With more than $38 trillion in assets under custody or administration, Bank of New York Mellon BK is the largest custodian in the world. While core custody can be an undifferentiated offering, scale and the stickiness of clients have helped the firm generate double-digit returns on tangible equity.
BNY Mellon’s investment services segment is much more than asset servicing. Within this segment, the company offers issuers services that include corporate trustee and depositary receipts such as ADRs. Though it’s the largest provider of depositary receipts, BNY Mellon has lost ground to competitors. Its clearance and collateral management (about 7% of revenue) is unique in that it is the sole provider of triparty repos for U.S. government securities. Pershing, acquired in 2003, provides broker/dealer clearing and RIA custody services and has been a bright spot for BNY Mellon. We expect Pershing to continue to benefit from the secular growth of registered investment advisors.
About one fourth of BNY Mellon’s revenue is from its $2 trillion asset management business. Given the lower switching costs, we’d consider the asset management division to have a narrower economic moat than the investment services division.
The largest impact to the firm’s revenue from COVID-19 has been from low interest rates. We expect net interest income to decline meaningfully in 2020 and 2021 as low interest rates and a flatter yield curve weigh on net interest margins. In addition, management expects to enter 2021 with roughly $600 million in annualized money market fee waivers, primarily from the Pershing and wealth management businesses.
BNY Mellon has faced criticism for a lack of cost control and integration failures in the Mellon merger. While we acknowledge some of the criticism and can see how BNY Mellon’s seven lines of business seem bulky, management in recent years has been aggressively focusing on expense control, and the firm consistently sees 15%-plus returns on tangible equity. Given pricing pressure and the low-interest-rate environment, we expect management to keep a lid on expense growth.
BNY Mellon Has a Wide Moat We believe custody tends to be a wide-moat business built on cost advantages and switching costs. BNY Mellon slightly edges out State Street as the number-one custodian based on assets under custody or administration. Given the low basis points paid for custody services, we believe this is a business where scale matters. There are high up-front costs to develop software systems and processes to serve a large amount of assets. As an example, State Street and BNY Mellon each spent over $2 billion on technology in 2019, a level of spending that smaller firms cannot match.
Clients of BNY Mellon’s investment services face switching costs due to process disruption, the interconnectedness of clients’ workflows, and a custodian’s infrastructure as well as onboarding costs. As a result, we believe BNY Mellon’s clients tend to be sticky.
Within asset servicing, hedge fund administration is a lucrative business for BNY Mellon, in our view. Given that hedge funds have high fees, they are less sensitive to the basis points paid for fund administration fees. In addition, in some cases, these fees are passed through to investors. Finally, during investor due diligence, switching fund administrators can invite additional scrutiny in a similar way as switching auditors can.
On the less moaty side is BNY Mellon’s investment management and wealth management business, which makes up about one fourth of company revenue. We believe its narrow moat is based on scale and switching costs from investor inertia, though this segment faces strong competition from large asset managers such as BlackRock, Vanguard, Fidelity, and State Street.
BNY Mellon’s moat trend is negative, in our view, as a result of fee pressure and client concentration. BNY Mellon is a large servicer of exchange-traded funds, and the two largest players (BlackRock’s iShares and Vanguard) continue to maintain or gain share in the United States at the expense of competitors. At the end of 2019, BlackRock had 38.4% of the ETF market by assets (virtually unchanged from 38.5% in 2016) and Vanguard had 26.0% (up from 24.0% in 2016). We believe as customers get larger, their negotiating leverage increases, and that in some cases it may become viable for them to take certain functions, such as securities lending, in house.
While its asset management business boasts $2 trillion in assets, BNY Mellon is still smaller than market leaders BlackRock, Vanguard, Fidelity, and State Street. Flows, which can be volatile from year to year. have generally been lackluster, and fee pressure continues to be a powerful force in asset management.
Sound Financial Structure BNY Mellon's revenue is roughly 80% fee-based with the remainder primarily net interest income. Net interest income tends to do better with higher interest rates and a steeper yield curve, but COVID-19 has brought lower rates and a flatter yield curve. In addition, money market fee waivers have weighed on the Pershing and wealth management businesses. We do believe the rest of the firm's fee revenue tends to be relatively stable, but it is affected by market levels, foreign-exchange volume, and securities lending volume. BNY Mellon's asset servicing revenue is sensitive to equity markets, though we'd note that only about one third of its assets under custody or administration are equity-based and that some contracts are priced on a per account/transactions volume basis. The firm's investment management revenue is also affected by changes in the equity markets. We estimate that a 10% change in the markets results in a 1.0%-1.5% change in firmwide revenue.
In an extreme bear case, we believe the weakness in servicing fees would be partially offset by higher volatility-driven foreign-exchange trading services and securities finance revenue.
The level of net interest income is more uncertain, as net interest margin and balance sheet size can be difficult to forecast. The firm’s NIM rose in 2018 due to rising rates. However, BNY Mellon’s NIM declined in 2019 and will probably do so again in 2020 and 2021.
BNY Mellon’s financial structure is sound, in our view. As of Sept. 30, 2020, the firm had a common equity Tier 1 ratio of 13.5%, comfortably exceeding its regulatory minimum of 8.5%. BNY Mellon’s supplementary leverage ratio was 8.5% as of Sept. 30, meaningfully above the 5.0% minimum. While the firm had some extraordinary losses during the financial crisis related to structured finance products, we believe it has learned from the crisis and we’re unlikely to see a repeat of this. In addition, we believe BNY Mellon’s balance sheet is conservatively invested, and its loan and leases have historically resulted in negligible charge-offs.