Keeping It Simple

Robert Kelly has been a CEO for little more than two years, but few people know the ins and outs of financial marketsu00e2u20ac”or how to pull off a successful big mergeru00e2u20ac”better than the head of the recently merged Bank of New York Mellon Corp.

While running Toronto Dominion Banku00e2u20acu2122s 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 TDu00e2u20acu2122s 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.u00e2u20acu2122s CFO both for his candor, and as a key architect of the successful 2001 merger that created todayu00e2u20acu2122s giant Wachovia Corp. His performance in that role led the board of Mellon Financial Corp. to make Kelly the Pittsburgh companyu00e2u20acu2122s 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 worldu00e2u20acu2122s 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 organizationsu00e2u20ac”one founded in 1784 by Alexander Hamilton; the other in 1869 by Andrew Mellonu00e2u20ac”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 Mellonu00e2u20acu2122s 18-member board, including 11 current or former CEOs, (including Kelly himself and Executive Chairman Thomas Renyi, BoNYu00e2u20acu2122s former CEO), is providing plenty of oversight and advice to management. Thereu00e2u20acu2122s even a special integration committee that meets monthly to evaluate the process.

While the merger is going well, BNY Mellon hasnu00e2u20acu2122t escaped the industryu00e2u20acu2122s 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 theyu00e2u20acu2122re 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 youu00e2u20acu2122re sitting?

The economy is a mess right now. Itu00e2u20acu2122s clearly still deteriorating, and frankly, I think it will continue to deteriorate until some time in 2009. Iu00e2u20acu2122m not an economist, but thereu00e2u20acu2122s 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 weu00e2u20acu2122ve 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 governmentu00e2u20acu2122s actionsu00e2u20ac”the combination of tax breaks and interest-rate reductionsu00e2u20ac”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 thatu00e2u20acu2122s overvalued.

How does that impact your strategic thinking?

It probably means that revenue growth this year wonu00e2u20acu2122t be as strong as it was last year. And if you think thatu00e2u20acu2122s the case, then youu00e2u20acu2122re 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 donu00e2u20acu2122t 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 itu00e2u20acu2122s going to be more than a small number.

That means weu00e2u20acu2122ve got to continue to do a great job of executing against our business plans and the merger strategies, and weu00e2u20acu2122ve 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 thereu00e2u20acu2122s 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 classu00e2u20ac”housingu00e2u20ac”equities are unvalued. I think investors will figure it out at some point this year or early next year, and itu00e2u20acu2122s going to be great for the equities market.

If you think about some of these financial stocks that have gotten just completely beaten up, theyu00e2u20acu2122re 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?

Itu00e2u20acu2122s not clear to me. I think if you have a superb management team and there are great synergies between the businessesu00e2u20ac”and where itu00e2u20acu2122s possible to aggregate risk across the enterprise and see where all your risks lieu00e2u20ac”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 itu00e2u20acu2122s essentially two business lines: asset management and securities servicing. We want to get bigger in both of those spacesu00e2u20ac”predominantly organically, but potentially with fill-in acquisitions as well. There is a lot of synergy between the two.

Itu00e2u20acu2122s a simple model and itu00e2u20acu2122s rapidly globalizing. At the end of December, 32% of our companyu00e2u20acu2122s 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 donu00e2u20acu2122t keep it simple, your financial institution will underperform versus more-focused institutions. Itu00e2u20acu2122s a trade-off. If you think of monolines, for example, like credit card companies, if youu00e2u20acu2122re 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. Theyu00e2u20acu2122ve 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 Iu00e2u20acu2122m 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. Itu00e2u20acu2122s just the board members and me, spending an hour-and-a-half in an informal atmosphere.

Initially, itu00e2u20acu2122s me talking about all the big things Iu00e2u20acu2122m working onu00e2u20ac”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.

Itu00e2u20acu2122s 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 donu00e2u20acu2122t know. My sense is that in the post-Enron environment, youu00e2u20acu2122d want to minimize the number of surprises to the board. Iu00e2u20acu2122d also think that effective management teams want to make the best use of senior resources. So itu00e2u20acu2122s 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. Theyu00e2u20acu2122re saying, u00e2u20acu02dcWhat are the risks? Whatu00e2u20acu2122s in your portfolios?u00e2u20acu2122 So weu00e2u20acu2122re focused on more disclosure in our 10-Ks and Qs, about whatu00e2u20acu2122s on our balance sheet.

Weu00e2u20acu2122re one of the few banks in the country that actually took our [off-balance-sheet] conduit and brought it onto our balance sheet. It wasnu00e2u20acu2122t 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.

Weu00e2u20acu2122re trying to be very transparent with our shareholders, to show them how our businesses are doingu00e2u20ac”where the risks are and where they are not. And weu00e2u20acu2122re 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, weu00e2u20acu2122ve spent more time on a relative basis looking at risk issuesu00e2u20ac”both existing and potential risks.

The board wants to hear more about markets and market trends. Thereu00e2u20acu2122s 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. Weu00e2u20acu2122re 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 werenu00e2u20acu2122t 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 donu00e2u20acu2122t think they understood that liquidity risk could be just as importantu00e2u20ac”and sometimes more importantu00e2u20ac”than credit risk. That is a very new phenomenon.

And I donu00e2u20acu2122t 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 spaceu00e2u20ac”say, conduits or SIVsu00e2u20ac”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 todayu00e2u20acu2122s risks, but also our view of what will happen to those risks three, six, or 12 months from nowu00e2u20ac”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, theyu00e2u20acu2122ve 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 didnu00e2u20acu2122t want to buy that paper any more. So weu00e2u20acu2122re 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 itu00e2u20acu2122s 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, youu00e2u20acu2122re seeing the reintermediation of balance sheets. We have talked about that extensively with our board, and theyu00e2u20acu2122ve 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, u00e2u20acu00a6 they just canu00e2u20acu2122t 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?

Iu00e2u20acu2122d say its importance is small to medium. Itu00e2u20acu2122s 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 thereu00e2u20acu2122s 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, youu00e2u20acu2122re 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 combinationu00e2u20ac”being in higher-growth spaces, gaining a bit of market share organically and doing some M&Au00e2u20ac”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. Thatu00e2u20acu2122s so important, because if you overpay, youu00e2u20acu2122re never going to make money for one of the shareholder groups. Thatu00e2u20acu2122s 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, itu00e2u20acu2122s very clear what your decisions are going to be and when theyu00e2u20acu2122re going to occur, because thereu00e2u20acu2122s a dominant party. In a merger of equals, itu00e2u20acu2122s a little more difficult. Youu00e2u20acu2122re taking the best of both, and you always have a fear that youu00e2u20acu2122re not going to be able to make the hard decision. You have to make sure that you make crisp decisions, otherwise youu00e2u20acu2122re 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.

Weu00e2u20acu2122re going to take our time, because you canu00e2u20acu2122t lose your customers. In the end itu00e2u20acu2122s all about revenue. If you merge the two companies together too quickly, youu00e2u20acu2122re 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 thereu00e2u20acu2122s no confusion among employees as to whou00e2u20acu2122s 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. Thatu00e2u20acu2122s very important.

And in both deals, the expense saves were realistic, not extreme. You donu00e2u20acu2122t 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, youu00e2u20acu2122ve 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 hadnu00e2u20acu2122t 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 youu00e2u20acu2122re 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 isnu00e2u20acu2122t 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 wouldnu00e2u20acu2122t 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 committeeu00e2u20ac”we had one with First Union/Wachovia, as wellu00e2u20ac”that meets before every board meeting, and focuses entirely on, how are we doing against our original plan? Whatu00e2u20acu2122s 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. Iu00e2u20acu2122m delighted with their involvement.

We will eventually disband that committee. But right now, itu00e2u20acu2122s the most work going on in this companyu00e2u20ac”and the greatest amount of change going on in the companyu00e2u20ac”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, weu00e2u20acu2122re doing an offsite [meeting] for a couple of days where, now that our companies are together, weu00e2u20acu2122re 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.