Exhibit 13.2
Long-Term Global Trends are Creating Demand for our Services
Financial markets worldwide are large and growing. There is approximately $20
trillion worth of stock trading around the world, and over $21 trillion of
bonds, according to Salomon Brothers' most recent estimates. Analysis of the
major markets State Street serves indicates they will continue to grow strongly
over the next five years. While there is considerable overlap between
industries, the estimated size and future growth rates of these markets suggest
an outstanding opportunity for those who serve them.
The long-term, global trends discussed here convince us that these markets will
grow strongly for years. And State Street is better able than anyone to meet
these institutional investors' needs for technologically advanced, reliable
products and services.
State Street's Global Markets
1996 Estimated Estimated Annual
Global Assets Growth Rate
US$ Trillions 1996-2001
Mutual Funds $ 6.4 15%
Pension Funds 8.2 10%
Asset Management Industry 14.6 10%
Insurance Industry 8.9 9%
Sources: InterSec Research Corporation; Investment Company Institute;
State Street internal estimates
[graphic omitted]
State Street is focused on serving institutional investors worldwide. Our
customers include mutual fund and insurance companies, corporate and government
pension funds, and investment managers, who serve large and growing markets.
Fundamental demographic, social, political, and economic changes -- long-term,
global trends -- ensure their markets will continue to grow well into the
future. And State Street, committed to serving institutional investors' needs,
plans to grow with its customers.
Aging Populations Worldwide
In 1950, life expectancy at birth, worldwide, was 46 years. Many people couldn't
expect to live long enough to retire. In less than 50 years, life expectancy
worldwide has risen 44%, to 66 years today; and 75 years in more developed
regions. Longer life spans are leading to longer retirements -- and longer
retirements require bigger pensions, more retiree services, and more personal
savings. Institutional investors, like mutual fund companies and corporate and
government pension plans, serve these needs, and State Street serves those
investors.
Increasing longevity is also causing a redistribution of the world's population.
Between 1997 and 2025, the over-60 population will increase by more than 100%.
The under-60 population will increase by less than 30%.
World Population by Age
Year
------------------------------------
Age 1997 2005 2025
--- ---- ---- ----
(Millions of People)
(000 omitted)
60 Plus 567 665 1,178
40-59 1,091 1,345 1,854
20-39 1,842 2,018 2,335
0-19 2,346 2,433 2,537
Source: U.S. Census Bureau International Programs Center
Pressures on Pension Systems
More older people collecting retirement benefits from traditional, pay-as-you-go
pension systems, and proportionately fewer younger people paying into those
systems, presents tremendous challenges for public pension funds. As the ratio
of workers to retirees declines, many national governments are moving away from
pay-as-you-go plans, and funded pension plans are gaining popularity. In 1997
alone, Australia, Hungary, Italy, Mexico and Spain introduced major reforms to
their traditional systems to encourage personal savings and private pension
plans. In France, Germany, Hong Kong, Poland, the United States, and other
countries, governments are considering major changes.
Growing pools of assets funding these pension systems means more demand for
institutional investors' services -- which means more demand for the services
State Street offers.
Workers Per Retiree
Year
------------------------------------
Country 1950 1990 2030
------- ---- ---- ----
China -- 11.49 4.30
Germany 7.18 4.61 2.00
Japan 11.41 5.85 2.20
United Kingdom 6.24 4.17 2.60
United States 7.97 5.35 2.00
Brazil 22.75 13.90 5.50
Sources: OECD; World Bank
Increased Cross-Border Investing
Non-home country investments by pension funds worldwide
Year US$ billions
---- ------------
1990 345
1995 892
2001 2,309
Source: InterSec Research Corporation
Aging populations and the resulting pressures on pension systems have created
growing demand to improve returns and decrease risk for savings and investments.
Greater diversification can help achieve both these goals. The demand for
diversified investments, coupled with technological advances, has led to
explosive growth in cross-border investing. Where once many countries required
that pension and other assets be invested in the home country, and many
investors preferred to keep their funds at home, investing across national
borders is common today. Between 1990 and 2001, InterSec Research Corporation
expects non-home country investment by pension funds worldwide to more than
quintuple, rising from $345 billion to more than $2 trillion.
At State Street, we're seeing the results of this change as our customers look
to us for more services, including foreign exchange and currency management
services, global investment management strategies, and information services.
Complex, Global Investment Strategies
The growth in cross-border investing is part of a larger trend toward
increasingly complex, global investment strategies. Investors around the world
can choose from an increasingly wide range of securities and strategies for
their investments that includes blue chip and penny stocks; private placements
and IPOs; savings bonds and junk bonds; CDs and money market funds; global bond
funds, specialty stock funds, emerging markets index funds, active,
single-country balanced funds; puts and calls; LEAPS, ABS, REITs, SPDRs, OEICs,
and of course much more.
Our customers look to State Street for the value-added products and services --
from information to settlement -- that enable them to execute their strategies.
Mutual Funds o Interest Rate Swaps o U.S. Equities o Tactical Asset Allocation o
Japanese Warrants o Emerging Markets Equities o S&P 500 Index Funds o High Yield
Bonds o Gold Futures o Mortgage-Backed Securities o Commercial Paper o Thai Bhat
o Municipal Bonds o Growth o Value o Income o Emerging Markets Index Funds o
Asset-Backed Securities o Money Market Funds o Malaysian Utility Debt o Private
Placements o Active o Enhanced o Passive o Small Cap Stocks o Global Bonds o
Eastern European Stock Funds o Convertibles o Stockpicking o Quantitative o
Illinois Hogs o Socially-Conscious Stock Funds o Technology Stocks o Brady Bonds
o Blue Chip Stocks o Reverse Repos o Annuities o Canadian Dollar Options o
Collateralized Mortgage Obligations o REITs o GICs o Derivatives o SPDRs o
Sovereigns
Financial Review State Street Corporation
This section provides management's discussion and analysis of State Street's
consolidated results of operation for the three years ended December 31, 1997,
and its financial condition at year-end 1997. It should be read in conjunction
with the Consolidated Financial Statements and Supplemental Financial Data.
State Street is the world's leading specialist in serving institutional
investors. Among the services State Street provides customers worldwide are:
o Custody, accounting, daily o Information and trading
pricing and administration
o Credit services
o Foreign exchange, cash
management and securities
lending
o Investment management
RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------
SUMMARY
- --------------------------------------------------------------------------------
In 1997, State Street exceeded both its financial goals and historical trends by
substantial margins. Earnings per diluted share of $2.32 were up 30% from 1996.
Revenue increased 24% from the previous year. Return on stockholders' equity was
20.6%.
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 17% per year, compounded annually. State
Street's two supporting financial goals are for 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 15% nominal growth annually. Nominal revenue has increased 17% per
year, compounded annually, in the decade to date. Return on stockholders' equity
was 20.6% for 1997, above State Street's goal of 18%.
This was State Street's twentieth consecutive year of double digit earnings per
share growth. The Corporation achieved this record through periods of inflation,
disinflation, recession, gyrations in securities markets, and rapid market
innovation. State Street's consistent financial performance demonstrates
successful execution of its strategic plan to build value for its stockholders
while continuing to invest in technology, new products and services, and
expansion into new markets.
Growth in revenue contributed importantly to this consistent financial
performance. Revenue growth was driven primarily by customers' expanding needs,
arising in part from the continuation of the long-term trends (discussed in the
fold-out on page 5) that create demand for services provided by State Street. In
1997, State Street was positioned to benefit not only from these long-term
trends, especially the continued strong level of cross-border investing, but
also from several other external factors. Securities values were higher, on
average, than in 1996. Currency markets were active and volatile. U.S. mutual
funds experienced strong cash inflows.
State Street signed a record level of new business in 1997, some of which was
installed during the year, and some of which will be installed in 1998.
With record new business signed in 1997 and the continuation of the long-term
trends driving demand for services provided by State Street, management is
optimistic about State Street's prospects. Since external factors may not be as
favorable in the future, management expects State Street's long-term earnings
per share growth rates to be more in keeping with its long-term, historical
performance. Management remains confident that execution of its strategic
business plan will continue to create value for stockholders.
Diluted Earnings Per Share
(Dollars)
1993 ................ 1.14
1994 ................ 1.32
1995 ................ 1.47
1996 ................ 1.78
1997 ................ 2.32
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REVENUE
State Street specializes in providing services and investment management for
institutional investors worldwide and focuses on customer relationships. This
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 5.5 products in 1997, up from 5.3 in 1996 and 4.9 in 1995.
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 1997, total revenue grew 24%, to $2.3 billion, with
a $371 million increase in fee revenue and an $89 million increase in net
interest revenue.
Total Revenue
(Dollars in billions)
1993 ................. 1.2
1994 ................. 1.4
1995 ................. 1.6
1996 ................. 1.9
1997 ................. 2.3
FEE REVENUE
In 1997, fee revenue accounted for 71% of total revenue and was $1.7 billion, up
$371 million, or 28%, over 1996 due to strong new business from both existing
customers and new customers; customer growth; and a favorable operating
environment. Fee revenue growth came from fiduciary compensation, up $234
million; foreign exchange trading revenue, up $119 million; and servicing and
processing fees, up $34 million.
- -----------------------------------------------------------------------
FEE REVENUE Change
(Dollars in millions) 1997 1996 1995 96-97
- -----------------------------------------------------------------------
Fiduciary compensation ..... $1,252 $1,018 $ 824 23%
Foreign exchange trading ... 245 126 141 95
Servicing and processing ... 159 125 113 28
Other ...................... 17 33 41 (50)
------ ------ ------ --
Total fee revenue ........ $1,673 $1,302 $1,119 28
====== ====== ====== ==
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FIDUCIARY COMPENSATION
Fiduciary compensation, up 23%, is the largest component of fee revenue and is
derived from accounting, custody, information, investment management, securities
lending and trusteeship services.
Fees recorded in fiduciary compensation are a function of the mix and volume of
assets under custody and 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.
Securities lending revenue is sensitive to the short-term interest-rate yield
curve. Revenue benefits from cross-border investing. In 1997, non-U.S. assets of
U.S. customers increased 31%, despite unchanged equity values as measured by
Morgan Stanley's EAFE index.
Fees increasingly reflect the use of services other than basic custody and
accounting, such as mutual fund administration, services for offshore mutual
funds, performance and analytics, and compliance monitoring.
The following sections discuss services that contribute to fiduciary
compensation and the factors driving fiduciary compensation growth. These
services also generate other forms of revenue, such as foreign exchange trading
revenue and net interest revenue from deposits, that are not recorded as
fiduciary compensation. The amount of these other forms of revenue may affect
the amount of fiduciary compensation received. The first three services are
included in the line of business that reports on services for institutional
investors; investment management is reported separately. Many institutional
investors use multiple services, including investment management.
MUTUAL FUND SERVICES. State Street is the world's largest mutual fund custodian,
accounting agent and administrator. In the United States, State Street provides
custody services to 41% of registered mutual funds. State Street is distinct
from 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 services for more than
five times the assets serviced by the next largest accounting service provider.
State Street is responsible for 25% of the U.S. mutual fund prices that appear
daily in The Wall Street Journal. Services such as fund administration,
accounting for multiple classes of shares, master/feeder accounting, and
services for offshore funds and for local funds in locations outside the United
States add importantly to fiduciary compensation. Shareholder services are
provided through an affiliate, Boston Financial Data Services, Inc.
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
substantially from the growth of its customers. At year-end 1997, 254 mutual
fund complexes used State Street's services, up from 248 a year ago. This
continued a long record of growth despite ongoing industry consolidation.
Mutual Fund Complexes
1993 ................. 187
1994 ................. 231
1995 ................. 242
1996 ................. 248
1997 ................. 254
In 1997, nearly 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 growth in assets, particularly non-U.S.
assets; additional mutual funds; and a higher volume of trades. This growth
reflects in part the strong net cash flows into U.S. mutual funds during the
year. Revenue from servicing offshore funds and from mutual fund administration
continued to increase rapidly.
In 1997, total mutual fund assets under custody increased 33%. The total number
of funds serviced increased by 347, to 3,321. There were 648 new funds serviced,
555 from existing customers and 93 from new customers, partially offset by 301
funds no longer serviced due primarily to mergers and consolidations of funds.
The number of offshore funds serviced was up 27% from a year ago and offshore
assets increased 52%. The number of funds for which State Street provides mutual
fund administration was up 42%, and assets under administration more than
doubled.
SERVICES FOR 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 is developing the products and
services, such as performance and analytics, global reporting, and compliance
monitoring, that these institutional customers require for their increasingly
complex needs.
Market Share of U.S. Pension Assets
(Percent of market)
1993 .................. 15
1994 .................. 17
1995 .................. 21
1996 .................. 22
1997 .................. 24
Source: Money Market Directory data
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 15% to 24%. Substantial revenue growth in 1997 came
from growth in current customer relationships as well as from new customers.
CUSTOMERS OUTSIDE THE UNITED STATES. As part of its global expansion plan, State
Street has built systems to deliver tailored services to meet customers' needs
in their local markets. Assets under custody for customers outside the United
States have increased at a compound annual growth rate of 35% since 1992. In
1997, assets for those customers totaled $266 billion, an increase of 32% from
1996, with strong growth in Europe and Canada. Revenue grew rapidly in 1997 due
to new customers and additional business from existing customers.
Assets Under Custody for
Non-U.S. Customers
(Dollars in billions)
1993 ................. 90
1994 ................. 102
1995 ................. 152
1996 ................. 202
1997 ................. 266
INVESTMENT MANAGEMENT. State Street provides an extensive range of investment
management services, including investment management for corporations, public
funds, and other institutional investors; recordkeeping and investment services
for defined contribution plans; and investment management and other services for
high-net-worth individuals. These services are offered through State Street
Global Advisors ("SSgA"). In 1997, strong revenue growth occurred across all
services. In the United States, SSgA is the second largest manager of tax-exempt
assets, the fourth largest manager of total assets, and one of the five largest
managers of defined contribution plan 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 on the investment strategy, the
amount of the investment, and the customer's total State Street relationship.
Assets Under Management
(Dollars in billions)
1993 ................. 142
1994 ................. 161
1995 ................. 227
1996 ................. 292
1997 ................. 390
In 1997, revenue from managing assets for institutional investors was driven
primarily by new relationships, additional contributions from existing customers
and higher values of U.S. equities. The two strategies contributing most to the
increase in revenue were international and domestic passive equities.
Revenue from providing participant services to defined contribution plans grew
significantly as a result of new business and growth in existing business. The
number of participants served increased to 2.4 million from 2.0 million in 1996.
ASSETS UNDER CUSTODY AND MANAGEMENT. The amounts of assets under custody and
assets under management indicate the relative size of various markets served
and, as adjusted for market-value changes, serve as proxies for business growth.
Changes in asset levels do not necessarily cause corresponding revenue changes
due to the structure of asset-based fee schedules and the many services that are
priced on factors other than asset size.
Market value changes had a positive impact on the value of assets under custody
and management in 1997. The U.S. equity market, as measured by the S&P 500
index, increased 31%. U.S. bond markets, as measured by the Lehman Brothers
Aggregate Bond index, increased 2%. International equity markets, as measured in
dollars by the Morgan Stanley EAFE index, were virtually unchanged at year end.
In 1997, total assets under custody increased $961 billion, or 33%, to $3.9
trillion. Using broad assumptions, management estimates that approximately half
of the increase was due to the impact of higher securities market values, and
half was due to additional contributions to mutual funds, pension plans and
other portfolios, and to new business.
- ----------------------------------------------------------------------------------------------------------------
ASSETS UNDER CUSTODY AND MANAGEMENT Compound
DECEMBER 31, Growth
Change Rate
(Assets in billions) 1997 1996 1995 1994 1993 1992 96-97 92-97
- ----------------------------------------------------------------------------------------------------------------
ASSETS UNDER CUSTODY
Customers in the U.S.:
Mutual Funds ............ $1,705 $1,281 $1,001 $ 788 $ 796 $ 656 33% 21%
Pension, insurance and
other investment pools . 1,932 1,459 1,125 838 798 674 32 23
Customers outside the U.S. 266 202 152 102 90 59 32 35
------ ------ ------ ------ ------ ------
Total ................. $3,903 $2,942 $2,278 $1,728 $1,684 $1,389 33 23
====== ====== ====== ====== ====== ======
ASSETS UNDER MANAGEMENT
Equities:
Passive .................. $ 168 $ 119 $ 83 $ 55 $ 48 $ 34 41 38
Active ................... 26 20 18 14 11 10 30 21
Employer securities ....... 51 39 34 18 17 17 31 25
Fixed income .............. 28 24 19 12 11 10 17 23
Money market .............. 117 90 73 62 55 40 30 24
------ ------ ------ ------ ------ ------
Total ................. $ 390 $ 292 $ 227 $ 161 $ 142 $ 111 34 29
====== ====== ====== ====== ====== ======
- ----------------------------------------------------------------------------------------------------------------
At year-end, approximately 55% of assets under custody at State Street were
equities, 25% were fixed income instruments and 20% were short-term instruments.
Non-U.S. securities comprised 10% of total assets under custody, with emerging
markets less than 1%.
Assets managed by State Street increased to $390 billion, up $98 billion, or
34%, from year-end 1996. State Street estimates that approximately 40% of the
$98 billion year-over-year increase was due to higher securities market values
and 60% was due to additional contributions and new business. At year end,
non-U.S. securities comprised 20% of total securities, with emerging markets
securities comprising less than 3%.
FOREIGN EXCHANGE TRADING
Institutional investors need comprehensive foreign exchange services. State
Street understands their needs and provides these services. New currency
research, risk management, electronic execution services, and additional
currencies traded helped earn State Street a position among the ten best foreign
exchange service providers overall in a 1997 worldwide survey of institutional
investors by Global Investor magazine.
Investment Managers Using
Foreign Exchange Services
1993 ................. 369
1994 ................. 405
1995 ................. 499
1996 ................. 575
1997 ................. 625
In 1997, the number of institutional investors trading with State Street
increased to 625, up from 575 a year ago, and existing relationships expanded,
positioning State Street to benefit substantially from active currency markets.
In 1997, foreign exchange trading revenue was $245 million, up 95% from the
prior year. Major currencies were about 50% more volatile than in 1996,
contributing to revenue growth. The volume of customer trades, measured in
dollars, was up 54% from a year ago.
SERVICING AND PROCESSING
Servicing and processing revenue includes fees from software licensing and
maintenance, loans, brokerage services, trade banking, investment banking, and
cash management. Servicing and processing revenue of $159 million was up 28%
from 1996. This reflected, in part, the acquisition of Princeton Financial
Systems, Inc. in November 1996 and its subsequent growth. Revenue increased from
all other sources, particularly brokerage fees. Revenue growth was partially
offset by the sale of a non-strategic business.
OTHER FEE REVENUE
Other fee revenue includes gains and losses on sales of investment securities,
other assets, leveraged leasing residuals, and currency translation; trading
account profits and losses; profit or loss from joint ventures; and amortization
of investments in tax-advantaged financings. In 1997, other fee revenue declined
$16 million, with about half the decline due to a write-down of real estate
acquired for expansion occurring elsewhere.
NET INTEREST REVENUE
In serving institutional investors worldwide, State Street provides deposit
services and repurchase agreements for the short-term cash positions associated
with customers' investment activities. The revenue from these services and from
lending activities 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 1997 was $685 million, up $97
million, or 17%, over 1996, driven by balance sheet growth.
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NET INTEREST REVENUE
(Dollars in millions; Change
taxable equivalent) 1997 1996 1995 96-97
- -------------------------------------------------------------------------
Interest revenue ............ $1,755 $1,443 $1,336
Taxable equivalent adjustment 44 37 35
------ ------ ------
1,799 1,480 1,371
Interest expense ........... 1,114 892 907
------ ------ ------
Net interest revenue ..... $ 685 $ 588 $ 464 17%
====== ====== ======
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The Corporation manages its balance sheet to support its businesses worldwide.
In 1997, State Street continued to expand globally, installing new customers and
benefiting from existing customers' growth, activity, and use of additional
services. State Street's balance sheet expanded, due to additional funds in the
form of short-term cash placed in non-U.S. deposits, repurchase agreements and
noninterest-bearing deposits. Customer funds from these sources rose $4.7
billion and funded, along with increased long- term debt, the growth in average
interest-earning assets of $5.1 billion, or 19%, to $31.4 billion. Loans
increased $838 million, or 19%, due to growth in securities settlement advances,
commercial loans, and leveraged leases.
Key Customer Liabilities
(Average dollars in bilions)
1993 ................. 13.2
1994 ................. 17.1
1995 ................. 19.7
1996 ................. 22.8
1997 ................. 27.5
Net interest margin, which is defined as taxable-equivalent net interest revenue
as a percent of average interest-earning assets, declined from 2.23% in 1996 to
2.18% in 1997 due to narrower interest rate spreads.
OPERATING EXPENSES
- --------------------------------------------------------------------------------
In 1997, operating expenses were $1.7 billion, up 24%, supporting current
business growth and investments for future growth. Installation of a substantial
amount of new business and existing customers' internal growth resulted in
significantly greater business volume. Total average assets under custody
increased 31% and the volume of securities transactions was up 31%. Average
assets under management were up 32%.
Salaries and employee benefits, the largest component of expense, was $973
million, up 25% from 1996, due to higher salary expense, incentive compensation
and employee benefits costs. Because of State Street's strong financial
performance in 1997, an increase in the number of participants in State Street's
incentive plans, record new business, and a higher stock price, incentive
compensation comprised a larger proportion of expenses than it did in 1996.
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OPERATING EXPENSES
Change
(Dollars in millions) 1997 1996 1995 96-97
- --------------------------------------------------------------------------------
Salaries and employee benefits .... $ 973 $ 775 $ 651 25%
Transaction processing services ... 184 164 125 12
Equipment ......................... 164 138 124 19
Occupancy ......................... 119 100 84 18
Other ............................. 294 221 190 34
------ ------ ------ --
Total operating expenses ........ $1,734 $1,398 $1,174 24
====== ====== ====== ==
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Transaction processing services expense is comprised of volume-related expenses
including external contract services, subcustodian fees, and fees related to
securities settlement. Despite substantial volume increases, this expense
category was only up $20 million, or 12%.
Equipment expense was $164 million, up 19%, due primarily to the purchase of
additional desktop computers, servers, communications equipment and other
peripheral devices, as well as software rental and maintenance, supporting
volume growth and additional or enhanced products and services.
Occupancy expense increased 18%, to $119 million, due to additional office space
required to support growth worldwide.
Other expenses include professional services, advertising, sales promotion,
office supplies, and telecommunications. In 1997, other expenses increased $73
million to $294 million, due to increased use of professional services,
including outsourced software development; additional fees for legal, accounting
and other services; and increased expense related to the introduction of new
products and branding initiatives.
INCOME TAXES
- --------------------------------------------------------------------------------
Income tax expense was $184 million in 1997 and $154 million in 1996. In 1997,
the effective tax rate was 32.6%, down from 34.5% in 1996. The lower effective
tax rate for 1997 was due to higher tax credits, initiatives to minimize tax
expense worldwide, and the phase-in of a lower state tax rate.
ACQUISITIONS, ALLIANCES AND DIVESTITURES
- --------------------------------------------------------------------------------
State Street's emphasis is on internal growth. However, the Corporation makes
acquisitions for strategic purposes, provided there is no long-term earnings per
share dilution. Acquisitions and alliances enhance established capabilities by
adding new products or services, expand geographic reach, or increase, very
selectively, market share.
During 1997, State Street took several initiatives to expand its investment
management services. In February, State Street and a minority partner formed
European Direct Capital Management, specializing in direct equity investing in
Eastern and Central Europe. In June, State Street formed a joint venture with
Mansion House Group Ltd. to provide investment management and mutual fund
services in the People's Republic of China. In October, State Street purchased
the research division of Advanced Investment Technology Inc. ("AIT"), which
performs quantitative analysis using nonlinear tools described as genetic
algorithms or neural networks, and purchased a majority interest in AIT's asset
management business, with $150 million in assets under management.
In June, State Street acquired a New England-based corporate trust business,
becoming the paying agent for an additional 6,300 corporate trust issues
representing about $96 billion in outstanding bonds. At year-end, the
Corporation had a total of $488 billion in bonds under trusteeship. State Street
estimates that it is among the five largest providers of corporate trust
services in the United States.
Additionally in June, State Street sold its subsidiary Wendover Funding, a
non-strategic business focused on loan servicing for home lenders, governmental
agencies, and other investors.
In December, State Street announced plans to acquire the unit trust trustee
business of Bank of Scotland, with $22 billion in assets under administration
for 183 collective investment funds. The Corporation expects to complete the
acquisition, subject to regulatory approval, in early 1998. Bank of Scotland's
capabilities in the unit trust trustee business complement State Street's
established expertise in accounting and fund administration, providing a
foundation on which State Street can build a full-service trustee, accounting,
and fund administration operation for the U.K. collective investment fund
market.
YEAR 2000
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Many computer systems and software products worldwide and throughout all
industries will not function properly as the year 2000 approaches unless
changed, due to a once-common programming standard that represents years using
two-digits. This is the "Year 2000" problem that has received considerable media
coverage. State Street implemented a comprehensive program in 1996 that
addresses Year 2000 compliance and is supported by a corporate-wide structure of
compliance teams, a central program management office, and a governance and
oversight structure.
As part of this program, State Street has identified those systems and
applications that require modification, redevelopment or replacement. The
program has established appropriate testing procedures and a schedule for
completion of this work. State Street's Year 2000 program also establishes
standards and deadlines for the Corporation's vendors and other third-party
providers, and procedures for determining reasonable alternatives to those
third-party providers, including subcustodians, who do not meet compliance
standards.
State Street's goal is to be Year 2000 compliant by December 31, 1998 with
respect to its internal systems. Testing and integration of third-party
providers' systems will continue into 1999. As of year-end 1997, the program is
well under way.
State Street is fully committed to achieving its compliance goal. This program
requires hiring staff and consultants, purchasing equipment, and incurring other
expenses. Management estimates that the total cost of the program for the
five-year period 1996-2000 will be less than 2% of total operating expenses, or
in aggregate, less than $200 million. The Corporation expects to absorb these
expenses within normal spending levels.
COMPARISON OF 1996 VERSUS 1995
- --------------------------------------------------------------------------------
In 1996, diluted earnings per share increased 21% to $1.78. Total revenue
increased 19% and return on stockholders' equity was 18.1%, up from 16.7% in
1995.
This strong performance exceeded all financial goals. 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 business lines
reported at any other company.
Revenue and expenses are directly charged or allocated to the lines of business
through algorithm-based management information systems. Because State Street
prices on total customer relationships and other factors, 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.
- -----------------------------------------------------------------------------------------------------------------------
LINES OF BUSINESS Services for Investment Commercial
Institutional Investors Management Lending
(Dollars in millions;
taxable equivalent) 1997 1996 1995 1997 1996 1995 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------------
Fee revenue ............ $ 1,211 $ 940 $ 846 $407 $318 $235 $ 55 $ 44 $ 38
Net interest revenue ... 469 411 302 33 23 23 167 146 131
------- ------- ------- ---- ---- ---- ------ ------ ------
Total revenue ........ 1,680 1,351 1,148 440 341 258 222 190 169
Operating expenses ..... 1,293 1,043 908 345 268 191 96 87 75
------- ------- ------- ---- ---- ---- ------ ------ ------
Operating profit ..... $ 387 $ 308 $ 240 $ 95 $ 73 $ 67 $ 126 $ 103 $ 94
======= ======= ======= ==== ==== ==== ====== ====== ======
Pretax margin .......... 23% 23% 21% 22% 21% 26% 57% 54% 56%
Percentage contribution 64% 64% 60% 15% 15% 17% 21% 21% 23%
Average assets ......... $31,031 $25,722 $23,010 $696 $556 $428 $3,699 $3,205 $2,744
- -----------------------------------------------------------------------------------------------------------------------
Contribution to Total Revenue
Services for Institutional Investors ... 72%
Investment Management .................. 19%
Commercial Lending ..................... 9%
SERVICES FOR INSTITUTIONAL INVESTORS
This line of business is comprised of services for institutional investors
worldwide. Accounting, custody, daily pricing and information services are
provided for large portfolios of investment assets. Foreign exchange, cash
management, securities lending and other 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
72% of State Street's total revenue for 1997.
Revenue increased to $1.7 billion, up 24% from $1.4 billion in 1996. The $329
million increase in revenue was driven by strong new business from both existing
and new customers and from customer growth, facilitated by a favorable operating
environment. Fee revenue was up $271 million, or 29%, due to growth in fiduciary
compensation and foreign exchange trading revenue. Fiduciary compensation, up
21%, reflected substantial revenue increases from services for mutual funds, for
U.S. pension and other investment pools, and for customers outside the United
States. Foreign exchange trading revenue nearly doubled from a year ago due to
growth in the volume of transactions and volatile currency markets.
Net interest revenue, up 14%, reflected the results of investing customer
deposits and other short-term customer funds in interest-earning assets. In
1997, customer funds, particularly non-U.S. deposits, repurchase agreements, and
noninterest-bearing deposits, grew substantially.
Operating expenses were $1.3 billion, 24% higher than in 1996, supporting
business growth and investments for future growth.
In 1997, operating profit was $387 million, an increase of $79 million, or 26%,
from 1996, reflecting strong revenue growth.
INVESTMENT MANAGEMENT
State Street manages financial assets worldwide for both institutions and
individuals and provides related services, including participant services for
defined contribution plans. Investment management features a broad array of
services, including passive and active equity, money market, and fixed income
strategies. Revenue from this line of business comprised 19% of State Street's
total revenue for 1997.
Revenue grew 29%, to $440 million, due to strong growth across the business --
investment management for institutions and high-net-worth individuals, defined
contribution plan services, and brokerage services.
Operating expenses increased $77 million, or 29%, due to additional staff,
office space and systems in support of business growth.
Operating profit was $95 million, an increase of $22 million, or 30%, from $73
million 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 leasing and
international trade finance. Revenue from this line of business comprised 9% of
State Street's total revenue for 1997.
Revenue grew to $222 million, up 17% from $190 million in 1996, due primarily to
a 22% increase in loans and leases, and increased fee revenue. Loans to
businesses in the northeastern United States and specialty industries
nationwide, leveraged leases, and international trade finance all grew.
Increased fees came from lending activity and gains on leasing residuals.
In 1997, non-performing assets declined and other measures of credit quality
remained strong. Commercial Lending provided for loan losses at $15 million, up
from $8 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, 1997, is shown in Note D to the Consolidated
Financial Statements on page 30.
Operating expenses increased 10% and operating profit was $126 million, an
increase of $23 million, or 22%, from 1996.
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 12.5% real, or inflation adjusted, compound annual growth in
revenue for the decade of the 1990's. This translates to approximately 15%
nominal compound annual growth. The ROE goal is to achieve 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 its evaluation of these factors, management is currently optimistic
about the Corporation's long-term prospects.
CROSS-BORDER INVESTING. Cross-border investing by customers worldwide benefits
State Street's revenue. Future revenue may increase or decrease depending upon
the extent of cross-border investments made by customers or future customers.
SAVINGS RATE OF INDIVIDUALS. State Street benefits from the savings of
individuals that are invested in mutual funds or defined contribution plans.
Changes in savings rates or investment styles may affect revenue.
VALUE OF WORLDWIDE FINANCIAL MARKETS. As worldwide financial markets increase or
decrease in value, State Street's opportunities to invest and service financial
assets may change. Since a portion of the Corporation's fees are based on the
value of assets under custody and management, fluctuations in worldwide
securities market valuations will affect revenue, as discussed on page 11.
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 changes in monetary policy, could also affect
results of operations.
INTEREST RATES. Market interest rate levels, the shape of the yield curve and
the direction of interest rate changes affect both net interest revenue and
fiduciary compensation from securities lending. In a stable rate environment,
State Street benefits from high interest rates, because it has a larger amount
of interest-earning assets than interest-bearing liabilities, and from a steeper
curve. All else being equal, in the short term State Street 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.
PACE OF PENSION REFORM. State Street expects to benefit from worldwide pension
reform that creates additional pools of assets that use custody and related
services and investment management services. The pace of pension reform may
affect the pace of revenue growth.
PRICING/COMPETITION. Future prices the Corporation is able to
obtain for its products may increase or decrease from current
levels depending upon demand for its products, its competitors' activities, and
the introduction of new products into the marketplace.
PACE OF NEW BUSINESS. The pace at which existing and new customers use
additional services and assign additional assets to State Street for management
or custody will affect future results.
BUSINESS MIX. Changes in business mix, including the mix of U.S. and non-U.S.
business, will affect future results.
RATE OF TECHNOLOGICAL CHANGE. Technological change creates opportunities for
product differentiation and reduced costs as well as the possibility of
increased expenses. State Street's financial performance depends in part on its
ability to develop and market new and innovative services and to adopt or
develop new technologies that differentiate State Street's products or provide
cost efficiencies.
YEAR 2000 MODIFICATIONS. The costs and projected completion date of State
Street's 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 strategic alliances are an active part of State Street's
overall business strategy, and the Corporation has completed several
acquisitions 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.
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 invests these funds,
primarily in low risk assets. Thus, 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.
LIABILITIES
The growth in State Street's balance sheet is driven by growth in liabilities.
State Street uses its balance sheet capacity to support customers' transactions
and short-term investment strategies. Customers' needs, along with management's
objectives, determine the volume, mix and currencies of the liabilities.
Average Liabilities and Equity
Customer Funds With Interest ............ 72%
Customer Funds Without Interest ......... 15%
Debt and Equity ......................... 7%
Other Non-interest Bearing .............. 6%
Average interest-bearing liabilities increased $4.3 billion, or 20%, in 1997.
The most significant growth in liabilities occurred in non-U.S. time, call and
transaction deposits, used by both non- U.S. and U.S. customers; and in
securities sold under repurchase agreements, used primarily by mutual funds
customers. Non-U.S. deposits grew 22%, to $12.6 billion; 43% 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 23%, to an average of $9.6 billion for the year.
Noninterest-bearing deposits grew $650 million, or 14%, primarily due to
additional deposits from mutual funds. Customers use noninterest-bearing
deposits 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 and have less credit
risk than a loan portfolio. Investment securities, principally classified as
available-for-sale, are comprised of 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,
multicurrency instruments, primarily Eurocurrency placements, invested with
major U.S. and non-U.S. banks.
Average Assets
Investments ............................. 74%
Loans ................................... 15%
Other Assets ............................ 8%
Cash .................................... 3%
During 1997, the loan portfolio comprised 15% of State Street's assets.
Approximately one-third of the loan portfolio supports the liquidity needs of
institutional investors in their trading and settlement activity. These loans
are short-term, with relatively low credit risk.
Average interest-earning assets increased $5.1 billion, or 19%,
in 1997. Total investment securities grew $2.4 billion, or 30%, from 1996, with
the majority of growth occurring in the U.S. Treasury and Agency portfolio.
Interest-bearing deposits with banks increased 21% from 1996, to $8.5 billion.
Total loans increased 19%, to $5.4 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
their balance sheet value. See Note T to the Consolidated Financial Statements,
page 39, 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 44 and Notes C-H to the
Consolidated Financial Statements, pages 30-32.
LIQUIDITY AND CAPITAL
- --------------------------------------------------------------------------------
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 financial markets, its ability to
gather additional deposits from its customers, maturing short-term assets, the
sale of securities, and payment of loans. Customer funds provide a
multicurrency, 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. banking companies. At December 31, 1997, the
Corporation's liquid assets were 77% of total assets.
State Street manages its business to maintain high ratings on its debt, as
measured by independent credit 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 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 26 provides additional
information.
CAPITAL
State Street ensures it is well capitalized in order to support its customers.
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 12.2% 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 Tier 1 risk-based capital ratio of 13.7% is
likewise among the highest for U.S. bank holding companies. See Note K to the
Consolidated Financial Statements, on page 33, for further information.
In March 1997, State Street issued $300 million of 30-year, 8.035% Capital
Securities, redeemable at the option of State Street in ten years. The Capital
Securities and long-term debt are discussed further in Note H to the
Consolidated Financial Statements, on page 31.
State Street's Board of Directors has authorized the purchase of common stock
for use in employee benefit programs and for general corporate purposes. State
Street purchased 2.8 million shares in 1997. As of December 31, 1997, 3 million
shares were authorized to be purchased.
- ----------------------------------------------------------------
DIVIDENDS AND COMMON STOCK
Market Price
------------------------------
Dividends End of
Declared Low High Period
- ----------------------------------------------------------------
1996
First .......... $ .09 $ 20 7/8 $ 25 1/2 $ 25
Second ......... .095 22 9/16 26 7/8 25 1/2
Third .......... .095 23 11/16 28 15/16 28 11/16
Fourth ......... .10 28 3/8 34 1/4 32 5/16
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
- ----------------------------------------------------------------
Dividends Per Share
(Dollars)
1983-1997 .05 .34 .38 .44
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 6,199 stockholders of record at year-end 1997.
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.
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: 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, 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 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, 1997, the notional amount of these derivative instruments was
$94 billion, of which $92 billion was foreign exchange forward contracts. Long
and short foreign exchange forward positions are closely matched to minimize
currency and interest rate risk. All foreign exchange contracts are valued daily
at current market rates.
The Corporation uses a variety of risk measurement and estimation techniques
including value at risk. Value at risk is an estimate of potential loss for a
given period of time within a stated statistical confidence interval. State
Street estimates value at risk daily for all material trading positions using a
methodology based on the distribution of historical market movements. The
Corporation has adopted standards for estimating value at risk, and 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 an
historical observation period of one year. A 99% one-tail confidence interval
implies that daily trading losses should not exceed the estimated value at risk
more than 1% of the time, or approximately three days out of the year. The
methodology takes into account observed correlations between interest rates and
foreign exchange rates, and the resulting diversification benefits provided from
the mix of the Corporation's trading positions.
Like all quantitative measures, value at risk is subject to certain limitations
and assumptions inherent to the methodology. State Street's methodology uses an
assumption of normal distribution of market returns. The estimate is calculated
using static portfolios consisting of positions held at the end of the trading
day in Boston. Implicit in the estimate is the assumption that no intraday
action is taken by management during adverse market movements. As a result, the
methodology does not represent risk associated with intraday changes in
positions or intraday price volatility.
The following table presents State Street's market risk for its trading
activities as measured by its value at risk methodology:
- -----------------------------------------------------------------
VALUE AT RISK FOR 1997
(Dollars in millions) Average Maximum Minimum
- -----------------------------------------------------------------
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 1997, State Street did not experience
any foreign exchange trading loss in excess of its end of day value at risk
estimate.
NON-TRADING ACTIVITIES: FOREIGN EXCHANGE
State Street has approximately $13 billion of non-U.S. denominated non-trading
assets as of December 31, 1997, which are primarily funded by non-U.S.
denominated deposits. State Street's non-U.S. denominated non-trading assets are
comprised of 48 non-U.S. currencies. Approximately 90% of these assets are in 13
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 the non-trading assets and liabilities are also
matched and are short term. To the extent duration mismatches exist, they are
managed as part of State Street's normal 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 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. 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, 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.
- -----------------------------------------------------------------------------------------------------------------------------
INTEREST SENSITIVITY POSITION AT DECEMBER 31, 1997 Interest Sensitivity Period in Months
--------------------------------------------------------------------
(Dollars in millions) Balance 0 to 3 4 to 6 7 to 12 13 to 24 over 24
- -----------------------------------------------------------------------------------------------------------------------------
Interest-earning assets:
Interest-bearing deposits with banks ............. $ 10,080 $ 9,116 $ 484 $ 480 $ $
Other money market assets (1) .................... 3,870 3,870
Investment securities ............................ 10,375 1,705 1,310 3,132 2,548 1,680
Loans ............................................ 4,693 2,974 274 212 219 1,014
-------- ------- ------ ------ ------ ------
Total interest-earning assets .................. 29,018 17,665 2,068 3,824 2,767 2,694
-------- ------- ------ ------ ------ ------
Interest-bearing liabilities:
Domestic deposits ................................ 2,374 2,200 3 10 161
Non-U.S. deposits ................................ 14,719 14,706 13
Federal funds purchased and repurchase agreements 7,598 7,536 62
Other interest-bearing liabilities ............... 1,427 653 774
-------- ------- ------ ------ ------ ------
Total interest-bearing liabilities ............. 26,118 25,095 78 10 935
-------- ------- ------ ------ ------ ------
(7,430) 1,990 3,814 2,767 1,759
Interest rate swaps .............................. 243 (1) (46) (196)
------- ------ ------ ------ ------
Interest rate sensitivity position ................. (7,187) 1,990 3,813 2,721 1,563
Cumulative interest rate sensitivity position ...... (7,187) (5,197) (1,384) 1,337 2,900
Cumulative gap percentage (2) ...................... (21)% (15)% (4)% 4% 9%
- -----------------------------------------------------------------------------------------------------------------------------
(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
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, deposit sensitivity and management's
capital planning. 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, 1997, the
Corporation would expect a decrease in net interest revenue of $32 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 a $14 million increase 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, 1997, the Corporation would expect a decrease in the economic
value of assets net of liabilities of $19 million 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 increase of
$12 million 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. At year-end 1997, 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.
NEW ACCOUNTING DEVELOPMENTS
- --------------------------------------------------------------------------------
Information related to new accounting developments appears in Note A to the
Consolidated Financial Statements on page 28.