A year after mutual fund scandals rocked the industry, increased regulation may mean new business and additional revenue for large custody banks that sell outsourcing services, according to analysts and executives.
State Street Corp., J.P. Morgan Chase & Co., and Bank of New York Co., the three largest custodian banks, have the most to gain while asset managers, including other banking companies, look to outsource their back-office services because of increased regulatory pressures.
Alan D. Greene, an executive vice president at State Street and member of its executive operating group, said the outsourcing business "is an area that has gotten more of our clients' attention because of, among other things, the increased regulatory focus. Clients are trying to figure out how to keep up with new regulations and are looking hard at what can be outsourced."
"We have a number of very interesting and ultimately fruitful prospects on the way," he said.
State Street clients are interested in specific services, including fund treasury, fund administration, financial reporting, and compliance, Mr. Greene said. The Boston company has a product to help asset management companies' chief compliance officers meet all regulatory requirements.
The Securities and Exchange Commission has adopted a rule requiring every asset manager to designate a chief compliance officer by Oct. 5 to ensure that the company complies with a code of ethics and fully discloses its market timing and late trading policies.
Analysts said companies are learning it is more cost-effective to outsource in order to comply with such regulations.
"Transparency is a primary concern in order to fulfill the new requirements," Mr. Greene said. "Clients are trying to protect themselves through outsourcing."
TowerGroup Inc., a Needham, Mass., investment research company, says asset management outsourcing will yield $2.6 billion of revenue this year. Tower predicts that revenue will grow 12% annually, to $3.7 billion by 2007.
Tim Lind, an analyst at TowerGroup who wrote the report, said this revenue will go primarily to the largest providers - State Street, J.P. Morgan Chase, and Bank of New York. The top 15 providers worldwide bring in $18 billion to $19 billion of revenue a year.
Mr. Lind said fresh regulation would be an important driver in maintaining this growth.
"Having a third-party firm outsourcing back-office services really plays well with regulators and customers because a third-party firm does not have the conflicts of interest," he said. "Regulation is going to be another reason for asset managers to turn to outsourcing."
Bank of New York has been increasing its outsourcing effort in the past three years. It established a stand-alone business unit, BNY Smartsource, in 1999 to offer outsourcing to investment companies. Stella Vanguestaine, a managing director at Bank of New York who manages BNY Smartsource, said the business offers a real opportunity.
"There is such a demand for transparency and the ability to provide data that firms are examining their infrastructure and realizing that they can't meet these requirements alone," she said, and are "looking to outsource."
Ms. Vanguestaine said her unit has developed seven full-service, fully bundled clients since opening. The company will announce a new client firm in the next week or two, she said, and has a letter of intent from another company.
Paula Sausville-Arthus, a senior vice president and head of the asset manager solutions group at JPMorgan Investor Services, said this is not the first wave of interest in outsourcing. Her group, which focuses on managing middle and back-office services for investment managers, has recognized outsourcing as a trend since 1999, she said, an interest that began with Y2K technology concerns.
Investment managers are forming partnerships with banking companies like Morgan Chase, Bank of New York, and State Street, Ms. Sausville-Arthus said, because they want the economies of scale a large provider can supply. "It is just better and less expensive coming from us than an asset manager building it de novo," she said.
Ms. Sausville-Arthus said regulatory changes concern asset managers and will be a key driver as outsourcing continues to grow.
Analysts said that, despite the business' growth potential in the new regulatory environment, asset management outsourcing has thus far fallen short of once-lofty expectations. TowerGroup's Mr. Lind said some industry observers three years ago expected a flood of outsourcing contracts, predicting it would become a $30 billion business line.
Though this growth has not materialized, he said, optimism has revived in the past six months.
"There is value in outsourcing, but there … [are] still a lot of inherent obstacles that would cause the market to grow" more slowly than predicted, he said. "I see this as a slower-moving creature. I am still positive about growth."
The slow-go thus far, he said, is because even the largest custodian banks can do only two to four major contracts a year. "You are talking about major integrations," he said. "It is very difficult to have the economies of scale in order to grow at any significant rate."
Mr. Greene said State Street's platform and products are scalable. The company is ready, he said, as the asset management industry looks to increase outsourcing. "This isn't a new phenomenon for us," he said. "We have been at this for a while. We can leverage growth better than our competitors."
Mr. Lind said it would be difficult for other companies to offer these services. Besides the Big Three, he said, just a handful of companies, like Northern Trust and Mellon, are in a position to gather market share.
"The barrier to entry is huge," Mr. Lind said. "Financial services is a relationship business. We are talking about the global custody business. This is a business that most of these large firms have been in since the 1960s. They have existing long-term relationships and now can look to cross-sell."
Mr. Greene said that having a strong track record is crucial in the outsourcing business. "It is hard to get someone to award you business if you haven't done this a half a dozen times," he said.
Ms. Sausville-Arthus said many opportunities are visible on the horizon for growth at the largest companies but that the growth of outsourcing in the United States has lagged behind that in the United Kingdom and Australia.
"In the United States there is more interest in outsourcing specific components right now, where asset managers look at particular areas," she said. "We believe it is just a matter of time before asset managers in the United States pursue the same sort of comprehensive outsourcing that we have seen in the United Kingdom."
