OREANDA-NEWS. State Street Corporation's (STT) cost base control in the second quarter of 2016 (2Q16) remains a key driver for producing positive operating leverage, according to Fitch Ratings. On a GAAP basis, the company's return on average equity (ROE) improved to 12.4% in 2Q16, from 6.8% in the sequential quarter and 8.2% in the year-ago quarter. Prior quarter's results included a $62 million net after tax restructuring charge ($97 million pre-tax) related to the company's cost of 'Beacon' initiatives. The charge declined to $8 million net after tax in 2Q16.

On an operating basis, which adjusts largely for the charges above as well as a pre-tax gain of approximately $53 million from the sale of WM/Reuters branded FX benchmark business to Thomson Reuters and a net pre-tax charge of about $58 million on previously established reserve for certain expenses invoiced clients, STT's 2Q16 ROE was 12.3%, up from 8.4% in the sequential quarter and 11.9% in the year-ago quarter.

STT also produced positive operating leverage relative to both the sequential and year-ago quarters in 2Q16 on the same basis. Relative to the sequential quarter expenses were down 5.9% because costs in the prior quarter were seasonally higher as a result of deferred incentive compensation expense. Compared to the prior year, expenses were down 2.8%, helped by lower professional services, securities processing costs and travel expenses.

Expense management continues to be a key focus for STT. The company's recently rolled out efficiency initiative, labeled the Beacon program, should significantly aid in this effort. Nonetheless, Fitch believes STT may incur an additional $300 million of pre-tax restructuring charges over the next 18 quarters in addition to the charges noted above.

To the extent that this initiative permanently reduces STT's cost base in the long-term, it could help the company sustain returns that exceed its cost of equity. The Beacon program has been progressing well and is ahead of the company's original schedule. In 2016, the Beacon program is forecast to deliver $140 million of annualized pre-tax savings, compared to its previously estimate of $100 million, inclusive of the company's headcount reduction announced in October 2015. Year-to-date, Beacon has delivered approximately $75 million savings.

On an operating basis revenues were up 3.9% from the sequential quarter, and down 1.9% from the year ago quarter. Servicing and management fees increased 4.2% relative to the sequential quarter but down 3% from year-ago quarter. The linked quarter increase was due to favorable net new business and higher global equity markets. The decline relative to the level a year-ago quarter reflects weaker global equity conditions, as STT tends to have a higher proportion of equity related servicing assets. This began to reverse during the latter half of 1Q16 and into 2Q16 due to improvements in developed markets.

Foreign exchange (FX) revenue was up slightly relative to the sequential quarter, but decreased relative to the year-ago quarter, primarily due to lower client related volume. Securities finance revenue increased relative to both the sequential and year-ago quarters, due to seasonality.

Net interest revenue (NIR) expanded by 1.3% relative to the sequential quarter due to disciplined liability pricing, higher interest earnings assets, and income associated with a small number of discrete security prepayments. NIR was down 1.8% relative to the year-ago quarter due primarily to STT's success in reducing its balance sheet size in 2015. The company's net interest margin (NIM) on an operating basis was relatively flat at 1.11% in 2Q16, compared to 1.12% in 1Q16 and 96 basis points in 2Q15.

Fitch continues to view STT's capital and liquidity positions as solid and supportive of the company's ratings. STT's estimated fully phased-in Basel III Common Equity Tier 1 (CET1) ratio on a standardized basis was 11.5% at 2Q16 and on an advanced approach basis was 11.6%. Fitch continues to expect convergence between the standardized and advanced approach CET1 ratios, but the lower of the two in any one quarter is STT's binding constraint.

More binding than the CET1 ratios noted above, however, is the enhanced supplementary leverage ratio (SLR) for STT and its peer large processing banks. As of 2Q16, STT's SLR at the holding company was 6.1%, above the 5% requirement, and at the main bank subsidiary was 6.3%, 30 basis points above the requirement.

Additionally, STT's balance sheet remains very liquid with client deposits representing nearly 76% of total assets and with 93% of the company's investment portfolio carrying either 'AAA' or 'AA' ratings.

In 2Q16, the Federal Reserve and FDIC released their review of STT's July 2015 resolution plan submission and deemed it not credible. Fitch expects STT to address additional modeling and monitoring capabilities among others concerns and to address the deficiencies by Oct. 1, 2016.

Fitch does not view the lack of acceptance of STT's resolution plan by regulators to be indicative of the company's current and ongoing financial health. STT's ratings incorporate the expectation that it will satisfy the regulators' requirements around its resolution planning.

STT announced in July 2016 it expects to resolve all pending litigation matters in the U. S. in connection with its Indirect FX Business. In total, the company expects to pay $530 million to settle claims that had been asserted. Fitch views the settlement as a credit positive as the settlement will be fully covered by STT's previously established legal reserves and it removes management distraction and uncertainty relating to potential legal expenses that could have arisen from these matters as they continue to linger.