Northern Trust unit has lost its luster

Northern Trust is worried about COVID-19's effects on its business like all other banks, but it has an additional concern most of them don't. The monied institutional clients Chicago's largest locally headquartered bank built a costly global platform to serve aren't paying like they once did for the work, leaving analysts wondering about the value of a Northern Trust linchpin that for decades was an unquestioned triumph.

Northern Trust is one of three banks that dominate the business of holding and processing trillions of assets for the world's largest institutional investors. The fees Northern is paid for custody and fund administration accounted for 40% of the bank's $3.86 billion in fees last year.

But, in what one analyst dubbed "the world's worst oligopoly" a few years ago, the fees Northern and its trust-bank peers, Boston-based State Street and New York-based Bank of New York Mellon, are paid for the service aren't coming close to keeping pace with the growth in the assets the companies are husbanding.

It's one reason Northern's stock price is down 27% this year despite a relatively small lending operation that makes it less vulnerable to the potential COVID-19-related collapse of business borrowers than commercial banks. Northern Trust isn't alone; State Street and BNY Mellon are down 26% and 32%, respectively.

Through the first nine months of 2020, Northern has collected $1.17 billion in custody and fund administration fees, nearly the same amount as the $1.15 billion it generated over the same period last year. That's despite an improbably decent year for the markets that has grown Northern's assets under custody and administration by 9%, to $13.08 trillion as of Sept. 30 from $12.05 trillion as of Dec. 31, 2019.

It's little better for State Street and BNY Mellon. Their custody fees grew 2% each for the same period.

"That's not fundamentally a business dynamic you like to see," says Jeffery Harte, an analyst at Piper Sandler in Chicago.

It wasn't any better in 2019. Northern Trust's custody fees grew 3% as its assets under custody increased 19%.

Northern executives say they measure the profitability of the custody business on revenues vs. costs. But they allow that fees aren't keeping up with assets. In part, that's because less than half of the bank's custody fees are tied directly to the level of assets these days. In response to a request for comment, a spokesman referred to Northern's recent earnings call with analysts.

"More and more, frankly, there's going to be less of connectivity between the asset level and revenue level," Chief Financial Officer Jason Tyler said on Northern's Oct. 21 call. "And (in) a lot of the negotiations to take place, we're thinking about trying to include a more holistic approach to the relationship."

That means Northern wants to provide additional services to clients that now are just using the bank to hold their assets and move money around. Those include asset management, trading and statement processing. The other two trust banks, though, are trying to do the same thing, which potentially creates the same pricing pressures in those other service lines.

"They're all pursuing that, but that's probably not delivered as much as I would have thought," Mr. Harte says.

"What we're positioning ourselves strategically for is that as these operating models need to be overhauled, we want to be (the) enterprise outsourcer that's doing it for (clients), taking on as much as we can of the front, middle and back office," State Street CEO Ronald O'Hanley said on the bank's Oct. 16 earnings call.

Likewise, BNY Mellon. On the bank's Oct. 16 call, Mike Mayo, an analyst with Wells Fargo, asked CEO Thomas Gibbons, "Can you change your fee model or how you charge your customers? It seems like your customers are getting the better end of the arrangement." Responded Gibbons before launching into all the measures BNY Mellon is taking to offset that, "Yeah, sometimes it feels (like) that."

Adding pressure to fees is that asset managers that are the trust banks' clients are struggling with fee pressures of their own and the need to cut costs. More are merging, with Morgan Stanley's recently announced acquisition of Boston-based asset manager Eaton Vance capturing attention, as well as news that San Francisco-based Wells Fargo is open to selling its wealth management arm. If a real consolidation trend emerges, servicers like Northern Trust could find themselves losing clients just due to a transaction rather than competition.

These dynamics put pressure on Northern Trust, the smallest of the three trust banks, to accelerate profitable growth or cut costs to improve profitability. Not helping, at least in the short term, is that Northern Trust's other big business — wealth management for the nation's most affluent families and households — isn't growing robustly, either.

Through nine months, wealth management fees in 2020 are up 2% to $1.24 billion from $1.21 billion in the same period last year. In the central region, dominated by Northern's Chicago home base, fees are actually down 2% in that time frame. That includes a third-quarter fee decline in the central region, which should have reflected the stock market's surge in the second quarter.

"We've had to shift our sales and new business strategy as a result (of COVID-19)," Northern CEO Michael O'Grady said on the earnings call. "I'm very optimistic on the long-term prospects for that. ... But there's some bumpiness that we've had this year that we haven't had in previous years."

Ultra-low interest rates will force Northern to waive fees normally charged on its $288 billion in money market funds in order to ensure investors don't lose money on them. That could total $20 million to $25 million in the fourth quarter, Mr. Tyler said.

The good news for Northern Trust? It's big enough to ward off would-be buyers, and its stock valuation compared with its larger rivals is higher. A successful initiative to improve revenues will move the needle more for Northern than it likely would for BNY Mellon or State Street, just due to Northern Trust's smaller size.

But if those revenue ambitions fizzle, the other option is cost-cutting. None of Northern Trust's thousands of Chicago employees want to hear about that.

This story was published by Crain's Chicago Business, a sister publication to Pensions & Investments.