The slightly disappointing results presented by UBS last week and the persistently low price tag attached to both big Swiss banks by the stock market shows that there are strategic issues that need to be resolved, writes Teodoro Cocca in an exclusive essay for finews.first.
This article is published on finews.first, a forum for authors specialized in economic and financial topics.
Let’s start with something trivial. The business model of a big bank is built mainly – «nomen est omen» – upon its size. It is based on the assumption that size is a distinguishing feature that implies an advantage. But size alone is neither a pure end in itself nor is the simple fact of being bigger than rivals going to carry an automatic advantage. The underlying business case for achieving size as a corporate goal is pursuing economies of scale.
But that’s where the trivial part of this observation ends. Even if people, in general, believe in the credo that a bank has to grow to become more profitable and efficient, the empirical evidence remains shaky. In particular, if it is seen in connection with specific attributes of business segments.
«The complexity costs refer to the difficulty of running a big corporation in an extremely dynamic environment»
The fact that many areas of banking contain economies of scale can’t be rejected out of hand. An analysis, for instance, revealed significant economies of scale for regulatory costs in Swiss wealth management.
But, what also became apparent was that the connection wore off for the level of profitability and efficiency of the entire company. Evidently, there are sizable counter-effects that compensate for the economies of scale in one area with dis-functional effects of size in other areas, and partly even overcompensate for them. Taken together, these could be termed complexity costs and refer to the difficulty of running a big corporation in an extremely dynamic environment.
The big two banks’ main areas of business are investment and private banking. Both big Swiss banks today see private banking as their primary business and investment banking more as a service provider. The core of the problem lies in this strategic conception: there is no arguing away that the conditions in the European market, in general, are anything but attractive (regulatory pressures, market development, interest rates). The problems stand to explain why quarterly results to some extent were disappointing.
«Economies of scale are very limited in private banking, but very large in investment banking»
And yet, despite all the adverse circumstances, many questions put to the banks' representatives at their presentations of annual results, media gatherings, analyst conferences, and annual general meetings focus on the one key issue: what about investment banking?
Put in a simple way, economies of scale are very limited in private banking, but by contrast very large in investment banking. If you now choose to combine the two units strategically and reduce the size of the investment bank to correspond with the strategy of it being a mere service provider, you will end up with a problem. Namely that a cut-to-size investment bank will struggle to compete with U.S. giants and at the same time needs to maintain an expensive (more-or-less global) platform.
If an investment bank struggles, the effect will be magnified in this hugely competitive industry, and thus the position in the market gets eroded, leading clients to pose questions about the quality of service. In the context of the best-in-class approach, a client will increasingly consider whether he would get a better (and maybe more independent) service from a U.S. rival than from his Swiss principal bank.
«The core issue: you are strong where economies of scale are minor, and week where economies of scale are big»
This (potential) disadvantage should be (over-)compensated for by the advantage of having an exceedingly strong client base in global private banking, a client base that requires such investment banking services and appreciates solutions coming from one source. It is mainly the ultra-rich private clientele that demands such solutions – hence the big banks’ focus on this clientele (UHNWI, family offices).
In principle, this makes sense, not least with respect to the goal of boosting volumes on the platform of the investment bank in an efficient way (through the acquisition of a relatively few extra major clients, assets under management can be increased strongly). But it is exactly this customer segment that is far from attractive in terms of net margin because clients are demanding and expensive to serve, yet anything but happy to pay for it.
And that’s the core issue: you are strong where economies of scale are minor, and weak where economies of scale are big.
«The strategy of both big Swiss banks is in principle neither good nor bad»
The problem can be solved if the integration of the investment and private bank results in an added value for the client, who is also ready to pay a premium for this. In the end, this will also have to result in added value for the shareholder. Therefore, the strategy of both big Swiss banks in principle is neither good nor bad.
In the end, it is a question of implementation: will it work to get investment and private banking to cooperate to an extent that a clear added value is generated to boost the valuation of the company? The «objective» calculation made by the stock market shows that, to this day, this isn’t (yet) the case with both big Swiss banks.
Teodoro D. Cocca is a professor for asset and wealth management at Johannes Kepler University in Linz. Before joining the university in 2006, he worked in investment and private banking at Citibank for a number of years. He was a researcher at Stern School of Business in New York and a lecturer at Swiss Banking Institute in Zurich. The Swiss, who has Italian roots, is an adjunct professor for private banking at Swiss Finance Institute (SFI) in Zurich. He advises financial firms and government bodies in Switzerland and abroad. Since April 2011, Cocca has been a member of the board at VP Bank in Vaduz and heads the bank’s strategy and digitization committee.
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