Iain Morse finds regulation change may force some smaller captive custodians to re-think their business model

Belgium’s financial regulator CBFA licenses 43 local custodians and one foreign entity, the BNY Mellon.

Some of these smaller banks say they offer sub-custody services but they essentially act as custodians because they are already licensed to manage client monies on a discretionary basis or to manage investment funds which receive third party monies.

These banks’ custody assets are captive and they do not actively compete for third-party business. Banque de Groof is a good example of this type of institution. It manages some €22.9bn, much of this in over 65 unitised funds. More than half of these funds are domiciled in Belgium. The remainder are just across the border in Luxembourg. The Belgium-domiciled funds are mainly invested in Belgian assets - equities, bonds and real estate. Over 60% of all the assets managed by De Groof are in the euro-zone, including domestic assets.

The much larger Fortis Bank has over 240 Belgium-domiciled funds across a wide range of asset classes and geography. BNP Paribas, Dexia and KBC also have diversified suites of Belgium-domiciled funds, as well as funds domiciled in Luxembourg. The aggregate value of ‘captive’ assets subject to in-house custody in Belgium is therefore quite substantial, probably in excess of €200bn, according to the Belgian Fund Manager’s Association (BEAMA).

“There are still quite a number of local players in the Belgian market,” notes Gael Nicora, head of relationship management for Belgium at BNY Mellon Asset Servicing. He adds that some compete in the open market and some do not. The large Belgian banks use global custodians for exotic asset classes while continuing to custody domestic and euro-zone assets in-house.

The Belgian three-pillar pension system offers some limited opportunities to third-party custodians. The so-called Silver Fund, part of first pillar provision, is only permitted to invest in Belgian government debt. Fund reporting is annual; fund assets are today worth at least €16bn. According to Silver Fund spokesperson José Nys, bonds and cash are under custody from the Belgian Treasury and central bank.

Second-pillar occupational pension schemes offer only slightly better prospects to custodians. These can be set up on an employer-specific or industry-wide basis. There are a few defined benefit plans, mostly for white collar workers. The large schemes are all defined contribution but subject to a regulatory regime of guaranteed minimum annual returns - 3.75% from employee contributions, or 3.25% from employer contributions.

According to Mercer, the aggregate value of assets in these and less numerous third-pillar plans is more than €13bn. Most of these guaranteed minimum return funds are provided by domestic Belgian insurance companies, which typically do their custody in-house. Examples here include insurance companies run by Ethias, Fortis, Axa, ING, AGF and Delta Lloyd, all of which are also licensed as custodians by the CBFA.

A couple of trends in asset allocation deserve to be noted here because of their possible consequences for custody banks in this market. Belgian pension assets are almost equally divided between equities and bonds but funds continue to diversify out of the domestic asset pool and into the wider euro-zone. “There is some growing demand for investment strategies that require a high level of capability and competence from custodians,” says Nicora. This, in turn, requires higher levels of investment by custodians. “Will all the local players want to make this investment?” he adds.

Meanwhile, the regulatory context is tightening, posing a challenge to accepted patterns of business. “There is nothing unusual in Belgian banks providing custody in-house,” notes Revel Wood, head of Northern Trust’s Luxembourg office. “This is not a very active market for third-party custodians.” This is a familiar pattern seen in Germany and elsewhere. The question is whether such firms offer third-party investors fair value and best service. This question is likely to be thrown into much sharper focus as a result of EU directives.

Much recent discussion of the alternative investment fund managers (AIFM) directive has focused on the treatment of funds and managers outside Europe. Less discussed have been the possible consequences for local custody or depositary banks. “It will have an impact in Belgium as elsewhere,” warns Wood. The directive, framed in the wake of Lehman and Madoff, is intended to clarify and tighten the regulatory environment in which depositary or custody banks operate. Duties required of banks under the directive will include monitoring cash flows, safekeeping assets, interrogating third-party sub-custodians to ensure that assets exist, setting limits to hypothecation and ensuring timely and accurate valuation of assets.

How many of the existing Belgian local custodians rise to meet these standards remains to be seen. “Smaller, less sophisticated custody banks are going to find it harder to stay in this market,” says Nicora.

Among the many possible consequences of the directive, a trend to separate custody from asset management looks likely to emerge. One of the most talked about provisions of the directive involves a strict liability rule, in which a custodian will be required to make immediate compensation for any loss of assets. This might not matter much where the custodian holds domestic government bonds to maturity or has a ‘strategic’ portfolio of large-cap euro-zone-listed equities. But it will be much riskier, complex and expensive to do with the likes of emerging debt or futures and options.

On the other hand, Belgian investors are proving very conservative in the face of all this change. “While the sustained trend in Europe has been to embrace new investment strategies, in Belgium we see the opposite movement,” says Nicora. Clients are starting to limit their exposure to these types of investment. “This is primarily driven by regulators who are placing tighter restrictions around the use of such instruments,” he adds.

The credit crunch has also had an impact in reshaping Belgium’s domestic insurers and banks. Ethias, for instance, while Dexia bank was partly nationalised. “In Belgium, as elsewhere in Europe, we have a double-whammy effect - the credit crunch and regulatory change,” says Wood. “Taken together, these are likely to precipitate further change and encourage some players to reconsider whether they wish to continue with established business models.”