Jay Hooley • CEO • State Street
The new CEO of State Street is coming to the end of a challenging first 12 months on the job. While Jay Hooley is determined to consign the negative consequences of the financial crisis to the past, and focus in 2011 on building a more profitable future, he is not plotting revolution at 1 Lincoln Street.
“I have been at State Street for 24 years, but I have spent less than half of that time actually working for State Street, because I spent a good amount of time at its joint venture companies,” says Jay Hooley, who on March 1 this year completes his first 12 months as president and CEO of State Street. “So I have acquired a pretty good understanding of its strengths and weaknesses from the outside.” That is just as well, since the quiet Bostonian has taken charge at a time when it is far from obvious just how State Street can go on creating shareholder value. The share price has more or less doubled since the lows of early 2009, but it still ended 2010 at around half the levels it touched in the spring of 2008. The fact that the stock of The Bank of New York Mellon and Northern Trust has followed much the same trajectory only adds to the sense that investors are not convinced that the downturn in custody banking revenues is merely cyclical in nature. Where Hooley parts company with Bob Kelly and Rick Waddell is in his determination to act on that perception. In July last year, in the first major decision he took as CEO, Hooley opted to lay out $414 million of second quarter earnings to make whole investors in cash collateral investment pools managed by fund management arm SSgA. In November, he announced a 4-year cost-cutting program that will cost somewhere between $400 million and $450 million, the first tranche of which ate another $165 million of fourth quarter earnings. Then, just weeks before Christmas, just days away from succeeding Ron Logue as chairman in addition to being CEO of State Street, Hooley chose to take another $350 million hit in the fourth quarter. This was to upgrade the State Street investment portfolio, ditching $11 billion of mortgage-backed and asset-backed securities, many of them acquired when the property of three asset-backed commercial paper conduits was shifted on to the balance sheet in May 2009. That this will cut by $2.3 billion the boost net interest earnings have received from discount accretion is a measure of the importance Hooley attaches to putting the effects of the crisis behind the bank, cutting the risks it faces and increasing the strength of the balance sheet ahead of Basel III coming into effect.
When a custodian bank CEO starts to care about his Basel capital ratios it is a sure sign that something has changed in the mentalite of the securities services industry. Just a few years ago the American global custodians were vehemently opposed to the capital weighting of operational risk, as proposed by the Basel II capital adequacy regime, as a misdirected constraint on the profitability of an off-balance sheet business. That stance is somewhat harder to maintain today, with operational risks impinging on the balance sheets of the same banks, courtesy of Lehman Brothers, Icelandic sub-custodians, Bernie Madoff, in-house conduits, cash collateral reinvestment pools, indemnities for assets on loan, money market funds that “broke the buck,” fixed-income funds that invested in subprime assets, and a wide variety of lawsuits launched by investors and shareholders. It is enormously to the credit of Hooley that, alone among custodian bank CEOs, he has accepted that the world has changed. In the long run-in to the full implementation of Basel III in 2023, he accepts that the price of operational risk must rise, even to the point where the unwillingness of custodian banks to cover certain markets and instruments on behalf of its clients must constrain the growth of the fund management industry. “Nobody is going to be willing to underwrite all of the exposures of a fund manager in all circumstances,” he says. “There is already pressure for greater transparency into the risks being incurred, and custodians will be pushing for more. The price of covering risks will increase. And some risks will not be covered at any price. For the fund management industry, costs are going to go up, and some risks will be uninsurable. Inevitably, that will reduce returns.”
This realization may not mark a change in the nature of the relationship between State Street and the fund management industry, but it certainly represents a strategic challenge for a bank whose shareholders profited mightily for 30 years from its exposure to the rising value of assets under management. It was in 1975 that Bill Edgerly launched State Street on the trust banking plus investment management strategy that turned a piffling New England regional bank with a subscale lending business into what was for a time the largest global custodian and the largest asset manager anywhere on the planet. In retrospect, Edgerly got his timing spectacularly right, adopting the strategy at the beginning of a long boom in the growth of mutual, hedge and pension fund assets, and in the outsourcing of operational duties by all of these groups (see “What hath William Edgerly wrought at State Street?” Global Custodian, December 1990). In the 1990s under Marsh Carter, who emphasized the low-risk-high-return equation by averring that custody was more about information management than banking, State Street simply replicated the Edgerly strategy on a larger canvas, especially outside the United States.
In the boom period between the retirement of Carter in 2001 and the collapse of Lehman Brothers in September 2008, all State Street had to do under David Spina and then Ron Logue was more of the same. It was in the months that followed the Lehman failure that State Street shareholders discovered they were still invested in a bank. At the nadir in March 2009, roiled by revelations about conduits, the market capitalization of State Street was down to $9 billion. There followed litigation over losses in cash collateral reinvestment pools, alleged exploitation of clients in the foreign exchange markets, revelations of expensive errors of judgment at SSgA and lawsuits from unhappy shareholders. The last major decision taken by Logue before handing this difficult legacy to Hooley was to agree a $663 million settlement with the SEC and the Massachusetts attorney general and securities regulator to compensate investors in SSgA-managed active fixed-income investment strategies.
Yet the nature of that decision, taken not because Logue thought the bank was liable but because he wished to protect its reputation as a trusted fiduciary agent to investors, is a reminder that even the most difficult of legacies does have its positive side. In fact, throughout the crisis, State Street has adopted the difficult but admirable strategy of putting as much information into the public domain as possible, and opting to do the right thing even when it was not contractually liable. Nothing illustrated the continuity of this brand of thinking better than the first major decision Hooley took after assuming office: electing to absorb that $414 million hit to second quarter earnings in 2010 to make whole another set of SSgA clients. “Nobody likes to lay out $400 million, and we could have taken the short-term view, and insisted that we were not contractually liable with respect to the SSgA lending funds, to the benefit of ourselves,” explains Hooley. “But throughout the crisis, we have consistently taken a long-term view of our relationships with our clients.” It is certainly an approach in marked contrast to the attitudes of other custodian banks toward clients that have suffered losses of exactly the same kind. Hooley says it has earned State Street the respect not only of clients, but of others in the industry, and beyond.
There is of course a cynical case for arguing that a new CEO is always wise to get the bad news out of the way early, and with getting on for $1 billion of charges against earnings in his first 9 months in the job, things could certainly get better for Hooley from here on out. One sign that the worst is already behind him is the more selective approach the bank is taking to the remaining fallout from the financial crisis. State Street seems confident of defeating or settling at reasonable cost the rump of the SSgA lawsuits, including those launched by investors in mutual funds that held subprime securities, investors in other funds that used Lehman as prime broker, and a class action alleging losses were occasioned by the redemption restrictions the bank imposed on cash collateral reinvestment funds in October 2008 (a measure that was finally lifted in August 2010). Its attitudes toward lawsuits from disgruntled shareholders and a class action alleging an unfair division of the spoils from securities lending are equally robust, and the bank has not even bothered to reserve against a claim by investors in a cash collateral reinvestment pool that allege being repaid in specie cost them $49 million. Above all, the bank is so confident of defeating the highprofile $56 million lawsuit launched by former California Attorney General (and recently elected Governor) Jerry Brown on behalf CalPERS and CalSTRS, alleging unfair pricing of foreign exchange transactions, that it has actually paid $12 million to settle a similar claim by the State of Washington on grounds its contractual obligations were “significantly different.” Hooley will not be drawn into details on either case, saying only that each had distinctive characteristics, though he adds that the bank naturally takes the overall value of a relationship into account. “Pension funds are important to us as clients, and our reputation is important to us too,” he says. “We do not earn new revenue from existing clients who are unhappy. There are a number of situations before the courts, and they are all different. We have not been perfect. We will learn from this, and manage these things better in the future. We will sharpen up. We will also step up, when we are found to be in the wrong, or find ourselves to be in the wrong.”
This is a sensible approach to the problems of the past, whose value is as likely to be diluted as enhanced by the refusal of other custodians to face up to their fiduciary responsibilities in the same way. After all, investors will remember not which banks made them whole and which did not, but only that custody risks are real. And this is one aspect of the larger strategic challenge that faces Hooley: Are the present travails epiphenomena typical of this point in a credit cycle, or are they signs of a major structural shift in the operating environment? If the change is merely cyclical, time alone will restore revenue and margins.
But if the change is permanent, the bank needs to change its business model from one in which it relied on rising asset values to boost its earnings from investment management and low custody and fund accounting fees to attract assets it could exploit for market-related revenues from cash, foreign exchange and securities lending. Hooley has a clear view on this, which is that the problem is largely cyclical in nature. He points to the megatrends that will fuel growth in the industry, such as the growth of state, corporate and individual savings pools in every region of the world and the globalization of fund distribution as well as investing by fund managers and institutional investors. Interest rates will recover, he says, restoring net interest margin. Supply in a securities lending industry priced off 3-month interbank rates is bound to respond to rising interest rates as well, while the demand to borrow securities will pick up as markets become more directional in their movements. Likewise, foreign exchange revenues will revive as the confidence to trade and invest across borders returns. “This is not another Japan,” says Hooley.
But his confidence is carefully nuanced. Hooley points out that foreign exchange margins have shrunk for years, and will continue to do so. That was one reason why State Street bought Currenex in 2007, to keep a stake in the switch to electronic trading of foreign exchange, and to trade spread for volume. His views on securities lending are equally realistic. “Securities lending will not return to the levels we saw in 2007-08, but, with appropriate controls in place, institutional investors will continue to see it as a viable part of their portfolios,” says Hooley. “Lenders will have to decide for themselves what level of risk is appropriate in cash collateral reinvestment.” He also agrees that the industry needs to compensate for the lower profitability in these areas by charging a proper price for the safekeeping, asset servicing and fund accounting tasks it performs on behalf of clients. But he is not surprised that an industry content in the good times to underprice its core products, while profiting from market-led earnings, is finding it hard to put fees up. “It is more of a pricing issue than a business model issue,” says Hooley. “If it is a structural shift, the industry needs to reemphasize to clients the commitment and value we provide, and revisit what we receive for providing them. But if it is cyclical – and I believe that it is – we simply need to change the fee arrangements wherever possible.” He points out that State Street is less exposed on ad valorem fees than some of its competitors, collecting more from transaction fees than ad valorem fees on assets in custody or under management or (in the case of SSgA) performance fees. The bank reckons a 10% increase or decrease in worldwide equity values has only a 2% impact on its total revenues, while a similar movement in the valuation of fixed-income securities has only a 1% impact. Indeed, Hooley defends ad valorem fees and the linking of fees to market-related earnings as a “combined incentive for growth” on the part of the bank and its clients. “There is lots of upside in the potential growth of AuM and AuC, but also in clients paying fees to buy the services we provide for fees,” he adds. Hooley remains convinced that State Street can continue to profit from cross-selling, pointing to a list of 30 products, of which the top 100 clients buy an average of 12.7. “A hallmark of State Street for decades has been our ability to crosssell,” he says. “A significant proportion of our new revenue comes from existing customers.” As his own decision to embark on a 4-year cost-cutting campaign suggests, hard decisions cannot be escaped entirely. But even on that point Hooley sees the upside. “Bringing costs down is an important part of managing through the downturn, but a lower cost base will give us leverage as asset values recover,” he says.
As to what lies beyond the next revolution of the credit cycle, Hooley is content to embrace more of what came before. This is most evident in the acquisitions of Mourant International Finance Administration (April 2010), the Intesa custody business (May 2010) and Bank of Ireland Asset Management (October 2010), all of which reinforce existing strengths. Indeed, Hooley reckons the attractions of classic products were only increased by the experience of 2007-10. “The crisis has increased demand for the kind of value custodian banks deliver,” he explains. “Transparency, independent valuation and segregated safekeeping.” For State Street, Hooley sees these needs translating chiefly into demand for the middle office services where risks are managed and regulations complied with. “We have now got the people and the systems and the infrastructure,” he says. “We understand the middle office. Of the $20 trillion of assets we have in custody, $7 trillion is in the high value-added middle office services we now provide.”
Hooley insists that $7 trillion represents more than a relabeling of the liftouts of post-trade operations of PIMCO, Scottish Widows and Axa that State Street completed at the turn of the century, though he accepts that they are the foundation of its middle office platform today. Middle office services are already being bought by institutional clients of the bank, and Hooley is really expressing the hope sovereign wealth funds, central banks and other growing asset pools will want to buy them too, including the alternative asset managers spooked by the counterparty credit risks exposed in the winter of 2008-09. He has little time for those who believe there is a “prime custody” opportunity among hedge funds. “Three years ago, it looked like prime brokers versus global custodians for 130/30 business,” he says. “Prime brokers were also developing fund administration capabilities for their hedge fund clients, which competed with custodians. Post-crisis, it is investors that are driving the agenda, and they want independent valuations and segregated custody. The result is that prime brokers have settled into what they do best, which is credit and capital introductions, while the custodians have settled into what they do best, which is valuations and custody of securities and cash. Cash has definitely moved from the prime brokers to the custodians.” State Street has already introduced an “enhanced custody” product, which addresses the anxiety of investors concerned about prime broker counterparty credit risk by facilitating the lending of assets by the long-only arms of fund management groups to their colleagues on the short side.
Innovations such as that make it clear that the growth opportunity Hooley identifies is largely horizontal in nature (selling middle office services to more buy-side clients) but he is convinced it opens vertical opportunities in the front office too. “The middle office gives you the access to support the front office with decision support tools, in the form of data,” he says. “As a result of what we do in the middle office, we are seeing lots of opportunities in the front office that we would never have seen before.” By “front office” he means agency functions such as data analysis and warehousing and collateral management rather than any increase in the limited range of (mostly collateralized) principal risks State Street currently takes on behalf of clients. That said, Hooley rejects the extreme view that the future of the industry lies in reverting to a pure agency role, in which custodians would collect fees not only for safekeeping and asset servicing but for brokering cash management, securities lending and foreign exchange services supplied by third parties as well. Though he acknowledges that regulation is developing in a “challenging” way – namely, seeking to make custodians liable for any and every loss incurred by investors – he believes a tougher regulatory environment is manageable. Hooley accepts the paradox that obliging custodians to increase their risk exposure will diminish their return on equity by lifting their capital requirements, but argues the shift of more and more asset classes and instruments to on-exchange trading and centralized clearing and settlement through utility-style CSDs and CCPs will on balance be positive for State Street. “The flip side of regulation is opportunity,” says Hooley. “Moving more instruments on to public exchanges, for example, will be good for our business.” He adds that a consolidated and standardized infrastructure will help the bank cut its own costs and manage its risks better by making it easier for State Street to self-custody and self-clear. His message to members of the State Street sub-custody network is correspondingly uncompromising. “The sub-custody world is going through a transformation that is to everybody’s benefit,” says Hooley. The unexpressed sub-text is that sub-custodians can expect continuing pressure on their revenues and margins. If Hooley is not a radical, he is not a hypocrite either. As he would see it, he is not asking sub-custodians to do something he is not attempting himself: managing costs to improve efficiency.
The history of Hooley
JAY HOOLEY graduated from Boston College in 1979 with a B.Sc. in marketing. His first real job was with AT&T. This ensured he was present at the starting point of that long process of integration between the telecommunications and computing industries that culminated in the Internet, because the trade-off for the breaking of the AT&T telephone monopoly in 1982 was the right of the company to go into the nascent data processing business. As a young executive in sales, sales management and client service, Hooley was privileged to spend a lot of time at the Massachusetts Institute of Technology (MIT) learning how technology might be turned into commercially viable products and services. It was that background that brought him to the attention of Peter Madden, the former IBM executive that the then State Street CEO Bill Edgerly had appointed COO of State Street at the tender age of 34. In 1986 Hooley was just one of a number of former IBM and Xerox executives recruited by Madden to build and run and sell the technological capabilities required to fulfill the Edgerly vision of a modern trust bank as an entity that furnished institutional investors and fund managers with streams of data about the whereabouts, entitlements and performance of their assets.
By 1986 the Edgerly era at State Street was drawing to a close, but his strategy had created a demand for talents like those Hooley had honed at American Bell. Edgerly had launched the bank on its transformation from a traditional deposit-taking and lending institution into the global custodian it is today, and computing power was the only way to render the torrents of information manageable and – more importantly – make the business scalable. After a spell running US mutual fund sales, Hooley found himself at the center of the Edgerly experiment of applying data processing technology directly to the fund management industry, as the president and CEO of one part of a joint venture with DST Systems in Kansas City, Missouri. Called National Financial Data Services (NFDS), it was a transfer agency business supplying third-party share registration services to mutual fund managers. “I loved our time in Kansas City,” recalls Hooley. “We had young children at the time, and the lifestyle suited that well. NFDS also had a very Midwestern way of working. It was a very good and open environment.” Hooley made such a success of the job that in 1990 he was recalled to Boston to become president and CEO of the parent company of NFDS: the Boston Financial Data Services (BFDS) joint venture established between State Street and DST Systems way back in 1973.
Hooley stayed in that role for the next 10 years, overseeing a period of rapid growth in the third-party transfer agency business of State Street, and leading its expansion abroad. He took the business first into Canada through a local acquisition. In the United Kingdom, BFDS acquired the in-house transfer agency businesses of Save & Prosper from Robert Fleming and a joint venture between Gartmore and Henderson known as Tapal. These two acquisitions formed the basis of what is now International Financial Data Services (IFDS), the European arm of BFDS housed in an enormous, factory-like building at Basildon in Essex. Led for its first 10 years with enormous flair by Charlie Eppinger, a man Hooley had first identified as a leader when they worked together in Kansas City in the 1980s, IFDS quickly assumed its current dominant position in UK transfer agency, and later expanded into Europe through a Luxembourg operation. By the time Hooley returned to State Street proper in 2000, he had a better understanding of the distribution side of the mutual fund industry than any other executive.
So it is not surprising to learn that it was Hooley who was the moving influence behind the 2002 decision by IFDS to buy a 24% stake in Cofunds, the wrap platform it now co-owns with Legal & General (25%), Threadneedle (20%), Newhouse Capital Partners (18%), Jupiter (10%) and Prudential (3%). The investment signified the early perception by Hooley that the economics of the transfer agency business would be steadily wrecked by the rise of wrap platforms as service providers to fund distributors [see “Cofunds hits the jackpot,” Global Custodian, Summer Plus 2008, pages 66-75]. But the deal did more than hedge the mounting risk facing IFDS in the transfer agency business. It also secured for IFDS the operating contract to run Cofunds, where Charlie Eppinger is now CEO , and gave the business valuable experience in distribution support that State Street can now export to the burgeoning Asian markets. “Cofunds is a natural extension of our distribution support businesses,” is how Hooley describes the investment. “Platforms are already a dominant influence in distribution support in the UK and US markets, and we expect them to become steadily more influential in the Continental European and Asian markets as well.”
A career such as this makes Hooley more knowledgeable than most about how mutual funds are priced and distributed. Mutual funds are still demonstrably important at State Street (they and other collective funds make up more than two-fifths of assets in custody and administration with the bank) but it was obvious to Ron Logue (then COO), who had identified Hooley as a potential leader of the bank, that he needed exposure to the institutional side of the business if he was eventually to assume the top job. In 2000, in an obvious indication that he was being groomed for leadership, Hooley was invited to run the US domestic and global custody businesses of the bank. In this role, his business acumen was put to the ultimate test of making and integrating two major acquisitions. In 2003 State Street agreed to buy the global custody and Depotbank businesses of Deutsche Bank, giving the American global custodian a significant foothold in the European mutual funds business for the first time. Four years later Hooley also led the acquisition of Boston neighbors Investors Bank and Trust. Appointed vice chairman in 2006, Hooley became president and COO of State Street in 2008. This last role gave him ultimate responsibility for the three businesses – investment servicing, research and trading and securities finance – which account for 85% of revenues at State Street. By the time he became president and CEO on March 1, 2010, Hooley understood State Street, inside and out. –DSH