Of all the investment markets in Europe, Germany represents significant opportunities, with a population of 80m and around E800bn of assets invested in pension funds. Moreover, the pension fund reforms that came into effect on 1 January are designed to strengthen the second and third pillars – company and private provision respectively – of the pension system.
Those global custodians who have viewed these developments with mounting anticipation have been disappointed. The levels of increased investment expected as a result of the reforms have failed to materialise. “The reforms have indeed been a bit of a disappointment as the market expected they would have more of a momentum but they have not,” says Alfred Frei, regional market manager for North Central Europe at Citibank Global Securities Services. They have, however, made the German people aware of the need to make provisions for their retirement. Frei is confident that discussions now taking place will result in the second and third pillars being made more attractive to investors.
Yoram Matalon, managing director and head of continental Europe, Deutsche Bank, agrees. “Part of the problem has been that, for years, Germany has had a funded system with a large degree of pension obligations in book reserve. It was comfortable, and there was no pressure to change. There are some further changes that are needed to make the Riester reforms more attractive and enable people to pay more than lip service to them. When that occurs, there will be further change in the investment market.”
These changes include the squeezing out of domestic custodians by their global counterparts. The German market is moving to an ‘Anglo-Saxon’ model of custody based on greater transparency and a willingness among institutional investors to pay for certain services. Historically, asset management firms (KAGs) were meant to be separate legal entities from the depot banks, which provide full custody and administration services for certain classes of collective investment vehicles. In practice, most were separate in name only and the larger universal banks provided both functions and a great deal of cross-subsidisation occurred. If a pension fund awarded a mandate to a KAG, that KAG would appoint its ‘in-house’ depot bank. Therefore, a pension fund dealing with a number of KAGs would also have to establish relationships with the same number of depot banks.
“The traditional German model is on the way out,” says Martin Loesser, JP Morgan. “We will see much more transparency.”
Dietmar Roessler, business manager, international investor services at BNP Paribas Securities Services, agrees. ”For the past couple of years, German investors have wanted to break up the value chain. If they appoint five different KAGs, they do not want to deal with the same number of depot banks.” Enter the global custodians, which can bring transparency and additional services to the fray. And as pension fund assets grow, the global custodians argue they are in a far stronger position to manage large collective funds than are domestic German entities.
Thomas Bergenroth, general manager of State Street Munich, says investment behaviour in Germany has changed, with investors looking for more diversification and more willing to invest across borders. “The bar for custodians is rising because of the complexity of investments, the increased regulatory requirements for risk management and growing demand for performance measurement. Traditionally in Germany one bank has done everything; asset management and custody functions were under the one roof. Specialisation and the increase in investor demands will lead to the further unbundling of these functions.”
Roessler’s colleague, Sebastien Lecaudey, head of product development and operations, says KAGs now need to work with third-party depot banks – a scenario that is very new to them. 'This has made life for some of the KAGs very difficult. For example, out of around 75 KAGs in Germany, only about five are using Swift [the Brussels-based financial messaging_network] for communication,” he says.
In terms of automation, the market is very immature, says Lecaudey. Most KAGs still send faxes to depot banks for fund accounting and reconciliation is undertaken manually. “To date when pension funds have been looking for third-party custodians they haven’t really been interested in how the flows are processed. They are much more interested in how the funds are managed and the quality of risk analysis. However, some are starting to mention the processing of flows and I think we are at the early stage of funds looking at the handling of the back office processes.”
Domestic custodians are also under pressure from their global counterparts in the field of Spezialfonds, the funds developed specifically for institutional investors who outsource their own investments to a professional fund manager. Spezialfonds can invest in the same types of assets as mutual funds but as they are not being publicly offered they enjoy a number of exemptions, particularly with regard to tax. However, Spezialfonds are complex and need to comply with a number of regulatory criteria. Depot banks must ensure that the KAG invests within the prescribed guidelines; the KAG cannot make investments unless it has approval from the depot bank.
The complexity of the Spezialfonds has meant some smaller banks have shied away from setting up as a depot bank, says Citibank’s Frei. “As a result, the competition is very narrow, with Deutsche Bank, JP Morgan and State Street competing at the highest level in terms of service sophistication.” Citibank is seeking depot bank status to compete. Local banks such as Dresdner and Commerzbank service this market but not on the same level.
Matalon says funds are also seeking superior reporting via web-enabled tools. Performance measurement, securities lending and triparty functions are also in demand. “There is a whole slew of services that buyers are demanding. Only the large institutions can supply these and the local custodians will be squeezed out,” he says. All of Deutsche’s significant competitors are foreign, he adds.
Roessler points up that the German market is heavily regulated, which has resulted in compliance becoming an area of growing importance. Over the past few years BNP Paribas has set up a ‘significant depot bank’ that enables institutional investors to track what their asset managers are doing. “Foreign providers are seen as more neutral, and there has been a tendency for investors to go to foreign banks, which has led to a significant reduction in the number of domestic subcustodians,” says Roessler.
The heavy hand of German regulation is being somewhat tempered by EU directives. “In the past 12 months German regulators have had a more open attitude, mainly because EC directives have opened up new avenues to do business in Germany. For example, certain controls, systems, staff and back offices can be established remotely and this has helped competitors to enter the business. It has made life easier, but the German market is still quite complex,” says Frei.
Foreign players have also entered the market via the master KAGs, where up to five KAGs band together to set up a multimanager fund. The master KAGs provide direct access to foreign investment managers, enabling German pension funds to tap into the expertise of the larger US and UK names.
Insurance companies will play a critical role in the reform of the pension market, which should be good news for global custodians. “Insurance companies do not have the means to provide the infrastructure for back office for pension servicing,” says Loesser. “This is where we have experience that we can bring to the market. We are looking to move closer to the providers of pensions and work with them so they can take advantage of the reforms.”
The frenzy of interest among global custodians in the German market is unlikely to dissipate no matter how disappointing the reaction to the Riester reforms has been. In May, the news of a wide-ranging restructure at Deutsche Bank, in which it may hive off its global custody business, created much speculation that the business would be quickly snapped up. There are a number of options open. Some observers believe the bank could simply sell its US custody business, together with the passive management indexing business that came with the Bankers Trust acquisition. Others believe that if Deutsche has been prepared to put its mortgage business into a joint venture, there should be nothing to stop it doing the same with custody. A larger custodian could provide the value added services while Deutsche would remain the local depot bank. Alternatively, the bank could decide to divest itself of the custody business, sparking something of a bidding war, according to an observer. “All the main custodians would want a piece of that action because it would give them a serious presence in the German market. But I think it is unlikely that Deutsche would really be prepared to sell its local depot bank.”

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