December-January 2012

CUSTODY: The important piece in the partnership

AnchorConcerns over global financial stability are eroding confidence in broader markets, with custodian banks having to re-emphasise trust and transparency as a result. Stefanie Eschenbacher reports. Overall risks to global financial stability have increased for the first time in more than three years, according to the latest Global Financial Stability Report published by the International Monetary Fund. Warning of spillover effects, the report points to the network of highly interconnected and leveraged financial institutions. One of the lessons learnt from the collapse of Lehman Brothers in 2008 is that asset owners need to understand the legal framework of their custody agreements as well as the way in which their cash and assets are held. Sally-Anne Callick, a business development manager who covers asset owners at BNP Paribas Securities Services, says custodians have to answer more questions now. “The collapse of Lehman Brothers and the financial crisis that followed have certainly changed the attitude towards risk,” she says. “Before that, for many clients appointing a custodian bank was little more than an administrative task.” Custodian banks are typically responsible for settlement, safekeeping, and reporting of their clients’ marketable assets and cash. Regulation requires them to hold client assets in separate accounts, segregating them from their own and therefore limiting risk to investors. This practice enables custodians to identify client assets throughout the entire chain – from the global custodian through to sub-custodians in local markets, to central securities depositories. Should a custodian or one if its sub-custodians collapse, client assets will not be part of the estate available to the liquidator. Even though no major global custodian has gone into liquidation to date, asset owners are now increasingly questioning cash and asset safety. Experts from PwC say assessing the stability and safety of a custodian’s balance sheet is a sensible thing to do. Balance sheet strength, long-term credit ratings, credit default swap spreads, net asset shareholder equity and business portfolio diversity are some of the factors asset owners should take into consideration. Sean Sprackling, a director in PwC’s asset management team, says intangible factors are often critical when it comes to appointing a custodian bank. “Asset managers want to be comfortable with their choice,” he says. “Balance sheets and reputation are therefore very important. Many times such decisions are also based on prior experience and relationships.” Callick shares his line, saying that asset owners need to ask themselves who they trust with the safekeeping of their assets. “Strong balance sheets are important and it is worth looking at what this signifies,” she says. “It can point to a strong and stable organisation with a risk-averse culture, which is particularly important for clients.” Financial stability
Daron Pearce, the head of outsourcing for Europe, the Middle East and Africa at BNY Mellon Asset Servicing, says custodians require healthy balance sheets if they aim for new custody wins. “Financial stability is important when selecting a custodian,” says Pearce. “Knowing that the custodian will stay in business, focus on service delivery, and be able to provide a sustainable operating environment ensures that a client will be able to focus on their business of growing the asset base for their investors or scheme members.” Pearce says the robustness of the balance sheet is an indicator of a custodian's financial health and its ability to continue investment in its product and service. The credit rating of the custodian, he adds, is another indicator of this financial well-being. Other factors asset managers typically take into consideration are the size of the assets the custodian holds for others, the span of the global sub-custodian network and other services the asset managers might require. There are only a relatively small number of custodians that hold a vast amount of assets. In the Funds Europe Global Custody Survey 2011, which was published in September, BNY Mellon topped the list with assets under custody of €18.4 trillion, followed by JP Morgan with €11.7 trillion, State Street with €11.6 trillion and Citi with €9.7 trillion. F&C Investments started outsourcing for its institutional segregated business in July 2011, while its fund activities have always been outsourced. Finding the right custodian took up to four months, says Jeremy Charles, the group operations director. “We listed our requirements and compared them with what the custodians offered,” he says. “Then we checked whether they could meet them or whether they could make changes, if necessary.” Charles says although financial stability of the custodian bank is a factor, there are other risks to consider. Those include trade and settlement-related risks, safekeeping services risks, operational risks, collateral credit risks, securities borrowing and lending risks, as well as custody risks associated with derivative products. And even though the assets a custodian bank holds on behalf of its clients are held in segregated accounts, cash positions can be commingled. Callick says clients increasingly prefer segregated accounts over so-called omnibus accounts, where similar clients are pooled in one sub-account. She says global custodians are aiming to meet these preferences. Even though this model will be more expensive, clients appear to be willing to pay the price. Risk factor
According to the International Securities Services Association (Issa), an industry trade body, global custody is “rather a medium to low risk business than a high-risk service activity”. Compared with other parts of the financial services industry, custody banking is considered low risk with a typically stable – though declining in the long-term – stream of earnings.  Its analysis of global custody risks found that global custodians and sub-custodians with modern depository facilities, up-to-date organisational workflows and structures, experienced and well-trained personnel, efficient and reliable electronic data processing and data communications systems, should be able to avoid big losses. Modern due dilligence should make it easier for asset managers to monitor custody risk. Peter Gnepf, a spokesperson for Issa, says: “Compared with the early 1990s, methods to monitor, measure and manage risks are now more comprehensive and sophisticated. Today, this is a global business. It has become faster and more complex.” Gnepf says that as banks are dealing with the aftermath of the financial crisis, many banks may consider the “rather unspectacular” global custody industry a good business  to be involded in. “It is one of those businesses that do not place the stability of a bank in danger because the assets under custody are held in separate accounts,” he explains. Protective measures can help to eliminate or reduce at least some of these risks. Though global custodians and sub-custodians should be able to avoid losses on the scale seen with investment banks, system failures, lack of specific know-how and human errors remain. ©2011 funds europe

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