As interest rates move higher, more and more market participants get concerned about a potential recession. Historically, Federal Reserve policy hits the market with a lag, which is generally thought to be between nine months and two years for the full effect. This means that the rate hikes from this year are only beginning to really be felt by companies, and the long string of 75 basis point hikes this year probably has yet to truly impact the economy.
If growth slows down markedly going forward, many banks will likely experience elevated credit losses. Here is why Bank of New York Mellon (BK -0.61%) is probably more insulated than most from this adversity.
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Trust banks make most of their money from fees
Bank of New York Mellon is a trust bank, which means that it provides services to big institutional investors and corporations. Mutual funds will use a trust bank like Bank of New York Mellon to hold the fund's securities, process inflows and outflows, manage fund accounting and provide all sorts of ancillary services. Corporations might use Bank of New York for Treasury services, which include cash flow management and custody. Bank of New York Mellon also owns Pershing, which is a clearing firm for fixed-income trades. Clearing firms handle securities transactions and make sure the seller has the securities and the buyer has the money before consummating the trade.
Bank of New York Mellon has a somewhat different business model than the typical commercial bank. Generally speaking, most commercial banks make money by taking deposits and making loans. This is a highly cyclical business that often correlates with the economy. In other words, when the economy is doing well, borrowers tend to make their payments. When the economy weakens, borrowers tend to get into trouble, and performance slips.
The big difference between trust banks and commercial banks is in the source of revenue. Commercial banks generate most of their income from lending activities, while trust banks generate most of their income from fees. Fee income is often recurring and doesn't have the credit risk that, say, a commercial and industrial loan might have. This makes the company's income stream more resilient, especially if the economy worsens and defaults start increasing.
The bank is less sensitive to the economy but is not immune to a recession
While it is insulated, Bank of New York Mellon is not immune to market risk. The bank is often paid a fee based on assets under management, and that fee drops as assets under management fall. Over the past quarter, much of that was due to weak stock and bond markets. For Bank of New York Mellon, higher interest rates are generally a good thing, since it was forced to waive fees on money market accounts in order to ensure these funds "didn't break the buck" when interest rates were close to zero during the COVID-19 pandemic.
Bank of New York Mellon is trading at 9.8 times its expected 2022 earnings per share. Aside from the early days of the COVID-19 pandemic, Bank of New York Mellon is trading toward its historic low price-to-earnings ratio.
BK PE Ratio data by YCharts
The company's dividend yield is 3.9%, which is well in excess of the SPDR S&P 500 Bank ETF. For investors, Bank of New York Mellon is a port in the storm if the economy has a hard landing.
