“Banking is a very good business if you don’t do anything dumb.”
Banking is a fascinating business; not only does it provide the lifeblood of capitalism, credit, but its history woven with humanity’s history. Think about it, railroads, automobiles, telephones, airplanes, and all tech came after banks, with many of the US’s biggest banks tracing their lineage to the country’s beginnings.
Custodian banks have played a large part in that growth from the first colonies in the US, as holders of the wealth necessary to build and grow the country.
Along with commercial banks, brokerages, investment banks, and the good old community bank, banks have provided the financial backbone for the emergence of many people worldwide. Let us uncover a lesser-known type of bank that is nonetheless important to the economy’s financial health.
In today’s post, we will learn:
- What Does a Custodian Bank Do?
- How Does a Custodian Bank Make Money?
- How to Analyze Custodian Banks
- Top Custodian Banks
Ok, let’s dive in and learn more about the top custodian banks.
What Does a Custodian Bank Do?
Before we dive in and look deeper into what a custodian bank does, let’s define what the custodian bank is:
“A custodian or custodian bank is a financial institution that holds customers’ securities for safekeeping to prevent them from being stolen or lost. The custodian may hold stocks or other assets in electronic or physical form.”
Because these firms are responsible for the safety of assets and securities worth billions, the custodial banks tend to be large, reputable firms.
In some cases, the custodian banks operate only in this fashion, which means they don’t make deposits or loans in the conventional sense. Rather, they operate only in a custodial fashion.
Others offer custodial services as part of the overall package of banking services the bank offers its customers.
Custodians are also appointed to manage a minor child’s assets, but our conversation today will focus on custodial banks.
As mentioned above, custodian banks don’t offer the traditional services that most banks offer, such as mortgage lending, personal loans, branch banking, personal checking accounts, or ATMs.
Instead, the custodian banks offer:
- “hold in safekeeping assets/securities such as stocks, bonds, commodities such as precious metals and currency (cash), domestic and foreign
- arrange settlement of any purchases and sales and deliveries in/out of such securities and currency
- collect information on and income from such assets (dividends in the case of stocks/equities and coupons (interest payments) in the case of bonds) and administer related tax withholding documents and foreign tax reclamation
- administer voluntary and involuntary corporate actions on securities held such as stock dividends, stock splits, business combinations (mergers), tender offers, bond calls, etc.
- provide information on the securities and their issuers such as annual general meetings and related proxies
- maintain currency/cash bank accounts, effect deposits, and withdrawals and manage other cash transactions
- perform foreign exchange transactions
- often perform additional services for particular clients such as mutual funds; examples include fund accounting, administration, legal, compliance, and tax support services.”
The above list is comprehensive and outlines all the different functions that custodian banks offer their clients. The majority of the bank’s functions comprise of housing and handling the client’s assets.
Not only banks offer these services; for example, Charles Schwab also houses the assets of different investment firms. A firm might offer clients the opportunity to invest in a mutual fund, where the investment firm doesn’t hold the securities held by the mutual fund. Instead, they are held by Charles Schwab for the investment firm.
It is important to understand the custodian bank’s role, think of it this way. If you buy a share of Apple, you don’t physically own that share because of the transaction’s electronic nature.
With the chain of ownership occurring through the brokerage you purchased the share from, and Disney, the custodial bank or custodial service will hold that share for you, in the event ownership is ever disputed or questioned.
Long ago, the powers in charge considered it impractical to register each and every share ever traded on public exchanges in each specific shareholder’s name, thus creating custodian banks.
A great example of how the custodian bank functions are in the arena of retirement accounts and mutual funds.
In the case of the retirement accounts, the IRS code in the US requires that the custodian hold the assets of the IRA on behalf of the IRA owner. The custodian of the IRA assets performs all functions related to the management of the assets, such as:
- custody of assets
- processes all transactions
- maintains all records
- file reports with the IRS
In the mutual fund case, the custodian bank holds the securities owned by the mutual fund. The vast majority of mutual funds use third-party custodians as required by the SEC.
How Does a Custodian Bank Make Money?
Bank of New York Mellon (BK), with $1.9 trillion in assets under management, is one of the world’s largest asset managers. The bank primarily generates its revenues through:
- investment services
- asset and issuer servicing
- treasury services
- clearance and collateral management
- asset and wealth management
Based on all the services that Bank of New York Mellon offers, fees are the primary revenue source for any custodian bank. The bank generates revenue from fees collected for all of the above services that each bank coordinates.
Compare that to the traditional bank, which generates the majority of its income from deposits and loans. The income a traditional bank earns stems from the difference in interest rates it borrows from, and the rates in lends and the spread is the difference the bank earns.
The traditional bank looks to create better spreads from loans, whether from mortgages, auto, or personal by offering better terms to the customer, which encourages more borrowing. The same applies to deposits; by offering better savers rates, it attracts more customers, and the bank earns more by sheer volume.
Also, traditional banks earn money from fees, in many cases, similar to custodian banks’ services, but on a much smaller scale. Many of the bigger commercial banks such as JP Morgan and Wells Fargo offer these custodial services to its clients, and these segments of the banks earn fees for those services.
A brief story to illustrate how a custodian bank would earn their fees.
Simple Illustration of How a Custodian Bank Works
According to your account number, when Andrew deposits his money to any type of account, the checks are payable and deposited into the custodial account.
The custodial bank might or probably will charge Andrew a fee, known as a custodial fee for his money’s safekeeping. In addition to his money’s safekeeping, the bank will let him know quarterly or annually the status of his money, all part of the service offered to him.
Let’s say that Andrew is now tired of his investment in Apple and wants to sell his shares; the custodian bank will assist in that transaction. Because we live in the electronic world, the buyer and seller never meet, but the bank ensures that the money goes to the exact person and vice versa.
After Andrew informs the bank he wishes to sell his shares of Apple, the custodian will make the arrangements to find a buyer for his shares of Apple and trade his stock for money.
Note that the custodial bank will charge Andrew a transaction fee to buy or sell his Apple shares.
Now, let’s say that Andrew’s shares in Disney (DIS) announce a dividend offering.
Andrew needs to ensure he receives that dividend, and the custodian bank will make all the arrangements, so he receives his dividend, and the custodian bank will also file all paperwork necessary to report those dividends to the IRS.
The above illustration point highlights how a custodian bank makes money, primarily by the fees it charges for the services they offer their clients.
The primary source of fees comprises both the custodial fees for assets under management and transaction fees. Therefore, the larger the assets under management for a custodial bank, the better.
For example, one of the largest custodian banks out there, Bank of New York Mellon, earned, per their latest 10-k from 2019:
- Total Revenue – $16,642 million
- Fee Income – $13,218 million
- 79.42% of income from fees
Likewise, as the majority of its earnings are through services or fees, the vast majority of its expenses are vai staffing and other management expenses such as:
- Professional services
- Software and equipment
How to Analyze Custodian Banks
Many of the usual suspects are available to analyze a custodian bank, such as:
- Price to Earnings – P/E
- Price to Book – P/B
- Price to Free Cash Flow – P/FCF
- Net Interest Margin – NIM
As with analyzing other banks, many of the standard metrics are available to look into custodian banks’ viability. But we also need to analyze the fee margins and profits earnings from the fees, particularly in relation to the expenses associated with those fees.
As with traditional banks, the interest margin is also available to analyze. Like traditional banks, custodian banks make loans, but most of the earnings come from fees, as illustrated by the notation above.
Let’s take a glance at several of the bigger custodian banks and analyze them on a relative basis, which is the technique of comparing each bank to similar metrics.
Bank of New York Mellon:
- Net Interest Margin – 1.1%
- Return on Assets – 1.2%
- Return on Equity – 10.8%
- Price to Earnings – 10.21
- Price to Book – 1.19
- Dividends Per Share – $1.18
State Street (STT)
- Net Interest Margin – 1.3%
- Return on Assets – 0.9%
- Return on Equity – 9.1%
- Price to Earnings – 12.61
- Price to Book – 1.32
- Dividends Per Share – $1.98
Based on the preliminary ratios, it looks like Bank of New York Mellon is cheaper on a relative basis than State Street. It seems that Bank of New York Mellon is a bit more profitable based on equity and asset metrics.
Diving a little deeper into the ratios and financials of Bank of New York Mellon, we see:
- The bank’s net interest margin growth has grown, at 0.9% over the last ten years, or almost one full percentage growth in this margin over that period.
- Return on assets median returns over the last ten years is 0.9%, which shows the bank improved on that metric for 2019.
- The median return on equity was 8.1%, and the last trailing twelve months was 10.8%, an increase of 270 basis points, which translates to an increase of 2.7%.
- The bank has grown over the last ten years at CAGR:
- Gross loans – 4.1%
- Earnings assets – 6.4%
- Deposits – 6.7%
- The company has grown the market cap from $37.4 billion to 45.3 billion over the last ten years.
The company has also carried a credit rating of Aa2, per Moody’s, indicating strong financial strength and a strong balance sheet and debt management.
Looking at the company on an intrinsic value basis, we would use a dividend discount model, as we would with a traditional bank, to find the bank’s fair value.
Based on the following metrics, the dividend discount model yields a fair value of:
- Annual dividend – $1.24
- Payout ratio – 27%
- Retention ratio – 73%
- Return on Equity – 8%
- Beta – 1.04
- Risk-free rate – 0.76
- Risk Premium – 5.69
Results of the calculations – $139.38
Based on the calculation, it appears that the bank is undervalued, but I would put the number closer to the $45 range, as opposed to the calculation which focuses on the growth of the dividend and the cost of capital, of which is off because the interest rates are so low.
For example, as Bank of New York Mellon generates fees from the management of assets invested in the stock market, the assets will suffer losses when the markets fall like they did in March 2020. And when they rebound, as they have since the Corona quarter, the assets values will rise.
Realizing that impact is critical when analyzing any bank that manages investments, as the accounting rules state currently, the unrealized losses from those investments now occupy a line item on the income statement. But those losses or gains are not realized, so the impact on the company’s performance is not real, at least according to Warren Buffett, and I would concur.
As you can see from above, the methods and thought processes of looking at investing in custodian banks, many of the ideas you use for traditional banks apply.
Because custodian banks rely less upon interest rates than more traditional banks, it corresponds with an investment that is less reliant upon the vagaries of the interest rate environments. Which means they might be a safer investment during times of uncertainty.
Top Custodian Banks
The subsequent is a shortlist of some of the top custodian banks:
- Bank of New York Mellon – $25.08 trillion in assets
- State Street Corporation – $21.35 trillion in assets
- J.P. Morgan – $20.5 trillion in assets
- Citigroup – $13 trillion in assets
- BNP Paribas Securities Services – $646 billion in assets
The investment services are under attack from the low-fee and zero-fee brokerages that have become the norm over the last year or so, with the upstart Robinhood starting the trend.
As the pressure increases to reduce fees for investors, investment banks and custodian banks come under pressure because both banks’ styles derive most of their income from fees. And with the elimination or reduction of those fees, the income for these banks face risk.
The industry is adapting by trying to reduce the impact of fees by switching to becoming a full-service administrative outsourcer and trying to help money managers reduce costs on their side, thereby earning more fees for the banks.
Custodian banks are also adapting by improving their technologies and becoming more efficient, improving their margins and reducing fees.
Much of the industry will eventually switch to AI to perfrom many of the functions that people perform now, which will reduce the fees and maybe improve the performance of the investments.
Custodian banks play a central part in the economy’s function, and they are a great way to invest in the banking industry without some of the risks associated with traditional banks.
Custodian banks are analyzed similarly to traditional banks, but the focus is on the bank’s fee income and the efficiencies of the bank. Reducing or controlling costs is as important as the revenue the bank drives.
At one point, Buffett owned upwards of 9% of Bank of New York Mellon, with an investment valued at $4.1 billion. He recently started to sell out of his position, but he mentioned earlier that he liked the bank’s performance and thought they were a great investment after his initial purchase of shares in 2016.
Another plus for custodial banks is the dividends they pay, which tend to be higher than those of the S&P 500, excluding REITs. Bank of New York Mellon pays a dividend-yielding 3.36%, State Street yielding 3.15%, and JP Morgan yields a 3.57% dividend yielding.
With that, we are going to wrap up our discussion today regarding the top custodian banks.
As always, thank you for taking the time to read today’s post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,