• When we invest in any forms of financial assets, we will need someone to hold these assets on our behalf. This is where a custodian bank steps in, providing asset safekeeping and other custody-related services to investors.
• Custodian banks are in prime position to benefit from the booming demand for financial services worldwide, which will, in turn, drive future growth in demand for custody services.
• As a result of their fee-based revenue structure, custodian banks are usually more resilient during periods of market uncertainty compared to traditional commercial banks. The three global custodian banks, BNY Mellon (NYSE:BK), State Street (NYSE:STT), and Northern Trust (NASDAQ:NTRS) were among the “best performing banks” in the recent Fed stress test.
• The global custodian banks have been investing in new technologies to move up the value chain, offering new services in line with client needs. By tapping on new technologies, custodian banks can capture new revenue streams and reduce overall cost.
• At their current valuation levels, we see an average upside potential of about 30% based on 2022E earnings. Based on their respective third-quarter dividends, the three custodian banks are yielding at approximately 2.5% after taking into account dividend withholding taxes.
• Investors who prefer a diversified option should look at the Invesco KBW Bank ETF (NASDAQ:KBWB) which tracks both the US commercial banks and custodian banks.
When we invest in any forms of financial assets, we will need someone to hold these assets on our behalf. We will also need someone to receive dividends and interest payments on our behalf, as well as someone to inform us of any upcoming corporate actions initiated by the companies we hold in our portfolios.
This is where a custodian bank steps in – a specialised financial institution that provides asset safekeeping and other custody-related services to investors, acting as a storage for financial assets. A custodian bank usually provides such services to large institutional investors, including mutual funds, pension funds, insurance companies, official institutions, as well as private wealth institutions.
Unlike banks like JPMorgan (NYSE:JPM) or Citigroup (NYSE:C), custodian banks do not have much presence in the commercial banking space. They focus less on extending loans or taking in deposits, but they still play a crucial role in the global financial markets for these reasons:
a) Their services are required to help facilitate client access or participation in the global financial markets by acting as the intermediaries between investors and the necessary financial market infrastructure.b) Their services are often required by the regulatory bodies to protect investors from potential mishandling of funds or any illegal activities by the fund manager.
In this article, we will be focusing on the leading custodian banks that operate on a global scale, with presences in over 100 securities market worldwide. As of 2019, the top five largest custodian banks in the world are BNY Mellon, State Street, JP Morgan, Citigroup, and Northern Trust (Table 1).
Table 1: Top five largest global custodians in the world
| Assets under custody ($ trillions) | |
| BNY Mellon | 37.1 |
| State Street | 34.4 |
| JP Morgan | 26.8 |
| Citigroup | 20.3 |
| Northern Trust | 12.1 |
Source:
Respective annual reports, Global Custody, iFAST compilations Data as of 2019 |
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Business model of custodian banks
Custodian banks today offer a wide range of services for their clients, including the core custody services, such as safekeeping and asset servicing, as well as other custody-related services like securities lending services, foreign exchange services, and other administrative services (Table 2). You can think of the custody-related services as the non-core middle and back-office functions of a company.
Table 2: Examples of the services provided by custodian banks
| Type of services | Description |
| Safekeeping and record-keeping | - Record the amount of securities deposited by their clients; reconciling the securities holding of clients with a CSD or with a sub-custodian |
| Asset servicing | - Income and tax processing; corporate action processing; securities valuation |
| Banking services | - Provide short-term loans to make up for a shortfall in funds (when purchasing securities) |
| Transaction processing and settlement | - Transmit the purchase/sale settlement instructions to the relevant CSD or ICSD; help to facilitate the delivery of securities |
| Foreign exchange services | - Help to process transactions in multiple currencies which allows their clients to transact seamlessly |
| Fund accounting services | - Generate and calculate the fund's net asset value (NAV) |
| Outsourcing services | - Services to do the middle/back office work: transaction management, cash management, record-keeping and accounting, data management |
| Source: The Custody Services of Banks by the Clearing House, iFAST compilations | |
In return, these custodian banks charge a fee based on the total amount of assets under custody (AUC). As per all contracts, the percentage charged will depend on the arrangement between the custodian bank and the client, especially since different clients require different levels of support.
Therefore, in general, the majority of custodian banks’ income is earned through recurring fee revenue (approximately 78% on average) and the remaining through net interest income. This is in contrast to commercial banks, whose revenue is derived primarily from net interest income.
Thanks to their fee-based revenue structure, custodian banks are more resilient during periods of market uncertainty compared to traditional commercial banks, with their flow of income generally quite stable throughout the years. Besides, custodian banks are also less affected by the interest rate environment and they require a much lower loan provision given their lower level of credit exposure.
Custodian banks may not be as exciting as commercial or investment banks, but we believe a ‘boring’ business model has its merits, especially in this current period of market uncertainty. We like the top three pure-play global custodian banks, namely BNY Mellon (NYSE:BK), State Street (NYSE:STT) and Northern Trust (NASDAQ:NTRS). We believe the nature of their business allows them to capture the growth in demand for custody services worldwide as investments become increasingly globalised and investments in financial assets continue to grow exponentially.
Global custodian banks will ride on the growth of the asset management industry
The asset management industry is set for another decade of growth, driven by the increasing wealth of high-net-worth individuals and the mass affluent. These wealthy investors are constantly looking for more avenues to park and grow their assets, be it in investment products, such as mutual funds and ETFs, or protection-oriented products like long-term health insurance.
Therefore, the strong growth in financial assets, as well as increasing cross-border and multi-asset investing will drive global AUC in the coming years (Chart 1).
Chart 1: Global custodian banks will benefit from the growing client assets
Since AUC is one of the key leading indicators of the custodian banks’ revenue, the strong growth in financial assets will translate to higher revenue and earnings for the custodian banks.
Outsourcing services to the custodian banks will drive AUC and earnings growth
Due to the rising life expectancies across the world, there has been increasing pressure on asset managers to generate higher net returns for pension funds or insurance companies to counter the longevity risk. As such, cost control has increasingly become the main agenda of every asset manager. At the same time, many asset managers are also pressured to offer lower-cost investment options to end-investors given how zero-fee investing is on the rise.
In light of this, asset managers are increasingly outsourcing their non-core middle/back-office operations to custodian banks since many of them generally lack the economies of scale to carry out these functions efficiently. Hence, as more asset managers outsource these functions to custodian banks, not only will it help asset managers lower their cost of operations, it will also boost the fee revenue of custodian banks.
Nature of the business adds resiliency to bottom line
Given the nature of their business models, custodian banks have generally managed to produce a relatively stable bottom line as compared to commercial banks. In the first half of 2020, traditional commercial banks had to set aside huge provisions for credit losses, taking a huge bite off their profits. Meanwhile, the custodian banks only needed to set aside a fraction of what the commercial banks forked out (Table 2). On average, the three pure-play custodian banks managed to generate rather resilient earnings in 1H 2020 relative to the commercial banks.
Table 3: Provisions made by the big banks in the 1H20
| 1H20 provisions for credit losses (USD millions) | |
| BNY Mellon | 312 |
| State Street | 88 |
| Northern Trust | 127 |
| JPMorgan | 18,758 |
| Citigroup | 14,930 |
| Bank of America | 9,878 |
Source:
Respective quarterly earnings report, iFAST compilations Data as of July 2020 |
|
Another big plus of having a more resilient income is that it helps the custodian banks to maintain strong capital ratios in the event of an economic downturn. Custodian banks generally have very low credit risk on their balance sheet. During an economic downturn, when credit risks shoot through the roof, they are not as badly affected as other traditional banks that focus on extending loans to retail and institutional investors.
Hence, it is not surprising that BNY Mellon, State Street, and Northern Trust were among the “best performing” banks in the recent Fed stress test. They belong to the group with CET1 ratios in the higher bounds and at the same time, they are also expected to register a very minimal drop in their respective CET1 ratio under the Fed’s severely adverse scenario.
The stress test results have shown that the custodian banks are pretty insulated against further deterioration in the market and their strong capital positions should reassure investors that they do not have to worry about the possibility of insolvency or massive share dilution.
Investors will also be happy to know that the three banks will be able to continue their quarterly dividends, while still maintaining healthy capital and liquidity positions (Table 4). Based on their respective third-quarter dividends, the three custodian banks are yielding approximately 2.6% after taking into account dividend withholding taxes.
(Related article: US banks face toughened Fed stress test this year, but most are well-prepared for the worst)
Table 4: Pure-play custodian banks have solid capital positions
| CET1 Ratio | Fed's minimum requirement for CET1 | |
| BNY Mellon | 12.6% | 8.0% |
| State Street | 12.3% | 8.0% |
| Northern Trust | 13.4% | 7.0% |
Source: Quarterly earnings report, Financial Stability Board,
iFAST compilations Data as of August 2020 |
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Custodian banks are moving up the value chain and creating greater efficiencies – all thanks to technology
In the past, custodian banks were viewed as just a ‘processor’, helping their clients to process a trade settlement or corporate action. However, thanks to new technologies, many of them have evolved over the years and have expanded their services beyond just safeguarding their clients’ assets.
The adoption of new technologies will allow global custodian banks to move up the value chain, offering new services in line with client needs. Instead of just offering ‘processing services’, custodian banks are investing in technologies that will allow them to provide value-added services, such as data analytics, risk management, and other data-driven capabilities.
For instance, BNY Mellon has recently launched their new data analytics solutions to help investment managers better manage their data, understand how they can successfully gain market share through machine learning, and customise portfolios to individual ESG preferences through artificial intelligence. State Street also acquired Charles River to provide more value-added services for their clients, allowing them to offer “front office” software services on top of the traditional “middle and back office” custody services.
By tapping on new technologies, custodian banks can capture new revenue streams and increase their “stickiness” at the same time. The custodian banks will also able to improve their operational efficiency and reduce overall costs as they adopt these new technologies.
Key investment risks
Downwards pressure on service fees: In recent years, it is clear that many asset managers are facing a lot of pressure to reduce their costs due to the rise of low-cost passive investing. With their revenue under pressure, many asset managers have passed on their pain to custodian banks where they become less willing to pay up for the custody-related services. As a result, the custodian banks have been facing downward pressure on their custody-related fees over the years.
While it seems that a fee compression is inevitable, we like how the global custodian banks have been innovating and upgrading themselves to counter the declining fee rates. As mentioned previously, they have adopted new technologies like automation to improve their efficiency, which will in turn help to lower their cost of operations.
Besides, in our data-driven world today, services that help clients to analyse and understand data will create the most value. Therefore, investment in technologies will allow the custodian banks to move away from pure processing services and towards valuable data analytics services, which will help to improve overall fee structure for the custodian banks. These investments will also ensure that custodian banks remain important in the long-term as they continue to build up their capacity to deliver value-added services.
Compression in NIM and potential fall in AUC: From a short-term perspective, you should also be aware that even though the business models of the custodian banks are more resilient than commercial banks, their earnings will still be affected nonetheless. The low-interest-rate environment will be a challenge to the banks’ net interest income and their custody-related fees will also be affected in the event of another sell-off in the market given its direct correlation with AUC. The three custodian banks have also guided for more fee waivers on their money market funds for the rest of 2020.
Take part in the exciting growth of financial assets under custody
Alongside with US commercial banks, the share prices of the three global custodian banks were badly beaten down despite the broader market almost recovering to pre-COVID levels. We believe it is a good opportunity now for investors to consider loading up on some financial institutions, especially the custodian banks that are expected to benefit from the exciting growth of financial assets.
Our target prices for the three global custodian banks are based on a fair PE ratio methodology, given how their share prices are driven mainly by the earnings they are able to generate. At their current valuation levels, we see an average upside potential of about 30% by 2022.
Table 5: Valuations of the global custodian banks
| Stock rating | PE ratio | Target price (USD) | Current price (USD) | Upside potential | Dividend yield* | |
| BNY Mellon (NYSE:BK) | Strong Buy | 12.5 | 47.5 | 33.9 | 40.1% | 3.7% |
| State Street (NYSE: STT) | Strong Buy | 12.5 | 78.0 | 59.9 | 30.2% | 3.5% |
| Northern Trust (NASDAQ:NTRS) | Buy | 13.5 | 91.5 | 77.5 | 18.1% | 3.6% |
| Average: | 29.5% | 3.6% | ||||
Source: Bloomberg Finance L.P., iFAST estimations *Dividend yield is assumed to be maintained at 3Q20 levels Data as of September 2020 |
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As mentioned in our previous articles, it will probably be yet another few volatile quarters for the banking industry due to the economic uncertainty and the upcoming elections. While the custodian banks’ near-term earnings are likely to be hampered, we believe current valuations suggest that their long-term earnings power are underappreciated. A sooner-than-expected economic recovery or potential interest rate hikes in the future could spur a recovery in the custodian banks’ valuations.
Investors who prefer a diversified option should look at the Invesco KBW Bank ETF (NASDAQ:KBWB), which consists of not just the three global custodian banks, but also other traditional commercial banks, like JPMorgan (NYSE:JPM) and Citigroup (NYSE:C).
(Related articles: COVID-19 will hurt US bank profitability, but it’s time to buy the banks.)
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