US regulators may be well-intentioned in mandating that eight systemically important banks maintain higher supplementary leverage ratios (SLRs) than their European peers, but for some of the world’s largest custodians their decision could spell higher costs of doing business — and a trickle down effect on fund management clients.
With the new SLR requirements not taking effect until January 2018, custodians and fund managers are understandably hesitant to specify the impact to their operations and strategies. However operations specialists at US fund management shops tell FinOps Report that they are already being warned by custodians to expect potential changes in costs and services.
According to an analysis conducted by Fitch Ratings in New York, the new supplementary leverage ratio (SLR) will most severely affect two of the eight banks which fall under the designation of systemically important: BNY Mellon and State Street. Northern Trust and Brown Brothers Harriman won’t feel the impact, because they aren’t part of the group, which includes JP Morgan, Citigroup, Morgan Stanley, Goldman Sachs and Bank of America. Those banks fit the regulatory criteria of holding at least either US$700 billion in total reported assets or US$10 trillion in assets under custody.
“In its current state, the SLR could be problematic for both BNY Mellon and State Street, because they hold large balances of cash and low risk securities,” says Christopher Wolfe, Fitch’s managing director for financial institutions in a new commentary.
During the current low interest rate environment, banks make next to nothing on those holdings, but still have to pay a six percent capital charge at the banking subsidiary level. Bottom line: they are being penalized for standard industry practice. That’s why the banking community had lobbied so hard for deposits held at central banks to be excluded from leverage exposure numbers. Custodian banks use central bank accounts to hold the operational cash accounts of their institutional investors.
The Federal Deposit Insurance Corporation, Office of the Controller of the Currency and Federal Reserve Bank are requiring each of the eight banks to meet a 5 percent supplementary leverage ratio — compared to the 3 percent required under Basel III Accord — at the parent level so they can be considered well-capitalized. The ratio must be 6 percent at the bank subsidiary level. If a bank doesn’t fulfill the SLR it could be subject to limitations on capital distributions and payments on discretionary bonuses. BNY Mellon meets a 4.2 percent supplementary leverage ratio at the parent level, while State Street is doing even better at 5.2 percent.
The new supplementary leverage ratio is intended to offset the banks’ off-balance sheet exposure that US regulators believe presents greater risk during periods of stress. But this is what Wolfe fears and so do fund management executives who spoke with FinOps: in periods of market stress or crisis, many of the customers of custodian and trust banks will sell securities and hold cash, typically depositing them at their trust and custodian bank. If trust and custodian banks will see their balance sheets grow in terms of higher deposits, they will fall below SLR minimums. That means the banks’ leverage exposures will be inflated at a time when their capital base is already under more pressure.
Once this occurs, banks are left with two obvious alternatives, barring regulatory exemptions: the first is to move cash deposits to money market funds, and the second is to move customer assets to other banks.
Neither of those choices appear practical. The first will be an anathema to fund manager customers, says Wolfe, while the second decision will be an anathema to the banks for relationship management reasons. Therefore, the banks are left to either increase fees for fund managers to service their cash management accounts, or not take on certain clients. Of course, custodians could also decide to reduce their operating costs by reducing overhead elsewhere.
US fund managers contacted by FinOps say that based on their preliminary talks with custodians they are preparing for the worst. “We do think they might penalize us for deposits or place some restrictions on the amount of cash or low-risk securities we can keep with them,” says one operations specialist at a US East Coast fund management shop.
In a third-quarter earnings call last year, BNY Mellon’s Chief Financial Officer Thomas Gibbons said the bank expects cash holdings to be reduced in a “more normalized interest rate world,” and in the meantime the bank would deconsolidate asset management funds from its balance sheet. Bank officials were unavailable for further comment at press time.
Just as worrisome to custodians and fund managers will be how US regulators allow custodians to account for indemnifications provided in securities lending agreements in the supplementary leverage ratio. No one contacted by FinOps was able to provide clear answers on the grounds they didn’t have the opportunity to delve into the new regulatory requirement in much detail. They are still absorbing the basics.
Until now, indemnification — or making fund managers whole in case the borrowers of their securities go bust and don’t return the assets — has been a given. Custodians first sell off the collateral used to back the deal, and if not sufficient make up the difference. Should indemnification, an off-balance sheet practice, now become more expensive to offer, custodians and fund managers would be left to make some tough decisions.
No one seems is sure just how severe the impact will be at a time when custodians are already facing dwindling revenues from securities lending activities, but there is plenty of speculation that custodians will either reduce or eliminate indemnification altogether or charge more for the privilege. That charge could come in the form of specific fees or increases in their cut of the fees earned by fund managers for lending out securities. Fund managers will also have to decide whether the cost of indemnification is worth the return on their securities lending activities.
“Some fund managers may decide that in the case of lending liquid fixed-income securities, such as US government bonds, they would be willing to forgo indemnification, rather than pay higher fees,” says Oscar Huettner, senior consultant for Concord, MA-based global research firm Finadium. “The spreads wouldn’t be high enough to justify the cost.”
Regulators apparently did make one concession to custodian and trust banks– the denominator of the leverage ratio can be measured on a daily average, rather than based on a quarter-end average. “This may help these banks as they experience large inflows of deposits around quarter end, but it is unclear how much the concession is worth,” says Wolfe.
Middle and back office operations specialists at two US custodian banks tell FinOps, it isn’t worth anything to them. “We will have to do more work in calculating the figures on a daily rather than quarter-end basis,” says one. “As usual, regulators never think about us.”
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