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Plenty of Wide Moats in This Industry. But Can They Persist?

Custody banks may be moaty, but they face a tough pricing environment.

Rajiv Bhatia: The custody banks are really unique financial institutions. Unlike a traditional bank which focuses on gathering deposits and making loans, custody banks are in the asset-servicing business. When investors refer to the custody banks, they are often referring to banks such as State Street, BNY Mellon, and Northern Trust.

The custody banks monetize their assets in several ways. They earn servicing fees from custody and fund administration services; these fees are typically a few basis points on the assets held under custody. They earn subscription revenue from data services. They act as an agent for securities-lending activity, connecting borrowers and holders of securities. They also assist with foreign exchange trading activities. Finally, they also earn net interest income from client cash deposits.

Based on Morningstar’s moat methodology, we believe the custody banks do possess a wide moat from cost advantages and client-switching costs. The custody banks have scale from the upfront costs of developing software systems and processes to service trillions in assets. In addition, due to process disruption, onboarding costs, and a limited number of providers, the clients of the custody banks seldom switch.

That said, it’s not all sunshine for the custody banks. The custody banks face a tough pricing environment. Their client base of asset managers is increasingly concentrated, who themselves are facing significant fee pressure. In addition, clients are becoming more discerning on the interest earned on cash. As a result, we believe State Street and BNY Mellon have negative moat trends. While we believe Northern Trust’s custody segment also has a negative moat trend, we give Northern Trust a stable overall based on the strength of its wealth management franchise.

Overall, based on valuation, we currently find State Street to be the most attractive and rank it four stars. Northern Trust and BNY Mellon are both at three stars.