The Climate Custodians

The basis for this post is a new Harvard Business School Working Paper1 that expands on the idea of the climate custodians within the unique governance context of the Statement of Significant Audiences and Materiality for subsidiaries of large bank holding companies. Focusing on the Big Three global custody banks — State Street, BNY Mellon, and JPMorgan Chase — we make the case for large custody banks assuming the role of climate custodians for corporations and institutions.

Custody banks provide settlement, safekeeping, and reporting of customers’ marketable securities and cash, enabling liquid securities markets. These banks have no trading decision rights over their customers’ assets, and take direction from clients, regulators, and other claimants. In Q3 2015, three banks — State Street, BNY Mellon, and JPMorgan Chase — held $75.5 trillion in custody assets, which represent nearly two-thirds of tradeable global assets. These Big Three global custody banks are systemically important to the liquidity and safekeeping of the global economy. Both the banks and their largest clients and counterparties (asset managers, pension funds, other non-custody banks, securities trading entities, and large asset owners) are highly regulated.

There is growing recognition by major players in the global political and financial systems — such as The Financial Stability Board’s industry-led disclosure task force on climate-related financial risks, the two big U.S. pension funds of CalPERS and CALSTRS, the “Portfolio Decarbonization Coalition” assembled by the Swedish pension fund AP4 and French asset manager Amundi with committed assets of $600 billion, and the Ceres’ Investor Network on Climate Risk with $13 trillion in assets — that reversing the trend in climate change is key to the long-term survival of mankind. There is also a growing conversation about the role large corporations can play in addressing the perils of climate change and how institutional investors and regulators can support these efforts. We believe that global custody banks are key players that have been missing from the conversation.

Their absence from the narrative isn’t surprising, since few outside the financial industry have heard of custody banks or know what they do. Custody banks are the hidden plumbing fundamental to the functioning of the capital markets. Trading is where the exciting action is, but without custody banks there would be virtually no trading. We believe there is a strong case to be made for large, global custody banks taking on the role of climate custodian, and that doing so is consistent with — actually required by — the regulations under which they operate. However, the decision of whether or not to take on that role rests squarely on the shoulders of the boards that govern them.

In our earlier article “Why Boards Must Look Beyond Shareholders,” we said that shareholder primacy is an ideology, not a law. Corporate boards have the option to consider other stakeholders, and many do. In that paper, we suggested that boards make their point of view on the company’s direction clear by drawing up a short annual “Statement of Significant Audiences and Materiality.” Our research found that bank directors, in addition to putting the interests of the bank and its depositors above those of shareholders, are also required to consider at least eight audiences, including the global community and the global economy. Given the planetary breadth of these audiences, we are calling on global custody banks to become climate custodians. Taking on this role is a necessary, but not by itself sufficient, condition for fulfilling their cosmopolitan governance responsibility.

The Corporate Governance of Custody Banks

The Big Three custody banks — State Street, BNY Mellon, and JPMorgan Chase — are separate banking subsidiaries of their parent bank holding companies, and each is required to have a separate board of directors. In addition, they are U.S.-chartered custody banks, national banks, and large banks, classifications that fall under the supervision and regulation of the Department of the Treasury’s Office of the Comptroller of the Currency (OCC). The OCC’s Comptroller’s Handbook says that, in order to avoid personal liability, directors of large custody banks must act in the interest of the separate legal entity of the bank itself as well as in the interest of the bank’s depositors over and above the interest of the bank’s shareholders.

In addition to banks, bank depositors, and shareholders, the OCC also requires directors of large custody banks to consider five other significant audiences within their governance duties: their custody counterparties, global sub-custodian banks, regulators, the global community, and the global economy as a whole. The directors’ role toward the global community and the global economy audiences is specifically to “ensure that the bank has a beneficial influence on the economy of its community” (p. 5). While directors of these global custody banks are required to consider these specific eight significant audiences, they have the option to consider other significant audiences as well.

We have examined the corporate governance guidelines and principles published by State Street, BNY Mellon, and JPMorgan Chase for alignment with the OCC’s significant audience requirements for large global custody banks. For all three, governance guidelines and principles discuss audiences only for the bank holding companies. We found no statements that acknowledge the audiences of their legally distinct subsidiary custody banks. Furthest from the OCC standard is JPMorgan Chase, which states that its directors act “on behalf of the Firm’s shareholders” in clear contrast to the OCC’s guidelines, which relegate shareholders’ interests to, at best, secondary importance. BNY Mellon is slightly closer to the OCC standard in stating that their directors’ “primary responsibility is to oversee the management of the Corporation in the interest of the Corporation and its stockholders.” State Street’s perspective, on the other hand, is more closely aligned with the OCC’s significant audience standard: “State Street’s directors, in their role of overseeing the sound management of the Company, have the responsibility to exercise their business judgment in what they believe to be in the best interests of the Company and the shareholders, taking into account the interests of the employees, the customers and the community at large, and in so doing enhancing the long-term value of the Company.”

While State Street is missing four of the OCC’s eight audiences, it does recognize four of them (and adds employees as another), and therefore ranks highest on the significant audience scorecard. BNY Mellon recognizes two, and JPMorgan Chase only one.

Custody Banks and Climate Change

The OCC-required eight significant audiences for large custody banks could be aggregated as “everyone on the planet.” Our suggestion that global custody banks assume the climate custodian role may help Big Three directors integrate their consideration of “everyone on the planet” in their board’s materiality determination, strategy, and reporting oversight roles. For the custody and asset management industry, the Sustainability Accounting Standards Board’s (SASB) materiality standard includes a metric — the ratio of “Tons (t) embedded CO₂ / U.S. dollars ($)” — that could be tied to individual and aggregate custody assets. Adding this single climate-custodial metric to the $75.5 trillion in assets already being tracked by the Big Three would be a small but powerful first step in elevating the Big Three directors’ role of ensuring their banks have a beneficial influence on the global economy and on the global community.

By linking assets under custody to a key climate change measure, custody banks would be taking the first step in becoming climate custodians. This role would be compatible with their safekeeping, settlement, and reporting roles and would be aligned with their eight OCC-required significant audiences. It would also be in their economic self-interest to assume this role, since the fees on which their custody business is based are a function of assets under custody, which are at risk of losing value if climate change goes unchecked.

In our view, if one of the Big Three becomes a climate custodian, the other two will follow. Who will go first will be a function of each bank’s perspective on its fiduciary duty and on its analytical, risk, and operational capabilities. While we can’t assess the banks on their capabilities, publicly disclosed evidence seems to suggest that State Street could be first.

Regarding capabilities, State Street EVP Pat Centanni, a 32-year employee of the bank, says that “many of the financial products and services brought to market by a global custodian bank are, in a practical sense, somewhat ‘open source.’ In our safekeeping, settlement, and recordkeeping roles all these products and services must be interoperable and capable of exchanging key data with our competitors’, clients’ and industry utilities’ systems, be fully transparent on a real-time basis for regulatory monitoring, and provide an ‘open’ baseline platform for client and third party service provider innovation. Increasingly, the industry is looking to the custodians for greater analytics to better mine the tremendous amounts of data they process and manage.”

The open-source business model has a robust track record of generating entirely new industries. Perhaps the highly concentrated global custody bank industry, with its organic open-source attributes, can be an incubator for a new environmental, social, and governance (ESG)-value industry. Taking on the role of climate custodian is a good first step. Once this step is taken, we envision the role evolving into a larger ESG custodial role that includes the global community and the global economy, already a required considerations.

Our question now to the boards of the Big Three is, “Which of you will be the first climate custodian?”