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Morningstar | Trust Bank Moats Remain Wide, but Headwinds Exist

After updating our model for all three trust banks, we are maintaining our wide moat rating, but have reduced our moat trend ratings to negative from stable for State Street and BNY Mellon. We expect the custody business to continue to face a challenging environment as fee pressures on clients and increased client concentration weigh on the custody banks’ pricing power. We are maintaining our stable trend for Northern Trust on the strength of the firm’s wealth management operations. Despite the negative moat trend for State Street and BNY Mellon, we believe that the business models for each of the trust banks remain solid and that each will continue to earn excess returns on tangible equity for the foreseeable future.

The custody business has undoubtedly faced challenges in recent years with its monetization mechanisms. In terms of basis point yield, asset servicing fees have declined for all three trust banks. Relatively low volatility in the foreign exchange markets has kept a lid on trading income. For securities lending, we believe the move by Fidelity to take securities lending in-house from Goldman Sachs is indicative of the price sensitivity of clients. Finally, clients have become more discerning with their cash balances which has resulted in disappointing net interest income growth despite a rising rate environment.

In terms of fair value changes, we’re lowering our fair value estimate on State Street to $66 from $73 as we are reducing our net interest income expectations due to a tighter yield curve and a mix shift away from non-interest-bearing deposits. State Street currently trades at approximately 84% of our fair value estimate.

We are also tweaking our fair value estimate of Northern Trust lower to $87 from $90. Northern Trust currently trades slightly (3%) above our fair value estimate.

We are leaving our fair value estimate of BNY Mellon unchanged at $48. BNY Mellon currently trades at 90% of our fair value estimate.

For Northern Trust, we are big fans of the firm’s wealth management business. We believe the ultra-high net worth client base tends to be stickier than less affluent clients and the fact this client segment tends to be more conservatively invested (just 47% equity allocated) adds to the stability of segment revenues. We believe trends of RIA consolidation and flat industrywide advisor count sets up wealth management firms to be able to maintain their pricing in the future.

BNY Mellon’s investment servicing segment is similar to State Street’s but we do believe the firm’s Pershing business (RIA custody and broker/dealer clearing platform), tri-party repo platform, and ADR servicing business do differentiate the firm. In particular, the growth of RIAs should benefit the Pershing business. In addition, the firm’s assets under custody or administration is only about a third equities, thus giving the firm more stability. Overall, we have less fair value uncertainty with BNY Mellon than we do State Street.