State Street in Custody Battle

The processing bank could be the next to get hitched.
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The merger of

Bank of New York

(BK) - Get Report

and

Mellon Financial

(MEL)

may force the hands of its main competitors in the custodial and securities processing business.

The union of Bank of NY and Mellon will create the world's largest securities servicing and asset management firm. Wall Street is applauding the $16.5 billion stock swap because it creates a more scalable business and in the fee-driven custody and processing business, size is everything.

Shares of the two companies soared after the news. Bank of New York rose $4.11 or 11.6%, to $39.59, while Mellon rose $2.51 or 6.3%, to $42.56.

But also rising Monday were shares of

State Street

(STT) - Get Report

and

Northern Trust

(NTRS) - Get Report

, two other large trust and processing banks, with many on Wall Street predicting they will either come together in their own marriage of convenience, or get acquired by some big commercial lenders.

Shares of State Street rose $2.90 or 4.7%, to $64.40, while Northern Trust's stock rose $2 or 3.5%, to $58.47.

"The deal is so compelling that it is likely to pressure some of the company's competitors to think about acquisitions," says analyst Richard Bove of Punk Ziegel, in a research note. "It takes two aggressive price competitors and combines them, presumably allowing prices to stabilize in some sectors of their businesses."

Custody banks typically perform investor services, such as recordkeeping and back-office services for institutional investors, like mutual funds and pension funds. It's a business that's heavily dependent on fees and the bigger a bank is, the more say it has over pricing and the ability to take market share from smaller players.

David Hendler, an analyst with CreditSights, writes that Northern Trust "lacks the scale necessary to compete in the processor space at this point.'' He says, State Street "will feel more urgency to complete a large scale acquisition of its own, or be at risk for being bought."

It will be months before the Bank of NY and Mellon deal closes, but analysts on Wall Street already are playing match maker for their stand-alone rivals.

Bove, for one, suggests that State Street should consider merging with

Citigroup

(C) - Get Report

or

JPMorgan Chase

(JPM) - Get Report

. Northern Trust, meanwhile, should look toward linking up with

Bank of America

(BAC) - Get Report

.

In fact, there's already a budding relationship between Citigroup and State Street. The two banks are party to a joint venture called CitiStreet, which provides recordkeeping, administration and investment services to retirement plans.

State Street has $11.3 trillion in assets under custody and $1.6 trillion in assets under management. Northern Trust has $3.3 trillion in assets under custody and $667 billion under management.

The new Bank of NY Mellon will have more than $16 trillion in assets under custody and $1.1 trillion in assets under management.

Hedge funds are also jockeying for positions in State Street, possibly in preparation of a deal.

Atticus Capital, the $14 billion New York hedge fund, scooped up 1.88 million shares of the Boston processor last quarter. Atticus, run by hockey player turned hedge fund manager Timothy Barakett, has been known to agitate for change in the companies it invests in, including mergers.

Atticus recently scored large gains from several of its major investments this year, including

Phelps Dodge

(PD) - Get Report

, which recently got a takeout offer from

Freeport-McMoRan's

(FCX) - Get Report

. Atticus has a 10% equity stake in the copper miner.

Atticus also has profited from large run-ups in shares of the

New York Stock Exchange

(NYX)

and

MasterCard

(MA) - Get Report

.

Atticus did not return a request for comment.

One thing that makes State Street particularly attractive to a potential buyer is the fact that approximately 41% of its revenue comes from international business and it is much more than a domestic player.

A State Street spokeswoman says the company is always looking for strategic acquisitions but she would not comment on any particular deal. A Northern Trust spokesman, meanwhile, said the bank was committed to remaining independent.

Jason Tyler, a senior vice president of portfolio management at Ariel Capital Management says it is not imperative that Northern sell itself, but it's not out of the question.

"Northern now all of a sudden has some nice scarcity value," says Tyler, whose firm owns 4.7 million shars of Northern Trust. In regards to a deal with State Street, "I just hope they don't race to do something unless there is a big premium attached to it."