Will Citi snafu bring fresh scrutiny to custodial banks?

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Custodial banking, a typically sleepy part of the financial system controlled by only a handful of firms, could find itself under the microscope after Citigroup misdirected hundreds of millions of dollars in a blunder that has captured the attention of Wall Street and federal regulators.

The banking giant is seeking to claw back roughly $900 million in debt payments it mistakenly overpaid on behalf of the struggling retail company Revlon to several debtholders. Citi blamed the botched payments on an error made by an employee and said that new controls are being put in place, according to court documents filed this week.

But legal experts said they are shocked at how the operations of a bank handling trillions of dollars of payments for its clients could be upended by a single worker and how such an error wasn’t caught earlier. The problem has attracted the attention of Citi’s regulators, the Office of the Comptroller of the Currency and the Federal Reserve, which have met with bank officials about the incident, according to news reports and court documents.

"You would think, like launching an [intercontinental ballistic missile], the bank would have two keys to turn at the same time,” said Arthur Wilmarth, a banking law and contracts professor at George Washington University. “I would think the Fed would begin to ask questions around how this could happen."

Custodial banks hold clients’ funds and securities for safekeeping and offer administrative services, like debt and interest payments. This market, which exceeds $160 trillion of assets under custody, is dominated by four companies — Bank of New York Mellon, State Street, JPMorgan Chase and Citi.

Citi by itself handles more than $20 trillion.

The Fed’s interest in whether the industry requires more scrutiny could be two-pronged, according to Wilmarth. The central bank has taken a special interest recently in operational risk and has even included these potential problems in recent stress tests. The Fed has also made a priority of reviewing the payments system in general and has spearheaded the development of a public utility called FedNow that eventually could rival the proprietary payment systems.

A Fed spokesman did not comment for this story.

Parties in the Citi matter have spoken dramatically of the scope of the problem and the potential ramifications on the industry.

Citi has argued in its lawsuit against one of Revlon’s creditors, Brigade Capital Management, which has refused to return the payments, that the “very foundations of the modern banking system would be undermined” if the bank does not recoup the mistaken amounts. But Brigade has argued “the public interest is served by allowing a recipient that was rightfully owed the funds (as the lenders were here) to retain the transferred funds, whether made in error or not,” according to case documents.

So far, Citi has persuaded a judge to freeze what funds have not been returned to the bank, but Brigade has argued that because of the structure of the funds it manages, the money isn’t there to be returned.

A spokeswoman for Citi said the bank is upgrading a loan operations platform that was at the source of the employee error after a review that began last year. The bank says it believes that it will recover the outstanding funds.

“We take pride in the role that we play as a global leader in financial services and recognize that an operational error of this nature is unacceptable,” the Citi spokeswoman said. “We have put significant, additional controls in place until the new system is operational.”

Brigade has argued in court filings that it’s still unclear how the error was made, and regulators will be keen to get to the bottom of the problem, according to legal experts. In the meantime, other custodial banks could be taking a look at their own controls and contract language to guard against any further mistakes.

“Many back-operations people may have had a ‘there but for the grace of God’ moment when they heard of the Citi fiasco,” said Erik Gerding, a banking law professor at the University of Colorado. “But the best way of handling this mistake is to have the internal procedures in place to make sure it doesn’t happen in the first place.”

While some custodial banks may try to include an “exculpatory clause” in future contracts that would protect them in case of a mistake like the one made by Citi, it’s unlikely clients will go for it unless the industry moves in concert, Gerding said. And that may only occur if a larger, more systemic problem is discovered at the root of the Citi episode, he said.

“That kind of contract clause could be extremely disruptive," Gerding said. “Large institutional clients, just like households, want certainty that when they receive funds they can spend them.”

Wilmarth said the Citi mistake reminds him of past scandals that revealed broader, underlying issues that led to reforms, like JPMorgan’s London Whale debacle. And he wonders if there is some deeper problem lying beneath the surface of this latest issue for regulators to discover.

“This is a black eye,” Wilmarth said. “Everyone is straining for every extra basis point or two and are taking risks that you wouldn’t think they would.”

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Commercial banking Custody banks Faster payments Litigation GSIBs Risk management Federal Reserve OCC