ECB publishes paper on custodian banks
The ECB Eurosystem has recently published a paper (Occasional Paper Series) that analyses the profitability, capital and liquidity constraints of custodian banks through the lens of the supervisory review and evaluation process methodology.
It examines how custodians differ from traditional banks with regard to:
- balance sheet structure,
- income generation, and
- risks faced.
- 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.
- Custodians have unique risk profiles when compared with other credit institutions. Importantly, custodians are liability-driven institutions and have a limited risk appetite. The lack of active risk-taking and limited credit activity is a feature of the custody business and translates into a balance sheet that exhibits a low level of capital risk and a comfortable liquidity position, satisfying regulators’ requirements and clients’ expectations of their custodian acting as a safe haven.
- Nonetheless, the custody business is exposed to a high level of operational risk (which includes IT risk, restitution risk, reputational risk and legal risk) and to intraday credit and liquidity risk, which are part of its core business. These risks are harder to capture with 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 custodian.