Since 2008 the financial services industry has had a difficult time in keeping up with the deluge of regulatory requirements being thrust upon it. There is still much regulation to come and clients will be relying upon their custodians for assistance to meet the new compliance, reporting and risk management challenges.

The rules of the game have changed and today’s environment calls for a different kind of bank and a different kind of custodian. In terms of what we offer customers, custodians must restore trust through transparency and fair pricing, convenience, excellent services and solutions. In terms of how we operate as a custodian we must streamline processes, improve efficiency as an imperative to have a competitive edge as regulatory costs rise.

Risk is an important component for both a sub-custodian and a global custodian. We are all facing increasing risk and compliance requirements, and there is a cost for that. You have to pay much more for just hiring people who are able to focus solely on mitigating risk and ensuring compliance. Custodians are ready to make this move, but must understand what level of costs they will have to swallow and what level of costs, if any, can be passed on to clients. Hopefully, clients will also have greater understanding and appreciation of the fact that we are making large investments into risk mitigation and it is for their benefit.

A new regulation era
It is uncertain as to whether some custodians will have the resources and personnel to meet the new regulatory world. In the past custodians would receive from their clients annual due diligence questionnaires, annual compliance packages with intermittent regulatory and compliance questionnaires throughout the year. This was nothing out of the ordinary and was easily handled by the custodian. Nowadays, it seems that custodians are continually receiving requests from their clients to confirm and reconfirm their compliance with SEC, FSA or various Central Banks’ requirements, i.e. client assets are segregated. The front office relationship management role has now expanded significantly in that more and more of their time is spent on responding to such regulatory and compliance requests and less time on dealing with the usual relationship issues.

As an example, in 2011 the German Central Bank issued a three-point declaration related to client asset segregation to be completed by sub-custodians and CSDs or other depositories. The UK’s FSA also changed its rules requiring the re-signing of client segregation letters. Both seem like simple requests, but nothing is quite that simple when CEE countries are involved. Custodians and local CSDs/depositories, due to market particularities, i.e. lack of foreign nominee recognition, could not sign these declarations “as is,” thus custodians had to spend a lot of time liaising between the CSD and their clients to come to an agreed solution.

Further, to comply with regulations, some global custodians request annual external audit reports and external legal opinions from their sub-custodians, which, in some smaller less active markets, the obtaining of such external documents cost more than the revenues the sub-custodian may actually receive from the client. This places the sub-custodian is an untenable situation as their clients expect the sub-custodian to pay for this as a part of their service.

ING’s response
How does this new regulatory and compliance landscape affect the strategy of a sub-custodian like ING in CEE? For the most part, the strategy remains the same, but with more emphasis on improving its IT infrastructure and more emphasis on lobbying for market improvements which may lead to more straight-through-processing, which would hopefully save on operational costs, time and resources, which costs, time and resources can be allocated to assist our clients in meeting the new compliance, reporting and risk management challenges they encounter.

A (sub)custodian must continue to strive for operational excellence by offering simplified product offerings, standardised and consolidated services along with integrated and multi-channel offerings. They must offer a convenient, safe and trusted offer for their customers.

Of course, maintaining the necessary balance is becoming more difficult as clients see their revenues dwindling, thus, in turn, they request fee reductions from their providers and then inundate them with a flurry of regulatory and compliance requests to be done at no extra costs. As sub-custodian margins are diminishing, operational excellence takes top priority and processes must be streamlined so it can earn a living without sacrificing the quality of its services. A simpler organisation means more time to focus on serving the client and his needs and thus efficient end-to-end processes, centralised processing, when possible, fewer and more standardised systems and STP are essential.

In addition to the numerous regulatory requirements imposed over the past few years, the market conditions in the US, UK and Eurozone have impacted the amount of investment investors place in CEE. Such countries as Bulgaria and Slovakia have yet to see the volumes they have had prior to 2008 even though these countries weathered the crisis better than most. Bulgaria is characterised as having a stable political and macroeconomic environment, stable banking system and low tax rates. The Bulgarian Lev is pegged to the euro at fixed rate €1 = 1.95583 BGN, which provides comfort to foreign investors as there is no FX risk in the market and all these features combined give rise to favourable terms and conditions for doing business in Bulgaria. The ratings agencies have continually upgraded Bulgaria which is a positive sign in an environment of numerous sovereign debt ratings downgrades of countries. Slovakia’s banking sector has remained relatively healthy during crisis and Slovakia offers more favourable business environment than its regional peers. However the lack of investment is caused by market conditions around the world and custodians in Bulgaria and Slovakia must remain lean and efficient to survive while waiting for global recovery and increased interest in their markets.

European market performance
Poland seems to have hit the right path for a sustainable growth despite adverse economic circumstances around the world. The GDP growth stood at solid 3.8 percent in 2010 and the pace is likely to be continued in 2011-2012, which is something special among most of the European countries which struggle with their economic problems. The growth is accompanied by the steady development of the financial market. During turbulent times, market across the world are leaning towards more transparency and control, while Poland with introduction of the omnibus structure in 2012 will be giving up on transparency to gain a small advantage in requiring lesser documentation from investors and allowing providing custodians and their investors with another option as to how their assets can be held in that market.

It seems that the financial crisis in Europe has yet to reach the Ukraine. Expected 2011 GDP of 4.6 percent year-on-year is likely to be one of the highest levels among European countries. Ukrainian growth is currently being driven mainly by domestic, rather than external factors such as private consumption fuelled by growth in personal income and a gradual revival in local currency retail bank lending, investment in the infrastructure to prepare for the Euro 2012 football competition and relative “immunity” to the immediate effects of the European debt crisis due to the absence of European sovereign debt holdings by Ukrainian entities and banks. However, no matter how positive the figures appear, foreign investment in Ukraine is hampered by Ukraine’s strict regulatory requirements which deter investors. The custody and cash account opening requirements imposed by the National Bank of Ukraine make the Foreign Account Tax Compliance Act (FATCA) and Basel III seem manifestly unimposing.

Other markets such as Romania and the Czech Republic remain relatively strong and active, but are not immune to challenging market conditions and custodians in that market must are also struggling with keeping up with and complying with the regulatory and compliance demands of their foreign clients.

Hungary, which was such a promising market after considered a model for other markets during the 1990s and early 2000s is suffering from its own internal regulations and economic policies that outside influences in the Eurozone and the rest of the world are secondary.

Whether Russia showed a strong performance and passed the crisis period safely or not is still disputed. Some experts claim that the recovery was comparatively fast and others opine that the downturn and the depth of the fall of Russia’s financial market was the most significant amongst the major emerging economies. In any event it became clear that Russia was and continues to stay extremely dependant on the world’s largest economies, macro trends and it is not yet considered as an alternative to major markets or a safe haven by most investors.

Foreign investors still consider Russia as a pretty high risk market, attractive, but still of an emerging category. However in 2012 positive changes are on their way with the introduction of the new CSD and the introduction of the foreign nominee concept. These are crucial steps towards the migration of the infrastructure to a model suggested by a large number of foreign market professionals as the one needed to exercise further progress in the market. It will be interested to be seen if these measures can bring about more STP in the market and eventual cost savings to the market participants.

The impact of challenging market conditions and existing and pending regulatory framework will have an effect on a CEE custodian business model in that the custodian or sub-custodian will continue need to strive for operational excellence and streamlining its business processes in order to mitigate the effect from diminishing margins, decreased business due to less investment in CEE countries along with the increased costs involved in assisting clients with regulatory and compliance matters. It seems the new regulatory and compliance landscape is here to stay and this is something the custody industry must deal. Hopefully, the global economic crisis will improve and markets will see an increase in activity which will make dealing with regulatory and compliance matters more palatable.