Betsy Graseck - Morgan Stanley
Okay. Thanks everybody for joining us here on day two of our financials services conference. We are going to kick off with a poll question and I will remind folks that this session is going to be 50 minutes, and that means that we are looking forward to hearing your questions, okay. So think about the questions that you want to ask Marianne during the presentation.
Okay, so before I introduce Marianne Lake, JPMorgans CFO, I would like to ask the audience to poll questions. One poll question, what would drive you to buy JPM?
The five choices here, accelerating fee growth is A, B, positive net interest income growth C, a 100 basis point of positive operating leverage plus annually D, certainty of new more on litigation or E an 80% total payout ratio.
So A C growth will be NII growth, the answer is very evenly split between C NII and no more litigation, interesting. Okay, so hopefully the 80% pair ratio is already in your models. I guess that’s what that means. So for our team [ph] here today we are pleased to have with us Marianne Lake, CFO of JPMorgan. Marianne took on the role of CFO JPMorgan in January 2013 prior to which she served as CFO of the Consumer and Community Banking Division as well as having held many other positions within JPMorgan before that.
We are over weigh [ph] JPMorgan at Morgan Stanley on expectations for improving efficiency, rising client launch share and ultimately higher capital return, I think we are pushing into that 80% capital return target. So with that let me turn it over to Marianne, targets mine by the way, no JPs.
Okay. Thank you, Betsy. Good morning everyone, it’s pleasant to be here this morning. And just make sure I’m not going to spill my coffee. Okay, so I’m going to dive straight into the presentation and as Betsy said we’ll be happy to sensitize at the end on your questions.
On page one, I do think if there is reminding people that JPMorgan is a Company that has performed very strongly and consistently over an extended period and in times as you know of significant change. And you see on the page that the three years of '10 through '12 we reported return on tangible common equity of 15%, but also in 2013 it would have been 15% if you had adjusted the impact of significant legal expense as well as inactive reserve releases. And this is during the time when we have grown our capital significantly. During this period, we have added 50% capital that more than doubled since the crisis. And also as you know our compact set of rules that we’re navigating.
We’ve also operated the company and other the head ratio and adjusted overhead ratio of 58% to 59% during that time period, which is among best in class efficiency ratios, but we do acknowledge that that’s post the room and the need to deliver positive operating leverage over the next few years.
So the level of performance on this page does show the benefit of the firms diversified business model but also our ability to change and adapt with this key as we look forward. Having said that, 2014 is a transition year, it’s a transition year in many ways. Obviously we are optimizing against the capital and regulatory regime and also in the economy we are facing the smallest mortgage market that we’ve seen in over 14 years. As you know we are facing smaller markets, revenue year-over-year, and although charge-offs continue to be very low, reserve releases will be lower this year than last.
But what you see, I apologize I’ve gone too far forward. But what you see on the chart on the bottom right of the first item on page one is that even with all of that as a backdrop we did deliver a 13% return on tangible common equity in the first quarter, which is best-in-class performance four peers that have a meaningful global market presence. And if these two term headwins don’t change our long term objectives and they don’t change our long term performance targets. We are a company that would deliver $0.15, $0.16 return on tangible common equity and a mid-60s overhead ratio through the cycle.
And when we build our businesses, we build them with a long term view. So on page two, we are going to take a quick look at some of the performance drivers. To name a few, we do have among the highest consumer deposit growth in the industry. Year-over year we grew deposits at 9% with a three year CAGR of nearly 8.5%, 300 basis points above the large peer groups.
Also in consumer, we are growing our non-interest revenue or fee revenue in the high single digits year-over-year, which is driven by strong performance in growth in investments that are in card sales and merchant processing volumes. And we are ranked number one in customer satisfaction among large banks by J.D. Power. And closing the gap versus regional banks, which is the corner stone of our faculty. We’ve been focused over the last several years on making sure that we acquire the right relationships and we deepen them through superior customer service and its evidently working.
In the Corporate & Investment Bank, we are maintaining our number one share in global IB fees with 8.5% share year-to-date and a number one market’s revenue with over 14% share, and leadership positions with a number three ranking in 15 or 16 product categories.
In the Commercial Bank, we are number one traditional middle market syndicated lender in the U.S. and number one U.S. multi-family lender. And in Asset Management, we’ve had 20 consecutive quarters before this run of positive long term flows and we are set for our 21st, and the number one in U.S. and global long term active mutual fund flows, growing both our client asset and our loans and impressive pace.
So, not specifically on the page but before we leave it, just a moment on where we stand in terms of loan growth and the pipelines that we see them at the end of May and into June.
In 2013, we showed core loan growth of 5% and we gave you guidance that we are expecting core growth in 2014 at that same level of 5% plus or minus. And we are still tracking to that objective. We saw some strength in business banking that we talked about in the first quarter, that strength has persisted and we see pipelines that are still up 20% year-on-year.
In Auto, we see the continuation of the recovering market and growth in new sales with a solid pipeline but with re-emerging competition, but still factors before growth. And in card, we do expect modest core growth and card sales volumes continuing to grow strongly, continuing to be in that double digit year-over-year growth territory that we’ve been printing consistently.
And then finally in commercial, we did continue with a strong growth in commercial real estate that we’ve been talking about, but also in middle market we started to see pipelines as well as utilization pick up some. It’s a little early to necessarily call at trends that we are hopeful and although the absolute levels remain somewhat lower than the robust levels a couple of years ago.
So each of our businesses have a compelling story obviously in its own right. If I take you to page three, just to talk for a few minutes about the combination of the businesses and our profit and synergies. Again, to start with consumer, our consumer household have on average 7.9 product and services with us. And it’s being consistently growing its measure, which we do believe is truly best-in-class and we are a leader as I said among large banks in terms of customer satisfaction.
Over 55% of our commercial banking clients use our branches every quarter and our commercial banking lines have on average nine products with us. Everyday, we are converting more and more of our CB clients into payment type clients and commercial card clients. And being a part of JPMorgan Chase is a huge strategic advantage for the commercial banks sharing iconic brand, sharing access to talent, product, services that most of our competition doesn’t have access to.
And then within the CIB, over the last three years since 2010, we have seen the increase in card penetration. We have been broadening our client relationships doing more business with them, more products across the valley [ph]. And we’ve seen that shift towards multi product relationships. We’ve actually seen our single product relationship see reduce by some 35% in favor of two or more and in many cases five or more products.
And if you look at the diagram at the bottom of this page, it’s actually not new and we have shown this information before, it is a different way of showing the real interconnectedness across the firms. And you can see that in total, we estimate our upgrade [ph] synergies of $18 billion, but very importantly only $3 billion of that needs to be incremental as a result of our model or our scale in order to believe that we’re break even on 50 basis points more capital than peers, which is higher than where we are actually running.
So moving onto page four, just a moment then on our capital target and objectives over the longer term. We ended the first quarter with our Basel III common equity tier 1 ratio at 9.6% and a firm and bank supplementary leverage ratios at 5.1% and 5.3% respectively. Our targets for the year end for CET1 is to be above 10% and we are on track to deliver that with our ultimate target to run the company between 10% and 10.5% three times. During this quarter, you will see when we report that we have repurchased shares in excess of employee issuance which is accelerated relative to our expectations earlier this year that we talked about in first quarter earnings.
Including the impacts of those repurchases, we still expect our capitals remain broadly flat for the second quarter at 9.6% plus or minus. And we are going to build towards that 10% target by the end of the year as well as taking advantage to further repurchase capacity during that period.
If you look at the table, you can also see in the second quarter as estimated column that combination of cash flow retained as well as preferred issued during the quarter looked set to improve our SLR ratio to both the firm and the bank by 20 basis points this quarter, which means you can clearly see we’re on track to get the 5.5% for the firm if not by the end of the year shortly thereafter and then in the chart that you can see on the bottom we have shown you that we do have a clear path to get to 6% to the bank by the end of next year. And that that 6% target that we can get to in the next year and a half doesn’t include taking advantage of the likely adoption of SATCR [ph] by U.S. regulators and as we said before we estimate that would be an incremental 40 basis points of leverage.
So our 10% to 10.5% long term target does remain at the margin binding constraint. And it is consistent with our SLR requirements and also with our fully phased in stress results on the fee cost, which I want to show you on page five we updated our stress capital simulation that we had showed at Investor Day.
So, in the middle of the chart here, if you assume that we start at our high end of our long term range, starts at 10.5% CET1 for the purposes of this simulation and then you use the Fred the Fred’s stress results from this cycle to the results we just received in March or April. What we see is that our low point declined by about 350 basis points excluding the purchases, so that’s the first adjustment in rates downwards. Then we estimated the impact of fully phasing in the sensitivity of our WTA [ph] to stress.
Operational market and credit risk, that’s the additional 100 basis points of stress on the chart. So if you take the impact of those two together, that’s 450 basis points and it set our low point excluding repurchases all other things equal at 6% plus or minus when fully phased in. Again, a 2015 minimum of 4.5% which would translate $25 billion of potential for capital distribution and it’s not on the pages especially but we believe that we do the same analysis for leverage and its gets to the same page more than $25 billion of availability.
So we do have another set of stress results under our belts since we talked to you at investor day and the analysis continues to support our positions that when we get to our target capital levels, the company will be able to pass the government stress test and have access to all of our other incomes to use or to distribute. And we are pleased obviously to have had our plan for capital approved [ph] share but we do have more work to do. We have more work to do to satisfy our regulators that we have those repeatable, sustainable, robust qualitative processes that are looking for. We know what we need to do; we are fully committed to doing it.
So just to end this session with a couple of comments on our liquidity positions. In fact to the end of last year, the firm was fully compliant with all external and internal liquidity requirements to be on the [indiscernible] and so the impact of compliance was fully in our run rate and in our NIM before the end of the year. With respect to whether we are running an excess liquidity position, which I think is often the question in part, because we are running at over a 120% at LCR and also because of our balances of HQLA being over 500 billion with over $300 billion in cash.
Obviously getting our liquidity position is our highest priority, getting it right is our highest priority. We obviously measure and report Basel LCR because it’s a regulatory requirement. But we managed the firm to an internal stress frame work that we think is appropriately more conservative than that. So when we run the firm at a reported LCR ratio with a -- of over 20% that’s expectedly the same thing as managing to our internal framework and is consistent with a much more modest but on compliance with that FFR. So when we consider all of our liquidity constraints not just Basel LCR, we are running an appropriate liquidity position.
And if I just talk for a second about cash, in total we have cash balances of around $400 billion on our balance sheet. But if you remove from that balance our day sales operating cash as well as around $200 billion of wholesale non-operating deposits which as you now have limited liquidity value for us, that makes it very large sense in that number.
So when we think about managing the firm’s structural interest rate risk, which as you know we are positioned short duration today relative to our expectation of a rising late cycle. Given the low absolute level of rate, the opportunity cost to reinsure [ph] the market is rarely been cheaper than this. And so, ultimately when we think about the mix of our HQLA, it’s determined by our duration with capital [ph] and our positioning relative to rate, but also with our triangulation around our liquidity requirements and we are optimized against those constraints.
We do believe that we are the most liquid large bank in the world and later I’ll show you that we are also considering when we think about our forward timing on liquidity, the potential volatility following QE reversal and the impact that should have on our liquidity planning.
So then just to dive a little deeper into the balance sheet sensitivities on page seven through 10. So all the product franchisees are critical source of value for the firm, and as we said normalization of break would drive significant profitability for the firm which we estimate to have an incremental $8 to $10 billion of run rate NII which I’ll take you through in a little while.
Just a couple of quick comments on governance and risk management which is critical. We are acutely focused to the best of our abilities on getting deposit pricing, modeling and governance right. Because our ability to properly risk manage our balance sheet and monetize that $8 to $10 million is going to be a factor of how well we run our processes today. So we have a central team in our CIO and accessory functions which governs centrally the development and use of ALM models, our interest and liquidity limits under various stress scenarios, our interest and liquidity three times and also our firm like deposit pricing and sharing consistent deposit pricing strategy.
So let’s talk about deposit pricing sensitivity, what our assumptions are for the coming rate cycles in terms of reprice. There’s a lot on the page. Looking back at the 2004 through the 2007 interest rate cycle, the said increase set on target by 400 basis points. And during that same time frame the rates we paid on total deposits increased by about half of that 400 basis point in show rates.
For an average deposit reprice rate of about 45% the total deposit is about 60% for interest bearing deposit over that period. We then make two key adjustments to that sensitivity. First, the change in our interest expense will be a function of the rate we pay on interest bearing deposits. So we have to reflect the concurrent shift in mix from that we do expect to occur from non-interest bearing accounts to interest bearing and in particular the time deposit. We’ve put a chart on the bottom right and we are expecting something like a move back to the levels that you see in the last column in 2007, so from non-interest bearing accounts of about 30% to 20% with over 30% migrating to time deposits.
Second, the second adjustment we make is that as we look forward, we expect product specific deposit sensitivities to be likely generally higher in the next cycle than they were in the past, which would reflect a combination of factors, including potentially higher competition to deposits given regulation, given specifically LCR. Technologies advancements have taken place over the last several years which has made shopping for online deposit rates and moving money much easier and then generally a much higher level of consumer awareness and expectation in this net cycle.
So when we think about those two things together we adjust our expectations for our total deposit reprice to be above 60%. And it’s these conservative assumptions that we have embedded in our projections. So on the next page, if you have a page that we took from investor day, we did update you on each of these numbers but fundamentally it’s the same.
As we said at investor day, we do believe we did reach an inflection point at the end of 2013, with our outlook the core name to be relatively stable in 2014 and ’15 improving rent [ph] and rates improved, and for core NII to be stable in ’14 and stable to up in ’15.
So meeting on to talk about the chart on the page, broadly history is a good indicator of expectations through the future or I guess the start. But then we make certain structural adjustments to that. The adjustments we make most notably include adjusting for legacy consumer run off which is predominantly already in our run rate from the impact of implementing new liquidity standards also in our run rate and then as we look forward those conservative deposit reprice assumptions would represent a further structural reduction and that’s included in that 15 basis points also in red on the right hand side of the chart ahead.
So outside of those bigger macro adjustments, we would largely expect the NIM to improve back to the levels we saw through the cycle in ’05 to ’10 which would be a net increase in NIM about 45 basis points relative to last year and since 2013 implying incremental NII of $8 to $10 billion. We just added one other thing to the chart here in the call [ph] out box which is just a specific table showing the direction of the migration of the balance sheet that we are expecting and that’s implied in that normalization. So clearly we are expecting the deposit shift per mix to shift from non-interest bearing to interest bearing as I showed you on the prior page, but we are also expecting an improvement in the ratio of loans to deposit, which was running in 2013 at around 60% but through the cycle it’s more likely to grow at something closer to 70% plus or minus.
But before I leave this page, just a reminder that we obviously do this work at a very granular level, we model this under note to right pass and we do it bottoms up. When we do that, if you assume SLR is something like 400 basis points right [indiscernible] rates 200 and long over a couple of years and our – the bottoms up modeling gets you to that same $8 to $10 billion.
So then the final topic on that liquidity and reprice is to talk about the potential volatility or potential impact that we think QE reversal and Fed balance sheet contraction could have on our liquidity on page 10. So the potential impact of QE reversal is inherently uncertain ofcourse, we don’t have a crystal ball, however we do think that there are some important factors that will most likely impact our duration and liquidity position and we are monitoring those closely.
To start first, we should note that a significant portion of the growth in deposits that the industry has experienced has been as a direct result of the Fed’s QE policy and reserve bills. So if you look at JPMorgan, since the end of 2009, the firms deposit rate has grown by about $350 billion and we believe a significant portion of that growth has been a direct result from QE. If we didn’t know that’s given low rates some of those deposits from the -- would have appeared to be operating deposits with longer term liquidity value.
In terms of sequencing, what we expect is that Fred will seek asset purchases by the end of this year. The likely next step will be to drain liquidity from the system, potentially as much as a trillion dollars or so using the reverse three tier facility with non banks. This is likely to happen over a short period of time maybe a quarter or two and probably in the second or maybe in the second half of 2015. After which the Fed funds rates will start to be raised and lastly re-investments seeds [ph] were flowed inorder to shrink the remaining balance sheet there overtime.
So based upon our analysis of RRP in a test phase, we estimate that we could experience during that same short time period potentially in the second half of 2015, deposit outflows of upto $100 billion. And as I said, a portion of those would otherwise have seems to have relatively long term liquidity value. The second important assumption we are making is that as rates continue to normalize overtime, we are likely to also see a migration of particularly a high quality retail deposit in favor or more attractive rates and money funds.
We think ultimately those deposits will likely find their way back to bank balance sheet in the form of hotel deposits, which ofcourse is very important particularly in light of regulatory liquidity standards when notably if you take a retail deposit that has a low outflow assumption and ultimately replace it with a wholesale deposit that has a high outflow assumptions it could substantially reduce the liquidity.
And then finally as the reinvestments cease, we do expect the remaining QE deposit growth to flow out but that will be overshadowed by the broader growth in the economy and the deposits that we’re gaining from that. So to the best of our ability, we are monitoring these events and we are trying to reflect those in our forward planning. So I’m going to switch it [ph] and talk just for a second about markets activity, but also talk about our longer term, longer term prospect with CIB.
So on page 11, there is really honestly no new news since you’ve heard from Daniel and others at our recent forums in terms of the current say of the markets activity. To reiterate, we think abnormally low levels of volatility across asset classes which is what you can see in the top at the top of this page, in many cases near 15 year lows leading to low a bit of a spread, together with lower levels of play and activity to lower volumes, in part a result of challenging the current environment for investors on the back of maybe failure of global growth to materialize as expected. The combination of all of these factors is causing the market vallets [ph] to contract your ADA and it seems that I know you are going to ask for an update if I don’t volunteer it on the quarter.
So, our base case 20% down year-over-year as the total market revenue is still a rate case, still holds. But with even only three weeks ago there could still be some variability around that not just in the absolute level of trading, but also in the timing of some of the larger deals, so at this point its 20% plus or minus.
And when you compare year-over-year performance to peers which inevitably we will do, I just wanted to make sure that we all recall that with rates selling off in the second quarter of last year, many others did find themselves wrong footed, we did not and we printed stronger performance in the second quarter of 2013 than peers on a relative basis and we gained over 200 basis points in fixed share in that quarter.
So it is already clear that are secular factors consider when you think about fixed income markets, many of those are already in our run rate. What we are experiencing right now does not feel secular, it feels cyclical. And that is a time we should expect to see these cyclical headwins of – and get replaced with tailwinds. To get replaced with stronger and broader global economic growth, emerging market growth and financialization the rate normalization we just talked about and also cost structure changes. And we are positioned to get the benefits from all of those.
So if we look beyond the second quarter and just talk about the near term outlook for a second, across the industry the topline may be challenging in the near term until we see a change in the global growth environment which will then be a catalyst for market normalization. But it doesn’t change our expectations for longer term trends. So let’s just talk about that for a second on page 12.
We want to be a global leader to be in a top three position across products and across regions. And nothing that we are seeing right now makes us fundamentally releasing that strategy over the longer term. And relative to that objective if you look at the chart on the left the third column, the right hand column, you can see from the numbers and all the green net, we start from a position of strength. But if you get granular, if you dig down beneath it we still do have opportunities at the product level and the regional level to improve our positioning and we are focused on it.
The completeness of our model does enable us to have those strategic dialogues with clients that allow us to provide them with a full range of services that addresses their needs but allows us to get a reasonable return. It’s the way our clients want to work with us, want to do business with us and it’s more efficient for us, because with our share and our scale, we can better build the fixed cost and generate maximum profitability.
If you look at the top right, the chart on the top right consistent with investor day, long term macro trends including GDP growth as well as growth incremental assets especially in developing market favor a global wholesale model like us, with a scale and our complete platform. But it worth reminding you that we are starting with the business generated close to 17% return over the last four years on growing equity and delivered 13% return in last quarters challenging market, one that already has an industry leading overhead ratio and the lowest level of counter revenue in the industry, all of which is a very good track of adaptability, expense discipline and competitive pay for risk adjusted returns.
And although market conditions contain quickly and we are positioning ourselves to that, we also need to adjust to the current reality and that’s exactly what we are doing. We laid our focus on expense management in the CIB. And when we talk about doing expense work, we mean looking at processes end to end, I mean overall efficiency automation but also looking at some of these organizations. Even in the recent re-organization that Daniel affected when he brought together businesses like the macro businesses, that provides us with further opportunity for front to back efficiency looking for areas where there is overlap or doing the same thing twice and it’s an ongoing process not a structural change.
With respect to the short term revenue pressures right now, as we said, we see it mostly as a cyclical phenomenon and our scale and diversification does give us competitive advantage and gives us sustained power to get through the period and come out stronger without having to react too rapidly or too excessively to a cyclical low.
But obviously, while our performance remains at these levels, compensation will come down. And then longer term, the question is whether we will have too much capacity in businesses, which as the strict market structure evolves, May structure will require fewer resources.
It is possible that reductions maybe required interest in response to market evolution, but it will take time to play out.
So turning to Page 13, a few moments on mortgage, mortgage is a cornerstone financial product for our customers and we're fully committed to the mortgage business, but we must accomplish our control agenda. We must reduce our fixed cost and we have to embed fully the higher cost of capital and the higher cost of service in our pricing.
We do believe that there are still significant benefits to being a scale player in the mortgage space, but market share is less important to us than appropriate, sustainable return and as a result of our strategically positioning in 2014, we've given up market share in certain segments.
Specifically, lower credit quality loans including those under government programs, which have a much higher propensity to default and are complex and expensive to service properly when they are in default. Conversely, you can see on the bottom left that we are priced competitively in segments that we like, like Jumbo and we are gaining share there.
Moving on to talk specifically about production, the combination of re-fi burnout as well as slow purchase improvement has led to the smallest production market in over 14 years and for 2014, and for that matter, for 2015, the market is estimated to be $1.1 trillion or potentially smaller.
And going forward with re-fi largely burned out, the production business will be more exposed to recovering housing conditions than interest rate prima facie and housing conditions have been slow to recover so far in 2014.
Regarding margin on the top right, over the course of the last couple of years, high revenue HARP loans from our service book contributed significantly to volume, lifting revenue margin.
We now see a mix shift back towards correspondence and together with competitive pressures, we're seeing that impact revenue margins downwards.
After that, the dramatic reduction in volumes on a smaller market size and this is what's driving the negative pretax production margins we've guided to for the year.
But we are not waiting for the market to improve to attack the issues related to our profitability. We'll be removing over $800 million from our adjusted expense base this year.
But despite that, the production business is unprofitable at these market levels in this year when the higher degree of regulatory scrutiny is adding significantly to fixed cost, causing substantial negative operating leverage.
We will be able to reduce those costs over time. In this sense, scale is an increasing advantage and then just before I leave, a couple of comments on the bottom right on credit availability.
This is an industry chart that shows originations, purchase originations in 2013 and you can see that volume is migrating towards the top right in terms of LTV and FICO.
But the real takeaways are the following. High LTV credit is widely available today, in part due to GSE and government programs. Of course, the risk of the default and cost of default that services are thinking about may have an impact on that high end over time.
To date, the things that have really changed -- two things that have really changed, especially for low FICO borrowers. First regulation, together with tighter market underwriting standards requires borrowers to fully document their income and assets and defend their ability to pay in a much more rigorous way, which is leading to a fewer qualified borrowers, together with the fact that affordability products like option ARMs and IOs are not being broadly offered across the FICO segment.
So at JPMorgan, we think our credit box is largely where it needs to be, coming out of the crises and we don't see like there is an industry-wide credit appetite expansion likely to happen, but we think it's going to drive volume and market size is going to be the recovery in housing conditions.
So on the next page; I'll talk you through how we are responding over the longer term in our strategy for mortgage. We're executing on the strategy we outlined at Investor Day in order to build a smaller, less volatile, higher quality mortgage business in the next cycle, one that will deliver 15% returns through the cycle.
What that means is in production, we continue to simplify our product set, continue to invest in technology to improve efficiency, to improve our productivity as well as the mortgage experience and focus on optimizing our retail distribution strategy.
In servicing, we continue to build out our compliance infrastructure as well as to reduce the number of loans that we expect to be in default, by actively managing down existing inventory, selling or subservicing high risk and delinquent loans, but also originating higher quality loans with a lower probability of default for the future.
Relatively we have significant competitive advantages that differentiate us. In customer satisfaction, we are starting from a number one and number two position respectively in customer stats of large banks in originations and servicing and we have clear advantages that include a large respected customer base, our brand and our distribution footprint, the ability to invest in technology to improve efficiency and also the funding and expertise advantages that come as being cost to JPMorgan Chase.
So looking up on expenses, at Investor Day our guidance for adjusted expenses, which is principally excluding litigation expense, was to be down year-over-year versus 2013 at less than $59 billion, despite absorbing incremental cost of controls as well as business growth.
We're tracking consistent with that guidance before you contemplate the worth market revenues than expected. Clearly and we were clear in the queue and you can see on the page, expenses will be reduced relative to that guidance by lower performance-related compensation or lower market revenues.
But as a reminder, even though we understand that comps revenue is a well understood payer benchmark, is not how we pay people. We pay for risk-adjusted returns, risk-adjusted performance. We pay to be competitive and to protect the franchise.
So as a result, while clearly lower compensation will drive low adjusted expenses, the second half performance is going to be instructive in being able to size that properly for you. And you should expect in a challenging year that while comp dollars will absolutely come down, comps revenue may pick up slightly in the range of 30% to 35% we talked about.
A comment then on the cost of controls, we said the incremental cost of controls in 2014 relative to 2013 is around a $1 billion and we're still on track for that, bringing the total incremental spend over two years to over $2 billion.
We do believe control spend will reach a peak this year. We've hired the teams. We're standing out the processes and we'll have made significant progress in working through backlogs and execution.
And as we look forward, as those processes mature, as we invest in technology as we automate, we will deliver positive operating leverage over the next few years out of that incremental spend.
So finally, turning to our earnings power simulation another page from Investor Day, our conclusion hasn’t changed and just a reminder, because we got a lot of talk, this is a simulation, not a budget and is not a static analysis, but is also not the art of possible.
As I said at the beginning, we are transitioning. We're transitioning in terms of the economic cycle. We're transitioning in terms of capital and regulation and also in certain businesses, but we like the hand we have. We like each of our businesses and are confident in the ability for the fund to generate the performance on this page.
More than $27 billion of net income, a return on tangible common equity in the mid teens, overhead ratio in the mid 50's and throughout we will continue to provide superior customer service.
So with that, I will stop and join Betsy.
Betsy Graseck - Morgan Stanley
Thanks Marianne. Well that was very thoughtful and you answered a lot of my questions that essentially were ahead of time.
We do have about 10 minutes here for Q&A and if I just summarize what at least I heard, strong core loan growth 5%, cross-sell added 15% or was responsible for $15 billion worth of revenues in 2013, capital targets $10 billion to $10.5 billion on past to get there end of this year, middle and next, something like that, you’ve got excess liquidity, so that's under-earning a little bit during that…
Betsy Graseck - Morgan Stanley
Appropriate liquidity, which could shrink as retro.
Well, positioned for the impact of rates rising and own our lipids. We are positioned with the appropriate amount of liquidity to take into account those movements in the future, whether it's related or otherwise.
Betsy Graseck - Morgan Stanley
Okay. And as rates rise in your base case 200 Bps on the long and 400 Bps on the front end, $8 billion to $10 billion of higher net interest income, right, TID expenses will reflect the revenue environment that we get and expenses overall have been higher by about $2 billion, a function of control and that should at least be flat if not come down a little bit, is that fair.
And of course, over the next few years, yes.
Betsy Graseck - Morgan Stanley
Okay. All right. So that's what -- those are the kind of the key messages that I pulled out of your slide, I guess the question that we get from a lot of people is what if rates don't go up…
The only other thing I would -- sorry, not -- but the only other thing I would add is, if you look at the driver's page because we can get very caught up in for the short term performance, we focus on each of those drivers as being long term drivers of performance.
So when I talked about the simulation of the end, not being out of the possible, we've included a lot of our investments and benefits that would deliver, we haven’t included all of the organic growth that we might see in the future.
Betsy Graseck - Morgan Stanley
Got it. Okay. So then one topic that wasn’t discussed was what if rates do not go up.
Betsy Graseck - Morgan Stanley
So if rates don't rise, what is the opportunity set for creating operating leverage?
Right. Well, so specifically it's not often the case that rate is not going to rise obviously and we're positioned, optimized to the scenario that we talked about. Clearly, and we think GDP growth is going to be on trend. We think inflation is going to be towards trend. So we think there is a really good line of fight on that for that you could call the timing.
If it doesn’t happen, we would obviously reconsider our positioning and we would potentially cover our short duration or on duration go long potentially beyond that, but given where rates are right now, we haven’t disclosed the number, but the cost -- the NII pretax cost of the optionality to protect the upside is very low.
Betsy Graseck - Morgan Stanley
And how do you think about that, given what the ECB has done recently?
Well, so obviously we've seen Italy -- sorry, Spain and U.S. rates are the same basic rates right now, so you know anything that changes occupies this.
Betsy Graseck - Morgan Stanley
Just thinking that there is some negative deposit implications right in Europe and with your franchise and the custodial business that you have got how are you dealing with negative real pricing in the industry a year ago?
Yeah, I mean our expectation is we might see some migration of deposits to the U.S. but not that it’s going to be a step change.
Betsy Graseck - Morgan Stanley
Okay. Yeah question up here in the front.
I wanted to follow up on the question she was asking about rates, because in your forecast you have rates going up 400 basis points, but you have, you are preparing for a smaller mortgage market which is really happening because of the credit rationing for families below 700 cycle which is inhibiting household formation, causing a smaller housing market which is one of the driver for TDP. So how do you contrast those two forecasts where you forecast the higher rates and forecast the modest mortgage market and if you were on the other hand expecting them more broader loan markets that are below 700, I can understand the consistency, but I’m not sure how both happened at the same time?
So I’ll start by saying that our rate scenarios I’m going to – calling a forecast, so we needed in order to be able to give you fundamentalization to the impacts in our NII to choose a scenario. We choose a scenario that looked something more normal and in previous rate cycles of up 400 up 200. We obviously do multiple scenarios and it’s one of the reasons why we are ranked differently, and it’s three times. So you know we are expecting that to start into potentially in the second half of 2015 and take some time from that.
You are right, I mean we are seeing the purchase market recovery be lower than we would have expected given where the economic cycle is given where rates are and you called it the household formation income growth is there where it needs to be but we are still expecting that to be recovering over the course over the next several years and consistent with TDP at 3%.
Okay, so then one of the other questions on no rate hike expense management maybe it’s a sequel to that because as you indicated the expenses associated with control did go up a $1 billion each in ’13 and expected to be in ’14. Does that take class from here or is there an opportunity to you know peel that stack?
Let me just do our expenses in three categories ending with the cost of control broadly. So I’m going to start with in the CCB ex-mortgage, so you know mortgage has its own story, but in the consumer bank in particular we have been investing in our business both branches but also in digital and automation and efficiency over the course of the last five years where we had seen expenses growing. This is a year where we have seen that momentum flow dramatically and we are expecting overall like mortgage expense growth of 1%. And we are seeing a part too significant leverage going forward.
So at investor day, Gordon talked about the fact that the consumer bank will deliver $1billion low expenses in 2016 or close to $1 billion versus 2014 on the back of looking at branch format starting automation, customer preference ranges and you know that’s the beginning of the efficiency journey in the fee to date ex-mortgage. In the CIB even though I think we would we were proud of our track record, that is still – that we started the journey with a global corporate bank, we carried on with integrating the coverage team. We started with value to scale and strategic re-engineering. We continued to look front to back processes and you know Daniel is clear and still he is working through it. And we’ve never let our topline flatter our overhead ratio and we are not going to use it as an excuse not to do what we need to do now, so we are working on that.
But if you sit back and just talk about that see some billion dollars of incremental costs over the last few years, it’s very hard to believe and I’m you know Matt [ph] blames my self the whole operating unit and we talk about constantly, its very hard to believe that we can’t do as good if not -- than we are doing right now and controls more efficiently in the future, because we are working through backlogs, we are hiring large teams, we are investing in technology, we need the processes to mature and when that happens we will see that trend as I said we think it will reach – the share and then we would see it bend and come down and deliver a positive leverage in 2016, 17 and onwards.
And if you look then at the impact that having specifically for example on the commercial bank or asset management, even though it’s all inline with our expectations its causing margin pressure on those two businesses that would ultimately abate. And so when you look at that longer term target which for asset management is to have margin expenses to above 30%, 30% to 35%, and an overhead ratio of 35% in the commercial banks. Those are still our targets and that's where we are running.
Betsy Graseck - Morgan Stanley
Okay. And so you could even see that being to positively impact your operating leverage in 2015, right, because of lack of increased control expense.
Yes. So, there will be a lack of increased control expense. There is still a lot of work to be done in 2015. So, yes, it won't be growing as our outlook, but there will still be a lot of hard work to do in 2015.
Betsy Graseck - Morgan Stanley
Question in the middle of the room.
Marianne, I think it was the fourth quarter, you converted some inner company debt-to-equity to take care of some of the -- or to address the SLR at the bank level. I am wondering, there's been some talk about the pre-positioning requirement in some of the resolution stuff that may come down the road.
I am wondering if you may have more wood to chop on that front if you think you do or some of the issuance and all the things that you've talked about on the liquidity front sort of get you more ready for that.
Yeah, I mean I think if you just look at the top of the house we are very well positioned. So I mean if it wasn’t evidenced on the chart the intention of that was to show you that getting to – for the bank is in our line of sight pretty much no matter which way you profit through retaining earnings and capital efficiency and actions that we can take off that growth. If you look at it then from a more granular level at global resolution and you know home host presented [ph] past it is clear to us that you know I think the point of then to your capitalization is sufficient and would work, but is likely to be the case that some level of pre-positioning to be confident to the international regulator or home regulator might be a positive and we would be reachable but it obviously depends on the details and the levels.
You know it’s clearly we’ve already being held in many jurisdictions to local capital and independent. So it’s not as if we are already in our opinion you know well capitalized and very liquid where we need to be around the world and we’ll do whatever it takes. So we don’t see that being the need to do significant configurization that we already have.
Betsy Graseck - Morgan Stanley
Okay, so just in the last question up here.
Thank you. You talked about core loan growth in the 5% range. In the investor day there is a slide that illustrated on the mortgage business that there is a legacy portfolio that’s been running off and a core portfolio that’s been growing. Could you talk a little bit about loan growth on a net basis maybe it’s a 15th [ph] – comment because it sounds like legacy portfolios are shrinking off about the rate of the core portfolios are growing in 14, but that their lines are going to cross at some point.
Yeah, so we have a fairly large you know as a result of acquisitions we have a fairly large legacy portfolio not similar but its also in card and then there is some small other pieces of that. They have been running off, they have been running off a reasonably consistent pace that clearly adds [ph] balance reduces the impact get more meet it. In 2013, our reported growth was positive albeit it in the low single digit. So it is the case that our core loan growth at 5% plus or minus should be consistent with some reported growth but more modest than that in 2014. We haven’t actually gone out with 2015 targets for loan growth that we see incorporate the 5% plus or minus this year a reasonably good outlook for what we hope will be growth in the economy together with at least early signs of some you know positive sentiments. You could imagine core growths are above the severance [ph] maybe in 2015 so positive on a reported basis.
Betsy Graseck - Morgan Stanley
Alright. Well thank you very much Marianne for joining us this morning.
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