Like their investment banking counterparts, private bankers are also facing an identity crisis as the failure to protect clients' wealth threatens to tarnish the industry and inhibit future growth. There are many different responses. Writer Philip Alexander
It goes without saying that wealth managers are not miracle workers, and there were few ways to invest clients' capital over the past 12 to 18 months that would not have lost them money.
"Wealthy people were disproportionately exposed to financial markets. Usually, asset classes are not all correlated, for example, you have fixed income when equities are not doing well. Last year, only government bonds did well," says Chris Meares, CEO of global private banking at HSBC in London.
In the first half of 2009, the pricing on sovereign bonds also became more volatile as fears rose over excess supply from governments forced to finance huge budget deficits as a result of their anti-crisis measures. As if this mix was not potent enough, the Madoff scandal raised fresh questions about due diligence and how hedge funds were selected and sold to clients. Similarly, structured products, touted as offering absolute return, are in the doldrums.
"It has disappointed clients that they bought absolute return products with the expectation that in a downturn, they would face smaller losses. We have to acknowledge as an industry that the concept did not hold up, because the unexpected has happened - the corrections were just so broad-based," says Juerg Zeltner, CEO of global wealth management at UBS.
Choose carefully
Private banks are just one part of a highly fragmented industry that includes discretionary fund management stockbrokers, independent financial advisors (IFAs), pure asset managers, multi-family offices and accountancy firms with private client units. What was distinctive about the crisis was the focus on the fate of banks themselves, especially from the fourth quarter of 2008 after the fall of Lehman Brothers.
Initially, says Mike Bussey, CEO of a small UK private bank Arbuthnot Latham, there were flows to those systemically important banks that seemed to have de facto sovereign guarantees on deposits, such as the Irish banks and some nationalised or part-nationalised UK banks.
But the growing attention of many Western governments on tax transparency has unnerved clients, whose money is now effectively with state-owned banks. So too has uncertainty about the future structure and strategy of those banks.
This has gradually generated a flow of clients in two particular directions. First, toward the large banking groups that retained healthy capitalisation, such as HSBC or BNP Paribas globally, or BNY Mellon in the US market. Second, toward smaller local private banks that maintained very conservative risk and liquidity profiles, often with loan-to-deposit ratios as low as 60%, and without the links to a highly geared investment banking unit.
These banks can also benefit in the current environment because they still have the ability to provide credit facilities to private clients. Usually, high-net-worth individuals, by definition, only need credit for high-value purchases such as property, or short term for business acquisitions. But many private clients took on leveraged investment positions during the boom.
According to Mr Bussey, the banks' lending activities have allowed them to collect new clients even at high margins of about 450 basis points over UK base rates. "We are still attracting borrowers because they like the accompanying service and because their previous private bank was squeezing them on loan security and covenants," he says.
Costly business
However, turning new clients into new revenues on the wealth management side is no easy process, especially in the current climate. "Before 2008, average high-net-worth wealth was growing pretty much everywhere at 10% to 15% per year compared with 2% to 3% average GDP [gross domestic product] growth, so at some point that implied either a huge redistribution of wealth from the poor to the rich, or it would have to stop - which is what has happened now," says Eric Barnett, CEO of SG Hambros, which manages about 20% to 25% of Société Générale's global private banking business.
And even where net new money flowed into private banks, clients' increasingly conservative stance limited the opportunities for charging product fees. "Due to the fact that clients are reluctant to accept sophisticated products, in terms of margins there is a clear consequence," says Francois Debiesse, head of BNP Paribas Wealth Management.
"Our attitude is to deepen our dialogue with our clients to show them that, despite the environment, there are still some things to be done that are very interesting, while preserving our revenues," he adds.
While they are not capital-intensive like an investment or commercial bank balance sheet, private banks are not necessarily cheap to run. Competition for staff has become less severe than before 2008, but the crisis has intensified client and regulatory scrutiny.
Investors are co-ordinating action against Royal Bank of Scotland's private banking arm, Coutts, after they lost money on an AIG-backed fund product, and the Hong Kong authorities have pledged to investigate alleged mis-selling of equity 'accumulator' products. The UK Financial Services Authority has apparently increased the number of staff allocated to specific banking groups deemed 'high impact' from one per four banks to two per bank.
Add to this the breadth of the Madoff scandal, especially in Switzerland, and private banks need to take a fresh look at their advisory infrastructure. "Clients are not now going to tolerate a transfer of cost of the upgrading of a service that was supposed to be world class to start with," says Sebastian Dovey, the managing partner of Scorpio Partnership, a specialist consultancy to the wealth management industry that has undertaken some of the largest worldwide surveys of private banking clients.
"What you need to run a private bank is changing - regulation, availability and breadth of products, the complexity of asset and liability management, so the cost of entry is becoming higher," says SG Hambros' Mr Barnett.
Changing landscape
Logically, these costs should point to consolidation, especially at a time when bank valuations are at record lows. But the process is not so easy; and smaller banks are not potential targets, because they are among the best capitalised at present.
"Private banking is not especially scaleable. Of course you need a platform, but this you can buy from a service provider. Where you add value is where you advise the client, and this is not scaleable, so there will always be opportunities for smaller players," says Toni Scheiwiller, head of business development and strategy at Bank Julius Baer in Switzerland.
By contrast, the most troubled global banking groups for which private banking is a marginal business may divest wealth management teams and assets in non-core markets. AIG was forced to sell its Swiss private bank to Abu Dhabi's Aabar Investments in December 2008. In the most significant move to date, the private banking assets acquired by BNP Paribas from Belgian bank Fortis in May 2009 created the largest eurozone wealth management group, with €189bn of assets under management.
"I am confident of rapid integration because, in terms of culture and approach to clients, Fortis was very close to where we are. What is happening now, especially for the Fortis teams who have faced so many questions about their future from private banking clients, is very positive," says Mr Debiesse of BNP Paribas.
Would-be industry consolidators are closely watching RBS and Citi, in particular, to see if they are forced to go down the same route as AIG or Fortis - Citi has already sold a 51% stake in its brokerage, Smith Barney, to Morgan Stanley. "If your private banking unit constitutes 4% of your profits, but 30% of your reputational risk, for instance if it has exposure to offshore banking, that will spur you to consider whether you should sell," says one potential buyer.
Reinventing Switzerland
Under intensifying scrutiny, leading offshore banking sectors such as Switzerland, Luxembourg, Hong Kong and Singapore have all recently agreed to renegotiate bilateral tax and information exchange agreements to bring them into line with Organisation for Economic Co-operation and Development (OECD) norms.
"Pressure on bank secrecy and international tax competition is not something new. We would not have done our job if we had not prepared a strategy factoring in these changes; I am personally convinced these changes will come over time, and it is not necessarily a bad thing for Swiss banks," says Mr Scheiwiller.
Julius Baer has well-established onshore services in Germany and Italy, and Mr Scheiwiller says its UK office makes the starting assumption that clients there will make tax declarations in the UK. "We are capturing business on Swiss banking as a premium brand, not on old-style banking secrecy," he says.
Joachim Straehle, CEO of Switzerland's Bank Sarasin, says it is a misconception that offshore banking automatically corresponds to 'tax-neutral' banking. "We have many clients from Asia or the Middle East, and these countries have low or zero income taxes anyway," he says.
In fact, Mr Zeltner at UBS says that he supports the decision of Switzerland and other major offshore financial centres to adopt the OECD standard as a step towards a level playing field which would favour private banks with a global presence such as his own. He says that the financial crisis has, if anything, strengthened the demand for Swiss banking in many emerging markets that have been badly affected. "For many clients, they want to diversify assets, to diversify foreign currency exposure, to work with stable banks; they want political stability, reliable rules and regulations, and an industry that is fully evolved," he says.
Asia rising
There is a clear consensus among the CEOs that emerging markets is a vital growth area, with Asia topping the list due to its vast population base. According to Kwong Kin Mun, managing director of private banking at DBS in Singapore, the top group of Western banks such as UBS, Citi and Merrill Lynch that had begun to draw away from the pack in a highly fragmented Asian market have now been dragged back by the crisis, and regional players believe they have a unique opportunity.
Mr Kwong says that his bank's strategy since 2003, of positioning itself as the "Asian private bank of choice", in the portfolio of three or more banks that is standard among Asian high-net-worth clients, is now paying off. "There was a climax of inflows in the fourth quarter of 2008, when we saw clients deciding they just wanted to get out of global banks that had issues," he says. He believes that awareness of counterparty risks and the need to avoid concentrating funds in one private bank may be a permanent change in the market.
While Asia is at the heart of HSBC's private banking strategy, Mr Meares observes that the total pool of wealth is as important as population size in assessing market potential. On this basis, his bank devotes attention to the Gulf states despite their small populations, and is only active in Russia among the emerging European markets, because the high-net-worth segment elsewhere in the region is not large enough despite the population size.
The right mix
Mr Dovey of Scorpio Partnership suggests that the ultra-high-net-worth client with very specific and staff-intensive needs may ultimately be less attractive than a larger group of $5m to $20m clients who are satisfied with a more standardised but well-executed offering.
If this analysis is right, then constrained times will favour wealth management units that are well integrated with top-end retail banking activities - HSBC, with its Premier retail brand, and BNP Paribas would be two clear examples. BNP reshuffled its wealth management activities in February 2009 into two units, one of which - called Wealth Management Networks - ties in with its own-name retail bank and partners such as Türk Ekonomi Bankasi in Turkey.
Rebuilding the trust of clients and establishing the independence and integrity of wealth advisory teams is also vital. "There is growing demand from clients to segregate the fees for the broader planning and advice from those for the underlying execution of managing the money, as is already the case in the IFA world," says Mr Dovey.
The private banking arms of global groups emphasise their 'open architecture' propositions, pulling best-in-class funds and products from third-party providers. Julius Baer separated its private bank and asset management arms in May 2009.
But David Lamere, CEO of wealth management at BNY Mellon, questions whether this model has outperformed those private banks like his own that run most business through their in-house investment management arms. "We think that has served our clients well over the past couple of years, because we had no surprises about the funds where our client money was. Open architecture is a great concept, provided you can pick from the best. What remains to be seen is if the picking process really leads to a better result for the client, or if it just leads to a higher turnover that has higher costs in terms of tax and fees," he says.
Smaller private banks such as Sarasin tend to present a pre-defined specialised offering to clients - sustainable banking and investment funds in Sarasin's case - rather than attempting to cover the whole market. "We have closed down our own hedge fund and private equity teams because we feel this is not our core expertise, and we do not like their liquidity and transparency characteristics," says Mr Straehle.
Private bankers are unsure how much of the current conservatism among their clients will last beyond the next upswing. Mr Kwong says some Asian high-net-worth clients are already eschewing the safety-first mentality, and chasing higher deposit rates in Indian private banks - despite the downfall of three Icelandic banks offering high deposit rates in 2008.
Mr Meares says there have even been net inflows to high-quality hedge funds in the second quarter of 2009, after two quarters of redemptions. What has changed is that clients are pushing for monthly liquidity rather than quarterly or annual lock-ups. Another growing feature is the use of managed accounts, where the private bank remains custodian and the hedge fund simply instructs on precise portfolio construction. Those private banks that have significant custodial departments regard them as important potential business drivers in the short term.
Mr Lamere believes what will also have to change permanently is the approach to building clients' portfolios of investments. "Many financial organisations talk about risk parameters, are you moderate growth and so on, but this is really jargon. We can do a better job of objective-setting in clients' language," he says.
