Contrary to expectations, midsize banks are still competing vigorously for custody business. Is size not the advantage everyone thought?
By Jeanne Burke
September 2002
Institutional Investor Magazine
Here’s how it was supposed to play out: The biggest global custodians, with their sprawling multinational operations and superior back-office efficiencies, would lure business away from smaller, costlier regional rivals. At the same time, the behemoths would introduce a vast array of new products that would further cement customer relationships and lead to lucrative outsourcing contracts. In the end a mere handful of dominant custodians, each controlling trillions of dollars of securities, would snap up what was left of their outgunned competitors.
To date, it hasn’t worked out that way. With the bear market depressing portfolio valuations and revenue growth, custodians have been slow to close acquisition deals, and prospective outsourcing clients have grown wary of making radical operational changes.
Meanwhile, the smaller custodians have proved remarkably resilient. Institutional Investor’s annual global custody ranking (see table) shows, for example, that Canada’s RBC Financial Group boosted its cross-border assets 41 percent over 12 months, to $497.5 billion. It leaped from 13th to eighth place on the strength of several contract wins and the acquisition of the custody business of Perpetual Trustees Australia.
No. 9 Mellon Group, with $492 billion, is stepping up its commitment to global custody: In July it upgraded its European alliance with Amsterdam-based ABN Amro Bank into a full-fledged joint venture, ABN Amro Mellon Global Securities Services. Its clients have more than doubled in three years, to 111, with $250 billion under custody, says Nadine Chakar, chief executive officer of the new London-based unit.
“Size is no guarantee that you can stay and make money in this business,” says Andrew Tucker, partner in charge of custody operations in London and Zurich for Brown Brothers Harriman, which has carved a profitable niche lavishing attention and services on a small number of large investment managers. Stressing quality over quantity -- and boasting a new information management system called Infomediary -- Brown Brothers suffered an 11 per-cent decline in cross-border assets, to $528 billion, but remains in seventh place on the list.
To be sure, the biggest custodians keep getting bigger. Bank of New York, J.P. Morgan Chase & Co. and State Street Corp. each handle more than $6 trillion in total -- global and domestic -- custody assets, and Citibank oversees about $5 trillion; all grew over the past year. Citi, which has been especially aggressive internationally and as a subcustodian to J.P. Morgan and others, remains the biggest in cross-border assets, at $3.4 trillion.
But the fact remains that these organizations haven’t snuffed out all regionals or niche players, nor have their outsourcing strategies, built around add-ons like foreign exchange and fund accounting, accelerated the pace of change. Is consolidation just grinding on more slowly than anticipated, or are the dynamics of this business different than many strategists had thought? Over the next year, as continued market weakness and cost pressures force custodians to reassess their commitments to the business, the answer may be clearer.
II’s annual global custody ranking, based on March 31 data, indicates how little the pecking order has changed. Aside from RBC’s gains and London-based HSBC Holdings’ HSBC Bank slipping from ninth to 11th, the top ten are unchanged from a year earlier.
Yet there is one obvious sign of a pickup in the long-anticipated industry consolidation: In May Deutsche Bank -- No. 4 in global custody assets, with $1.7 trillion -- placed its business under “strategic review,” and a few prospective buyers have completed due diligence.
Only the four big U.S. companies, plus perhaps BNP Paribas and Mellon, could contemplate digesting Deutsche’s portfolio. But they can also anticipate more buying opportunities, because Deutsche won’t be the last sizable bank to throw in the towel, predicts Thomas Perna, senior executive vice president of investments at Bank of New York. “There have been a lot of smaller acquisitions so far,” says Perna, “but there will be a shakeout among the big guys, too.”
There are other, related developments that could ignite consolidation. Brussels-based Euroclear and London’s CrestCo agreed in July to merge and create what they call “a single domestic settlement service” for securities in five countries: Belgium, France, Ireland, the Netherlands and the U.K. Their objective, like that of the major custodians, is to lower transaction costs. “As that pricing margin gets squeezed out, the economics will put pressure on local and regional [custody] providers,” explains Thompson Swayne, head of global investor services at J.P. Morgan Chase. “Some might choose to exit and focus on other core competencies.”
Based on their recent financial performance, the biggest custodians can afford to be opportunistic. State Street Corp. reported a 3 percent year-over-year increase in servicing fees for the second quarter, to $440 million, while Bank of New York’s securities services revenues climbed 9 percent, to $436 million. J.P. Morgan reports custody results within its treasury and securities services group, whose revenues were up 2 percent, to $985 million. Citigroup said global securities services revenues were flat. However, the transaction services revenues in which they are included rose 5 percent, to $939 million, and profits jumped 76 percent, to $204 million.
As the proposed merger between CrestCo and Euroclear demonstrates, Europe’s fragmented marketplace is gradually unifying, providing more custodial opportunities. And privatized pension plans are also gaining ground, eliciting even more interest from custodians. Those that can export their fund accounting and shareholder reporting expertise from the U.S. stand to benefit. “These shifts change how funds are distributed and collected and also accelerate the trend toward transparency in performance,” says Swayne.
That explains some of the acquisitions that have occurred this year, including two brokerage purchases by Bank of New York: Autranet from Credit Suisse First Boston, and G-Trade Services from Crédit Lyonnais. J.P. Morgan in August agreed to acquire Los Angelesbased Plexus Group, a leading provider of trading-cost data to institutions.
“What’s interesting is that there hasn’t been a lot more consolidation,” says Sandra Jaffee, Citibank’s executive vice president of worldwide securities services. “There is talk, but there is a reluctance to disengage completely because the custody business really enhances cross-selling” of various bank services.
A similar cautiousness has prevented broader outsourcing deals from proliferating. State Street’s agreement to take over back-office functions for $240 billion-in-assets Pacific Investment Management Co. two years ago was supposed to start a trend -- but didn’t. Los Angelesbased Trust Company of the West, with $90 billion under management, last year awarded Mellon Financial a mandate for its back-office services, and Barclays Global Investors, the $500 billion indexing giant, turned over administrative functions to Investors Financial Services Corp. But it’s hardly been a flood, and none of it has been cross-border in nature. In fact, BGI withdrew a similar outsourcing plan in the U.K., saying the conversion costs there were much higher than in the U.S.
“In the slow economy people are behaving tactically rather than strategically,” says Timothy Lind, a custody industry analyst at Needham, Massachusettsbased research firm TowerGroup.
The biggest firms believe the bear market can help them. Customers will want to settle transactions faster and more cheaply as part of the drive toward fully automated straight-through processing of transactions. At the same time, September 11 underscored the need for security and reliability. “Clients want industrial-strength backup,” says J.P. Morgan’s Swayne. For that, of course, they’ll need the biggest custodians.
All figures for the survey are as of March 31, 2002. The custodians themselves provided the numbers in response to a questionnaire from II. Associate Editor Emily Fleckner gathered the data for this survey, under the guidance of Senior Editor Jane B. Kenney.
