Moody’s this week has placed the long-term ratings of BNY Mellon, Northern Trust and State Street on review for a one-notch downgrade. Senior analyst Allen Tischler tells Global Custodian about the drivers for the review and process that it will follow.
What is driving the review?
AT: The banks’ long-term profitability challenges. 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. 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. Net interest margins, the primary measure of net interest income, on the other hand, are low, both historically, because of low rates, and relative to traditional banks. This reflects the custodians’ different business mix – they’re not out there with big loan portfolios.
But this is not just about net interest margins. 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. So there’s an impact of low interest rates beyond net interest income. In other words, our review is not specifically tied to net interest income pressure.
To reiterate it’s a couple of things: 1) non-interest income is pretty similar to expenses, which is a long-term profitability challenge for these banks, and 2) the vulnerability that their business model has shown through low rates, which shows up in lower net interest margins but also in lower fees and that constitutes a concentration risk. Those are the revenue pressures we’re citing. The inability to generate fee income that exceeds expenses is challenging to overcome because there is very competitive pricing for some of these custody relationships.
We acknowledge that when rates rise the earnings pressures that were driven by the low rate environment will recede so the banks’ profitability will be better in a higher rate environment. However, by virtue of having their profitability squeezed from rates being as low as they are, that shows that their business model is susceptible to a low rate environment and that vulnerability is a concentration risk that perhaps isn’t fully accounted for in their very high double AA ratings. Keep in mind that these banks are among Moody’s highest rated on a global basis.
What measures are you expecting from the custodians to offset the low interest rate environment?
AT: Getting more profitability out of core custody is a reasonable way to respond to this environment. The profitability potential is to either get better pricing, attract more revenue by selling more ancillary services, or cut costs. So what we’re saying is the things they can control, which is generating more revenue from the core custody business, that will require more robust pricing, but pricing in that business is very competitive and that results in narrow margins. They can cut costs, which is something they’re all working on, specifically, improving their operational efficiency.
How will you benchmark whether these measures are successful?
AT: If we compare their total fee revenue to their total expenses – if we see that going materially above a one to one ratio, then we’ll know that they’ve either been successful at increasing their prices or generating more ancillary revenue or lowering their expense base, or some combination of the three.
How have recent securities lending litigations affected your decision to review the banks?
AT: The litigations which we touched on here is certainly something that has increased as a result of the financial crisis and there’s a lot of ongoing litigations still and we’ve seen increased expenses related to this. Yes that represents a challenge not only for profitability but it has resulted in some increased scrutiny on some of the pricing we have seen in the foreign exchange area and that’s something we continue to follow.
What would a one-notch downgrade mean for the banks?
AT: BNY Mellon was downgraded in the last two years in terms of one notch. Northern Trust’s rating has been more stable then the others and they have had nothing downgraded for a long time and State Street was downgraded one notch during the financial crisis. These banks, again are not only very highly rated within our bank rating scale but they’ve also been very stable. BNY has already been downgraded but its only been one notch – if you compare that with what is going on in general the average US bank and the medium US bank’s rating is two notches lower than pre-crisis. This has to be considered in the context that these [custody banks] are very strong and they are very good franchises but notwithstanding all that there are some profitability challenges that we’re observing and makes them slightly less credit worthy.
This some times results in divestments by the banks. Is that your experience?
AT: They still would be highly rated. So all of the banks have a high short term rating which is Prime 1 and what we said here is that they are going to remain Prime 1 and that’s our highest short term rating and even if the long term rating does come down one notch as I say they will still be at the top of the ratings scale so obviously investors will decide what the impact of any ratings action is but if they’re comparing these three with other places where they might put their money these will still be some of the highest rated banks we have even if we do end up downgrading them.