Stephen Lewis at Deutsche Bank examines the impact of the ‘quiet revolution’
A quiet revolution is taking place in Europe. It is not the type of revolution that stirs passionate debate on the boulevards of Paris or in the coffee houses of Vienna, but it is no less important for that. This revolution is starting to change the way in which investors approach and analyse the European market, and the way in which new investment products are developed and distributed.
There have been two major catalysts behind this transformation of the European investment landscape – the euro and the demographic time-bomb. Less than a year since its birth, the euro is already affecting the asset allocation strategies of major institutional investors. For many, Euroland has become a single market, within which there are industry sectors but no geographic boundaries. As capital has become more fluid within the region, the concept of pan-European asset allocation is rapidly becoming a reality.
For institutional investors based in Euro-land, the opportunities offered by the euro are huge. “European institutions are re-defining their domestic markets,” says Stefan Gmuer, head of sales and client management for Europe, Middle East and Africa, for Deutsche Bank’s Global Institutional Services division. “The euro has given them a unique opportunity to review the whole investment process and to refine their strategies. Some are already restructuring portfolios to take advantage of the fact that their domestic market has now become the whole of Euroland.”
These investors have an added incentive to rebalance their portfolios – the demographic time-bomb. As state pension schemes creak under the burden of an ageing population, the privatisation of pension provision has led to a massive surge in securities investment. Cross-border equities have been high on the list of priorities in the search for better returns, says Gmuer. “European pension funds have been diversifying their asset mix,” he notes, “with a shift from a purely domestic to a more international focus. The introduction of the euro has helped to accelerate this process.”
How will all these changes affect the role of the global custodian in Europe, and the way in which custodians service their clients? According to Roger Booth, global head of custody services for Deutsche Bank, Europe is the next frontier for the development of the global custody business. “We see three major trends across Europe,” Booth says. “First, there’s the liberalisation of savings regulations, which has led to more securities investment and cross-border activity. Second, there is the widespread privatisation of pension provision. And third, we’re witnessing significant changes in market infrastructures, with both exchanges and depositories reviewing the way they do business. Add all these together, and factor in the impact of the euro, and it is obvious that global custodians in Europe face a very challenging – and exciting - future.”
Booth is not convinced, however, that the development of global custody services in Europe will mirror the US experience. “There are fundamental differences between the two markets,” he says. “First, continental European banks, especially the universal banks, have always performed more services for clients than banks in the US The concept of the universal bank, delivering a broad range of services, is well accepted in Europe, and we expect this to continue. Second, the European banks recognise that custody is a risk business. The US banks have tended to concentrate on their ability to provide superior levels of administration at a competitive price, whilst focussing less on the assumption and management of risk. That’s a major divergence of attitude and approach.”
What is not in doubt is that European investors are taking a fresh look at how they are served by their custodians. “The shift towards a more international focus means that investors are looking for best of breed suppliers,” Gmuer says. “They’re no longer happy to do business with their house bank just because of long-standing relationships. Our clients are becoming more sophisticated and require new levels of service from their banking partners. At Deutsche, we’ve been planning for precisely this future and we’re confident of meeting the challenge. In fact, we welcome it.”
Gmuer also notes a fundamental shift in the way that institutional funds are being managed in Europe. “The euro, and the growth of the private pensions sector, have been major forces behind asset diversification,” he says. “As European pension funds diversify their assets, they are adding external managers to complement internal resources. With a combination of more external managers, and a higher level of international equities in the portfolio, there’s a much greater demand for specialist custody and administration services.
“Cross-border holdings are more complex to track and administer, and the opportunities for loss through operational error are therefore much higher. Using a specialist like Deutsche Bank – which has a network of more than 80 markets around the world - significantly reduces those risks.”
Historically, European investors have been comfortable with a relatively low investment risk profile, with capital preservation more important than growth. But Booth believes that this may be about to change, albeit gradually. “We expect European investors to raise their risk profile,” he says. “As they start to deal with the new investing universe, they will need to find a way to manage the risks and information requirements generated by global investment. Custodians are the ideal partners to help manage these issues, especially because we can leverage off the experience gained in the US.”
However, he again draws attention to the differences between the US and European scenes. “European investors will not be able to use carbon copies of US solutions,” he warns. “The euro gives the continent a common currency, but investment regulations, legal and tax requirements will remain local, as each nation state maintains its own local infrastructure, at least for the foreseeable future. Until there is a truly federal system in Europe, there will be a requirement for custodians to deliver a localised service, with customised reporting facilities.”
Information delivery is an integral part of the custody business, and European investors are starting to take advantage of what their custodians can offer. Gmuer perceives another trend emerging here: “Banks are uniquely positioned to deliver a full range of investment administration services,” he says, “because we can intermediate in the risk management process and can be a very valuable and reliable source of tailored information. We can handle performance attribution and measurement, fund accounting and portfolio analysis, for example. Traditionally these tasks might have been undertaken internally or by the external fund managers – or, in some cases, not at all – but it is much more cost-effective and efficient to use your custodian.”
The concept of a true European custody service, which has long been discussed but has not as yet materialised, may be finally coming to fruition as a result of the massive structural changes in both global and local markets. The euro has opened up new in-vestment horizons to many institutional in-vestors eager to enhance portfolio returns, and the major asset-gathering players - mutual funds, pension funds, banks, insurance companies and fund managers - are all boosting their cross-border holdings.
Booth is optimistic about the business. “The future prospects for banks in European custody are bright and enormously challenging. Some of the changes many of us have been predicting will happen with breathtaking speed; others may take longer than expected. However the new European custody market unfolds, it will prove especially rewarding for those banks that meet the special needs of the European investor.”
This is a point that is echoed by Gmuer. “As clients evolve and change,” he notes, “their relationship with the bank and, more importantly, the services provided by the bank, will change as well. Clients will rely on those banks they can trust to offer solutions that address their needs in a fast-moving investment environment. We believe that only a handful of large, full-service organisations will be able to deliver what these investors require. These organisations will maintain the essential feature of universal banking - the primacy of the client relationship - and will differentiate themselves with the broad range of services they offer to investors. Deutsche Bank will be in the vanguard of that development.”
Stephen Lewis is regional head of custody services Europe at Deutsche Bank in London