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Moody's Investors Service – the credit rating arm of Moody's Corp. (MCO - Analyst Report) – has put the ratings of three major U.S. trust and custody banks – The Bank of New York Mellon Corporation (BK - Analyst Report), Northern Trust Corporation (NTRS - Analyst Report) and State Street Corporation (STT - Analyst Report) – under review for downgrade. However, the short-term Prime-1 ratings of these banks have been affirmed.

According to Moody’s, these custody banks are expected to face a downgrade in their ratings by one notch.  At present, BNY Mellon is rated Aa3, three notches below triple A, the highest credit rating, and State Street and Northern Trust are rated four notches below at A1.

While reviewing the ratings of these custody banks, Moody’s will focus on the long-term profitability challenges bracing them. These banks aggressively price their core custody products and services, thereby creating a barrier-to-entry market for competitors.

As a result, their overall fee revenue is almost equal to their expenses.  Moreover, Moody’s will scrutinize these banks’ revenue generation capacity from custody-related services and their ability to cut costs through their expense saving programs.

However, these custody banks have a sustainable franchise due to which their core custody businesses are favorably poised to derive benefits, despite various barriers to entry and macroeconomic challenges. Additionally, these banks have large asset management franchises and a solid balance sheet position. This limits the downgrade of these banks to only one notch by Moody’s.

Although these custody banks have a huge market share, pricing in the core custody business is very competitive, which has resulted in narrow margins. This compelled these banks to depend more on revenues from ancillary services for increasing their profits. However, these revenue sources are under tremendous pressure due to low interest rates.

Moreover, foreign exchange revenues have been adversely affected by volatility and higher scrutiny of pricing, along with a drop in securities lending revenues due to lower demand. In this context, Moody’s will review these banks’ reliance on ancillary services to generate profit.

Further, Moody’s will consider these banks’ chances of altering their asset mixes with respect to changing capital requirement regulations. Moreover, under proposed Basel III regulations, banks would be required to include interest rate-related securities losses in their capital calculations.

However, a rise in the interest rate environment would cause the value of fixed-rate securities to fall, consequently resulting in regulatory capital reduction. All these would force the banks to change their investment mixes, thereby raising their risk profiles.

If Moody’s downgrades the ratings of these custody banks, it will lower investors’ confidence in the stock. Moreover, it might increase funding costs, thereby leading to higher expenses in the future.

While Northern Trust currently carries a Zacks Rank #2 (Buy), both BNY Mellon and State Street carry a Zacks Rank #3 (Hold).

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