In the high margin, high growth, minimal capital backed days of the late nineties, I recall computing a notional use of capital for the global business I was running. How simple life was then? The actual capital needed was minimal, the major risks were perceived to be operational and group management, with the mantra of cross selling being king, leveraged the fee power of the business to support other, more capital intensive product sales, especially from the corporate and investment bank.
The value of securities services to the firm could be summarised as primarily revenue based with assets under custody generating two or three basis points per annum average returns. On the risk side, documentation was exemption driven with much of the risk remaining, from a legal rather than practical perspective, with the client, although some perceptive clients such as Mark Mobius of Templeton would assert that the custodian was primarily their insurer. On the capital front, allocation was notional and often based, for smaller entities, around the demands of SEC 17f7 or, for the more sophisticated, a notional computation derived from the capital held by firms such as State Street, BNY Mellon or Northern Trust. On the relationship side, securities services were proclaimed to be the glue for the global relationship.
But this has all changed. Ad valorem and transaction fees, the bedrock of industry revenues, have been decimated and now stand lower in real terms than a couple of decades ago irrespective of the appreciation of markets, the salutary benefit of industry consolidation and the growth of global savings pools. Net interest income is currently a bad joke with absolute interest rates being often lower than the spreads historically applied to credit balances and the value of free balances suffering greatly as all markets enhance settlement efficiency. Stock financing, including collateral management, suffers but not as badly as some other areas although the big winners in that segment are the ICSDs and the major bank custodians. Prime services has often been added to the revenue equation but its value is threatened as funds move to multi-prime solutions, regulation precludes re-hypothecation and transparency has neutered over enthusiastic pricing. And other new ideas such as clearing have proven capital intensive and less attractive than was envisioned just a few years ago. On the cost side technology costs are only outstripped by growth in regulatory expenses and cost income ratios are very vulnerable to any downturn in markets, both fixed income and equity. The future looks bleak with the likelihood being for consolidation around the big hitters with a few outriders perhaps offering genuinely differentiated services.
On the risk side, we no longer need Mark Mobius to tell us we are the insurers as the regulators, in many key areas, have included that in regulation. The SEC wanted to get custodians to guarantee safety of assets in the 1990’s and were rebuffed at the most senior level. AIFMD and UCITS have gone through without anyone making a real whimper. The insurers of today, be they custodians, prime brokers or administrators, pretend this is not the case and delude themselves by hiding behind some uncertain wording in the different regulations despite all contrary indications that they are the guarantors of assets held. Some functions have direct capital allocation needs or are impacted by the various Basel liquidity rules, including stock lending, intraday facilities and leverage finance. In short the business now needs capital and liquidity resources from the corporate pool. The latter is the most worrying for, in truth, the whole settlement process is based on the ready availability of cash awaiting the availability of stock.
Relationships have also changed. Being mono-banked, in an era where regulators demand clear contingency plans and living wills, is not a benefit for clients. And bank structures are changing with investment banking becoming less profitable because foreign exchange and capital market margins are declining. Payment flows, especially post SEPA, are less profitable and also have liquidity and capital impacts. In short, financial institutional relationships are less valuable than they were when they generated high margin balances, substantial deposit revenues, market transaction income and the occasional bonus of a corporate finance deal.
So what is the future? The industry minors need to consolidate. And I suspect that the minors are now make up the majority of the industry global top-20. Local players will continue to exist as local asset gatherers but I suspect their role in the cross border market will be reduced as needs differ, liability increases and regional provision prevails over country specific selection. But beyond this, the industry has to change. Investment management fees are falling. More costs are being assigned to managers rather than the funds. Fees will be under pressure. The survivors need to look to cut unit costs in the 30-40% range. I have commented on the options in several past blogs and see the emergence of Fintech and the success of some of the new industry utilities as indicative of a need to eliminate duplicative effort, multiple record sources and unnecessary processing.
How will this happen? We need an industry wide group to draw up a template for the future. Most likely, this will be a small group of material market players willing to create a cooperative to protect their future. It is unlikely to be an altruistic, central bank-inspired grouping of the great and the good as in some past industry initiatives. This will not be a binary process but it needs to be considered in a world where my millennial friends are content with robo-advice, relaxed about electronic communication, expectant of data tailored to their needs using simple AI models and will be operating personal rather than corporate pension and savings plans, whilst expecting the pooling benefits of low-cost, large investment funds. And if banks cannot provide these services to millennials in the future, just as Jack Ma and Alibaba revolutionised the twenty year-old Chinese fund management business, someone, whose name we do not yet know but who will be worth billions within the decade, will do it for them. From there the step to an integrated platform is simple especially for those with no painful legacy to amortise or redundant skills to redeploy.
The future is bright for the brave and visionary. But who meets those criteria in our industry with its preference for gradual change at a time of revolution?