EX-13 6 dex13.htm 2006 FINANCIAL ANNUAL REPORT TO SHAREHOLDERS 2006 Financial Annual Report to Shareholders

Exhibit 13

 

FINANCIAL REVIEW

 

2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

32

MANAGEMENT’S REPORT ON INTERNAL CONTROL
OVER FINANCIAL REPORTING

 

33

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
WITH RESPECT TO INTERNAL CONTROL OVER FINANCIAL REPORTING

 

34

CONSOLIDATED FINANCIAL STATEMENTS

 

38

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

72

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

73

CONSOLIDATED FINANCIAL STATISTICS

 

76

SENIOR OFFICERS

 

77

BOARD OF DIRECTORS

 

78

CORPORATE INFORMATION


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA


($ IN MILLIONS EXCEPT PER SHARE INFORMATION)

    2006          2005          2004          2003          2002  

Noninterest Income

                                                   

Trust, Investment and Other Servicing Fees

  $ 1,791.6        $ 1,559.4        $ 1,330.3        $ 1,189.1        $ 1,161.0  

Foreign Exchange Trading Income

    247.3          180.2          158.0          109.6          106.4  

Treasury Management Fees

    65.4          71.2          88.1          95.6          96.3  

Security Commissions and Trading Income

    62.7          55.2          50.5          54.8          42.9  

Other Operating Income

    97.8          97.5          83.8          93.1          57.8  

Investment Security Gains

    1.4          .3          .2                   .3  
                                                     

Total Noninterest Income

    2,266.2          1,963.8          1,710.9          1,542.2          1,464.7  
                                                     

Net Interest Income

    729.9          661.4          561.1          548.2          601.8  

Provision for Credit Losses

    15.0          2.5          (15.0 )        2.5          37.5  
                                                     

Income before Noninterest Expenses

    2,981.1          2,622.7          2,287.0          2,087.9          2,029.0  
                                                     

Noninterest Expenses

                                                   

Compensation

    876.6          774.2          661.7          652.1          629.6  

Employee Benefits

    217.6          190.4          161.5          133.1          125.5  

Occupancy Expense

    145.4          133.7          121.5          132.7          101.8  

Equipment Expense

    82.5          83.2          84.7          88.2          85.0  

Other Operating Expenses

    634.8          553.4          502.3          469.2          418.1  
                                                     

Total Noninterest Expenses

    1,956.9          1,734.9          1,531.7          1,475.3          1,360.0  
                                                     

Income before Income Taxes

    1,024.2          887.8          755.3          612.6          669.0  

Provision for Income Taxes

    358.8          303.4          249.7          207.8          221.9  
                                                     

Net Income

  $ 665.4        $ 584.4        $ 505.6        $ 404.8        $ 447.1  
                                                     

PER COMMON SHARE

                                                   

Net Income–Basic

  $ 3.06        $ 2.68        $ 2.30        $ 1.84        $ 2.02  

–Diluted

    3.00          2.64          2.27          1.80          1.97  

Cash Dividends Declared

    .94          .86          .78          .70          .68  

Book Value–End of Period (EOP)

    18.03          16.51          15.04          13.88          13.04  

Market Price–EOP

    60.69          51.82          48.58          46.28          35.05  
                                                     

Average Total Assets

  $ 53,106        $ 45,974        $ 41,300        $ 39,115        $ 37,597  

Senior Notes–EOP

    445          272          200          350          450  

Long-Term Debt–EOP

    2,308          2,818          2,625          2,541          2,637  

Floating Rate Capital Debt–EOP

    276          276          276          276          268  
                                                     

RATIOS

                                                   

Dividend Payout Ratio

    30.8 %        32.1 %        33.9 %        38.1 %        33.8 %

Return on Average Assets

    1.25          1.27          1.22          1.04          1.19  

Return on Average Common Equity

    17.57          17.01          16.07          13.81          16.20  

Tier 1 Capital to Risk-Weighted Assets–EOP

    9.8          9.7          11.0          11.1          11.1  

Total Capital to Risk-Weighted Assets–EOP

    11.9          12.3          13.3          14.0          14.1  

Risk-Adjusted Leverage Ratio

    6.7          7.1          7.6          7.5          7.8  

Average Stockholders’ Equity to Average Assets

    7.13          7.47          7.62          7.61          7.63  
                                                     

Stockholders–EOP

    3,040          3,239          3,525          3,288          3,130  

Staff–EOP (full-time equivalent)

    9,726          9,008          8,022          8,056          9,317  

 

2  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW OF CORPORATION

Focused Business Strategy. Northern Trust is a leading provider of global financial solutions for investment management, asset servicing, fiduciary, and banking needs of corporations, institutions, and affluent individuals. Northern Trust is exclusively focused on the custody, management, and servicing of client assets in two target market segments, affluent individuals through its Personal Financial Services (PFS) business unit and institutional investors worldwide through its Corporate and Institutional Services (C&IS) business unit. An important element in this strategy is increasing the penetration of the PFS and C&IS target markets with investment management and related services and products provided by a third business unit, Northern Trust Global Investments (NTGI). In executing this strategy, Northern Trust emphasizes quality through a high level of service complemented by the effective use of technology. Operating and systems support for these business units is provided through the Worldwide Operations and Technology (WWOT) business unit.

 

 

LOGO

 

 

Business Structure. Northern Trust Corporation (Corporation) is a financial holding company under the Gramm-Leach-Bliley Act and was originally organized as a bank holding company in 1971 to hold all of the outstanding capital stock of The Northern Trust Company (Bank). The Bank is an Illinois banking corporation headquartered in Chicago and the Corporation’s principal subsidiary. PFS services are delivered through a network of over 80 offices in 18 U.S. states as well as offices in London and Guernsey. C&IS products are delivered to clients in approximately 40 countries through offices in North America, Europe, and the Asia-Pacific region.

Except where the context otherwise requires, the term “Northern Trust” refers to Northern Trust Corporation and its subsidiaries on a consolidated basis.

 

FINANCIAL OVERVIEW

During 2006, Northern Trust achieved excellent financial results as evidenced by record net income of $665.4 million and net income per common share of $3.00, each increasing 14% from 2005.

Revenues reached record levels, equaling $3.06 billion on a fully taxable equivalent (FTE) basis, an increase of 14% from 2005. Trust, investment and other servicing fees of $1.79 billion were the largest contributor to the growth in revenues, up 15% compared to the prior year, reflecting continued strong new business internationally.

Strong revenue growth was also driven by record net interest income (FTE) during 2006 of $794.7 million, up 10%, primarily due to 14% growth in average earning assets. Asset growth was achieved without sacrificing quality, as evidenced by the strong credit quality of our loan portfolio. Nonperforming loans at year end totaled only $35.7 million, or 0.16% of total loans.

We achieved positive operating leverage in 2006. Noninterest expenses totaled $1.96 billion in 2006, an increase of 13%, compared to the 14% increase in revenues.

Our strong financial performance in 2006 is reflected in the achievement of all four of our long-term, across cycle, strategic financial targets. In 2006, we achieved:

   

very strong revenue growth of 14% (goal of 8-10% revenue growth);

   

positive operating leverage;

   

double digit, 14% growth in earnings per share (goal of 10-12% earnings per share growth); and

   

a return on common equity of 17.6% (goal of 16-18% return on common equity).

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  3


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Our success during 2006 was also marked by record assets under custody and record assets under management. Increased new business and higher equity markets drove assets under custody up 21% to $3.5 trillion and assets under management up 13% to $697.2 billion. Global custody assets increased 36% to $1.69 trillion at year-end, primarily due to Northern Trust’s continued success internationally.

During 2006, Northern Trust continued to focus on attractive growth markets and broadening our capabilities to serve clients. In Personal Financial Services, we completed numerous initiatives that allow us to provide blended investment solutions to our clients – bringing to the market the best of Northern Trust’s investment capabilities along with investment products from outside managers. In Corporate and Institutional Services, we completed the integration of the largest acquisition in our history and now have a strong position in private equity, hedge fund, property, and other fund administration in the United Kingdom and Ireland. We are the largest private equity administrator in Europe and have the largest number of funds administered in Dublin. We opened a new operating center in India to support our growing Asian client base, and to augment our existing operations centers in North America and Europe. We also completed the migration of Insight Investment Services Limited’s back and middle office investment operations to our platform, representing $190 billion in assets.

The financial strength of Northern Trust is reflected in our strong capital levels as of December 31, 2006. During 2006, stockholders’ equity grew to $3.94 billion, primarily through the retention of earnings, offset in part by the repurchase of common stock pursuant to the Corporation’s share buyback program. In October 2006, the Board of Directors increased the quarterly dividend per common share by 8.7% to $.25, for a new annual rate of $1.00. The Board’s action reflects a policy of establishing the dividend rate commensurate with profitability while retaining sufficient earnings to allow for strategic initiatives and the maintenance of a strong balance sheet and capital ratios.

 

CONSOLIDATED RESULTS OF OPERATIONS

Financial Services Group Acquisition. On March 31, 2005, Northern Trust completed its acquisition of Baring Asset Management’s Financial Services Group (FSG), a fund services group that offered fund administration, custody, and trust services. The final adjusted purchase price totaled 261.5 million British Pounds Sterling. The acquisition increased Northern Trust’s global fund administration, hedge fund, private equity, and property administration capabilities.

FSG revenues for the nine months in 2005 subsequent to its acquisition were $130.8 million and acquisition related funding costs were $19.8 million. Operating and integration expenses totaled $105.9 million. The after-tax impact of this acquisition was neutral to full year 2005 results.

 

Noninterest Income. Noninterest income represented 74% of total taxable equivalent revenue in 2006 compared with 73% in 2005 and 74% in 2004.

 

2006 REVENUE (FTE)

 

LOGO

 

The components of noninterest income and a discussion of significant changes during 2006 and 2005 follow.

 

FOR THE YEAR


(IN MILLIONS)

    2006      2005      2004

Trust, Investment and Other Servicing Fees

  $ 1,791.6    $ 1,559.4    $ 1,330.3

Foreign Exchange Trading Income

    247.3      180.2      158.0

Treasury Management Fees

    65.4      71.2      88.1

Security Commissions and Trading Income

    62.7      55.2      50.5

Other Operating Income

    97.8      97.5      83.8

Investment Security Gains

    1.4      .3      .2
                     

Total Noninterest Income

  $ 2,266.2    $ 1,963.8    $ 1,710.9

 

2006 NONINTEREST INCOME

 

LOGO

 

Trust, Investment and Other Servicing Fees. Trust, investment and other servicing fees accounted for 79% of total noninterest income and 59% of total taxable equivalent revenue in 2006. Trust, investment and other servicing fees for 2006 increased 15% to $1.79 billion from $1.56 billion in 2005, which was up 17% from $1.33 billion in 2004. Over the past five years, trust, investment and other servicing fees have increased at an annual compound growth rate of 8.5%. For a more detailed discussion of trust, investment and other servicing fees, refer to the business unit reporting section beginning

 

4  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

on page 9. Total assets under custody at December 31, 2006 were a record $3.55 trillion, up 21% from $2.93 trillion a year ago, and included $1.69 trillion of global custody assets. Managed assets totaled a record $697.2 billion, up 13% from $617.9 billion at the end of 2005.

Trust, investment and other servicing fees are generally based on the market value of assets custodied, managed, and serviced; the volume of transactions; securities lending volume and spreads; and fees for other services rendered. Certain investment management fee arrangements also may provide for performance fees, based on client portfolio returns exceeding predetermined levels. Based on analysis of historical trends and current asset and product mix, management estimates that a 10% rise or fall in overall equity markets would cause a corresponding increase or decrease in Northern Trust’s trust, investment and other servicing fees of approximately 4% and in total revenues of approximately 2%. In addition, C&IS client relationships are generally priced to reflect earnings from activities such as foreign exchange trading and custody-related deposits that are not included in trust, investment and other servicing fees. Custody-related deposits maintained with bank subsidiaries and foreign branches are primarily interest-bearing and averaged $20.7 billion in 2006, $15.8 billion in 2005, and $12.8 billion in 2004.

 

ASSETS UNDER CUSTODY   DECEMBER 31   

PERCENT

CHANGE

   

FIVE-YEAR
COMPOUND
GROWTH

RATE

 

($ IN BILLIONS)

    2006      2005      2004      2003      2002    2006/05        

Corporate & Institutional

  $ 3,263.5    $ 2,699.7    $ 2,345.1    $ 1,900.9    $ 1,329.0    21 %   17 %

Personal

    281.9      225.6      209.3      184.9      150.6    25     12  
                                                

Total Assets Under Custody

  $ 3,545.4    $ 2,925.3    $ 2,554.4    $ 2,085.8    $ 1,479.6    21 %   16 %

 

C&IS ASSETS UNDER CUSTODY ($ in Billions)

 

LOGO

 

PFS ASSETS UNDER CUSTODY ($ in Billions)

 

LOGO

 

ASSETS UNDER MANAGEMENT   DECEMBER 31   

PERCENT

CHANGE

   

FIVE-YEAR
COMPOUND
GROWTH

RATE

 

($ IN BILLIONS)

    2006        2005        2004        2003        2002    2006/05        

Corporate & Institutional

  $ 562.5      $ 500.7      $ 461.5      $ 374.3      $ 214.8    12 %   20 %

Personal

    134.7        117.2        110.4        104.3        87.7    15     7  
                                                        

Total Managed Assets

  $ 697.2      $ 617.9      $ 571.9      $ 478.6      $ 302.5    13 %   17 %

 

C&IS ASSETS UNDER MANAGEMENT ($ in Billions)

 

LOGO

 

PFS ASSETS UNDER MANAGEMENT ($ in Billions)

 

LOGO

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  5


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Foreign Exchange Trading Income. Northern Trust provides foreign exchange services in the normal course of business as an integral part of its global custody services. Active management of currency positions, within conservative limits, also contributes to trading income. Foreign exchange trading income totaled $247.3 million in 2006 compared with $180.2 million in 2005. The increase primarily reflects increased client activity. 2005 foreign exchange results, which were 14% higher than the $158.0 million reported in 2004, reflected increased market volatility in the major currencies and increased client activity.

Treasury Management Fees. The fee portion of treasury management revenues totaled $65.4 million in 2006, a decrease of 8% from the $71.2 million reported in 2005 and compared with $88.1 million in 2004. The decreases in 2006 and 2005 were partially offset by improved net interest income as clients opted to pay for services via compensating deposit balances, consistent with historical experience in a higher interest rate environment.

Security Commissions and Trading Income. Revenues from security commissions and trading income totaled $62.7 million in 2006, compared with $55.2 million in 2005 and $50.5 million in 2004. This income is primarily generated from securities brokerage services provided by Northern Trust Securities, Inc. (NTSI). The increases in 2006 and 2005 primarily reflect higher revenue from core brokerage services and transition management services for institutional clients.

Other Operating Income. The components of other operating income were as follows:

 

(IN MILLIONS)

    2006      2005      2004  

Loan Service Fees

  $ 17.1    $ 18.1    $ 22.0  

Banking Service Fees

    35.8      34.3      31.8  

Gain (Loss) from Equity Investments

    .2      1.7      (.8 )

Gain on Sale of Nonperforming Loans

              5.1  

Gain on Sale of Buildings

         7.9       

Other Income

    44.7      35.5      25.7  
                       

Total Other Operating Income

  $ 97.8    $ 97.5    $ 83.8  

 

The 2006 and 2005 increases in the other income component resulted primarily from higher custody-related deposit revenue.

Investment Security Gains. Net security gains were $1.4 million in 2006. This compares with net gains of $.3 million in 2005 and $.2 million in 2004.

 

Net Interest Income. An analysis of net interest income on a FTE basis, major balance sheet components impacting net interest income, and related ratios is provided below.

 

ANALYSIS OF NET INTEREST INCOME [FTE]


                      PERCENT CHANGE  

($ IN MILLIONS)

    2006       2005       2004     2006/05     2005/04  

Interest Income

  $ 2,206.8     $ 1,590.6     $ 1,118.2     38.7 %   42.2 %

FTE Adjustment

    64.8       60.9       54.4     6.4     11.9  
                                     

Interest Income–FTE

    2,271.6       1,651.5       1,172.6     37.5     40.8  

Interest Expense

    1,476.9       929.2       557.1     58.9     66.8  
                                     

Net Interest Income–FTE Adjusted

  $ 794.7     $ 722.3     $ 615.5     10.0 %   17.4 %
                                     

Net Interest Income–Unadjusted

  $ 729.9     $ 661.4     $ 561.1     10.4 %   17.9 %
                                     

AVERAGE BALANCE

                                   

Earning Assets

  $ 45,994.8     $ 40,454.1     $ 37,009.7     13.7 %   9.3 %

Interest-Related Funds

    40,410.0       34,198.7       30,896.5     18.2     10.7  

Net Noninterest-Related Funds

    5,584.8       6,255.4       6,113.2     (10.7 )   2.3  
                                     
                      CHANGE IN PERCENTAGE  

AVERAGE RATE

                                   

Earning Assets

    4.94 %     4.08 %     3.17 %   .86     .91  

Interest-Related Funds

    3.65       2.72       1.80     .93     .92  

Interest Rate Spread

    1.29       1.36       1.37     (.07 )   (.01 )

Total Source of Funds

    3.21       2.29       1.51     .92     .78  

Net Interest Margin

    1.73 %     1.79 %     1.66 %   (.06 )   .13  
                                     

Refer to pages 74 and 75 for a detailed analysis of net interest income.

 

6  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Net interest income is defined as the total of interest income and amortized fees on earning assets, less interest expense on deposits and borrowed funds, adjusted for the impact of hedging activity with derivative instruments. Earning assets, which consist of securities, loans, and money market assets, are financed by a large base of interest-bearing funds, including retail deposits, wholesale deposits, short-term borrowings, senior notes, and long-term debt. Earning assets are also funded by net noninterest-related funds. Net noninterest-related funds consist of demand deposits, the reserve for credit losses, and stockholders’ equity, reduced by nonearning assets including cash and due from banks, items in process of collection, buildings and equipment, and other nonearning assets. Variations in the level and mix of earning assets, interest-bearing funds, and net noninterest-related funds, and their relative sensitivity to interest rate movements, are the dominant factors affecting net interest income. In addition, net interest income is impacted by the level of nonperforming assets and client use of compensating deposit balances to pay for services.

Net interest income for 2006 was $729.9 million, up 10% from $661.4 million in 2005, which was up 18% from $561.1 million in 2004. When adjusted to a FTE basis, yields on taxable, nontaxable, and partially taxable assets are comparable, although the adjustment to a FTE basis has no impact on net income. Net interest income on a FTE basis for 2006 was $794.7 million, an increase of 10% from $722.3 million in 2005 which in turn was up 17% from $615.5 million in 2004. The increase in net interest income in 2006 is primarily the result of a $5.5 billion or 14% increase in average earning assets, primarily securities, money market assets, and loans, offset in part by a reduction in the net interest margin. The net interest margin decreased to 1.73% from 1.79% in the prior year due in large part to the significant growth in global custody related deposits which have been invested in short-term money market assets and U.S. government sponsored agency securities. The net interest margin increase in 2005 from 1.66% in 2004 was due in large part to wider spreads earned on retail deposits and an improved funding mix.

Earning assets averaged $46.0 billion, up 14% from the $40.5 billion reported in 2005, which was up from $37.0 billion in 2004. The growth in average earning assets reflects a $1.8 billion increase in loans, a $1.9 billion increase in securities and a $1.9 billion increase in money market assets.

Loans averaged $20.5 billion, 9% higher than last year. The year-to-year comparison reflects a 20% increase in average commercial loans to $4.2 billion. Residential mortgages rose 4% to average $8.5 billion and personal loans increased 6% to $2.9 billion. Non-U.S. loans increased to $1.3 billion in 2006 from the prior year average of $933 million. The loan portfolio includes noninterest-bearing U.S. and non-U.S. short duration advances, primarily related to the processing of custodied client investments, which averaged $1.0 billion in 2006, up from $696 million a year ago. Securities averaged $11.8 billion in 2006, up 19% resulting primarily from higher levels of government sponsored agency securities. Money market assets averaged $13.7 billion in 2006, up 16% from 2005 levels.

The increase in average earning assets of $5.5 billion was funded primarily through growth in interest-bearing deposits and short-term borrowings. The deposit growth was concentrated in foreign office time deposits, up $4.7 billion resulting from increased global custody activity. Savings and money market deposits were down 9%, partially offset by higher levels of savings certificates. Other interest-related funds averaged $9.8 billion, up $1.9 billion, principally from higher levels of federal funds purchased and securities sold under agreements to repurchase and the third quarter 2006 issuance of $250 million of senior notes by the Corporation. Average net noninterest-related funds decreased 11% and averaged $5.6 billion, due primarily to higher levels of noninterest-bearing cash and due from bank balances. Stockholders’ equity for the year averaged $3.8 billion, an increase of $351.9 million or 10% from 2005, principally due to the retention of earnings, offset in part by the repurchase of over 2.3 million shares of common stock at a total cost of $131.3 million ($55.65 average price per share) pursuant to the Corporation’s share buyback program.

For additional analysis of average balances and interest rate changes affecting net interest income, refer to the Average Statement of Condition with Analysis of Net Interest Income on pages 74 and 75.

 

Provision for Credit Losses. The provision for credit losses was $15.0 million in 2006 compared with a $2.5 million provision in 2005 and a negative $15.0 million provision in 2004. For a discussion of the reserve and provision for credit losses, refer to pages 26 through 28.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  7


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Noninterest Expenses. Noninterest expenses for 2006 totaled $1.96 billion, up 13% from $1.73 billion in 2005. Noninterest expenses for 2005 included FSG operating and integration expenses of $105.9 million and was up 13% from $1.53 billion in 2004. The components of noninterest expenses and a discussion of significant changes in balances during 2006 and 2005 are provided below.

 

NONINTEREST EXPENSES


(IN MILLIONS)

    2006      2005      2004

Compensation

  $ 876.6    $ 774.2    $ 661.7

Employee Benefits

    217.6      190.4      161.5

Occupancy Expense

    145.4      133.7      121.5

Equipment Expense

    82.5      83.2      84.7

Other Operating Expenses

    634.8      553.4      502.3
                     

Total Noninterest Expenses

  $ 1,956.9    $ 1,734.9    $ 1,531.7

 

Compensation and Benefits. Compensation and employee benefits of $1.09 billion represented 56% of total noninterest expenses. The year-over-year increase was $129.6 million, or 13%, from $964.6 million in 2005, which was 17% higher than the $823.2 million in 2004. 2006 included $17.7 million of expense associated with the expensing of stock options. Compensation costs, which are the largest component of noninterest expenses, totaled $876.6 million, reflecting the impact of higher staff levels, annual salary increases, and performance-based compensation. The higher compensation level in 2005 compared with 2004 resulted primarily from the addition of FSG, annual salary increases, and higher performance-based compensation. Staff on a full-time equivalent basis averaged 9,312 in 2006, up 7% compared with 8,731 in 2005 due primarily to additional staff to support international growth. Staff on a full-time equivalent basis totaled 9,726 at December 31, 2006 compared with 9,008 at December 31, 2005.

Employee benefit costs for 2006 totaled $217.6 million, up $27.2 million or 14% from $190.4 million in 2005, which was 18% higher than the $161.5 million in 2004. The current year reflects higher expenses related to employment taxes, pension, and health care costs. The 2005 increase reflects the addition of FSG and higher expenses related to employment taxes, pension, and health care costs.

Occupancy Expense. Net occupancy expense totaled $145.4 million, up 9% from $133.7 million in 2005, which was 10% higher than $121.5 million in 2004. Occupancy expense for 2006 reflects increased levels of rental costs, real estate taxes, and building maintenance. Occupancy expense for 2005 included $12.2 million from FSG. After adjusting for FSG, 2005 occupancy expense was unchanged from 2004 levels.

Equipment Expense. Equipment expense, comprised of depreciation, rental, and maintenance costs, totaled $82.5 million, down 1% from $83.2 million in 2005, which was 2% lower than the $84.7 million in 2004. The decrease in the expense level for 2006 resulted from lower depreciation of computer hardware.

 

Other Operating Expenses. The components of other operating expenses were as follows:

 

(IN MILLIONS)

    2006      2005      2004

Outside Services Purchased

  $ 316.2    $ 268.0    $ 228.0

Software Amortization & Other Costs

    122.8      113.4      108.1

Business Promotion

    65.2      60.8      45.7

Other Intangibles Amortization

    22.4      20.4      9.8

Other Expenses

    108.2      90.8      110.7
                     

Total Other Operating Expenses

  $ 634.8    $ 553.4    $ 502.3

 

Other operating expenses for 2006 totaled $634.8 million, up 15% from $553.4 million in 2005, which was up 10% from $502.3 million in 2004. The increase in outside services purchased was due primarily to higher consulting and other professional services, and volume driven growth in global subcustody expense. The 2005 expenses included $34.7 million from the addition of FSG, as well as higher consulting and other professional services, and volume driven growth in global subcustody expense. Other expenses in 2004 included a $17.0 million charge related to a litigation settlement and an $11.6 million loss from securities processing activities.

 

Provision for Income Taxes. The provision for income taxes was $358.8 million in 2006 compared with $303.4 million in 2005 and $249.7 million in 2004. The 2006 provision includes two reserve adjustments associated with Northern Trust’s leveraged leasing portfolio. In the second quarter of 2006, Northern Trust increased by approximately $11 million its tax reserves for uncertainties associated with the timing of tax deductions related to certain leveraged lease transactions that have been challenged by the Internal Revenue Service (IRS). Northern Trust also recorded a net after tax adjustment of $4.0 million in the second quarter of 2006 as a result of the enactment of legislation repealing the exclusion from federal income taxation of certain income generated by a form of a leveraged lease known as an Ownership Foreign Sales Corporation transaction. This $4.0 million after tax adjustment represented a $5.8 million tax provision offset by $1.8 million of interest income on the related leases. These items were partially offset by a $7.9 million reduction in deferred tax liabilities due to management’s decision to reinvest indefinitely the 2006 earnings of certain non-U.S. subsidiaries. The effective tax rate was 35% for 2006, 34% for 2005 and 33% for 2004.

 

8  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

BUSINESS UNIT REPORTING

Northern Trust, under Chairman and Chief Executive Officer William A. Osborn, is organized around its two principal client-focused business units, C&IS and PFS. Investment management services and products are provided to the clients of these business units by NTGI. Operating and systems support is provided to each of the business units by WWOT. For financial management reporting purposes, the operations of NTGI and WWOT are allocated to C&IS and PFS. Mr. Osborn has been identified as the chief operating decision maker because he has final authority over resource allocation decisions and performance assessment.

C&IS and PFS results are presented in order to promote a greater understanding of their financial performance. The information, presented on an internal management-reporting basis, is derived from internal accounting systems that support Northern Trust’s strategic objectives and management structure. Management has developed accounting systems to allocate revenue and expenses related to each segment, as well as certain corporate support services, worldwide operations and systems development expenses. The management reporting systems also incorporate processes for allocating assets, liabilities and the applicable interest income and expense. Tier 1 and tier 2 capital are allocated based on the U.S. federal risk-based capital guidelines at a level that is consistent with Northern Trust’s consolidated capital ratios, coupled with management’s judgment of the operational risks inherent in the business. Allocations of capital and certain corporate expenses may not be representative of levels that would be required if the segments were independent entities. The accounting policies used for management reporting are the same as those described in note 1, “Accounting Policies,” in the notes to consolidated financial statements. Transfers of income and expense items are recorded at cost; there is no intercompany profit or loss on sales or transfers between business units. Northern Trust’s presentations are not necessarily consistent with similar information for other financial institutions. For management reporting purposes, certain corporate income and expense items are not allocated to the business units and are presented as part of “Treasury and Other.” These items include the impact of long-term debt, holding company investments, and certain corporate operating expenses.

 

The following table summarizes the consolidated results of operations of Northern Trust.

 

CONSOLIDATED RESULTS OF OPERATIONS


($ IN MILLIONS)

    2006      2005      2004  

Noninterest Income

                     

Trust, Investment and Other Servicing Fees

  $ 1,791.6    $ 1,559.4    $ 1,330.3  

Other

    474.6      404.4      380.6  

Net Interest Income (FTE)*

    794.7      722.3      615.5  
                       

Revenues (FTE)*

    3,060.9      2,686.1      2,326.4  

Provision for Credit Losses

    15.0      2.5      (15.0 )

Noninterest Expenses

    1,956.9      1,734.9      1,531.7  
                       

Income before Income Taxes*

    1,089.0      948.7      809.7  

Provision for Income Taxes*

    423.6      364.3      304.1  
                       

Net Income

  $ 665.4    $ 584.4    $ 505.6  
                       

Average Assets

  $ 53,105.9    $ 45,974.1    $ 41,300.3  
                       

*Stated on a FTE basis. The consolidated figures include $64.8 million, $60.9 million, and $54.4 million of FTE adjustment for 2006, 2005, and 2004, respectively.

 

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  9


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Corporate and Institutional Services. The C&IS business unit, under the direction of Timothy J. Theriault, President – C&IS, is a leading worldwide provider of asset servicing, asset management, and related services to corporate and public retirement funds, foundations, endowments, fund managers, insurance companies, and government funds. C&IS also offers a full range of commercial banking services, placing special emphasis on developing and supporting institutional relationships in two target markets: large corporations and financial institutions. Asset servicing, asset management, and related services encompass a full range of state-of-the-art capabilities including: global master trust, asset servicing, fund administration, settlement, and reporting; cash management; and investment risk and performance analytical services. Non-U.S. client relationships are managed principally through the Bank’s Canada, London, and Singapore branches and the Bank’s and the Corporation’s non-U.S. subsidiaries, including support from international offices in North America, Europe, and the Asia-Pacific region. Trust and asset servicing relationships managed by C&IS often include investment management, securities lending, transition management, and commission recapture services provided through the NTGI business unit. C&IS also provides related foreign exchange services in Chicago, London, and Singapore.

The following table summarizes the results of operations of C&IS for the years ended December 31, 2006, 2005, and 2004 on a management-reporting basis.

 

CORPORATE AND INSTITUTIONAL SERVICES

RESULTS OF OPERATIONS


($ IN MILLIONS)

    2006       2005       2004  

Noninterest Income

                       

Trust, Investment and Other Servicing Fees

  $ 1,010.3     $ 851.4     $ 680.4  

Other

    361.5       292.3       279.0  

Net Interest Income (FTE)

    315.2       246.5       180.0  
                         

Revenues (FTE)

    1,687.0       1,390.2       1,139.4  

Provision for Credit Losses

    9.1       (2.0 )     (22.3 )

Noninterest Expenses

    1,018.9       872.0       706.7  
                         

Income before Income Taxes

    659.0       520.2       455.0  

Provision for Income Taxes

    267.2       202.5       176.8  
                         

Net Income

  $ 391.8     $ 317.7     $ 278.2  
                         

Percentage of Consolidated Net Income

    59 %     54 %     55 %
                         

Average Assets

  $ 33,903.5     $ 26,408.4     $ 21,198.4  

 

Net income for C&IS increased 23% in 2006 and totaled $391.8 million compared with $317.7 million in 2005, which increased 14% from $278.2 million in 2004. Net income increased in 2006 resulting primarily from record levels of trust, investment and other servicing fees and foreign exchange trading results, and a 28% increase in net interest income. Net income increased in 2005 resulting primarily from higher levels of trust, investment and other servicing fees and foreign exchange trading income, and a 37% increase in net interest income.

C&IS Trust, Investment and Other Servicing Fees. C&IS trust, investment and other servicing fees are attributable to four general product types: Custody and Fund Administration Services, Investment Management, Securities Lending, and Other Services. Custody and fund administration services are priced, in general, using asset values at the beginning of the quarter. There are, however, fees within custody and fund administration services that are not related to asset values, but instead are based on transaction volumes or account fees. Investment management fees are primarily based on market values throughout the quarter. Securities lending revenue is impacted by market values and the demand for securities to be lent, which drives volumes, and the interest rate spread earned on the investment of cash deposited by investment firms as collateral for securities they have borrowed. The other services fee category in C&IS includes such products as benefit payment, performance analysis, electronic delivery, and other services. Revenues from these products are generally based on the volume of services provided or a fixed fee.

 

10  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Trust, investment and other servicing fees in C&IS increased 19% in 2006 to $1.0 billion from $851.4 million in 2005. Trust, investment and other servicing fees in 2005 included $87.0 million of revenue from FSG and was up 25% from $680.4 million in 2004. The components of trust, investment and other servicing fees and a breakdown of assets under custody and under management follow.

CORPORATE AND INSTITUTIONAL SERVICES

TRUST, INVESTMENT AND OTHER SERVICING FEES


(IN MILLIONS)

    2006      2005      2004

Custody and Fund Administration

  $ 500.3    $ 399.0    $ 272.1

Investment Management

    256.3      242.0      230.2

Securities Lending

    191.5      148.7      120.1

Other Services

    62.2      61.7      58.0
                     

Total Trust, Investment and Other Servicing Fees

  $ 1,010.3    $ 851.4    $ 680.4

 

CORPORATE AND INSTITUTIONAL SERVICES

ASSETS UNDER CUSTODY


         DECEMBER 31

(IN BILLIONS)

    2006     2005     2004

U.S. Corporate

  $ 623.2   $ 565.5   $ 536.6

Public Entities and Institutions

    806.8     681.8     633.7

International

    1,581.2     1,231.7     984.1

Securities Lending

    247.9     217.2     187.9

Other

    4.4     3.5     2.8
                   

Total Assets Under Custody

  $ 3,263.5   $ 2,699.7   $ 2,345.1

 

CORPORATE AND INSTITUTIONAL SERVICES

ASSETS UNDER MANAGEMENT


         DECEMBER 31

(IN BILLIONS)

    2006      2005      2004

U.S. Corporate

  $ 92.5    $ 85.5    $ 86.8

Public Entities and Institutions

    94.1      91.7      93.2

International

    104.3      85.8      73.4

Securities Lending

    247.9      217.2      187.9

Other

    23.7      20.5      20.2
                     

Total Assets Under Management

  $ 562.5    $ 500.7    $ 461.5

 

2006 C&IS FEES

 

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2006 C&IS ASSETS UNDER CUSTODY

 

 

LOGO

 

 

2006 C&IS ASSETS UNDER MANAGEMENT

 

 

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The increase in C&IS trust, investment and other servicing fees reflects growth in all major products. Custody and fund administration fees increased 25% to $500.3 million compared with $399.0 million a year ago, reflecting strong growth in global fees. Fees from investment management totaled $256.3 million compared with $242.0 million in the year-ago period. Higher investment management fees were generated primarily by growth in the Northern Institutional Funds and higher fees from passive management of equity securities. Securities lending fees increased 29% to $191.5 million compared with $148.7 million last year primarily reflecting higher volumes and improved spreads on the investment of cash collateral.

C&IS assets under custody totaled $3.26 trillion at December 31, 2006, 21% higher than $2.70 trillion at December 31, 2005. Managed assets totaled $562.5 billion and $500.7 billion at December 31, 2006 and 2005, respectively, and as of the current year-end were invested 36% in equity securities, 12% in fixed income securities and 52% in cash and other assets. The cash and other assets that have been deposited by investment firms as collateral for securities they have borrowed from custody clients are invested by

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  11


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Northern Trust and are included in assets under custody and under management. The collateral totaled $247.9 billion and $217.2 billion at December 31, 2006 and 2005, respectively.

C&IS Other Noninterest Income. Other noninterest income in 2006 increased 24% from the prior year primarily due to a 37% increase in foreign exchange trading income. The increase in other noninterest income in 2005 compared with 2004 resulted from a 16% increase in foreign exchange trading income, offset in part by a 19% decrease in treasury management fees.

C&IS Net Interest Income. Net interest income increased 28% in 2006, resulting primarily from a $5.6 billion or 25% increase in average earning assets, primarily short-term money market assets and loans. The net interest margin was 1.12% in 2006 and 1.10% in 2005. Net interest income for 2005 increased 37% from the previous year primarily due to an increase in earning assets, primarily short-term money market assets and loans.

C&IS Provision for Credit Losses. The provision for credit losses was $9.1 million for 2006, resulting primarily from overall growth in the commercial loan portfolio and the migration of certain loans to higher risk credit ratings, partially offset by repayments received on lower rated loans. This compares with a negative $2.0 million provision for 2005, resulting primarily from an improvement in overall credit quality. The negative $22.3 million provision in 2004 resulted primarily from the elimination of reserves for two nonperforming loans which were sold and improvement in the credit quality of the portfolio.

C&IS Noninterest Expenses. Total noninterest expenses of C&IS, which include the direct expenses of the business unit, indirect expense allocations from NTGI and WWOT for product and operating support, and indirect expense allocations for certain corporate support services, increased 17% in 2006 and 23% in 2005. The growth in expenses for 2006 reflects the impact of higher staff levels, annual salary increases, performance-based compensation, employee benefit charges, increased occupancy expense, higher consulting and other professional services, and indirect expense allocations for product and operating support. Total expenses for 2005 include $98.6 million of FSG operating and integration expenses. The growth in expenses for 2005 also reflects annual salary increases, higher performance-based compensation, employee benefit charges, costs associated with business promotion and indirect expense allocations for product and operating support.

 

Personal Financial Services. The PFS business unit, under the direction of Sherry S. Barrat and William L. Morrison, Co-Presidents – PFS, provides personal trust, custody, philanthropic, and investment management services; financial consulting; guardianship and estate administration; qualified retirement plans; and private and business banking. PFS focuses on high net worth individuals, business owners, executives, professionals, retirees, and established privately-held businesses in its target markets. PFS also includes the Wealth Management Group, which provides customized products and services to meet the complex financial needs of families and individuals in the United States and throughout the world with assets typically exceeding $75 million. PFS services are delivered through a network of over 80 offices in 18 U.S. states as well as offices in London and Guernsey.

 

The following table summarizes the results of operations of PFS for the years ended December 31, 2006, 2005, and 2004 on a management-reporting basis.

 

PERSONAL FINANCIAL SERVICES

RESULTS OF OPERATIONS


($ IN MILLIONS)

    2006       2005       2004  

Noninterest Income

                       

Trust, Investment and Other Servicing Fees

  $ 781.3     $ 708.0     $ 649.9  

Other

    96.7       98.4       93.1  

Net Interest Income (FTE)

    497.7       487.1       445.9  
                         

Revenues (FTE)

    1,375.7       1,293.5       1,188.9  

Provision for Credit Losses

    5.9       4.5       7.3  

Noninterest Expenses

    856.2       797.8       766.5  
                         

Income before Income Taxes

    513.6       491.2       415.1  

Provision for Income Taxes

    199.0       190.4       160.8  
                         

Net Income

  $ 314.6     $ 300.8     $ 254.3  

Percentage of Consolidated Net Income

    47 %     51 %     50 %
                         

Average Assets

  $ 17,980.7     $ 16,933.2     $ 16,185.4  

 

12  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

PFS net income totaled $314.6 million in 2006, an increase of 5% from 2005, which in turn was 18% above the net income achieved in 2004. The increase in net income in 2006 resulted primarily from record levels of trust, investment and other servicing fees, increasing 10% from the previous year. The increase in 2005 earnings is attributable primarily to higher trust, investment and other servicing fees and a 9% increase in net interest income, partially offset by a moderate increase in operating expenses of 4%.

PFS Trust, Investment and Other Servicing Fees. A summary of trust, investment and other servicing fees and assets under custody and under management follows.

 

PERSONAL FINANCIAL SERVICES

TRUST, INVESTMENT AND OTHER SERVICING FEES


(IN MILLIONS)

    2006      2005      2004

Illinois

  $ 260.6    $ 239.3    $ 226.2

Florida

    189.2      177.0      166.5

California

    82.8      78.1      74.8

Arizona

    42.5      39.1      37.5

Texas

    32.5      28.7      26.8

Other

    60.5      49.4      41.5

Wealth Management

    113.2      96.4      76.6
                     

Total Trust, Investment and Other Servicing Fees

  $ 781.3    $ 708.0    $ 649.9

 

PERSONAL FINANCIAL SERVICES

ASSETS UNDER CUSTODY


      DECEMBER 31

(IN BILLIONS)

    2006      2005      2004

Illinois

  $ 48.9    $ 46.0    $ 45.8

Florida

    31.3      30.1      28.8

California

    14.5      13.7      13.7

Arizona

    7.2      6.5      6.4

Texas

    5.9      5.4      5.2

Other

    14.5      10.2      8.8

Wealth Management

    159.6      113.7      100.6
                     

Total Assets Under Custody

  $ 281.9    $ 225.6    $ 209.3

 

PERSONAL FINANCIAL SERVICES

ASSETS UNDER MANAGEMENT


      DECEMBER 31

(IN BILLIONS)

    2006      2005      2004

Illinois

  $ 37.1    $ 34.8    $ 34.7

Florida

    25.8      24.2      23.4

California

    10.2      9.3      9.2

Arizona

    5.4      5.1      5.0

Texas

    4.1      3.5      3.3

Other

    24.6      17.9      14.9

Wealth Management

    27.5      22.4      19.9
                     

Total Assets Under Management

  $ 134.7    $ 117.2    $ 110.4

 

2006 PFS FEES

 

 

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2006 PFS ASSETS UNDER CUSTODY

 

 

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2006 PFS ASSETS UNDER MANAGEMENT

 

 

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Fees in the majority of locations that PFS operates in and all mutual fund-related revenue are accrued based on market values throughout the current quarter. PFS trust, investment and other servicing fees totaled a record $781.3 million for the year, compared with $708.0 million in 2005 and $649.9 million in 2004. The current year performance was positively impacted by new business and higher equity markets. The 2005 performance was positively impacted by higher equity markets, new business, and the addition of $6.3 million of fees from FSG.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  13


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

At December 31, 2006, assets under custody in PFS totaled $281.9 billion, compared with $225.6 billion at December 31, 2005. Included in assets under custody are those for which Northern Trust has management responsibility. Managed assets totaled $134.7 billion at December 31, 2006 and were invested 49% in equity securities, 34% in fixed income securities and 17% in cash and other assets.

PFS Other Noninterest Income. Other noninterest income for 2006 totaled $96.7 million compared with $98.4 million last year which included a $3.2 million nonrecurring gain from the sale of a building. Noninterest income for 2005 was 6% higher than the previous year primarily due to a 14% increase in security commissions and trading income and the nonrecurring gain previously mentioned.

PFS Net Interest Income. Net interest income of $497.7 million was 2% higher than the previous year. Average loan volume grew $1.2 billion or 8%, while the net interest margin decreased from 3.00% in 2005 to 2.88%, reflecting a higher cost of funding as the increase in interest rates on deposits and borrowed funds exceeded the increase in asset yields. Net interest income for 2005 of $487.1 million was 9% higher than 2004 resulting primarily from higher average loan volume and an improvement in the net interest margin from 2.89% in 2004 to 3.00%.

PFS Provision for Credit Losses. The 2006 provision for credit losses of $5.9 million was $1.4 million higher than the previous year which was down $2.8 million from 2004. The current year provision reflects overall growth in the loan portfolio and the migration of certain loans to higher risk credit ratings. The reduction in 2005 in the provision for credit losses resulted from an improvement in the credit quality of the portfolio.

PFS Noninterest Expenses. PFS noninterest expenses, which include the direct expenses of the business unit, indirect expense allocations from NTGI and WWOT for product and operating support, and indirect expense allocations for certain corporate support services, increased 7% in 2006 and 4% in 2005. The growth in expenses for 2006 reflects annual salary increases, higher performance-based compensation, employee benefit charges, higher occupancy costs, and expenses associated with consulting and other professional services. In addition, indirect expense allocations for product and operating support increased $32.9 million or 10% from the prior year. The increase in 2005 expenses primarily reflected annual salary increases, higher performance-based compensation, employee benefit charges, costs associated with business promotion, and indirect expense allocations for product and operating support.

 

Northern Trust Global Investments. The NTGI business unit, under the direction of Terence J. Toth, President – NTGI, provides a broad range of investment management and related services and other products to U.S. and non-U.S. clients of C&IS and PFS through various subsidiaries of the Corporation. Clients include institutional and individual separately managed accounts, bank common and collective funds, registered investment companies, non-U.S. collective investment funds, and unregistered private investment funds. NTGI offers both active and passive equity and fixed income portfolio management, as well as alternative asset classes (such as private equity and hedge funds of funds) and multi-manager products and services. NTGI’s activities also include brokerage, securities lending, transition management, and related services. NTGI’s business operates internationally and its revenues and expenses are fully allocated to C&IS and PFS.

At year-end, Northern Trust managed a record $697.2 billion in assets for personal and institutional clients, up 13% from $617.9 billion at year-end 2005. The increase in assets is attributable to higher equity markets and strong new business. Assets under management have grown at a five-year compound annual rate of 17%.

 

NORTHERN TRUST GLOBAL INVESTMENTS $697.2 BILLION ASSETS UNDER MANAGEMENT

 

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14  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Worldwide Operations and Technology. The WWOT business unit, under the direction of Jana R. Schreuder, President – WWOT, supports all of Northern Trust’s business activities, including the processing and product management activities of C&IS, PFS, and NTGI. These activities are conducted principally in the operations and technology centers in Chicago, London, and Bangalore and a fund administration center in Dublin.

 

Corporate Financial Management Group. The Corporate Financial Management Group, under the direction of Steven L. Fradkin, Executive Vice President and Chief Financial Officer, includes the Corporate Controller, Corporate Treasurer, Corporate Development, Investor Relations, and Strategic Sourcing functions. The Group is responsible for Northern Trust’s accounting and financial infrastructure and for managing the Corporation’s financial position.

 

Corporate Risk Management Group. Headed by Kelly R. Welsh, Executive Vice President, the Corporate Risk Management Group includes the Credit Policy and other Corporate Risk Management functions. The Credit Policy function is described in the “Loans and Other Extensions of Credit” section on page 22. The Corporate Risk Management Group monitors, measures, and facilitates the management of risks across the businesses of the Corporation and its subsidiaries. Mr. Welsh also serves as General Counsel and in that capacity heads the Corporation’s Legal Department.

 

Treasury and Other. Treasury and Other includes income and expense associated with the wholesale funding activities and the investment portfolios of the Corporation and the Bank. Treasury and Other also includes certain corporate-based expenses and nonrecurring items not allocated to the business units and certain executive level compensation.

 

The following table summarizes the results of operations of Treasury and Other for the years ended December 31, 2006, 2005, and 2004 on a management-reporting basis.

 

TREASURY AND OTHER

RESULTS OF OPERATIONS


($ IN MILLIONS)

    2006       2005       2004  

Other Noninterest Income

  $ 16.4     $ 13.7     $ 8.5  

Net Interest Income (Expense) (FTE)

    (18.2 )     (11.3 )     (10.4 )
                         

Revenues (FTE)

    (1.8 )     2.4       (1.9 )

Noninterest Expenses

    81.8       65.1       58.5  
                         

Loss before Income Taxes

    (83.6 )     (62.7 )     (60.4 )

Benefit for Income Taxes

    42.6       28.6       33.5  
                         

Net Income (Loss)

  $ (41.0 )   $ (34.1 )   $ (26.9 )
                         

Percentage of Consolidated Net Income

    (6 )%     (5 )%     (5 )%
                         

Average Assets

  $ 1,221.7     $ 2,632.5     $ 3,916.5  

 

Treasury and Other noninterest income was $16.4 million compared with $13.7 million in the prior year. Net interest income for 2006 was a negative $18.2 million compared with a negative $11.3 million in 2005 and a negative $10.4 million in 2004. Noninterest expenses totaled $81.8 million for 2006 compared with $65.1 million in the prior year. Contributing to the current year increase in noninterest expenses are higher compensation costs associated with the expensing of stock options. Expenses in 2005 increased due to higher allocations for product and operating support and increased costs associated with employee compensation and benefits.

 

CRITICAL ACCOUNTING ESTIMATES

The use of estimates and assumptions is required in the preparation of financial statements in conformity with generally accepted accounting principles and actual results could differ from those estimates. The Securities and Exchange Commission has issued guidance and proposed rules relating to the disclosure of critical accounting estimates. Critical accounting estimates are those that require management to make subjective or complex judgments about the effect of matters that are inherently uncertain and may change in subsequent periods. Changes that may be required in the underlying assumptions or estimates in these areas could have a material impact on Northern Trust’s future financial condition and results of operations.

For Northern Trust, accounting estimates that are viewed as critical are those relating to reserving for credit losses, pension plan accounting, estimating useful lives of purchased and internally developed software, and accounting for structured leasing transactions. Management has discussed the development and selection of each critical accounting estimate with the Audit Committee of the Board of Directors.

 

   

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Reserve for Credit Losses. The reserve for credit losses represents management’s estimate of probable inherent losses that have occurred as of the date of the financial statements. The loan and lease portfolio and other credit exposures are regularly reviewed to evaluate the adequacy of the reserve for credit losses. In determining the level of the reserve, Northern Trust evaluates the reserve necessary for specific nonperforming loans and also estimates losses inherent in other credit exposures. The result is a reserve with the following components:

Specific Reserve. The amount of specific reserves is determined through a loan-by-loan analysis of nonperforming loans that considers expected future cash flows, the value of collateral and other factors that may impact the borrower’s ability to pay.

Allocated Inherent Reserve. The amount of the allocated portion of the inherent loss reserve is based on loss factors assigned to Northern Trust’s credit exposures based on internal credit ratings. These loss factors are primarily based on management’s judgment of estimated credit losses inherent in the loan portfolio as well as historical charge-off experience. The Credit Policy function, which is independent of business unit management, determines credit ratings at the time each loan is approved. These credit ratings are then subject to periodic reviews by Credit Policy. Credit ratings range from “1” for the strongest credits to “9” for the weakest credits; a “9” rated loan would normally represent a complete loss.

Unallocated Inherent Reserve. Management determines the unallocated portion of the inherent loss reserve based on factors that cannot be associated with a specific credit or loan category. These factors include management’s subjective evaluation of local and national economic and business conditions, portfolio concentration and changes in the character and size of the loan portfolio. The unallocated portion of the inherent loss reserve reflects management’s recognition of the imprecision inherent in the process of estimating probable credit losses.

Loans, leases and other extensions of credit deemed uncollectible are charged to the reserve. Subsequent recoveries, if any, are credited to the reserve. The related provision for credit losses, which is charged to income, is the amount necessary to adjust the reserve to the level determined through the above process. Actual losses may vary from current estimates and the amount of the provision may be either greater than or less than actual net charge-offs.

The control process maintained by Credit Policy and the lending staff and the quarterly analysis of specific and inherent loss components are the principal methods relied upon by management for the timely identification of, and adjustment for, changes in estimated credit loss levels. In addition to Northern Trust’s own experience, management also considers the experience of peer institutions and regulatory guidance.

Management’s estimates utilized in establishing an adequate reserve for credit losses are not dependent on any single assumption. Management evaluates numerous variables, many of which are interrelated or dependent on other assumptions and estimates, in determining reserve adequacy. Due to the inherent imprecision in accounting estimates, other estimates or assumptions could reasonably have been used in the current period and changes in estimates are reasonably likely to occur from period to period. However, management believes that the established reserve for credit losses appropriately addresses these uncertainties and is adequate to cover probable inherent losses which have occurred as of the date of the financial statements.

 

Pension Plan Accounting. As summarized in Note 21 to the consolidated financial statements, Northern Trust maintains a noncontributory defined benefit pension plan covering substantially all U.S. employees. Certain European-based employees also participate in various defined benefit pension plans that have been closed to new employees in prior years. Measuring cost and reporting liabilities resulting from defined benefit pension plans requires the use of several assumptions regarding future interest rates, asset returns, compensation increases, and other actuarial-based projections relating to the plan. Due to the long-term nature of this obligation and the estimates that are required to be made, the assumptions used in determining the periodic pension expense and the projected pension obligation are closely monitored and annually reviewed for adjustments that may be required. For 2005 and prior periods presented, Northern Trust accounted for differences between these estimates and actual experience under the Financial Accounting Standards Board’s (FASB) Statement No. 87 (SFAS No. 87), “Employers’ Accounting for Pensions,” which did not require recognition of these differences in the period in which they arose, but rather allowed them to be recognized systematically and gradually over subsequent periods. Northern Trust adopted FASB Statement No. 158 (SFAS No. 158), “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” on its effective date, December 31, 2006. SFAS No. 158 requires that differences between the estimates and actual experience be recognized as other comprehensive income in the period in which they occur. The differences continue to be amortized into net periodic pension expense from accumulated other comprehensive income over the future working lifetime of eligible participants in accordance with SFAS No. 87. As a result, differences between the estimates made in the calculation of

 

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

periodic pension expense and the projected pension obligation and actual experience affect stockholders’ equity in the period in which they occur but continue to be recognized as expense systematically and gradually over subsequent periods.

Northern Trust recognizes the significant impact that these pension-related assumptions have on the determination of the pension obligations and related expense and on stockholders’ equity and has established procedures for monitoring and setting these assumptions each year. These procedures include an annual review of actual demographic and investment experience with the pension plan’s actuaries. In addition to actual experience, adjustments to these assumptions consider published interest rate indices, known compensation trends and policies and economic conditions that may impact the estimated long-term rate of return on plan assets.

In determining the pension expense for the U.S. plans in 2006, Northern Trust utilized a discount rate of 5.50% for the Qualified Plan and 5.00% for the Nonqualified Plan. The rate of increase in the compensation level is based on a sliding scale that averaged 3.80%. The expected long-term rate of return on Qualified Plan assets was 8.25%.

In evaluating possible revisions to pension-related assumptions for the U.S. plans as of Northern Trust’s September 30, 2006 measurement date, the following were considered:

Discount Rate: Northern Trust utilizes the Moody’s AA Corporate Bond rate in establishing the discount rate for the Qualified Plan since the duration of the bonds included in this index reasonably approximates the average duration of the plan’s liabilities. Since this benchmark rate increased 30 basis points, Northern Trust increased the discount rate for the Qualified Plan from 5.50% to 5.75%. Northern Trust has historically referenced the long-term U.S. Treasury bond rate in establishing the discount rate for the Nonqualified Plan as benefits under the plan were calculated, similar to lump sum payments, based on that rate. The Pension Protection Act of 2006 (PPA) requires the use of corporate bond rates in the calculation of lump sum payments beginning in 2008. As such, the discount rate for the Nonqualified Plan was established using the same benchmark rate used for the Qualified Plan, the Moody’s AA Corporate Bond rate. Northern Trust has, accordingly, increased the discount rate for the Nonqualified Plan from 5.00% to 5.75%.

Compensation Level: As compensation policies remained consistent with prior years, no changes were made to the compensation scale assumption.

Rate of Return on Plan Assets: The expected return on plan assets is based on an estimate of the long-term rate of return on plan assets, which is determined using a building block approach that considers the current asset mix and estimates of return by asset class, giving proper consideration to diversification and rebalancing. Current market factors such as inflation and interest rates are also evaluated before long-term capital market assumptions are determined. Peer data and historical returns are reviewed to check for reasonability and appropriateness. As a result of these analyses, Northern Trust’s rate of return assumption for 2007 was set at 8.25%, which is consistent with the rate used in 2006.

Mortality Table: Northern Trust adopted the mortality table proposed by the U.S. Treasury for use in accordance with the provisions of the PPA for both pre- and post-retirement mortality assumptions. This table is based on the RP2000 mortality table used by Northern Trust in 2005 but includes projections of expected future mortality.

In order to provide an understanding of the sensitivity of these assumptions on the expected periodic pension expense in 2007 and the projected benefit obligation, the following table is presented to show the effect of increasing or decreasing each of these assumptions by 25 basis points.

 

(IN MILLIONS)

  25 BASIS
POINT
INCREASE
 
 
 
   25 BASIS
POINT
DECREASE
 
 
 

Increase (Decrease) in 2007 Pension Expense

            

Discount Rate Change

  (3.8 )    4.0  

Compensation Level Change

  2.4      (2.2 )

Rate of Return on Asset Change

  (1.5 )    1.5  

Increase (Decrease) in Projected Benefit Obligation

            

Discount Rate Change

  (25.7 )    27.3  

Compensation Level Change

  10.6      (10.0 )

 

As a result of the pension-related assumptions currently utilized and other actuarial experiences of the qualified and nonqualified plans, the estimated U.S. pension expense is expected to decrease by approximately $2.3 million in 2007.

The PPA also provided for an increase in the deduction limits specified by the Internal Revenue Code for contributions made by sponsors of defined benefit pension plans. This increase provided Northern Trust with the opportunity to make an additional $105.0 million contribution to the Qualified Plan, which was made in December 2006. The investment return on this one-time contribution is expected to decrease the estimated U.S. pension expense by an additional $6.5 million in 2007. This benefit will be partially offset by the related forgone net interest income. The continuing effect of the PPA on Northern Trust’s annual contributions is not expected to be significant. The minimum required contribution is expected to be zero in 2007 and for the following several years. As a result of the December 2006 contribution, the maximum deductible contribution is expected to be

 

   

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

slightly lower under the provisions of the PPA than it would have been under previous rules, with the maximum deductible contribution for 2007 estimated at $45.0 million.

 

Purchased and Internally Developed Software. A significant portion of Northern Trust’s products and services is dependent on complex and sophisticated computer systems based primarily on purchased and internally developed software programs. Under Northern Trust’s accounting policy, purchased software and allowable internal costs, including compensation, relating to software developed for internal use are capitalized. Capitalized software is then amortized over its estimated useful life, generally ranging from 3 to 10 years. Northern Trust believes that the accounting estimate relating to the determination and ongoing review of the estimated useful lives of capitalized software is a critical accounting policy. Northern Trust has this view because rapidly changing technology can unexpectedly change software functionality, resulting in a significant change in the useful life, including a complete write-off of software applications. In addition, product changes can also render existing software obsolete requiring a write-off of the carrying value of the asset.

In order to address this risk, Northern Trust’s accounting procedures require a quarterly review of significant software applications to confirm the reasonableness of asset book values and remaining useful lives. Modifications which may result from this process are reviewed by senior management. At December 31, 2006, capitalized software totaled $417.5 million and software amortization in 2006 totaled $93.5 million.

 

Accounting for Structured Leasing Transactions. Through its leasing subsidiary, Norlease, Inc., Northern Trust acts as a lessor in leveraged lease transactions primarily for transportation equipment, including commercial aircraft and railroad equipment. Northern Trust’s net investment in leveraged leases is reported at the aggregate of lease payments receivable and estimated residual values, net of non-recourse debt and unearned income. Unearned income is required to be recognized in interest income in a manner that yields a level rate of return on the net investment. Determining the net investment in a leveraged lease and the interest income to be recognized requires management to make assumptions regarding the amount and timing of cash flows, estimates of residual values, and the impact of income tax regulations and rates. Changes in these assumptions in future periods could affect asset balances and related interest income.

As further described in Note 2 to the consolidated financial statements, the FASB’s Staff Position No. FAS 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction” (FSP 13-2), effective January 1, 2007, requires a recalculation of the allocation and rate of return of income from the inception of a leveraged lease if, during the lease term, the expected timing of the income tax cash flows generated by the leveraged lease is revised.

Northern Trust has entered into certain leveraged leasing transactions commonly referred to as LILO’s and SILO’s. The IRS is challenging the timing of tax deductions with respect to these types of transactions and proposing to assess related interest and penalties. The Corporation believes its tax treatment relating to these transactions is appropriate based on its interpretation of the tax regulations and legal precedents; a court or other judicial authority, however, could disagree. Accordingly, managements’ estimates of future cash flows related to these leveraged leasing transactions and other similar transactions include assumptions about the eventual resolution of this matter, including the timing and amount of any potential payments. Due to the nature of this tax matter, it is difficult to estimate future cash flows with precision. Based on management’s current estimates, the impact of adopting FSP 13-2 on January 1, 2007 reduced Northern Trust’s stockholders’ equity by approximately $75 million. Management does not believe that subsequent changes that may be required in these assumptions would have a material effect on the consolidated financial position or liquidity of Northern Trust, although they could have a material effect on operating results for a particular period.

 

IMPLEMENTATION OF ACCOUNTING STANDARDS

Information related to new accounting pronouncements adopted during 2006 is contained in Notes 1 and 2 of the consolidated financial statements on pages 41 and 42.

 

CAPITAL EXPENDITURES

Proposed significant capital expenditures are reviewed and approved by Northern Trust’s senior management. This process is designed to assure that the major projects to which Northern Trust commits its resources produce benefits compatible with corporate strategic goals.

Capital expenditures in 2006 included ongoing enhancements to Northern Trust’s hardware and software capabilities and expansion or renovation of several existing offices. Capital expenditures for 2006 totaled $242.4 million, of which $139.1 million was for software, $40.5 million was for building and leasehold improvements, $49.1 million was for computer hardware and machinery, and $13.7 million was for furnishings. These capital expenditures are designed principally to support and enhance Northern Trust’s transaction processing, investment management, and securities handling capabilities,

 

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

as well as relationship management and client interaction. Additional capital expenditures planned for systems technology will result in future expenses for the depreciation of hardware and amortization of software. Depreciation on computer hardware and machinery and software amortization associated with these capital expenditures are charged to equipment and other operating expenses, respectively. Depreciation on building and leasehold improvements is charged to occupancy expense.

 

OFF-BALANCE SHEET ARRANGEMENTS

Assets Under Custody. Northern Trust, in the normal course of business, holds assets under custody, management and servicing in a fiduciary or agency capacity for its clients. In accordance with accounting principles generally accepted in the U.S., these assets are not assets of Northern Trust and are not included in its consolidated balance sheet.

 

Financial Guarantees and Indemnifications. Northern Trust issues financial guarantees in the form of standby letters of credit to meet the liquidity and credit enhancement needs of its clients. Standby letters of credit obligate Northern Trust to meet certain financial obligations of its clients, if, under the contractual terms of the agreement, the clients are unable to do so. These instruments are primarily issued to support public and private financial commitments, including commercial paper, bond financing, initial margin requirements on futures exchanges and similar transactions.

Credit risk is the principal risk associated with these instruments. The contractual amounts of these instruments represent the credit risk should the instrument be fully drawn upon and the client defaults. To control the credit risk associated with issuing letters of credit, Northern Trust subjects such activities to the same credit quality and monitoring controls as its lending activities. Certain standby letters of credit have been secured with cash deposits or participated to others. Northern Trust is obligated to meet the entire financial obligation of these agreements and in certain cases is able to recover the amounts paid through recourse against cash deposits or other participants.

The following table shows the contractual amounts of standby letters of credit.

 

    DECEMBER 31

(IN MILLIONS)

    2006      2005

Standby Letters of Credit:

            

Corporate

  $ 1,008.2    $ 968.7

Industrial Revenue

    1,097.1      1,209.5

Other

    637.0      659.2
              

Total Standby Letters of Credit*

  $ 2,742.3    $ 2,837.4
              

*These amounts include $301.2 million and $344.3 million of standby letters of credit secured by cash deposits or participated to others as of December 31, 2006 and 2005, respectively. The weighted average maturity of standby letters of credit was 23 months at December 31, 2006 and 24 months at December 31, 2005.

 

As part of the Corporation’s securities custody activities and at the direction of clients, Northern Trust lends securities owned by clients to borrowers who are reviewed and approved by the Senior Credit Committee. In connection with these activities, Northern Trust has issued certain indemnifications to clients against loss resulting from the bankruptcy of the borrower of securities. The borrower is required to fully collateralize securities received with cash, marketable securities, or irrevocable standby letters of credit. As securities are loaned, collateral is maintained at a minimum of 100 percent of the fair value of the securities plus accrued interest, with the collateral revalued on a daily basis. The amount of securities loaned as of December 31, 2006 and 2005 subject to indemnification was $156.7 billion and $135.2 billion, respectively. Because of the borrower’s requirement to fully collateralize securities borrowed, management believes that the exposure to credit loss from this activity is remote.

 

Variable Interests. In 1997, Northern Trust issued $150 million of Floating Rate Capital Securities, Series A, and $120 million of Floating Rate Capital Securities, Series B, through statutory business trusts wholly-owned by the Corporation (“NTC Capital I” and “NTC Capital II”, respectively). The sole assets of the trusts are Subordinated Debentures of Northern Trust Corporation that have the same interest rates and maturity dates as the corresponding distribution rates and redemption dates of the Floating Rate Capital Securities.

The outstanding principal amount of the Subordinated Debentures, net of discount, held by the trusts totaled $276.5 million as of December 31, 2006. The book value of the Series A and Series B Securities totaled $268.2 million as of December 31, 2006. Both Series A and B Securities qualify as tier 1 capital for regulatory purposes. NTC Capital I and NTC Capital II are considered variable interest entities. However, as the Corporation has determined that it is not the primary

 

   

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

beneficiary of the trusts, they are not consolidated by the Corporation.

Northern Trust has interests in other variable interest entities which are also not consolidated as Northern Trust is not considered the primary beneficiary of these entities. Northern Trust’s interests in these entities are not considered significant and do not have a material impact on its consolidated financial position or results of operations.

 

LIQUIDITY AND CAPITAL RESOURCES

Liquidity Risk Management. The objectives of liquidity risk management are to ensure that Northern Trust can meet its cash flow requirements and capitalize on business opportunities on a timely and cost effective basis. Management monitors the liquidity position on a daily basis to make funds available at a minimum cost to meet loan and deposit cash flows. The liquidity profile is also structured so that the capital needs of the Corporation and its banking subsidiaries are met. Management maintains a detailed liquidity contingency plan designed to adequately respond to dramatic changes in market conditions.

Liquidity is secured by managing the mix of items on the balance sheet and expanding potential sources of liquidity. The balance sheet sources of liquidity include the short-term money market portfolio, unpledged available for sale securities, maturing loans, and the ability to securitize a portion of the loan portfolio. Further, liquidity arises from the diverse funding base and the fact that a significant portion of funding comes from clients that have other relationships with Northern Trust.

A significant source of liquidity is the ability to draw funding from both U.S. and non-U.S. markets. The Bank’s senior long-term debt is rated AA- by Standard & Poor’s, Aa3 by Moody’s Investors Service, and AA- by Fitch. These ratings allow the Bank to access capital markets on favorable terms.

Northern Trust maintains a liquid balance sheet with loans representing only 37% of total assets. Further, at December 31, 2006, there was a significant liquidity reserve on the consolidated balance sheet in the form of cash and due from banks, securities available for sale, and money market assets, which in aggregate totaled $33.0 billion or 54% of total assets.

The Corporation’s uses of cash consist mainly of dividend payments to the Corporation’s stockholders, the payment of principal and interest to note holders, purchases of its common stock and acquisitions. These cash needs are met largely by dividend payments from its subsidiaries, and by interest and dividends earned on investment securities and money market assets. Bank subsidiary dividends are subject to certain restrictions that are explained in Note 28 to the consolidated financial statements on pages 65 and 66. Bank subsidiaries have the ability to pay dividends during 2007 equal to their 2007 eligible net profits plus $780.2 million. The Corporation’s liquidity, defined as the amount of marketable assets in excess of commercial paper, was strong at $257.9 million at year-end 2006 and $198.1 at year-end 2005. The cash flows of the Corporation are shown in Note 32 to the consolidated financial statements on page 71. The Corporation also has available a $150 million revolving line of credit.

 

The following table shows Northern Trust’s contractual obligations at December 31, 2006.

 

CONTRACTUAL OBLIGATIONS   PAYMENT DUE BY PERIOD

(IN MILLIONS)

    TOTAL     
 
ONE YEAR
AND LESS
    
 
1-3
YEARS
    
 
4-5
YEARS
    
 
OVER 5
YEARS

Senior Notes*

  $ 445.4    $    $    $ 445.4    $

Subordinated Debt*

    943.1           300.0      150.0      493.1

Federal Home Loan Bank Borrowings*

    1,354.0      509.0      234.9      275.0      335.1

Floating Rate Capital Debt*

    278.4                     278.4

Capital Lease Obligations**

    13.9      2.5      5.0      3.0      3.4

Operating Leases**

    657.3      59.4      110.3      102.4      385.2

Purchase Obligations***

    175.9      90.9      68.3      13.7      3.0
                                   

Total Contractual Obligations

  $ 3,868.0    $ 661.8    $ 718.5    $ 989.5    $ 1,498.2
                                   

Note: Obligations as shown do not include deposit liabilities or interest requirements on funding sources.

* Refer to Notes 12 and 13 to the consolidated financial statements for further details.

** Refer to Note 9 to the consolidated financial statements for further details.

*** Purchase obligations consist primarily of ongoing operating costs related to outsourcing arrangements for certain cash management services and the support and maintenance of the Corporation’s technological requirements. Certain obligations are in the form of variable rate contracts and, in some instances, 2006 activity was used as a base to project future obligations.

 

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Capital Management. One of management’s primary objectives is to maintain a strong capital position to merit and maintain the confidence of clients, the investing public, bank regulators and stockholders. A strong capital position helps Northern Trust take advantage of profitable investment opportunities and withstand unforeseen adverse developments. In 2006, capital levels were strengthened as average common equity increased 10.2% or $351.9 million reaching a record $3.9 billion at year-end. This increase in capital was accomplished after paying common dividends and buying back shares. In October 2006, the Board of Directors increased the quarterly dividend by 8.7% to $.25 per common share. The common dividend has increased 47% from its level five years ago. During 2006, the Corporation purchased over 2.3 million of its own common shares at a cost of $131.3 million, as part of its share buyback program. The buyback program is used for general corporate purposes, including management of the Corporation’s capital level and as an offset of the dilutive effect of stock issuances under the Corporation’s incentive stock programs. Under the share buyback program, the Corporation may purchase up to 11.9 million additional shares after December 31, 2006.

 

CAPITAL ADEQUACY       DECEMBER 31  

($ IN MILLIONS)

    2006       2005  

TIER 1 CAPITAL

               

Common Stockholders’ Equity

  $ 3,944     $ 3,601  

Floating Rate Capital Securities

    268       268  

Goodwill and Other Intangible Assets

    (548 )     (533 )

Pension and Other Postretirement Benefit Adjustments

    174        

Other

    (8 )     4  
                 

Total Tier 1 Capital

    3,830       3,340  
                 

TIER 2 CAPITAL

               

Reserve for Credit Losses Assigned to Loans and Leases

    140       125  

Off-Balance Sheet Credit Loss Reserve

    11       11  

Reserves Against Identified Losses

    (20 )     (20 )

Long-Term Debt*

    714       769  
                 

Total Tier 2 Capital

    845       885  
                 

Total Risk-Based Capital

  $ 4,675     $ 4,225  
                 

Risk-Weighted Assets**

  $ 39,209     $ 34,414  
                 

Total Assets–End of Period (EOP)

  $ 60,712     $ 53,414  

Average Fourth Quarter Assets**

    56,751       46,932  

Total Loans–EOP

    22,610       19,969  
                 

RATIOS

               

Risk-Based Capital to Risk-Weighted Assets

               

Tier 1

    9.8 %     9.7 %

Total (Tier 1 and Tier 2)

    11.9       12.3  

Leverage

    6.7       7.1  
                 

COMMON STOCKHOLDERS’ EQUITY TO

               

Total Loans EOP

    17.4 %     18.0 %

Total Assets EOP

    6.5       6.7  
                 

*Long-Term Debt that qualifies for risk-based capital amortizes for the purpose of inclusion in tier 2 capital during the five years before maturity.

**Assets have been adjusted for goodwill and other intangible assets, net unrealized (gain) loss on securities and excess reserve for credit losses that have been excluded from tier 1 and tier 2 capital, if any.

 

The 2006 capital levels reflect Northern Trust’s ongoing retention of earnings to allow for strategic expansion while maintaining a strong balance sheet. The Corporation’s capital supported risk-weighted asset growth of 13.9% in 2006 with all of its capital ratios well above the ratios that are a requirement for regulatory classification as “well-capitalized”. At December 31, 2006, the Corporation’s tier 1 capital was 9.8% and total capital was 11.9% of risk-weighted assets. The “well- capitalized” minimum ratios are 6.0% and 10.0%, respectively. The Corporation’s leverage ratio (tier 1 capital to fourth quarter average assets) of 6.7% is also well above the “well-capitalized” minimum requirement of 5.0%. In addition, each of the subsidiary banks had a ratio of at least 8.8% for tier 1 capital, 10.1% for total risk-based capital, and 5.7% for the leverage ratio.

 

   

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

RISK MANAGEMENT

Asset Quality and Credit Risk Management – Securities. Northern Trust maintains a high quality securities portfolio, with 83% of the total portfolio composed of U.S. Treasury or government sponsored agency securities. The remainder of the portfolio consists of obligations of states and political subdivisions, preferred stock and other securities, including Federal Home Loan Bank stock and Federal Reserve Bank stock. At December 31, 2006, 84% of these securities were rated triple-A or double-A, 1% were rated single-A and 15% were below A or not rated by Standard and Poor’s and/or Moody’s Investors Service.

Northern Trust is an active participant in the repurchase agreement market. This market provides a relatively low cost alternative for short-term funding. Securities purchased under agreements to resell and securities sold under agreements to repurchase are recorded at the amounts at which the securities were acquired or sold plus accrued interest. To minimize any potential credit risk associated with these transactions, the fair value of the securities purchased or sold is continuously monitored, limits are set on exposure with counterparties, and the financial condition of counterparties is regularly assessed. It is Northern Trust’s policy to take possession of securities purchased under agreements to resell. Securities sold under agreements to repurchase are held by the counterparty until the repurchase transaction matures.

 

Loans and Other Extensions of Credit. Credit risk is inherent in Northern Trust’s various lending activities. Northern Trust focuses its lending efforts on clients who are looking to build a full range of financial services. Credit risk is managed through the Credit Policy function, which is designed to assure adherence to a high level of credit standards. Credit Policy reports to the Corporation’s Head of Corporate Risk Management. Credit Policy provides a system of checks and balances for Northern Trust’s diverse credit-related activities by establishing and monitoring all credit-related policies and practices throughout Northern Trust and assuring their uniform application. These activities are designed to diversify credit exposure on an industry and client basis, thus lessening overall credit risk. These credit management activities also apply to Northern Trust’s use of derivative financial instruments, including foreign exchange contracts and interest risk management instruments.

Individual credit authority for commercial and other loans is limited to specified amounts and maturities. Credit decisions involving commitment exposure in excess of the specified individual limits are submitted to the appropriate Credit Approval Committee (Committee). Each Committee is chaired by the executive in charge of the area and has a Credit Policy officer as a voting participant. Each Committee’s credit approval authority is specified, based on commitment levels, credit ratings and maturities. Credits involving commitment exposure in excess of these limits require the approval of the Senior Credit Committee.

The Counterparty Risk Management Committee established by Credit Policy manages counterparty risk. This committee has sole credit authority for exposure to all non-U.S. banks, certain U.S. banks which Credit Policy deems to be counterparties and which do not have commercial credit relationships within the Corporation, and certain other exposures.

Under the auspices of Credit Policy, country exposure limits are reviewed and approved on a country-by-country basis.

As part of Northern Trust’s ongoing credit granting process, internal ratings are assigned to each client and credit before credit is extended, based on an assessment of creditworthiness. Credit Policy performs, at least annually, a review of selected significant credit exposures to identify, at an early stage, clients who might be facing financial difficulties. Internal credit ratings are also reviewed during this process. Above average risk loans receive special attention by both lending officers and Credit Policy. This approach allows management to take remedial action in an effort to deal with potential problems.

An integral part of the Credit Policy function is a formal review of past due and potential problem loans to determine which credits, if any, need to be placed on nonaccrual status or charged off. As more fully described on pages 26 through 28, the provision for credit losses is reviewed quarterly to determine the amount necessary to maintain an adequate reserve for credit losses.

A further way in which credit risk is managed is by requiring collateral. Management’s assessment of the borrower’s creditworthiness determines whether collateral is obtained. The amount and type of collateral held varies but may include deposits held in financial institutions, U.S. Treasury securities, other marketable securities, income-producing commercial properties, accounts receivable, property, plant and equipment, and inventory. Collateral values are monitored on a regular basis to ensure that they are maintained at an appropriate level.

 

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The largest component of credit risk relates to the loan portfolio. In addition, credit risk is inherent in certain contractual obligations such as legally binding unfunded commitments to extend credit, commercial letters of credit, and standby letters of credit. These contractual obligations and arrangements are discussed in Note 26, “Off-Balance Sheet Financial Instruments,” to the consolidated financial statements and are presented in the tables that follow.

 

COMPOSITION OF LOAN PORTFOLIO           DECEMBER 31

(IN MILLIONS)

    2006      2005      2004      2003      2002

U.S.

                                 

Residential Real Estate

  $ 8,674.4    $ 8,340.5    $ 8,095.3    $ 7,975.3    $ 7,808.1

Commercial

    4,679.1      3,545.3      3,217.9      3,412.3      3,977.1

Commercial Real Estate

    1,836.3      1,524.3      1,307.5      1,297.1      1,168.5

Personal

    3,415.8      2,961.3      2,927.2      2,699.9      2,480.8

Other

    979.2      797.8      609.7      743.9      959.3

Lease Financing

    1,291.6      1,194.1      1,221.8      1,228.0      1,276.0
                                   

Total U.S.

  $ 20,876.4    $ 18,363.3    $ 17,379.4    $ 17,356.5    $ 17,669.8

Non-U.S.

    1,733.3      1,605.2      563.3      457.3      393.9
                                   

Total Loans and Leases

  $ 22,609.7    $ 19,968.5    $ 17,942.7    $ 17,813.8    $ 18,063.7

 

SUMMARY OF OFF-BALANCE SHEET FINANCIAL INSTRUMENTS WITH CONTRACT

AMOUNTS THAT REPRESENT CREDIT RISK

          DECEMBER 31

(IN MILLIONS)

    2006      2005

Unfunded Commitments to Extend Credit

            

One Year and Less

  $ 6,008.9    $ 6,279.7

Over One Year

    13,969.3      11,671.8
              

Total

  $ 19,978.2    $ 17,951.5
              

Standby Letters of Credit

    2,742.3      2,837.4

Commercial Letters of Credit

    28.2      31.4

Custody Securities Lent with Indemnification

    156,697.3      135,229.3

 

UNFUNDED COMMITMENTS TO EXTEND CREDIT AT DECEMBER 31, 2006

BY INDUSTRY SECTOR

 

(IN MILLIONS)

    COMMITMENT EXPIRATION
INDUSTRY SECTOR  

TOTAL

COMMITMENTS

   ONE YEAR
AND LESS
   OVER ONE
YEAR
  

OUTSTANDING

LOANS

Finance and Insurance

  $ 2,110.7    $ 914.1    $ 1,196.6    $ 482.8

Holding Companies

    307.3      148.6      158.7      375.2

Manufacturing

    4,361.2      482.9      3,878.3      989.6

Mining

    170.8      19.0      151.8      35.1

Public Administration

    25.9      6.1      19.8      210.7

Retail Trade

    575.9      72.4      503.5      95.2

Security and Commodity Brokers

    120.0      100.0      20.0      19.7

Services

    3,613.4      1,514.7      2,098.7      1,702.1

Transportation and Warehousing

    405.7      91.5      314.2      59.2

Utilities

    449.9      1.0      448.9      62.8

Wholesale Trade

    632.1      114.2      517.9      382.8

Other Commercial

    446.8      147.3      299.5      263.9
                            

Total Commercial*

  $ 13,219.7    $ 3,611.8    $ 9,607.9    $ 4,679.1

Residential Real Estate

    2,147.9      260.4      1,887.5      8,674.4

Commercial Real Estate

    520.4      128.1      392.3      1,836.3

Personal

    3,238.8      1,472.5      1,766.3      3,415.8

Other

    393.4      296.8      96.6      979.2

Lease Financing

                   1,291.6

Non-U.S.

    458.0      239.3      218.7      1,733.3
                            

Total

  $ 19,978.2    $ 6,008.9    $ 13,969.3    $ 22,609.7
                            

*Commercial industry sector information is presented on the basis of the North American Industry Classification System (NAICS).

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  23


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Although credit exposure is well diversified, there are certain groups of credits that meet the accounting definition of credit risk concentrations under SFAS No. 107. According to this standard, group concentrations of credit risk exist if a number of borrowers or other counterparties are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The fact that a credit exposure falls into one of these groups does not necessarily indicate that the credit has a higher than normal degree of credit risk. These groups are: residential real estate, banks and bank holding companies, commercial real estate and commercial aircraft leases.

Residential Real Estate. The residential real estate loan portfolio, totaled $8.7 billion or 42% of total U.S. loans at December 31, 2006, compared with $8.3 billion or 45% at December 31, 2005. Residential real estate loans consist of conventional home mortgages and equity credit lines, which generally require a loan to collateral value of no more than 75% to 80% at inception.

Of the total $8.7 billion in residential real estate loans, $3.4 billion were in the greater Chicago area with the remainder distributed throughout the other geographic regions within the U.S. served by Northern Trust. Legally binding commitments to extend residential real estate credit, which are primarily equity credit lines, totaled $2.1 billion and $1.8 billion at December 31, 2006 and 2005, respectively.

Banks and Bank Holding Companies. On-balance sheet credit risk to banks and bank holding companies, both U.S. and non-U.S., consists primarily of short-term money market assets, which totaled $16.8 billion and $16.0 billion at December 31, 2006 and December 31, 2005, respectively, and noninterest-bearing demand balances maintained at correspondent banks, which totaled $4.7 billion and $2.9 billion at December 31, 2006 and December 31, 2005, respectively. Northern Trust also provides commercial financing to banks and bank holding companies with which it has a substantial business relationship. Northern Trust’s outstanding lending exposure to these entities, primarily U.S. bank holding companies located in the Greater Midwest, was not considered material to its consolidated financial position as of December 31, 2006 or 2005.

Commercial Real Estate. In managing its credit exposure, management has defined a commercial real estate loan as one where: (1) the borrower’s principal business activity is the acquisition or the development of real estate for commercial purposes; (2) the principal collateral is real estate held for commercial purposes, and loan repayment is expected to flow from the operation of the property; or (3) the loan repayment is expected to flow from the sale or refinance of real estate as a normal and ongoing part of the business. Unsecured lines of credit to firms or individuals engaged in commercial real estate endeavors are included without regard to the use of loan proceeds. The commercial real estate portfolio consists of interim loans and commercial mortgages.

Short-term interim loans provide financing for the initial phases of the acquisition or development of commercial real estate, with the intent that the borrower will refinance the loan through another financial institution or sell the project upon its completion. The interim loans are primarily in those markets where Northern Trust has a strong presence and a thorough knowledge of the local economy. The interim loans, which totaled $591.4 million and $459.5 million as of December 31, 2006 and 2005, respectively, are composed primarily of loans to developers that are highly experienced and well known to Northern Trust.

Commercial mortgage financing, which totaled $1.2 billion and $1.1 billion as of December 31, 2006 and 2005, respectively, is provided for the acquisition of income producing properties. Cash flows from the properties generally are sufficient to amortize the loan. These loans average less than $1 million each and are primarily located in the suburban Chicago and Florida markets.

At December 31, 2006, legally binding commitments to extend credit and standby letters of credit to commercial real estate developers totaled $520.4 million and $67.9 million, respectively. At December 31, 2005, legally binding commitments were $367.2 million and standby letters of credit were $50.9 million.

Commercial Aircraft Leases. Through its leasing subsidiary, Norlease, Inc., Northern Trust has entered into leveraged lease transactions involving commercial aircraft totaling $269 million, which are a part of the $1.3 billion lease financing portfolio at December 31, 2006. $149 million of the leveraged leases involve aircraft leases to non-U.S. airlines, where the leases are fully backed by a combination of pledged marketable securities and/or guarantees from either a U.S. based “AA” rated insurance company or a large U.S.-based banking institution. $8 million represents leases to U.S.-based airlines; $64 million to commercial transport companies; $31 million to an “A” rated U.S.-based aircraft component manufacturer; and the balance of $17 million for commuter aircraft leases, which are guaranteed by aircraft manufacturers or by sovereign entities.

 

Non-U.S. Outstandings. As used in this discussion, non-U.S. outstandings are cross-border outstandings as defined by the Securities and Exchange Commission. They consist of loans, acceptances, interest-bearing deposits with financial institutions, accrued interest and other monetary assets. Not

 

24  

2006

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

included are letters of credit, loan commitments, and non-U.S. office local currency claims on residents funded by local currency liabilities. Non-U.S. outstandings related to a specific country are net of guarantees given by third parties resident outside the country and the value of tangible, liquid collateral held outside the country. However, transactions with branches of non-U.S. banks are included in these outstandings and are classified according to the country location of the non-U.S. banks’ head office.

Short-term interbank time deposits with non-U.S. banks represent the largest category of non-U.S. outstandings. Northern Trust actively participates in the interbank market with U.S. and non-U.S. banks. International commercial lending activities also include import and export financing for U.S.-based clients.

Northern Trust places deposits with non-U.S. counterparties that have high internal (Northern Trust) and external credit ratings. These non-U.S. banks are approved and monitored by Northern Trust’s Counterparty Risk Management Committee, which has credit authority for exposure to all non-U.S. banks and employs a review process that results in credit limits. This process includes financial analysis of the non-U.S. banks, use of an internal rating system and consideration of external ratings from rating agencies. Each counterparty is reviewed at least annually. Separate from the entity-specific review process, the average life to maturity of deposits with non-U.S. banks is deliberately maintained on a short-term basis in order to respond quickly to changing credit conditions. Additionally, the Committee performs a country-risk analysis and imposes limits to country exposure. The following table provides information on non-U.S. outstandings by country that exceed 1.00% of Northern Trust’s assets.

 

NON-U.S. OUTSTANDINGS


(IN MILLIONS)

    BANKS     
 
COMMERCIAL
AND OTHER
     TOTAL

At December 31, 2006

                   

France

  $ 3,187    $ 1    $ 3,188

United Kingdom

    2,176      52      2,228

Netherlands

    1,313      219      1,532

Ireland

    654      374      1,028

Hong Kong

    951           951

Belgium

    871      13      884

Germany

    791      3      794

Sweden

    727      2      729
                     

At December 31, 2005

                   

France

  $ 1,727    $ 1    $ 1,728

United Kingdom

    1,636      29      1,665

Italy

    1,152           1,152

Ireland

    561      510      1,071

Germany

    837           837

Canada

    729      11      740

Belgium

    733           733

Switzerland

    645      10      655
                     

At December 31, 2004

                   

United Kingdom

  $ 2,032    $ 207    $ 2,239

France

    1,162           1,162

Belgium

    1,066           1,066

Sweden

    898      1      899

Netherlands

    815      51      866

Switzerland

    587      12      599

Canada

    542      25      567

Ireland

    533      24      557

Singapore

    423      39      462
                     

Countries whose aggregate outstandings totaled between .75% and 1.00% of total assets were as follows: Canada with aggregate outstandings of $489 million at December 31, 2006, Netherlands with aggregate outstandings of $432 million at December 31, 2005, and Germany and Australia with aggregate outstandings of $800 million at December 31, 2004.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  25


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

NONPERFORMING ASSETS   DECEMBER 31

(IN MILLIONS)

        2006          2005          2004          2003          2002

Nonaccrual Loans

                                 

U.S.

                                 

Residential Real Estate

  $ 8.1    $ 5.0    $ 2.8    $ 4.5    $ 4.8

Commercial

    18.8      16.1      29.5      75.3      87.6

Commercial Real Estate

              .1      .1      .7

Personal

    7.6      8.7      .5      .1      .3

Non-U.S.

    1.2      1.2               
                                   

Total Nonaccrual Loans

    35.7      31.0      32.9      80.0      93.4

Other Real Estate Owned

    1.4      .1      .2      .3      1.2
                                   

Total Nonperforming Assets

  $ 37.1    $ 31.1    $ 33.1    $ 80.3    $ 94.6
                                   

90 Day Past Due Loans Still Accruing

  $ 24.6    $ 29.9    $ 9.9    $ 21.0    $ 15.2

 

Nonperforming Assets and 90 Day Past Due Loans. Nonperforming assets consist of nonaccrual loans and Other Real Estate Owned (OREO). OREO is comprised of commercial and residential properties acquired in partial or total satisfaction of problem loans. Past due loans are loans that are delinquent 90 days or more and still accruing interest. The level of 90 day past due loans at any reporting period can fluctuate widely based on the timing of cash collections, renegotiations and renewals.

Maintaining a low level of nonperforming assets is important to the ongoing success of a financial institution. In addition to the negative impact on both net interest income and credit losses, nonperforming assets also increase operating costs due to the expense associated with collection efforts. Northern Trust’s comprehensive credit review and approval process is a critical part of its ability to minimize nonperforming assets on a long-term basis.

The previous table presents the nonperforming assets and past due loans for the current and prior four years. Of the total loan portfolio of $22.6 billion at December 31, 2006, $35.7 million, or .16%, was nonaccrual, compared with $31.0 million, or .15%, at December 31, 2005.

Included in the portfolio of nonaccrual loans are those loans that meet the criteria of being “impaired.” A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. As of December 31, 2006, impaired loans, all of which have been classified as nonaccrual, totaled $31.9 million. These loans had $19.6 million of the reserve for credit losses allocated to them.

 

Provision and Reserve for Credit Losses. Changes in the reserve for credit losses were as follows:

 

(IN MILLIONS)

    2006        2005        2004  

Balance at Beginning of Year

  $ 136.0      $ 139.3      $ 157.2  

Charge-Offs

    (1.8 )      (7.6 )      (7.3 )

Recoveries

    1.6        1.8        4.4  
                           

Net Charge-Offs

    (.2 )      (5.8 )      (2.9 )

Provision for Credit Losses

    15.0        2.5        (15.0 )

Effect of Foreign Exchange Rates

    .2                
                           

Balance at End of Year

  $ 151.0      $ 136.0      $ 139.3  

 

The provision for credit losses is the charge to current earnings that is determined by management, through a disciplined credit review process, to be the amount needed to maintain a reserve that is sufficient to absorb probable credit losses that have been identified with specific borrower relationships (specific loss component) and for probable losses that are believed to be inherent in the loan and lease portfolios, unfunded commitments, and standby letters of credit (inherent loss component). The following table shows (1) the specific portion of the reserve, (2) the allocated portion of the inherent reserve and its components by loan category and (3) the unallocated portion of the reserve at December 31, 2006 and each of the prior four year-ends.

 

26  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

ALLOCATION OF THE RESERVE FOR CREDIT LOSSES


    DECEMBER 31  
    2006     2005     2004     2003     2002  

($ IN MILLIONS)

   
 
RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
 
 
 
   
 
RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
 
 
 
   
 
RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
 
 
 
   
 
RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
 
 
 
   
 
RESERVE
AMOUNT
  PERCENT OF
LOANS TO
TOTAL LOANS
 
 
 

Specific Reserve

  $ 19.6   %   $ 20.3   %   $ 24.0   %   $ 37.0   %   $ 25.0   %
                                                             

Allocated Inherent Reserve

                                                           

Residential Real Estate

    13.4   38       12.4   42       11.6   45       11.9   45       11.5   43  

Commercial

    55.0   21       48.3   18       49.9   18       60.9   19       85.2   22  

Commercial Real Estate

    21.5   8       17.7   7       17.1   7       16.8   7       15.5   7  

Personal

    5.9   15       6.1   15       5.5   16       5.2   15       5.0   14  

Other

      4         4         4         4         5  

Lease Financing

    3.7   6       3.9   6       4.5   7       4.3   7       4.8   7  

Non-U.S.

    6.6   8       2.9   8       1.6   3       1.6   3       1.4   2  
                                                             

Total Allocated Inherent Reserve

  $ 106.1   100 %   $ 91.3   100 %   $ 90.2   100 %   $ 100.7   100 %   $ 123.4   100 %
                                                             

Unallocated Inherent Reserve

    25.3         24.4         25.1         19.5         20.1    
                                                             

Total Reserve for Credit Losses

  $ 151.0   100 %   $ 136.0   100 %   $ 139.3   100 %   $ 157.2   100 %   $ 168.5   100 %
                                                             

Reserve Assigned to:

                                                           

Loans and Leases

  $ 140.4         $ 125.4         $ 130.7         $ 149.2         $ 161.1      

Unfunded Commitments and Standby Letters of Credit

    10.6           10.6           8.6           8.0           7.4      
                                                             

Total Reserve for Credit Losses

  $ 151.0         $ 136.0         $ 139.3         $ 157.2         $ 168.5      

 

Specific Component of the Reserve. The specific component of the reserve is determined on a loan-by-loan basis as part of the regular review of impaired loans and potential charge-offs. The specific reserve is based on a loan’s current book value compared with the present value of its projected future cash flows, collateral value or market value, as is relevant for the particular loan.

At December 31, 2006, the specific reserve component amounted to $19.6 million compared with $20.3 million at the end of 2005. The $.7 million decrease reflects principal repayments received offset in part by increased reserves on loans that were classified to nonperforming.

The decrease in the specific loss component of the reserve from $24.0 million in 2004 to $20.3 million in 2005 was due primarily to the charge-off of a commercial loan reserved for in a prior period and principal repayments. Offsetting these decreases in part were increased reserves on loans that were classified to nonperforming.

Allocated Inherent Component of the Reserve. The allocated portion of the inherent reserve is based on management’s review of historical charge-off experience as well as its judgment regarding the performance of loans in each credit rating category over a period of time that management determines is adequate to reflect longer-term economic trends. One building block in reaching the appropriate allocated inherent reserve is an analysis of loans by credit rating categories. Credit ratings are determined by members of the Credit Policy function, which is independent of business unit management, at the time each loan is approved. These credit ratings are then subject to periodic reviews by Credit Policy. Credit ratings range from “1” for the strongest credits to “9” for the weakest credits; a “9” rated loan would normally represent a complete loss.

Several factors are considered by management in determining the level of the allocated inherent component of the reserve. One of the factors is the historical loss ratio for each credit rating category over the prior five years. The historical loss ratios are evaluated by management and adjusted based on current facts and circumstances. The historical loss factors on higher-risk loans, those rated “5” through “8”, are also refined by considering the current economic environment and regulatory guidelines in order to provide a more consistent and reliable method for taking account of credit trends in measuring loss exposure.

Management also maintains a reserve for the commercial, commercial real estate and non-U.S. segments of the portfolio that have credit ratings from “1” through “4”, in order to measure the loss estimated to be inherent in these riskier segments. Because of the higher degree of uncertainty in these portfolios and Northern Trust’s historical experience, which includes significant losses related to a small number of loans over brief periods of time, management believes it appropriate to maintain a reserve higher than recent charge-off experience would suggest. This is intended to prevent an understatement of reserves based upon over-reliance on more favorable economic conditions included in the historic look-back period.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  27


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The allocated inherent component of the reserve also covers the credit exposure associated with undrawn loan commitments and standby letters of credit. To determine the exposure on these instruments, management uses conversion rates used in risk-based capital calculations to determine the balance sheet equivalent amount and assigns a loss factor based on the methodology utilized for outstanding loans.

The allocated portion of the inherent reserve increased $14.8 million to $106.1 million at December 31, 2006 compared with $91.3 million at December 31, 2005. The increase in this component of the reserve is due primarily to growth in the commercial loan portfolio and the migration of certain loans to higher risk credit ratings, partially offset by repayments received on lower rated loans.

In 2005, the allocated portion of the inherent reserve increased $1.1 million from $90.2 million at December 31, 2004. The increase during 2005 was due primarily to growth in the loan portfolio offset partially by the reduction of higher risk loans as a result of principal repayments.

Unallocated Inherent Component of the Reserve. The unallocated portion of the inherent loss reserve is based on management’s review of other factors affecting the determination of probable inherent losses, primarily in the commercial portfolio, which are not necessarily captured by the application of historical loss ratios. This portion of the reserve analysis involves the exercise of judgment and reflects considerations such as management’s view that the reserve should have a margin that recognizes the imprecision inherent in the process of estimating expected credit losses. The unallocated inherent portion of the reserve at year-end was $25.3 million compared with $24.4 million last year.

Other Factors. The total amount of the two highest risk loan groupings, those rated “7” and “8” (based on Northern Trust’s internal rating scale, which closely parallels that of the banking regulators), increased $4 million to $82 million, of which $31.9 million was classified as impaired. This compares with $78 million last year-end when $28.6 million was classified as impaired. The increase in 2006 primarily reflects the migration of certain loans to higher risk credit ratings. There were no “9” rated loans reported at any time during the periods because loans are charged-off when they are so rated. At December 31, 2006, these highest risk loans represented .36% of outstanding loans.

Overall Reserve. In establishing the overall reserve level, management considers that 38% of the loan portfolio consists of lower risk residential mortgage loans. The evaluation of the factors above resulted in a reserve for credit losses of $151.0 million at December 31, 2006 compared with $136.0 million at the end of 2005. The reserve of $140.4 million assigned to loans and leases, as a percentage of total loans and leases, was .62% at December 31, 2006, compared with .63% at December 31, 2005. The increase in the reserve level reflects growth in the commercial loan portfolio and the migration of certain loans to higher risk credit ratings, partially offset by repayments received on lower rated loans.

Reserves assigned to unfunded loan commitments and standby letters of credits totaled $10.6 million at December 31, 2006 and 2005.

Provision. The provision for credit losses was $15.0 million for the year and net charge-offs totaled $.2 million in 2006. This compares with a $2.5 million provision for credit losses and net charge-offs of $5.8 million in 2005 and a negative $15.0 million provision for credit losses and net charge-offs of $2.9 million in 2004.

 

MARKET RISK MANAGEMENT

Overview. To ensure adherence to Northern Trust’s interest rate and foreign exchange risk management policies, the Corporate Asset and Liability Policy Committee (ALCO) establishes and monitors guidelines to control the sensitivity of earnings to changes in interest rates and foreign currency exchange rates. The guidelines apply to both on- and off- balance sheet positions. The goal of the ALCO process is to maximize earnings while maintaining a high quality balance sheet and carefully controlling interest rate and foreign exchange risk.

 

Asset/Liability Management. Asset/liability management activities include lending, accepting and placing deposits, investing in securities, issuing debt, and hedging interest rate and foreign exchange risk with derivative financial instruments. The primary market risk associated with asset/liability management activities is interest rate risk and, to a lesser degree, foreign exchange risk.

Interest Rate Risk Management. Sensitivity of earnings to interest rate changes arises when yields on assets change in a different time period or in a different amount from that of interest costs on liabilities. To mitigate interest rate risk, the structure of the balance sheet is managed so that movements of interest rates on assets and liabilities (adjusted for off-balance sheet hedges) are highly correlated which allows Northern Trust’s interest-bearing assets and liabilities to contribute to earnings even in periods of volatile interest rates.

Northern Trust utilizes the following measurement techniques in the management of interest rate risk: simulation of earnings; simulation of the economic value of equity; and gap analysis. These three techniques are complementary and are used in concert to provide a comprehensive interest rate risk management capability.

 

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MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Simulation of earnings is the primary tool used to measure the sensitivity of earnings to interest rate changes. Using modeling techniques, Northern Trust is able to measure the potential impact of different interest rate assumptions on pre-tax earnings. All U.S. dollar-based on-balance sheet positions, as well as derivative financial instruments (principally interest rate swaps) that are used to manage interest rate risk, are included in the model simulation.

Northern Trust used model simulations as of December 31, 2006 to measure its earnings sensitivity relative to management’s most likely interest rate scenarios for the following year. Management’s most likely 2007 interest rate scenario assumes declining rates in the second quarter of the year and relatively stable rates during the second half of the year. The interest sensitivity was tested by running alternative scenarios above and below the most likely interest rate outcome. The following table shows the estimated impact on 2007 pre-tax earnings of 100 and 200 basis point upward and downward movements in interest rates relative to management’s most likely interest rate assumptions. Each of the movements in interest rates was assumed to have occurred gradually over a one-year period. The 100 basis point increase, for example, consisted of twelve consecutive monthly increases of 8.3 basis points. The following assumptions were also incorporated into the model simulations:

   

the balance sheet size was assumed to remain constant over the one-year simulation horizon;

   

maturing assets and liabilities were replaced on the balance sheet with the same terms;

   

prepayments on mortgage loans were projected under each rate scenario using a mortgage analytics system that incorporated market prepayment assumptions; and

   

changes in the spreads between retail deposit rates and asset yields were estimated based on historical patterns and current competitive trends.

INTEREST RATE RISK SIMULATION OF PRE-TAX INCOME AS OF DECEMBER 31, 2006


(IN MILLIONS)

   
 

 
 
ESTIMATED IMPACT ON
 2007

PRE-TAX INCOME
INCREASE/(DECREASE)
 
 

 
 

INCREASE IN INTEREST RATES ABOVE MANAGEMENT’S INTEREST RATE FORECAST

       

100 Basis Points

  $ (10.8 )

200 Basis Points

    (22.2 )

DECREASE IN INTEREST RATES BELOW MANAGEMENT’S INTEREST RATE FORECAST

       

100 Basis Points

  $ 8.0  

200 Basis Points

    14.3  

 

The simulations of earnings do not incorporate any management actions that might moderate the negative consequences of actual interest rate deviations. For that reason and others, they do not reflect likely actual results but serve as conservative estimates of interest rate risk.

A second technique used to measure interest rate risk is simulation of the economic value of equity, which is defined as the present value of assets minus the present value of liabilities net of the value of off-balance sheet instruments. This measurement of interest rate risk provides estimates of the potential future impact on the economic value of equity of various changes in interest rates. The potential effect of interest rate changes on economic equity is derived from the impact of such changes on the market values of assets, liabilities and off-balance sheet instruments. Northern Trust limits aggregate market risk, as measured in this fashion, to an acceptable level within the context of risk-return trade-offs.

The third technique that is used to measure interest rate risk is gap analysis. The calculation of the interest sensitivity gap measures the timing mismatches between assets and liabilities. This interest sensitivity gap is determined by subtracting the amount of liabilities from the volume of assets that reprice or mature in a particular time interval. A liability sensitive position results when more liabilities than assets reprice or mature within a given period. Under this scenario, as interest rates decline, increased net interest revenue will be generated. Conversely, an asset sensitive position results when more assets than liabilities reprice within a given period; in this instance, net interest revenue would benefit from an increasing interest rate environment. The economic impact of a liability or asset sensitive position depends on the magnitude of actual changes in interest rates relative to the current expectations of market price participants. Northern Trust utilizes interest rate risk gap analysis to measure and limit the interest rate risk of its assets, liabilities and off-balance sheet positions denominated in foreign currencies.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  29


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

A variety of actions are used to implement risk management strategies including:

   

purchases of securities;

   

sales of securities that are classified as available for sale;

   

sales of held for sale residential real estate loans;

   

issuance of senior notes and subordinated notes;

   

collateralized borrowings from the Federal Home Loan Bank;

   

placing and taking Eurodollar time deposits; and

   

hedging with various types of derivative financial instruments.

 

Northern Trust strives to use the most effective instruments for implementing its interest risk management strategies, considering the costs, liquidity, collateral and capital requirements of the various alternatives.

Foreign Exchange Risk Management. Northern Trust is exposed to non-trading foreign exchange risk as a result of its holdings of non-U.S. dollar denominated assets and liabilities, investment in non-U.S. subsidiaries, and other transactions in non-U.S. dollar currencies. To manage non-trading foreign exchange volatility and minimize the earnings impact of translation gains and losses, Northern Trust utilizes non-U.S. dollar denominated liabilities to fund non-U.S. dollar denominated net assets. If those currency offsets do not exist on the balance sheet, Northern Trust will use various foreign exchange forward contracts to mitigate its currency exposure. The remaining foreign exchange positions that exist are managed as part of foreign exchange trading as described below.

 

Foreign Exchange Trading. Foreign exchange trading activities consist principally of providing foreign exchange services to clients. Most of these services are provided in connection with Northern Trust’s growing global custody business. However, in the normal course of business Northern Trust also engages in proprietary trading of non-U.S. currencies. The primary market risk associated with these activities is foreign exchange risk.

Foreign currency positions exist when aggregate obligations to purchase and sell a currency other than the U.S. dollar do not offset each other, or offset each other in different time periods and also include holdings of non-U.S. dollar denominated non-trading assets and liabilities that are not converted to U.S. dollars through the use of hedge contracts. Northern Trust mitigates the risk related to its non-U.S. currency positions by establishing limits on the amounts and durations of its positions. The limits on overnight inventory positions are generally lower than the limits established for intra-day trading activity. All overnight positions are monitored by a risk management function, which is separate from the trading function, to ensure that the limits are not exceeded. Although position limits are important in controlling foreign exchange risk, they are not a substitute for the experience or judgment of Northern Trust’s senior management and its currency traders, who have extensive knowledge of the non-U.S. currency markets. Non-U.S. currency positions and strategies are adjusted as needed in response to changing market conditions.

As part of its risk management activities, Northern Trust regularly measures the risk of loss associated with non-U.S. currency positions using a value at risk model. This statistical model provides an estimate, based on a 95% confidence level, of the potential loss in earnings that may be incurred if an adverse one-day shift in non-U.S. currency exchange rates were to occur. The model, which is based on a variance/co-variance methodology, incorporates historical currency price data and historical correlations in price movement among the currencies. All non-U.S. currency positions, including non-U.S. dollar denominated non-trading assets and liabilities that were not converted to U.S. dollars through the use of hedge contracts, are included in the model.

Northern Trust’s value at risk based on non-U.S. currency positions totaled $79 thousand and $109 thousand as of December 31, 2006 and 2005, respectively. Value at risk totals representing the average, high and low for 2006 were $181 thousand, $583 thousand and $31 thousand, respectively, with the average, high and low for 2005 being $173 thousand, $540 thousand and $39 thousand, respectively. These totals indicate the degree of risk inherent in non-U.S. currency dispositions as of year-end and during the year; however, it is not a prediction of an expected gain or loss. Actual future gains and losses will vary depending on market conditions and the size and duration of future non-U.S. currency positions. During 2006 and 2005, Northern Trust did not incur an actual trading loss in excess of the daily value at risk estimate.

 

Other Trading Activities. Market risk associated with other trading activities is negligible. Northern Trust is a party to various derivative financial instruments, most of which consist of interest rate swaps entered into to meet clients’ interest risk management needs. When Northern Trust enters into such swaps, its policy is to mitigate the resulting market risk with an offsetting swap or with futures contracts. Northern Trust carries in its trading portfolio a small inventory of securities that are held for sale to its clients. The interest rate risk associated with these securities is insignificant.

 

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NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OPERATIONAL RISK MANAGEMENT

In providing banking, trust, and other asset related services, Northern Trust, in addition to safekeeping and managing trust and corporate assets, processes cash and securities transactions which expose Northern Trust to operational and fiduciary risk. Controls over processing activities are closely monitored to safeguard the assets of Northern Trust and its clients. However, from time to time Northern Trust has incurred losses related to these risks and there can be no assurance that such losses will not occur in the future.

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This risk is mitigated through a system of internal controls and risk management practices that are designed to keep operational risk at levels appropriate to Northern Trust’s corporate standards in view of the risks inherent in the markets in which Northern Trust operates. The system of internal controls and risk management practices include policies and procedures that require the proper authorization, approval, documentation and monitoring of transactions. Each business unit is responsible for complying with corporate policies and external regulations applicable to the unit, and is responsible for establishing specific procedures to do so. Northern Trust’s internal auditors monitor the overall effectiveness of the system of internal controls on an ongoing basis.

Fiduciary risk is the risk of loss that may occur as a result of breaching a fiduciary duty to a client. To limit this risk, the Fiduciary Risk Committee oversees corporate policies and procedures to reduce the risk that obligations to clients would not be discharged faithfully or in compliance with applicable legal and regulatory requirements. These policies and procedures provide guidance and establish standards related to the creation, sale, and management of investment products, trade execution, and counterparty selection.

 

FACTORS AFFECTING FUTURE RESULTS

This report contains statements that may be considered forward-looking, such as the statements relating to Northern Trust’s financial goals, dividend policy, expansion and business development plans, anticipated expense levels and projected profit improvements, business prospects and positioning with respect to market, demographic and pricing trends, strategic initiatives, re-engineering and outsourcing activities, new business results and outlook, changes in securities market prices, credit quality including reserve levels, planned capital expenditures and technology spending, anticipated tax benefits and expenses, and the effects of any extraordinary events and various other matters (including developments in litigation and regulation involving Northern Trust and changes in accounting policies, standards and interpretations) on Northern Trust’s business and results.

Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “may increase,” “may fluctuate,” “plan,” “goal,” “strategy,” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” and “could.” Forward-looking statements are Northern Trust’s current estimates or expectations of future events or future results. Actual results could differ materially from the results indicated by these statements because the realization of those results is subject to many risks and uncertainties including: the health of the U.S. and international economies; changes in financial and equity markets impacting the value of financial assets; changes in foreign currency exchange rates; Northern Trust’s success in managing various risks inherent in its business, including credit risk, interest rate risk and liquidity risk; geopolitical risks and the risks of extraordinary events such as natural disasters, terrorist events, war and the U.S. government’s response to those events; the pace and extent of continued globalization of investment activity and growth in worldwide financial assets; regulatory and monetary policy developments; failure to obtain regulatory approvals when required; changes in tax laws, accounting requirements or interpretations and other legislation in the U.S. or other countries that could affect Northern Trust or its clients; changes in the nature and activities of Northern Trust’s competition; Northern Trust’s success in maintaining existing business and continuing to generate new business in its existing markets; Northern Trust’s success in identifying and penetrating targeted markets, through acquisition, strategic alliance or otherwise; Northern Trust’s success in integrating recent and future acquisitions, strategic alliances, and preferred provider arrangements; Northern Trust’s ability to maintain a product mix that achieves acceptable margins; Northern Trust’s ability to continue to generate investment results that satisfy its clients and continue to develop its array of investment products; Northern Trust’s ability to continue to fund and accomplish innovation, improve risk management practices and controls, and address operating risks, including human errors or omissions, systems defects, systems interruptions, and breakdowns in processes or internal controls; Northern Trust’s success in controlling expenses; risks and uncertainties inherent in the litigation and regulatory process; and the risk of events that could harm Northern Trust’s reputation and so undermine the confidence of clients, counterparties, rating agencies, and stockholders.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  31


MANAGEMENTS DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Some of these and other risks and uncertainties that may affect future results are discussed in more detail in “Item 1A – Risk Factors” of the 2006 Annual Report on Form 10-K (beginning on page 27), in the sections of “Item 1 – Business” of the 2006 Annual Report on Form 10-K captioned “Government Polices,” “Competition,” and “Regulation and Supervision” (pages 6 - 13), in the sections of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” captioned “Risk Management,” “Market Risk Management,” and “Operational Risk Management” in the 2006 Financial Annual Report to Shareholders (pages 22 - 31), and in the section of the “Notes to Consolidated Financial Statements” in the 2006 Financial Annual Report to Shareholders captioned “Note 24, Contingent Liabilities” (page 62). All forward-looking statements included in this report are based upon information presently available, and Northern Trust assumes no obligation to update any forward-looking statements.

 

MANAGEMENTS REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Management of Northern Trust Corporation (Northern Trust) is responsible for establishing and maintaining adequate internal control over financial reporting. This internal control contains monitoring mechanisms, and actions are taken to correct deficiencies identified.

Management assessed Northern Trust’s internal control over financial reporting as of December 31, 2006. This assessment was based on criteria for effective internal control over financial reporting described in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2006, Northern Trust maintained effective internal control over financial reporting, including maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of Northern Trust, and policies and procedures that provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States and that receipts and expenditures of Northern Trust are being made only in accordance with authorizations of management and directors of Northern Trust. Additionally, KPMG LLP, the independent registered public accounting firm that audited Northern Trust’s consolidated financial statements as of, and for the year ended, December 31, 2006, included in this Financial Annual Report, has issued an attestation report (included herein on page 33) on management’s assessment of, and the effective operation of, Northern Trust’s internal control over financial reporting.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF NORTHERN TRUST CORPORATION:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Controls over Financial Reporting, that Northern Trust Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Northern Trust Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of Northern Trust Corporation’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Northern Trust Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in “Internal Control – Integrated Framework” issued by COSO. Also, in our opinion, Northern Trust Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in “Internal Control – Integrated Framework” issued by COSO.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Northern Trust Corporation and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated February 28, 2007 expressed an unqualified opinion on those consolidated financial statements.

 

/s/ KPMG LLP

 

CHICAGO, ILLINOIS

FEBRUARY 28, 2007

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  33


CONSOLIDATED FINANCIAL STATEMENTS

 

CONSOLIDATED BALANCE SHEET

 

            DECEMBER 31  

($ IN MILLIONS EXCEPT SHARE INFORMATION)

    2006        2005  

ASSETS

                

Cash and Due from Banks

  $ 4,961.0      $ 2,996.2  

Federal Funds Sold and Securities Purchased under Agreements to Resell (Note 5)

    1,299.7        4,845.1  

Time Deposits with Banks

    15,468.7        11,123.1  

Other Interest-Bearing

    21.9        67.5  

Securities (Notes 4 and 27)

                

Available for Sale

    11,249.6        9,970.7  

Held to Maturity (Fair value–$1,122.1 in 2006 and $1,161.6 in 2005)

    1,107.0        1,135.5  

Trading Account

    8.6        2.8  
                  

Total Securities

    12,365.2        11,109.0  
                  

Loans and Leases (Notes 6 and 27)

                

Commercial and Other

    13,935.3        11,628.0  

Residential Mortgages

    8,674.4        8,340.5  
                  

Total Loans and Leases (Net of unearned income–$507.9 in 2006 and $451.1 in 2005)

    22,609.7        19,968.5  
                  

Reserve for Credit Losses Assigned to Loans and Leases (Note 7)

    (140.4 )      (125.4 )

Buildings and Equipment (Notes 8 and 9)

    487.2        471.5  

Customers’ Acceptance Liability

    1.2        .7  

Trust Security Settlement Receivables

    339.3        317.0  

Other Assets (Notes 11 and 29)

    3,298.7        2,640.6  
                  

Total Assets

  $ 60,712.2      $ 53,413.8  
                  

LIABILITIES

                

Deposits

                

Demand and Other Noninterest-Bearing

  $ 5,434.0      $ 5,383.6  

Savings and Money Market

    6,297.6        8,278.9  

Savings Certificates

    1,999.3        1,565.2  

Other Time

    459.6        391.6  

Non-U.S. Offices–Demand

    3,880.9        2,043.2  

  –Time

    25,748.8        20,857.0  
                  

Total Deposits

    43,820.2        38,519.5  

Federal Funds Purchased

    2,821.6        1,096.9  

Securities Sold under Agreements to Repurchase (Note 5)

    1,950.5        1,610.8  

Commercial Paper

           144.6  

Other Borrowings

    2,976.5        2,647.9  

Senior Notes (Note 12)

    445.4        272.5  

Long-Term Debt (Note 12)

    2,307.9        2,818.1  

Floating Rate Capital Debt (Note 13)

    276.5        276.4  

Liability on Acceptances

    1.2        .7  

Other Liabilities (Notes 7 and 29)

    2,168.5        2,425.6  
                  

Total Liabilities

    56,768.3        49,813.0  
                  

STOCKHOLDERS’ EQUITY

                

Common Stock, $1.66 2/3 Par Value; Authorized 560,000,000 shares; Outstanding 218,700,956 shares in 2006 and 218,128,986 shares in 2005 (Notes 14 and 16)

    379.8        379.8  

Additional Paid-in Capital

    30.9         

Retained Earnings

    4,131.2        3,672.1  

Accumulated Other Comprehensive Income (Note 15)

    (148.6 )      (18.7 )

Common Stock Issuable–Stock Incentive Plans (Note 22)

           55.5  

Deferred Compensation

           (29.5 )

Treasury Stock (at cost–9,220,568 shares in 2006 and 9,792,538 shares in 2005)

    (449.4 )      (458.4 )
                  

Total Stockholders’ Equity

    3,943.9        3,600.8  
                  

Total Liabilities and Stockholders’ Equity

  $ 60,712.2      $ 53,413.8  
                  

See accompanying notes to consolidated financial statements on pages 38-71.

 

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CONSOLIDATED FINANCIAL STATEMENTS

 

CONSOLIDATED STATEMENT OF INCOME

 

                    FOR THE YEAR ENDED DECEMBER 31  

($ IN MILLIONS EXCEPT PER SHARE INFORMATION)

    2006      2005        2004  

Noninterest Income

                       

Trust, Investment and Other Servicing Fees

  $ 1,791.6    $ 1,559.4      $ 1,330.3  

Foreign Exchange Trading Income

    247.3      180.2        158.0  

Treasury Management Fees

    65.4      71.2        88.1  

Security Commissions and Trading Income

    62.7      55.2        50.5  

Other Operating Income (Note 18)

    97.8      97.5        83.8  

Investment Security Gains, net (Note 4)

    1.4      .3        .2  
                         

Total Noninterest Income

    2,266.2      1,963.8        1,710.9  
                         

Net Interest Income (Note 17)

                       

Interest Income

    2,206.8      1,590.6        1,118.2  

Interest Expense

    1,476.9      929.2        557.1  
                         

Net Interest Income

    729.9      661.4        561.1  

Provision for Credit Losses (Note 7)

    15.0      2.5        (15.0 )
                         

Net Interest Income after Provision for Credit Losses

    714.9      658.9        576.1  
                         

Noninterest Expenses

                       

Compensation (Notes 22 and 23)

    876.6      774.2        661.7  

Employee Benefits (Note 21)

    217.6      190.4        161.5  

Occupancy Expense (Notes 8 and 9)

    145.4      133.7        121.5  

Equipment Expense (Notes 8 and 9)

    82.5      83.2        84.7  

Other Operating Expenses (Note 19)

    634.8      553.4        502.3  
                         

Total Noninterest Expenses

    1,956.9      1,734.9        1,531.7  
                         

Income before Income Taxes

    1,024.2      887.8        755.3  

Provision for Income Taxes (Note 20)

    358.8      303.4        249.7  
                         

Net Income

  $ 665.4    $ 584.4      $ 505.6  
                         

Per Common Share (Note 16)

                       

Net Income–Basic

  $ 3.06    $ 2.68      $ 2.30  

–Diluted

    3.00      2.64        2.27  

Cash Dividends Declared

    .94      .86        .78  
                         

Average Number of Common Shares Outstanding–Basic

    217,766,035      218,101,996        219,492,478  

–Diluted

    221,784,114      221,557,188        223,135,699  

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

 

 

                    FOR THE YEAR ENDED DECEMBER 31  

(IN MILLIONS)

    2006      2005        2004  

Net Income

  $ 665.4    $ 584.4      $ 505.6  

Other Comprehensive Income (net of tax and reclassifications)

                       

Net Unrealized Gains (Losses) on Securities Available for Sale

    9.7      (4.5 )      (3.4 )

Net Unrealized Gains (Losses) on Cash Flow Hedge Designations

    3.0      (1.3 )      .2  

Foreign Currency Translation Adjustments

    17.0      2.3        (.9 )

Minimum Pension Liability Adjustment

    14.2      (.5 )      (1.7 )
                         

Other Comprehensive Income (Note 15)

    43.9      (4.0 )      (5.8 )
                         

Comprehensive Income

  $ 709.3    $ 580.4      $ 499.8  
                         

See accompanying notes to consolidated financial statements on pages 38-71.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  35


CONSOLIDATED FINANCIAL STATEMENTS

 

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

 

    FOR THE YEAR ENDED
DECEMBER 31
 

(IN MILLIONS)

    2006        2005        2004  

COMMON STOCK

                         

Balance at January 1

  $ 379.8      $ 379.8      $ 379.8  
                           

Balance at December 31

    379.8        379.8        379.8  
                           

ADDITIONAL PAID-IN CAPITAL

                         

Balance at January 1

                   

Transferred from Common Stock Issuable–Stock Incentive Plans

    55.5                

Transferred from Deferred Compensation

    (29.5 )              

Treasury Stock Transaction–Stock Options and Awards

    (43.9 )              

Stock Options and Awards–Amortization

    27.5                

Stock Options and Awards–Taxes

    21.3                
                           

Balance at December 31

    30.9                
                           

RETAINED EARNINGS

                         

Balance at January 1

    3,672.1        3,300.6        2,990.7  

Net Income

    665.4        584.4        505.6  

Dividends Declared–Common Stock

    (206.3 )      (187.7 )      (171.2 )

Stock Incentive Plans

           (25.2 )      (24.5 )
                           

Balance at December 31

    4,131.2        3,672.1        3,300.6  
                           

ACCUMULATED OTHER COMPREHENSIVE INCOME

                         

Balance at January 1

    (18.7 )      (14.7 )      (8.9 )

Other Comprehensive Income (Loss)

    43.9        (4.0 )      (5.8 )

Pension and Other Postretirement Benefit Adjustments

    (173.8 )              
                           

Balance at December 31

    (148.6 )      (18.7 )      (14.7 )
                           

COMMON STOCK ISSUABLE–STOCK INCENTIVE PLANS

                         

Balance at January 1

    55.5        63.0        88.6  

Transferred to Additional Paid-in Capital

    (55.5 )              

Stock Issuable, net of Stock Issued

           (7.5 )      (25.6 )
                           

Balance at December 31

           55.5        63.0  
                           

DEFERRED COMPENSATION

                         

Balance at January 1

    (29.5 )      (25.0 )      (26.4 )

Transferred to Additional Paid-in Capital

    29.5                

Compensation Deferred

           (17.7 )      (11.5 )

Compensation Amortized

           13.2        12.9  
                           

Balance at December 31

           (29.5 )      (25.0 )
                           

TREASURY STOCK

                         

Balance at January 1

    (458.4 )      (408.1 )      (368.5 )

Stock Options and Awards

    140.3        119.5        111.0  

Stock Purchased

    (131.3 )      (169.8 )      (150.6 )
                           

Balance at December 31

    (449.4 )      (458.4 )      (408.1 )
                           

Total Stockholders’ Equity At December 31

  $ 3,943.9      $ 3,600.8      $ 3,295.6  
                           

See accompanying notes to consolidated financial statements on pages 38-71.

 

36  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


CONSOLIDATED FINANCIAL STATEMENTS

 

CONSOLIDATED STATEMENT OF CASH FLOWS

 

            FOR THE YEAR ENDED DECEMBER 31  
(IN MILLIONS)   2006      2005      2004  

CASH FLOWS FROM OPERATING ACTIVITIES:

                         

Net Income

  $ 665.4      $ 584.4      $ 505.6  

Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:

                         

Provision for Credit Losses

    15.0        2.5        (15.0 )

Depreciation on Buildings and Equipment

    83.7        85.0        82.6  

Amortization of Computer Software

    93.5        86.3        84.0  

Amortization of Intangibles

    22.4        20.4        9.8  

(Increase) Decrease in Receivables

    (147.2 )      (129.1 )      11.0  

Increase in Interest Payable

    13.0        11.8        1.5  

Amortization and Accretion of Securities and Unearned Income

    (161.2 )      (190.9 )      (113.4 )

Gain on Sale of Buildings (Note 18)

           (7.9 )       

Deferred Income Tax

    83.9        71.1        96.5  

Net (Increase) Decrease in Trading Account Securities

    (5.8 )      (.2 )      4.8  

Other Operating Activities, net

    (274.2 )      49.7        (12.6 )
                           

Net Cash Provided by Operating Activities

    388.5        583.1        654.8  
                           

CASH FLOWS FROM INVESTING ACTIVITIES:

                         

Net (Increase) Decrease in Federal Funds Sold and Securities Purchased under Agreements to Resell

    3,545.4        (3,505.2 )      (585.3 )

Net (Increase) Decrease in Time Deposits with Banks

    (4,345.6 )      3,588.6        (3,025.5 )

Net (Increase) Decrease in Other Interest-Bearing Assets

    45.6        (33.1 )      8.4  

Purchases of Securities–Held to Maturity

    (53.3 )      (99.8 )      (161.1 )

Proceeds from Maturity and Redemption of Securities–Held to Maturity

    86.4        93.2        86.5  

Purchases of Securities–Available for Sale

    (87,092.2 )      (56,789.3 )      (16,442.2 )

Proceeds from Sale, Maturity and Redemption of Securities–Available for Sale

    85,966.7        54,841.6        16,804.7  

Net Increase in Loans and Leases

    (2,588.6 )      (1,612.5 )      (83.7 )

Purchases of Buildings and Equipment, net

    (99.4 )      (85.9 )      (49.3 )

Proceeds from Sale of Buildings

           21.2         

Purchases and Development of Computer Software

    (139.1 )      (109.0 )      (83.8 )

Net (Increase) Decrease in Trust Security Settlement Receivables

    (22.3 )      (168.1 )      21.7  

Decrease in Cash Due to Acquisitions, net of Cash Acquired

           (464.9 )      (4.2 )

Other Investing Activities, net

    (686.8 )      253.5        30.9  
                           

Net Cash Used in Investing Activities

    (5,383.2 )      (4,069.7 )      (3,482.9 )
                           

CASH FLOWS FROM FINANCING ACTIVITIES:

                         

Net Increase in Deposits

    5,300.7        4,341.0        4,787.6  

Net Increase (Decrease) in Federal Funds Purchased

    1,724.7        78.6        (1,611.1 )

Net Increase (Decrease) in Securities Sold under Agreements to Repurchase

    339.7        (1,237.1 )      1,020.1  

Net Increase (Decrease) in Commercial Paper

    (144.6 )      (.8 )      3.1  

Net Increase (Decrease) in Short-Term Other Borrowings

    316.6        1,193.7        (581.4 )

Proceeds from Term Federal Funds Purchased

    107.0        210.2        693.6  

Repayments of Term Federal Funds Purchased

    (95.0 )      (212.2 )      (697.2 )

Proceeds from Senior Notes & Long-Term Debt

    649.1        815.2        285.0  

Repayments of Senior Notes & Long-Term Debt

    (1,046.0 )      (498.8 )      (351.1 )

Treasury Stock Purchased

    (127.4 )      (165.3 )      (147.6 )

Net Proceeds from Stock Options

    84.4        50.6        35.4  

Excess Tax Benefits from Stock Incentive Plans

    21.3                

Cash Dividends Paid on Common Stock

    (200.5 )      (183.5 )      (167.0 )

Other Financing Activities, net

    (123.5 )      131.7        (19.5 )
                           

Net Cash Provided by Financing Activities

    6,806.5        4,523.3        3,249.9  
                           

Effect of Foreign Currency Exchange Rates on Cash

    153.0        (93.0 )      34.8  
                           

Increase (Decrease) in Cash and Due from Banks

    1,964.8        943.7        456.6  

Cash and Due from Banks at Beginning of Year

    2,996.2        2,052.5        1,595.9  
                           

Cash and Due from Banks at End of Year

  $ 4,961.0      $ 2,996.2      $ 2,052.5  
                           

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

                         

Interest Paid

  $ 1,463.9      $ 917.3      $ 555.7  

Income Taxes Paid

    304.1        179.6        165.0  
                           

See accompanying notes to consolidated financial statements on pages 38-71.

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  37


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1. Accounting Policies – The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States and reporting practices prescribed for the banking industry. A description of the significant accounting policies follows:

A. Basis of Presentation. The consolidated financial statements include the accounts of Northern Trust Corporation (Corporation) and its wholly-owned subsidiary, The Northern Trust Company (Bank), and their wholly-owned subsidiaries. Throughout the notes, the term “Northern Trust” refers to the Corporation and its subsidiaries. Intercompany balances and transactions have been eliminated in consolidation. The consolidated statement of income includes results of acquired subsidiaries from the dates of acquisition.

B. Nature of Operations. The Corporation is a financial holding company under the Gramm-Leach-Bliley Act. The Bank is an Illinois banking corporation headquartered in Chicago and the Corporation’s principal subsidiary. The Corporation conducts business in the United States (U.S.) and internationally through the Bank, a national bank subsidiary, a federal savings bank subsidiary, trust companies, and various other U.S. and non-U.S. subsidiaries.

Northern Trust generates the majority of its revenues from its two primary business units: Corporate and Institutional Services (C&IS) and Personal Financial Services (PFS). Investment management services and products are provided to C&IS and PFS through a third business unit, Northern Trust Global Investments (NTGI). Operating and systems support for these business units is provided by a fourth business unit, Worldwide Operations and Technology (WWOT).

The C&IS business unit provides asset servicing, asset management, and related services to corporate and public retirement funds, foundations, endowments, fund managers, insurance companies, and government funds; a full range of commercial banking services to large corporations and financial institutions; and foreign exchange services. C&IS products are delivered to clients from offices in 15 locations in North America, Europe, and the Asia-Pacific region.

The PFS business unit provides personal trust, custody, philanthropic, and investment management services; financial consulting; guardianship and estate administration; qualified retirement plans; and private and business banking. PFS focuses on high net worth individuals, business owners, executives, professionals, retirees, and established privately-held businesses. PFS services are delivered through a network of over 80 offices in 18 U.S. states as well as offices in London and Guernsey.

C. Use of Estimates in the Preparation of Financial Statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

D. Foreign Currency Translation. Asset and liability accounts denominated in a foreign currency are remeasured into functional currencies at period end rates of exchange, except for buildings and equipment which are remeasured at exchange rates in effect at the date of acquisition. Income and expense accounts are remeasured at period average rates of exchange. Results from remeasurement are reported in other operating income.

Asset and liability accounts of entities with functional currencies that are not the U.S. dollar are translated at period end rates of exchange. Income and expense accounts are translated at period average rates of exchange. Translation adjustments are reported directly to accumulated other comprehensive income, a component of stockholders’ equity. Translation adjustments related to retained earnings are reported net of tax, except for those non-U.S subsidiaries whose accumulated earnings are considered to be indefinitely reinvested outside the U.S.

E. Securities. Securities Available for Sale are reported at fair value, with unrealized gains and losses credited or charged, net of the tax effect, to accumulated other comprehensive income, a component of stockholders’ equity. Realized gains and losses on securities available for sale are determined on a specific identification basis and are reported in the consolidated statement of income as investment security gains, net. Interest income is recorded on the accrual basis adjusted for amortization of premium and accretion of discount.

Securities Held to Maturity consist of debt securities that management intends to, and Northern Trust has the ability to, hold until maturity. Such securities are reported at cost, adjusted for amortization of premium and accretion of discount. Interest income is recorded on the accrual basis adjusted for the amortization of premium and accretion of discount.

Securities Held for Trading are stated at fair value. Realized and unrealized gains and losses on securities held for trading are reported in the consolidated statement of income under security commissions and trading income.

 

38  

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

   


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

F. Derivative Financial Instruments. Northern Trust is a party to various derivative instruments as part of its risk management activities, to meet the risk management needs of its clients, and as part of its trading activity for its own account. Derivative financial instruments include interest rate swap and option contracts, foreign exchange contracts, credit default swaps, and similar contracts. Derivative financial instruments are recorded at fair value based on quoted market prices, dealer quotes, pricing models or quoted market prices of financial instruments with similar characteristics. Unrealized gains and receivables are reported as other assets and unrealized losses and payables are reported as other liabilities in the consolidated balance sheet. Derivative asset and liability positions with the same counterparty are reflected on a net basis in cases where legally enforceable master netting agreements exist.

Risk Management Instruments. Fair value, cash flow or net investment hedge derivatives are designated and formally documented as such contemporaneous with the transaction. The formal documentation describes the hedge relationship and identifies the hedging instruments and hedged items. Included in the documentation is a discussion of the risk management objectives and strategies for undertaking such hedges, as well as a description of the method for assessing hedge effectiveness at inception and on an ongoing basis. A formal assessment is performed on a calendar quarter basis to verify that derivatives used in hedging transactions continue to be highly effective as offsets to changes in fair value or cash flows of the hedged item. If a derivative ceases to be highly effective, or if the hedged item matures, is sold, or is terminated, or if a hedged forecasted transaction is no longer expected to occur, hedge accounting is terminated and the derivative is treated as if it were a trading instrument.

Derivatives are designated as fair value hedges to limit Northern Trust’s exposure to changes in the fair value of recognized fixed earning assets due to movements in interest rates. Interest accruals and changes in fair value of the derivative are recognized as a component of the interest income classification of the hedged item. Changes in fair value of the hedged asset attributable to the risk being hedged are reflected in its carrying amount and are also recognized as a component of its interest income.

Derivatives are designated as cash flow hedges to minimize the variability in cash flows of earning assets or forecasted transactions caused by movements in interest or foreign exchange rates. The effective portion of unrealized gains and losses on such derivatives is recognized in accumulated other comprehensive income, a component of stockholders’ equity. Any hedge ineffectiveness is recognized currently in the income or expense classification of the hedged item. When the hedged forecasted transaction impacts earnings, balances in other comprehensive income are reclassified to the same income or expense classification as the hedged item.

Foreign exchange contracts and qualifying nonderivative instruments are designated as net investment hedges to minimize Northern Trust’s exposure to foreign currency translation gains and losses on our net investments in non-U.S. branches and subsidiaries. Changes in the fair value of the hedging instrument are recognized in accumulated other comprehensive income. Any ineffectiveness is recorded in other income.

Other derivatives transacted as economic hedges of non-U.S. dollar denominated assets and liabilities and of credit risk are carried on the balance sheet at fair value and any changes in fair value are recognized currently in income.

G. Loans and Leases. Loans that are held for investment are reported at the principal amount outstanding, net of unearned income. Residential real estate loans classified as held for sale are reported at the lower of aggregate cost or market value. Loan commitments for residential real estate loans that will be classified as held for sale at the time of funding and which have an interest-rate lock are recorded on the balance sheet at fair value with subsequent gains or losses recognized as other income. Unrealized gains are reported as other assets, with unrealized losses reported as other liabilities. Other unfunded loan commitments that are not held for sale are carried at the amount of unamortized fees with a reserve for credit loss liability recognized for any probable losses.

Interest income on loans is recorded on an accrual basis unless, in the opinion of management, there is a question as to the ability of the debtor to meet the terms of the loan agreement, or interest or principal is more than 90 days contractually past due and the loan is not well-secured and in the process of collection. At the time a loan is placed on nonaccrual status, interest accrued but not collected is reversed against interest income of the current period. Loans are returned to accrual status when factors indicating doubtful collectibility no longer exist. Interest collected on nonaccrual loans is applied to principal unless, in the opinion of management, collectibility of principal is not in doubt.

A loan is considered to be impaired when, based on current information and events, management determines that it is probable that Northern Trust will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans are measured based upon the loan’s market price, the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the fair value of the collateral if the loan is collateral dependent. If

 

   

2006

NORTHERN TRUST CORPORATION FINANCIAL ANNUAL REPORT

  39


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

the loan valuation is less than the recorded value of the loan, a specific reserve is established for the difference.

Premiums and discounts on loans are recognized as an adjustment of yield using the interest method based on the contractual terms of the loan. Commitment fees that are considered to be an adjustment to the loan yield, loan origination fees and certain direct costs are deferred and accounted for as an adjustment to the yield.

Unearned lease income from direct financing and leveraged leases is recognized using the interest method. This method provides a constant rate of return on the unrecovered investment over the life of the lease. Lease residual values are established at the inception of the lease based on in-house valuations and market analyses provided by outside parties. Lease residual values are reviewed at least annually for other than temporary impairment. A decline in the estimated residual value of a leased asset determined to be other than temporary would be recorded as a reduction of other operating income in the period in which the decline is identified.

H. Reserve for Credit Losses. The reserve for credit losses represents management’s estimate of probable inherent losses which have occurred as of the date of the financial statements. The loan and lease portfolio and other credit exposures are regularly reviewed to evaluate the adequacy of the reserve for credit losses. In determining the level of the reserve, Northern Trust evaluates the reserve necessary for specific nonperforming loans and also estimates losses inherent in other credit exposures. The result is a reserve with the following components:

Specific Reserve. The amount of specific reserves is determined through a loan-by-loan analysis of nonperforming loans that considers expected future cash flows, the value of collateral and other factors that may impact the borrower’s ability to pay.

Allocated Inherent Reserve. The amount of the allocated portion of the inherent loss reserve is based on loss factors assigned to Northern Trust’s credit exposures based on internal credit ratings. These loss factors are primarily based on management’s judgment of estimated credit losses inherent in the loan portfolio as well as historical charge-off experience.

Unallocated Inherent Reserve. Management determines the unallocated portion of the inherent loss reserve based on factors that cannot be associated with a specific credit or loan category. These factors include management’s subjective evaluation of local and national economic and business conditions, portfolio concentration and changes in the character and size of the loan portfoli