Private banks have spent the last 18 months dealing with one of the most difficult periods in modern financial history. A “perfect storm” of asset price declines and the near or actual collapse of some of the best-known wealth management firms has altered the behaviour of clients, prompting them to move into less risky financial instruments that are much less profitable for the banks. All of this has pushed revenue levels down by 25 to 30 per cent. As an added challenge, governments are cracking down on their wealthy citizens’ untaxed offshore accounts, forcing many private banks to find new value propositions.
Not everything has been negative, however. “Private banks have continued to deliver profits and many banks are starting to move strongly into emerging markets, especially in places like Asia and India where the populations of high-net-worth individuals are expanding rapidly,” said Peter Vayanos, a partner at Booz & Company.
An Industry in Transition
Over the last few months, Booz & Company has taken a closer look at the world’s leading wealth management markets by conducting in-depth interviews with more than 140 bankers, advisors, and regulators in 15 markets around the world, to understand the core drivers of private banking, while forming a perspective on the new rules of the industry and what it means for private bankers to adapt to the new realities ‘after the storm’
The Three Core Drivers of Private Banking
While the financial crisis has jolted the private banking industry, three fundamental characteristics of the industry remain intact:
1. Fundamentally Geared for Growth
While world wealth generally expands at the rate of GDP growth, the number of high-net-worth individuals (HNWIs), defined as people with more than US$1 million in investable assets, has been growing at anywhere from 1.5 to three times the rate of GDP. The increase in HNWIs is creating substantial wealth. The financial crisis of 2008 took its toll on HNWIs as massive devaluations hit all major asset categories and geographies. “But as economies around the world rebound, the asset base of HNWIs will return to its long-term growth trajectory, generating a steady flow of net new assets for the private banking segment, especially in Asia and Middle East,” explained Dr. Daniel Diemers, a principal at Booz & Company.
2. Cyclical in Nature
There is no question that the revenue of private banks is highly correlated with the performance of equity markets. This cyclicality is no surprise; revenue in private banking depends heavily on transaction volumes and asset-based fees. As a change appears unlikely for the industry’s revenue-generating model, this correlation likely will hold. For the near term, that means the industry’s revenues will depend on the extent to which the markets can continue the rally they started in March 2009.
3. Profitable Even in Difficult Times
Since the beginning of this financial crisis, the wealth management industry has lost 25 to 30 per cent of its revenue because of a lower asset base, cautious market behavior, and a shift toward low-margin financial products. Yet more than 95 per cent of private banks analyzed worldwide were able to deliver positive pretax profits during this period. Private banks’ persistent profitability is a reflection of the speed at which they can adjust their operating models to align them with current business conditions.
Private Banking Change Levers
While the underlying dynamics are fundamentally promising for private banks, the industry must navigate through a number of significant changes going forward:
1. Tectonic Shift in Global Wealth Distribution
“While the majority of industrialized countries are just beginning to recover from the financial crisis, most emerging markets have already returned to pre-crisis growth rates,” explained Vayanos. “We believe that these varying rates of recovery will persist for the next few years, shifting the global wealth concentration to the East.”
Latin America: Prior to the crisis, private banking in Latin America was experiencing double-digit annual growth, with clients increasingly demanding onshore/offshore convergence and open architectures, which provide clients with access to best-of-breed products from top suppliers in each asset class. Though 2009 was challenging in the region, Latin America’s immediate future looks brighter as its equity markets pick up, creating wealth through IPOs and M&A transactions.
Middle East and Africa: Countries rich in natural resources will likely return to accelerated wealth creation even before the global economy fully recovers. Large government-led infrastructure projects will further boost the regional economies and many HNW and UHNW clients will benefit either directly or indirectly from these projects.
Asia/Pacific: Led by China and India, the Asia/Pacific region will be where most new HNWIs will be created, driven by the strength of the underlying economies and a strong entrepreneurial spirit. By the end of 2011, nearly 3.6 million HNWIs are expected to live in the Asia/Pacific region, up from 2.57 million in 2008.
Europe: GDP growth rates for key European markets are expected to remain flat for the next few years. A significant shift of assets among European countries is likely, due to the new regulatory regimes.
North America: North America continues to hold a significant share of the world’s HNWIs and UHNWIs (ultra-high-net-worth individuals). Slow growth in productivity and in North America’s economies is expected over the short to medium term, limiting the overall growth in asset markets and in the number of wealthy households.
Many emerging-market countries are also expected to become more politically stable and thus offer good investment opportunities. This will create another disincentive to bring the new wealth offshore.
2. The End of the Tax-induced Offshore Business Model
While the offshore business has traditionally been an essential part of private banking, it has recently come under increasing scrutiny, especially due to widespread perceptions that it enables tax evasion. “In tandem with the recent G20 decision to crack down on tax havens, offshore locations are increasingly implementing standards of cooperation on tax evasion and softening their strict banking secrecy rules,” noted Diemers. This change will presumably accelerate the crisis-induced fundamental changes in the competitive landscape and will affect especially private banking in traditional offshore locations.
3. More Pragmatism in Client Behavior
Client behavior changed during the crisis. The changes have come in phases and have created significant challenges for private banks. The first phase came after the market collapsed and clients lost money in late 2008 and early 2009. In the wake of this implosion, clients shifted their assets toward simple, transparent, liquidity-oriented products with lower margins. Structured products in particular fell from favor, and clients largely retreated from risky and complex asset classes. A main cause of this behavior was the reduced trust that clients had in banks, products, and relationship managers—a problem worsened by the fact that relationship managers, in turn, did not trust their own product providers anymore. The result is that clients have become more hesitant to delegate and have shifted assets from managed portfolios to nondiscretionary and self-directed mandates.
4. Pressure on Costs Will Endure
Most private banks have responded to diminishing revenue pools by removing costs from their operations in a variety of ways. Although the rebound in financial markets since March 2009 has helped private banks to stabilize their top lines, profitability will remain under pressure for several reasons:
Transaction volumes during the recent market recovery have stayed quite low, and asset allocation remains biased toward low risk asset classes.
Clients have become wary of complex, non transparent or expensive products.
Many clients have shifted assets from managed accounts to self directed mandates, lowering the profitability of their accounts.
The relatively high-margin offshore assets will gradually transform into local onshore assets, at far lower price points.
Compliance requirements and the need to cope with operational and reputational risks will increase the cost of doing business.
5. New Business Models Taking Shape
There is a distinct sense that open product architecture solutions will predominate in the future, with clients demanding access to best-of-breed products from top suppliers in each asset class. “The integrated operating model served clients poorly in the financial crisis, eliminating the possibility of an objective intermediary and increasing the moral hazard of selling the structured products that were profitable for the banks but risky for clients,” commented Vayanos. In the wake of that trust-shattering period, private banks need to further demonstrate their expertise in the areas of risk profiling, asset allocation, product selection, and due diligence. This also means that the model of the integrated bank will be more closely scrutinized than in the past.
The New Imperative for Success
While long-term prospects for the private banking industry are distinctly positive, private banks need to adapt their business models to the new realities:
1. Seriously Commit to Emerging Markets
The expansion and evolving behavior of the HNWI population in China, India, and the Middle East will require private banks to operate in new ways in these markets. Wealth management players with global ambitions need an emerging market strategy to capture the large wealth expected to be generated in these regions in the coming years. They will also need to acquire or develop a deep understanding of, and access to, local investment opportunities as new wealth is increasingly invested locally.
2. Become a Declared Multi-shoring Player
The tax-neutral, offshore private banking proposition of many domiciles will not survive the current regulatory pressure and offshore clients are likely to withdraw part of their funds and increase local investments. Private banks will have to proactively approach and support offshore clients whose governments are applying pressure on tax-optimized accounts. “The goal is to serve as a truly trusted advisor and holistic wealth manager, helping clients repatriate their money and shift assets to onshore locations, thereby keeping assets within the bank, even if at significantly reduced margins,” said Diemers.
In the future, private banks will need to ensure full cross-border compliance and prepare for a time when pure offshore banking may be attractive only for selected domiciles. This requires banks to understand and closely monitor the regulatory environments in all markets in which they participate to enable them to react quickly and appropriately to regulatory changes in countries where they have clients. Offshore private banking will continue but will offer different value propositions. Smaller banks, as well as most subsidiaries of international banks will not be able to expand their onshore footprint and build the required level of capabilities, and these will likely become acquisition targets.
3. Develop New Client Service Models
“The financial turmoil of the last few years has clearly changed how clients feel about their banking relationships,” Vayanos said. Clients are looking for consistent, reliable, and unbiased advice with a focus on what is right for them rather than what is right for their banker. The client service models of the future will have two main parts. First, clients will need to be segmented according to their true needs. Qualitative segmentations will become increasingly important in the future—they will put wealth managers in a better position to consider all client requirements, emotional as well as financial. The second change involves client coverage models. Leading private banks have started to adopt new client coverage models in which relationship managers focus on a limited number of client segments (in some cases, just one), as opposed to heterogeneous client portfolios in which the clients have diverse needs and backgrounds and are located in a wide range of domiciles.
4. Learn to Make Money (Again)
With revenue pools likely to remain depressed for the immediate future, and with higher compliance costs, wealth managers need to learn—or relearn—how to earn money. Three areas will be key: First, banks must use rebates and fee discounts more sparingly. Second, they must optimize the product/ service mix for each client. Third, they must adopt a disciplined approach to cost management. Top banks have already started to use advanced client profitability steering tools, which show the level of the economic profit by client, to fully understand where value is either created or destroyed.
5. Build Scale, Build Capabilities
“There are several factors causing M&A to intensify in private banking including the push to separate distribution, production, and operations,” explained Diemers. A second factor is the need to quickly build scale in new markets, where indigenous companies are rapidly adding capabilities and gaining momentum. A third factor driving M&A is the desire to add revenue at a time when revenue pools are depressed. A fourth factor is that regulatory pressure has left some banks without a viable business model. Together, these factors have led to a burst of deals in the last year which are expected to continue, making the wealth management industry very attractive for players with a well-defined M&A strategy. “We also expect to see more alliances and cooperative deals in which traditional private bankers try to expand the scope of their business,” he added.
Finance companies that were once icons of the industry only two years ago either have disappeared or find themselves struggling to survive at a fraction of their earlier strength. “Other once-powerful companies are now operating under the wings of one-time rivals, while players who have done most things right are now positioned to lead the industry consolidation that is now taking shape,” said Vayanos.
As 2010 begins, the private banking industry is poised to find a new equilibrium. Given the industry’s fundamental attractiveness, institutions that have lost ground will embark on strategies to regain the trust of their clients, employees, and markets, while the players who received significant net new asset inflows over the course of the financial crisis will try to maintain their improved positions. Private banking after the 2008–2009 storm will look familiar in some aspects but very different in others. The bottom line is that there are plenty of opportunities ahead for the private banker who is strategically prepared.