The planned merger of Bank of New York (NYSE: BK ) and Mellon Financial (NYSE: MEL ) seems compelling by virtue of the scale and market dominance that the combination would achieve. The Bank of New York Mellon Corporation, as the firm would be known, is expected to be the largest custody bank, with more than $16 trillion of assets under custody. By comparison, JP Morgan Chase (NYSE: JPM ) , currently the largest custody bank, has around $13 trillion in assets under custody. The merger would also enhance Mellon's strength in asset management, placing the new firm among the world's top 10 asset managers, with more than $1 trillion in assets under management.
Investors have reacted positively to the merger announcement. Shares of Bank of New York closed yesterday at $39.75, a 12% increase over Friday's price. Mellon stock closed at $42.78, a nearly 7% increase for the day. Besides increased market shares, what other factors are contributing to investor enthusiasm for this deal?
Expected cost savings is a good starting point for measuring the benefits of this merger. The average expense savings from recent mergers of financial services firms is 9.1%. Executives of BoNY and Mellon project expense reductions of $700 million or approximately 8.5% of the firms' combined expenses in 2006. Assuming stable revenues, the lower expense structure of the combined firm would increase pre-tax earnings by 18% to $4.5 billion. Merger-related charges of $1.3 billion would initially dilute per-share earnings for BoNY shareholders, but the deal would be immediately accretive to Mellon shareholders on a per-share basis. Cash earnings would be immediately accretive to all shareholders.
In fact, management may be understating potential savings from this merger. There is a high fixed cost associated with building and maintaining the systems that process client transactions, keep records, facilitate cross-border activities, and perform other related functions at a custody bank. Such services are generally standardized rather than relationship-oriented, and the marginal cost of servicing an additional client is relatively low. This operating leverage should make it easier to identify redundancies in the technology expenditures and employee functions of BoNY and Mellon. Accordingly, management seems conservative in projecting below-average cost savings compared to the mergers of other, more diversified financial services companies.
The complementary profiles of BoNY and Mellon suggest that an opportunity to realize meaningful synergies is another potential benefit of the merger of these two firms. BoNY's list of custody clients is broad, but the firm has had less success capturing business from giant pension funds and endowments. Mellon's custody business, on the other hand, counts many pension funds and endowments among its most prominent clients, but the relationships remain underdeveloped. In a combined firm, BoNY's higher-margin services, such as foreign exchange and securities lending, could be sold to those new custody clients. Similarly, Mellon's superior asset management capabilities could be targeted to existing BoNY clients.
Executives of BoNY and Mellon identify international expansion as an important strategic goal, and a larger custody firm would be in a better position to develop new markets. The U.S. market for custody is relatively mature. European and, increasingly, Asian markets will provide most new business to global custody firms. The combination of BoNY and Mellon would be distinguished by a bigger global footprint and deeper experience with the complex cross-border transactions required by international clients.
After suffering years of underwhelming stock performance, investors in Bank of New York and Mellon should be optimistic about the prospects for the combined firm. The merger promises to produce substantial improvements in profitability and help develop new revenue opportunities. The virtues of this merger seem so compelling, it will be interesting to see whether other prominent custody banks such as JP Morgan, State Street (NYSE: STT ) , and Citigroup (NYSE: C ) feel pressure to match the new leader's scale.