Financial Reform: Custody Banks and the Supplementary Leverage Ratio

Financial Reform: Custody Banks and the Supplementary Leverage Ratio

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January 18, 2018
Financial Reform: Custody Banks and the Supplementary
Leverage Ratio
What Do Custody Banks Do?
Figure 1. Banks with Large Custody Businesses Based
Custody banks engage in the safekeeping and servicing of
on Assets Under Custody (AUC)
assets owned by others. Custody banks may also perform
services such as the settlement, holding, and reporting of
customers’ marketable securities and cash. Customers are
often asset managers, mutual funds, retirement plans,
insurance companies, corporations, endowments, other
banks and financial entities, or large private investors. The
other unique feature of custody banks is that they often act

similarly to escrow in financial transactions, holding onto
Source: The 2016 annual report for each bank.
assets or collateral for the parties to a financial
transaction—such as a derivatives trade or a “securities
Custody banks have argued that some of the Basel III
lending” trade—until the trade is finalized and the rightful
requirements implemented after the 2008 financial crisis
owner of the asset or collateral collects it. Custody banks do
were inappropriate for their business model, which focuses
not have a special charter, but are ordinary banks that
on the servicing of client assets. Basel III is an
engage in custody activities.
internationally agreed-upon set of measures developed by
the Basel Committee on Banking Supervision in response to
The custody services industry is highly concentrated.
the financial crisis of 2007-2009. In particular, several
According to one study, as of the end of the first quarter of
custody banks have complained about the impact of the
2017, the four largest custody banks were Bank of New
supplementary leverage ratio (SLR) under Basel III. They
York Mellon, State Street, J.P. Morgan, and Citigroup, and
argued that it makes their fee-based, high-volume business
they held 47% of the total assets under custody in the
disproportionately costly due to reasons discussed below.
United States, then totaling $103 trillion.
What Is the Leverage Ratio and
Supplementary Leverage Ratio?
Although the safekeeping function is not viewed as
presenting much underlying credit risk (or risk of loss) to
In response to the financial crisis, both the Dodd-Frank Act
the custody bank itself, the sheer volume of transactions
and Basel III requirements broadly aimed to increase banks’
and size of related assets such banks hold highlight the
capital holdings to strengthen the financial system’s
crucial role custody banks play in the functioning of the
resiliency against future crises. Basel III included risk-
global financial system. The Office of the Comptroller of
based capital requirements to ensure banks hold more
the Currency (OCC) sees operational risk as one of the
capital against riskier assets. It also included a leverage
largest risks for custody banks, because the provision of
ratio that imposed the same capital charge for every asset,
custody services is largely dependent on the successful
no matter how safe, to provide a backstop and ensure banks
execution of very large volumes of operational tasks and
hold a minimum amount of capital regardless of their type
transactions and requires sophisticated systems. Operational
of assets. The leverage ratio also captures a certain “size
risk is broadly defined as the risk of loss resulting from
footprint” of a bank’s total financial activities. Currently,
inadequate or failed internal processes, people, and systems,
almost all U.S. banks and bank holding companies are
or from external events, such as cyberattacks.
subject to a minimum 4% leverage ratio, as measured by
the ratio of a firm’s high quality or “tier 1” capital, over the
Figure 1 shows the U.S. banks with the largest custody
sum of all its on-balance sheet assets.
businesses. Two of the banks, JP Morgan and Citigroup, are
diversified conglomerates whose primary line of business is
The U.S. Basel III SLR rule also requires large,
not custody services, and that also engage in investment
internationally active U.S. banking organizations (typically,
banking and commercial lending. The other two, Bank of
those with $250 billion or more in total consolidated assets
New York Mellon and State Street, according to their
or $10 billion or more in on-balance sheet foreign
annual reports, derive the largest chunk of their revenue
exposures) to meet a minimum 3% SLR. The SLR is
from investment servicing fees, including custody fees.
measured as the ratio of a firm’s tier 1 capital to the sum of
Such fee-based revenue often entails lower risk than
all on-balance sheet assets and certain off-balance sheet
revenue from trading or lending activities, which carry
exposures. The enhanced supplemental leverage ratio
credit and market volatility risk. Another bank, Northern
(eSLR) standard requires a U.S.-based global systemically
Trust, though smaller in terms of total assets, also has a
important bank holding company (G-SIB) to hold an
large custody business as a share of its total revenue.
additional 2% buffer over the minimum SLR requirement
for a total of 5% to avoid restrictions on capital
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Financial Reform: Custody Banks and the Supplementary Leverage Ratio
distributions and certain discretionary bonus payments.
current legal definitions of custody activities vary because
Eight of the largest banks in the United States have been
custody services are used in banking (overseen by a number
designated as G-SIBs and are subject to such additional
of prudential regulators); in securities and asset
prudential requirements. An insured depository institution
management (overseen by the Securities and Exchange
subsidiary of a U.S. G-SIB is required to meet a 6%
Commission [SEC]); and in derivatives trading (primarily
minimum SLR to be considered “well capitalized” under
overseen by the Commodity Futures Trading Commission
the bank regulatory framework.
[CFTC] with some SEC oversight). For calculating deposit
insurance assessments, the Federal Deposit Insurance
The principal difference between the leverage ratio and the
Corporation (FDIC) defines a custodial bank as one that
SLR is that the SLR includes both on-balance sheet assets
had over the previous calendar year at least $50 billion in
(those that are owned outright and more easily measurable
total fiduciary, custody, and safekeeping assets; or had
in terms of their potential worth) and off-balance sheet
derived more than 50% of its total revenue from trust
assets. Off-balance sheet assets include, for instance,
activity.
derivatives trades and other assets that could pose a
contingent demand for capital and are viewed by some as
The bills would specify that funds of such a custodial bank
less transparent risks. An example of off-balance sheet
deposited into accounts with certain central banks shall not
assets includes certain structured investment vehicles
be taken into account when calculating the SLR for the
(SIVs). In the run-up to the 2008 financial crisis, some
custodial bank. Both House and Senate committee bills
banks used SIVs to profit from the difference between
specify that accounts qualify only when held at the Federal
short-term borrowing rates and longer-term returns from
Reserve System, European Central Bank, and central banks
complex mortgage-backed securities (MBS), while keeping
of Organization for Economic Cooperation and
the SIVs off the balance sheet. When the value of those
Development countries that meet certain creditworthiness
MBS and SIVs fell during the financial crisis, some SIVs
standards. In practice, the bills would enable banks meeting
incurred losses that were transmitted to the banks. A
the custody bank definition to hold less capital against
principal objective of the SLR is to require banking firms to
certain assets viewed as safe—namely, money held in
hold a minimum amount of capital against on-balance sheet
accounts at central banks.
assets and off-balance sheet exposures, regardless of the
measured risk associated with individual exposures.
Views of Fed Governors
Lawmakers have been aware of custody banks’ concerns
Custody banks have argued that because the SLR does not
for some time. At a July 2017 Senate Banking Committee
account for the riskiness of assets, it may overstate the
hearing, Federal Reserve Chair Janet Yellen testified that
amount of capital needed to protect against potential losses
the Fed is examining adjusting the calibration of the SLR
and unnecessarily tie up capital. This is especially true, they
for custody banks in case it is too high relative to risk-based
argue, for institutions that disproportionately hold less risky
capital requirements. She also noted that one approach
assets, as is the case for custody banks.
other countries had taken is to exempt certain items, such as
central bank accounts, from those banks’ SLR, and said the
What Do Bills in Congress Propose?
Fed is considering reexamining its own approach.
A provision in S. 2155 (reported by the Senate Banking
Committee on December 18, 2017) would exclude funds
In his farewell speech, former Fed Governor Daniel Tarullo
(subject to some limitations) of an eligible custodial bank’s
also said it might be worth adjusting the SLR for banks
holding company from that company’s SLR calculation
primarily in the custody business. He discussed two
when those funds were deposited into accounts at certain
approaches—that proposed in S. 2155 and his preferred
central banks. S. 2155 defines custodial bank as any
approach. Tarullo’s preferred approach would allow only
depository institution holding company “predominantly
those large banks with the lowest risk-based capital
engaged in custody, safekeeping and asset servicing
surcharges (meaning those with less-risky, primarily fee-
activities, including any insured depository subsidiary of
for-service custodial businesses) to hold less capital through
such a holding company.” A similar bill, H.R. 2121, was
a lower SLR. He argued against the approach (taken in S.
agreed to by the House Committee on Financial Services on
2155) of excluding certain “safe” assets such as central
October 12, 2017, with amendments. The House committee
bank reserves from leverage ratio requirements for two
bill defines the SLR more broadly, adding SLR “means the
reasons. First, he argued that the purpose of a leverage
supplementary leverage ratio including applicable buffers,
ratio—by contrast to risk-based capital requirements—is to
surcharges, and well-capitalized requirements relating to
place a cap on total leverage, no matter what the assets may
such supplementary leverage ratio.”
be. Second, he noted, if “safe” assets like central bank
reserves were excluded, why not exclude other types of
Both bills would leave it to prudential regulators to further
assets viewed as safe, like certain sovereign debt holdings?
specify which companies are “predominantly engaged” in
Doing so could create a “slippery slope” where it becomes
such activities. The question, for instance, of how broadly
difficult to distinguish between other classes of assets.
regulators interpreted “asset-servicing activities,” would
potentially impact whether larger, diversified banks, such as
Rena S. Miller, Specialist in Financial Economics
Citigroup and J.P. Morgan, with active custodial businesses
might be affected. Looking at existing approaches, the
IF10812

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Financial Reform: Custody Banks and the Supplementary Leverage Ratio

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