Welcome to Catatonia
Custodian banks are now in the fourth year of a prolonged crisis. The stock prices of all of the stand-alone global custodian banks are 50% below where they stood when Lehman Brothers failed in September 2008. With revenues yet to advance on the levels achieved three years ago, and opportunities for growth without acquisition far from evident, it is not obvious why anybody should invest in a custodian bank today. The owners of every business must from time to time ask themselves whether they are invested in the wrong assets through the wrong businesses run in the wrong way by the wrong people. Certainly the response of the leaders of the industry to its current difficulties is a curious mixture of Wilkins Micawber and Sam Ward. On the one hand, they seem content to wait for interest rates to revive, leverage to return, hedge funds to wax and retirement savings to resume their steady accumulation. On the other hand, their lobbyists are swarming across Capitol Hill, the Berlaymont and Westminster to blunt the impact of regulation. As thinkers trivial and profound have noted for centuries, every problem presents an opportunity, but custodian bankers seem determined to deal with the problem only, by waiting or paying for it to go away. Yet a combination of waiting for the restoration of the status quo ante, plus expensive lobbying of politicians and regulators to preserve as much of the past as possible, scarcely amounts to a stratagem, let alone a strategy.A strategy is by definition forward-looking, not backward-looking. If the industry cannot envisage a future other than one that looks as much like the past as possible, it is by definition refusing to accept that anything fundamental changed between 2007 and 2009. It is not surprising. Most business leaders are more adept at exploiting what they know than identifying what is growing. If they think about the future at all, it is only as an extrapolation of the past. Even the newest information is processed through existing preconceptions. The result is a bias to conservatism, even conformity. The result is an industry trapped by the unimaginative strategies it adopted during the bull market. Its leadership then operated on the belief that the business was commoditized, and that the only sustainable source of growth in revenue and profit was through the reduction of competition through consolidation, and the lowering of costs through economies of scale. Positive feedback from this approach further reduced the incentive to think. As revenues in the core business of safekeeping were allowed to stagnate, it encouraged the belief that the industry was commoditized. Though the strategy worked, it was not for the reason senior executives assumed. Growth came not from consolidation and the lowering of costs but from cyclical windfalls: securities lending, net interest margin and foreign exchange. It left the industry singularly ill prepared for the shock of the financial crisis.Even now, the leaders of the industry remain convinced that current market conditions are a temporary aberration. The possibility that the world has changed, and their business needs to change with it, is not one they are prepared to entertain. Their strategy is simply to do more of the same: cut costs, buy other businesses and look to lend more cash and securities. Some custodian CEOs have even accepted that more of the same will be done to them. Though they would never admit the possibility to staff, they fully expect to be merged or acquired. Yet it is entirely possible that the world really has changed, and changed permanently. If it has, regulation - routinely named by custodians as their top priority - is the least of the problems they confront. Equity markets are still below the level at which they peaked at the height of the TMT boom. Despite the efforts of governments and central banks to restart the credit cycle with zero rates of interest, and oceans of printed money, real economies remain unresponsive and unbalanced. All of the factors that made custody such a lucrative business through the last credit cycle - rising markets, positive rates of interest, high leverage, short selling and frenetic transactional activity at spreads the clients never saw or understood - may not return for years, if not decades. In many areas, a mixture of electronic trading platforms, central counterparties and central securities depositories threaten disintermediation of the custodians from the bulk of the business that remains.Most importantly of all, clients are distrustful. However unfairly, custodians are part of an industry that has acquired a reputation among clients for being less than straightforward about how it gets paid. Paradoxically, this is also the principal opportunity custodians now confront. With the possible exception of corporate actions, it is difficult for a custodian bank to differentiate itself through the quality of its clearing and settlement, safekeeping, asset servicing, corporate trust, fund accounting or transfer agency services. Indeed, clients often prefer to purchase inferior versions of these services in order to gain access to something they genuinely value, such as credit or creditworthiness, or local market presence. The real differentiator now is not what services a custodian provides but how it provides them. That custodian bank that can make its customers trust it, persuade them that its values as well as its incentives coincide with theirs, and convince them that it acts on those values as well as talks about them, is the one that is best positioned for the evolution of the marketplace. Given the starting point - confidence in the banking industry has evaporated - the journey back to a position of trust will be long and circuitous. But there are two obvious steps that custodians could take to start that journey now.The first is to eliminate the conflicts of interest that plague the hybrid agent-principal business model custodians have developed. Over the last 20 years, custodians have cut the price of the core, off-balance sheet, feeearning businesses of safekeeping and asset servicing in return for the right to exploit assets in custody through stock loan, net interest margin and foreign exchange bargains. By agreeing to act purely as a fee-based agent in the cash, foreign exchange and securities lending markets, custodians could eliminate the temptation to widen the spreads they take from client portfolios when they execute the business directly. Custodians of this kind would continue to charge fees for collecting income and tax reclaims, processing entitlements and voting stock. But they would also be paid fees for obtaining on behalf of clients the optimum combination of safety and return for their cash; the best rates and the most reliable sources of credit; the ideal combination of size and price for trade execution; the cheapest rates of exchange; and the highest prices for lending their portfolios. None of this is incompatible with continuing to benefit from rising asset prices through ad valorem fees. It has the further benefit of eliminating the risk of ostensibly off-balance sheet risks finding their way on to the balance sheet when backstop facilities are called in (as with conduits) or a client litigates (as in securities lending and foreign exchange). Being less capital intensive, agentonly custody will also be cheaper to provide in an era when the cost of capital is likely to increase. It is also well suited to an environment in which regulators are increasingly inclined to separate utility banking from socalled casino banking.The second step custodians could take is to be more open. Openness will to some extent be a natural consequence of reversion to an agency model, since there will be no need to conceal the true price of services from clients any more. There is a cant word for openness - transparency - that is widely used in the custody industry today, but it should not be confused with the real thing. True openness is not the creature of the compliance department. It entails taking the risk of telling clients, competitors, employees, suppliers and even journalists what is wrong with the business as well as what is right with it, and what it cannot do as well as what it can. Genuine openness entails taking the risk of losing control of critical business information, including the prices at which business is being done. This is the paradox of openness. By taking the risk of trusting people, custodians will themselves become more trustworthy. The benefits will not show up immediately. But they will over time, through reduced distrust and complexity in negotiations with clients, increased repeat business and greater innovation at lower risk through the formation of deeper relationships with clients. Trust will also lower the cost of capital, because investors will have a better understanding of the costs, revenues and risks the business is facing, and so help to restore confidence in the banking system as a whole. Trust cannot be earned unless an organization encourages its people to hide nothing, including information and insights that are to its disadvantage. It entails not just telling the truth, but refusing to lie. It is, in a word, integrity.In an industry as compromised as modern banking, it ought to be obvious that the principled provider - the provider who chooses to do the right thing - will be at a competitive advantage. Unfortunately, I see little evidence that the necessary changes in the mental universe of custodian bankers has yet taken place. The surveys that we run and publish in the magazine offer an intriguing contemporary insight into the moral and cultural condition of custodian banks. The providers that build the survey process into their relationships with their customers, and ensure that customers understand they take the findings seriously, tend to get better results. But they are a small minority. Only a handful of banks make the modest investment required to obtain full details of the scores and comments, even though customers have often made dozens of lengthy and well-considered comments on their people and services. Some banks are confident that they have told their customers what to say and have no need to hear the ventriloquist. More believe they know already what their customers think. If the survey results differ from their own perceptions, or the results of an internal survey, it is our methodology that is at fault. It is not unknown for providers to demand "withdrawal" from a survey after they have seen their results, on grounds the poor outcome could not possibly be a true reflection of either their capabilities or the opinion of their clients. The overwhelming majority of service providers are still interested not in finding out what their customers think, but only in ensuring that the results reflect how they think of themselves.In fact, every survey we run is now reduced to an arms race between the efforts of the majority of service providers to manipulate the outcome and our own efforts to preserve the integrity of the process. There is no survey in which we have not had to make elaborate modifications to the methodologies in order to counter the fact that providers are completing questionnaires on behalf of their clients, or making sure they are present when they do so, or even fabricating responses. In some surveys, we are now disposing of hundreds of junk responses of this kind and doubtless failing to eliminate many more that are too subtly concealed. The only information conveyed by the perfect and near-perfect scores that some providers insist upon is that such institutions are not interested in information they did not manufacture themselves. It is an infallible rule of our survey process that, if an institution makes even a fraction of personal remuneration contingent on the result, ethics are immaterial. It is hard to know how seriously to take the individuals who say that a poor result will lead to their dismissal, but it speaks volumes about the culture of the organizations that employ them. In short, our surveys are a small but disquieting gauge of the continuing propensity of custodians to lie to themselves, and to make their staff and their clients complicit in their lies.As to openness, the prospect is no more pleasing. One of the main reasons why custodians find it so hard to conceive of doing things differently is that they have chosen to keep themselves in a state of dense ignorance about their industry, and so of their competitive position within it. The prices they charge for their services are completely unknown. Even the structures of the fees they charge are kept deliberately vague. As to trading revenues, a custodian would rather field a lawsuit than disclose the price at which a foreign exchange bargain was struck. Details of the value of new business won, which were the subject of league table compilations in other parts of the banking industry 40 years ago, remain hidden from view. (I have myself read several Kafkaesque press releases in which even the name of the client was withheld.) The only figure likely to be disclosed is the one that serves a sales or marketing purpose. The 14-digit numbers given for assets in custody are the classic example of the genre. Repeated attempts to make these large figures more useful by breaking them down between different geographies (even international and domestic) or client perspectives (buy- or sell-side) or forms of safekeeping (own branches or third parties) or client types (pension funds or fund managers) or business lines (corporate trust or fund administration) or nature (affiliated or independent) or distance (internal or external) are greeted as if they were requests for a statement of sexual preferences.Information given by the few forwardthinking banks is rendered useless by the majority that stonewall impertinent inquiries with tired formulae such as "proprietary information" or "not disclosed" or (my personal favorite) "client confidentiality." It would be a marvel that regulators allow custodians to make such lavish claims about the size of their businesses without substantiating them, were it not for the fact that the regulators are complicit. Secrecy is a plague that affects the whole of the banking industry because the central banks know that in a fractional reserve banking system every bank is technically insolvent every day. They continue to worry that, if creditors had enough information to work out what risks a bank were really running, it would provoke a run on the entire banking system. This superstition has somehow survived the crisis of 2007-08, when it was precisely the fact that nobody knew who owned what that desiccated the markets in short-term liquidity.It is impossible to think of a more complete demonstration of the want of trust in the banking industry than the events of 2007 and 2008, when no bank would lend to any other bank for fear of what that bank might be hiding from its creditors. In the end, of course, only central banks with the power to manufacture money would lend, and they remain a disturbingly large source of funding for banks today. Banks are lucky that they operate in an environment so privileged that politicians will dragoon taxpayers into bailing them out rather than allow them to fail in the way that Digital Equipment Corporation or the Polaroid Corporation was allowed to fail. But eternal life is not promised to businesses within banks, or to particular banks within the banking industry. The securities services businesses of the major international banks are a trifle within their organizations as a whole, and the stand-alone custodian banks are too small to be invulnerable to acquisition. If bankruptcy is not a possibility, acquisition, disposal or breakup is. Even in the custodian banking industry, there is no such thing as perpetual safety or stability. But if custodians lack control over how the markets will evolve, they can at least redesign their organizations to evolve more successfully within those markets. Unfortunately, there is as yet no sign that they have understood either the gravity of their position or the need to exercise what ingenuity they have to escape their current predicament.