As the big banks report fourth-quarter earnings, the biggest questions have been revolving around their stress tests and credit losses. In early 2020, most banks instituted the current expected credit losses (CECL) format, which tries to estimate losses over an entire economic cycle. This coincided with the beginning of the COVID-19 pandemic, and banks generally took large precautionary writedowns in anticipation of losses down the line. While those credit losses have remained well-contained -- so far -- banks have felt the effects of lower benchmark interest rates as the Federal Reserve has dropped the fed funds rate to near zero.

But this has hurt some more than others: Trust banks like Bank of New York Mellon (NYSE:BK) have particularly noticeable issues when rates are close to the zero bound. These effects were evident in the fourth-quarter earnings report it delivered Wednesday.

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Trust banks have a different business model

Typical commercial banks take deposits and make loans -- an old, easy-to-understand business model. Trust banks do those things too, but a large portion of their business is custodial banking. Some of the biggest U.S. corporations and asset managers keep their funds at Bank of New York Mellon. It then administers these funds on behalf of the customer, which includes things like sending bond interest payments to the right parties and processing investments or redemptions for mutual funds. In addition, Bank of New York Mellon is in the asset management business, and clears transactions for most of the fixed-income trades in the U.S. market through its clearing firm, Pershing.

For the fourth quarter, Bank of New York Mellon earned $0.79 per share, compared to $1.52 a share in the prior-year period. These numbers are in accordance with generally accepted accounting principles (GAAP). However, some extraordinary items distorted the results, including gains and losses on business sales, severance, litigation, and other expenses. If these items are stripped out, earnings per share fell slightly, from $0.98 to $0.96. One of the big drivers of the decline was money market fee waivers. Bank of New York Mellon manages money market funds, and normally, it can charge management fees to investors in them. However, money market funds are not supposed to have negative returns (i.e. "break the buck"), so if the interest earned on the funds doesn't cover the cost of administering them, the bank has to waive the management fees -- and eat the costs. These money market fee waivers decreased non-GAAP fee revenue by 4%.

Lower interest rates eat into fee income

Lower interest rates will continue to affect the bank. However, its other businesses have been performing reasonably well, as investment and wealth management revenue increased 2%, assets under management increased 15%, and pre-tax income rose 30%. More than 80% of Bank of New York Mellon's revenue comes from fees, which means it has a lot less credit risk than the typical commercial bank. The pandemic has depressed commercial real estate prices, creating issues that many commercial banks will need to work through. Trust banks are generally more stable over the credit cycle.

Bank of New York Mellon is currently trading at 10.6 times expected 2021 earnings per share. Historically, the stock has usually commanded a higher multiple due to its more stable business model.

BK PE Ratio Chart

BK PE Ratio data by YCharts

As more of the population receives the COVID-19 vaccine and the economic effects of the pandemic fade, banks' earnings multiples should probably expand. Note that the last time benchmark interest rates were stuck at the zero bound (pre-2015), Bank of New York Mellon had a much higher multiple, and it traded with a higher multiple during the rate-hike cycle. After the first quarter of 2021, the tough year-over-year comparisons will end, as rates went to zero in March. Bank of New York Mellon also has a reasonable dividend that at current share prices yields 3%, which makes the stock worth considering for income investors. 

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