Iain Morse reviews Germany’s custody market as it experiences externally-driven transformation

Germany has done a good job of protecting its domestic financial services industry – a thicket of local regulation, products specific to the national market and distribution via a multi layered banking system. Change is often predicted, and if it happens it will be slow.
But the custody market is the exception to this rule. It has changed considerably over the last decade; five years ago there were over 70 Depotbanks, now there are 48, with smaller players expected to quit or merge. “A lot of mergers have already taken place,” says Torsten Köpke, head of investment consulting at Aon Hewitt in Germany. “There has also been a trend towards outsourcing of mid and back-office functions”. 

The extent of this is manifest in data recently published by the BVI asset management association in its first annual survey of the Depotbank sector by assets and funds under management. Foreign bank-owned Depotbanks service assets worth €689.8bn, out of a total of €1.2trn. The remaining 42% of assets are split between domestic Landesbanken with 10.9%, credit unions, with 10.25%, and large domestic banks with 9.67%. The remainder is with savings banks, private banks and others.

The assets under custody are either in Spezialfonds – open only to institutional investors – or mutual funds. Both categories can be further split between Wertpapierfonds, typically investing in equities, bonds, cash and derivatives, and Immobilienfonds, which invest in real estate. Securities funds account for the largest share of all fund assets, around €1trn, of which Spezialfonds account for 84%.

The different types of German banks require explanation. The Landesbanken are regional-government owned, wholesale banks. Among them, NORD/LB, the north-German Landesbank, stands out. It provides master KAG and Depotbank  facilities to 145 Spezialfonds and 14 mutual funds, of which two thirds also use NORD/LB’s in-house asset management teams. All these funds are then distributed by NORD/LB to institutional and retail customers. Elsewhere, Commerzbank – classified as a large domestic bank and one of the largest in this group – provides Depotbank services but reportedly wants to sell the entity.

These vertical silos, or one-stop shops, remain the dominant model in Germany. “The Sparkassen and Landesbanken, in particular, have good access to their local, regional markets,” adds Köpke. Retaining a Depotbank capability facilitates cross-selling to retail and institutional clients. “There will be a reluctance to withdraw from any business area that increases customer contact,” he adds.

Domestic providers have been under a decade-long siege from foreign banks. BNP Paribas has the largest market share in the custody market with 316 Spezialfonds, with assets of €161bn, and 57 mutual funds with total assets of €3trn. Next come State Street, BNY Mellon, JP Morgan and HSBC.

These foreign providers have not, of course, given up the vertical silo model but they offer unbundled fees and charges, providing each service component on a free-standing basis. They have also been able to exploit global economies of scale, which have served them well as German investors seek diversification, initially out of domestic into pan-European markets, and then beyond. “We can offer services including our global networks, which local Depotbanks simply cannot,” says Patrick Stoess, head of sales and relationship management at BNY Mellon Asset Servicing in Germany. There is nothing surprising in this as the Depotbank system was designed before the advent of the euro and portfolio diversification.

Any analysis of the changing fortunes of the Depotbanks must take into account KAG and master KAG arrangements.

As originally conceived, the master KAG serves as a fund administration company, selecting a Depotbank for safekeeping and custody but determined fund NAVs itself. In this model, the Depotbank performs a relatively small subset of the core safekeeping functions associated with custody banks. The master KAG  outsources asset management. Nothing prevented the same banking group from providing these three elements under one roof. The Spezialfonds set up by the master KAGs could then be ‘sold-out-front’, but investors would only have direct relationship with the master KAG.

The Depotbank was required to double-check any NAV calculations by the master KAG but not independently verify. At the start of 2011, the regulator BAFin decided to render the valuation process more robust. As a result, Depotbanks must now either have full access to the master KAG’s process for valuation equivalent to independent valuation or carry out a separate, fully independent process of valuation and reconcile this with the master KAG – the latter model being generally preferred. This method for calculating fund values meets international best practice and also recognises the range of investments administered by the master KAGs. This change has prised open the previously seamless link between master KAG and in-house Depotbank.

A greater threat lies ahead. The Alternative Investment Fund Managers Directive, due to be implemented in July 2013, will introduce strict liability. “This will cause some providers to reconsider whether they can afford to stay in the market,” warns Gerald Noltsch, head of security services at BNP Paribas in Germany. A wide range of investments will be exempt, and the final shape of regulation is yet to be determined, but fund of funds and life settlement funds look set to be included.

Depotbanks will have to consider whether they can afford to meet this contingency risk from their existing balance-sheet reserves, or whether they can buy insurance against such investment risk. The latter, if available, might be disproportionately expensive as the investment banks themselves are being forced to increase their reserves of risk capital. “After all this, some will withdraw from the market,” says Noltsch.

The future of the Depotbanks depends on how far they can be re-engineered to meet a changing environment. Fees are already low.

“They range from as little as 1bp for core service to 2bp in the open market,” says Stoess. Fees are charged monthly, typically subject to a cash minimum, subject to transactional volumes and reporting requirements. “The market is already competitive,” he adds. “We are in a continuing price fight.” As few as 20 Depotbanks are predicted to survive.