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Bank of New York's Growing Pains

Bank of New York's (NYSE: BK  ) operating performance may have slipped in the third quarter, but management was happy to explain why investors should not be concerned about long-term growth trends.

Overall, net income from continuing operations fell from $391 million in the second quarter to $360 million in the third quarter, or from $0.52 per diluted share to $0.47 (excluding merger and integration costs). This downturn in the bottom line was partly the result of rising expenses, but largely caused by falling revenues. Bank of New York saw net interest income slip by 1% in the quarter, while noninterest income dropped by nearly 8%. According to management, this negative swing in the bank's fortunes was related to seasonal factors and accounting rules rather than a shift in fundamental outlook.

The third quarter also saw a seasonal slowdown in trading volumes and market volatility for Bank of New York. This Q3 decline in market activity is a usual event, and it directly impacts the fee income earned by custody banks like Bank of New York. Servicing fees related to the company's huge custody function now represent nearly two-thirds of the firm's noninterest income.

Accounting rules required Bank of New York to prepare a somewhat distorted presentation of its ongoing business condition. Earlier this year, the company reached an agreement to swap its retail banking unit for the corporate trust business of JPMorgan Chase (NYSE: JPM  ) . Although that transaction had not yet closed in the third quarter, the firm reported its retail bank results as "discontinued operations," but did not report the results of the trust business it was in the process of acquiring. Consequently, the third-quarter snapshot of the bank's revenues and net income from continuing operations did not represent the full scope of its business activities.

Moreover, growth trends appear intact when Bank of New York's results are examined on a year-over-year basis, with net income increasing 10% from the third quarter of 2005. Indeed, long-term prospects for Bank of New York look strong, with the bank focused squarely on its core asset servicing and custody operations. The firm is the second largest custody bank behind JPMorgan Chase, and this business line has been more profitable and less risky than the consumer and middle market lending functions of the discontinued retail bank unit. In addition, the globalization of capital markets and the expansion of the hedge fund industry are creating a need for higher-margin services related to the custody function, such as securities lending and foreign exchange trading. This growth in demand promises to benefit the dominant custody banks like Bank of New York, State Street (NYSE: STT  ) , and Citigroup (NYSE: C  ) .

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Fool contributorMichael Leibert welcomes your feedback. He owns shares of Bank of New York. The Fool has a disclosure policy.

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