
Interest expense .......... 892 907 544
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Net interest revenue ... $ 588 $ 464 $ 417 27%
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The Corporation manages its balance sheet to support the expansion of its
businesses worldwide. In 1996, State Street continued to expand globally,
installing new customers and benefiting from existing customers' growth and use
of additional services. This new business, combined with growth of capital,
fueled the expansion of State Street's balance sheet, reflecting the
Corporation's ability to offer competitive short-term, multicurrency investment
options. The additional funds were mostly in the form of short-term cash that
was placed in non-U.S. deposits, repurchase agreements and noninterest-bearing
deposits. Customer funds from these sources increased $3.2 billion and funded
the increase in average interest-earning assets of $3.2 billion, or 14%, to
$26.4 billion. Loans increased $849 million, or 23%, due to growth in securities
settlement advances, which reflected increased volumes of customers' securities
settlement activity; in loans to New England businesses and selected industries
nationwide; and in leveraged leases. Growth in interest-earning assets
contributed approximately half of the increase in net interest revenue.
KEY CUSTOMER LIABILITIES
(Average dollars in billions)
1996 1995 1994 1993 1992
Non-U.S. Deposits ............ 10,372 8,470 7,392 4,954 3,955
Repurchase agreements ........ 7,819 7,080 4,958 4,181 3,346
Noninterest-Bearing Deposits . 4,638 4,113 4,701 4,059 3,305
The difference between the interest rate State Street earned on its assets and
paid on its liabilities increased from 1.21% in 1995 to 1.53% in 1996. This was
a significant factor in the growth of net interest revenue. Because State Street
was managing its balance sheet so that interest-bearing liabilities repriced
faster than interest-earning assets, the declining rate environment and steeper
Treasury yield curve had a positive impact on the spread.
Net interest margin, which is defined as taxable equivalent net interest revenue
as a percent of average interest-earning assets, increased from 2.01% in 1995 to
2.23% in 1996 for the same reasons net interest revenue increased.
OPERATING EXPENSES
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In 1996, operating expenses were $1.4 billion, up 19%, supporting business
growth. Installation of a substantial amount of new business and growth of
existing customers' business resulted in significantly greater volume. Total
average assets under custody increased 30%. Average daily U.S. transaction
volume was up 27%. Average assets under management were up 41%, with the
non-U.S. component up 35%. Because State Street's service is differentiated by a
high level of customer service, growth necessitated additional customer service
staff.
The Corporation continued to execute its strategic plan for creating stockholder
value by investing for future growth. Investment spending, which was 9% of total
revenue in 1995, returned to State Street's more typical 8% of total revenue in
1996.
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OPERATING EXPENSES
Change
(Dollars in millions) 1996 1995 1994 95-96
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Salaries and employee benefits $ 775 $ 651 $ 588 19%
Transaction processing services 164 125 113 31
Equipment ..................... 138 124 112 11
Occupancy ..................... 100 84 73 20
Other ......................... 221 190 172 15
Total operating expenses ... $ 1,398 $ 1,174 $ 1,058 19
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Salaries and employee benefits, the largest component of expense, was $775
million, up 19% from 1995, due to higher salary expense, incentive compensation
and employee benefits costs.
Transaction processing services expense is comprised of volume-related expenses
including subcustodian fees, external contract services, and fees related to
domestic securities settlement. This expense was up $39 million, or 31%. An
increase in subcustodian fees reflected a 43% increase in average non-U.S.
assets custodied by State Street and a 37% increase in average daily non-U.S.
transactions. In addition, higher expenses reflect the implementation of same
day funds settlement mandated by a primary U.S. depository, increased mutual
fund shareholder activity and other business volume growth.
Equipment expense was $138 million, up 11% due to additional capacity to support
database and transaction growth, client service workstations, purchased
software, and networking equipment.
Occupancy expense increased 20%, to $100 million. Approximately half of the
growth was due to a scheduled rate increase on a long-term lease and the
remainder to additional space to support growth.
Other expenses include professional services and advertising and sales
promotion. In 1996, other expenses increased 15%, to $221 million, due to
increased use of professional services, including outsourced customization of
systems and reports for customers, investment banking, legal, accounting and
other service fees; and increased expense related to the introduction of new
products and branding initiatives. The amortization of goodwill and intangibles,
and travel-related expenses also increased.
INCOME TAXES
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Income tax expense was $154 million in 1996 and $119 million in 1995. In 1996,
the effective tax rate was 34.5%, the same as the effective rate for the full
year 1995 when the effect of non-recurring items is excluded.
ACQUISITIONS AND ALLIANCES
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State Street's emphasis is on internal growth. However, the Corporation makes
acquisitions for strategic purposes, provided there is no long-term dilution.
Acquisitions and alliances add new products or services that enhance established
capabilities, expand geographic reach, or increase, very selectively, market
share.
In March, State Street announced an alliance with Watson Wyatt Worldwide, one of
the world's largest human resources consulting and benefits outsourcing firms,
to provide total employee benefits outsourcing services through a jointly-held
subsidiary, Wellspring Resources.
Likewise in March, State Street and Bridge, a leading provider of information
and analytical services to the financial services industry, entered into a
strategic business alliance. The alliance allows for product development,
distribution and marketing activities for a range of value-added services.
In May, State Street acquired the assets of Lattice Trading Inc., a provider of
an advanced, event-driven, electronic trading system.
In July, State Street announced a strategic alliance with Bank of Ireland to
provide custody, accounting and administration services to offshore mutual funds
registered or managed in Dublin.
In November, State Street acquired Princeton Financial Systems, Inc., a leading
provider of client/server software for investment managers, with particular
focus on the insurance industry. The acquisition of Princeton positions State
Street as a market leader in services to the insurance industry. Princeton's
software is already being used to service nearly $1 trillion of investment
assets for more than 250 institutional investors in the United States and
Europe.
In December, State Street and Windham Capital Management formed an alliance to
provide advanced market-risk management technology, analytical tools and hedging
strategies to investors worldwide.
COMPARISON OF 1995 VERSUS 1994
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In 1995, fully diluted earnings per share were $2.95, up from $2.64 in 1994.
Total revenue for 1995 was 11% higher than for 1994. Over the same period, net
income increased 12%. Return on stockholders' equity was 16.7% in 1995, versus
17.2% in 1994.
1995 earnings per share growth was driven by revenue from new business growth
worldwide for both existing customers and new relationships, by international
transactions including foreign exchange activity, by higher securities market
values, and by improvements in operating efficiency. Some trends in the business
environment seen in 1994 continued, including growth in cross-border investing
and industry consolidation.
LINES OF BUSINESS
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State Street reports three lines of business: Financial Asset Services,
Investment Management and Commercial Lending. The business lines are fully
integrated and pricing for customer relationships may encompass more than one
line of business. The basis for presentation reflects the current management
accounting policies that conform to and support the strategic and tactical
objectives of State Street. Therefore, the operating results of these lines of
business are not necessarily comparable with business lines reported at any
other company.
Revenue and expenses collected in various management information systems are
directly charged or allocated to the lines of business. Because State Street
prices on a relationship basis, 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.
CONTRIBUTION TO TOTAL REVENUE
Financial Asset Services .................... 72%
Investment Management ....................... 18%
Commercial Lending .......................... 10%
On the following page is a summary of line of business operating results for the
years ended December 31, 1996, 1995 and 1994. Certain previously reported line
of business information has been restated to conform to the current method of
presentation.
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LINES OF BUSINESS Financial Investment Commercial
Asset Services Management Lending
(Taxable equivalent basis,
dollars in millions) 1996 1995 1994 1996 1995 1994 1996 1995 1994
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Fee revenue.................. $ 940 $ 846 $ 781 $ 318 $ 235 $ 195 $ 44 $ 38 $ 41
Net interest revenue......... 411 302 299 23 23 8 146 131 99
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Total revenue............. 1,351 1,148 1,080 341 258 203 190 169 140
Operating expenses........... 1,043 908 822 268 191 160 87 75 76
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Operating profit $ 308 $ 240 $ 258 $ 73 $ 67 $ 43 $ 103 $ 94 $ 64
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Pretax margin................ 23% 21% 24% 21% 26% 21% 54% 56% 46%
Percentage contribution...... 64% 60% 71% 15% 17% 12% 21% 23% 17%
Average assets............... $ 25,722 $ 23,010 $ 20,112 $ 556 $ 428 $ 333 $ 3,205 $ 2,744 $ 2,350
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FINANCIAL ASSET SERVICES
Financial Asset Services provides accounting, custody, daily pricing,
information, foreign exchange, cash management, securities lending and other
services for investors with large pools of investment assets worldwide; and
corporate trusteeship. Revenue from this line of business comprised 72% of State
Street's total revenue for 1996.
Revenue increased to $1.4 billion, up 18% from $1.1 billion in 1995. The $203
million increase in revenue was driven primarily by strong business growth and
secondarily by more favorable market interest rates. Total fee revenue was up
11%, despite lower foreign exchange trading revenue and a decline in net
securities gains. Fiduciary compensation was up 20% and reflected substantial
revenue increases from services for mutual funds and master trust, master
custody and global custody for customers worldwide.
Net interest revenue, up 36%, reflected the results of investing customer
deposits and other short-term customer funds in interest-earning assets. In
1996, customer funds, particularly non-U.S. deposits, repurchase agreements, and
noninterest-bearing deposits, grew substantially. These funds were invested at
more favorable spreads than in 1995.
Operating expenses were $1.0 billion, 15% higher than in 1995, supporting
business growth.
In 1996, operating profit was $308 million, an increase of $68 million, or 28%,
from 1995 and reflected strong revenue growth as well as improvement in the
pretax margin.
INVESTMENT MANAGEMENT
State Street manages financial assets worldwide for both institutions and
individuals and provides related services, particularly participant
recordkeeping for defined contribution plans. State Street's investment
management services feature a broad array of products, including quantitative
equity management, both passive and active, money market funds, and fixed income
strategies. Revenue from this line of business comprised 18% of State Street's
total revenue for 1996.
Revenue grew 33%, to $341 million, due to broad-based growth in both investment
management and related businesses, attributable to both new customers and
additional business from existing customers.
Operating expenses increased 41% due to higher salary expense, including
performance-based incentive compensation; promotional and advertising expenses;
and the up-front costs associated with a substantial amount of new defined
contribution plan recordkeeping business. Staff increased 22% in support of
global growth and from an acquisition.
Operating profit was $73 million, an increase of $6 million, or 9%, from $67
million in 1995. The pretax profit margin declined from 26% in 1995 to 21% in
1996.
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, and for broker/dealers. Other credit services include asset-based
finance, leasing and international trade finance. Revenue from this line of
business comprised 10% of State Street's total revenue for 1996.
Revenue grew to $190 million, up 12% from $169 million in 1995, due primarily to
a 17% increase in loans. Loans to New England businesses and specialty
industries nationwide, leveraged leases, and international trade finance all
grew.
During 1996, all measures of credit quality improved. In 1996, Commercial
Lending provided for loan losses at $8 million, up from $7 million a year ago,
commensurate with the increase in loans outstanding. Commercial Lending
represents nearly all of the Corporation's provision for loan losses. The
provision for loan losses and the credit experience of State Street for the
three years ended December 31, 1996, is shown in Footnote D to the Financial
Statements on page 28.
Operating expenses increased 16%, supporting business growth.
Operating profit was $103 million, an increase of $9 million, or 10%, from 1995.
FINANCIAL GOALS AND FACTORS THAT MAY AFFECT THEM
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State Street's primary financial goal is sustainable real growth in earnings per
share. There are two supporting goals, one for total revenue and one for return
on common stockholders' equity ("ROE"). The revenue goal is 12.5% real, or
inflation adjusted, growth in revenue per year for the decade of the 1990s.
Decade-to-date, this has translated into a nominal growth goal of 15.2%
compounded per year. The ROE goal is to achieve 18%.
State Street considers these to be financial goals, not projections or
forward-looking statements. However, if these goals are perceived to be
forward-looking statements, they, as with any other statement that may be
considered forward looking, should be considered in conjunction with the factors
listed below, which could cause actual results to differ materially.
The following issues and factors, among others, should be considered in
evaluating the outlook for State Street's goals and forward-looking statements:
o Cross-border investing. Cross-border investing by customers worldwide benefits
revenue. Future revenue may increase or decrease depending upon the extent of
cross-border investments made by customers or future customers.
o Savings rate of individuals. State Street benefits from the savings of
individuals which are invested in mutual funds or defined contribution plans.
Changes in savings rates or styles may lead to increased or decreased revenue.
o 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 11.
o Dynamics of markets served. Changes in the markets served can affect revenue,
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.
o Interest rates. Market interest rate levels, the direction of interest rate
changes, and the shape of the yield curve affect both net interest revenue and
fiduciary compensation from securities lending. All else being equal, State
Street benefits from higher rather than lower interest rates because it has a
larger amount of interest-earning assets than interest-bearing liabilities. The
effect of interest rate movements is discussed on page 19.
o 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 or investment management services. The pace of pension reform will
affect the pace of revenue growth.
o Pricing/competition. Future prices the company is able to obtain for its
products may increase or decrease from current levels depending upon demand for
its products and its competitors' activities. State Street, or its competitors,
could introduce new products into the marketplace.
o Pace of new business. The pace at which existing and new customers use
additional services will affect future revenue.
o Business mix. Changes in business mix, including the mix of U.S. and non-U.S.
business, will affect earnings growth rates.
o Rate of technological change. Technological change creates opportunities for
product differentiation and reduced costs as well as the possibility of
increased expenses.
Based on its evaluation of these factors, management is currently optimistic
about the Corporation's long-term prospects.
Financial Condition
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BALANCE SHEET COMPOSITION
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State Street manages its balance sheet to serve the particular needs of its
customer base, primarily institutional investors worldwide. As a result, the
balance sheet contains a distinct mix of assets and liabilities.
Institutional investors, with responsibility for investing large pools of
assets, need short-term investment vehicles and deposit accounts to facilitate
their transactions. State Street provides customers with a range of on- and
off-balance sheet alternatives for short-term funds, including various deposit
facilities and securities sold under repurchase agreements. These short-term
deposits and other customer funds comprise the majority of State Street's
liabilities. The Corporation invests these funds principally in short-term,
high-quality, interest-earning assets.
As a result, State Street has a low-risk, highly liquid balance sheet. The
balance sheet composition affects the Corporation's approach to managing
interest rate sensitivity, liquidity, and credit risk.
LIABILITIES
The growth of State Street's balance sheet is liability-driven. Customers use
the Corporation's balance sheet capacity for deposits and short-term investments
based on their surplus cash, short-term investment strategies, risk profiles and
regulatory environments. Their needs, in conjunction with management's
parameters, determine the mix, volume and currencies of the liabilities they
place with State Street. While customers have the option of using various
off-balance sheet financial instruments, many prefer or are required to have
on-balance sheet deposits and short-term investments. Providing these facilities
is fundamental to State Street's ability to serve its customers.
AVERAGE LIABILITIES AND EQUITY
Customer Funds With Interest ..................... 73%
Customer Funds Without Interest .................. 16%
Debt And Equity .................................. 6%
Other Noninterest-bearing ........................ 5%
The principal liabilities are non-U.S. time, call, and transaction-account
deposits, used by both non-U.S. and U.S. customers; and securities sold under
repurchase agreements, used principally by mutual funds customers.
Noninterest-bearing deposits are used for transaction settlements and to
compensate State Street for services.
In 1996, average interest-bearing deposits increased 20%, to $12.6 billion, from
1995. Non-U.S. deposits, the largest component of interest-bearing deposits,
grew 22%, to $10.4 billion. Securities sold under repurchase agreements
increased 10%, to an average of $7.8 billion for the year.
ASSETS
Almost half of State Street's assets are money market assets and investment
securities, which are generally more marketable and have higher credit quality
profiles than a normal loan portfolio. Investment securities, principally
available for sale, include U.S. Treasury and Agency securities, highly-rated
municipal securities, and asset-backed securities. Interest-bearing deposits
with banks are short-term multicurrency instruments, primarily Eurocurrency
placements, invested with major U.S. and non-U.S. banks. Approximately
two-thirds of the total loan portfolio is commercial loans and lease financing.
The remaining one-third is loans supporting the liquidity needs of financial
asset services customers and securities brokers in trading and settlement
activity. These are short-term, usually overnight, and have relatively low
credit risk.
AVERAGE ASSETS
Investments ............................ 74%
Cash ................................... 4%
Loans .................................. 15%
Other Assets ........................... 7%
Average interest-bearing deposits with banks increased 29% in 1996 from 1995, to
$7.0 billion. Total loans increased 23%, to $4.5 billion.
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
its balance sheet value. See Footnote S to the Financial Statements, page 38,
for a further discussion.
FURTHER INFORMATION
Further quantitative information on State Street's assets and liabilities is
furnished in the Supplemental Financial Data on page 42 and Footnotes C-H to the
Financial Statements, pages 28-30.
LIQUIDITY AND CAPITAL RESOURCES
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CAPITAL STRENGTH
State Street maintains a strong capital base to support its customers. Strong
capital levels provide financial flexibility as well, which facilitates funding
corporate growth and other business 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. The Corporation 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 12.1%, the Bank's Tier 1 risk-based capital ratio
significantly exceeds the regulatory minimum of 4% and is among the highest for
U.S. banks. The Corporation's total risk-based capital ratio of 13.6% is
likewise among the highest for U.S. bank holding companies. See Footnote K to
the Financial Statements, on page 31 for further information.
LIQUIDITY
The primary objective of State Street's liquidity management is to ensure that
the Corporation has sufficient funds to conduct its activities, including
accommodating the transaction and cash management requirements of its customers,
meeting loan commitments, and replacing maturing liabilities. Liquidity is
provided by the Corporation'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 funds provide a
multicurrency, geographically diverse source of funding.
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 of U.S. banking companies. At December 31, 1996, the Corporation's
liquid assets were 78% of total assets.
State Street manages its business to maintain high ratings on its debt, as
measured by rating agencies. This not only ensures minimum borrowing costs, but
also 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 Investor Services and AA by IBCA, Inc. State Street
Bank's long-term certificate of deposit ratings are AA by Standard & Poor's, Aa2
by Moody's Investor Services and AA+ by IBCA, Inc.
The Consolidated Statement of Cash Flows on page 24 provide additional
information.
CAPITAL STRUCTURE
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In 1996, State Street lowered its long-term after-tax cost of capital in order
to provide for a more efficient after-tax funding of its growth.
DEBT ISSUANCE
In April 1996, State Street filed a shelf registration with the Securities and
Exchange Commission which provided for the issuance of up to $500 million of
senior or subordinated debt securities and preferred stock. In June 1996, the
Corporation issued $150 million of 30-year 7.35% debentures redeemable at the
option of the holder in ten years. As of December 31, 1996, $350 million was
available for issuance.
LONG-TERM DEBT AND EQUITY
(Dollars in billions)
1995 1996
Long-term debt ........................ .127 .476
Equity ................................ 1.588 1.775
Total Long-term debt and Equity ....... 1.715 2.251
In December, State Street issued $200 million of 30-year 7.94% Capital
Securities, redeemable at the option of State Street in ten years. The Capital
Securities and long-term debt are discussed further in Footnote H to the
Financial Statements, on pages 29-30.
STOCK PURCHASE PROGRAM
In 1996, State Street purchased 2.7 million shares of its stock for use in
employee compensation programs and for general corporate purposes. At December
31, a total of 3.1 million shares had been purchased under the authorization to
purchase six million shares.
DIVIDENDS
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 16% annually on a compound basis.
There were 5,752 stockholders of record at year-end 1996.
DIVIDENDS PER SHARE
(Dollars)
1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982
0.760 0.680 0.600 0.520 0.445 0.385 0.340 0.3 0.26 0.22 0.18 0.148 0.125 0.113 0.1
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DIVIDENDS AND COMMON STOCK
Market Price
----------------------------------
Dividends End of
Declared Low High Period
- --------------------------------------------------------------------
1995
First ........... $ .16 $ 28 $ 34 1/8 $ 31 7/8
Second .......... .17 30 3/8 37 5/8 36 7/8
Third ........... .17 35 1/8 41 1/2 40
Fourth .......... .18 38 5/8 46 1/4 45
1996
First ........... .18 41 3/4 51 50
Second .......... .19 45 1/8 53 3/4 51
Third ........... .19 47 3/8 57 7/8 57 3/8
Fourth .......... .20 56 3/4 68 1/2 64 5/8
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INTEREST RATE SENSITIVITY MANAGEMENT
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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 manages
the structure of interest-earning assets and interest-bearing liabilities by
adjusting the mix, yields and maturity, or repricing characteristics, based on
changing market conditions.
State Street uses three tools for measuring interest rate risk: simulation,
duration and gap analysis. Simulation models facilitate the evaluation of the
potential range of net interest revenue under "most likely" and alternative
interest rate scenarios. Duration measures the change in the economic value of
assets and liabilities for given changes in interest rates.
The third measure of interest rate risk, gap analysis, is the difference in
asset and liability repricing on a cumulative basis within a specified time
frame. At year-end 1996, within the subsequent 12 months interest-bearing
liabilities were repricing faster than interest-earning assets, 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 which 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.
State Street maintains flexibility to adjust its interest rate sensitivity.
Because 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 are used as part of overall asset and liability
management. Financial futures and interest rate swaps are used modestly to
augment State Street's management of interest rate exposure.
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INTEREST SENSITIVITY POSITION AT DECEMBER 31, 1996 Interest Sensitivity Period in Months
-----------------------------------------------------------
(Dollars in millions) Balance 0-3 4-6 7-12 13-24 over 24
- ----------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Interest-bearing deposits with banks ............... $ 7,565 $ 6,812 $ 448 $ 305 $ $
Other money market assets (1)....................... 3,609 3,609
Investment securities ............................ 9,387 890 695 2,607 3,564 1,631
Loans ............................................ 3,978 2,907 98 74 38 861
------- -------- ------ ------- ------ -------
Total interest-earning assets .................... 24,539 14,218 1,241 2,986 3,602 2,492
------- -------- ------ ------- ------ -------
Interest-bearing liabilities:
Domestic deposits .................................. 2,071 1,864 8 13 186
Non-U.S. deposits .................................. 11,053 11,040 11 2
Federal funds purchased and repurchase agreements .. 7,504 7,453 51
Other interest-bearing liabilities ................. 1,211 564 85 43 43 476
------- -------- ------ ------- ------ -------
Total interest-bearing liabilities ............... 21,839 20,921 155 58 43 662
------- -------- ------ ------- ------ -------
Interest rate swaps .................................. 296 (98) (5) (193)
-------- ------ ------- ------ -------
Interest rate sensitivity position .................... (6,407) 1,086 2,830 3,554 1,637
Cumulative interest rate sensitivity position ......... (6,407) (5,321) (2,491) 1,063 2,700
Cumulative gap percentage (2).......................... (24)% (20)% (9)% 4% 10%
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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
RISK MANAGEMENT
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In providing financial asset services 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. Rigorous credit approval processes cover traditional credit
facilities, foreign exchange, placements, credit-enhancement services,
securities lending and securities-clearing facilities. 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.
Fiduciary risk is the risk of financial loss as a consequence of breaching a
fiduciary duty to a customer. Business units have the primary responsibility to
operate within the rules and regulations applicable to their businesses,
including any corporate guidelines. Additionally, the Corporate Fiduciary Review
Committee and the Compliance Committee work with the business units to oversee
adherence to corporate standards.
Because State Street is a large servicer and manager of financial assets on a
global scale, management of operations and settlement risk is an integral part
of the management process throughout the Corporation. This 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 arises from price changes in various markets. Market risk from
foreign exchange and trading activities is monitored and controlled through
established limits on positions and aggregate limits based on estimates of
potential loss of earnings under assumptions about changes in market conditions.
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.
In the securities lending business, State Street acts as an agent to lend
customer-owned securities to broker/dealers and banks. The Corporation is not a
principal in these transactions and, therefore, the associated loans are not
reflected on its balance sheet. Customers' and State Street's potential exposure
to each borrower is approved and monitored through State Street's credit risk
approval and management process. Collateral in the form of cash, securities, or
letters of credit secures the borrower's promise to return customers'
securities. Securities are marked to market and compared to the value of
collateral daily. Investment of customer cash collateral is managed in
compliance with approved investment parameters.
FOREIGN EXCHANGE AND DERIVATIVE FINANCIAL INSTRUMENTS
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State Street uses foreign exchange and a variety of financial derivative
instruments to support customers' needs, conduct trading activities, and manage
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 an international investment portfolio. 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.
As part of its trading activities, the Corporation assumes market positions in
both the foreign exchange and interest rate markets using financial derivatives
including forward foreign exchange contracts, foreign exchange and interest rate
options, and interest rate swaps.
As of December 31, 1996, the notional amount of these instruments was $65.4
billion, of which $62.7 billion was foreign exchange forward contracts. Long and
short foreign exchange forward positions are closely matched to minimize
currency and interest rate risk. In order to estimate changes in the value of
the outstanding contracts, all forward foreign exchange contracts are valued
daily at current market rates.
State Street uses various derivatives to minimize the interest rate and foreign
exchange risks associated with its global business activities. As of year-end
1996, the notional amount of these derivatives was $411 million.
Trading activities involving both foreign exchange and interest rate derivatives
are managed using earnings-at-risk measures and trading limits as established by
risk management policies. Interest rate and foreign exchange derivatives used as
part of the asset and liability management process undergo the same credit and
interest rate risk analyses as on-balance sheet financial instruments.
NEW ACCOUNTING DEVELOPMENTS
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Statement of Financial Accounting Standards (SFAS) No. 125, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities"
is effective for fiscal years beginning after December 31, 1996. Certain
provisions of this statement have a postponed effective date of 1998. State
Street plans to adopt the required provisions of this statement in 1997, and the
provisions are not expected to have a material impact on State Street's
financial statements.