The Custody Banks Have Gotten Cheaper, but Investors Need to Be Discerning

The custody banks have gotten visibly cheaper in recent years, but we think investors need to be discerning. At the onset of COVID-19, lower interest rates weighed heavily on the banks’ net interest income, or NII, and resulted in hefty money market fee waivers. However, higher interest rates were not the panacea many investors hoped for. The custody banks’ asset-manager and asset-owner clients tend to be sophisticated, a fact that State Street mentioned multiple times on its most recent earnings call. While money market fee waivers have been eliminated, deposit betas over 100% for State Street and BNY Mellon have meant that these firms have had to rapidly increase the interest they pay on the deposits of these sophisticated clients. In addition, the inflationary environment has had a negative impact on expense growth, particularly at Northern Trust NTRS.

State Street and BNY Mellon trade at similar forward earnings multiples, but we prefer BNY Mellon, as its diversified businesses result in a diversified deposit base and a higher share of non-interest-bearing deposits. In our view, BNY Mellon’s balance sheet is better positioned if inflation and thus rate hikes are more than expected. In addition to BNY Mellon, we like Northern Trust. Northern Trust’s stock has suffered from outsize expense growth and a lower NII outlook. We believe expense efficiency can be improved and do not think investors should overreact to NII guidance changes, as a custody bank’s NII trajectory can be bumpy. We think investors should appreciate the positive characteristics of the firm’s wealth-management franchise, which makes up about half of the firm’s profit. At current prices, we see State Street as roughly fairly valued, thus do not view State Street’s risk-reward profile as compelling.