Can a niche player also be a low-cost processing giant? It sounds unlikely, but State Street is close to pulling it off.
By Jeanne Burke
November 2002
Institutional Investor Magazine
It was hardly a surprise that State Street Corp. was an active bidder when Deutsche Bank put its $4 trillion global custody portfolio on the block last spring. The Boston-based firm services $6 trillion in assets worldwide and competes most closely with custody giants Bank of New York Co. and J.P. Morgan Chase & Co. What’s more, Deutsche has a large European client base that State Street coveted to further its international expansion.
The firm’s bid became especially intriguing when, in August, State Street sold its $689 billion corporate trust business to U.S. Bancorp. That operation was one of the last vestiges of State Street’s traditional banking business, which it had begun to jettison more than two decades ago.
Why go after Deutsche’s custody portfolio, the fifth largest in the world, while selling off corporate trust, a complementary function that involves the servicing and support of securities on behalf of issuers? Don’t Bank of New York and J.P. Morgan maintain huge corporate trust businesses, and isn’t massive scale the key to success in these processing activities?
For State Street the sale and potential acquisition could help to refine its strategy and market position. Without a traditional customer base of commercial borrowers, the bank no longer views corporate trust as a core business. Though it utilized many of State Street’s technology skill sets, the trust business didn’t serve the right client base. “Our customers are the world’s largest asset managers and pension funds,” explains president and chief operating officer Ronald Logue. “We want to earn as many dollars of revenue per dollar of assets as we can by offering as many value-added products to that pool of assets as we can.”
Defying conventional logic and following a narrowly focused strategy are nothing new for State Street. During the 1970s and 1980s, the bank exited mainstream retail and business banking to channel its resources toward investor services and technology. Now, in effect, it’s saying it can run the world’s biggest custody business (in September State Street won the right to negotiate exclusively with Deutsche and stands to be by far the largest custodian if it succeeds) with a narrower client base than those of its leading rivals.
Such a bold strategic turn entails some risks. For one, there is the possibility -- even likelihood -- that many of Deutsche’s customers will not stay with State Street, or will at least invite other custodians to woo them away. “This a great time for us to win business,” says Neil Henderson, J.P. Morgan’s securities processing executive and senior vice president of fund services. “All Deutsche Bank clients will be asking, ‘Do we want to be part of a mass migration, or do we take advantage of this opportunity to do a review and consider alternatives?’”
Meanwhile, as it further narrows its business base, State Street could be even more exposed to financial market downturns. For now, analysts aren’t worried; specialization has served State Street well. In the tough third quarter it cut costs and increased earnings 8 percent on a 1 percent decline in revenues. Gerard Cassidy, a Portland, Mainebased banking analyst with RBC Capital Markets, says it would take “a Draconian scenario similar to the 1930s, which we consider highly improbable,” to undo State Street’s strategy. But he notes that the price and structure of any deal with Deutsche are still unknowns.
To custody market observers bulk is the ultimate issue; State Street obviously sees it as desirable. But Timothy Lind, a securities processing industry analyst at Needham, Massachusettsbased research company TowerGroup, says, “There will be people concerned about going with such a large custodian.”
State Street, which reportedly bested bids from BoNY and Mellon Financial Corp. to get on the inside track with Deutsche, figures to change the structure of a market that is already dominated by a handful of companies leveraging large scale and low unit costs. Deutsche’s custody assets would vault State Street to about $10 trillion, well ahead of BoNY’s $6.6 trillion and J.P. Morgan’s $6.4 trillion.
With its sell-off of corporate trust, State Street is also putting that market in flux. By outbidding BoNY, among others, Minneapolis-based U.S. Bancorp leaped over BoNY to become No. 1 in municipal finance trusteeship and jumped to No. 3 from No. 7 in corporate structured finance.
Deutsche’s decision to abandon the custody market, a result of the restructuring initiated this year by chief executive Josef Ackermann, is a sure sign that size doesn’t guarantee a highly profitable, high-growth business. “Global custody is a good business, but we have certain benchmarks in these trying times, and global custody isn’t meeting those benchmarks,” explains a senior Deutsche Bank official who asked not to be identified.
The success of firms below the industry’s top tier, notably Brown Brothers Harriman & Co. and Investors Financial Services Corp., also demonstrates that economies of scale don’t always rule. Each is thriving with less than $900 billion in assets by focusing on a specific region or by lavishing attention on a small number of big clients.
Neither BoNY nor J.P. Morgan is going to concede anything to State Street. As banks with broader customer bases, they emphasize multifaceted relationships that typically include commercial banking, cash and treasury management and corporate trust. “We take a relationship view. We look at how many products we can sell to a company,” says Thomas Perna, senior executive vice president and head of Bank of New York’s investment services.
State Street doesn’t disagree with that philosophy; it’s simply sharpening its focus on a certain class of clients. COO Logue expects that more banks will be scrutinizing and reshaping their business lines in coming months and that they will find it harder to justify custody’s thin margins, regardless of how many services they sell. “Whether they will continue to offer custody is the question,” says Logue.
Yet some second-tier custodians will still tolerate low margins. Says Stephan Zimmermann, head of operations for Switzerland’s UBS: “We don’t concentrate on custody for custody’s sake. We see it as part of a full-service chain.”
For State Street global custody blends well with its fund administration and accounting services. Wherever possible the bank tries to bundle these investor products, which increasingly include middle- and front-office as well as back-office functions.
Especially attractive to State Street is Deutsche Bank’s multinational scope. Only 18 percent of State Street’s custody assets are cross-border, compared with 47 percent at Deutsche. State Street can thus apply its economies of scale to more non-U.S. and cross-border assets, which tend to yield higher margins than do domestic assets. “You’ll see us put a lot of effort into growing outside of the U.S. as fast as we have grown in the U.S. over the past several years,” Logue asserts. He points out that the company’s U.S. operating revenue has doubled in five years.
But State Street’s gambit doesn’t make the market any less competitive, and investment managers will be eager to play the combatants off against each other. In one instructive case, £25 billion-in-assets ($39 billion) Royal London Asset Management until recently used each of the top five custodians -- BoNY, Citibank, Deutsche, J.P. Morgan and State Street. When Royal London decided to consolidate down to one, the firm considered proposals from all but Deutsche, which it eliminated because of the bank’s diminishing commitment to custody.
Royal London, which gained prominence in the securities operations world this year by becoming the first user of the Omgeo network for straight-through processing of trades, finally settled on J.P. Morgan. But Julian Barnes, Royal London’s investment services manager, says that no custodian can complacently consider any relationship permanent. “J.P. Morgan knows, from the way we did the conversion, that we can move very quickly if we want to. They have to hustle,” says Barnes.
So, too, will State Street have to hustle to keep Deutsche’s clients in the fold. Incompatible technologies will have to be integrated, and service levels can suffer. “There will be massive migration issues, and the process of rationalizing systems is costly and time-consuming,” warns TowerGroup’s Lind.
The whole issue of reach becomes less important at a certain point, notes BoNY’s Perna. “Once you are big enough, it becomes a matter of product offering rather than size,” he says. “It’s a matter of whether the market feels you’re committed. No matter the size [of the custody business], you have to look at where it fits into an institution’s strategy.”
State Street seems pretty certain about where size fits in its overall plan -- and about where it wants to be. “We want to be No. 1 or No. 2 in all our marketplaces,” declares COO Logue.
