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Analysing Profitability, Capital and Liquidity Constraints of Custodian Banks Through the Lens of the SREP Methodology

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Analysing Profitability, Capital and Liquidity Constraints of Custodian Banks Through the Lens of the SREP Methodology Occasional Paper Series Charles-Enguerrand Coste, Céline Tcheng, One size fits some: Ingmar Vansieleghem analysing profitability, capital and liquidity constraints of custodian banks through the lens of the SREP methodology No 256 / January 2021 Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. Contents Abstract 3 Non-technical summary 4 1 Introduction – A different type of bank 6 1.1 Custodians as asset servicing providers 6 1.2 Custodians share many features with banks and FMIs 7 2 Prudential supervision of custodian banks 14 2.1 Introduction to the objectives and tools of banking supervision 14 2.2 How do the prudential constraints faced by banks differ from those faced by FMIs? 14 2.3 Prudential supervision under the Single Supervisory Mechanism (SSM) 15 3 Business model and profitability analysis 19 3.1 Custody business landscape 19 3.2 High-level analysis of the challenges faced by the custody industry 21 3.3 How these challenges translate into a supervisory assessment of custodian banks 24 4 Risks related to capital 27 4.1 Capital position and RWA density 27 4.2 Credit risk, concentration risk and large exposures 31 4.3 Operational risk 35 4.4 Market risk 39 4.5 Interest rate risk in the banking book 40 5 Liquidity risk 43 5.1 Custodian exposure to funding sustainability 43 5.2 Limits of liquidity regulation tool for custodian liquidity risk 45 6 Conclusion 49 Annexes 50 ECB Occasional Paper Series No 256 / January 2021 1 Annex 1: Detailed list of services provided by custodians and associated risks 50 Annex 2: Main differences between UCITS and alternative investment funds 51 Annex 3: Functioning of European financial markets and the custodians’ role in securities settlement 51 Annex 4: Expansion and contraction of a bank’s balance sheet due to money creation and payment 56 Annex 5: Proposed indicators worth exploring in building an exposure-based operational risk model 57 Annex 6: Interest rate profile of banks and custodians 58 Annex 7: Why LCR is an ill-suited indicator of a custodian’s short-term liquidity risk 60 Annex 8: data for weighted average custodian used in Table 8 64 References 65 ECB Occasional Paper Series No 256 / January 2021 2 Abstract Custodians play a key but discrete role in the global financial market infrastructure. In Europe, they are licensed as “credit institutions1”, a legal requirement for European deposit-taking institutions, and therefore they face the same prudential requirements as “traditional” banks. However, their business model and risk profile are different from those of traditional banks since the core of their activity does not encompass balance sheet transformation and the associated risks. This paper examines how custodians differ from traditional banks with regard to (i) balance sheet structure, (ii) income generation, and (iii) risks faced; and how these differences should be incorporated in custodians’ internal risk measures and supervisory authorities’ risk assessment methodologies to prevent severe capital and liquidity misallocation by the credit institutions and inadequate decisions from supervisory authorities. Keywords: bank, custodian, credit institution, prudential supervision JEL classification: G15, G21, G28, L22 1 Pursuant to Article 4(1)(1) of Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, “credit institution” means “an undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account”. ECB Occasional Paper Series No 256 / January 2021 3 Non-technical summary In Europe, custodians are licensed as credit institutions as per CRR2 Article 4(1) as they collect deposits3 from their clients, which means that custodians face the same prudential requirements as “traditional” banks4. However, a custodian’s main business is to provide asset servicing solutions, rather than long-term lending to customers which means that they exhibit a different risk profile. This paper explores the specificities of custodians’ business models, risks and balance sheet composition. We claim that a custodian is a safekeeper of financial information and a conduit ensuring smooth financial transactions. As a result, a custodian’s balance sheet is liability driven and they have a very limited risk appetite. By contrast, a banks’ role is to create credit and manage investment risk on behalf of other public and private sector actors. Custodians are credit institutions but share common features with financial market infrastructures (FMIs) like central securities depositories, as their primary function is to serve as an interface between their clients and various central securities depositories. Supervisors should acknowledge these differences and pay particular attention to custodians’ internal capacity to identify, measure, and mitigate risks that are idiosyncratic to their business model. They can also leverage the growing literature on risks faced by FMIs. In particular, we emphasise the following points: • The “passive, liquid and low-risk” structure of the asset side of the balance sheet of a custodian is a feature of its business model. Nonetheless, balance sheet analysis alone does not tell us much about the resilience of a given custodian or its ability to recover from threats to its viability. The main risks mainly relate to operational risk, intraday credit risk and intraday liquidity risk, which are in essence not captured in the balance sheet of a credit institution. Custodians exhibit a lower RWA density than other financial institutions and in jurisdictions where central bank deposits are not excluded from leverage ratio, their leverage ratio is by far their primary capital constraint. Even when supervisory authorities impose additional weighted capital requirements, the primary capital constraint remains the leverage ratio • In a protracted low or negative interest rate environment, most custodian placements and instruments yield negative interest. Custodians are not active loan makers and mainly generate revenue through fees and commissions charged to their clients. In a low or negative interest rate environment, most of their balance sheet yields negative interest, which acts as an incentive for them 2 Regulation (EU) No 575/2013 of the European Parliament and of the Council (Capital Requirement Regulation). 3 And other repayable funds. 4 In this paper, a “bank” will be defined as “a credit institution that provides long-term credit funded by customer deposits and short-term wholesale funding”. ECB Occasional Paper Series No 256 / January 2021 4 to (i) reduce the size of their balance sheet, (ii) pass on the negative rates to their clients, and/or (iii) increase their risk appetite. • Past operational losses are not an adequate estimate of capital needs to cover operational risk because the operational risk threat to the capital position arises from low-frequency/high-severity (tail) events, whereas operational losses reported by custodians exhibit a high-frequency/low-severity loss profile. Therefore, custodians should be encouraged to develop innovative and comprehensive internal approaches to capture risks arising from their operational risk exposure. • The liquidity coverage ratio (LCR) has limited value as an indicator of custodians’ short-term liquidity risk, as it does not adequately capture the main type of liquidity risk they face, i.e. intraday liquidity risk. Furthermore, a bank run can ultimately improve their LCR position. Supervisors should acknowledge the specific nature of custodians’ intraday liquidity risk exposure and ensure that custodians develop internal measures to adequately capture their intraday liquidity risk in the internal liquidity adequacy assessment process (ILAAP). In the first part of the paper, the role and the business model of custodians will be explained in detail. In particular, we will show how they differ from other banks and from central securities depositories (CSDs). The second part describes how banking supervision works, its objectives and tools and how it compares to other forms of regulatory supervision such as financial market infrastructure oversight. In the third part, we analyse current and foreseen profitability challenges of custodian banks and how the main actors react to these constraints. The fourth part provides a detailed analysis of how custodians’ exposure to risks to capital (capital position, credit risk, operational risk, market risk and interest rate risk in the banking book) differs from traditional banks’ exposure to those risks. Finally, the last part analyses how custodians’ liquidity risk profile differs from that of traditional banks. ECB Occasional Paper Series No 256 / January 2021 5 1 Introduction – A different type of bank 1.1 Custodians as asset servicing providers Custodians derive their name from their main activity, which is to hold their clients’ assets “in custody”. To understand what “keeping assets in custody” entails, we need to know where assets are located. That is not such a trivial question: we generally know where our money is (in our wallet or in our bank account) but few of us know where financial assets are physically held. In reality, most financial assets5 are located in central securities depositories (CSDs)6. CSDs7 are financial institutions that ensure (i) issuance, (ii) settlement and (iii) safekeeping of financial securities. Generally speaking, there is one CSD in each country and securities issued in that country are held in that particular CSD in the name of asset owners (or of an intermediary). Most investors do not have a direct access to CSDs. Direct participation to a CSD entails financial, operational and legal constraints and investing in several markets would require an account in each of these CSDs. To alleviate these burdens, investors hold their financial assets in a custodian which acts as an intermediary between investors and the CSDs of the various markets in which they invest.
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