Risky Activities Have Narrowed Swiss Banks' Economic Moats
Investment banking adds unwanted volatility to private banking results.
We see private banking as an attractive, wide-moat business, and with CHF 1.2 trillion and CHF 2.0 trillion, respectively, in assets under management, Credit Suisse (CS) and UBS (UBS) are two of the world's most powerful private banks. Returns in this business are high and fairly stable. Pretax returns on average equity regularly clock in at around 50%, and returns on assets are consistently above 1% and sometimes over 5%.
However, these two companies' large, narrow-moat investment banks pose significant risks to shareholder returns and to the private banks' reputations. In response, we recently reduced our economic moat ratings for Credit Suisse and UBS to narrow from wide.
In our opinion, wide moats in private banking are built on both high switching costs and valuable intangible assets. Private banking customers tend to be very sticky, even more so than the clients of regular banks, in large part because of the personal nature of clients' relationships with their bankers. For customers, switching banks would mean losing their relationship with their valued financial advisor. Advisors are sticky, too, as moving firms would be disruptive to clients, who may have to switch among branded investment products, visit less-convenient offices, and learn new interface systems, and would almost certainly mean losing some customers. This, together with the value of the banks' brand names--few clients want to risk using a discount private bank--limits price competition and gives the banks significant pricing power.
Investment banking, on the other hand, is a narrow-moat business at best, in our opinion. Returns at Credit Suisse's and UBS' investment banks have been significantly lower and highly volatile, even in the post-subprime-crisis period. The sources of moats in investment banking vary by product, in our view. In equity underwriting, intangible assets and reputation are crucial and create pricing power. An offering underwritten by a top bank lends credibility to the client, while an offering underwritten by a lower-tier firm can be automatically suspect. In other products, like derivatives trading, efficient scale is more important because volume is only large enough to support a limited number of market makers. In these markets, the limited number of players can effectively operate as an oligopoly and price above purely competitive levels. However, much of the value created can be captured by key employees who control relationships with clients. While investment banks--especially large ones--typically benefit from moats, these advantages are somewhat offset by the inherent riskiness of many of their activities. Trading losses can be large and sudden when markets shift, and unauthorized trading appears to be nearly impossible to completely control.
Investment Banking Losses Hurt Private Banking Results
Reputational damage caused by investment banking activities can affect private banking performance. The following charts compare investment banking returns on average allocated equity, lagged by three quarters, with net asset inflows at UBS and Credit Suisse. We compare the asset inflows not to current investment banking profitability, but to lagged profitability, because we have observed that it takes clients and advisors about three quarters to conclude that poor investment banking results are part of a systemic problem rather than a one-off result. It may also be the amount of time it takes advisors to find new jobs, as especially poor investment banking results can affect firmwide bonus pools.
Source: Company filings, Morningstar.
The charts show that UBS suffered much stronger and deeper asset outflows than Credit Suisse, largely as a result of UBS' much worse performance in investment banking, in our opinion. In comparison, Credit Suisse's asset inflows remained positive and stable throughout the crisis, which we think is a product of its investment bank's relatively strong performance. We note that asset inflows at UBS have been positive since the third quarter of 2010, which is a testament to the private bank's moat, in our opinion.
We argue that the risks posed by investment banking cannot be eliminated. UBS recently announced a strategic shift away from investment banking, but we've heard this song before, and we believe the bank will resume expanding its investment bank when markets improve. We urge investors not to see a period of reasonable performance as evidence that risk has been reduced. For example, even after two years of reforms under Oswald Gruebel, UBS' September 2011 rogue trader scandal cost the bank $2.3 billion and raised doubts about whether the CEO had improved risk controls as much as had been believed.
We Don't Expect Moats to Decline Further
We see few things on the horizon that materially threaten either bank's competitive position. Our view is underscored by the fact that UBS remains the largest private bank in the world, despite the reputational damage caused by setbacks at its investment bank, and that it has resumed attracting net new money. We have seen little evidence to date proving that changes in Swiss bank secrecy laws have reduced overall customer stickiness, as many affected customers are converting to onshore accounts, and both banks are growing in competing jurisdictions like Singapore. This means that even if clients move their assets to other jurisdictions that may offer more privacy, they can continue to use UBS or Credit Suisse as their bank. We also see little reason to expect price competition, and therefore margin erosion, among private banks. Several Swiss banks have recently initiated pricing changes aimed at defending margins in an environment of client risk aversion.
The one Swiss pure-play private bank that we cover, Julius Baer (BAER), has retained its wide moat rating and remains one of our favorite names in Europe.
Erin Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.