With the US economy slowing due to interest rate hikes, the financial sector worried about a looming recession in 2023. A recession will almost certainly increase loan losses, which will hurt banks. In such an environment, banks that focus on fee income have an easier time. Bank of New York Mellon (BK -0.63%) has an unusual business model that could make sense in this environment.
Trust banks mainly generate fee income
The Bank of New York Mellon was founded by Alexander Hamilton in 1784 and was the first stock to be traded on the New York Stock Exchange. The company is known as a trust bank, meaning it acts as a custodian for companies and wealth managers. Bank of New York Mellon has three business units: Securities Services, Market and Wealth Services, and Investment and Wealth Management.
Securities Services accounts for the bulk of Bank of New York Mellon’s revenue. This is the custody side of the business, which includes mutual fund, exchange traded fund and securities lending services. If you ever go short a stock, you need to get a “loan,” which means you need to find someone to lend you the stock. The Bank of New York Mellon is one of the biggest players in securities lending, and the company earns a fee for stocks it borrows (usually from mutual funds whose shares are held there).
Among other things, the Bank of New York manages inflows and outflows for mutual funds, handles fund accounting and ensures that payments go where they need to go. The Securities Services segment also provides corporate trusteeship services, such as maintaining trustee accounts, processing principal and interest on-lending for bond issuers, and other services. The beauty of the securities services business is that the credit risk is very low. It’s pretty much pure fee income.
The Market and Wealth Services business includes securities clearing, another fee-based service. The clearing house settles a trade on settlement day, ensuring that the buyer has the money and the seller has the securities. This segment also includes treasury services that handle liquidity and cash management for companies. Investment and Wealth Management is the last line that includes wealth management, advisory and active management.
Rising interest rates should help boost revenue
The post-pandemic landscape has been a bit difficult for Bank of New York Mellon as it manages many money market funds that are not allowed to post losses. This means that the Bank of New York Mellon had to forego management fees for these funds because short-term interest rates were so low that very little income was generated from them. The bank still had to bear the costs of managing these funds, which weighed on revenues until interest rates began to rise.
Fourth quarter and 2022 results were negatively impacted by market movements. The Bank of New York gets a percentage of the assets under management, and when the stock market falls, the value of the assets under management also falls, which means lower fees. Year-over-year, earnings were flat compared to 2021, although the company suffered a loss as it repositioned its bond portfolio. It sold some of its lower-yielding bonds and replaced them with higher-yielding bonds. This required the company to take a loss upfront, but it will mean increased revenue going forward. Excluding bond repositioning and other special items, fourth-quarter revenue rose 9% and earnings per share rose 25%.
A slower growth but stable in a recession
The Bank of New York Mellon is generally developing steadily and growing more or less in line with the broader economy. It should rise better in a recession and not be exciting in a bull market. Bank of New York Mellon trades at 9.3 times forward 2023 earnings per share and has a dividend yield of 3%. Bank of New York should be viewed as a defensive financial stock and could be a good stock to switch to if you think the US is headed for recession and credit losses will widen.