Keeping It Simple
John R. Engen

In his first year as CEO of giant BNY Mellon Corp., Robert Kelly is proving that doing a couple of complementary things globally—and extremely well—can generate top-flight performance.

Robert Kelly has been a CEO for little more than two years, but few people know the ins and outs of financial markets—or how to pull off a successful big merger—better than the head of the recently merged Bank of New York Mellon Corp.

While running Toronto Dominion Bank’s European trading desk in the 1980s, Kelly, now 53, made big profits as the first trader to use computers to manage a complex derivative portfolio. Later, as TD’s chief financial officer, the Nova Scotia native oversaw its landmark $525 million purchase of Waterhouse Securities.

Earlier this decade, Kelly won accolades as the old First Union Corp.’s CFO both for his candor, and as a key architect of the successful 2001 merger that created today’s giant Wachovia Corp. His performance in that role led the board of Mellon Financial Corp. to make Kelly the Pittsburgh company’s CEO in February 2006.

Less than a year later, he engineered a $16.5 billion merger of equals with the old BoNY, creating one of the world’s largest asset-management and servicing shops, with $23.1 trillion in assets under custody, $11.3 billion in annual revenues, and a market cap of more than $50 billion.

Bringing together two big, tradition-rich organizations—one founded in 1784 by Alexander Hamilton; the other in 1869 by Andrew Mellon—is no easy task. The deal closed last July, and Kelly is applying the same steady, methodical pace to the integration that made the Wachovia deal a shareholder winner.

BNY Mellon’s 18-member board, including 11 current or former CEOs, (including Kelly himself and Executive Chairman Thomas Renyi, BoNY’s former CEO), is providing plenty of oversight and advice to management. There’s even a special integration committee that meets monthly to evaluate the process.

While the merger is going well, BNY Mellon hasn’t escaped the industry’s broader troubles. In the fourth quarter, Kelly took a $118 million writedown on collateralized debt obligations due to the mortgage collapse. It took another $180 million charge for bringing an off-balance-sheet debt vehicle back on the books. The net effect, muddied by a big one-time gain in 2006, was a decline in quarterly per-share earnings to 45 cents, from $2.27 a year earlier.

Even so, investors seem enthused with what they’re seeing. In 2007, BNY Mellon ranked tops in total shareholder returns among large-cap financial institutions. Bank Director recently talked with Kelly about the economy, strategy and M&A in his new company, and how a good board helps drive BNY Mellon forward.

Below is an edited version of that conversation.

How does the economy look from where you’re sitting?
The economy is a mess right now. It’s clearly still deteriorating, and frankly, I think it will continue to deteriorate until some time in 2009. I’m not an economist, but there’s a severe contraction in growth. I would call this a recession.

The reason lies in one asset class: the housing bubble. In spite of the fact that we’ve had nine quarters of declines in residential construction, prices to date have only declined about 10%, and they probably have at least another 10% to go. My guess is, that will take more than a year to work through.

The government’s actions—the combination of tax breaks and interest-rate reductions—will reduce the length of the downturn and probably make it a little shallower. But no matter what you do on fiscal stimulus or monetary stimulus, we still have an asset class that’s overvalued.

How does that impact your strategic thinking?
It probably means that revenue growth this year won’t be as strong as it was last year. And if you think that’s the case, then you’re going to have to be more careful on the expense side.

[BNY Mellon] is going to be particularly blessed this year by the fact that we still have a lot of cost saves and revenue synergies from the merger that our peers simply don’t have. That will be coming through the income statement, which will be very helpful.

The other thing [the economic situation] does is, I think at some point later this year or next year, it is going to create some potentially interesting acquisition opportunities. And I suspect it’s going to be more than a small number.

That means we’ve got to continue to do a great job of executing against our business plans and the merger strategies, and we’ve got to keep our powder dry for something that might come along that could be very, very attractive to our shareholders.

Equity markets are clearly important to your business. What do you expect to happen there?
Usually the equity markets will lead the turnaround by six to nine months. I think there’s a scenario where sometime in the fourth quarter the equity markets start to turn. That would clearly be good for our company.

In my view, U.S. equities are very cheap, particularly compared to a lot of other countries. Look at PE ratios, for example. The S&P 500 is trading at 15.3 times 2008 earnings right now. That is probably half of what it was in 2000, and is below the historic average.

So in comparison to an overvalued asset class—housing—equities are unvalued. I think investors will figure it out at some point this year or early next year, and it’s going to be great for the equities market.

If you think about some of these financial stocks that have gotten just completely beaten up, they’re going to be wonderful buys in the near-term.

Is that true for the megabanks? Some of these large institutions have taken very big losses. Are they too big to manage effectively?
It’s not clear to me. I think if you have a superb management team and there are great synergies between the businesses—and where it’s possible to aggregate risk across the enterprise and see where all your risks lie—it is possible to be diverse and successful. But there is a lot more complexity with that model. And I think there is some evidence that the complexity risk can outweigh the benefits of the revenue and expense synergies.

Bank of New York is huge. As CEO, how do you confront those risks and still find growth?
What I like about our model is that it’s essentially two business lines: asset management and securities servicing. We want to get bigger in both of those spaces—predominantly organically, but potentially with fill-in acquisitions as well. There is a lot of synergy between the two.

It’s a simple model and it’s rapidly globalizing. At the end of December, 32% of our company’s revenues came from outside the U.S. Our growth rates in Europe and Asia are faster than in the U.S., so that proportion will continue to rise.

If you don’t keep it simple, your financial institution will underperform versus more-focused institutions. It’s a trade-off. If you think of monolines, for example, like credit card companies, if you’re not the best in the industry, the strategy is not a winner.

How can your board help achieve those longer-term objectives?
Our directors are terrific on this. They’ve been very helpful to me, all the way along, with great discussions about priorities, tone, culture, and major activities under way at any one time.

A lot of my board members are CEOs, and I’m always running things past them. I love having senior people with diverse views, both geographically and in terms of being in other industries, providing me with the benefit of their experiences through multiple cycles and through their own acquisition activities.

Can you offer an example of how you get those insights?
Sure. When the board gets together, we have committee meetings on one day, a dinner that night, and the next day we have a full board meeting, which is usually done by 1 p.m.

We start off the second day as a group, before the board meeting, over breakfast. It’s just the board members and me, spending an hour-and-a-half in an informal atmosphere.

Initially, it’s me talking about all the big things I’m working on—everything from branding to human resource issues to strategy issues to acquisitions and divestitures. I give the directors an update over the course of 20 or 30 minutes. Then I open it up for very general questions on any of those topics or other things for the next hour.

It’s probably the most valuable thing I do each month. The board is the ultimate source of senior ideas and feedback.

Are most CEOs utilizing their boards enough?
I don’t know. My sense is that in the post-Enron environment, you’d want to minimize the number of surprises to the board. I’d also think that effective management teams want to make the best use of senior resources. So it’s probably become a much more heavily used resource.

BNY Mellon felt some earnings pain in the fourth quarter, due to CDOs and the like. How is the board letting shareholders know the company is on top of things in this environment?

The tone [from shareholders] has changed enormously since the third quarter. The buy-side and sell-side are focused on downside stuff. They’re saying, ‘What are the risks? What’s in your portfolios?’ So we’re focused on more disclosure in our 10-Ks and Qs, about what’s on our balance sheet.

We’re one of the few banks in the country that actually took our [off-balance-sheet] conduit and brought it onto our balance sheet. It wasn’t huge, and we had the capital ratios to do it. The move reduces the complexity of our company and actually should help us make more money.

We’re trying to be very transparent with our shareholders, to show them how our businesses are doing—where the risks are and where they are not. And we’re trying to continually simplify our business model to make it easier for shareholders to understand the strategy and how we make money.

Compared to a year ago, is the board going about its business any differently?
Yes. Twelve months ago, we focused a lot more time on growth strategies. The last six months, we’ve spent more time on a relative basis looking at risk issues—both existing and potential risks.

The board wants to hear more about markets and market trends. There’s a huge thirst for understanding the market risks, and the risks to our company in this environment. Todd Gibbons, our chief risk officer, comes to board meetings and talks about each one of our businesses, and where the risks lie in those businesses.

For us, the other big change is the merger. We’re spending a huge amount of time educating the board on exactly how we make money in each one of our businesses, as well as the major strategies for each of our businesses and how we are going to outperform our peers.

Can you give an example about the kinds of risk that directors are asking about now, but weren’t before?
Liquidity risk is front-and-center. A year or two ago, most people would have thought about balance-sheet instruments as being primarily about credit risk and market risk. I don’t think they understood that liquidity risk could be just as important—and sometimes more important—than credit risk. That is a very new phenomenon.

And I don’t think a lot of participants realized how interlinked the fixed-income and equity markets are, not just nationally, but internationally. So that if something went wrong in one space—say, conduits or SIVs—that it would be a natural outcome that shortly thereafter you might see an issue with, for example, monolines.

Our risk-management teams have spent an enormous amount of time over the last six months not only looking at today’s risks, but also our view of what will happen to those risks three, six, or 12 months from now—what could be the emerging risk at some point in the relatively near future.

How have those discussions gone?
We talked about monolines last August, as a small example. And we talked about the financial institution commercial paper market and where we thought it would end up over time.

If you think about corporate commercial paper markets, they’ve been relatively stable through the economic cycle, in terms of the amount of issuance. But the volume of financial institution commercial paper issuance created by conduits, SIVs, and other off-balance-sheet instruments just caused the commercial paper market to explode.

In the last eight months, people essentially decided they didn’t want to buy that paper any more. So we’re seeing a complete reversal in the amount of outstandings of financial institution commercial paper. Compared to, say, 2004 or 2005, it probably grew from $600 billion in the U.S. to $1.2 trillion. Now it’s quickly gone back to $600 billion to $800 billion, simply because no one is interested in investing in it.

What that means for financial institutions is, you’re seeing the reintermediation of balance sheets. We have talked about that extensively with our board, and they’ve been very interested in the entire topic. Balance sheets are growing a lot faster than the capital accounts are, because as people have been writing off things, building reserves, … they just can’t build the capital account as quickly as the balance sheet is growing.

This kind of environment highlights the importance of liquidity and of having strong ratings and a fortress balance sheet. Stocks that have strong balance sheets and strong capital and liquidity tend to have a lot less downside to market downturns.

How important is M&A to your overall strategy?
I’d say its importance is small to medium. It’s very clear to me that, over time, shareholder value is created first through intense focus on revenue growth versus expense growth. Expense management is important, but there’s a much higher correlation between shareholder value and revenue growth.

The second thing is you need to have portfolios of businesses that, on average, are in spaces that are growing faster as a whole than other companies. If you position yourself in faster-growth spaces, and then can grow a little bit of market share in those spaces, you’re really going to outperform.

M&A can help achieve those objectives. If you can do some acquisitions, at the margin, that make sense financially to help you become even stronger in those higher-growth spaces, you can clearly benefit.

That combination—being in higher-growth spaces, gaining a bit of market share organically and doing some M&A—over time will lead to first-quartile shareholder returns.

You were a key architect of the First Union/Wachovia merger. Were you able to apply lessons from that experience to the Mellon/Bank of New York merger?
Yes. In fact, there were enormous similarities between the two deals.

First, low-premium mergers are critical to both shareholder groups. The premium was essentially 6% in both mergers. That’s so important, because if you overpay, you’re never going to make money for one of the shareholder groups. That’s the advantage of mergers of equals.

Second, in both cases we were able to avoid the downside of mergers of equals. When you simply acquire something, it’s very clear what your decisions are going to be and when they’re going to occur, because there’s a dominant party. In a merger of equals, it’s a little more difficult. You’re taking the best of both, and you always have a fear that you’re not going to be able to make the hard decision. You have to make sure that you make crisp decisions, otherwise you’re going to leave a lot of value on the table.

How has this all played out in practice?
In the Wachovia merger, we announced on Day 1 that we were going to take three years to completely merge. In the Bank of New York/Mellon merger, we announced that it would take 2 1/2 years, so almost as long.

We’re going to take our time, because you can’t lose your customers. In the end it’s all about revenue. If you merge the two companies together too quickly, you’re going to lose your greatest source of value, which are customers.

The second thing is, you need to understand who your team is on Day 1, so there’s no confusion among employees as to who’s in charge. In both deals, we announced the members of the top [management] team on the first day, so everyone knew who their boss was. That’s very important.

And in both deals, the expense saves were realistic, not extreme. You don’t want to cut costs in a way that would either slow down revenue growth or potentially raise your risks of internal-control or regulatory problems.

Finally, you’ve got to realize that while expense saves add a lot of shareholder value in the short-term, the biggest [long-term] opportunity is revenue synergy. Both mergers really focused a lot on cross-selling and customer service and delivering more to the combined customer base.

In the case of this merger, we only had 15% overlap of customers. So we have a gigantic opportunity, which at a minimum is somewhere between $250 million and $400 million in additional revenue, that never would have occurred if our companies hadn’t come together.

How do you ensure that the integration goes as smoothly as possible internally?
You need to overcommunicate and be very transparent about everything you’re doing. You want it so that no one feels anything is being hidden and that there are no surprises. And you have to treat everyone fairly and with respect. No one group can be considered superior to another.

Everyone has to recognize that there are some expense synergies that need to come out, and that undoubtedly means people, as well as technology. The key is being honest and upfront about it, and treating everyone as fairly as possible.

How about shareholders? How do you sell them on the deal when the history of most MOEs isn’t that great?
If you think back to Wachovia/First Union, the shareholder returns that were created over the first three or four years after the merger ranked No. 1 among the top 20 banks around the world in terms of market cap.

My expectation was that shareholders wouldn’t start to reward us for the [BNY/Mellon] deal until they saw strong evidence of merger integration coming along. But the reality is, we had a 19.5% return in 2007 to shareholders in an environment where the average bank was down 19%. That was the best of all financial institutions with market caps of more than $50 billion in the U.S. last year. No. 2 was Goldman Sachs with an 8.5% return. So we were pretty happy with how investors rewarded us.

What is the board doing to prepare for the year ahead?
Directors are very interested in how the merger is going. We still have a lot to do. We have a merger-integration committee—we had one with First Union/Wachovia, as well—that meets before every board meeting, and focuses entirely on, how are we doing against our original plan? What’s going on right now with the merger? And how are future quarters looking on all of the merger integration plans versus what we said upfront?

We have some senior technology staff in that group, as well. There is great value being added there. I’m delighted with their involvement.

We will eventually disband that committee. But right now, it’s the most work going on in this company—and the greatest amount of change going on in the company—so it makes sense for the board to be intimately involved in the integration.

Second, directors are very much involved in understanding the risks and the new business strategies of our company. This June, we’re doing an offsite [meeting] for a couple of days where, now that our companies are together, we’re going to educate the board, by business unit, about our overall strategies, as well as our tactical financial strategies for the next three years, by business unit. That includes something that is incredibly important: our succession strategies for the team going forward.

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