**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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| **(Mark  One)**                                    |
|----------------------------------------------------|
|                                               |
| **ý**                                         |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|                                               |   |   |
| **For the Quarterly period ended March 31,  2004** |
|                                               |   |   |
| **or**                                             |
|                                               |   |   |
| o                                                  |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**For the Transitionperiod from         to        **

** **

**0-26996**(Commission File Number)

 

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**INVESTORS FINANCIAL SERVICES CORP.**

(Exact name ofregistrant as specified in its charter)

 

 

| **Delaware**                                                    |   | **04-3279817**                    |
|-----------------------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (IRS Employer Identification No.) |
|                                                            |   |                              |
| **200 Clarendon Street,  P.O. Box 9130, Boston, MA**            |   | **02117-9130**                    |
| (Address of principal executive offices)                        |   | (Zip Code)                        |

 

**(617) 937-6700**(Registrant’s telephone number, including area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes ý No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2). Yes ý       No o

 

As of April 30, 2004 there were 66,110,416 shares of Common Stockoutstanding.

 

 

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**INVESTORS FINANCIAL SERVICES CORP.**

 

**INDEX**

 
| **PART I.**    |   | **FINANCIAL INFORMATION**                                                                                                   |   |
|----------------|--------|-----------------------------------------------------------------------------------------------------------------------------|--------|
|           |   |                                                                                                                        |   |
| Item 1.        |   | Unaudited Condensed  Consolidated Financial Statements                                                                      |   |
|           |   |                                                                                                                        |   |
|           |   | Unaudited  Condensed Consolidated Balance Sheets  March 31, 2004 and December 31, 2003                                      |   |
|           |   |                                                                                                                        |   |
|           |   | Unaudited  Condensed Consolidated Statements of Income and Comprehensive Income  Three months ended March 31, 2004 and 2003 |   |
|           |   |                                                                                                                        |   |
|           |   | Unaudited  Condensed Consolidated Statements of Stockholders’ Equity  Three months ended March 31, 2004 and 2003       |   |
|           |   |                                                                                                                        |   |
|           |   | Unaudited  Condensed Consolidated Statements of Cash Flows  Three months ended March 31, 2004 and 2003                      |   |
|           |   |                                                                                                                        |   |
|           |   | Notes  to Unaudited Condensed Consolidated Financial Statements                                                             |   |
|           |   |                                                                                                                        |   |
|           |   | Independent  Accountants’ Review Report                                                                                |   |
|           |   |                                                                                                                        |   |
| Item 2.        |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                 |   |
|           |   |                                                                                                                        |   |
| Item 3.        |   | Quantitative and  Qualitative Disclosures about Market Risk                                                                 |   |
|           |   |                                                                                                                        |   |
| Item 4.        |   | Controls and Procedures                                                                                                     |   |
|           |   |                                                                                                                        |   |
| **PART II.**   |   | **OTHER INFORMATION**                                                                                                       |   |
|           |   |                                                                                                                        |   |
| Item 6.        |   | Exhibits and Reports on  Form 8-K                                                                                           |   |
|           |   |                                                                                                                        |   |
| **SIGNATURES** |   |

 

2

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**PART I**.  FINANCIAL INFORMATION

 

**Item1**.    UnauditedCondensed Consolidated Financial Statements

** **

**INVESTORS FINANCIAL SERVICES CORP.UNAUDITED CONDENSED CONSOLIDATEDBALANCE SHEETSMarch 31, 2004 and December 31, 2003 (Dollars in thousands, except share data)**

 
|                                                                                                                                                                                                                          |   | **March 31,  2004** |       | **December  31,  2003** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|-------------------------|------------|
|                                                                                                                                                                                                                          |   |                | ** ** |                    | ** ** |
| **Assets**                                                                                                                                                                                                                    |   |                |       |                    |       |
| Cash and due from banks                                                                                                                                                                                                       |   | $                   | 45,429     |                    | $          | 39,689 |   |
| Federal Funds sold                                                                                                                                                                                                            |   | 185,000             |       | —                  |       |
| Securities held to maturity (approximate  fair value of $4,928,619 and $4,308,578 at March 31, 2004 and December 31,  2003, respectively)                                                                                     |   | 4,906,905           |       | 4,307,610               |       |
| Securities available for sale                                                                                                                                                                                                 |   | 4,387,142           |       | 4,296,637               |       |
| Nonmarketable equity securities                                                                                                                                                                                               |   | 50,000              |       | 50,000                  |       |
| Loans, less allowance for loan losses of  $100 at March 31, 2004 and December 31, 2003                                                                                                                                        |   | 153,104             |       | 199,530                 |       |
| Accrued interest and fees receivable                                                                                                                                                                                          |   | 76,451              |       | 72,816                  |       |
| Equipment and leasehold improvements, less  accumulated depreciation of $54,730 and $47,683 at March 31, 2004 and  December 31, 2003, respectively                                                                            |   | 73,943              |       | 76,420                  |       |
| Goodwill, net                                                                                                                                                                                                                 |   | 79,969              |       | 79,969                  |       |
| Other assets                                                                                                                                                                                                                  |   | 141,800             |       | 101,901                 |       |
|                                                                                                                                                                                                                          |   |                |       |                    |       |
| **Total Assets**                                                                                                                                                                                                              |   | $                   | 10,099,743 |                    | $          | 9,224,572 |   |
|                                                                                                                                                                                                                          |   |                |       |                    |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                 |   |                |       |                    |       |
| **Liabilities:**                                                                                                                                                                                                              |   |                |       |                    |       |
| Deposits:                                                                                                                                                                                                                     |   |                |       |                    |       |
| Demand                                                                                                                                                                                                                        |   | $                   | 855,696    |                    | $          | 334,823 |   |
| Savings                                                                                                                                                                                                                       |   | 3,959,080           |       | 3,682,295               |       |
| Time                                                                                                                                                                                                                          |   | 160,512             |       | 190,000                 |       |
| Total deposits                                                                                                                                                                                                                |   | 4,975,288           |       | 4,207,118               |       |
|                                                                                                                                                                                                                          |   |                |       |                    |       |
| Securities sold under repurchase agreements                                                                                                                                                                                   |   | 3,479,681           |       | 3,258,001               |       |
| Short-term and other borrowings                                                                                                                                                                                               |   | 849,704             |       | 1,098,087               |       |
| Due to brokers for open trades payable                                                                                                                                                                                        |   | 32,870              |       | —                  |       |
| Junior subordinated deferrable interest  debentures                                                                                                                                                                           |   | 24,774              |       | 24,774                  |       |
| Other liabilities                                                                                                                                                                                                             |   | 126,616             |       | 95,757                  |       |
| Total liabilities                                                                                                                                                                                                             |   | 9,488,933           |       | 8,683,737               |       |
|                                                                                                                                                                                                                          |   |                |       |                    |       |
| Commitments and contingencies                                                                                                                                                                                                 |   | —              |       | —                  |       |
|                                                                                                                                                                                                                          |   |                |       |                    |       |
| **Stockholders’ Equity:**                                                                                                                                                                                                |   |                |       |                    |       |
| Preferred stock, par value $0.01 (shares  authorized: 1,000,000; issued and outstanding: none at March 31, 2004 and  December 31, 2003)                                                                                       |   | —              |       | —                  |       |
| Common stock, par value $0.01 (shares  authorized: 100,000,000 at March 31, 2004 and December 31, 2003; issued and  outstanding:  66,027,734 and  65,436,788 at March 31, 2004 and December 31, 2003, respectively) |   | 661                 |       | 655                     |       |
| Surplus                                                                                                                                                                                                                       |   | 256,583             |       | 242,662                 |       |
| Deferred compensation                                                                                                                                                                                                         |   | (962                | )          | (1,076                  | )          |
| Retained earnings                                                                                                                                                                                                             |   | 319,961             |       | 286,138                 |       |
| Accumulated other comprehensive income, net                                                                                                                                                                                   |   | 35,117              |       | 13,006                  |       |
| Treasury stock, at cost (26,508 shares at  March 31, 2004 and December 31, 2003)                                                                                                                                              |   | (550                | )          | (550                    | )          |
| Total stockholders’ equity                                                                                                                                                                                               |   | 610,810             |       | 540,835                 |       |
|                                                                                                                                                                                                                          |   |                |       |                    |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                                           |   | $                   | 10,099,743 |                    | $          | 9,224,572 |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

3

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**INVESTORS FINANCIALSERVICES CORP.UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF INCOME AND COMPREHENSIVE INCOMEThree Months Ended March 31, 2004 and 2003 (Dollars in thousands, except pershare data)**

 
|                                              |   | **March 31,  2004** |       | **March 31,  2003** |       |
|---------------------------------------------------|--------|---------------------|------------|---------------------|------------|
| **Fees and Other Revenue:**                       |   |                | ** ** |                | ** ** |
| Asset servicing fees:                             |   |                |       |                |       |
| Core service fees                                 |   | $                   | 76,094     |                | $          | 56,761 |   |
| Ancillary service fees                            |   | 30,093              |       | 17,385              |       |
| Total asset servicing fees                        |   | 106,187             |       | 74,146              |       |
| Other operating income                            |   | 349                 |       | 770                 |       |
| Gain on sale of investment                        |   | 234                 |       | —              |       |
| Total fees and other revenue                      |   | 106,770             |       | 74,916              |       |
|                                              |   |                |       |                |       |
| Interest income                                   |   | 71,176              |       | 60,349              |       |
| Interest expense                                  |   | 25,215              |       | 21,566              |       |
| Net interest income                               |   | 45,961              |       | 38,783              |       |
| Net operating revenue                             |   | 152,731             |       | 113,699             |       |
|                                              |   |                |       |                |       |
| **Operating Expenses:**                           |   |                |       |                |       |
| Compensation and benefits                         |   | 55,323              |       | 49,771              |       |
| Transaction processing services                   |   | 10,940              |       | 6,808               |       |
| Technology and telecommunications                 |   | 10,266              |       | 9,291               |       |
| Depreciation and amortization                     |   | 7,954               |       | 6,079               |       |
| Occupancy                                         |   | 7,391               |       | 7,325               |       |
| Professional fees                                 |   | 3,238               |       | 2,951               |       |
| Travel and sales promotion                        |   | 1,082               |       | 985                 |       |
| Other operating expenses                          |   | 3,940               |       | 2,509               |       |
| Total operating expenses                          |   | 100,134             |       | 85,719              |       |
|                                              |   |                |       |                |       |
| **Income Before Income Taxes**                    |   | 52,597              |       | 27,980              |       |
|                                              |   |                |       |                |       |
| Provision for income taxes                        |   | 17,622              |       | 22,568              |       |
|                                              |   |                |       |                |       |
| **Net Income**                                    |   | $                   | 34,975     |                | $          | 5,412 |   |
|                                              |   |                |       |                |       |
| **Basic Earnings Per Share**                      |   | $                   | 0.53       |                | $          | 0.08 |   |
|                                              |   |                |       |                |       |
| **Diluted Earnings Per Share**                    |   | $                   | 0.52       |                | $          | 0.08 |   |
|                                              |   |                |       |                |       |
| **Comprehensive Income:**                         |   |                |       |                |       |
| Net income                                        |   | $                   | 34,975     |                | $          | 5,412 |   |
| Other comprehensive income:                       |   |                |       |                |       |
| Net unrealized investment gain                    |   | 23,356              |       | 6,721               |       |
| Net unrealized derivative instrument (loss)  gain |   | (1,162              | )          | 1,543               |       |
| Cumulative translation adjustment                 |   | (83                 | )          | (9                  | )          |
| Other comprehensive income                        |   | 22,111              |       | 8,255               |       |
| Comprehensive income                              |   | $                   | 57,086     |                | $          | 13,667 |   |

 

***See Notes toUnaudited Condensed Consolidated Financial Statements.***

 

4

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**INVESTORSFINANCIAL SERVICES CORP.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**ThreeMonths Ended March 31, 2004 and 2003 (Dollars in thousands, except share data)**

 
|                                                                                                      |   | **March 31,  2004** |    | **March 31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------|--------|---------------------|---------|---------------------|--------|
| **Common shares**                                                                                         |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | 65,436,788          |    | 64,775,042          |   |
| Exercise of stock options                                                                                 |   | 590,946             |    | 217,805             |   |
| Balance, end of period                                                                                    |   | 66,027,734          |    | 64,992,847          |   |
|                                                                                                      |   |                |    |                |   |
| **Treasury shares**                                                                                       |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | 26,508              |    | 10,814              |   |
| Balance, end of period                                                                                    |   | 26,508              |    | 10,814              |   |
|                                                                                                      |   |                |    |                |   |
| **Common stock**                                                                                          |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | $                   | 655     |                | $      | 648 |   |
| Exercise of stock options                                                                                 |   | 6                   |    | 2                   |   |
| Balance, end of period                                                                                    |   | 661                 |    | 650                 |   |
|                                                                                                      |   |                |    |                |   |
| **Surplus**                                                                                               |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | 242,662             |    | 233,337             |   |
| Exercise of stock options                                                                                 |   | 8,578               |    | 516                 |   |
| Tax benefit from exercise of stock options                                                                |   | 5,343               |    | 913                 |   |
| Balance, end of period                                                                                    |   | 256,583             |    | 234,766             |   |
|                                                                                                      |   |                |    |                |   |
| **Deferred compensation**                                                                                 |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | (1,076              | )       | (1,599              | )      |
| Amortization of deferred compensation                                                                     |   | 114                 |    | 141                 |   |
| Balance, end of period                                                                                    |   | (962                | )       | (1,458              | )      |
|                                                                                                      |   |                |    |                |   |
| **Retained earnings**                                                                                     |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | 286,138             |    | 198,282             |   |
| Net income                                                                                                |   | 34,975              |    | 5,412               |   |
| Cash dividend, $0.0175 and $0.0150 per  share in the periods ending March 31, 2004 and 2003, respectively |   | (1,152              | )       | (972                | )      |
| Balance, end of period                                                                                    |   | 319,961             |    | 202,722             |   |
|                                                                                                      |   |                |    |                |   |
| **Accumulated other comprehensive income, net**                                                           |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | 13,006              |    | 12,288              |   |
| Net unrealized investment gain                                                                            |   | 23,356              |    | 6,721               |   |
| Net unrealized derivative instrument (loss)  gain                                                         |   | (1,162              | )       | 1,413               |   |
| Amortization of transition-related  adjustment                                                            |   | —              |    | 130                 |   |
| Effect of foreign currency translation                                                                    |   | (83                 | )       | (9                  | )      |
| Balance, end of period                                                                                    |   | 35,117              |    | 20,543              |   |
|                                                                                                      |   |                |    |                |   |
| **Treasury stock**                                                                                        |   |                |    |                |   |
| Balance, beginning of period                                                                              |   | (550                | )       | —              |   |
| Balance, end of period                                                                                    |   | (550                | )       | —              |   |
| **Total Stockholders’ Equity**                                                                       |   | $                   | 610,810 |                | $      | 457,223 |   |

 

***See Notes toUnaudited Condensed Consolidated Financial Statements.***

 

5

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**INVESTORSFINANCIAL SERVICES CORP.UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSThree Months Ended March 31, 2004 and 2003 (Dollars in thousands)**

 
|                                                                               |   | **March 31,  2004** |       | **March 31,  2003** |       |
|------------------------------------------------------------------------------------|--------|---------------------|------------|---------------------|------------|
|                                                                               |   |                | ** ** |                | ** ** |
| **Cash Flows From Operating Activities:**                                          |   |                |       |                |       |
| Net income                                                                         |   | $                   | 34,975     |                | $          | 5,412 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                |       |                |       |
| Equity in undistributed loss of  unconsolidated subsidiary                         |   | 7                   |       | —              |       |
| Depreciation and amortization                                                      |   | 7,954               |       | 6,079               |       |
| Amortization of deferred compensation                                              |   | 114                 |       | 141                 |       |
| Amortization of premiums on securities, net  of accretion of discounts             |   | 9,465               |       | 7,097               |       |
| Gain on sale of investment                                                         |   | (234                | )          | —              |       |
| Changes in assets and liabilities:                                                 |   |                |       |                |       |
| Accrued interest and fees receivable                                               |   | (3,635              | )          | 1,135               |       |
| Other assets                                                                       |   | (39,906             | )          | (1,145              | )          |
| Other liabilities                                                                  |   | 22,021              |       | 21,089              |       |
| Net cash provided by operating activities                                          |   | 30,761              |       | 39,808              |       |
|                                                                               |   |                |       |                |       |
| **Cash Flows From Investing Activities:**                                          |   |                |       |                |       |
| Proceeds from maturities and paydowns of  securities available for sale            |   | 291,797             |       | 311,514             |       |
| Proceeds from maturities and paydowns of  securities held to maturity              |   | 281,471             |       | 533,650             |       |
| Proceeds from sale of securities available  for sale                               |   | 25,041              |       | —              |       |
| Purchases of securities available for sale                                         |   | (373,214            | )          | (542,353            | )          |
| Purchases of securities held to maturity                                           |   | (887,838            | )          | (782,669            | )          |
| Net increase (decrease) in due to brokers  for open trades payable                 |   | 32,870              |       | (203,477            | )          |
| Net increase in Federal Funds sold                                                 |   | (185,000            | )          | —              |       |
| Net decrease in loans                                                              |   | 46,426              |       | 36,555              |       |
| Purchases of fixed assets, capitalized  software and leasehold improvements        |   | (5,470              | )          | (8,795              | )          |
| Net cash used for investing activities                                             |   | (773,917            | )          | (655,575            | )          |
|                                                                               |   |                |       |                |       |
| **Cash Flows From Financing Activities:**                                          |   |                |       |                |       |
| Net increase in demand deposits                                                    |   | 520,873             |       | 53,589              |       |
| Net increase (decrease) in time and savings  deposits                              |   | 247,297             |       | (527,346            | )          |
| Net increase in securities sold under  repurchase agreements                       |   | 221,680             |       | 686,942             |       |
| Net (decrease) increase in short-term and  other borrowings                        |   | (248,383            | )          | 437,370             |       |
| Proceeds from exercise of stock options                                            |   | 8,584               |       | 518                 |       |
| Cash dividends to shareholders                                                     |   | (1,152              | )          | (972                | )          |
| Net cash provided by financing activities                                          |   | 748,899             |       | 650,101             |       |
|                                                                               |   |                |       |                |       |
| **Effect of exchange rates on cash**                                               |   | (3                  | )          | (9                  | )          |
|                                                                               |   |                |       |                |       |
| **Net Increase In Cash And Due From Banks**                                        |   | 5,740               |       | 34,325              |       |
|                                                                               |   |                |       |                |       |
| **Cash and Due From Banks, Beginning of Period**                                   |   | 39,689              |       | 14,568              |       |
|                                                                               |   |                |       |                |       |
| **Cash and Due From Banks, End of Period**                                         |   | $                   | 45,429     |                | $          | 48,893 |   |

 

*See Notes to Unaudited Condensed ConsolidatedFinancial Statements.*

 

6

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**INVESTORS FINANCIALSERVICES CORP.**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**(Information is as of and for the three months ended March 31, 2004 and 2003)

 

**1.****       Descriptionof Business**

 

Investors Financial Services Corp. (‘IFSC’) provides asset administrationservices for the financial services industry through its wholly-ownedsubsidiary, Investors Bank & Trust Company (the ‘Bank’).  As used herein, the defined term “theCompany” shall mean IFSC together with the Bank and its domestic and foreignsubsidiaries.  The Company provides coreservices and value-added services to avariety of financial asset managers, including mutual fund complexes,investment advisors, family offices, banks and insurance companies.  Core services include global custody,multicurrency accounting and mutual fund administration.  Value-added services include securitieslending, foreign exchange, cash management, performance measurement,institutional transfer agency, investment advisory services, lines of credit,middle office outsourcing and brokerage and transition managementservices.  The Company is subjectto regulation by the Federal Deposit Insurance Corporation, the Federal ReserveBoard of Governors, the Office of the Commissioner of Banks of the Commonwealthof Massachusetts, the Securities and Exchange Commission, the NationalAssociation of Securities Dealers, Inc., the Office of the Superintendent ofFinancial Institutions in Canada, the Irish Financial Services RegulatoryAuthority, and the State of Vermont Department of Banking, Insurance,Securities & Health Care Administration.

 

**2.****       InterimFinancial Statements**

 

The unaudited condensed consolidated interim financial statements ofthe Company and subsidiaries as of March 31, 2004 and December 31, 2003, andfor the three-month periods ended March 31, 2004 and 2003 have been prepared bythe Company pursuant to the rules and regulations of the Securities andExchange Commission.  Certaininformation and footnote disclosures normally included in annual financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America (‘GAAP’) have been condensed or omitted as permittedby such rules and regulations.  Alladjustments, consisting of normal recurring adjustments, necessary for theirfair presentation in conformity with GAAP are included.  Management believes that the disclosures areadequate to present fairly the financial position, results of operations andcash flows at the dates and for the periods presented. It is suggested thatthese interim financial statements be read in conjunction with the financialstatements and the notes thereto included in the Company’s latest annual reporton Form 10-K. Results for interim periods are not necessarily indicative of thoseto be expected for the full fiscal year. Certain amounts in prior financialstatements have been reclassified to conform to the current presentation.

 

***Employee Stock-BasedCompensation –*** The Company measures compensationcost for stock-based compensation plans using the intrinsic value method. Theintrinsic value method measures compensation cost as the difference of theoption exercise price and the fair market value of the common stock on themeasurement date, which is typically the date of grant.  Generally, options granted have an exerciseprice equivalent to the fair market value at the measurement date.  Accordingly, no compensation cost has beenrecorded.  If stock-based compensationwere recognized using the fair value method, stock options would be valued atgrant date using the Black-Scholes valuation model and compensation costs wouldhave decreased net income as indicated below (Dollars in thousands, exceptshare data):

 
|                                                                                                                                                |   | **For the  Three Months Ended  March 31,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                                                                |   | **2004**                                   |   | **2003** |   |
|                                                                                                                                                |   |                                       |   |   |   |
| Net income as reported                                                                                                                              |   | $                                          | 34,975 |   | $ | 5,412 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based method for all awards, net of related tax effects |   | (1,485                                     | )      | (1,684 | ) |
| Pro forma net income                                                                                                                                |   | $                                          | 33,490 |   | $ | 3,728 |   |
|                                                                                                                                                |   |                                       |   |   |   |
| Earnings per share:                                                                                                                                 |   |                                       |   |   |   |
| Basic-as reported                                                                                                                                   |   | $                                          | 0.53   |   | $ | 0.08 |   |
| Basic-pro forma                                                                                                                                     |   | $                                          | 0.51   |   | $ | 0.06 |   |
|                                                                                                                                                |   |                                       |   |   |   |
| Diluted-as reported                                                                                                                                 |   | $                                          | 0.52   |   | $ | 0.08 |   |
| Diluted-pro forma                                                                                                                                   |   | $                                          | 0.49   |   | $ | 0.06 |   |

 

7

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The fair value of each option grant was estimated on the date of grantusing the Black-Scholes valuation model with the following assumptions for thethree months ended March 31, 2004 and 2003, respectively: an average assumedrisk-free interest rate of 2.38% and 2.30%, an expected life of four years, anaverage expected volatility of 53.95% and 56.18%, and an average dividend yieldof 0.17% and 0.25%.

 

***Earnings Per Share –***Basic earnings per share (‘EPS’) were computed bydividing net income by the weighted-average number of common shares outstandingduring the year. Diluted EPS reflects the potential dilution that could occurif contracts to issue common stock were exercised into common stock that thenshared in the earnings of the Company. The reconciliation from Basic to Diluted EPS is as follows (Dollars inthousands, except share data):

 
|                                        |   | **For the Three Months Ended  March 31,** |   |
|---------------------------------------------|--------|-------------------------------------------|--------|
|                                        |   | **2004**                                  |   | **2003** |   |
|                                        |   |                                      |   |   |   |
| Income available to common stockholders     |   | $                                         | 34,975 |   | $ | 5,412 |   |
|                                        |   |                                      |   |   |   |
| Basic weighted-average shares outstanding   |   | 65,837,110                                |   | 64,885,852 |   |
| Dilutive effect of stock options            |   | 1,875,842                                 |   | 1,433,396 |   |
| Diluted weighted-average shares outstanding |   | 67,712,952                                |   | 66,319,248 |   |
|                                        |   |                                      |   |   |   |
| Earnings per share:                         |   |                                      |   |   |   |
| Basic                                       |   | $                                         | 0.53   |   | $ | 0.08 |   |
|                                        |   |                                      |   |   |   |
| Diluted                                     |   | $                                         | 0.52   |   | $ | 0.08 |   |

 

There were 722 and 3,620,549 option shares which were not considereddilutive for purposes of earnings per share calculations for the three-monthperiods ended March 31, 2004 and 2003, respectively.

 

8

----

 

**3.****       Securities**

 

Amortized cost amounts and fair values of securities are summarized asfollows as of March 31, 2004 (Dollars in thousands):

 
| **Held to Maturity**             |   | **Amortized  Cost** |      | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Fair  Value** |   |
|----------------------------------|--------|---------------------|-----------|-----------------------|--------|--------------------------|--------|-----------------|--------|
|                             |   |                |      |                  |   |                     |   |            |   |
| Mortgage-backed securities       |   | $                   | 2,807,819 |                  | $      | 19,380                   |   | $               | (1,681 | ) | $ | 2,825,518 |   |
| Federal agency securities        |   | 1,974,095           |      | 3,752                 |   | (6,715                   | )      | 1,971,132       |   |
| State and political subdivisions |   | 124,991             |      | 7,068                 |   | (90                      | )      | 131,969         |   |
|                             |   |                |      |                  |   |                     |   |            |   |
| Total                            |   | $                   | 4,906,905 |                  | $      | 30,200                   |   | $               | (8,486 | ) | $ | 4,928,619 |   |

 
| **Available for Sale**           |   | **Amortized  Cost** |      | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Fair  Value** |   |
|----------------------------------|--------|---------------------|-----------|-----------------------|--------|--------------------------|--------|-----------------|--------|
|                             |   |                |      |                  |   |                     |   |            |   |
| Mortgage-backed securities       |   | $                   | 3,685,641 |                  | $      | 43,990                   |   | $               | (4,319 | ) | $ | 3,725,312 |   |
| State and political subdivisions |   | 333,658             |      | 23,976                |   | (46                      | )      | 357,588         |   |
| Corporate debt                   |   | 177,851             |      | 111                   |   | (1,618                   | )      | 176,344         |   |
| U.S. Treasury securities         |   | 111,180             |      | 6,935                 |   | —                   |   | 118,115         |   |
| Foreign government securities    |   | 9,532               |      | 251                   |   | —                   |   | 9,783           |   |
|                             |   |                |      |                  |   |                     |   |            |   |
| Total                            |   | $                   | 4,317,862 |                  | $      | 75,263                   |   | $               | (5,983 | ) | $ | 4,387,142 |   |

 

Amortized cost amounts and fair values of securities are summarized asfollows as of December 31, 2003 (Dollars in thousands):

 
| **Held to Maturity**             |   | **Amortized  Cost** |      | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Fair  Value** |    |
|----------------------------------|--------|---------------------|-----------|-----------------------|--------|--------------------------|--------|-----------------|---------|
|                             |   |                |      |                  |   |                     |   |            |    |
| Mortgage-backed securities       |   | $                   | 2,273,466 |                  | $      | 11,596                   |   | $               | (6,310  | ) | $ | 2,278,752 |   |
| Federal agency securities        |   | 1,906,512           |      | 1,699                 |   | (12,800                  | )      | 1,895,411       |    |
| State and political subdivisions |   | 127,632             |      | 6,890                 |   | (107                     | )      | 134,415         |    |
|                             |   |                |      |                  |   |                     |   |            |    |
| Total                            |   | $                   | 4,307,610 |                  | $      | 20,185                   |   | $               | (19,217 | ) | $ | 4,308,578 |   |

 
| **Available for Sale**           |   | **Amortized  Cost** |      | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Fair  Value** |    |
|----------------------------------|--------|---------------------|-----------|-----------------------|--------|--------------------------|--------|-----------------|---------|
|                             |   |                |      |                  |   |                     |   |            |    |
| Mortgage-backed securities       |   | $                   | 3,600,924 |                  | $      | 22,658                   |   | $               | (11,602 | ) | $ | 3,611,980 |   |
| State and political subdivisions |   | 333,777             |      | 22,119                |   | (68                      | )      | 355,828         |    |
| Corporate debt                   |   | 178,394             |      | 314                   |   | (2,892                   | )      | 175,816         |    |
| U.S. Treasury securities         |   | 111,305             |      | 2,396                 |   | —                   |   | 113,701         |    |
| Federal agency securities        |   | 29,600              |      | 9                     |   | —                   |   | 29,609          |    |
| Foreign government securities    |   | 9,644               |      | 59                    |   | —                   |   | 9,703           |    |
|                             |   |                |      |                  |   |                     |   |            |    |
| Total                            |   | $                   | 4,263,644 |                  | $      | 47,555                   |   | $               | (14,562 | ) | $ | 4,296,637 |   |

 

The carrying value of securities pledged amounted to approximately $5.6billion at March 31, 2004 and December 31, 2003.  Securities are pledged primarily to secure clearings with otherdepository institutions, to secure repurchase agreements and to secureoutstanding Federal Home Loan Bank of Boston (‘FHLBB’) borrowings.

 

The Company regularly reviews its held to maturity and available forsale securities portfolios for possible impairment. At March 31, 2004, no securitieswere permanently impaired.

 

9

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**4.****       Loans**

 

Loans consist of demand loans to custody clients of the Company,including individuals, not-for-profit institutions and mutual fund clients. Theloans to mutual funds and other pooled product clients include lines of creditand advances pursuant to the terms of the custody agreements between theCompany and those clients to facilitate securities transactions andredemptions. Generally, the loans are, or may be, in the event of default,collateralized with marketable securities held by the Company as custodian.There were no impaired or nonperforming loans at March 31, 2004 and December31, 2003.  In addition, there were noloan charge-offs or recoveries during the three months ended March 31, 2004 andthe year ended December 31, 2003. Loans are summarized as follows (Dollars inthousands):

 
|                           |   | **March 31,  2004** |    | **December 31,  2003** |   |
|--------------------------------|--------|---------------------|---------|-----------------------------|--------|
|                           |   |                |    |                        |   |
| Loans to individuals           |   | $                   | 73,747  |                        | $      | 67,641 |   |
| Loans to mutual funds          |   | 47,759              |    | 104,954                     |   |
| Loans to others                |   | 31,698              |    | 27,035                      |   |
| Gross loans                    |   | 153,204             |    | 199,630                     |   |
| Less allowance for loan losses |   | (100                | )       | (100                        | )      |
|                           |   |                |    |                        |   |
| Total                          |   | $                   | 153,104 |                        | $      | 199,530 |   |

 

**5.****       SecuritiesSold Under Repurchase Agreements**

 

The components of securities sold under repurchase agreements are asfollows (Dollars in thousands):

 
|                             |   | **March 31,  2004** |      | **December  31,  2003** |   |
|----------------------------------|--------|---------------------|-----------|-------------------------|--------|
|                             |   |                |      |                    |   |
| Repurchase agreements-short term |   | $                   | 2,929,681 |                    | $      | 2,858,001 |   |
| Repurchase agreements-long term  |   | 550,000             |      | 400,000                 |   |
| Total                            |   | $                   | 3,479,681 |                    | $      | 3,258,001 |   |

 

Approximately $3.5 billion and $3.4 billion of securities were pledgedto collateralize repurchase agreements as of March 31, 2004 and December 31,2003, respectively.

 

**6.****       Short-termand Other Borrowings**

 

The components of short-term and other borrowings are as follows(Dollars in thousands):

 
|                                                 |   | **March 31,  2004** |    | **December  31,  2003** |   |
|------------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
|                                                 |   |                |    |                    |   |
| Federal Home Loan Bank of Boston long-term  advances |   | $                   | 100,000 |                    | $      | 150,000 |   |
| Federal Home Loan Bank of Boston overnight  advances |   | 400,000             |    | 250,000                 |   |
| Federal funds purchased                              |   | 349,615             |    | 697,855                 |   |
| Treasury, Tax and Loan account                       |   | 89                  |    | 232                     |   |
|                                                 |   |                |    |                    |   |
| Total                                                |   | $                   | 849,704 |                    | $      | 1,098,087 |   |

 

The Company has borrowing arrangements with the FHLBB and the FederalReserve Discount Window, which have been utilized on an overnight and long-termbasis to satisfy funding requirements. Approximately $1.8 billion and $1.9 billion of securities were pledgedto collateralize these advances as of March 31, 2004 and December 31, 2003,respectively.

 

10

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**7.****       Stockholders’Equity**

 

The Company has three stock option plans: the Amended and Restated 1995Stock Plan (‘Stock Plan’), the Amended and Restated 1995 Non-Employee DirectorStock Option Plan (‘Director Plan’), and the 1997 Employee Stock Purchase Plan(‘ESPP’).  There were no amendments tothese plans during the three months ended March 31, 2004.

 

During the three months ended March 31, 2004, the following activityoccurred under the Director Plan and the Stock Plan:

 
|                                       |   | **March 31,  2004** |   |
|--------------------------------------------|--------|---------------------|--------|
|                                       |   | **Shares**          |   | **Weighted-  Average  Exercise  Price** |   |
|                                       |   |                |   |   |   |
| Outstanding at December 31, 2003           |   | 6,547,086           |   | $ | 24 |   |
| Granted                                    |   | 14,129              |   | 38 |   |
| Exercised                                  |   | (618,293            | )      | 16 |   |
| Canceled                                   |   | (15,056             | )      | 33 |   |
| Outstanding at March 31, 2004              |   | 5,927,866           |   | $ | 25 |   |
|                                       |   |                |   |   |   |
| Outstanding and exercisable March 31, 2004 |   | 4,195,765           |   |   |   |

 

A summary of activity under the ESPP is as follows:

 
|                                                        |   | **For the  Three  Months Ended  March 31,  2004** |   | **For the  Year Ended  December 31,  2003** |   |
|-------------------------------------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------|--------|
|                                                        |   |                                              |   |                                        |   |
| Total shares available under the Plan,  beginning of period |   | 227,504                                           |   | 356,875                                     |   |
| Issued at June 30                                           |   | —                                            |   | (70,606                                     | )      |
| Issued at December 31                                       |   | —                                            |   | (58,765                                     | )      |
|                                                        |   |                                              |   |                                        |   |
| Total shares available under the Plan, end  of period       |   | 227,504                                           |   | 227,504                                     |   |

 

For the three months ended March 31, 2004, there was no stock issuanceor purchase activity under the ESPP.

 

**8.**                      EmployeeBenefit Plans

*** ***

***Pension Plan -***The Company has a trusteed, noncontributory, qualified defined benefit pensionplan covering substantially all of its employees who were hired before January1, 1997.  The benefits are based onyears of service and the employee’s compensation during employment.  Generally, the Company’s funding policy isto contribute annually the maximum amount that can be deducted for federalincome tax purposes.  Contributions areintended to provide not only for benefits attributed to service to date, butalso for benefits expected to be earned in the future. The plan document wasamended in December 2001 to freeze benefit accruals for certain highlycompensated participants as of December 31, 2001, as well as to change themaximum allowable compensation projected for future years.  Such highly compensated participants willreceive their future full benefit accrual under the Company’s nonqualifiedsupplemental retirement plan, as described below.  The Company uses a December 31 measurement date for this plan.

 

***SupplementalRetirement Plan*** - The Company also has anonqualified, unfunded, supplemental retirement plan (‘SERP’) which wasestablished in 1994 and covers certain employees and pays benefits that supplementany benefits paid under the qualified plan. Benefits under the supplemental plan are generally based on compensationnot includable in the calculation of benefits to be paid under the qualifiedplan. The Company uses a December 31 measurement date for this plan.

 

11

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Net periodic pension cost for the Company’s qualified defined benefitpension plan and supplemental retirement plan included the following components(Dollars in thousands):

 
|                                                |   | **March 31,  2004** |   | **March 31,  2003** |   |
|-----------------------------------------------------|--------|---------------------|--------|---------------------|--------|
|                                                |   | **Pension  Plan**   |   | **SERP Plan**       |   | **Pension  Plan** |   | **SERP Plan** |   |
|                                                |   |                |   |                |   |   |   |   |   |
| Service cost-benefits earned / benefit  obligations |   | $                   | 286    |                | $      | 238 |   | $ | 209 |   | $ | 219 |   |
| Interest cost on projected benefit  obligations     |   | 351                 |   | 242                 |   | 256 |   | 225 |   |
| Expected return on plan assets                      |   | (367                | )      | —              |   | (271 | ) | — |   |
| Net amortization and deferral                       |   | 62                  |   | 148                 |   | 62 |   | 162 |   |
| Net periodic pension cost                           |   | $                   | 332    |                | $      | 628 |   | $ | 256 |   | $ | 606 |   |

 

The Company expects to contribute approximately $2 to $4 million to itspension plan during 2004.  During thethree months ended March 31, 2004, the Company did not make any contribution tothe plan.

 

At March 31, 2004, the SERP plan remained an unfunded plan.  Consistent with the Company’s expectationsat December 31, 2003, no contributions to the SERP plan are anticipated during2004.

 

**9.**        Off-Balance SheetFinancial Instruments

 

***Lines of Credit****-*At March 31, 2004, the Company had commitments to individuals and mutual fundsunder collateralized open lines of credit totaling $1.0 billion, against which$83.0 million in loans were drawn. The credit risk involved in issuing lines ofcredit is essentially the same as that involved in extending demand loans. TheCompany does not anticipate any loss as a result of these lines of credit.

 

***Securities Lending****-*On behalf of its clients, the Company lends securities to creditworthybroker-dealers.  In certaincircumstances, the Company may indemnify its clients for the fair market valueof those securities against a failure of the borrower to return such securities.  The Company requires the borrowers toprovide collateral in an amount equal to, or in excess of, 102% of the fairmarket value of U.S. dollar-denominated securities borrowed and 105% of thefair market value of non-U.S. dollar-denominated securities borrowed.  The borrowed securities are revalued dailyto determine whether additional collateral is necessary.  As guarantor, the Company is required torecognize, at the inception of a guarantee, a liability for the fair value ofthe obligation undertaken in issuing the guarantee.  The Company measures the fair value of its indemnificationobligation by marking its securities lending portfolio to market on a dailybasis and comparing the value of the portfolio to the collateral holdingsposition.  The fair value of theindemnification obligation to be recorded would be the deficiency of collateralas compared to the value of the securities out on loan.

 

With respect to the indemnified securities lending portfolio, the cashand U.S. government securities held by the Company as collateral at March 31,2004 totaled $4.9 billion while the fair value of the portfolio totaledapproximately $4.7 billion.  Given thatthe collateral held was in excess of the value of the securities that theCompany would be required to replace if the borrower defaulted and failed toreturn such securities, the Company’s indemnification obligation was zero andno liability was recorded.

 

All securities loans are categorized as overnight loans. The maximumpotential amount of future payments that the Company could be required to makewould be equal to the market value of the securities borrowed.  Since the securities loans areovercollateralized by 2% (for U.S. dollar-denominated securities) to 5% (fornon-U.S. dollar-denominated securities) of the fair market value of the loanmade, the collateral held by the Company would be used to satisfy theobligation.  In addition, each borrowingagreement includes “set-off” language that allows the Company to use any excesscollateral on other loans to that borrower to cover any collateral shortfall ofthat borrower.  However, there is apotential risk that the collateral would not be sufficient to cover such anobligation if the security on loan increased in value between the time theborrower defaulted and the time the security is “bought-in.”  In such instances, the Company would“buy-in” the security using all available collateral and a loss would resultfrom the difference between the value of the security “bought-in” and the valueof the collateral held.  The Company hasnever experienced a broker default.

 

12

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**10.**            Derivative Financial Instruments

 

***Interest RateContracts*** - Interest rate contracts involve anagreement with a counterparty to exchange cash flows based on an underlyinginterest rate index.  A swap agreementinvolves the exchange of a series of interest payments, either at a fixed orvariable rate, based upon the notional amount without the exchange of theunderlying principal amount. The Company’s exposure from these interest ratecontracts results from the possibility that one party may default on itscontractual obligation when the contracts are in a gain position.  The Company has experienced no terminationsby counterparties of interest rate swaps. Credit risk is limited to the positive fair value of the derivativefinancial instrument, which is significantly less than the notional value.  During the periods presented, the Companyhad agreements to assume fixed-rate interest payments in exchange for receivingvariable market-indexed interest payments. The contractual or notional amounts of the interest rate swap agreementsheld by the Company were approximately $1.2 billion at March 31, 2004 andDecember 31, 2003. The effect of these agreements was to lengthen short-termvariable-rate liabilities into longer-term fixed-rate liabilities.  These contracts had net fair values ofapproximately $(16.8) million and $(14.9) million at March 31, 2004 andDecember 31, 2003, respectively. These fair values are included in therespective other assets and other liabilities categories on the Company’sconsolidated balance sheet.  Theseinstruments have been designated as cash flow hedges.  Changes in fair value of effective portions are included as acomponent of other comprehensive income. Changes in fair value of ineffective portions are included in netinterest income.

 

***Foreign ExchangeContracts*** - Foreign exchange contracts involve anagreement to exchange the currency of one country for the currency of anothercountry at an agreed-upon rate and settlement date.  Foreign exchange contracts consist of spot, forward and swapcontracts.  Spot contracts call for theexchange of one currency for another and usually settle in two business days.  Forward contracts call for the exchange ofone currency for another at a date beyond spot.  In a currency swap, the holder of a currency transactssimultaneously both a spot and a forward transaction in that currency for anequivalent amount of another currency to get temporary liquidity in thecurrency owned.  The Company’s risk fromforeign exchange contracts results from the possibility that one party maydefault on its contractual obligation or from movements in exchange rates.  Credit risk is limited to the positivemarket value of the derivative financial instrument, which is significantlyless than the notional value. The notional values of the Company’s foreignexchange contracts as of March 31, 2004 and December 31, 2003 were $2.7 billionand $1.6 billion, respectively. Unrealized gains or losses resulting from purchases and sales of foreignexchange contracts are included within the respective other assets and otherliabilities categories on the Company’s consolidated balance sheet.  Unrealized gains in other assets were $16.8million and $16.1 million as of March 31, 2004 and December 31, 2003,respectively.  Unrealized losses inother liabilities were $15.8 million and $15.9 million as of March 31, 2004 andDecember 31, 2003, respectively.  Foreignexchange contracts have been reduced by offsetting balances with the samecounterparty where a master netting agreement exists.  These contracts have not been designated as hedging instruments;therefore, all changes in fair value are included in asset servicing fees.

 

***Other***- The Company also enters into fixed price purchase contracts that are designedto hedge the variability of the consideration to be paid for the purchase ofinvestment securities.  By entering intothese contracts, the Company is fixing the price to be paid at a future datefor certain investment securities. At March 31, 2004 and December 31, 2003, theCompany had $742.7 million and $792.1 million, respectively, of fixed pricepurchase contracts outstanding to purchase investment securities. Changes infair value of these cash flow hedges are included as a component of othercomprehensive income.

 

13

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**11.**            Commitments and Contingencies

 

***Restrictions on CashBalances*** - The Company is required to maintaincertain average cash reserve balances. The average required reserve balancewith the Federal Reserve Bank (‘FRB’) for the two-week period including March31, 2004 was approximately $32.8 million. In addition, the Company’s other assets category includes depositstotaling approximately $67.4 million, which were pledged to secure clearingswith depository institutions.

 

***Contingencies***- Assets processed held by the Company in a fiduciary capacity are not includedin the consolidated balance sheets since such items are not assets of theCompany.  Management conducts regularreviews of its fiduciary responsibilities and considers the results inpreparing its consolidated financial statements.  In the opinion of management, there are no contingent liabilitiesat March 31, 2004 that are material to the consolidated financial position orresults of operations of the Company.

 

**12.**            Regulatory Matters

 

The Company and the Bank are subject to various regulatory capitalrequirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory and possibly additional discretionary actions byregulators that, if undertaken, could have a direct material adverse effect onthe Company’s and the Bank’s consolidated financial position and results ofoperations.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, the Bankmust meet specific capital guidelines that involve quantitative measures of theBank’s assets, liabilities, and certain off-balance sheet items as calculatedunder regulatory accounting practices. The Company’s and the Bank’s capital amounts and classification are alsosubject to qualitative judgments by the regulators about components, riskweightings, and other factors.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Company and the Bank to maintain minimum amounts andratios (set forth in the following table) of Total and Tier 1 capital (asdefined in the regulations) to risk-weighted assets (as defined), and of Tier 1capital (as defined) to average assets (as defined).  Management believes, as of March 31, 2004, that the Company andthe Bank meet all capital adequacy requirements to which they are subject.

 

As of March 31, 2004, the most recent notification from the FederalDeposit Insurance Corporation categorized the Company and the Bank aswell-capitalized under the regulatory framework for prompt correctiveaction.  To be categorized as well-capitalized,the Company and the Bank must maintain minimum Total risk-based, Tier 1risk-based, and Tier 1 leverage ratios as set forth in the followingtable.  There are no conditions orevents since that notification that management believes have changed theCompany’s or the Bank’s category.

 

14

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The following table presents the capital ratios for the Bank and theCompany (Dollars in thousands):

 
|                                                  |   | **Actual** |    | **For  Capital  Adequacy Purposes** |   | **To Be Well  Capitalized  Under Prompt  Corrective Action  Provisions** |   |
|-------------------------------------------------------|--------|------------|---------|-------------------------------------|--------|--------------------------------------------------------------------------|--------|
|                                                  |   | **Amount** |    | **Ratio**                           |   | **Amount**                                                               |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
| **As of March 31, 2004:**                             |   |       |    |                                |   |                                                                     |   |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets-the Company)  |   | $          | 520,867 |                                | 18.12  | %                                                                        | $      | 230,005 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital  (to Risk-Weighted Assets-the Bank)     |   | $          | 508,415 |                                | 17.69  | %                                                                        | $      | 229,916 |   | 8.00 | % | $ | 287,396 |   | 10.00 | % |
| Tier 1 Capital  (to Risk-Weighted Assets-the Company) |   | $          | 520,767 |                                | 18.11  | %                                                                        | $      | 115,002 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital  (to Risk-Weighted Assets-the Bank)    |   | $          | 508,315 |                                | 17.69  | %                                                                        | $      | 114,958 |   | 4.00 | % | $ | 172,437 |   | 6.00 | % |
| Tier 1 Capital  (to Average Assets-the Company)       |   | $          | 520,767 |                                | 5.49   | %                                                                        | $      | 379,281 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital  (to Average Assets-the Bank)          |   | $          | 508,315 |                                | 5.36   | %                                                                        | $      | 379,189 |   | 4.00 | % | $ | 473,987 |   | 5.00 | % |
|                                                  |   |       |    |                                |   |                                                                     |   |   |   |   |   |   |   |
| **As of December 31, 2003:**                          |   |       |    |                                |   |                                                                     |   |   |   |   |   |   |   |
| Total Capital  (to Risk-Weighted Assets-the Company)  |   | $          | 472,511 |                                | 17.79  | %                                                                        | $      | 212,479 |   | 8.00 | % | N/A |   | N/A |   |
| Total Capital  (to Risk-Weighted Assets-the Bank)     |   | $          | 466,933 |                                | 17.60  | %                                                                        | $      | 212,297 |   | 8.00 | % | $ | 265,371 |   | 10.00 | % |
| Tier 1 Capital  (to Risk-Weighted Assets-the Company) |   | $          | 472,411 |                                | 17.79  | %                                                                        | $      | 106,240 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital  (to Risk-Weighted Assets-the Bank)    |   | $          | 466,833 |                                | 17.59  | %                                                                        | $      | 106,148 |   | 4.00 | % | $ | 159,223 |   | 6.00 | % |
| Tier 1 Capital  (to Average Assets-the Company)       |   | $          | 472,411 |                                | 5.41   | %                                                                        | $      | 349,516 |   | 4.00 | % | N/A |   | N/A |   |
| Tier 1 Capital  (to Average Assets-the Bank)          |   | $          | 466,833 |                                | 5.35   | %                                                                        | $      | 349,331 |   | 4.00 | % | $ | 436,663 |   | 5.00 | % |

 

Under Massachusetts law, trust companies such as the Bank, likenational banks, may pay dividends no more often than quarterly, and only out ofnet profits and to the extent that such payments will not impair the Bank’scapital stock and surplus account. Moreover, prior Commissioner approval is required if the total dividendsfor a calendar year would exceed net profits for that year combined withretained net profits for the previous two years.  These restrictions on the ability of the Bank to pay dividends tothe Company may restrict the ability of the Company to pay dividends to itsstockholders.

 

The operations of the Company’s securities broker affiliate, InvestorsSecurities Services, Inc., are subject to federal and state securities laws, aswell as the rules of both the Securities and Exchange Commission and theNational Association of Securities Dealers, Inc.  Management believes, as of March 31, 2004, that InvestorsSecurities Services, Inc. is in material compliance with all of the foregoingrequirements to which it is subject.

 

15

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**13.**            Geographic Reporting and Service Lines

 

The Company does not utilize segment information for internal reportingas management views the Company as one segment. The following represents netoperating revenue and long-lived assets (including goodwill) by geographic area(Dollars in thousands):

 
|                        |   | **Net  Operating Revenue**                 |    | **Long-Lived  Assets** |   |
|-----------------------------|--------|--------------------------------------------|---------|------------------------|--------|
|                        |   | **For the  Three Months Ended  March 31,** |    | **March 31,**          |   | **December  31,** |   |
| **Geographic Information:** |   | **2004**                                   |    | **2003**               |   | **2004** |   | **2003** |   |
|                        |   |                                       |    |                   |   |   |   |   |   |
| United States               |   | $                                          | 145,583 |                   | $      | 109,496 |   | $ | 147,269 |   | $ | 149,631 |   |
| Ireland                     |   | 6,098                                      |    | 3,759                  |   | 6,544 |   | 6,698 |   |
| Canada                      |   | 1,006                                      |    | 427                    |   | 99 |   | 60 |   |
| Cayman Islands              |   | 44                                         |    | 17                     |   | — |   | — |   |
|                        |   |                                       |    |                   |   |   |   |   |   |
| Total                       |   | $                                          | 152,731 |                   | $      | 113,699 |   | $ | 153,912 |   | $ | 156,389 |   |

 

Barclays Global Investors, N.A. (‘BGI’) accounted for approximately 17%and 15% of the Company’s consolidated net operating revenues for thethree-month periods ended March 31, 2004 and 2003, respectively.  No client other than BGI accounted for morethan 10% of the Company’s consolidated net operating revenues for thethree-month periods ending March 31, 2004 and 2003.

 

The following represents the Company’s asset servicing fees by servicelines (Dollars in thousands):

 
|                                       |   | **For the  Three Months Ended** |    |
|--------------------------------------------|--------|---------------------------------|---------|
|                                       |   | **March 31,  2004**             |    | **March 31,  2003** |   |
|                                       |   |                            |    |   |   |
| **Asset servicing fees by service lines:** |   |                            |    |   |   |
| Core service fees:                         |   |                            |    |   |   |
| Custody, accounting and administration     |   | $                               | 76,094  |   | $ | 56,761 |   |
| Ancillary service fees:                    |   |                            |    |   |   |
| Foreign exchange                           |   | 18,495                          |    | 6,733 |   |
| Cash management                            |   | 5,600                           |    | 5,035 |   |
| Investment advisory                        |   | 3,470                           |    | 3,215 |   |
| Securities lending                         |   | 2,143                           |    | 2,188 |   |
| Other service fees                         |   | 385                             |    | 214 |   |
| Total ancillary service fees               |   | 30,093                          |    | 17,385 |   |
| Total asset servicing fees                 |   | $                               | 106,187 |   | $ | 74,146 |   |

 

**14.**            Net Interest Income

 

The components of interest income and interest expense are as follows(Dollars in thousands):

 
|                                                           |   | **For the  Three Months Ended** |   |
|----------------------------------------------------------------|--------|---------------------------------|--------|
|                                                           |   | **March 31,  2004**             |   | **March 31,  2003** |   |
| **Interest income:**                                           |   |                            |   |   |   |
| Federal Funds sold                                             |   | $                               | 162    |   | $ | 16 |   |
| Investment securities held to maturity and  available for sale |   | 69,890                          |   | 59,485 |   |
| Loans                                                          |   | 1,124                           |   | 848 |   |
| Total interest income                                          |   | 71,176                          |   | 60,349 |   |
|                                                           |   |                            |   |   |   |
| **Interest expense**:                                          |   |                            |   |   |   |
| Deposits                                                       |   | 11,369                          |   | 9,117 |   |
| Short-term and other borrowings                                |   | 13,846                          |   | 12,449 |   |
| Total interest expense                                         |   | 25,215                          |   | 21,566 |   |
|                                                           |   |                            |   |   |   |
| **Net interest income**                                        |   | $                               | 45,961 |   | $ | 38,783 |   |

 

16

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INDEPENDENT ACCOUNTANTS’ REVIEW REPORT

 

To the Board of Directors and Stockholders of

Investors Financial Services Corp.

Boston, Massachusetts

 

We have reviewed the accompanying condensed consolidated balance sheetof Investors Financial Services Corp. and subsidiaries (the “Company”) as ofMarch 31, 2004, and the related condensed consolidated statements of income andcomprehensive income for the three-month periods ended March 31, 2004 and 2003,and the consolidated stockholders’ equity and cash flows for the three-monthperiods ended March 31, 2004 and 2003. These interim financial statements are the responsibility of theCompany’s management.

 

We conducted our reviews in accordance with standards established bythe American Institute of Certified Public Accountants.  A review of interim financial informationconsists principally of applying analytical procedures and making inquiries of personsresponsible for financial and accounting matters.  It is substantially less in scope than an audit conducted inaccordance with auditing standards generally accepted in the United States ofAmerica, the objective of which is the expression of an opinion regarding thefinancial statements taken as a whole. Accordingly, we do not express such an opinion.

 

Based on our reviews, we are not aware of any material modificationsthat should be made to such condensed consolidated interim financial statementsfor them to be in conformity with accounting principles generally accepted inthe United States of America.

 

We have previously audited, in accordance with auditing standardsgenerally accepted in the United States of America, the consolidated balancesheet of Investors Financial Services Corp. and subsidiaries as of December 31,2003, and the related consolidated statements of income and comprehensiveincome, stockholders’ equity and cash flows for the year then ended (notpresented herein); and in our report dated February 20, 2004, we expressed anunqualified opinion on those consolidated financial statements.  In our opinion, the information set forth inthe accompanying condensed consolidated balance sheet as of December 31, 2003is fairly stated, in all material respects, in relation to the consolidatedbalance sheet from which it has been derived.

 

DELOITTE & TOUCHE LLP

Boston, Massachusetts

# May 7, 2004

 

17

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**Item 2**.           Management’s Discussion and Analysis ofFinancial Condition and Results of Operations

 

**Overview**

 

*You should read the following discussiontogether with our Unaudited Consolidated Financial Statements and related Notesto Unaudited Consolidated Financial Statements, which are included elsewhere inthis Report.  The following discussioncontains forward-looking statements that reflect plans, estimates andbeliefs.  Our actual results coulddiffer materially from those discussed in the forward-looking statements.*

 

We provide asset administration services forthe financial services industry through our wholly-owned subsidiary, InvestorsBank & Trust Company.  We providecore services and value-added services to a variety of financial assetmanagers, including mutual fund complexes, investment advisors, family offices,banks and insurance companies.  Coreservices include global custody, multicurrency accounting and mutual fundadministration.  Value-added servicesinclude securities lending, foreign exchange, cash management, performancemeasurement, institutional transfer agency, investment advisory services, linesof credit, middle office outsourcing and brokerage and transition managementservices.  We have offices located inthe United States, Ireland, Canada and the Cayman Islands, as well as a networkof global subcustodians in more than 90 countries.  At March 31, 2004, we provided services for approximately $1.1trillion in net assets, including approximately $183 billion in foreign netassets.

 

We grow our business by selling our servicesto new clients and by further penetrating our existing clients.  We believe that we currently service lessthan 10% of the assets managed by our existing clients, and we havetraditionally achieved significant success in growing client relationships.  Our ability to service new clients andexpand our relationships with existing clients depends on our provision ofsuperior client service.  Our growth isalso affected by overall market conditions, the regulatory environment for usand our clients and the success of our clients at marketing their products.

 

We derive our asset servicing revenue fromproviding these core and value-added services. We derive our net interest income by investing the cash balances ourclients leave on deposit with us.  Ourshare of earnings from these investments is viewed as part of the totalcompensation that our clients pay us for servicing their assets.  Our service offerings are priced on abundled basis.  In establishing a feestructure for a specific client, we analyze all expected revenue andexpenses.  We believe net operatingrevenue (net interest income plus noninterest income) and net income are themost meaningful measures of our financial results.

 

As a provider of asset administrationservices, the amount of net operating revenue that we generate is impacted byoverall market conditions, client activity, and the prevailing interest rateenvironment.  Over the course of thepast year, we have benefited from the appreciation of the market values of theassets we service for our clients. A significant portion of our core servicesrevenue is based upon the amount of assets under administration.  As market values of underlying assetsfluctuate, so will our revenue.  We havemanaged this volatility by offering a tiered pricing structure for ourasset-based fees.  As asset valuesincrease, the basis point fee is reduced for the incremental assets.  Many of our value-added services aretransactional based, and we receive a fee for each transaction processed.  We have also continued to experience netinterest margin compression in this low interest rate environment because wehave little room to reduce further the rates we pay on our interest-bearingliabilities, yet high volumes of prepayments in our investment portfolio havecaused us to reinvest these cash flows in lower-yielding assets.  We expect the Federal Open Market Committee(‘FOMC’) to begin to raise the Federal Funds rate in the second half of2004.  As such, we have structured ourbalance sheet in anticipation of this rise in rates.

 

We continue to remain focused on our salesefforts, prudent expense management and increasing operational efficiency.  These goals are complicated by our need tobuild infrastructure to support our rapid growth, maintain and enhance ourtechnology and retain and motivate our workforce.

 

In our 2003 earnings releases, in addition toreporting GAAP results, we also reported operating income and operatingearnings per share information that excluded the effect of the previouslydisclosed $13.9 million, or $0.21 per diluted share, one-time tax accrual thatwe recorded in the first quarter of 2003. The accrual resulted from a retroactive tax law change by theCommonwealth of Massachusetts disallowing a dividends received deduction takenby Investors Bank & Trust Company on dividends received since 1999 from awholly-owned real estate investment trust. In the second quarter of 2003, we settled this tax matter pursuant to anagreement to pay 50% of the liability. We believe that pro forma operating income and operating earnings pershare provide a more meaningful presentation of our results of operationsbecause they do not include the one-time tax charge which was unrelated to ourongoing operations.

 

18

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The following table presents a reconciliation between net income andearnings per share presented on the face of our Unaudited CondensedConsolidated Statements of Income and the non-GAAP measure of net operatingincome and operating earnings per share referenced in our earnings releases (Dollarsin thousands, except per share data):

 

**GAAP Earnings (unaudited)**

 
|                       |   | **For the  Three Months Ended  March 31,** |   |
|----------------------------|--------|--------------------------------------------|--------|
|                       |   | **2004**                                   |   | **2003** |   |
|                       |   |                                       |   |   |   |
| Income before taxes        |   | $                                          | 52,597 |   | $ | 27,980 |   |
| Provision for income taxes |   | 17,622                                     |   | 22,568 |   |
| Net income                 |   | $                                          | 34,975 |   | $ | 5,412 |   |
| Earnings per share:        |   |                                       |   |   |   |
| Basic                      |   | $                                          | 0.53   |   | $ | 0.08 |   |
|                       |   |                                       |   |   |   |
| Diluted                    |   | $                                          | 0.52   |   | $ | 0.08 |   |

 

**Pro Forma Operating Earnings (unaudited)**

 
|                          |   | **For the  Three Months Ended  March 31,** |   |
|-------------------------------|--------|--------------------------------------------|--------|
|                          |   | **2004**                                   |   | **2003** |   |
|                          |   |                                       |   |   |   |
| Income before taxes           |   | $                                          | 52,597 |   | $ | 27,980 |   |
| Provision for income taxes    |   | 17,622                                     |   | 8,668 | (1) |
| Net operating income          |   | $                                          | 34,975 |   | $ | 19,312 |   |
| Operating earnings per share: |   |                                       |   |   |   |
| Basic                         |   | $                                          | 0.53   |   | $ | 0.30 |   |
|                          |   |                                       |   |   |   |
| Diluted                       |   | $                                          | 0.52   |   | $ | 0.29 |   |

 

----

(1)          Provision for income taxes for the three months ended March 31, 2003excludes a $13.9 million charge, net of federal income tax benefit, related toa retroactive change in Massachusetts tax law enacted in the first quarter of2003. The effect of the exclusion is an increase in net income of $0.22 perbasic share and  $0.21 per dilutedshare.

 

**CertainFactors That May Affect Future Results**

 

From time totime, information provided by us, statements made by our employees, orinformation included in our filings with the Securities and Exchange Commission(‘SEC’) (including this Form 10-Q) may contain statements which are nothistorical facts, so-called “forward-looking statements,” and which involverisks and uncertainties.  These statements relate to future events or ourfuture financial performance and are identified by words such as “may,” “will,”“could,” “should,” “expect,” “plan,” “intend,” “seek,” “anticipate,” “believe,”“estimate,” “potential,” or “continue” or other comparable terms or thenegative of those terms.  Forward-lookingstatements in this Form 10-Q include certain statements regarding futurechanges in operating expenses (including compensation and benefits, transactionprocessing services, technology and telecommunications, depreciation andamortization, and other operating expenses), net interest income, clientfunding, the effective tax rate for 2004, hedge ineffectiveness, liquidity,annual dividend payments, interest rate conditions, interest rate sensitivity,loss exposure on lines of credit, future pension costs and funding levels, thetiming and effect on earnings of derivative gains and losses, the effect onearnings of changes in equity values and the effect of certain legal claimsagainst us.  Our actual future resultsmay differ significantly from those stated in any forward-looking statements.  Factors that may cause such differencesinclude, but are not limited to, the factors discussed below.  Each of these factors, and others, arediscussed from time to time in our filings with the SEC.

 

*Our operating results are subject tofluctuations in interest rates and the securities markets.*

 

A significant portion of our fees are based on the market value of theassets we process.  Accordingly, ouroperating results are subject to fluctuations in interest rates and securitiesmarkets as these fluctuations affect the market value of assets processed.  Current market conditions, including therecent volatility in the equity markets, can have a material effect on ourasset-based fees.  While reductions inasset servicing fees may be offset by increases in other sources of revenue, asustained downward movement of the broad equity markets will likely have anadverse impact on our earnings. Fluctuations in interest rates or the securities markets can also leadto investors seeking alternatives to the investment offerings of our clients,which could result in a lesser amount of assets processed and correspondinglylower fees.  Also, our net interestincome is earned by investing depositors’ funds and making loans.  Rapid, sustained changes in interest ratesand/or the relationship between short-

 

19

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term andlong-term interest rates could adversely affect the market value of, or theearnings produced by, our investment and loan portfolios, and thus couldadversely affect our operating results.

 

*A material portion of our revenues is derivedfrom our relationship with Barclays Global Investors, N.A. (‘BGI’) and relatedentities.*

 

As a result of our selection in 2003 toservice assets for Barclays Global Investors Canada, Ltd., our assumption ofthe operations of the U.S. asset administration unit of BGI in 2001 and ourongoing relationship with BGI’s iShares and Master Investment Portfolios, BGIaccounted for approximately 17% and 15% of our net operating revenue during thethree months ended March 31, 2004 and 2003, respectively.  We expect that BGI will continue to accountfor a significant portion of our net operating revenue.  While we provide services to BGI underlong-term contracts, those contracts may be terminated for certain regulatoryand fiduciary reasons.  The loss ofBGI’s business would cause our net operating revenue to decline and wouldlikely have an adverse effect on our quarterly and annual results.

 

*Wemay incur losses due to operational errors.*

 

The services that we provide require complexprocesses and interaction with numerous third parties.  While we maintain sophisticated computersystems and a comprehensive system of controls, and our operational history hasbeen excellent, from time to time we may make operational errors for which weare responsible to our clients.  Inaddition, even though we maintain appropriate errors and omissions and otherinsurance policies, an operational error could result in significant liabilityto us and may have a material adverse effect on our financial condition andresults of operations.

 

*We face significant competition from otherfinancial services companies, which could negatively affect our operatingresults.*

 

We are part of an extremely competitive assetservicing industry.  Many of our currentand potential competitors have longer operating histories, greater namerecognition and substantially greater financial, marketing and other resourcesthan we do.  These greater resourcescould, for example, allow our competitors to develop technology superior to ourown. In addition, we face the risk that large mutual fund complexes may buildin-house asset servicing capabilities and no longer outsource these services tous.  As a result, we may not be able tocompete effectively with current or future competitors, which could result in aloss of existing clients or difficulty in gaining new clients.

 

*We may incur significant costs defendinglegal claims.*

 

We have been named in a lawsuit inMassachusetts state court alleging, among other things, violations of acovenant of good faith and fair dealing in a contract. While we believe thisclaim is without merit, we cannot be sure that we will prevail in the defenseof this claim.  Litigation is costly andcould divert the attention of management. We may become subject to other legal claims in the future.

 

*Our future results depend, in part, onsuccessful integration of possible future acquisitions and outsourcingtransactions.*

 

Integration of acquisitions and outsourcingtransactions is complicated and frequently presents unforeseen difficulties andexpenses which can affect whether and when a particular acquisition oroutsourcing transaction will be accretive to our earnings per share.  Any future acquisitions or outsourcingtransactions will present these or similar challenges. These acquisitions andoutsourcing transactions can also consume a significant amount of management’stime.

 

*The failure to properly manage our growthcould adversely affect the quality of our services and result in the loss ofclients.*

 

We have been experiencing a period of rapidgrowth that has required the dedication of significant management and otherresources. Continued rapid growth could place a strain on our management andother resources.  To manage futuregrowth effectively, we must continue to invest in our operational, financialand other internal systems, and in our human resources.

 

*We must hire and retain skilled personnel inorder to succeed.*

 

Qualified personnel, in particular managersand other senior personnel, are in great demand throughout the financialservices industry, especially as the economy begins to recover.  We could find it increasingly difficult tocontinue to attract and retain sufficient numbers of these highly skilled employees,which could affect our ability to attract and retain clients.

 

20

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*We may not be able to protect our proprietarytechnology.*

 

Our proprietary technology is important toour business.  We rely on trade secret,copyright and trademark laws and confidentiality agreements with employees andthird parties to protect our proprietary technology, all of which offer onlylimited protection.  These intellectualproperty rights may be invalidated or our competitors may develop similartechnology independently.  Legalproceedings to enforce our intellectual property rights may be unsuccessful,and could also be expensive and divert management’s attention.

 

*Our quarterly and annual operating resultsmay fluctuate.*

 

Our quarterly and annual operating resultsare difficult to predict and may fluctuate from quarter to quarter and annuallyfor several reasons, including:

 

•                                          The timing of commencement or termination ofclient engagements;

 

•                                          The rate of net inflows and outflows of investorfunds in the investment vehicles offered by our clients; and

 

•                                          Rapid, sustained changes in interest rates andequity values.

 

Most of our expenses, like employeecompensation and rent, are relatively fixed. As a result, any shortfall in revenue relative to our expectations couldsignificantly affect our operating results.

 

*We are subject to extensive federal and stateregulations that impose complex restraints on our business.*

 

Federal and state laws and regulationsapplicable to financial institutions and their parent companies apply tous.  Our primary regulators are theFederal Reserve Board (‘FRB’), the Federal Deposit Insurance Corporation  (‘FDIC’), the Massachusetts Commissioner ofBanks and the National Association of Securities Dealers, Inc. (‘NASD’).  Virtually all aspects of our operations aresubject to specific requirements or restrictions and general regulatoryoversight including the following:

 

•                                          The FRB and the FDIC maintain capitalrequirements that we must meet. Failure to meet those requirements could leadto severe regulatory action or even receivership. We are currently consideredto be “well capitalized”;

 

•                                          Under Massachusetts law, the Bank may berestricted in its ability to pay dividends to Investors Financial, which may inturn restrict our ability to pay dividends to our stockholders;

 

•                                          The FRB and the FDIC are empowered to assessmonetary penalties against, and to order termination of activities by,companies or individuals who violate the law; and

 

•                                          The NASD maintains certain regulatoryrequirements that our securities broker affiliate, Investors SecuritiesServices, Inc. must meet.  Failure tomeet those requirements could lead to severe regulatory action.

 

Banking law restricts our ability to own thestock of certain companies and also makes it more difficult for us to beacquired.  Also, we have not electedfinancial holding company status under the federal Gramm-Leach-Bliley Act of1999.  This may place us at acompetitive disadvantage with respect to other organizations.

 

21

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**Statementsof Operations**

 

***Comparison of Operating Results for the Three Months EndedMarch 31, 2004 and 2003***

 

Net income forthe three months ended March 31, 2004 was $35.0 million, up 546% from $5.4million for the same period in 2003.  Aspreviously disclosed, we recorded a $13.9 million tax accrual during the firstquarter of 2003 relating to a specific tax assessment. Refer to *Income Taxes*within this section for further discussion regarding our settlement of this taxassessment. Absent this charge, net income for the three months ended March 31,2004 increased 81% from net operating income for the same period in 2003.  Overall the increase in net income can beattributed to growth in operating revenue and net interest income due to newbusiness, strong equity markets and a favorable interest rate environmentcoupled with the continued leverage in our business model, as net operatingrevenue grew 34% with only a 17% increase in operating expenses.

 

*Feesand Other Revenue*

 

The componentsof fees and other revenue are as follows (Dollars in thousands):

 
|                         |   | **For the  Three Months Ended  March 31,** |    |
|------------------------------|--------|--------------------------------------------|---------|
|                         |   | **2004**                                   |    | **2003** |   | **Change** |   |
|                         |   |                                       |    |   |   |   |   |
| Total asset servicing fees   |   | $                                          | 106,187 |   | $ | 74,146 |   | 43 | % |
| Other operating income       |   | 349                                        |    | 770 |   | (55 | )% |
| Gain on sale of investment   |   | 234                                        |    | — |   | 100 | % |
|                         |   |                                       |    |   |   |   |   |
| Total fees and other revenue |   | $                                          | 106,770 |   | $ | 74,916 |   | 43 | % |

 

Asset servicing fees for the three months ended March 31, 2004increased 43% to $106.2 million from the same period in 2003.  The largest components of asset servicingfees are custody, accounting and administration, which increased 34% to $76.1million.  Custody, accounting andadministration fees are based in part on the value of assets processed.  Assets processed is the total dollar value offinancial assets on the reported date for which we provide global custody ormulticurrency accounting.  The change innet assets processed includes the followingcomponents (Dollars in billions):

 
|                                      |   | **For the Three  Months Ended  March 31, 2004** |   | **For the  Three Months Ended  March 31, 2003** |   |
|-------------------------------------------|--------|-------------------------------------------------|--------|-------------------------------------------------|--------|
|                                      |   |                                            |   |                                            |   |
| Net assets processed, beginning of period |   | $                                               | 1,057  |                                            | $      | 785 |   |
| Sales to new clients                      |   | 1                                               |   | —                                          |   |
| Further penetration of existing clients   |   | 7                                               |   | 4                                               |   |
| Lost clients                              |   | (1                                              | )      | —                                          |   |
| Fund flows and market gain (loss)         |   | 67                                              |   | (5                                              | )      |
| Net assets processed, end of period       |   | $                                               | 1,131  |                                            | $      | 784 |   |

 

The majority of the increase in assetsprocessed resulted from solid equity market performance, the ability of ourclients to develop and sell product, which generates fund flows that have adirect, positive impact on our business, and strong international fundflows.  Our core services fees aregenerated by charging a fee based upon the value of assets processed.  As market values or clients’ asset levels fluctuate,so will our revenue.  Our tiered pricingstructure, coupled with minimum and flat fees, allow us to manage thisvolatility.  As asset values increase,the basis point fee typically declines, while when asset values decrease,revenue is only impacted by the asset decline at the then marginal rate.

 

If the value of equity assets held by ourclients was to increase or decrease by 10%, we estimate that this, by itself,would currently cause a corresponding change of approximately 3% in ourearnings per share.  If the value offixed-income assets held by our clients was to increase or decrease by 10%, weestimate that this, by itself, would currently cause a corresponding change ofapproximately 2% in our earnings per share. In practice, earnings per share do not track precisely to the value ofthe equity markets because conditions present in a market increase or decreasemay generate offsetting increases or decreases in other revenue items.  For example, market volatility often resultsin increased transaction fee revenue. Also, market declines may result in increased net interest income andsweep fee income as clients move larger amounts of assets into the cashmanagement vehicles that we offer. However, there can be no assurance thatthese offsetting revenue increases will occur during any future downturn in theequity markets.

 

Transaction-driven income includes ourancillary services, such as foreign exchange, cash management, securitieslending and investment advisory services. Foreign exchange fees were $18.5 million for the three months endedMarch 31, 2004,

 

22

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up 175%from the same period in 2003.  Theincrease in foreign exchange fees is attributable to new clients, furtherpenetration of existing clients, higher transaction volumes and increasedvolatility of the currencies traded by our clients.  Future foreign exchange income is dependent on the volume ofclient activity and the overall volatility in the currencies traded.  Cash management fees, which consist of sweepfees, were $5.6 million for the three months ended March 31, 2004, up 11% fromthe same period in 2003. The increase is primarily due to increased clientbalances.  Cash management revenue willcontinue to depend on the level of client balances maintained in the cashmanagement products we offer.  If ourclients’ investment products continue to maintain increasing cash balances, ourcash management revenue will be positively impacted. Investment advisory feeswere $3.5 million for the three months ended March 31, 2004, up 8% from thesame period in 2003.  The increase ininvestment advisory fees is attributable to growth in the asset size of theMerrimac Master Portfolio, an investment company for which we act asadvisor.  Future investment advisory feeincome is dependent upon asset levels within the Merrimac Master Portfoliowhich are driven by overall market conditions, client activity and transactionvolumes.  Securities lending fees were $2.1million for the three months ended March 31, 2004, down 2% from the same periodin 2003, primarily due to narrower spreads. Securities lending transaction volume is positively affected by themarket value of the securities on loan, merger and acquisition activity,increased IPO activity and a steeper short-end of the yield curve.  If the capital markets experience any of theaforementioned activity, it is likely that our securities lending revenue willbe positively impacted.  If weexperience a reduction in our securities lending portfolio, lower market valuesand continued compression of the spreads earned on securities lending activity,our securities lending revenue will likely be negatively impacted.

 

Otheroperating income consists of dividends received relating to the Federal HomeLoan Bank of Boston (‘FHLBB’) stock investment and miscellaneous fees forsystems consulting services.  For thethree months ended March 31, 2004, other operating income decreased 55%compared to the same period last year due to a lower yield paid on the FHLBBstock investment and client systems development projects completed in2003.  Operating income for the threemonths ended March 31, 2004 also included a $0.2 million gain on the sale of amortgage-backed security from our available for sale portfolio.  No securities gains were recorded for thesame period in 2003.

 

*Net Interest Income*

 
|                      |   | **For the  Three Months Ended March 31,** |   |
|---------------------------|--------|-------------------------------------------|--------|
|                      |   | **2004**                                  |   | **2003** |   | **Change** |   |
|                      |   |                                      |   |   |   |   |   |
| Interest income           |   | $                                         | 71,176 |   | $ | 60,349 |   | 18 | % |
| Interest expense          |   | 25,215                                    |   | 21,566 |   | 17 | % |
|                      |   |                                      |   |   |   |   |   |
| Total net interest income |   | $                                         | 45,961 |   | $ | 38,783 |   | 19 | % |

 

Net interest income was $46.0 million for thethree months ended March 31, 2004, up 19% from the same period in 2003.  Net interest income is affected by thevolume and mix of assets and liabilities, and the movement and level ofinterest rates. The improvement in our net interest income was the result ofbalance sheet growth driven by strong client funding and a steep yield curve.During 2004, we continued to experience high volumes of prepayments from ourinvestment portfolio.  The cash flowsfrom these prepayments were reinvested in lower yielding interest-earningassets.  We continue to run a closelymatched balance sheet by investing in low duration, variable-rate securitiesand adding interest rate swaps against client liabilities, including clientrepurchase agreements.

 

During 2004, the Company continued to employa strategy of prepaying long-term FHLBB borrowings and replacing them withlower cost funding in order to preserve net interest margin.  Although the average funding balanceincreased $2.3 billion from $6.6 billion for the three months ended March 31,2003 to $8.9 billion for the same period in 2004, the average rates paid oninterest-bearing liabilities declined. Our average rate paid oninterest-bearing liabilities was 1.20% for the three months ended March 31,2004, a 20 basis point decline from 1.40% for the same period in 2003.  The decrease was primarily the result of alower Federal Funds rate from which the majority of our funding sources arepriced.

 

23

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The table below presents the changes in netinterest income resulting from changes in the volume of interest-earning assetsor interest-bearing liabilities and changes in interest rates for the threemonths ended March 31, 2004 compared to the same period in 2003.  Changes attributed to both volume and ratehave been allocated based on the proportion of change in each category (Dollarsin thousands):

 
|                               |   | **For the  Three Months Ended  March 31, 2004** |   |
|------------------------------------|--------|-------------------------------------------------|--------|
|                               |   | **Change  Due to  Volume**                      |   | **Change  Due to  Rate** |   | **Net** |   |
|                               |   |                                            |   |   |   |   |   |
| **Interest-earning assets:**       |   |                                            |   |   |   |   |   |
| Federal Funds sold                 |   | $                                               | 151    |   | $ | (5 | ) | $ | 146 |   |
| Investment securities              |   | 18,392                                          |   | (7,987 | ) | 10,405 |   |
| Loans                              |   | 506                                             |   | (230 | ) | 276 |   |
|                               |   |                                            |   |   |   |   |   |
| Total interest-earning assets      |   | $                                               | 19,049 |   | $ | (8,222 | ) | $ | 10,827 |   |
|                               |   |                                            |   |   |   |   |   |
| **Interest-bearing liabilities:**  |   |                                            |   |   |   |   |   |
| Deposits                           |   | $                                               | 5,619  |   | $ | (3,367 | ) | $ | 2,252 |   |
| Borrowings                         |   | 591                                             |   | 806 |   | 1,397 |   |
|                               |   |                                            |   |   |   |   |   |
| Total interest-bearing liabilities |   | $                                               | 6,210  |   | $ | (2,561 | ) | $ | 3,649 |   |
|                               |   |                                            |   |   |   |   |   |
| Change in net interest income      |   | $                                               | 12,839 |   | $ | (5,661 | ) | $ | 7,178 |   |

 

In addition to investing in both variable andfixed-rate securities, we use derivative instruments to manage exposure tointerest rate risks.  We routinely enterinto interest rate swap agreements in which we pay a fixed interest rate andreceive a floating interest rate.  Thesetransactions are designed to hedge a portion of our client liabilities,including client repurchase agreements. By entering into a pay fixed/receive floating interest rate swap, aportion of our liabilities is effectively converted to a fixed-rate liabilityfor the term of the interest rate swap agreement.  Our derivatives are designated as highly effective cash flowhedges.  To the extent there is hedgeineffectiveness it is included as a component of the net interest margin.  Hedge ineffectiveness had an insignificantimpact on earnings for the three months ended March 31, 2004 and 2003.  We expect that hedge ineffectiveness willcontinue to have an insignificant effect on net interest margin in 2004.

 

We regularly run interest rate simulationmodels to understand the effect of various interest rate scenarios on ourcapital and net income.  The results ofthe income simulation model as of March 31, 2004 indicated that an upward shiftof interest rates by 200 basis points over a twelve-month period would resultin a reduction in projected net interest income of 6.17%.  We also simulate a 200 basis point rate reductionover a twelve-month period, however, in the simulation we do not reduce ratesbelow 0%. This modified simulation results in a decrease in projected netinterest income of 10.38% over the same twelve-month period.  We expect the FOMC to begin increasinginterest rates in the second half of 2004. While our simulation model projects a decrease in net interest income ina rising rate environment, we generally expect the absolute amount of netinterest income to increase, driven by higher levels of client funding andcapital. Refer to the ‘Market Risk’ section of this document for more detailedinformation regarding our income simulation methodology and policies.

 

24

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The following tables present average balances, interest income andexpense, and yields earned or paid on the major categories of assets andliabilities for the periods indicated (Dollars in thousands):

 
|                                                              |   | **Three  Months Ended March 31, 2004** |      | **Three  Months Ended March 31, 2003** |   |
|-------------------------------------------------------------------|--------|----------------------------------------|-----------|----------------------------------------|--------|
|                                                              |   | **Average  Balance**                   |      | **Interest**                           |   | **Average  Yield/Cost** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/Cost** |   |
|                                                              |   |                                   |      |                                   |   |   |   |   |   |   |   |   |   |
| **Interest-earning assets:**                                      |   |                                   |      |                                   |   |   |   |   |   |   |   |   |   |
| Federal Funds sold                                                |   | $                                      | 67,560    |                                   | $      | 162 |   | 0.96 | % | $ | 4,911 |   | $ | 16 |   | 1.30 | % |
| Investment securities(1)                                          |   | 8,858,773                              |      | 69,890                                 |   | 3.16 | % | 6,611,391 |   | 59,485 |   | 3.60 | % |
| Loans                                                             |   | 198,970                                |      | 1,124                                  |   | 2.26 | % | 115,489 |   | 848 |   | 2.94 | % |
| Total interest-earning assets                                     |   | 9,125,303                              |      | 71,176                                 |   | 3.12 | % | 6,731,791 |   | 60,349 |   | 3.59 | % |
| Allowance for loan losses                                         |   | (100                                   | )         |                                   |   |   |   | (100 | ) |   |   |   |   |
| Noninterest-earning assets                                        |   | 481,062                                |      |                                   |   |   |   | 446,005 |   |   |   |   |   |
|                                                              |   |                                   |      |                                   |   |   |   |   |   |   |   |   |   |
| Total assets                                                      |   | $                                      | 9,606,265 |                                   |   |   |   |   | $ | 7,177,696 |   |   |   |   |   |
|                                                              |   |                                   |      |                                   |   |   |   |   |   |   |   |   |   |
| **Interest-bearing liabilities:**                                 |   |                                   |      |                                   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                         |   |                                   |      |                                   |   |   |   |   |   |   |   |   |   |
| Savings                                                           |   | $                                      | 3,924,863 |                                   | $      | 11,369 |   | 1.16 | % | $ | 2,193,981 |   | $ | 9,117 |   | 1.66 | % |
| Time                                                              |   | 129                                    |      | —                                 |   | — |   | — |   | — |   | — |   |
| Securities sold under repurchase agreements                       |   | 3,691,117                              |      | 7,649                                  |   | 0.83 | % | 3,092,673 |   | 7,337 |   | 0.95 | % |
| Trust preferred stock (2)                                         |   | 24,774                                 |      | 605                                    |   | 9.77 | % | 24,000 |   | 586 |   | 9.77 | % |
| Other borrowings (3)                                              |   | 732,527                                |      | 5,592                                  |   | 3.05 | % | 855,274 |   | 4,526 |   | 2.12 | % |
| Total interest-bearing liabilities                                |   | 8,373,410                              |      | 25,215                                 |   | 1.20 | % | 6,165,928 |   | 21,566 |   | 1.40 | % |
| Noninterest-bearing liabilities:                                  |   |                                   |      |                                   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                   |   | 308,916                                |      |                                   |   |   |   | 212,569 |   |   |   |   |   |
| Savings                                                           |   | 80,953                                 |      |                                   |   |   |   | 166,897 |   |   |   |   |   |
| Noninterest-bearing time deposits                                 |   | 164,121                                |      |                                   |   |   |   | 90,000 |   |   |   |   |   |
| Other liabilities                                                 |   | 106,744                                |      |                                   |   |   |   | 94,514 |   |   |   |   |   |
| Total liabilities                                                 |   | 9,034,144                              |      |                                   |   |   |   | 6,729,908 |   |   |   |   |   |
| Equity                                                            |   | 572,121                                |      |                                   |   |   |   | 447,788 |   |   |   |   |   |
| Total liabilities and equity                                      |   | $                                      | 9,606,265 |                                   |   |   |   |   | $ | 7,177,696 |   |   |   |   |   |
| Net interest income                                               |   |                                   |      | $                                      | 45,961 |   |   |   |   |   | $ | 38,783 |   |   |   |
| Net interest margin (4)                                           |   |                                   |      |                                   |   | 2.01 | % |   |   |   |   | 2.30 | % |
| Average interest rate spread (5)                                  |   |                                   |      |                                   |   | 1.92 | % |   |   |   |   | 2.19 | % |
| Ratio of interest-earning assets to  interest-bearing liabilities |   |                                   |      |                                   |   | 108.98 | % |   |   |   |   | 109.18 | % |

 

----

(1)                    Averageyield/cost on available for sale securities is based on amortized cost.

(2)                    EffectiveOctober 1, 2003, the Company adopted provisions of FIN 46 (revised December2003), which resulted in a deconsolidation of Investors Capital Trust I, thetrust that holds the trust preferred securities.

(3)                    Interestexpense includes a penalty of $2.6 million for the three months ended March 31,2004 for prepayment of FHLBB borrowings.

(4)                    Net interestincome divided by total interest-earning assets.

(5)                    Yield oninterest-earning assets less rate paid on interest-bearing liabilities.

 

25

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*Operating Expenses*

 

Totaloperating expenses were $100.1 million for the three months ended March 31,2004, up 17% from the same period in 2003. The majority of the increase in operating expenses is in compensationand benefits expense and transaction processing services.  It is expected that only incremental expenseassociated with new business as well as commitments related to depreciation andtechnology and telecommunications will be added during the remainder of2004.  The components of operatingexpenses were as follows (Dollars in thousands):

 
|                              |   | **For the  Three Months Ended March 31,** |    |
|-----------------------------------|--------|-------------------------------------------|---------|
|                              |   | **2004**                                  |    | **2003** |   | **Change** |   |
|                              |   |                                      |    |   |   |   |   |
| Compensation and benefits         |   | $                                         | 55,323  |   | $ | 49,771 |   | 11 | % |
| Transaction processing services   |   | 10,940                                    |    | 6,808 |   | 61 | % |
| Technology and telecommunications |   | 10,266                                    |    | 9,291 |   | 10 | % |
| Depreciation and amortization     |   | 7,954                                     |    | 6,079 |   | 31 | % |
| Occupancy                         |   | 7,391                                     |    | 7,325 |   | 1 | % |
| Professional fees                 |   | 3,238                                     |    | 2,951 |   | 10 | % |
| Travel and sales promotion        |   | 1,082                                     |    | 985 |   | 10 | % |
| Other operating expenses          |   | 3,940                                     |    | 2,509 |   | 57 | % |
|                              |   |                                      |    |   |   |   |   |
| Total operating expenses          |   | $                                         | 100,134 |   | $ | 85,719 |   | 17 | % |

 

Compensation and benefits expense was $55.3million for the three months ended March 31, 2004, up 11% from the same periodin 2003, due to higher employment taxes, annual merit raises, new hires neededto support new business and higher bonuses that are directly tied to earningsper share outperformance during the first quarter of 2004.  Further increases in compensation expense in2004 will be dependent upon new business wins.

 

Transaction processing services expense was$10.9 million for the three months ended March 31, 2004, up 61% from the sameperiod in 2003, relating to subcustodian fees resulting from higher assetsprocessed and increased transaction volumes. Future transaction processingservices expense will be dependent upon asset levels and the volume of clienttransaction activity.

 

Technology and telecommunications expense was$10.3 million for the three months ended March 31, 2004, up 10% from thesame period in 2003 due to increased software license and maintenance fees, aswell as higher contract programming costs. Future technology and telecommunications expense will be dependent onthe level of new business, ongoing improvement to our infrastructure and clientintegrations.  Technology reinvestmentis targeted at approximately 18-20% of net operating revenue.

 

Depreciation and amortization expense was$8.0 million for the three months ended March 31, 2004, up 31% from thesame period in 2003. This increase resulted from the completion of capitalizedsoftware projects in late 2003 and their placement into service. Depreciationexpense is expected to continue to accrue at this rate for the remainder of2004.

 

Other operating expense was $3.9 million forthe three months ended March 31, 2004, up 57% from the same period in 2003,largely due to increased insurance premiums relating to the increasinglyexpensive market for property and casualty, director and officer andprofessional liability insurance coverages.

 

*Income Taxes*

 

Income taxeswere $17.6 million for the three months ended March 31, 2004, down 22% from thesame period in 2003 due to a one-time tax accrual recorded in the first quarterof 2003 for a tax assessment by the Commonwealth of Massachusetts Department ofRevenue, offset by increased pretax earnings and an increase in our effectivetax rate in 2004 to 33.5%.

 

In March 2003, a retroactive change in the Commonwealth ofMassachusetts tax law disallowed a dividends received deduction taken by theBank on dividends it received since 1999 from a wholly-owned real estateinvestment trust.  In the second quarterof 2003, we settled this disputed tax matter with the Massachusetts Departmentof Revenue, pursuant to an agreement to pay 50% of the liability.

 

26

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**Financial Condition**

 

At March 31,2004, our total assets were $10.1 billion, up 9% from $9.2 billion at December31, 2003, driven by strong client funding. Average interest-earning assets increased $2.4 billion, or 36%, for thethree months ended March 31, 2004 compared to the same period in 2003.  Funding for our asset growth was provided byan increase in average client balances of approximately $2.9 billion offset bya decrease in average external borrowings of approximately $0.6 billion for thethree months ended March 31, 2004.

 

*Investment Portfolio*

 

Our investment portfolio is used to invest depositors’ funds and is acomponent of our asset processing business. In addition, we use the investment portfolio to secure open positions atsecurities clearing institutions in connection with our custody services. Thefollowing table summarizes our investment portfolio as of the dates indicated(Dollars in thousands):

 
|                                |   | **March 31,  2004** |      | **December  31,  2003** |   |
|-------------------------------------|--------|---------------------|-----------|-------------------------|--------|
| **Securities held to maturity**     |   |                |      |                    |   |
| Mortgage-backed securities          |   | $                   | 2,807,819 |                    | $      | 2,273,466 |   |
| Federal agency securities           |   | 1,974,095           |      | 1,906,512               |   |
| State and political subdivisions    |   | 124,991             |      | 127,632                 |   |
|                                |   |                |      |                    |   |
| Total securities held to maturity   |   | $                   | 4,906,905 |                    | $      | 4,307,610 |   |
|                                |   |                |      |                    |   |
| **Securities available for sale**   |   |                |      |                    |   |
| Mortgage-backed securities          |   | $                   | 3,725,312 |                    | $      | 3,611,980 |   |
| State and political subdivisions    |   | 357,588             |      | 355,828                 |   |
| Corporate debt                      |   | 176,344             |      | 175,816                 |   |
| U.S. Treasury securities            |   | 118,115             |      | 113,701                 |   |
| Federal agency securities           |   | —              |      | 29,609                  |   |
| Foreign government securities       |   | 9,783               |      | 9,703                   |   |
|                                |   |                |      |                    |   |
| Total securities available for sale |   | $                   | 4,387,142 |                    | $      | 4,296,637 |   |

 

The overall increases in our held to maturity andavailable for sale portfolios are attributable to investing client deposits,including client repurchase agreements, and borrowed funds to effectivelyutilize the Bank’s capital and to accommodate client fund flows.  Our held to maturity portfolio increased$599.3 million, or 14%, to $4.9 billion at March 31, 2004 from $4.3 billion atDecember 31, 2003.  Since net interestincome is an integral part of our compensation for asset processing services,we purchase investment securities that will protect our net interest margin,while maintaining both an acceptable credit and interest rate risk profile.

 

The increase in the heldto maturity portfolio stems primarily from purchases of floating-ratemortgage-backed securities, which offer an attractive effective yield and willreprice when interest rates increase.

 

Our available for sale portfolio remained relativelyflat at $4.4 billion at March 31, 2004 compared to $4.3 billion at December 31,2003.  We continue to invest infloating-rate and adjustable-rate mortgage-backed securities in an effort tomaintain our net interest margin, diversify our portfolio with assets thatreprice more frequently, and take advantage of an attractive effective yieldand limited extension risk, which aligns with our overall asset-liabilitystrategy. Refer to the gap analysis under the ‘Market Risk’ section foradditional details regarding the matching of our interest-earning assets andinterest-bearing liabilities.

 

During the three monthsended March 31, 2004, we sold a security issued by the Government NationalMortgage Association (‘GNMA’ or ‘Ginnie Mae’) resulting in the recognition of a$0.2 million gain in noninterest income.

 

The average balance of ourcombined investment portfolios for the three months ended March 31, 2004 was$8.9 billion, with an average yield of 3.16%, compared to an average balance of$6.6 billion with an average yield of 3.60% during the same period in 2003.  The decline in yield is primarily due to theoverall low interest rate environment. Securities that matured and paid down inthe first quarter of 2004 were originally purchased in a higher interest rateenvironment, the proceeds of which are now being reinvested at lower interestrates.  In addition, prepayments havecaused us to recognize a greater amount of premium amortization associated withthe larger population of affected securities purchased through March 31, 2004.

 

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We recognized net amortization of $9.5 million for the three monthsended March 31, 2004 compared to $7.1 million of net amortization in the sameperiod of 2003.  The effect of thisadditional amortization was a lower effective yield on the investment portfolio.A significant portion of our investment portfolio is variable rate innature.  If interest rates were to riseduring 2004, we would expect slower prepayments and our overall yield toincrease as our variable-rate securities reprice.  Conversely, if interest rates were to decline in 2004, we wouldexpect that prepayments would accelerate, with the cash flows from theseprepayments being reinvested in lower-yielding assets of equal quality andrisk.

 

We invest inmortgage-backed securities, Federal agency bonds and corporate debt to increasethe total return of the investment portfolio. Mortgage-backed securities generally have a higher yield than U.S.Treasury securities due to credit and prepayment risk.  Credit risk results from the possibility thata loss may occur if a counterparty is unable to meet the terms of thecontract.  Prepayment risk results fromthe possibility that changes in interest rates may cause mortgage-backedsecurities to be paid off prior to their maturity dates.  Federal agency bonds generally have a higheryield than U.S. Treasury securities due to credit and call risk.  Credit risk results from the possibilitythat the Federal agency issuing the bonds may be unable to meet the terms ofthe bond.  Call risk is similar to prepaymentrisk and results from the possibility that fluctuating interest rates and otherfactors may result in the exercise of the call option by the Federal agencyprior to the maturity date of the bond. Credit risk related to mortgage-backed securities and Federal agencybonds is substantially reduced by payment guarantees and credit enhancements.

 

We invest in municipal securities to generate stable,tax advantaged income.  Municipalsecurities generally have lower stated yields than Federal agency and U.S.Treasury securities, but their after-tax yields are comparable.  Municipal securities are subject to creditrisk.  However, all municipal securitiesthat we invest in are insured and AAA rated.

 

*Loan Portfolio*

 

Our loanportfolio decreased $46.4 million, or 23%, to $153.1 million at March 31, 2004from $199.5 million at December 31, 2003. The majority of the decrease relatesto repayments of advances on clients’ lines of credit, partially offset by anincrease in client overdrafts. At March 31, 2004, client overdrafts were $66.9million compared to $54.3 million at December 31, 2003.

 

We make loans to individually managed accountcustomers and to mutual funds and other pooled product clients.  We offer overdraft protectionand lines of credit to our clients for the purpose of funding redemptions,covering overnight cash shortfalls, leveraging portfolios and meeting otherclient borrowing needs.  Virtually all loans to individually managedaccount customers are written on a demand basis, bear variable interest ratestied to the Prime rate or the Federal Funds rate and are fully secured byliquid collateral, primarily freely tradable securities held in custody by usfor the borrower.  Loans to mutual fundsand other pooled product clients include unsecured lines of credit that may, inthe event of default, be collateralized at our option by securities held incustody by us for those clients.  Loansto individually managed account customers, mutual funds and other pooled productclients also include advances that we make to certain clients pursuant to theterms of our custody agreements with those clients to facilitate securitiestransactions and redemptions.

 

At March 31, 2004, our only lendingconcentrations that exceeded 10% of total loan balances were the lines ofcredit to mutual fund clients discussed above. These loans were made in the ordinary course of business on the sameterms and conditions prevailing at the time for comparable transactions.

 

Our credit loss experience has beenexcellent.  There have been no loancharge-offs in the last five years, or in the history of our Company.  It is our policy to place a loan onnonaccrual status when either principal or interest becomes 60 days pastdue and the loan’s collateral is not sufficient to cover both principal andaccrued interest.  As of March 31, 2004,there were no loans on nonaccrual status, no loans greater than 90 dayspast due, and no troubled debt restructurings. Although virtually all of our loans are fully collateralized with freelytradable securities, management recognizes some credit risk inherent in theloan portfolio, and has an allowance for loan losses of $0.1 million atMarch 31, 2004, a level which has remained consistent for the past five years.  This amount is not allocated to any particularloan, but is intended to absorb any risk of loss inherent in the loanportfolio. Management actively monitors the loan portfolio and the underlyingcollateral and regularly assesses the adequacy of the allowance for loanlosses.

 

*Repurchase Agreements and Short-Term andOther Borrowings*

 

Asset growthwas funded in part by increased securities sold under repurchaseagreements.  Repurchase agreementsincreased $221.7 million, or 7%, to $3.5 billion at March 31, 2004 from $3.3billion at December 31, 2003. Repurchase agreements provide for the sale of securities for cashcoupled with the obligation to repurchase those securities on a set date or ondemand.  The majority of our repurchaseagreements are with clients. We use repurchase agreements, including clientrepurchase agreements, because they provide a lower cost source of funding thanother short-term borrowings and allow our

 

28

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clients the extra benefit ofcollateralization of their deposits.  Theaverage balance of securities sold under repurchase agreements for the threemonths ended March 31, 2004 was $3.7 billion with an average cost ofapproximately 0.83%, compared to an average balance of $3.1 billion and anaverage cost of approximately 0.95% for the same period in 2003.  The decline in the average rate paid onrepurchase agreements relates to the decline in the Federal Funds rate to whichthe repurchase agreements are linked.

 

Short-term and other borrowings decreased $248.4 million, or 23%, to$849.7 million at March 31, 2004 from $1.1 billion at December 31, 2003.  We use short-term and other borrowings tooffset variability of deposit flow.  Theaverage balance of short-term and other borrowings for the three months endedMarch 31, 2004 was $732.5 million with an average cost of approximately 3.05%,compared to an average balance of $855.3 million and an average cost ofapproximately 2.12% for the same period last year.   The average cost of borrowing for the three months ended March31, 2004 included prepayment fees of $2.6 million.  These fees were incurred to employ an asset-liability strategy inwhich we replaced a high cost borrowing with a new borrowing at a lower rateand purchased assets with a similar maturity to lock in a spread.

 

**MarketRisk**

 

We engage in investment activities toaccommodate clients’ cash management needs and to contribute to overallcorporate earnings.  Our clients, in thecourse of their financial asset management, maintain cash balances, which theycan deposit with us on a short-term basis in interest-bearing accounts orclient repurchase agreements.  We eitherdirectly invest these cash balances to earn interest income, or place thesedeposits in third-party vehicles and remit a portion of the earnings on theseinvestments to our clients after deducting a fee as our compensation for theinvestment. In the conduct of these activities, we are subject to marketrisk.  Market risk is the risk of anadverse financial impact resulting from changes in market prices and interestrates.  The level of risk we assume is afunction of our overall strategic objectives and liquidity needs, clientrequirements and market volatility.

 

The active management of market risk isintegral to our operations.  Theobjective of interest rate sensitivity management is to provide sustainable netinterest revenue under various economic conditions.  We manage the structure of interest-earning assets andinterest-bearing liabilities by adjusting their mix, yield, maturity and/orrepricing characteristics based on market conditions.  Since client deposits and repurchase agreements, our primarysources of funds, are predominantly short term, we maintain a generallyshort-term interest rate repricing structure for our interest-earningassets.  We also use term borrowings andinterest rate swap agreements to augment our management of interest rateexposure.  The effect of the interestrate swap agreements is to lengthen short-term variable-rate liabilities intolonger-term fixed-rate liabilities.

 

Our Board of Directors has set asset andliability management interest rate policies that define the overall frameworkfor managing interest rate sensitivity, including accountabilities and controlsover investment activities.  Thesepolicies delineate investment limits and strategies that are appropriate, givenour liquidity and regulatory requirements. For example, we have established a policy limit stating that projectednet interest income over the next twelve months will not be reduced by morethan 10% given a change in interest rates of up to 200 basis points (+ or -)over twelve months.  Each quarter, ourBoard of Directors reviews our asset and liability positions, includingsimulations of the effect of various interest rate scenarios on our capital.  Due to current interest rate levels, theCompany’s Board of Directors has approved a temporary exception to the 10%limit for decreases in interest rates. The Board of Directors approved the policy exception because, with theFederal Funds target rate currently at 1.00%, a 200 basis point furtherreduction would move rates into a negative position and is therefore not likelyto occur.

 

Our Board of Directors has delegatedday-to-day responsibility for oversight of the Asset and Liability Managementfunction to our Asset and Liability Committee (‘ALCO’).  ALCO is a senior management committeeconsisting of the Chief Executive Officer, the President, the Chief FinancialOfficer, the Chief Risk Officer and members of the Treasury function. ALCOmeets twice monthly.  Our primary toolin managing interest rate sensitivity is an income simulation model. Keyassumptions in the simulation model include the timing of cash flows,maturities and repricing of financial instruments, changes in marketconditions, capital planning and deposit sensitivity.  The model assumes that the composition of our interest-sensitiveassets and liabilities existing at the beginning of a period will changeperiodically over the period being measured. The model also assumes that a particular change in interest rates isreflected uniformly across the yield curve regardless of the duration tomaturity or repricing of specific assets and liabilities.  These assumptions are inherently uncertain,and as a result, the model cannot precisely predict the effect of changes ininterest rates on our net interest income. Actual results may differ from simulated results due to the timing,magnitude and frequency of interest rate changes and changes in marketconditions and management strategies.

 

The results of the income simulation model asof March 31, 2004 and 2003 indicated that an upward shift of interest rates by200 basis points over a twelve-month period would result in a reduction inprojected net interest income of 6.17% and 5.97%, respectively.  We also simulate a 200 basis point ratereduction over a twelve-month period, however, in the simulation we do notreduce rates below 0%.  This modifiedsimulation results in a decrease in projected net interest income of 10.38% and13.64% at March 31, 2004 and 2003, respectively.

 

29

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We also use gap analysis as a secondary toolto manage our interest rate sensitivity. Gap analysis involves measurement of the difference in asset andliability repricing on a cumulative basis within a specified time frame.  A positive gap indicates that moreinterest-earning assets than interest-bearing liabilities mature in a timeframe, and a negative gap indicates the opposite.  By seeking to minimize the net amount of assets and liabilitiesthat could reprice in the same time frame, we attempt to reduce the risk ofsignificant adverse effects on net interest income caused by interest ratechanges.  As shown in the cumulative gapposition in the table presented below, at March 31, 2004, interest-bearingliabilities repriced faster than interest-earning assets in the short term, ashas been typical for us.  Generallyspeaking, during a period of falling interest rates, net interest income wouldbe higher than it would have been until interest rates stabilize.  During a period of rising interest rates,net interest income would be lower than it would have been until interest ratesstabilize.  However, at the currentabsolute level of interest rates, lower interest rates may also lead to lowernet interest income due to a diminished ability to lower the rates paid oninterest-bearing liabilities, including certain client funds, as rates approachzero.  Other important determinants ofnet interest income are general interest rate levels, balance sheet growth andmix, and interest rate spreads.

 

The followingtable presents the repricing schedule of our interest-earning assets andinterest-bearing liabilities at March 31, 2004 (Dollars in thousands):

 
|                                                                                   |   | **Within Three  Months** |       | **Three to  Six  Months** |       | **Six to  Twelve  Months** |       | **One Year  to  Five Years** |       | **Over Five  Years** |       | **Total** |       |
|----------------------------------------------------------------------------------------|--------|-------------------------------|------------|---------------------------|------------|----------------------------|------------|------------------------------|------------|----------------------|------------|-----------|------------|
|                                                                                   |   |                          | ** ** |                      | ** ** |                       | ** ** |                         | ** ** |                 | ** ** |      | ** ** |
| Interest-earning assets(1)                                                             |   |                          |       |                      |       |                       |       |                         |       |                 |       |      |       |
| Federal Funds sold                                                                     |   | $                             | 185,000    |                      | $          | —                     |       | $                            | —     |                 | $          | —    |       | $ | — |   | $ | 185,000 |   |
| Investment securities (2),(3)                                                          |   | 4,928,241                     |       | 546,395                   |       | 939,244                    |       | 2,479,653                    |       | 367,644              |       | 9,261,177 |       |
| Loans - variable rate                                                                  |   | 153,192                       |       | —                    |       | —                     |       | —                       |       | —               |       | 153,192   |       |
| Loans - fixed rate                                                                     |   | —                        |       | —                    |       | —                     |       | 12                           |       | —               |       | 12        |       |
| Total interest-earning assets                                                          |   | $                             | 5,266,433  |                      | $          | 546,395                    |       | $                            | 939,244    |                 | $          | 2,479,665 |       | $ | 367,644 |   | $ | 9,599,381 |   |
| Interest-bearing liabilities:                                                          |   |                          |       |                      |       |                       |       |                         |       |                 |       |      |       |
| Savings accounts                                                                       |   | $                             | 3,852,195  |                      | $          | —                     |       | $                            | —     |                 | $          | 39,139    |       | $ | — |   | $ | 3,891,334 |   |
| Time deposits                                                                          |   | 512                           |       | —                    |       | —                     |       | —                       |       | —               |       | 512       |       |
| Interest rate contracts                                                                |   | (1,160,000                    | )          | 90,000                    |       | 180,000                    |       | 890,000                      |       | —               |       | —    |       |
| Securities sold under repurchase agreements                                            |   | 2,929,681                     |       | —                    |       | —                     |       | 550,000                      |       | —               |       | 3,479,681 |       |
| Short-term and other borrowings                                                        |   | 749,704                       |       | —                    |       | —                     |       | 100,000                      |       | —               |       | 849,704   |       |
| Trust preferred stock                                                                  |   | —                        |       | —                    |       | —                     |       | 24,774                       |       | —               |       | 24,774    |       |
| Total interest-bearing liabilities                                                     |   | $                             | 6,372,092  |                      | $          | 90,000                     |       | $                            | 180,000    |                 | $          | 1,603,913 |       | $ | — |   | $ | 8,246,005 |   |
| Net interest-sensitivity gap during the  period                                        |   | $                             | (1,105,659 | )                         | $          | 456,395                    |       | $                            | 759,244    |                 | $          | 875,752   |       | $ | 367,644 |   | $ | 1,353,376 |   |
|                                                                                   |   |                          |       |                      |       |                       |       |                         |       |                 |       |      |       |
| Cumulative gap                                                                         |   | $                             | (1,105,659 | )                         | $          | (649,264                   | )          | $                            | 109,980    |                 | $          | 985,732   |       | $ | 1,353,376 |   |   |   |
|                                                                                   |   |                          |       |                      |       |                       |       |                         |       |                 |       |      |       |
| Interest-sensitive assets as a percent of  interest sensitive liabilities (cumulative) |   | 82.65                         | %          | 89.95                     | %          | 101.66                     | %          | 111.95                       | %          | 116.41               | %          |      |       |
|                                                                                   |   |                          |       |                      |       |                       |       |                         |       |                 |       |      |       |
| Interest-sensitive assets as a percent of  total assets (cumulative)                   |   | 52.14                         | %          | 57.55                     | %          | 66.85                      | %          | 91.41                        | %          | 95.05                | %          |      |       |
|                                                                                   |   |                          |       |                      |       |                       |       |                         |       |                 |       |      |       |
| Net interest-sensitivity gap as a percent  of total assets                             |   | (10.95                        | )%         | 4.52                      | %          | 7.52                       | %          | 8.67                         | %          | 3.64                 | %          |      |       |
|                                                                                   |   |                          |       |                      |       |                       |       |                         |       |                 |       |      |       |
| Cumulative gap as a percent of total assets                                            |   | (10.95                        | )%         | (6.43                     | )%         | 1.09                       | %          | 9.76                         | %          | 13.40                | %          |      |       |

 

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(1)                    Adjustablerate assets are included in the period in which interest rates are nextscheduled to adjust rather than in the period in which they are due.  Fixed-rate loans are included in the periodin which they are scheduled to be repaid.

(2)                    Mortgage-backedsecurities are included in the pricing category that corresponds with theearlier of their first repricing date or principal paydown schedule generatedfrom industry sourced prepayment projections.

(3)                    Excludes $32.9million of unsettled securities purchases as of March 31, 2004.

 

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**Liquidity**

 

Liquidityrepresents the ability of an institution to meet present and future financialobligations through either the sale or maturity of existing assets or theacquisition of additional funds through liability management.  For a financial institution such as ours,these obligations arise from the withdrawals of deposits and the payment ofoperating expenses.

 

Our primarysources of liquidity include cash and cash equivalents, Federal Funds sold,Federal Reserve Discount Window, client deposits, short-term borrowings,interest and principal payments on securities held to maturity and availablefor sale, and fees collected from asset administration clients.  As a result of our management of liquidassets and the ability to generate liquidity through deposits and repurchaseagreements, management believes that we maintain overall liquidity sufficientto meet our depositors’ needs, to satisfy our operating requirements and tofund the payment of an anticipated annual cash dividend of $0.07 per share for2004 (approximately $4.6 million based upon 66,027,734 shares outstandingas of March 31, 2004).

 

Our ability topay dividends on Common Stock may depend on the receipt of dividends from theBank. Any dividend payments by the Bank are subject to certain restrictionsimposed by the Massachusetts Commissioner of Banks.  During all periods presented in this report, the Company did notrequire dividends from the Bank in order to fund the Company’s owndividends.  In addition, we may not paydividends on our Common Stock if we are in default under certain agreements enteredinto in connection with the sale of our Capital Securities.  The Capital Securities were issued byInvestors Capital Trust I, a Delaware statutory business trust sponsored by us,and qualify as Tier 1 capital under the capital guidelines of the FederalReserve.

 

We haveinformal borrowing arrangements with various counterparties.  Each counterparty has agreed to make fundsavailable to us at the Federal Funds overnight rate.  The aggregate amount of these borrowing arrangements as of March31, 2004 was $2.5 billion.  Eachbank may terminate its arrangement at any time and is under no contractualobligation to provide us with requested funding.  Our borrowings under these arrangements are typically on anovernight basis.  We cannot be certain,however, that such funding will be available. Lack of availability of liquid funds could have a material adverseimpact on our operations.

 

We also haveMaster Repurchase Agreements in place with various counterparties.  Each broker has agreed to make fundsavailable to us at various rates in exchange for collateral consisting ofmarketable securities. The aggregate amount of available borrowings under thesearrangements at March 31, 2004 was $4.1 billion.

 

We also have aborrowing arrangement with the FHLBB. We may borrow amounts determined by prescribed collateral levels and theamount of FHLBB stock we hold.  We arerequired to hold FHLBB stock equal to no less than (i) 1% of ouroutstanding residential mortgage loan principal (including mortgage pool securities)or (ii) total advances from the FHLBB, divided by a leverage factor of20.  The aggregate amount of borrowingavailable to us under this arrangement at March 31, 2004 was $3.3 billion.  The amount outstanding under thisarrangement at March 31, 2004 was $0.5 billion.

 

On April 19, 2004, the FHLBB implemented anew capital structure mandated for all Federal Home Loan Banks by theGramm-Leach-Bliley Act of 1999 and regulations that were subsequentlypromulgated in 2001 by the FHLBB’s regulator, the Federal Housing FinanceBoard.  The Bank’s capital stockinvestment in the FHLBB will remain at its current level of $50 million underthe new capital plan.  The $50 millioncapital stock investment includes both a $25 million membership component and a$25 million activity-based component. Under the new capital plan, the FHLBB capital stock investments requirea five-year advance notice of withdrawal. The Bank’s $50 million capital stock investment in the FHLBB willprovide a borrowing capacity of approximately $555 million.

 

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**Capital Resources**

 

Historically, we have financed our operations principally throughinternally generated cash flows.  Weincur capital expenditures for furniture, fixtures, capitalized software andmiscellaneous equipment needs.  Capitalexpenditures have been incurred and operating leases entered into on anas-required basis, primarily to meet our growing operating needs.  As a result, our capital expenditures were$5.5 million and $8.8 million for the three months ended March 31, 2004and 2003, respectively.  For the threemonths ended March 31, 2004, capital expenditures were comprised ofapproximately $3.0 million in capitalized software and projects in process and$2.5 million in fixed assets.  For thethree months ended March 31, 2003, capital expenditures were comprised ofapproximately $3.5 million in capitalized software and projects in process,$1.2 million in fixed assets and $4.1 million in leasehold improvements.  Leasehold improvement expenditures for thethree months ended March 31, 2003 were related to increased space in our Dublinoffice, which was needed to support new business.

 

Stockholders’ equity at March 31, 2004 was $610.8 million, up 13%from December 31, 2003, primarily due to net income growth and increased othercomprehensive income due to the appreciation of our available for salesecurities portfolio.  The ratio ofaverage stockholders’ equity to average assets remained constant atapproximately 6% for March 31, 2004 and December 31, 2003.

 

The FRB has adopted a system usinginternationally consistent risk-based capital adequacy guidelines to evaluatethe capital adequacy of banks and bank holding companies. Under the risk-basedcapital guidelines, different categories of assets are assigned different riskweights, based generally upon the perceived credit risk of the asset. Theserisk weights are multiplied by corresponding asset balances to determine a“risk-weighted” asset base. Certain off-balance sheet items are added to therisk-weighted asset base by converting them to a balance sheet equivalent andassigning them the appropriate risk weight.

 

FRB and FDIC guidelines require that bankingorganizations have a minimum ratio of total capital to risk-adjusted assets andoff-balance sheet items of 8.0%. Total capital is defined as the sum of “Tier1” and “Tier 2” capital elements, with at least half of the total capitalrequired to be Tier 1. Tier 1 capital includes, with certain restrictions, thesum of common stockholders’ equity, noncumulative perpetual preferred stock, alimited amount of cumulative perpetual preferred stock, and minority interestsin consolidated subsidiaries, less certain intangible assets. Tier 2 capitalincludes, with certain limitations, subordinated debt meeting certain requirements,intermediate-term preferred stock, certain hybrid capital instruments, certainforms of perpetual preferred stock, as well as maturing capital instruments andgeneral allowances for loan losses.  OurTotal and Tier 1 capital ratios at March 31, 2004 were 18.12% and 18.11%,respectively, which are in excess of minimum requirements.  The Bank’s Total and Tier 1 capital ratiosat March 31, 2004 were each 17.69%, which are in excess of minimumrequirements.

 

In addition to the risk-based capital guidelines, the FRB and the FDICuse a “Leverage Ratio” as an additional tool to evaluate capital adequacy.  The Leverage Ratio is defined to be acompany’s Tier 1 capital divided by its adjusted average total assets.  The Leverage Ratio adopted by the federalbanking agencies requires a ratio of 3.0% Tier 1 capital to adjusted averagetotal assets for top-rated banking institutions.  All other banking institutions are expected to maintain aLeverage Ratio of 4.0% to 5.0%. The computation of the risk-based capital ratiosand the Leverage Ratio requires that the capital of Investors Financial andthat of Investors Bank be reduced by most intangible assets.  Our Leverage Ratio at March 31, 2004was 5.49%, which is in excess of regulatory minimums. Investors Bank’s LeverageRatio at March 31, 2004 was 5.36%, which is also in excess of regulatoryminimums.

 

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**Item 3**.           Quantitative andQualitative Disclosures about Market Risk

 

The information required by this item is contained in the ‘Market Risk’section in the ‘Management’s Discussion and Analysis of Financial Condition andResults of Operations,’ as part of this Report.

 

**Item 4**.           Controls and Procedures

 

We evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures as of March 31, 2004. Our disclosure controls and procedures are the controls and otherprocedures that we designed to ensure that we record, process, summarize andreport in a timely manner the information we must disclose in reports that wefile or submit to the SEC.  Kevin J.Sheehan, our Chairman and Chief Executive Officer, and John N. Spinney, Jr.,our Senior Vice President and Chief Financial Officer, reviewed andparticipated in this evaluation.  Basedon this evaluation, Messrs. Sheehan and Spinney concluded that, as of the dateof the evaluation, our disclosure controls and procedures were effective.

 

As a result of the evaluation completed by us, and in which Messrs.Sheehan and Spinney participated, we have concluded that no changes occurredduring our fiscal quarter ended March 31, 2004 in our internal controls overfinancial reporting, which changes have materially affected, or are reasonablylikely to materially affect, our internal controls over financial reporting.

 

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**PARTII**.  OTHERINFORMATION

 

**Item6**.  Exhibits and Reports on Form 8-K.

 

**(a)**          Exhibits

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                  |
|------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **31.1**         |   | **Certification of Kevin J. Sheehan, Chief Executive  Officer**                                                                                                                                                                  |
|             |   |                                                                                                                                                                                                                             |
| **31.2**         |   | **Certification of John N. Spinney, Jr., Chief Financial  Officer**                                                                                                                                                              |
|             |   |                                                                                                                                                                                                                             |
| **32.1**         |   | **Certification of Kevin J. Sheehan, Chief Executive  Officer, and John N. Spinney, Jr., Chief Financial Officer, pursuant to 18  U.S.C. Section 1350, as adopted, pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.** |

 

**(b)**         A Form 8-K was furnished to the Securities and Exchange Commission onJanuary 22, 2004 furnishing information pursuant to Item 12 (Results ofOperation and Financial Condition) relating to the press release of Investors FinancialServices Corp. dated January 22, 2004 reporting Investors Financial ServicesCorp.’s financial results for the fiscal quarter ended December 31, 2003.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                    |   |   | **INVESTORS FINANCIAL SERVICES CORP.**             |
|-------------------------|--------|--------|----------------------------------------------------|
|                    |   |   |                                               |
| Date:  May 7, 2004 |   | By:    | /s/ Kevin J. Sheehan                               |
|                    |   |   | Kevin J. Sheehan                                   |
|                    |   |   | Chairman and Chief  Executive Officer              |
|                    |   |   |                                               |
|                    |   |   |                                               |
|                    |   | By:    | /s/ John N. Spinney,  Jr.                          |
|                    |   |   | John N. Spinney, Jr.                               |
|                    |   |   | Senior Vice President  and Chief Financial Officer |
|                    |   |   | (Principal Financial  and Accounting Officer)      |

 

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