Moody’s Reviews Custodians for Downgrade over Profitability Fears

(July 3, 2013) — Three of the world’s largest custodian banks could be in line for a downgrade as rating agency Moody’s has begun a review of their on-going profitability.

BNY Mellon, State Street, and Northern Trust are to undergo review, Moody’s announced on July 2, over concerns they are not earning enough revenue on their main business lines.

BNY Mellon, with $23.6 trillion, and State Street, with $25.4 trillion, claim spots in the top three custodian banks—in terms of assets—alongside JP Morgan. Northern Trust is slightly behind with $5 trillion. However, revenue on most of their business lines is small, Moody’s said.

“These profitability challenges are driven by the aggressive pricing of all three banks’ core custody products and services, such that their overall fee revenue is roughly similar to their total expenses,” Moody’s said in a statement.

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“Despite each of the banks’ significant market share, pricing in the core custody business is very competitive, resulting in narrow margins. This makes the banks reliant on revenue from ancillary services to add to profitability, but these revenue sources have come under pressure.”

Moody’s highlighted that net interest income had been constrained by low interest rates, foreign exchange revenue had been hurt by lower volatility and increased scrutiny of pricing, and securities lending revenue had declined due to lower demand.

Custodians have branched out in recent years and offered a league of other services to their investors in an effort to generate revenue while often giving their basic custody products for little or no fee.

“The review will consider if the banks are overly dependent on ancillary services to generate a healthy level of profitability,” Moody’s said.

The number of law suits faced by the two largest banks under review is also a concern for the ratings agency, it said. Each is fighting legal battles with large institutional investors about various actions.

Additionally, banking regulation Basel III is to apply to the institutions and could potentially demand a shake-up in their portfolio to satisfy capital requirements.

BNY Mellon’s role as a dominant clearing bank is also a concern for the ratings agency due to inherent operational risk and its capital ratio, which-in simple leverage terms-is “materially weaker than those of its peers”.

However, any downgrade would limited to one notch, Moody’s said, due to the overall strength of the banks’ businesses, which included significant asset management franchises.

State Street and Northern Trust declined to comment; BNY Mellon had not returned requests for comment by the time of going to press.

(July 3, 2013) — The changing regulatory environment is the main driver of expanding due diligence by hedge fund investors, according to Deutsche Bank’s latest survey.

The bank’s hedge fund consulting group polled 68 institutional investors from around the world, whose assets totaled $2.13 trillion with a hedge fund allocation of $724 billion. Nearly three-quarters of respondents ranked a fund’s compliance and regulatory framework as their top priority for 2013.

The large majority (70%) of external operational due diligence (ODD) teams had explicit veto authority in the investment decision making process, and 63% of investors said they would not consider allocating to a fund previously vetoed by an ODD team. Investors reported conducting an average of 50 manager reviews a year, and 80% said they have a dedicated ODD group.

The survey also found the majority of respondents had little to no tolerance for expenses such as non-research related travel or external employee compensation.

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Those surveyed preferred hedge fund boards to be heavy on independent directors. Investment in human capital and proper segregation of duties ranked as investors’ top two operational wishes when assessing start-up managers.

“This survey demonstrates the critical importance of operational due diligence to hedge funds as the industry experiences an ongoing evolution,” Pam Kiernan, Deutsche Bank’s global head of hedge fund consulting said. “Our results show that these teams have advanced in sophistication and provide valuable insights as to how managers can prepare for the road ahead.”