Trust bankers call it the "Calpers effect," and it's wreaking havoc on profit margins in their custody businesses.

Calpers, short for the California Public Employees Retirement System, is one of the largest pension funds in the world. In a move that rocked the trust banking business earlier this year, State Street Boston Corp. won a custody contract by offering to accept a shockingly low fee from the $68 billion fund.

Soon after the Boston bank won the account - with a bid 50% lower than its competitors - it was awarded a second heavily discounted contract from the $40 billion California State Teachers Retirement System.

Bankers worried that the contracts, the first of which was inked in January, would set off a price war for custodial services, which include accounting and record-keeping for corporate and public pension funds, mutual funds, and other institutional investors.

Fees on a Nosedive

Their worst fears have been realized.

Custodial fees today are 30% to 50% lower than they were a year ago, say bankers and pension fund consultants. And even one year ago, they add, price competition was already intense.

How long the banks can maintain their bidding wars remains unclear. But the Calpers effect was highlighted again last week when the city of New York signed a contract with Citibank at half the value of its previous contract with the New York bank.

Battle Lines Being Drawn

It seems clear that long-term relationships are easily forgotten in the new bidding battles.

Citibank has been custodian of New York City's $44 billion retirement system - the sixth largest pension system in the world - since 1979. But the city spent seven months negotiating with eight banks on its new contract.

Citibank, the flagship bank of Citicorp, eventually won the bidding with a $2 million contract. That's about half the value of its previous contract, which expires Sept. 30, according to city officials.

"Our exhaustive review of the industry's major custodian banks has allowed the city to reap the benefits of increased competition in the marketplace, resulting in additional services and lower fees," Elizabeth Holzman, New York City's comptroller said in a statement.

Citibank officials acknowledged that they were squeezed.

"The Calpers effect is indeed something we're all facing," said Jerry Hourihan, relationship manager for pension fund sales at Citibank. "To be in the public fund market, you need to have a sales atmosphere that allows you to go in at lower margins than other types of businesses."

Mr. Hourihan maintains that the bank can offset the lower New York City custodial fees with profits from other services it will provide under the contract, such as securities lending. "We're satisfied with the profit margins on the contract," he said.

Chase, Citicorp on Upper Rungs

Citibank is the third-largest U.S.-based global custodian, according to industry estimates, with $86 billion of assets under management. The largest custodian in the world is believed to be Chase Manhattan Corp., which has about $150 billion of assets under management.

Citibank's custodian activities, housed in its financial institutions and transaction services group, provide cash management, funds transfer, and other securities-tracking services to banks, corporations, institutional investors, and broker/dealers. In 1991, the group eamed $310 million, up 10% from the previous year.

Allan Emkin, a principal at Pension Consulting Alliance, Studio City, Calif., said the big custody banks haven't yet felt the full impact of the price wars.

Survival Tacties Drafted

But he believes the lower fee structure will take its toll, driving some custodians out of the business and forcing others to join forces and develop joint ventures to survive.

"There's been an across-the-board restructuring of custodial fees by the major banks," said Mr. Emkin. It will create further concentration among those banks that can provide world class custodial services."

His roster of survivors include Chase, State Street, Bankers Trust New York Corp., Northern Trust Co., and foreign banks such as Barclays Bank and Algemene Bank Nederland.

Bankers concur with Mr. Emkin.

"The first question is do you want to play the game," said Allan Martin, senior vice president at Bankers Trust. "Then you have two choices: try to, increase your revenue from ancillary sources like securities lending and foreign exchange, or reduce expenses through automation."

Concessions to Be Made

Bankers Trust, which earns 20% of its revenues from custodial and related information management services, will continue to be a player, but may form a joint venture or partnership with other custodians in the future, Mr. Martin said.

Chase bankers who earlier this year were outraged over State Street's price-cutting initiatives, now claim that the Calpers effect is neither widespread nor pernicious.

Chase this year has won several contracts, including one from the state of Wyoming, where the pricing was competitive but not discounted as heavily as in the Calpers deal.

But even Chase is making concessions. With lower fees apparently here for the indefinite future, the bank's officials say they are considering joint ventures with other custodians.

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