SState Street said it is optimistic that it can fix relationship profitability with many customers by layering on additional products. At a Bernstein Research-hosted event with CEO, Jay Hooley and CFO, Edward Resch to discuss State Street’s strategy and the long-term outlook for the custody industry, the two opined that customers recognize a need to compensate custodians fairly to ensure appropriate reinvestment in services and to keep pace with customers’ changing demands.
Both expressed optimism that the custody business remains characterized by superior growth opportunities and is worthy of continued heavy reinvestment, echoing a theme expressed at the State Streets recent Investor Day.
Hooley started the meeting by confirming his confidence in the health of the trust business. Looking forward the CEO indicated that the company is targeting an 8-12% long-term growth rate. At the bottom of the range, this is expected to be driven by 5% annual growth from cross selling products and services to existing clients, 1% growth from market appreciation, 1% from acquisitions and 1% from additional market share gains.
State Street continues to pursue relationship profitability through cross selling less commoditized services such as fund administration, middle office outsourcing and investment products. The firm continues to express a cautious view about the ability of industry participants to exercise pricing power. The firm believes pricing suffers from an abundance of medium-sized rivals, competition and consultant intermediation in bidding for new mandates, and a high degree of commoditization in the vast majority of the trust banks’ services.
Through State Street’s middle office outsourcing business, Hooley explained the bank can expand penetration of its client base. Once a customer chooses to outsource middle office support, the relationship shifts from being a simple fee-for-service business transacted with back-office personnel to one in which State Street’s high-quality accountants and risk management staff support and interact with front-office traders and portfolio managers, he said.
Hooley pointed out that profitability tends to be more concentrated within certain sectors of custody clients. He drew a comparison between asset managers such as mutual fund clients at the high end, and asset owners such as pension funds at the low end. Mutual fund clients tend to be more concerned with high quality of service and view custodial bank fees as de minimis as a percentage of fund returns, he said. At the other end of the spectrum are pension funds, which are directly footing the bill and in for which the RFP process and absolute dollars paid a larger role in proving that the fiduciaries are acting prudently, added Hooley.
He also noted that middle office mandates tend to have much longer relationship tenure and are very sticky, as there are very few commoditized middle-office services.
State Streets management said it would not be in not be in the firms best interest to sell or spin off its asset management business. 75% of the largest one hundred State Street clients use both asset servicing and asset management products. The firm believes evidence of cross selling between servicing and asset management is tangible, such that disposing of SSGA would reduce revenue at both businesses.
Hooley noted that much of the growth of the bank in the coming years would come from abroad. Currently, 60% of State Streets revenues come from domestic sources and 40% are from international clients. State Street management pointed out that the custody business is becoming more global, as offshore asset managers embrace the third-party global custody model.
Hooley noted that some of the firm’s products, including mutual fund administration and middle office outsourcing, are highly differentiated and can command premium pricing. Hooley was optimistic about the prospects of hardening pricing on existing multi-product client relationships given high switching costs on customers.
State Street is targeting at 10% Tier 1 common equity ratio under Basel III. State Street estimates it currently has a 12.1% Tier 1 common ratio under Basel III, and management has said it would consider running this ratio well below its 10% target while the rules are being phased in through 2019. It was noted that this surplus capital position provides the financial resources to pursue acquisitions, which the firm appears intent on doing if it can capture assets and market share at an attractive price.
According to State Street senior management, the acquisition pipeline for global custody M&A remains slow. There are many European banks, which are still operating subscale custody operations. These businesses, according to Hooley, will eventually be sold and State Street intends to opportunistically look at these operations. And management noted that some of the largest players in Europe may be under pressure to shed non-core business in order to boost profitability and raise capital levels.Hooley opined that although revised capital rules had been introduced in Europe, until recently firms were not being held accountable to these standards. He said that appears to be changing, with the pressure.
Also, as funding pressures in Europe becomes less of an issue, firms may become less dependent on the liquidity generated by the custody business and therefore less averse to selling them. Hooley also said he believes there are fewer strategic buyers in the M&A landscape right now. Finally, Hooley expressed a tepid appetite for joint ventures wherein the parent bank of the custody target retains the use of the custody deposits and allows State Street to do the servicing (an idea put forth by BNY Mellon’s CFO). However, he seemed open to a transition period in which the target’s parent retains the deposits for two to three years, as was the case when the firm acquired Deutsche Bank’s asset servicing business.
Hooley noted that despite its strong capital position, State Street will only pursue new acquisitions if the bank can capture assets and market share at an attractive price. Hooley notes that State Street normally can cut approximately one half of the cost base as a roll up buyer.
(JDC)