ECB Paper Explores Challenges in Supervision of Custodian Banks

Custodian banks are credit institutions but share common features with financial market infrastructures such as central securities depositories, as their primary function is to serve as an interface between their clients and various central securities depositories. In EU, custodian banks are licensed as credit institutions, a legal requirement for European deposit-taking institutions; therefore, they face the same prudential requirements as traditional banks. However, their business model and risk profile are different from those of traditional bank. Thus, supervisors face several challenges in supervising custodians because custodians have to comply with the same requirements as traditional banks, despite the significant differences in their business model and risk profile. This paper 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. It also analyzes how custodians’ liquidity risk profile differs from that of traditional banks. The analysis points out the following with respect to custodian banks:

• 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. However, 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.
• 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 to reduce the size of their balance sheet, pass on the negative rates to their clients, and/or 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—that is, the 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).

The risk profiles of custodian banks are unique when compared with other credit institutions. Supervisors should acknowledge these differences and focus on custodians’ internal capacity to identify, measure, and mitigate risks that are idiosyncratic to their business model. Importantly, custodians are liability-driven institutions and have a limited risk appetite. Nonetheless, the custody business is exposed to a high level of operational risk and to intraday credit and liquidity risk, which are part of its core business. These risks are harder to capture with the existing regulatory tools, because their main focus is on-balance sheet risks. In the absence of regulatory requirements that are sufficient to capture these risks, supervisory authorities should encourage custodians to develop innovative and comprehensive risk-based approaches to capture their respective idiosyncratic risks in their internal capital and liquidity risk computation frameworks to ensure adequate capital and liquidity allocation by custodians.

Related Link: Paper (PDF)

Keywords: Europe, EU, Banking, Custodian Banks, SREP, Operational Risk, ILAAP, IRRBB, Liquidity Risk, Basel, Regulatory Capital, ECB