BNY Mellon (NYSE:BK) recently formed a new business division to handle all collateral management functions in a bid to capture a bigger share of the collateral business, which is expected to show considerable growth in coming months.  The world’s largest custodian bank formerly provided collateral services through its other operating divisions. The new division will allow BNY Mellon to concentrate it efforts better to take on competitors like JP Morgan Chase (NYSE:JPM) and State Street (NYSE:STT) who are also keen on growing their presence in the market.
We maintain a price estimate of $27 for BNY Mellon’s stock, which is around 20% above the current market price. We largely attribute this premium to the weak short-term outlook for global custody banking compounded by the deteriorating economic conditions in the Eurozone. The bank’s foreign-exchange related lawsuits are also a bitter pill for investors to swallow.
The business of collateral management essentially involves holding, moving and valuing the collateral that companies post as part of their asset-backed security contracts.
Among the various conditions that are soon to be imposed as part of the Dodd-Frank Act is the mandatory requirement that various types of derivatives be handled by clearing houses. This would require parties entering into these derivative contracts to post collateral with clearing houses. Considering that interest rate swaps and credit default swaps which form a significant chunk of notional derivatives outstanding will now have to comply with this requirement points toward a considerable growth in the collateral business in coming years. Recent estimates indicate that trading collateral may rise by as much as $2 trillion in the near future.
And adding to that, Basel III rules mandate a detailed reporting of the collateral and margin money that companies post with clearing houses. This would in turn drive up the demand for collateral valuation and management services.
We represent BNY Mellon’s revenues from collateral management services as part of its clearing services revenues. The impact of an increase in collateral services revenue on the bank’s total value can be understood by making changes to the chart above.Notes:
- Bank of New York Forms New Unit to Grab More Collateral Business, The Wall Street Journal, Jun 27 2012 [↩]