Investor services – is custody still king?

The leading investor services banks (State Street, BNY Mellon, JP Morgan, Citibank and so on) seem to be bifurcating into two distinct types: the Trust Banks (BNY Mellon, Northern Trust and State Street) and the universal banks (JP Morgan, Citibank, HSBC, BNP Paribas). At the same time we are seeing several banks re-shape their offerings and/or exit from certain services. Why is this?

It probably all boils down to two connected factors – profitability and capital requirements.

Profitability
For some years now investor services banks have seen a continuing squeeze on profitability – pressure on fees, increasing cost of regulation, and the squeeze on non-fee revenue sources such as FX and Securities Lending. There has also been a decline in usage of such services by investors, and close scrutiny into practices exhibited by some in these areas – resulting in significant fines and settlements.

However, industry analysis demonstrates that investor services businesses still drive a significant proportion of their revenues from market services (FX and Securities Lending) and particularly Net Interest Income earned on client cash balances. Analysis of the Trust Banks’ investor services revenues* shows that in aggregate average earnings from investor services are about 3.2 basis points of total assets under administration/custody.

The breakdown of this revenue is interesting. Fees account for 1.71 basis points (or 54%), FX and Securities Lending together for 0.31 basis points (10%), and Net Interest income 1.13 basis points (and 36%) of total investor service revenues. Even in prevailing low interest rate conditions the spread these banks make from managing their balance sheets – largely funded by cash balances held as a result of being custodian – is now over 1% being an aggregate of 134 basis points as at the end of 1Q18.

And interestingly, over the past three years the absolute earnings from Net Interest Income, the Net Interest Margin Spread, and the percentage of total income from interest income have all increased – and the rate of this growth exceeds the growth in fees.

So there is still good money in being a custodian – as it is acting as custodian that delivers the assets – both securities and cash – that can be sweated to maximize such non-fee revenues.

But in the investor services banks defence, their efficiency ratios (Operating Costs/Operating Revenues) remain in the 68-70% range – and this continues to require tight expense control.

Capital Requirements
Our current regulatory environment is demanding and creating safer banks – banks that successfully complete stress tests and have increased capital buffers to insulate against loss. This affects all of the investor services banks – but to differing degrees.

Universal banks – such as JPM and HSBC – have the most onerous capital requirements under the G-SIB rules. For example JPM and HSBC have a 2.5% and 2.0% additional capital burden respectively – whereas BNYM and SSB only have a 1% burden**.

Interestingly, the universal banks are aligning their investor services divisions with their Investment Banking and Markets business lines. Why? Firstly, investor services businesses have a lower risk capital rating – and so this helps balance capital requirements. Secondly there are synergies between the servicing of investors assets and the execution and trading of those assets. And thirdly, the investor services revenue stream tends to be less volatile and provide a stable foundation (for example at JPM, investor services revenues have grown from 11% to 13% of overall Investment Banking and Markets revenues between 2010-14***).

What conclusions can we draw?
Investor services businesses will be profitable as long as, firstly, they can capture, retain and grow a greater share of clients’ wallets, in particular non-fee revenue streams; and secondly, can generate strong synergies and cross-sell opportunities within their organisation.

But with increasing regulation, capital requirements, and costs there will continue to be focus on determining if each client’s business is – or can become – satisfactorily profitable for an investor service provider.

* Jefferies Equity Research: “ Americas / Trust Banks: Trust Bank Tallies: Maket Levels Mixed, Activity Pulls Back in April”, 7 May 2018, Ken Usain, Equity Analyst.

** FSB: 2017 list of global systemically important banks (G-SIBs) 21 November 2017

*** JPM Investor Day presentation 24 February 2015.

 

About the author

Throughout my career I have advised the investment industry on creating the operating and servicing models that will best serve their increasingly complex business goals, whether as a banker to – or working for – such firms, or now as an advisor to both.