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THE BANK OF NEW YORK COMPANY, INC.
Quarterly Report on Form 10-Q
For the quarterly period ended September 30, 2003
The Quarterly Report on Form 10-Q and cross reference index is on page 57.
THE BANK OF NEW YORK COMPANY, INC.
FINANCIAL REVIEW
TABLE OF CONTENTS
Consolidated Financial Highlights 1
Management's Discussion and Analysis of Financial
Condition and Results of Operations
- Introduction 2
- Overview 2
- Summary of Results 2
- Pershing 3
- Consolidated Income Statement Review 8
- Business Segments Review 12
- Consolidated Balance Sheet Review 23
- World Trade Center Disaster Update 31
- Critical Accounting Policies 32
- Liquidity 34
- Capital Resources 36
- Trading Activities 38
- Asset/Liability Management 39
- Statistical Information 41
- Forward Looking Statements 43
- Website Information 44
Consolidated Financial Statements
- Consolidated Balance Sheets
September 30, 2003 and December 31, 2002 45
- Consolidated Statements of Income
For the Three Months and Nine Months
Ended September 30, 2003 and 2002 46
- Consolidated Statement of Changes In
Shareholders' Equity For the Nine
Months Ended September 30, 2003 47
- Consolidated Statements of Cash Flows
For the Nine Months Ended September 30, 2003 and 2002 48
- Notes to Consolidated Financial Statements 49 - 56
Form 10-Q
- Cover 57
- Controls and Procedures 58
- Legal Proceedings 58
- Changes in Securities and Use of Proceeds 59
- Exhibits and Reports on Form 8-K 59
- Signature 60
1
THE BANK OF NEW YORK COMPANY, INC.
Financial Highlights
(Dollars in millions, except per share amounts)
(Unaudited)
September 30, June 30, September 30,
2003 2003 2002
--------------------- ------------------- ------------
Reported Operating Reported Operating Reported
--------- --------- -------- --------- ------------
Quarter
- -------
Net Income $ 260 $ 322 $ 295 $ 311 $ 79
Basic EPS 0.34 0.42 0.39 0.41 0.11
Diluted EPS 0.34 0.42 0.39 0.41 0.11
Cash Dividends Per Share 0.19 0.19 0.19 0.19 0.19
Return on Average Common
Shareholders' Equity 12.82% 15.85% 15.56% 16.41% 4.73%
Return on Average Assets 1.06 1.31 1.30 1.37 0.40
Efficiency Ratio 70.7 63.8 64.8 63.0 56.4
Year-To-Date
- ------------
Net Income $ 850 $ 929 $ 590 $ 607 $ 802
Basic EPS 1.14 1.24 0.80 0.82 1.11
Diluted EPS 1.13 1.23 0.80 0.82 1.10
Cash Dividends Per Share 0.57 0.57 0.38 0.38 0.57
Return on Average Common
Shareholders' Equity 15.23% 16.63% 16.61% 17.08% 16.74%
Return on Average Assets 1.27 1.39 1.39 1.43 1.35
Efficiency Ratio 65.5 62.4 62.5 61.6 55.0
Assets $95,193 $99,604 $80,987
Loans 37,540 37,796 34,242
Securities 22,862 20,392 18,023
Deposits - Domestic 35,660 37,319 32,964
- Foreign 23,283 27,336 24,005
Long-Term Debt 6,298 6,515 5,528
Common Shareholders' Equity 8,223 8,113 6,633
Common Shareholders'
Equity Per Share $ 10.63 $ 10.50 $ 9.15
Market Value Per Share
of Common Stock 29.11 28.75 28.74
Allowance for Credit Losses
as a Percent of Loans 2.18% 2.18% 1.99%
Allowance for Credit Losses as
a Percent of Non-Margin Loans 2.55 2.50 2.01
Tier 1 Capital Ratio 7.08 6.83 7.70
Total Capital Ratio 11.18 11.07 11.73
Leverage Ratio 5.64 5.85 6.77
Tangible Common Equity Ratio 4.66 4.33 5.38
Employees 22,926 23,106 18,905
Assets Under Custody (In trillions)
Total Assets Under Custody $7.9 $7.8 $6.6
Cross-Border Assets 2.2 2.2 1.8
Equity Securities 32% 32% 26%
Fixed Income Securities 68 68 74
Assets Under Administration
(In billions) $32 $27 $27
Total Assets Under Management
(In billions) 85 83 71
Equity Securities 31% 32% 29%
Fixed Income Securities 22 23 26
Alternative Investments 10 9 9
Liquid Assets 37 36 36
2
Management's Discussion and Analysis of Financial Condition and
- ---------------------------------------------------------------
Results of Operations
- ---------------------
INTRODUCTION
The Bank of New York Company, Inc.'s (the "Company") actual results of future
operations may differ from those estimated or anticipated in certain forward-
looking statements contained herein for reasons which are discussed below and
under the heading "Forward Looking Statements". When used in this report, the
words "estimate," "forecast," "project," "anticipate," "expect," "intend,"
"believe," "plan," "goal," "should," "may," "strategy," and words of similar
meaning are intended to identify forward looking statements in addition to
statements specifically identified as forward looking statements.
OVERVIEW
The Bank of New York Company, Inc. (NYSE: BK) is a global leader in
securities servicing for issuers, investors and financial intermediaries. The
Company plays an integral role in the infrastructure of the capital markets,
servicing securities in more than 100 markets worldwide. The Company provides
quality solutions through leading technology for global corporations,
financial institutions, asset managers, governments, non-profit organizations,
and individuals. Its principal subsidiary, The Bank of New York (the "Bank"),
founded in 1784, is the oldest bank in the United States and has a
distinguished history of serving clients around the world through its five
primary businesses: Securities Servicing and Global Payment Services, Private
Client Services and Asset Management, Corporate Banking, Global Market
Services, and Retail Banking. Additional information on the Company is
available at www.bankofny.com.
The Company has focused its strategy on historically high-growth, fee-
based businesses that have transformed the Company from a traditional
commercial bank into a premier global securities servicing provider. The
Company's breadth of products and services allows it to build client
relationships with investors, issuers and financial intermediaries through
many different avenues in major markets and regions throughout the world. The
Company's well-diversified franchise has become an integral part of the
infrastructure of the global capital markets.
SUMMARY OF RESULTS
The Company's third quarter diluted earnings per share were 34 cents and
operating earnings were 42 cents per share, compared with reported earnings of
39 cents per share and operating earnings of 41 cents per share in the second
quarter. Third quarter reported results include previously announced merger
and integration costs associated with the acquisition of Pershing of 2 cents
per share and the cost of the settlement of claims related to the Company's
1999 sale of BNY Financial Corporation to General Motors Acceptance
Corporation ("GMAC") of 6 cents per share.
Net income for the third quarter was $260 million, compared with $79
million or 11 cents per share a year ago, when the Company incurred credit
charges and a valuation adjustment on its bank stock portfolio. Year-to-date
net income was $850 million, or $1.13 per share, compared to $802 million, or
$1.10 per share in 2002.
The third quarter results showed continued improvement in the Company's
primary businesses, including securities servicing and related foreign
exchange, and private client services and asset management. The quarter also
included a full quarter of results from Pershing, which closed on May 1, 2003.
This contributed to record securities servicing fees of $657 million in the
third quarter. Noninterest income grew to a new high of 72% of total
revenues.
3
Excluding Pershing, securities servicing fees increased 1.2% over the
second quarter, or 5% annualized, led by global custody, broker-dealer
services and mutual fund services. Core noninterest expenses were essentially
flat, as reductions in discretionary expenditures offset continued investments
in strategic initiatives. Nonperforming assets declined by $49 million, or
11% in the third quarter, while the ratio of the allowance to non-performing
assets improved from 188.6% to 210.5%.
New business wins and the general improvement in market tone assisted the
Company in achieving a second consecutive quarter of improving operating
earnings, in spite of the normal seasonal slowdown in equity transaction
volume. Combining top line growth with solid day-to-day expense control
resulted in a restoration of positive operating leverage.
The Company's program to enhance its credit risk profile advanced well as
reflected by the decline in nonperforming assets as well as further reductions
in corporate exposures. This quarter also marked the first full reporting
period with Pershing, where the Company remains on track to achieve its stated
goals for integration costs and synergy benefits.
Overall, the continued firming of the global capital markets bodes well
for the Company's business model. Pershing in particular is well positioned
to benefit from the increased level of confidence shown by the retail
investor.
PERSHING
Supplemental Financial Information
- ----------------------------------
For the quarter and nine months ended September 30, 2003, the Company has
prepared information in four categories:
- - Reported results which are in accordance with Generally Accepted
Accounting Principles (GAAP).
- - Core operating results which exclude the Pershing acquisition.
- - Pershing results which reflect the revenues and expenses since the May 1
acquisition of Pershing but excluding the merger and integration costs.
- - Other non-operating expenses including merger and integration costs
related to the Pershing acquisition and the settlement with GMAC.
The Company believes that providing supplemental non-GAAP financial
information is useful to investors in understanding the underlying operational
performance of the Company and its businesses and performance trends and,
therefore, facilitates comparisons with the performance of other financial
service companies. Specifically, the Company believes that the exclusion of
the merger and integration costs, and the settlement with GMAC, permits
evaluation and a comparison of results for ongoing business operations, and it
is on this basis that the Company's management internally assesses
performance. Although the Company believes that the non-GAAP financial
measures presented in this report enhance investors' understanding of the
Company's business and performance, these non-GAAP measures should not be
considered an alternative to GAAP. The following is a reconciliation of the
Company's financial results for the quarter and nine months ended September
30, 2003:
4
THE BANK OF NEW YORK COMPANY, INC.
Supplemental Information
(In millions, except per share amounts)
(Unaudited)
Income Statement
Quarter ended September 30
SUPPLEMENTAL GAAP
----------------------------------- -----------------------
Operating 2003 2002
------------ Reported Reported
Core Pershing (a) Other(c) Results Results
---- -------- ----------- -------- --------
Net Interest Income $ 387 $ 20 $ - $ 407 $ 418
- -------------------
Provision for Credit Losses 40 - - 40 225
----- ----- ----- ----- -----
Net Interest Income After
Provision for
Credit Losses 347 20 - 367 193
----- ----- ----- ----- -----
Noninterest Income
- ------------------
Servicing Fees
Securities 495 162 - 657 480
Global Payment Services 80 - - 80 74
----- ----- ----- ----- -----
575 162 - 737 554
Private Client Services and
Asset Management Fees 97 - - 97 85
Service Charges and Fees 88 1 - 89 90
Foreign Exchange and Other
Trading Activities 80 12 - 92 49
Securities Gains 9 - - 9 (188)
Other 35 4 - 39 46
----- ----- ----- ----- -----
Total Noninterest Income 884 179 - 1,063 636
----- ----- ----- ----- -----
Noninterest Expense
- -------------------
Salaries and Employee Benefits 443 90 - 533 397
Net Occupancy 57 12 - 69 76
Furniture and Equipment 35 15 - 50 32
Clearing 28 14 - 42 32
Sub-custodian Expenses 18 - - 18 18
Software 36 9 - 45 29
Amortization of Intangibles 4 4 - 8 -
Merger and Integration Costs - - 23 23 -
Other 145 28 78 251 122
----- ----- ----- ----- -----
Total Noninterest Expense 766 172 101 1,039 706
----- ----- ----- ----- -----
Income Before Income Taxes 465 27 (101) 391 123
Income Taxes 159 11 (39) 131 44
----- ----- ----- ----- -----
Net Income $ 306 $ 16 $ (62) $ 260 $ 79
- ---------- ===== ===== ===== ===== =====
Diluted Earnings Per Share $0.43 ($0.01)(b) ($0.08) $0.34 $0.11
Notes:
Reported results agree with the Company's Consolidated Statement of Income
(a) Includes $8 million of net interest costs attributable to the Pershing acquisition financing.
(b) The ($0.01) dilution is due to changes in shares outstanding attributable to the acquisition.
(c) Consists of merger and integration costs related to the Pershing acquisition and the settlement
with GMAC of $78 million, net of reserves.
5
THE BANK OF NEW YORK COMPANY, INC.
Supplemental Information
(In millions, except per share amounts)
(Unaudited)
Income Statement
Nine Months ended September 30
SUPPLEMENTAL GAAP
----------------------------------- -----------------------
Operating 2003 2002
------------ Reported Reported
Core Pershing (a) Other(c) Results Results
---- -------- ----------- -------- --------
Net Interest Income $1,159 $ 31 $ - $1,190 $1,253
- -------------------
Provision for Credit Losses 120 - - 120 295
------ ----- ----- ------ ------
Net Interest Income After
Provision for
Credit Losses 1,039 31 - 1,070 958
------ ----- ----- ------ ------
Noninterest Income
- ------------------
Servicing Fees
Securities 1,457 271 - 1,728 1,411
Global Payment Services 238 - - 238 220
------ ----- ----- ------ ------
1,695 271 - 1,966 1,631
Private Client Services and
Asset Management Fees 281 - - 281 256
Service Charges and Fees 277 1 - 278 264
Foreign Exchange and Other
Trading Activities 224 22 - 246 183
Securities Gains 26 - - 26 (131)
Other 100 7 - 107 106
------ ----- ----- ------ ------
Total Noninterest Income 2,603 301 - 2,904 2,309
------ ----- ----- ------ ------
Noninterest Expense
- -------------------
Salaries and Employee Benefits 1,305 149 - 1,454 1,202
Net Occupancy 172 20 - 192 175
Furniture and Equipment 108 26 - 134 101
Clearing 89 22 - 111 91
Sub-custodian Expenses 53 - - 53 48
Software 107 16 - 123 84
Amortization of Intangibles 11 7 - 18 5
Merger and Integration Costs - - 48 48 -
Other 423 47 78 548 345
------ ----- ----- ------ ------
Total Noninterest Expense 2,268 287 126 2,681 2,051
------ ----- ----- ------ ------
Income Before Income Taxes 1,374 45 (126) 1,293 1,216
Income Taxes 473 18 (48) 443 414
------ ----- ----- ------ ------
Net Income $ 901 $ 27 $ (78) $ 850 $ 802
- ---------- ====== ===== ===== ====== ======
Diluted Earnings Per Share $1.25 ($0.02)(b) ($0.10) $1.13 $1.10
Notes:
Reported results agree with the Company's Consolidated Statement of Income
(a) Includes $14 million of net interest costs attributable to the Pershing acquisition financing.
(b) The ($0.02) dilution is due to changes in shares outstanding attributable to the acquisition.
(c) Consists of merger and integration costs related to the Pershing acquisition and the settlement
with GMAC of $78 million, net of reserves.
6
The following is a supplemental balance sheet showing the impact of the
Pershing acquisition.
THE BANK OF NEW YORK COMPANY, INC.
Supplemental Information
(In millions)
(Unaudited)
Balance Sheet
September 30, 2003 GAAP
SUPPLEMENTAL REPORTED
----------------------------------------- ------------------
Core Pershing Elimination
September 30, September 30, Entries September 30, December 31,
2003 2003 2003 2002
---- ---- ------- ---- ----
Assets
- ------
Cash and Due from Banks $ 3,668 $ 62 $ - $ 3,730 $ 4,748
Interest-Bearing Deposits in Banks 4,873 448 - 5,321 5,104
Securities 22,845 17 - 22,862 18,300
Trading Assets at Fair Value 6,709 180 - 6,889 7,309
Federal Funds Sold and
Securities Purchased Under
Resale Agreements 2,832 3,851 - 6,683 1,385
Margin Loans 73 5,399 - 5,472 352
Loans (less allowance for
credit losses of $817 in 2003
and $831 in 2002) 29,358 1,893 - 31,251 30,156
Premises and Equipment 963 125 - 1,088 975
Due from Customers on Acceptances 233 - - 233 351
Accrued Interest Receivable 271 8 - 279 204
Investment in/Advances to Pershing 3,542 - (3,542)
Goodwill & Intangible Assets 2,645 1,327 - 3,972 2,575
Other Assets 6,256 1,157 - 7,413 6,105
------- ------- ------- ------- -------
Total Assets $84,268 $14,467 $(3,542) $95,193 $77,564
======= ======= ======= ======= =======
Liabilities and Shareholders' Equity
- ------------------------------------
Deposits $58,943 $ - $ - $58,943 $55,387
Federal Funds Purchased and
Securities Sold Under
Repurchase Agreements 622 337 - 959 636
Trading Liabilities 2,779 70 - 2,849 2,800
Payables to Customers and Broker-Dealers 1,419 8,751 - 10,170 870
Other Borrowed Funds 739 1,755 (1,507) 987 475
Acceptances Outstanding 235 - - 235 352
Accrued Taxes and Other Expenses 3,987 112 - 4,099 4,066
Accrued Interest Payable 122 3 - 125 101
Other Liabilities 901 1,404 - 2,305 753
Long-Term Debt 6,298 - - 6,298 5,440
------ ------ ------ ------- -------
Total Liabilities 76,045 12,432 (1,507) 86,970 70,880
------ ------ ------ ------- -------
Shareholders' Equity 8,223 2,035 (2,035) 8,223 6,684
------- ------- ------- ------- -------
Total Liabilities and
Shareholders' Equity $84,268 $14,467 $(3,542) $95,193 $77,564
======= ======= ======= ======= =======
- --------------------------------------------------------------------------------------------------
Note: The balance sheet at December 31, 2002 has been derived from the audited financial statements
at that date.
7
Pershing Integration Plan
- -------------------------
The Company's integration plan related to Pershing has two main
priorities. First is the successful conversion of the clients of BNY Clearing
and BNY Global Clearing onto the platform of Pershing. Conversions are
proceeding on schedule with all domestic clients converted and all
international conversions expected to be completed in the fourth quarter
except for those clients acquired in the Tilney acquisition. See Notes to
Consolidated Financial Statements. As expected, the Company's existing
clearing clients have been overwhelmingly supportive of converting to the
Pershing platform and the client retention levels will meet the Company's
targets.
The second priority is achieving projected cost and revenue synergies.
Synergies were projected to be $22 million in 2003 and $115 million in 2004.
The Company is on target for the $22 million of synergies in 2003, which is
primarily achieved through cost synergies related to closing the Company's
existing clearing operations.
With respect to Pershing's results, total revenues were $207 million for
the quarter, after adjusting net interest income for $8 million of financing
costs. Third quarter monthly average revenue was equal to the monthly average
in the second quarter despite equity trading volumes being lower in the
third quarter. The current run rate is slightly less than the revenue run
rate anticipated when the transaction was announced. However, the modest
shortfall reflects more optimistic assumptions on trading volumes in the
second half of 2003 than has occurred. The operating margin, excluding
financing costs and amortization of intangibles, was 19% in the
third quarter, which was flat with last quarter.
8
CONSOLIDATED INCOME STATEMENT REVIEW
Noninterest Income
- ------------------
Noninterest income for the third quarter of 2003 was $1,063 million, an
increase of 7% sequentially and 67% from a year ago. Noninterest income for
the nine months ended September 30, 2003 was $2,904 million, an increase of
26% over the comparable 2002 period. The increases are principally due to the
acquisition of Pershing, improved performance in the core businesses, and the
absence in 2003 of the negative valuation adjustment in the third quarter of
2002. Pershing's contribution to the Company's noninterest income was $179
million for the quarter and $301 million for the nine months ended September
30, 2003.
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-Date
------- ------- ------- ------------
(In millions) 2003 2003 2002 2003 2002
----- ---- ---- ---- ----
Servicing Fees
Securities $ 657 $598 $480 $1,728 $1,411
Global Payment Services 80 80 74 238 220
------ ---- ---- ------ ------
737 678 554 1,966 1,631
Private Client Services
and Asset Management Fees 97 94 85 281 256
Service Charges and Fees 89 92 90 278 264
Foreign Exchange and
Other Trading Activities 92 88 49 246 183
Securities Gains 9 9 (188) 26 (131)
Other 39 35 46 107 106
------ ---- ---- ------ ------
Total Noninterest Income $1,063 $996 $636 $2,904 $2,309
====== ==== ==== ====== ======
Securities servicing fees were up 10% sequentially to a record $657
million, primarily reflecting a full quarter's results for Pershing which
closed on May 1.
Excluding Pershing, core securities servicing fees were up 1.2%
sequentially, or 5% annualized, despite the seasonal slowdown in equity
trading volumes. The primary growth drivers were the Company's investor
services and broker-dealer services businesses, which combined were up a
healthy 5% sequentially. Within these segments, custody and mutual fund
services both grew from new business and the benefit of higher equity prices.
Government securities clearance and global collateral management
continued to generate good growth due to strength in fixed income trading
volumes and new business wins in the broker-dealer community.
Issuer services were roughly flat this quarter, as a pick up in corporate
trust fees was offset by lower activity in depositary receipts, evidenced by
light capital raising activity in the quarter.
Execution and clearing services increased overall due to the addition of
Pershing for the full quarter, but execution services businesses in particular
were negatively impacted by the decrease in equity trading volumes in the
quarter.
Global payment services fees were flat compared with the prior quarter
and increased 8% from the third quarter of 2002. Year-over-year growth is
attributable to the build-out of multi-currency product capabilities and
further penetration of the financial institutions market segment.
9
Private client services and asset management fees for the third quarter
were up 3% from the prior quarter, and 14% from the third quarter of 2002.
The sequential quarter and year-over-year increases reflect higher equity
price levels as well as the continued strong demand for alternative
investments from Ivy Asset Management and higher short-term money management
fees, partially offset by higher seasonal tax-oriented fees in the second
quarter. In addition, the year-over-year comparison also benefited from
acquisitions. Total assets under management were $85 billion at September 30,
2003, up from $83 billion at June 30, 2003 and $71 billion a year ago.
Service charges and fees have remained generally stable. The increase of
5% on a year-to-date basis over 2002 primarily reflects higher fees from loan
syndication and underwriting fees.
Foreign exchange and other trading revenues were up 5% compared with the
prior quarter and up $43 million, or 88% from one year ago. The increase from
the second quarter was primarily due to Pershing contributing for the full
third quarter compared to only two months in the second quarter. Excluding
Pershing, foreign exchange remained strong, increasing slightly from the
second quarter as higher client activity levels and volatility in September
offset the seasonal slowdown in August. Compared to a year ago, the
significant increase resulted from increased client-driven foreign exchange
and interest rate hedging activity and the Pershing acquisition. For the nine
months ended September 30, 2003, foreign exchange and other trading revenues
were up 34% over the nine months ended September 30, 2002.
Securities gains in the third quarter were $9 million, flat with the
prior quarter and up significantly from a loss of $188 million a year ago.
Year-to-date securities gains were $157 million higher than the prior year
period. Both year-to-year comparisons reflected a $210 million equity write-
down in the third quarter of 2002.
Other noninterest income increased $4 million from the second quarter of
2003 and decreased $7 million from the third quarter of 2002. Third quarter
2002 results included a $32 million Empire State Development Corporation
("ESDC") grant covering relocation and other costs.
Net Interest Income
- -------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-Date
(Dollars in millions) ------- ------- ------- ------------
2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Net Interest Income $407 $398 $418 $1,190 $1,253
Tax Equivalent Adjustment 9 9 11 27 36
---- ---- ---- ------ ------
Net Interest Income on a
Tax Equivalent Basis $416 $407 $429 $1,217 $1,289
==== ==== ==== ====== ======
Net Interest Rate
Spread 1.87% 1.95% 2.32% 1.99% 2.31%
Net Yield on Interest
Earning Assets 2.10 2.22 2.66 2.24 2.65
Net interest income on a taxable equivalent basis was $416 million in the
third quarter of 2003, compared with $407 million in the second quarter of
2003, and $429 million in the third quarter of 2002. The net interest rate
spread was 1.87% in the third quarter of 2003, compared with 1.95% in the
second quarter of 2003, and 2.32% in the third quarter of 2002. The net yield
on interest earning assets was 2.10% in the third quarter of 2003, compared
with 2.22% in the second quarter of 2003, and 2.66% in the third quarter of
2002.
The increase in net interest income from the second quarter of 2003 is
primarily due to the full quarter impact of Pershing and modest growth in the
Company's investment securities portfolio. This was partially offset by the
10
impact of the Federal Reserve rate reduction in June. The decline in net
interest income from the third quarter of 2002 reflects lower reinvestment
yields on fixed income securities, planned decreases in loan balances, and the
impact of Federal Reserve interest rate reductions in 2002 and 2003, which
were partially offset by the Pershing acquisition and higher average balances
of investment securities.
For the first nine months of 2003, net interest income on a taxable
equivalent basis amounted to $1,217 million compared with $1,289 million in
the first nine months of 2002, reflecting the same factors that affected the
comparison with last year's quarter. The year-to-date net interest spread was
1.99% in 2003 compared with 2.31% in 2002, while the net yield on interest
earning assets was 2.24% in 2003 and 2.65% in 2002.
In this report a number of amounts related to net interest income are
presented on a "taxable equivalent basis". The Company believes that this
presentation provides comparability of net interest income arising from both
taxable and tax-exempt sources and is consistent with industry standards.
Noninterest Expense and Income Taxes
- ------------------------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-date
------- ------- ------- ------------
(In millions) 2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Salaries and Employee Benefits $ 443 $439 $397 $1,305 $1,202
Net Occupancy 57 57 76 172 175
Furniture and Equipment 35 38 32 108 101
Clearing 28 31 32 89 91
Sub-custodian Expenses 18 19 18 53 48
Software 36 36 29 107 84
Amortization of Intangibles 4 4 - 11 5
Other 145 139 122 423 345
------ ---- ---- ------ ------
Total Core 766 763 706 2,268 2,051
Merger and Integration Costs 23 25 - 48 -
Pershing 172 115 - 287 -
GMAC Settlement 78 - - 78 -
------ ---- ---- ------ ------
Total Noninterest Expense $1,039 $903 $706 $2,681 $2,051
====== ==== ==== ====== ======
Noninterest expense for the third quarter of 2003 was $1,039 million,
compared with $903 million in the prior quarter. The increase principally
reflects the full quarter impact of Pershing and non-operating merger and
integration expenses as well as net costs related to the GMAC settlement.
Core noninterest expense was $766 million, essentially flat with the
second quarter of 2003. On a core basis salaries and employee benefits were
up only 1% from the second quarter. Core headcount decreased by 180 during the
quarter bringing the year-to-date core headcount reductions to 385. Other
expense categories also reflected the Company's focus on reducing
discretionary spending. The business process reviews the Company has been
conducting are also producing results and enabling the Company to absorb the
cost of investments important to its future growth, such as technology
spending, business continuity planning, quality programs, and marketing and
branding initiatives within the overall expense base.
The increase in core expenses compared with the third quarter and first
nine months of 2002 primarily reflects the impact of acquisitions, the
inception of stock option expensing in 2003, a lower pension credit, increased
technology investments and higher business continuity spending.
Reflecting the shift in the Company's business mix including the Pershing
acquisition, the efficiency ratio, excluding non-operating expenses related to
11
the GMAC settlement and the Pershing's merger and integration costs, increased
to 63.8% for the third quarter of 2003, compared with 63.0% in the previous
quarter and 56.1% in the third quarter of 2002, excluding the impact of the
ESDC grant and the associated sublease expense.
The effective tax rate for the third quarter of 2003 was 33.4%, compared
to 34.6% in the second quarter of 2003, and 35.9% in the third quarter 2002.
The effective tax rate for the nine months ended September 30, 2003 was 34.3%,
compared with 34.0% for the nine months ended September 30, 2002. The
decrease in the effective tax rate reflects the tax benefit on the GMAC
settlement and lower state and local taxes.
Credit Loss Provision and Net Charge-Offs
- -----------------------------------------
3rd 2nd 3rd
Quarter Quarter Quarter Year-to-Date
------- ------- ------- ------------
(In millions) 2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Provision $ 40 $ 40 $225 $120 $295
==== ==== ==== ==== ====
Net Charge-offs:
Commercial $ (25) $ (34) $(150) $ (85) $(197)
Foreign (12) (7) (5) (18) (5)
Other (4) - - (15) (14)
Consumer (6) (5) (5) (16) (14)
------ ------ ------ ----- ------
Total $ (47) $ (46) $(160) $(134) $(230)
====== ====== ====== ===== ======
Other Real Estate Expenses $ - $ - $ - $ - $ -
The provision for credit losses was $40 million in the third quarter of
2003, flat with $40 million in the second quarter of 2003 and down
significantly from $225 million in the third quarter of 2002. The larger
provision in 2002 was attributable to the deterioration in the loan portfolio
particularly in a limited number of borrowers in the telecommunications
portfolio. On a year-to-date basis, the provision was $120 million in 2003
compared with $295 million in 2002.
The allowance for credit losses was $817 million at September 30, 2003,
$824 million at June 30, 2003, and $681 million at September 30, 2002. The
allowance for credit losses as a percent of non-margin loans was 2.55% at
September 30, 2003, compared with 2.50% at June 30, 2003, and 2.01% at
September 30, 2002. The ratio of the allowance to nonperforming assets was
210.5% at September 30, 2003, compared with 188.6% at June 30, 2003, and
123.5% at September 30, 2002.
12
BUSINESS SEGMENTS REVIEW
The Company has an internal information system that produces performance data
for its four business segments along product and service lines.
Business Segments Accounting Principles
- ---------------------------------------
The Company's segment data has been determined on an internal management basis
of accounting, rather than the generally accepted accounting principles used
for consolidated financial reporting. These measurement principles are
designed so that reported results of the segments will track their economic
performance. Segment results are subject to restatement whenever improvements
are made in the measurement principles or organizational changes are made. In
the second quarter of 2003 the Company modified the funds transfer rates based
on an updated analysis of the duration of assets and liabilities. Prior
periods have been restated.
The measure of revenues and profit or loss by operating segment has been
adjusted to present segment data on a taxable equivalent basis. The provision
for credit losses allocated to each reportable segment is based on
management's judgment as to average credit losses that will be incurred in the
operations of the segment over a credit cycle of a period of years.
Management's judgment includes the following factors among others: historical
charge-off experience and the volume, composition, and size of the loan
portfolio. This method is different from that required under generally
accepted accounting principles as it anticipates future losses which are not
yet probable and therefore not recognizable under generally accepted
accounting principles. Assets and liabilities are match funded. Support and
other indirect expenses are allocated to segments based on general internal
guidelines.
Description of Business Segments
- --------------------------------
The Company reports data for the four business segments: Servicing and
Fiduciary, Corporate Banking, Retail Banking, and Financial Markets.
The Servicing and Fiduciary businesses segment comprises the Company's
core services, including securities servicing, global payment services, and
private client services and asset management. These businesses all share
certain favorable attributes: they are well diversified and fee-based; the
Company serves the role of an intermediary rather than principal, thereby
limiting risk and generating more stable earnings streams; and the businesses
are scalable, which result in higher margins as revenues grow. Long-term
trends that favor these businesses include the growth of financial assets
worldwide, the globalization of investment activity, heightened demand for
financial servicing outsourcing, and continuing structural changes in
financial markets.
Securities servicing provides financial institutions, corporations and
financial intermediaries with a broad array of products and customized
services for every step of the investment lifecycle. The Company facilitates
the movement, settlement, recordkeeping and accounting of financial assets
around the world by delivering timely and accurate information to issuers,
investors and broker-dealers. The Company groups its securities servicing
businesses into four categories, each comprised of separate, but related
businesses. These are: issuer services, which include corporate trust,
depositary receipts and stock transfer; investor services, which include
global custody, securities lending and separate account services; broker-
dealer services, which include mutual fund services, government securities
clearance, collateral management, hedge fund servicing, exchange traded funds
and UITs; and execution and clearing services, which include all of the
activities in BNY Securities Group including Pershing. This segment also
includes customer-related foreign exchange.
Global payment services facilitates the flow of funds between the
Company's customers and their clients through such business lines as funds
transfer, cash management and trade services. Private client services and
asset management includes traditional banking and trust services to affluent
clients and investment management services for institutional and high net
worth clients.
13
The Company's strategy is to be a market leader in these businesses and
continue to build out its product and service capabilities and add new
clients. The Company has completed 51 acquisitions since 1998 in this
segment, has made significant investments in technology to maintain its
industry-leading position, and has continued the development of new products
and services to meet its clients' needs.
The Corporate Banking segment provides lending and credit-related
services to large public and private financial institutions and corporations
nationwide, as well as to public and private mid-size businesses in the New
York metropolitan area. Special industry groups focus on industry segments
such as banks, broker-dealers, insurance, media and telecommunications,
energy, real estate, retailing, and government banking institutions. Through
BNY Capital Markets, Inc., the Company provides syndicated loans, bond
underwriting, private placements of corporate debt and equity securities, and
merger, acquisition, and advisory services.
Corporate Banking coordinates delivery of all of the Company's services
to customers through its global relationship managers. The two main client
bases served are financial institution clients and corporate clients. The
Company's strategy is to focus on those clients and industries that are major
users of securities servicing and global payment services and by leveraging
existing relationships to create new business opportunities.
The Company believes that credit is an important product for many of its
customers to execute their business strategies. However, the Company has
continued to reduce its credit exposures in recent years by culling its loan
portfolio of non-strategic exposures, focusing on increasing total
relationship returns through cross-selling and limiting the size of its
individual credit exposures and industry concentrations to reduce earnings
volatility.
The Retail Banking segment includes retail deposit services, branch
banking, and consumer and residential mortgage lending. The Company operates
341 branches in 23 counties in the Tri-State region. The retail network is a
stable source of low cost funding and provides a platform to cross-sell core
services from the Servicing and Fiduciary businesses to both individuals and
small businesses in the New York metropolitan area.
The Financial Markets segment includes trading of foreign exchange and
interest rate risk management products, investing and leasing activities, and
treasury services to other business segments. The segment offers a
comprehensive array of multi-currency hedging and yield enhancement
strategies, and complements the other business segments. The Financial
Markets segment centralizes interest rate risk management for the Company.
There were no major customers from whom revenues were individually
material to the Company's performance.
14
Servicing and Fiduciary Businesses
- ----------------------------------
(In Millions)
3rd 2nd 3rd
Quarter Quarter Quarter Year to date
2003 2003 2002 2003 2002
------- ------- ------- ---- ----
Net Interest Income $ 132 $ 120 $ 118 $ 357 $ 362
Provision for
Credit Losses - - - - -
Noninterest Income 904 838 685 2,430 2,035
Noninterest Expense 709 650 488 1,882 1,434
Income Before Taxes 327 308 315 905 963
Average Assets $21,385 $15,724 $ 8,086 $14,959 $ 8,507
Average Deposits 34,039 33,499 32,008 32,899 30,846
Nonperforming Assets 16 16 16 16 16
(In billions)
Assets Under Custody $ 7,878 $ 7,787 $ 6,609 $ 7,878 $ 6,609
Assets Under Management 85 83 71 85 71
S&P 500 Index (Period End) 996 975 815 996 815
NASDAQ Index (Period End) 1,787 1,623 1,172 1,787 1,172
NYSE Volume (In billions) 87.3 93.0 99.2 266.9 269.8
NASDAQ Volume (In billions) 110.7 112.5 107.4 312.0 330.3
The third quarter results showed continued improvement in the Company's
primary businesses, including securities servicing and related foreign
exchange, and private client services and asset management. The quarter also
included a full quarter of results from Pershing, which closed on May 1, 2003.
This contributed to record securities servicing fees of $657 million in the
third quarter. For the first nine months of 2003, securities servicing fees
were $1,728 million, an increase of $317 million from $1,411 million for the
first nine months of 2002, principally due to Pershing and other acquisitions.
Pershing's securities servicing fees included in the quarter and nine months
ended September 30, 2003 were $162 million and $271 million, respectively.
Earnings were strong in business areas that benefited from rising equity
prices in the capital markets during the quarter. At the same time, areas that
are dependent on equity trading volumes, particularly execution services
businesses, had a more challenging quarter, due to the seasonal declines in
trading volumes that normally occur in August. In addition, the depositary
receipts business continued to be challenged by the lower level of corporate
actions, such as new equity issues and cross-border acquisitions that drive
client demand for the Company's services.
As of September 30, 2003, assets under custody rose to $7.9 trillion,
from $7.8 trillion at June 30, 2003 and $6.6 trillion at September 30, 2002.
The modest sequential quarter increase in assets under custody reflects higher
equity market values as well as net new business converted, however, as nearly
two-thirds of the Company's custody assets are in fixed income assets, these
were negatively impacted by higher interest rates and this mitigated the
impact of new business wins and higher equity prices. Cross-border custody
assets were $2.2 trillion at September 30, 2003. The acquisition of Pershing
added approximately $557 billion to custody assets at September 30, 2003.
Equity securities composed 32% of the assets under custody at September 30,
2003, while fixed income securities were 68%.
Strong new business momentum in global custody and higher equity prices
drove investor services fees higher on both a sequential quarter and year-
over-year basis. The higher fees compared to last year were also due to
strong performance in securities lending.
15
Global issuer services fees were essentially flat on a sequential quarter
basis and down from a year ago. Corporate trust fees were up modestly from
the second quarter, while depositary receipts (DRs) decreased on a sequential
quarter basis due to a lack of equity market activity in August and fewer
corporate actions during the quarter. The decline versus a year ago was also
related to DRs.
Broker-dealer services fees also increased significantly both
sequentially and year-over-year driven by strong performance in government
securities clearance and collateral management services. These businesses
continue to benefit from new business wins and higher fixed income transaction
volumes. Mutual fund servicing also increased in the third quarter due to
higher equity price levels.
Execution and clearing services fees increased both sequentially and in
comparison with last year due to the full quarter impact of Pershing.
Execution services decreased sequentially and in comparison with last year due
to lower equity market trading volumes. Average daily combined third quarter
NYSE and NASDAQ trading volume was down 5% from the second quarter of 2003 and
4% from the third quarter of 2002. Average monthly fees from Pershing
remained flat with last quarter despite the lower trading volumes due to
relative strength in retail investor activity. Pershing's operating margin,
excluding financing costs and amortization of intangibles, was 19% in the
third quarter, which was flat with last quarter.
Global payment services fees were flat compared with the prior quarter
and increased 8% from the third quarter of 2002. Year-over-year growth is
attributable to the build-out of multi-currency product capabilities and
further penetration of the financial institutions market segment.
Private client services and asset management fees for the third quarter
were up 3% from the prior quarter, and 14% from the third quarter of 2002.
The sequential quarter and year-over-year increases reflect higher equity
price levels as well as the continued strong demand for alternative
investments from Ivy Asset Management and higher short-term money management
fees, partially offset by higher seasonal tax-oriented fees in the second
quarter. In addition, the year-over-year comparison also benefited from
acquisitions. Ivy Asset Management has grown assets under management from $2.4
billion when it was acquired in 2000 to $8 billion at September 30, 2003.
Assets under management ("AUM") were $85 billion at September 30, 2003,
up from $83 billion at June 30, 2003 and $71 billion at September 30, 2002.
Assets under administration were $32 billion compared with $27 billion at June
30, 2003 and September 30, 2002. The increase in assets under management since
June 30, 2003 reflects growth in the Company's alternative investments
business, and a rise in asset values. The increase in AUM since September 30,
2002 reflects acquisitions, growth in the Company's alternative investment
business, and a rise in equity market values. Institutional clients represent
66% of AUM while individual clients equal 34%. AUM at September 30, 2003, are
31% invested in equities, 22% in fixed income, 10% in alternative investments
and the remainder in liquid assets.
Client-driven foreign exchange remained robust as September was one of
the Company's strongest months ever due to exchange rate movements and
increased activity from equity fund managers offsetting the seasonally slow
August.
Net interest income in the Servicing and Fiduciary businesses segment was
$132 million for the third quarter of 2003 compared with $120 million for the
second quarter of 2003 and $118 million in the third quarter of 2002. The
increase in net interest income on a sequential quarter basis is primarily
attributable to the full quarter impact of the Pershing acquisition. The
increase in net interest income from the third quarter of 2002 is primarily
due to the Pershing acquisition partially offset by the decline in interest
rates. Net interest income for the nine months ended September 30, 2003 was
$357 million compared with $362 million in the first nine months of 2002. The
decline in net interest income mainly reflects the Federal Reserve rate cuts
in 2003 and 2002, partially offset by the Pershing acquisition. Average
16
assets for the quarter ended September 30, 2003 were $21.4 billion compared
with $15.7 billion in the second quarter of 2003 and $8.1 billion in the third
quarter of 2002. Average assets for the nine months ended September 30, 2003
were $15.0 billion compared with $8.5 billion in the first nine months of
2002. The increase in assets in 2003 compared with 2002 is attributable to
the Pershing acquisition. The third quarter of 2003 average deposits were
$34.0 billion compared with $33.5 billion in the second quarter of 2003 and
$32.0 billion in the third quarter of 2002. Average deposits for the first
nine months of 2003 were $32.9 billion compared with $30.8 billion for the
first nine of 2002.
Net charge-offs in the Servicing and Fiduciary Businesses segment were
zero in each of the relevant periods. Nonperforming assets were $16 million in
each of the relevant periods.
Noninterest expense for the third quarter of 2003 was $709 million,
compared with $650 million in the second quarter of 2003 and $488 million in
the third quarter of 2002. The rise in noninterest expense from the second
quarter reflects the full quarter impact of the Pershing acquisition. For the
first nine months of 2003, noninterest expense was $1,882 million compared
with $1,434 million in 2002. The rise in noninterest expense from 2002 was
primarily due to the Pershing acquisition, the Company's continued investment
in technology, a reduced pension credit, higher insurance expense, as well as
higher volume-related sub-custodian expenses and higher variable compensation
related to revenue growth.
Corporate Banking
- -----------------
(In Millions)
3rd 2nd 3rd
Quarter Quarter Quarter Year to date
2003 2003 2002 2003 2002
------- ------- ------- ---- ----
Net Interest Income $ 95 $ 95 $ 105 $282 $ 319
Provision for
Credit Losses 27 30 35 87 105
Noninterest Income 72 86 74 233 216
Noninterest Expense 52 53 52 155 148
Income Before Taxes 88 98 92 273 282
Average Assets $18,900 $19,858 $22,250 $19,760 $23,029
Average Deposits 6,699 6,583 6,802 6,832 6,904
Nonperforming Assets 368 410 526 368 526
Net Charge-offs 41 42 155 118 215
The Corporate Banking segment's net interest income was $95 million in the
third quarter of 2003, flat with the second quarter of 2003 and down from $105
million in the third quarter of 2002. On a year-to-date basis, net interest
income for 2003 was $282 million compared with $319 million in 2002. The
decrease from the year-to-date 2002 periods reflect the continued reduction of
average loans outstanding as well as a decline in the value of low cost short-
term deposits given the lower interest rate environment. Average assets for
the quarter were $18.9 billion compared with $19.9 billion in the second
quarter of 2003 and $22.3 billion in the third quarter of last year. Average
deposits in the corporate bank were $6.7 billion versus $6.6 billion in the
second quarter of 2003 and $6.8 billion in 2002. For the nine months ended
September 30, 2003, average assets were $19.8 billion compared to $23.0
billion for the first nine months of 2002. For the first nine months of 2003
and 2002, average deposits were $6.8 billion and $6.9 billion.
The third quarter 2003 provision for credit losses was $27 million
compared with $30 million in the second quarter of 2003 and $35 million last
year. On a year-to-date basis, the provision for credit losses was $87 million
for 2003 and $105 million for 2002. The lower provision primarily reflects the
benefits of the Company's corporate loan exposure reduction program. Net
charge-offs in the Corporate Banking segment were $41 million in the third
quarter of 2003, $42 million in the second quarter of 2003, and $155 million
17
in the third quarter of 2002. The charge-offs in 2003 primarily relate to
loans to corporate borrowers. The charge-offs in 2002 primarily reflects
deterioration in the Company's portfolio of telecom credits. Net charge-offs
for the first nine months of 2003 were $118 million compared with $215 million
in 2002. Nonperforming assets were $368 million at September 30, 2003, down
from $410 million at June 30, 2003 and $526 million in the third quarter of
2002. The decrease in nonperforming assets from the third quarter of 2002
primarily reflects reductions in the levels of nonperforming cable and telecom
credits.
Noninterest income was $72 million in the current quarter, compared with
$86 million in the second quarter of 2003 and $74 million in the third quarter
a year ago. The second quarter of 2003 benefited from unusually high volumes
of standby letters of credit and increased capital markets activity. For the
first nine months of 2003, noninterest income was $233 million compared with
$216 million for the first nine months of 2002.
Noninterest expense in the third quarter were $52 million, compared with
$53 million in the second quarter of 2003 and $52 million in the third quarter
of 2002. For the first nine months of 2003, noninterest expense was $155
million compared with $148 million in 2002. The increases over 2002 reflect
higher compensation costs due in part to a reduced pension credit.
Retail Banking
- --------------
(In Millions)
3rd 2nd 3rd
Quarter Quarter Quarter Year to date
2003 2003 2002 2003 2002
------- ------- ------- ---- ----
Net Interest Income $ 120 $ 118 $ 121 $354 $ 359
Provision for
Credit Losses 5 5 2 14 8
Noninterest Income 30 33 30 92 88
Noninterest Expense 88 90 79 265 238
Income Before Taxes 57 56 70 167 201
Average Assets $ 5,018 $ 5,329 $ 5,245 $5,242 $ 5,056
Average Noninterest
Bearing Deposits 4,738 4,565 4,109 4,711 4,040
Average Deposits 14,585 14,252 13,224 14,321 13,161
Nonperforming Assets 4 11 9 4 9
Net Charge-offs 6 5 5 16 15
Number of Branches 341 341 342 341 342
Total Deposit Accounts
(In Thousands) 1,170 1,183 1,222 1,170 1,222
Net interest income in the third quarter of 2003 was $120 million,
compared with $118 million in the second quarter of 2003 and $121 million in
the third quarter of 2002. Net interest income on a year-to-date basis for
2003 and 2002 was $354 million and $359 million. Net interest income has been
essentially flat as spread compression on deposits has been offset by higher
levels of noninterest bearing deposits.
Noninterest income was $30 million for the quarter compared with $33
million on a sequential quarter basis and $30 million last year. Noninterest
income for the first nine months of 2003 was $92 million compared with $88
million in the first nine months of 2002. The sequential quarter decline in
noninterest income as well as the year-to-date increase from 2002 reflects a
gain on the sale of $230 million of mortgage loans in the second quarter of
2003.
Noninterest expense in the third quarter of 2003 was $88 million,
compared with $90 million in the second quarter of 2003 and $79 million last
18
year. Noninterest expense for the first nine months of 2003 was $265 million
compared with $238 million in the first nine months of 2002. The year-over-
year change reflects a reduced pension credit and higher medical benefit
expenses.
Net charge-offs were $6 million in the third quarter of 2003, compared
with $5 million in the second quarter of 2003 and third quarter of 2002. Net
charge-offs were $16 million and $15 million for the nine months ending
September 30, 2003 and September 30, 2002. Nonperforming assets were $4
million in the third quarter of 2003 compared with $11 million at June 30,
2003 and $9 million at September 30, 2002 reflecting a reduction in the level
of nonperforming small business loans.
Average deposits generated by the Retail Banking segment were $14.6
billion in the third quarter of 2003, compared with $14.3 billion in the
second quarter of 2003 and $13.2 billion in the third quarter of 2002. For the
first nine months of 2003, average deposits were $14.3 billion as compared to
$13.2 billion in the first nine months of 2002. Noninterest bearing deposits
were $4.7 billion this quarter, compared with $4.6 billion in the second
quarter of 2003 and $4.1 billion in the third quarter of 2002. The increase in
total deposits reflects current consumer preferences for the safety of bank
deposits versus the volatility of the equity markets as well as the low
interest rates offered on other investment choices. Noninterest bearing
deposits for the first nine months of 2003 were $4.7 billion compared with
$4.0 billion in the first nine months of 2002. Average assets in the retail
banking sector were $5.0 billion, compared with $5.3 billion in the second
quarter of 2003 and $5.2 billion in the third quarter of 2002. On a year-to-
date basis, average assets were $5.2 billion for 2003 and $5.1 billion for
2002.
19
Financial Markets
- -----------------
(In Millions)
3rd 2nd 3rd
Quarter Quarter Quarter Year to date
2003 2003 2002 2003 2002
------- ------- ------- ---- ----
Net Interest Income $ 80 $ 80 $ 84 $237 $245
Provision for
Credit Losses 5 6 5 16 15
Noninterest Income 53 33 37 136 154
Noninterest Expense 26 25 20 75 63
Income Before Taxes 102 82 96 282 321
Average Assets $47,920 $46,463 $40,850 $46,252 $40,481
Average Deposits 4,355 4,153 1,593 4,473 1,800
Average Investment
Securities 20,604 18,720 16,798 19,110 14,747
Net Charge-offs - - - - -
Net interest income for the third quarter was $80 million compared with
$80 million on a sequential quarter basis and $84 million a year ago. Net
interest income was $237 million in the first nine months of 2003 compared to
$245 million in the first nine months of 2002. The declines from 2002 reflect
lower reinvestment yields partially offset by an increase in assets, primarily
highly-rated mortgage-backed securities. Average third quarter 2003 assets in
the Financial Markets segment composed primarily of short-term liquid assets
and investment securities were $47.9 billion, up from $46.5 billion on a
sequential quarter basis and $40.9 billion last year. Average assets for the
first nine months of 2003 were $46.3 billion compared to $40.5 billion for the
first nine months of 2002. The increase in assets reflects the Company's
continuing strategy to reduce investment in higher risk corporate loans and
increase holdings of highly rated, more liquid investment securities.
Noninterest income was $53 million in the third quarter of 2003, compared
with $33 million in the second quarter of 2003 and $37 million in the third
quarter of 2002. On a year-to-date basis, noninterest income was $136 million
in 2003 and $154 million in 2002. The positive variance versus the second
quarter of 2003 reflects higher trading related revenues related both to
foreign exchange and fixed income activities as well as improved hedging of
foreign currency investments. The decrease versus a year ago was caused by
declines in securities gains and structured product fees.
Net charge-offs were zero in each of the relevant periods. Noninterest
expense was essentially flat at $26 million in the third quarter of 2003,
compared with $25 million in the second quarter of 2003 but up from $20
million in last year's third quarter. Noninterest expense for the nine months
ended September 30, 2003 was $75 million, compared with $63 million for the
nine months ended September 30, 2002 reflecting higher compensation costs.
20
The consolidating schedule below shows the contribution of the Company's
segments to its overall profitability.
In Millions
Servicing
and
For the Quarter Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
September 30, 2003 Businesses Banking Banking Markets Items Total
- --------------------- ---------- --------- ------- --------- ----------- ------------
(In Millions)
Net Interest Income $ 132 $ 95 $ 120 $ 80 $ (20) $ 407
Provision for
Credit Losses - 27 5 5 3 40
Noninterest Income 904 72 30 53 4 1,063
Noninterest Expense 709 52 88 26 164 1,039
----- ---- ----- ---- ----- ------
Income Before Taxes $ 327 $ 88 $ 57 $102 $(183) $ 391
===== ==== ===== ==== ===== ======
Contribution Percentage 57% 15% 10% 18%
Average Assets $21,385 $18,900 $5,018 $47,920 $ 3,930 $97,153
In Millions
Servicing
and
For the Quarter Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
June 30, 2003 Businesses Banking Banking Markets Items Total
- --------------------- ---------- --------- ------- --------- ----------- ------------
(In Millions)
Net Interest Income $ 120 $ 95 $ 118 $ 80 $ (15) $ 398
Provision for
Credit Losses - 30 5 6 (1) 40
Noninterest Income 838 86 33 33 6 996
Noninterest Expense 650 53 90 25 85 903
----- ---- ----- ---- ----- -----
Income Before Taxes $ 308 $ 98 $ 56 $ 82 $ (93) $ 451
===== ==== ===== ==== ===== =====
Contribution Percentage 57% 18% 10% 15%
Average Assets $15,724 $19,858 $5,329 $46,463 $ 3,550 $90,924
In Millions
Servicing
and
For the Quarter Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
September 30, 2002 Businesses Banking Banking Markets Items Total
- --------------------- ---------- --------- ------- --------- ----------- ------------
Net Interest Income $ 118 $105 $ 121 $ 84 $ (10) $ 418
Provision for
Credit Losses - 35 2 5 183 225
Noninterest Income 685 74 30 37 (190) 636
Noninterest Expense 488 52 79 20 67 706
----- ---- ----- ---- ----- -----
Income Before Taxes $ 315 $ 92 $ 70 $ 96 $(450) $ 123
===== ==== ===== ==== ===== =====
Contribution Percentage 55% 16% 12% 17%
Average Assets $ 8,086 $22,250 $5,245 $40,850 $ 2,379 $78,810
21
In Millions
Servicing
and
For the Nine Months Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
September 30, 2003 Businesses Banking Banking Markets Items Total
- ----------------------- ---------- --------- ------- --------- ----------- ------------
Net Interest Income $ 357 $ 282 $ 354 $ 237 $ (40) $1,190
Provision for
Credit Losses - 87 14 16 3 120
Noninterest Income 2,430 233 92 136 13 2,904
Noninterest Expense 1,882 155 265 75 304 2,681
------ ----- ----- ----- ----- ------
Income Before Taxes $ 905 $ 273 $ 167 $ 282 $(334) $1,293
====== ===== ===== ===== ===== ======
Contribution Percentage 56% 17% 10% 17%
Average Assets $14,959 $19,760 $ 5,242 $46,252 $ 3,366 $89,579
In Millions
Servicing
and
For the Nine Months Ended Fiduciary Corporate Retail Financial Reconciling Consolidated
September 30, 2002 Businesses Banking Banking Markets Items Total
- ----------------------- ---------- --------- ------- --------- ----------- ------------
Net Interest Income $ 362 $ 319 $ 359 $ 245 $ (32) $1,253
Provision for
Credit Losses - 105 8 15 167 295
Noninterest Income 2,035 216 88 154 (184) 2,309
Noninterest Expense 1,434 148 238 63 168 2,051
------ ----- ----- ----- ----- ------
Income Before Taxes $ 963 $ 282 $ 201 $ 321 $(551) $1,216
====== ===== ===== ===== ===== ======
Contribution Percentage 55% 16% 11% 18%
Average Assets $ 8,507 $23,029 $ 5,056 $40,481 $ 2,293 $79,366
22
Reconciling Items
- -----------------
Description - Reconciling items for net interest income primarily relate to
the recording of interest income on a taxable equivalent basis, reallocation
of capital and the funding of goodwill and intangibles. Reconciling items for
noninterest income primarily relate to the sale of certain securities and
certain other gains. Reconciling items for noninterest expense primarily
reflects corporate overhead as well as amortization of intangibles and
severance. In the second and third quarter of 2003, merger and integration
costs associated with Pershing and in the third quarter of 2003 the GMAC
settlement are also reconciling items. In the third quarter of 2002 the loss
on a sublease was also a reconciling item. The adjustment to the provision for
credit losses reflects the difference between the aggregate of the credit
provision over a credit cycle for the reportable segments and the Company's
recorded provision. The reconciling items for average assets consist of
goodwill and other intangible assets.
3rd 2nd 3rd
Quarter Quarter Quarter Year to date
(In millions) 2003 2003 2002 2003 2002
------- ------- ------- ------ -----
Segments' revenue $ 1,486 $1,403 $1,254 $4,121 $3,778
Adjustments:
Earnings associated with
assignment of capital (33) (28) (24) (81) (74)
Securities gains - - (215) - (213)
Other gains 4 6 25 13 29
Taxable equivalent basis and
other tax-related items 13 13 14 41 42
------- ------ ------ ------ ------
Subtotal-revenue adjustments (16) (9) (200) (27) (216)
------- ------ ------ ------ ------
Consolidated revenue $1,470 $1,394 $1,054 $4,094 $3,562
======= ====== ====== ====== ======
Segments' income before tax $ 574 $ 544 $ 573 $1,627 $1,767
Adjustments:
Revenue adjustments (above) (16) (9) (200) (27) (216)
Provision for credit losses
different than GAAP (3) 1 (183) (3) (167)
Severance (2) (4) (1) (8) (15)
Goodwill and
intangible amortization (8) (7) - (18) (4)
Pershing-related
integration expenses (23) (25) - (48) -
GMAC settlement (78) - - (78) -
Loss on sublease - - (22) - (22)
Corporate overhead (53) (49) (44) (152) (127)
------- ------- ------ ------ ------
Consolidated income
before tax $ 391 $ 451 $ 123 $1,293 $1,216
======= ======= ====== ====== ======
Segments' total
average assets $93,223 $87,374 $76,431 $86,213 $77,073
Adjustments:
Goodwill and intangibles 3,930 3,550 2,379 3,366 2,293
------- ------- ------- ------- -------
Consolidated average assets $97,153 $90,924 $78,810 $89,579 $79,366
======= ======= ======= ======= =======
23
Allocation to Segments - Earnings associated with the assignment of capital
relate to preferred trust securities which are assigned as capital to
segments. Since the Company considers these issues to be capital, it does not
allocate the interest expense associated with these securities to individual
segments. If this interest expense were allocated to segments, it could be
assigned based on segment capital, assets, risks, or some other basis.
The reconciling item for securities gains relates to the Financial
Markets business. Other gains in 2002 include a $32 million ESDC grant. The
taxable equivalent adjustment is not allocated to segments because all
segments contribute to the Company's taxable income and the Company believes
it is arbitrary to assign the tax savings to any particular segment. Most of
the assets that are attributable to the tax equivalent adjustment are recorded
in the Financial Markets segment.
The reconciling item for the provision for loan losses primarily relates
to Corporate Banking and in 2003 to aircraft leases in Financial Markets.
Goodwill and intangible amortization primarily relates to the Securities
Servicing and Fiduciary segment. Corporate overhead is difficult to
specifically identify with any particular segment. Approaches to allocating
corporate overhead to segments could be based on revenues, expenses, number of
employees, or a variety of other measures. Merger and integration charges
would be allocated to the Securities and Fiduciary businesses segment. The
GMAC settlement would be allocated to Corporate Banking.
CONSOLIDATED BALANCE SHEET REVIEW
Total assets were $95.2 billion at September 30, 2003, compared with
$99.6 billion at June 30, 2003, and $77.6 billion at December 31, 2002. The
decrease in total assets on a sequential quarter basis reflects lower client
deposit levels given a more orderly securities settlement process across the
industry relative to the June quarter end. Within the asset composition of the
balance sheet, while loans continue to be reduced, average investment
securities, largely high quality short duration mortgage-backed securities,
were up $2.3 billion, continuing a strategic shift to enhance the liquidity
and risk profile of the Company's balance sheet. The increase versus a year
ago mainly reflects the Pershing acquisition. Total shareholders' equity was
$8.2 billion at September 30, 2003, compared with $8.1 billion at June 30,
2003, and $6.7 billion at December 31, 2002. The major reasons for the
increase in shareholders' equity from a year ago are the issuance of
approximately $1 billion of common stock to fund the Pershing acquisition and
the retention of earnings.
Return on average common equity on a reported basis for the third quarter
of 2003 was 12.82%, compared with 15.56% in the second quarter of 2003, and
4.73% in the third quarter of 2002. On an operating basis, return on average
common equity for the third quarter of 2003 was 15.85%, compared with 16.41%
in the second quarter of 2003.
For the first nine months of 2003, the reported return on average common
equity was 15.23% compared with 16.74% in 2002 and the return on average
assets was 1.27% for the first nine months of 2003 compared with 1.35% in
2002. On an operating basis, return on average common equity was 16.63% and
the return on average assets was 1.39% for the first nine months of 2003.
On a reported basis, return on average assets for the third quarter of
2003 was 1.06%, compared with 1.30% in the second quarter of 2003, and 0.40%
in the third quarter of 2002. On an operating basis, return on average assets
for the third quarter of 2003 was 1.31%, compared with 1.37% in the second
quarter of 2003.
24
Investment Securities
- ---------------------
The table below shows the distribution of the Company's securities portfolio:
Investment Securities (at Fair Value)
(In millions) 09/30/03 12/31/02
-------- --------
Fixed Income:
Mortgage-Backed Securities $18,497 $13,084
Asset-Backed Securities 96 37
Corporate Debt 1,339 1,112
Short-Term Money Market Instruments 1,156 1,999
U.S. Treasury Securities 456 537
U.S. Government Agencies 207 469
State and Political Subdivisions 306 403
Emerging Market Debt 111 114
Other Foreign Debt 516 273
------- -------
Subtotal Fixed Income 22,684 18,028
Equity Securities:
Money Market Funds 53 91
Bank Stocks - 91
Federal Reserve Bank Stock 96 66
Other 27 22
------- -------
Subtotal Equity Securities 176 270
------- -------
Total Securities $22,860 $18,298
======= =======
Total investment securities were $22.9 billion at September 30, 2003,
compared with $20.4 billion at June 30, 2003, and $18.3 billion at December
31, 2002. Average investment securities were $20.6 billion in the third
quarter of 2003, compared with $18.7 billion in the second quarter of 2003 and
$16.8 billion in the third quarter of last year. Average investment
securities were $19.1 billion in the nine months ended September 30, 2003,
compared with $14.7 billion in the nine months ended September 30, 2002. The
increases were primarily due to growth in the Company's portfolio of highly
rated mortgage-backed securities which are 97% rated AAA, 1% AA, and 2% A.
Since December 31, 2002, the Company has added approximately $5.4 billion of
mortgage-backed securities to its investment portfolio. The Company has been
adding either adjustable or short life classes of structured mortgage-backed
securities, both of which have short average lives. The Company has
maintained a duration of approximately 2.3 years on its mortgage portfolio to
best match its liabilities and reduce the adverse impact from a rise in
interest rates.
Net unrealized gains for securities available-for-sale were $245 million
at September 30, 2003, compared with $338 million at December 31, 2002. As
interest rates rise, the Company expects the unrealized gains will decline,
which will lower shareholders' equity and adversely impact the Company's
tangible common equity ratio.
Loans
- -----
Total loans were $37.5 billion at September 30, 2003, compared with $37.8
billion at June 30, 2003, and $31.3 billion at December 31, 2002. The increase
in total loans since year-end 2002 primarily reflects the addition of margin
loans from the Pershing acquisition, which were partially offset by a
reduction in Corporate exposures. Non-margin loans were $32.1 billion at
September 30, 2003, compared with $32.9 billion at June 30, 2003, and $33.8
billion at December 31, 2002. The decrease reflects the Company's strategy of
reducing non-strategic and outsized corporate loan exposures to improve its
credit risk profile. Average total loans were $37.4 billion in the third
25
quarter of 2003, compared with $35.7 billion in the second quarter of 2003 and
$33.7 billion at September 30, 2002. Pershing contributed $6.6 billion to the
increase in average loans from September 30, 2002. Excluding Pershing, average
loans were $30.8 billion in the third quarter of 2003 and $32.7 billion in the
second quarter of 2003.
The Company has made steady progress in reducing its exposure to higher
risk credits and will continue its intensive efforts to do so in the telecom
segment as well as throughout the loan portfolio. The Company continued to
make progress in its risk reduction efforts during the third quarter.
Corporate exposures were reduced by over $1 billion, bringing the total
reductions to date to $6.7 billion. Telecom industry exposures were reduced to
approximately $0.9 billion at September 30, 2003, down from $1.5 billion at
December 31, 2002. The Company's $9 billion corporate exposure reduction
program is ahead of schedule with the Company 74% towards its targeted goal
with five quarters remaining. The improvement in credit spreads in 2003 and
resulting price improvement and greater liquidity in the secondary loan market
created favorable conditions for the Company to reduce non-strategic exposure
and certain large credits. The following tables provide additional details on
the Company's loan exposures and outstandings at September 30, 2003 in
comparison to December 31, 2002.
Overall Loan Portfolio
Unfunded Total Unfunded Total
(dollars in billions) Loans Commitments Exposure Loans Commitments Exposure
----------------------------- ------------------------------
9/30/03 9/30/03 9/30/03 12/31/02 12/31/02 12/31/02
-------- ------- ------- -------- -------- --------
Financial Institutions(4) $10.7 $21.1 $31.8 $ 6.6 $24.1 $30.7
Corporate(4) 5.3 21.0 26.3 8.2 23.4 31.6
----- ----- ----- ----- ----- ----
16.0 42.1 58.1 14.8 47.5 62.3
----- ----- ----- ----- ----- ----
Consumer & Middle Market 8.0 4.0 12.0 8.0 4.1 12.1
Leasing Financings 5.6 0.1 5.7 5.6 0.1 5.7
Commercial Real Estate 2.4 0.8 3.2 2.5 0.8 3.3
Margin loans 5.5 - 5.5 0.4 - 0.4
----- ----- ----- ----- ----- -----
Total $37.5 $47.0 $84.5 $31.3 $52.5 $83.8
===== ===== ===== ===== ===== =====
(1) Includes assets held for sale.
(2) Unfunded commitments include letters of credit.
(3) Excludes acceptances due from customers.
(4) The Company reclassified $0.9 billion of exposures from Corporate to Financial
Institutions to better reflect the underlying nature of the credit. Prior periods
have been restated.
26
Financial Institutions
- ----------------------
The financial institutions portfolio exposure was $31.8 billion at September
30, 2003 compared to $30.7 billion at December 31, 2002. These exposures are
of high quality, with 88% meeting the investment grade criteria of the
Company's rating system. The exposures are generally short-term, with 76%
expiring within one year and are frequently secured. For example, mortgage
banking, securities industry, and investment managers often borrow against
marketable securities held in custody at the Company. The diversity of the
portfolio is shown in the accompanying table.
(Dollars in billions)
09/30/03 12/31/02
------------------------------ -----------------------------
Unfunded Total %Inv %due Unfunded Total
Lending Division Loans Commitments Exposures Grade <1 Yr Loans Commitments Exposures
- ---------------- ------ ----------- --------- ----- ------ ------ ----------- ---------
Banks $ 3.4 $ 3.1 $ 6.5 71% 82% $2.9 $ 4.5 $ 7.4
Securities
Industry 2.6 3.5 6.1 93 96 1.3 3.9 5.2
Insurance 0.3 4.8 5.1 96 61 0.4 5.5 5.9
Government 0.1 5.3 5.4 99 57 0.2 5.5 5.7
Asset Managers 3.7 3.4 7.1 86 79 1.2 3.9 5.1
Mortgage Banks 0.4 0.5 0.9 87 78 0.4 0.5 0.9
Endowments 0.2 0.5 0.7 98 87 0.2 0.3 0.5
----- ----- ----- --- ---- ---- ----- -----
Total $10.7 $21.1 $31.8 88% 76% $6.6 $24.1 $30.7
===== ===== ===== === ==== ==== ===== =====
Corporate
- ---------
The corporate portfolio exposure declined to $26.3 billion at September
30, 2003 from $31.6 billion at year-end 2002. Approximately 74% of the
portfolio is investment grade while 34% of the portfolio matures within one
year. In December 2002, the Company announced its intention to reduce its
corporate exposure by $9 billion to $24 billion by the end of 2004. Since that
time, corporate credit exposures have been reduced by $6.7 billion of the $9
billion target. Reductions have been achieved through loan run-offs and
reduced rollover commitments, as well as loans sales which have taken
advantage of improved liquidity in the secondary loan market.
(Dollars in billions)
09/30/03 12/31/02
----------------------------- -----------------------------
Unfunded Total %Inv %due Unfunded Total
Lending Division Loans Commitments Exposures Grade <1 Yr Loans Commitments Exposures
- ---------------- ------ ----------- --------- ----- ------ ------ ----------- ---------
Media $ 1.5 $ 2.3 $ 3.8 68% 18% $1.9 $ 2.4 $4.3
Cable 0.7 0.6 1.3 36 4 1.0 0.6 1.6
Telecom 0.3 0.6 0.9 60 29 0.7 0.8 1.5
----- ----- ----- -- -- ---- ----- -----
Subtotal 2.5 3.5 6.0 59% 17% 3.6 3.8 7.4
Utilities 0.2 2.8 3.0 87 67 0.7 3.0 3.7
Retailing 0.1 2.4 2.5 75 46 0.2 2.6 2.8
Automotive 0.2 2.1 2.3 77 39 0.2 2.6 2.8
Oil & Gas 0.2 1.5 1.7 81 36 0.4 1.7 2.1
Healthcare 0.3 1.4 1.7 84 35 0.4 1.5 1.9
Other* 1.8 7.3 9.1 75 29 2.7 8.2 10.9
----- ----- ----- -- -- ---- ----- -----
Total $ 5.3 $21.0 $26.3 74% 34% $8.2 $23.4 $31.6
===== ===== ===== == == ==== ===== =====
* Diversified portfolio of industries and geographies
Media, cable, and telecommunications has been a significant industry
specialization of the Company historically. The Company has specifically
targeted the telecom portfolio for continued reduction in exposure with a goal
of reducing the telecom portfolio below $750 million by December 31, 2004. In
27
the first nine months of 2003, the Company reduced telecom exposure by $0.6
billion. The percentage of investment grade borrowers in the telecom
portfolio has increased to 60% from 54% at year-end 2002, due to reductions in
lower rated exposures.
The Company's exposure to the airline industry consists of a $635 million
leasing portfolio as well as $48 million of direct lending. The airline
leasing portfolio consists of $286 million to major U.S. carriers, $254
million to foreign airlines and $95 million to U.S. regionals. During 2003,
the domestic airline industry witnessed structural improvements, including
favorable labor developments, continued cost containment, and increased
liquidity due to government aid. Notwithstanding the recent improvements, the
industry faces sustained challenges from a tepid recovery in air travel,
ongoing tension in labor relations, intense domestic competition, future
pension funding requirements, and geopolitical uncertainty. Because of these
factors, the Company continues to carefully monitor its airline exposure.
Nonperforming Assets
- -------------------------
Change Change
9/30/03 vs. 9/30/03 vs.
(Dollars in millions) 9/30/03 6/30/03 6/30/03 12/31/02 12/31/02
-------- -------- -------- -------- --------
Category of Loans:
Commercial $265 $312 $(47) $321 $(56)
Foreign 79 84 (5) 84 (5)
Other 44 41 3 34 10
---- ---- ---- ---- ----
Total Nonperforming Loans 388 437 (49) 439 (51)
Other Real Estate - - - 1 (1)
---- ---- ---- ---- ----
Total Nonperforming Assets $388 $437 $(49) $440 $(52)
==== ==== ===== ==== ====
Nonperforming Assets Ratio 1.2% 1.3% 1.4%
Allowance/Nonperforming Loans 210.5 188.6 189.1
Allowance/Nonperforming Assets 210.5 188.6 188.7
Nonperforming assets declined $49 million during the third quarter to
$388 million from $437 million at June 30, 2003. The decrease primarily
reflects sales and charge-offs of commercial loans.
Interest income would have been increased by $4 million and $8 million
for the third quarters of 2003 and 2002 if loans on nonaccrual status at
September 30, 2003 and 2002 had been performing for the entire period.
Interest income would have been increased by $12 million and $15 million for
the nine months ended September 30, 2003 and 2002 if loans on nonaccrual
status at September 30, 2003 and 2002 had been performing for the entire
period.
28
Impaired Loans
- --------------
The table below sets forth information about the Company's impaired loans. The
Company uses the discounted cash flow, collateral value, or market price
methods for valuing its impaired loans:
September 30 June 30 December 31
(Dollars in millions) 2003 2003 2002
------------ ------- -----------
Impaired Loans with an Allowance $352 $393 $376
Impaired Loans without an Allowance(1) - 4 27
---- ---- ----
Total Impaired Loans $352 $397 $403
==== ==== ====
Allowance for Impaired Loans(2) $150 $189 $167
Average Balance of Impaired Loans
during the Quarter $387 $404 $343
Interest Income Recognized on
Impaired Loans during the Quarter $ - $0.4 $0.1
(1) When the discounted cash flows, collateral value or market price equals
or exceeds the carrying value of the loan, then the loan does not require
an allowance under the accounting standard related to impaired loans.
(2) The allowance for impaired loans is included in the Company's allowance
for credit losses.
Allowance
- ---------
September 30 June 30 September 30
(Dollars in millions) 2003 2003 2002
------- -------- -------
Total Loans $37,540 $37,796 $34,242
Margin Loans 5,472 4,877 407
Non-Margin Loans 32,068 32,919 33,835
Allowance 817 824 681
Allowance for Loan Losses
As a Percent of Loans 2.18% 2.18% 1.99%
Allowance for Loan Losses As a
Percent of Non-Margin Loans 2.55 2.50 2.01
The allowance for credit losses to total loans was $817 million, or 2.18%
of loans at September 30, 2003, compared with $824 million, or 2.18% of loans
at June 30, 2003, and $831 million, or 2.65% of loans at December 31, 2002.
The ratio of the allowance for credit losses to non-margin loans was
2.55% for September 30, 2003, compared with 2.50% for June 30, 2003 and 2.68%
at December 31, 2002, reflecting stability in credit quality in the first nine
months of 2003. The May 1 acquisition of Pershing added $5.4 billion of
secured margin loans to the Company's balance sheet at September 30, 2003.
The Company has rarely suffered a loss on these types of loans and doesn't
allocate any of its allowance for credit losses to these loans. The Company
believes the ratio of allowance for credit losses to non-margin loans is a
more appropriate metric for the allowance for credit losses than the ratio of
allowance for loan losses to total loans.
The ratio of the allowance to nonperforming assets was 210.5% at
September 30, 2003, up from 188.6% at June 30, 2003, and 188.7% at December
31, 2002. Included in the Company's allowance for credit losses at September
30, 2003 is an allocated transfer risk reserve related to Argentina of $20
million.
The allowance for credit losses consists of four elements: (1) an
allowance for impaired credits (nonaccrual commercial credits over $1
million), (2) an allowance for higher risk rated credits, (3) an allowance for
29
pass rated credits, and (4) an unallocated allowance based on general economic
conditions and risk factors in the Company's individual markets.
The first element - impaired credits - is based on individual analysis of
all nonperforming commercial credits over $1 million. The allowance is
measured by the difference between the recorded value of impaired loans and
their fair value. Fair value is either the present value of the expected
future cash flows from borrowers, the market value of the loan, or the fair
value of the collateral.
The second element - higher risk rated credits - is based on the
assignment of loss factors for each specific risk category of higher risk
credits. The Company rates each credit in its portfolio that exceeds $1
million and assigns the credits to specific risk pools. A potential loss
factor is assigned to each pool, and an amount is included in the allowance
equal to the product of the amount of the loan in the pool and the risk
factor. Reviews of higher risk rated loans are conducted quarterly and the
loan's rating is updated as necessary. The Company prepares a loss migration
analysis and compares its actual loss experience to the loss factors on an
annual basis to attempt to ensure the accuracy of the loss factors assigned to
each pool. Pools of past due consumer loans are included in specific risk
categories based on their length of time past due.
The third element - pass rated credits - is based on the Company's
expected loss model. Borrowers are assigned to pools based on their credit
ratings. The expected loss for each loan in a pool incorporates the borrower's
credit rating, loss given default rating, estimated exposure at default, and
maturity. The credit rating is judgmental and is dependent upon the borrower's
estimated probability of default. The loss given default incorporates a
recovery expectation based on historical experience, collateral, and
structure. Borrower and loss given default ratings are reviewed semi-annually
at minimum and are periodically mapped to third party rating agency, default
and recovery data bases to ensure ongoing consistency and validity. Commercial
loans over $1 million are individually analyzed before being assigned a credit
rating. All current consumer loans are included in the pass rated consumer
pools.
The fourth element - an unallocated allowance - is based on management's
judgment regarding the following factors:
- Economic conditions including duration of the current economic cycle
- Past experience including recent loss experience
- Credit quality trends
- Collateral values
- Volume, composition, and growth of the loan portfolio
- Specific credits and industry conditions
- Results of bank regulatory and internal credit exams
- Actions by the Federal Reserve Board
- Delay in receipt of information to evaluate loans or confirm
existing credit deterioration
- Geopolitical issues and their impact on the economy
30
Based on an evaluation of these four elements, including individual
credits, historical credit losses, and global economic factors, the Company
has allocated its allowance for credit losses as follows:
September 30 December 31
2003 2002
------------ -----------
Domestic
Real Estate 2% 3%
Commercial 75 75
Consumer 1 1
Foreign 9 9
Unallocated 13 12
--- ---
100% 100%
=== ===
Such an allocation is inherently judgmental, and the entire allowance for
credit losses is available to absorb credit losses regardless of the nature of
the loss.
Deposits
- --------
Total deposits were $58.9 billion at September 30, 2003, compared with
$64.7 billion at June 30, 2003 and $55.4 billion at December 31, 2002. The
decrease on a sequential quarter basis was primarily due to lower cash
balances from securities processing customers. At June 30, 2003, high
securities settlement volumes resulted in a higher than normal level of
uncompleted trades across the industry, which added to the cash levels in
customer accounts. The settlement process across the industry was more
orderly at September 30, 2003. Noninterest-bearing deposits were $16.4
billion at September 30, 2003, compared with $13.3 billion at December 31,
2002. Interest-bearing deposits were $42.6 billion at September 30, 2003,
compared with $42.1 billion at December 31, 2002.
31
WORLD TRADE CENTER DISASTER UPDATE
During the first nine months of 2003, the Company incurred $34 million in
expenses associated with interim space, business interruption, and the
restoration of facilities, which was offset by an insurance recovery.
The Company is actively engaged in subletting its interim operating
facilities. Through September 30, 2003, the Company had terminated or sublet
1,000,000 square feet and had 300,000 square feet remaining to sublet. The
Company has recorded a liability for its sublease loss as of September 30,
2003 of $173 million. At September 30, 2003, the Company had reserved for
approximately 57% of the future costs associated with the subleases. The
Company expects the remainder of the costs to be covered by income from
subletting these properties.
The financial statement impact of the WTC disaster is shown in the table
below:
(In millions) 2003
----
WTC Expenses $ 34
Insurance Recovery 34
-----
Pre-tax Impact $ -
=====
Cumulative Insurance Recovery $ 678
Cumulative Cash Advances from
Insurance Companies (600)
-----
Receivable from Insurance Companies
at September 30, 2003 $ 78
=====
Future cash advances will largely relate to business interruption costs.
The Company expects to record modest additional insurance recoveries in 2003
and 2004 above the current $678 million as it completes the move of its data
centers from interim locations to final locations.
32
CRITICAL ACCOUNTING POLICIES
The Company's significant accounting policies are described in the "Notes to
Consolidated Financial Statements" under "Summary of Significant Accounting
and Reporting Policies" in the Company's 2002 Annual Report on Form 10-K.
Three of the Company's more critical accounting policies are those related to
the allowance for credit losses, to the valuation of derivatives and
securities where quoted market prices are not available, and goodwill and
other intangibles.
Allowance for Credit Losses
- ---------------------------
The allowance for credit losses represents management's estimate of
probable losses inherent in the Company's loan portfolio. This evaluation
process is subject to numerous estimates and judgments. Probabilities of
default ratings are assigned after analyzing the credit quality of each
borrower/counterparty and the Company's internal ratings are consistent with
external rating agency default databases. Loss given default ratings are
driven by the collateral, structure, and seniority of each individual asset
and are consistent with external loss given default/recovery databases. The
portion of the allowance related to impaired credits is based on the present
value of future cash flows. Changes in the estimates of probability of
default, risk ratings, loss given default/recovery rates, and cash flows could
have a direct impact on the allocated allowance for loan losses.
The Company's unallocated allowance is established via a process that
begins with estimates of probable loss inherent in the portfolio, based upon
the following factors:
- Economic conditions, including duration of the current cycle
- Past experience, including recent loss experience
- Credit quality trends
- Collateral values
- Volume, composition, and growth of the loan portfolio
- Specific credits and industry conditions
- Results of bank regulatory and internal credit exams
- Actions by the Federal Reserve Board
- Delay in receipt of information to evaluate loans or confirm existing
credit deterioration
- Geopolitical issues and their impact on the economy
To the extent actual results differ from forecasts or management's
judgment the allowance for credit losses may be greater or less than future
charge-offs.
The Company considers it difficult to quantify the impact of changes in
forecast on its allowance for credit losses. Nevertheless, the Company
believes the following discussion may enable investors to better understand
the variables that drive the allowance for credit losses.
One key variable in determining the allowance is management's judgment in
determining the size of the unallocated allowance. At September 30, 2003, the
unallocated allowance was 13% of the total allowance. If the unallocated
allowance were five percent higher or lower, the allowance would have
increased or decreased by $41 million, respectively.
The credit rating assigned to each pass credit is another significant
variable in determining the allowance. If each pass credit were rated one
grade better, the allowance would have decreased by $57 million, while if each
pass credit were rated one grade worse, the allowance would have increased by
$71 million.
For non pass rated credits, if the loss given default were 10% worse, the
allowance would have increased by $43 million, while if the loss given default
were 10% better, the allowance would have decreased by $54 million.
For impaired credits, if the fair value of the loans were 10% higher or
lower, the allowance would have increased or decreased by $20 million,
respectively.
33
Valuation of Derivatives and Securities Where Quoted Market Prices Are Not
- --------------------------------------------------------------------------
Available
----------
When quoted market prices are not available for derivatives and securities
values, such values are determined at fair value, which is defined as the
value at which positions could be closed out or sold in a transaction with a
willing counterparty over a period of time consistent with the Company's
trading or investment strategy. Fair value for these instruments is determined
based on discounted cash flow analysis, comparison to similar instruments, and
the use of financial models. Financial models use as their basis independently
sourced market parameters including, for example, interest rate yield curves,
option volatilities, and currency rates. Discounted cash flow analysis is
dependent upon estimated future cash flows and the level of interest rates