Banking regularly has a bout of extreme dysfunctional myopia. This has been evidenced throughout history by its love affairs with leveraging and leveraged lending, its adoption of fads such as the tech boom or the earlier Latin American and emerging market funding catastrophes. It has been compounded by its ignorance of the risks of unfettered mortgage based loans or the craziness of its willingness to accept exposure, with uncertain legality, to structures such as rehypothecated assets or liens based on uncertain precedent.
I have had concerns about the securities services business for some time ever since, after a few whimpers of protest, the concept of unlimited liability for the safety of assets was accepted under the EU’s alternative and UCIT rules. This aberration appears likely to be joined by several others.
Firstly, the critical risk vehicle of trading markets, the Central Counterparty, could soon, at least in the EU, see its risk policies subordinated to Central Bank monetary policy. Secondly, Investment houses are talking more of their suppliers being digital custodians and insuring them against the risks of cyber and other digital frauds or events. Allied to this, the major custodians are talking of broader outsourcing whereby the fund manager becomes the manufacturer, strategic distributor and operator of a fund with all other tasks and risks residing with a turnkey supplier meeting operational, technical, data management and some judgemental functions.
The latest EU data I have seen from the EBA shows non-performing bank loans at 6% of total loans and advances. That equates to the Spanish GDP. US banks perform better at 3% of loans and advances. In addition, banks have paid $321 billion in regulatory fines since 2008. Their continued imprudence, given that few banks have made an economic profit over this period, is staggering. In this light, it might be worthwhile highlighting the dangers of the recent additions to the custodian risk ladder as well as reminding ourselves of the risks implicit in asset safety rules. As a ratio of two dollars of assets under custody to each dollar of assets in their balance sheet is a common one for many custodians, the fact that custodial assets are seen as less risky is not a comfort but a necessity. As markets get more complex, as investments become more geographically diverse, as investment types expand, technology choice becomes ever more mission critical and as conflict of cross border law and regulation becomes more of a challenge, the relative scale of the two portfolios, custodial and direct risk bearing, is an issue. At what point could a risk in the custodial world translate into a balance sheet threatening event? The Central Counterparty issue and the challenges of changing liability across the post trade landscape, especially with growing outsourcing arrangements, could well be the driver for the next banking crisis.