Fund Management

Is Product Specialisation the Path to Sustained Profits?

A staff reporter, 29 January 2005

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The private banking industry is facing a tough time ahead due to the pressures of six months of declining equity markets. Senior managers ar...

The private banking industry is facing a tough time ahead due to the pressures of six months of declining equity markets. Senior managers are being forced to look closely at their balance sheets and review costs. This has come at a time when private clients numbers are reputedly growing and their demands for product and service from private banks are escalating. Indeed, as a financial services business, private banks are obliged to respond to the client, but the costs involved are beginning to force a rationalisation. Consequently, several leading institutions are now formalising specialist initiatives with a focus on product.

The overriding aims appear to be the retention of accounts and the preservation of strong income streams. In this Private Client Management feature, Jonathan Newman examines the pressures on profitability of private banks serving clients with more than £500,000 to invest and analyses how the above situation will affect future strategy.

The impact of the global markets downturn during the second half of 2000 began to be reflected in the private banking pre-tax profits for the first quarter of 2001. The figures were mixed as different institutions weathered the storm more effectively. For example, UBS Private Banking recorded pre-tax profits of SFr780m and Credit Suisse Private Banking saw a net operating profit of SFr645m. Both houses experienced drops in their performance, which showed that even the giants are not immune.

Smaller players are also feeling the squeeze as is evident in Rathbones relatively small increase in pre-tax profits compared to 1999, from £22.45m to £25.17m. Micky Ingall, chairman stated in his 2001 statement: "The year 2000 has been a challenging one for all areas of our business and, for the first time in a number of years, stock markets have had a negative effect on our overall results. This weakness has continued through the first quarter of the current year and inevitably affects our revenues in the short term. However, the recruitment of new investment managers and new client gains have continued and this fundamental growth underscores our optimism for the medium term".

Essentially, during the latter half of 2000 investor behaviour responded to a decline in equity markets by globally reducing equity holdings with a significant move towards lower risk investments such as fixed income funds and cash deposits. Neither of these product types can generate the same level of fee income that can be generated from more sexy offerings. At the same time, clients sought out other investment options to re-balance their portfolio.

"Private banking is meant to be a counter cyclical industry where the asset preservation approach is most effective when markets are down. The proof of this theory is going to be borne out now. Those that were not effectively prepared will now feel it," said Sebastian Dovey, director at Scorpio Partnership, a strategy think tank in London. From this and the above pre-tax profits it is evident that the private banking strategic thinking is shifting. The pressure on identifying new sustainable income streams from products and services are evident. However, it is worth analysing 'What exactly has changed?'

Specialisation

Rebalancing the portfolio in tight markets is now the private banker’s main activity. The 2001 Merrill Lynch Cap Gemini Report has predicted that over the next three years global HNWI investment in specialised products will grow dramatically. Albert van Zadelhoff, head of private banking at Friesland Bank, concurs with this finding. "The profitable banks have turned away from trading profits and increased their fee based investment products...Furthermore, on a true definition, mortgage products and other financing have grown fast. Special products, like hedge funds and tax advantaged investment products have also fared well. In my opinion the occasional securities trade will yield less in the coming years and are not enough to shore up any private bank".

Although the shift to specialised products has not occurred en masse, a banking trend has begun. The importance to the industry’s strategists of the above statements is that for ‘specialised’ read ‘strong fee income’, particularly relative to the low margin mutual fund offerings. The main specialised product area is alternative investments and its close relative, structured products. At one level, these products meet with both the private bank and the private investor's requirements: they are able to generate good performance, achieve risk diversification and expose clients to a broader financial spectrum not covered by the more traditional products such as equities, bonds and deposits.

Already, the private banking industry is piling into this area of business. Indeed, over the past six months, the introduction of new fund of hedge fund offerings appears to be a weekly phenomenon from private banks if one scans through the news and analysis pages of Private Client Management. Aside from hedge funds, the assets of which have increased 13 per cent on yearly average, popular structured product offerings include principal protected notes, income generating notes and index trackers. The dynamic of these offerings revolves around their risk mitigation capacity linked to the fact that they are intentionally not correlated to the dropping equity markets.

Crucially, the popularity of these offerings are increasing at such a rate that private banks that do not include them in their product line-up could risk losing out on a valid income stream. But, that phrase needs to be remembered in context. Less than 18 months ago, many private banking players felt if they were not online, they would also be the industry losers. Indeed, this experience shows that there should be a measure of caution and recognition that alternative investments are not nirvana but an important component in a complete private banking service.

“The internet experience should have at least shown to banks that they need a balanced strategy in their offerings. No single provision can dominate or else private banks will soon discover that clients perceive them as one horse wonders,” commented Dovey. In essence, the private banking industry must realise that there is no quick fix or all encompassing solution. Only through ensuring that the strategy they adopt includes the essential multitude of factors, can the private bank look to future prosperity and growth.

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