Threats facing major custodian banks, primarily falling revenue and the rising cost of regulation, have been well-documented in recent years. Likewise, it’s nothing new that the fear of repricing has been on the rise among their pension fund, asset manager and sovereign wealth clients.

This is particularly true when it comes to securities lending. With the tough market dynamics showing no signs of abating, some suggest the split of the fee from lending to borrowers is altering from the beneficial owner in favour of the agent lender. 

“The increased cost of doing business kicked in a while back,” said an individual from a leading US custodian bank who wished to remain anonymous. “Up until now, lending agents have been wearing those costs which has diluted profitability and, for some, made the business uneconomical. That’s not going to happen for much longer.” 

The individual, a twenty-year securities lending professional, says custodians are starting to ask more questions such as whether they can re-rate the borrowers, take higher haircuts, change collateral or alter the shape of the programme, as well as considering non-custodial lending. 

“Effectively, this is the agent lenders trimming around the edges and cutting back the scope of what they do. Once you’ve made these adjustments though, all you’re left with is the reality of having to reprice clients,” he adds. 

Basel III, which is being rolled out over the course of several years, is the major force at play. It requires agent lenders to hold more capital against the borrower defaults, hence the cost of providing these indemnifications is rising. 

There are now examples, the source claims, where some agents are completely repricing whole relationships, taking the fee split on a lending programme down from 90/10 (i.e. 90% for the asset owner and 10% for the agent) to 80/20 or even lower. 

Repricing a component of the lending programme is another approach, pricing equities and fixed income differently say 85/15 and 75/25. 

Indemnification 

Some agents are even choosing not to indemnify certain types of activities, according to the individual, while others are leaving fee splits at current levels but adding an indemnification charge on top. 

“These are interesting times,” admits Greg Korte, head of North American custody and securities lending consulting at Mercer. “When it comes to beneficial owners, there are a lot of grizzled veterans still in the market lending stock. They went through the downturn in 2008-09, now this has come up and their conversations with custodians will be difficult to say the least.” 

Moreover, Korte adds that agent lenders are now far more sophisticated when it comes to tracking client profitability. “If you’re dropping a certain amount of money in securities lending, alarm bells will start ringing as it impacts the overall profitability of the relationship. 

More clients are at risk of being rated lower than what’s acceptable in terms of profitability, so the bank has to think of an alternate plan to raise revenue. That could mean higher custody fees overall, or securities lending fee splits.” 

Jerry May, the securities lending officer and cash manager at the Ohio Public Employees Retirement System, agrees that costs will rise. “The business is changing. Custodians are still providing a service most beneficial owners wouldn’t or couldn’t do for themselves. However, the issue is whether the service they’re providing is significantly different than in the past and does new regulation translate into higher fees.” 

Many suggest large asset owners, those with multi-billion dollar lending accounts, may find themselves exempt to price changes. Smaller clients, on the other hand, making a couple of hundred thousand dollars in annual fees for the lending custodian, will be most at risk. 

“Will fee splits tilt back in favour to the custodian? In my opinion, the answer is yes if you are small and the bank has no other sizable business with you to offset the costs,” says Lance Doherty, director of securities lending at Pacific Life Insurance Company, based in California. 

“But if you are a large pension or corporate that can send them operational business then I don’t think custodial or third-party agent lenders will raise fees.” 

Another US-based expert, who specialises in helping public pension funds, mutual funds and foundations negotiate their stock loan fee splits, says price changes are becoming a reality. “I’ve seen the custodian banks crying poverty for some time,” says the individual, who declined to be named. 

“Now it’s clear to me that beneficial owners with smaller lending programmes, those who are perhaps uninformed or soft negotiators are experiencing changes. Sophisticated asset owners with sound vendor management practices are largely immune to the shift.” 

Lance Wargo, head of securities lending, North America at BNP Paribas, says he’s noticed the trend and has had several recent conversations with beneficial owners running modest lending programmes. “Some explain to us that their current provider is considering moving them from an 80/20 split down to 70/30. They ask us if we’re willing to step in providing something better.” 

Wargo says that the bank is adapting to meet specific needs by higher customisation, price transparency and educational content. “Not all large global custodians are faced with the same challenges,” he says. “Some custodians, including BNP Paribas, have the financial strength to remain competitive with splits and still provide indemnified programmes to clients.” 

At the end of 2015, David Maya, a corporate and institutional banking partner of Oliver Wyman, led a study on custodian banks. Maya says there has and will be direct action by providers, including when it comes to lending, which he characterised as a historically important driver of profitability for the asset servicing industry. 

“Some industry experts previously suggested that lending fee splits had reached their viable floor, and I believe that may well be accurate based on the recent developments we have seen. There’s now a much more open and realistic dialogue around pricing and splits, particularly given the rising cost of indemnification. That’s a positive for the industry.” 

Capabilities matter 

In addition, Maya says “beneficial owners are looking for a lot more than pricing these days. Risk management, expertise, clarity around counterparties, usage of different assets and indemnification. These are all important and might make the choice of a major custodian with capabilities and balance sheet compelling.” 

His views are echoed by Paul Wilson, global head of agent lending product and portfolio advisory at JPMorgan. “As one of the largest US banks, our financial strength and capital base are not in question. It’s this capital base that supports the indemnification, which is as deep and broad as any in the market place. 

“Our beneficial owner clients also value our global presence and reach, our approach to risk management that leverages many different parts of JPMorgan. That all contributes to the strong risk-adjusted returns.” 

Even so, Wilson has previously acknowledged that a “one-size-fits-all approach to pricing”, with some lending transactions not covering costs, will have to change. “You need an acceptable return at both the client relationship level and at the business level – pure and simple,” he said earlier this year at a Global Investor/ISF roundtable. 

When it comes to the increasing cost of indemnification, Bo Abesamis, the manager of Callan Associates’ trust, custody, and securities lending group, says it’s still mostly just talk. 

“Custodians are clearly trying to determine who has right inventory, which is driving how fee splits will be formulated or developed. But if you’re a rational lending agent trying to win business, why would you suddenly tell them they have to pay up for indemnity? 

“For the last three years, the requests for proposals (RFPs) we have seen have shown no added costs of indemnity. In our opinion if costs of indemnity do start to be passed on, they should not be applied to intrinsic value clients, those who provide premium revenues for lending agents.” Whatever route custodians choose to take, it will certainly be difficult to convince some to pay more. 

One large US asset manager, who declined to be named, simply said he would refuse to pay: “I’m not prepared to pay for their increased costs of regulation and we certainly wouldn’t be willing to adjust our fee split to have indemnification as part of our programme.”