Moody’s has put BNY Mellon, State Street and Northern Trust on review for possible ratings downgrades. We review the current status.
Here’s what Moody’s said on Tuesday, July 2, along with our comments:
“Moody’s Investors Service has placed the long-term ratings of three large US trust and custody banks (including the bank financial strength ratings, all long-term senior debt, subordinated debt, and preferred stock ratings) on review for downgrade. The short-term Prime-1 ratings of the three banks, at both the bank and holding company levels, were affirmed.”
This review is really looking at the long-term health of the three custodians. There are no immediate concerns on the horizon; Moody’s is taking a broader view. The fact that short-term ratings remain unchanged keeps the three banks on par with J.P. Morgan and HSBC.
“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. The review will also examine the banks’ ability to generate more revenue from custody-related services and cut costs.”
There is no doubt that all custodians including others not up for review are pricing very aggressively for core services. Pricing for ancillary services is also fiercely competitive, with securities lending fee split bids well under the already low 90/10 line. The big custodians have had no choice but to price more competitively as well, leading to Moody’s concern about revenues being about equal to expenses. This is a fair assessment and one that suggests more business model changes at the custodians going forward.
This is already underway. In a future post or report we will discuss “the new bundling”
of custodian pricing that includes outsourcing and collateral management services, two “ancillary” services that didn’t even really exist ten years ago.
“Net interest income has been constrained by low interest rates, foreign exchange revenue has been hurt by lower volatility and increased scrutiny of pricing, and securities lending revenue has declined due to lower demand. The review will consider if the banks are overly dependent on ancillary services to generate a healthy level of profitability.”
While this has been the general trend for years, we note multiple instances of custodians pricing custody more fairly and steering away from relying on securities lending, FX or other services to make up a loss. We think this is the direction that pricing takes from here. The best recent public example is BNY Mellon’s settlement with South Carolina, where the state agreed to pay an estimated $2.6 million a year in custody fees alone under a 10 year contract. The securities lending split is 90/10, which is fair. While BNYM had to pay $34 million to settle the lawsuit, we think that from a reputation and financial perspective, the custodian did pretty well. Non-public agreements that push more costs toward custody and away from foreign exchange and securities lending also disprove Moody’s argument here.
“The review will also consider the potential that the banks may alter their asset mixes in response to changing regulations…. the declining value of fixed-rate securities in a rising rate environment, realized or as part of a stress test, would reduce regulatory capital. This could influence the banks to alter their investment policies and result in an increase to their risk profiles.”
This is a tough one to comment on given the substantial uncertainties that surround specific holdings, RWA calculations and the results of stress tests. The Fed’s stress test from earlier this year actually showed BNY Mellon’s Tier 1 common ratio performing better under stressed conditions than now. State Street declined a bit but was still #2 in the group of banks. We are not sure that the custodians will really want to alter their holdings given how well they look in the current Fed stress testing model.
“Moody’s added that the review being announced today is focused on the banks’ standalone creditworthiness and not on Moody’s systemic support assumptions, which are not a component of this review.”
Hence, the current review, while necessary, may be for naught: since any downgrades right now “are likely to be limited to one notch,” the net effect could be nothing or a strengthening of ratings.
Regardless of the outcome, the Moody’s review of BNY Mellon, State Street and Northern Trust opens up important questions that should be discussed about the health and business models of major custodian banks. We don’t think that any of the three will be unduly damaged by Moody’s outcome. A real downgrade could create client defections as clients require their custodians to hold a certain rating in order to keep their assets safely. This is not an expected outcome of the current review. In the meanwhile, J.P. Morgan, BNP Paribas and HSBC (and maybe Societe Generale) must be pleased that the conversation shines any question on their competitors’ financial soundness at all.