Narrow margins in core custody services and receding net interest income have prompted Moody’s to review the long-term ratings of BNY Mellon, Northern Trust and State Street.
As part of its review, the ratings agency will consider whether the banks are overly dependent on ancillary services for profitability.
Moody’s has placed the long-term ratings of BNY Mellon (Aa3 holding company senior, Aa1 bank deposits, B/aa3 bank financial strength/baseline credit assessment), Northern Trust (A1 holding company senior, Aa3 bank deposits, B/aa3 bank financial strength/baseline credit assessment) and State Street (A1 holding company senior, Aa2 bank deposits, B/aa3 bank financial strength/baseline credit assessment) on review for a one-notch downgrade.
It will review the banks’ financial strength ratings, all long-term senior debt, subordinated debt, and preferred stock ratings.
The banks’ short-term debt ratings were assured at the bank and holding company levels with Prime-1 ratings given.
During its rating review, Moody’s will focus on the long-term profitability challenges facing the banks. It said these 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.
Moody’s said that due to several factors underpinning the banks’ high ratings, including their “strong, sustainable franchise”, with core custody businesses benefiting from significant barriers to entry, significant asset management franchises, as well as the banks’ liquid balance sheets and good capitalization, any downgrades of the banks are likely to be limited to one notch.
It also said that despite each of the banks’ significant market share, pricing in the core custody business is very competitive, resulting in narrow margins. This makes the banks reliant on revenue from ancillary services to add to profitability, but these revenue sources have come under pressure. Specifically, 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, said Moody’s. The review will consider if the banks are overly dependent on ancillary services to generate a healthy level of profitability.
“About three quarters of these banks’ revenue comes from non-interest income, but the overall level of non-interest income, for all three, is pretty similar to their total expenses,” said Allen Tischler, senior vice president, Moody’s banking team. “That is an important point in our view because what it means is that their bottom line is somewhat reliant on their ability to generate revenue from net interest income since fees from core custody alone is not sufficient to generate strong profitability.
“One point we’re making is that the protracted low interest rate environment has revealed a vulnerability, not just because it has pressured their net interest margins, but also because it has reduced some of their fees. For example, they’ve had to waive money market fees.”
BNY Mellon reported net-interest income of $719 million for the first quarter of 2013, down approximately 1% on the previous quarter. Net interest income at Northern Trust fell 12% in the first quarter, from $266.3 million in the same quarter last year to $233.7 million. State Street reported a 10% decrease in net income for the first quarter to $687 million.
As interest rates rise, the banks’ earnings pressure will recede, said Moody’s. “However, the demonstrated vulnerability of their business models to protracted low interest rates constitutes a concentration risk,” it said. “This concentration risk may not be consistent with the business model resilience expected for a very high aa3 standalone credit assessment.”
The review will also consider the potential that the banks may alter their asset mixes in response to changing regulations. Currently, these banks have large securities holdings and are not heavily focused on lending, said Moody’s.
However, under the emerging Basel III guidelines, not yet finalized, the impact of interest rate changes on securities are expected to be an input to regulatory capital, added the ratings agency. “In addition, regulatory stress testing also considers the effect of interest rate changes on banks’ securities,” it said. “Consequently, 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.”
Moody’s said BNY Mellon faces incremental operational risk by virtue of its standing as a dominant clearing bank, and its capital ratio measured in leverage terms is materially weaker than those of its peers.
Of the three, State Street is the most concentrated in investment securities, making it most at risk from the consequences of the emerging regulatory capital rules, said Moody’s. These two banks also face continued litigation risk that spiked during the financial crisis, it noted.
As for Northern Trust, although it has been less susceptible to litigation risk, and its securities portfolio is more conservatively structured, it is exposed to the structural pricing and operational challenges facing the industry, particularly as it deepens its presence in newer markets, such as servicing large hedge funds, said Moody’s.
Several litigious developments have occurred in securities lending in the continued aftermath of the 2008 financial crisis. Out of several recent suits, four of them were settled, two were dismissed and two cases resulted in the bank paying up, indicating a willingness of client and provider to reach settlement in the aftermath of losses on programs post-2008. As part of the latest settlement between BNY Mellon and the South Carolina state treasurer, the custodian bank secured the client’s commitment for securities lending, and potentially foreign exchange in a new 10-year custody contract.
Transition management, another ancillary service provided by some custody banks, has also come under the regulatory spotlight. The U.K. regulator has turned its attention to a much-awaited investigation into the conduct and transparency of industry providers and is expected to determine if there are wide-scale issues that it needs to act on. The Financial Conduct Authority has already begun talking to providers following the recent scandals over alleged overcharging on transition management deals and is digesting the materials received from them. The transition management industry was dominated by a handful of global providers. In a matter of months, that number has decreased by two. Unrelated to the investigation, Credit Suisse recently closed its American business while J.P. Morgan confirmed it is exiting the business in all regions except Asia Pacific.
BNY Mellon, State Street and Northern Trust declined to comment on the Moody’s review.