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If a Custody Bank Fails, Should Clients Fear for Their Assets?

BNY Mellon’s recent fine for inadequately protecting U.K. clients’ assets raised questions about safety measures during bank insolvencies.

Bank of New York Mellon Corp. got a spanking this past April. The London branch of the world’s largest custodian bank, with $28.5 trillion in assets under custody and administration, was fined £126 million ($185 million) by the U.K.’s Financial Conduct Authority for failing to follow the rules. The FCA found that between November 2007, when Bank of New York Co. bought Mellon Financial Corp., and August 2012, the custodian had inadequately safeguarded British clients’ assets against the event of insolvency. Although BNY Mellon’s London branch represents only about 5 percent of the firm’s global custodied assets, it’s considered systemically important to the U.K. market.

What steps do custodian banks take to prevent client assets from being swallowed up in an insolvency, particularly during turbulent times like the 2008–’09 financial crisis and its aftermath?

U.S. banks and regulators grapple with similar questions, though preventative measures are beefier than before the crisis. First, custodied assets can’t be used to pay back general creditors. In a U.S. insolvency, assets are directed to the Federal Deposit Insurance Corp. or a state banking authority, known as the receiver. Physical assets like stock certificates and title documents are automatically collectible and transferable by the owner to another bank. “That traditional concept is not as relevant anymore since the development of digital trading in the 1970s and 1980s,” says Edward Klees, author of a 2012 paper titled “How Safe Are Institutional Assets in a Custodial Bank’s Insolvency?” and general counsel of University of Virginia Investment Management Co., speaking in a personal capacity.

For institutions, assets held under custody are rarely physical. If a custodian bank goes belly-up, the FDIC relies on documents such as ownership records and valid custody agreements between the institutions and the bank to verify ownership. “Custodians and institutions are generally very disciplined in keeping clear records,” explains Sean Mahoney, a Boston-based partner at law firm K&L Gates who specializes in bank regulatory issues. “It’s something all parties are hypersensitive to.”

Another risk is improper allocation of traded securities. If, because of an error, securities end up outside the bank on the day of insolvency, the FDIC is powerless to trace and return those assets, and the client is out of luck.

Along with regulators, investment firms that store assets with custodians constantly monitor the financial health of each bank. Institutional investors tend to evaluate banks’ cybersecurity measures and technological progress. The FDIC’s free online institution directory allows anyone to generate customized reports of capital ratios, liquidity positions, the relative strength of a bank’s assets and other vital signs. All insured banks are also subject to regular on-site examinations whose frequency depends on the latest exam’s revelations and the existence of any trends that need particular attention, says William Kroener III, counsel at the Washington office of law firm Sullivan & Cromwell and general counsel of the FDIC from 1995 to 2006. Part of the exam process is gauging the firm’s solvency, adds Kroener, whose practice focuses on bank supervision and regulation.

The FDIC uses a composite rating system that evaluates CAMELS, or capital, assets, management, earnings, liquidity and sensitivity, to determine whether a bank is likely to collapse. “In a good economy less than half the banks on the probable fail list ever fail,” Kroener reckons.

Scale matters too: The risk of poor documentation is higher for smaller banks with fewer resources, and the Dodd-Frank Wall Street Reform and Consumer Protection Act requires an added layer of insurance for big banks. All systemically important financial institutions, including major custodians like BNY Mellon, State Street Corp. and J.P. Morgan, must design a road map showing how their failure would be managed in place of a bailout — a so-called living will, or orderly liquidation plan. The biggest banks also retain full-time teams of independent examiners.

Any deficiency found by an examiner must be corrected immediately, with repeat offenses leading to informal and formal enforcement orders. “There’s significant expense involved,” Mahoney says, from hiring external counsel and consultants to developing and executing a compliance plan. Enforcements are generally confidential so examiners can note and act on a troubling risk without causing a bank run, he adds. Publicly traded banks preempt public announcements by issuing press releases with a positive spin.

As in the wake of the 2008–’09 crisis, the regulator’s typical response to an insolvency is to arrange a merger or to take possession of the bank, close it and immediately sell its assets to a third party. Attorney Klees recommends having a second custodian because negotiating custody agreements can take months. “As a practical matter, it’s very rare for the FDIC to shut down a bank that fails,” says K&L Gates’s Mahoney.

Bank insolvency is low on Mahoney’s list of concerns these days — “probably after a catastrophic meteor event,” he jokes. In Kroener’s experience, insolvency issues don’t tend to be in the custody area. “If a bank fails,” he says, “it’s rarely a problem for a custodial client; it doesn’t produce economic losses.”

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