With the U.S. economy slowing down because of rate hikes, the financial sector worried about a looming recession in 2023. A recession will almost certainly increase credit losses, which will be a negative for the banks. In this sort of environment, banks that focus on fee income will have an easier time. Bank of New York Mellon (BK 1.18%) has an unusual business model that might make sense in this environment.
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Trust Banks mainly earn fee income
Bank of New York Mellon was established by Alexander Hamilton in 1784 and was the first stock traded on the New York Stock Exchange. The company is known as a trust bank, which means it acts as a custodian for corporations and asset 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 majority of Bank of New York Mellon's revenues. This is the asset custody side of the business, which includes services for mutual funds, exchange-traded funds, and security lending. If you ever short a stock, you have to get a "borrow," which means you have to find someone to lend the stock to you. Bank of New York Mellon is one of the biggest players in securities lending, and the company earns a fee on stocks borrowed (typically from mutual funds that have their shares held there).
The Bank of New York also manages inflows and outflows for mutual funds, handles fund accounting, and ensures that payments get routed where they need to go, among other services. The Securities Services segment also performs trust services for corporations, such as holding escrow accounts, handling the forwarding of principal and interest for bond issuers, and other services. The beautiful thing about the securities services business is that there is very little credit risk involved. It is pretty much straight fee income.
The Market and Wealth Services business involves securities clearing, which is another fee-based service. The clearing firm handles a trade on settlement day, ensuring that the buyer has the money and the seller has the securities. This segment also includes Treasury services, which handle liquidity and cash management for companies. Investment and Wealth Management is the final line, which includes asset management, advisory, and active management.
Rising interest rates should help increase revenue
The post-pandemic landscape had been somewhat difficult for Bank of New York Mellon in that it handles a lot of money market funds, which are not permitted to show losses. This means that Bank of New York Mellon had to waive management fees for these funds since short-term interest rates were so low that very little income was earned on them. The bank still had to bear the costs of managing these funds, so this was a drag on income until rates started rising.
Results in the fourth quarter and 2022 were negatively affected by market movements. Bank of New York is paid a percentage of assets under management, and when the stock market falls, so does the value of the assets under management, which means lower fees. On a year-over-year basis, revenues were flat compared to 2021, although the company took a loss on repositioning its bond portfolio. It sold off some of its lower-yielding bonds and replaced them with higher-yielding bonds. This required the company to take a loss up front, but it will mean higher income in the future. If you strip out the bond repositioning and other special items, revenue rose 9% in the fourth quarter, and earnings per share rose 25%.
A slower grower but stable in a recession
Bank of New York Mellon is generally a steady performer, growing more or less in line with the overall economy. It should up better in a recession and will be unexciting in a bull market. Bank of New York Mellon is trading at 9.3 times the expected 2023 earnings per share and has a 3% dividend yield. Bank of New York should be thought of as a defensive financial and could be a good stock to rotate into if you think the U.S. is heading into a recession and credit losses will increase.
