Switzerland’s 437-year-old Wolfsberg castle has welcomed the likes of Alexandre Dumas and Franz Liszt. In September, UBS AG Chief Executive Officer Sergio Ermotti gathered the bank’s top executives there for dinner.
On the table that night, in a hall where the words carpe diem were plastered over long ago, was a plan to boost returns for shareholders of the country’s biggest bank, Bloomberg Markets will report in its February issue.
UBS had been under pressure since losing more than $57 billion during the financial crisis. So had its main competitor, Credit Suisse Group AG. In 2011, Swiss lawmakers approved some of the strictest capital and liquidity rules in the world, forcing the banks to cut risk taking and boost equity at the expense of profit in their securities units.
The end of banking secrecy, which had helped the firms attract funds from rich clients around the world, was challenging a century-old wealth-management model. A 32-year-old former UBS employee, Kweku Adoboli, would go on trial in London the next week in connection with a $2.3 billion loss, the largest from unauthorized trading in British history.
“For banks domiciled in Switzerland, doing business and making money has become more difficult,” central bank President Thomas Jordan told financiers at a conference in Zurich two days before UBS’s Wolfsberg meeting. “Pressure on the Swiss financial center has been intensifying.”
Against that backdrop, Ermotti, 52, who had been CEO for less than a year, was ready to take action. Over two days, on a hilltop overlooking Lake Constance, he laid out a plan to shrink UBS’s investment bank, where Adoboli had worked, which posted record losses during the credit crisis and whose fixed-income unit was struggling. It was radical surgery: dismissing thousands of employees and rebuilding the 151-year-old Zurich-based bank’s foundations as a money manager.
“You look at your numbers and you look where you stand; you go through July and work on a hypothesis to narrow down the options; you go out a few weeks on holidays, come back and actually the situation is not better, it’s worse,” Ermotti says in an interview at the bank’s headquarters two months later, dressed in an anthracite-gray suit, white shirt and red tie, after the company announced it would fire 10,000 people and wind down most of its debt trading.
The biggest shake-up in Swiss banking in 80 years is leaving scars on the economy as financial firms, once seen globally as symbols of prestige and safety, reconfigure their operations. UBS and Credit Suisse, with combined assets more than four times the country’s gross domestic product, helped the financial industry contribute almost one-third of Switzerland’s growth from 1990 to 2009. Now, banking’s share of the economic output is shrinking. It was 6.2 percent in 2011, down from 8.7 percent in 2007, according to the Swiss Bankers Association.
“The too-big-to-fail problem is much more present here than it is in most other major financial centers in the world,” says Mark Branson, head of banking supervision at the Swiss Financial Market Supervisory Authority. “If you’re aware of that danger, and you’ve seen what can happen when things go wrong in the recent past, then I think it’d be irresponsible not to ask for buffers in the system.”
Tougher capital requirements had pushed UBS to announce in 2011 that it would shrink risk-weighted assets at the investment bank by about half under new rules. For the UBS executives gathered the morning after the September dinner around a U-shaped table at a modern conference center on the castle grounds, reversing course wasn’t an option.
Neither was getting rid of the business completely. Ermotti and his lieutenants had concluded a few months earlier that UBS needed to continue providing services such as stock sales to wealthy and corporate clients. What was left to decide was how much deeper to cut. By the time the 10-hour meeting adjourned, the bankers agreed on a proposal to bring to a board of directors meeting in Australia at the end of the month.
“Probably people were shocked to hear that we would do that,” Ermotti says of the reaction at the meeting in Sydney where the plan won the board’s preliminary blessing. “They were happy but probably didn’t believe that we’d propose that.”
Investors were happy, too. Shares jumped 18 percent, the highest weekly gain in 3 1/2 years, the week of the Oct. 30 announcement. For Ermotti, a former investment banker at UniCredit SpA, Italy’s largest bank, and for Axel Weber, a former Bundesbank president who became chairman of UBS in May, it was a vote of confidence.
Credit Suisse chose a different path. Instead of retreating from businesses built during the past two decades, as UBS is doing, it still wants to compete at all levels with global firms such as Goldman Sachs Group Inc. and JPMorgan Chase & Co.
Credit Suisse CEO Brady Dougan, an American who’s been with the Zurich-based company since 1990 and led its investment bank for three years before ascending to the top job in 2007, is betting he can boost returns by cutting costs rather than whole units and winning a bigger share of global securities revenue as others retrench.
Although both firms are shrinking risk-weighted assets and exiting proprietary trading to comply with new rules, Credit Suisse’s investment bank will end up about twice as big as UBS’s. Dougan says that in normal markets investment banking will contribute about half of the firm’s profit compared with 39 percent in the first nine months of 2012. At UBS, the business that generated almost 40 percent of pretax profits before 2007 will furnish about 20 percent in the future.
“If we can beat our cost of capital in investment banking, then I guess as an investor you should be happy for us to deploy capital there,” Dougan, 53, says in an interview at the bank’s headquarters in November. “We hope to convince them of that, but so far they’re yet to be convinced.”
Credit Suisse shares rose 0.9 percent last year, while UBS gained 28 percent.
Kian Abouhossein, a London-based banking analyst at JPMorgan, also isn’t persuaded. While returns at Credit Suisse will improve as a result of cost cutting, he says, UBS’s strategy has a better chance of success.
“Credit Suisse is still very committed to its credit business, and that’s a hugely volatile business,” Abouhossein says. “Time is ticking for Credit Suisse management. They need to deliver in 2013. The pressure to generate an adequate return for shareholders is material, and if they don’t deliver, they’ll have to take a UBS stance.”
Dougan was dealt a blow in June when the Swiss National Bank singled out Credit Suisse as needing a “marked increase” in capital before the end of 2012. The report sent the company’s shares down 10 percent in one day to a 20-year low. Dougan, who for years had been saying his bank was one of the best capitalized in the world, announced a plan a month later to boost capital by 15.3 billion francs ($16.5 billion).
Both Swiss banks had been facing calls by some investors since the subprime crisis to split off securities units seen as introducing unnecessary and little-understood risks to wealth management and retail banking. Shareholders have shown scant patience as the banks limited dividend payouts to accumulate more capital to support their investment banks.
Dougan, who led Credit Suisse through the subprime crisis avoiding the kind of losses that crippled UBS, says the bank has restructured its fixed-income business, what he calls “ground zero” for the impact of capital requirements. The firm cut more than $90 billion, or 31 percent, of risk-weighted assets at the investment bank in the 12 months ended on Sept. 30.
“Disruption to the industry is upside for us,” Dougan, a marathoner who runs most mornings before work, says of how he has positioned the bank.
Some investors question whether Dougan and Chairman Urs Rohner, who have a combined 30 years of experience at Credit Suisse, are able to take an ax to the businesses of old friends.
“They’ve been there for such a long time that one asks whether they can really make changes happen,” says Florian Esterer, a senior portfolio manager at MainFirst Schweiz AG in Zurich with $3.8 billion under management, including shares in the two banks. “UBS’s move is an acknowledgment that there aren’t actually as many synergies with wealth management as we’d been led to believe. The same is true for Credit Suisse.”
Restructuring may have been easier for UBS because its wealth-management business is about twice the size of Credit Suisse’s, while the investment bank has been shaky for years.
“It’s pretty clear what contributed to the success of UBS, and we’re trying to go back to those roots,” says Weber, 55, a former university professor. “UBS was once an icon of this country. It has lost a lot of this iconic value in the perception of people, and our job is to bring it back to that franchise value. It will be an uphill battle.”
Adoboli’s loss also may have hastened UBS’s retreat. Oswald Gruebel, a former Credit Suisse CEO who tried to rebuild the securities business when he joined UBS out of retirement in 2009, stepped down after the trades were discovered in 2011.
The disclosure also exposed faults in the bank’s risk controls three years after Switzerland injected 6 billion francs of capital to rescue the lender. Adoboli was sentenced to seven years in prison on Nov. 20 for fraud. UBS was fined 29.7 million pounds ($47.6 million) by the U.K.’s Financial Services Authority and reprimanded by the Swiss regulator for allowing unauthorized trading to go undetected.
In December, UBS was fined $1.5 billion by U.S., U.K. and Swiss regulators for trying to rig global interest rates. Andrea Orcel, CEO of the investment bank, said at a parliamentary hearing in London yesterday that UBS is in the process of rooting out “negative elements” of its corporate culture.
The reorganization comes at a fortunate moment: UBS, the best capitalized among major European banks, can afford it, and the risk of destabilizing the rest of the business by losing key people is low because job cuts are on the agenda for most financial companies. The plan also relieves the government of some of the burden posed by the firm’s size.
Regulators have required the two banks to hold capital equal to as much as 19 percent of risk-weighted assets by 2019. That compares with 13 percent for systemically important firms such as Deutsche Bank AG and JPMorgan, which face the biggest surcharge on top of new capital rules agreed upon by the Basel Committee on Banking Supervision. UBS and Credit Suisse can get rebates if they shrink.
For Ermotti and Weber, the restructuring was also about taking charge.
“What we realized in the past 12 months is that we need to come in control of our destiny,” says Ermotti, who was born in the Italian-speaking part of Switzerland and spent 16 years as an investment banker at Merrill Lynch & Co. before joining UniCredit. “We cannot have external events, or events that are not expected, trigger the organization to move.”
The U.S. probe into tax evasion by Americans, which brought UBS close to a criminal indictment, was one of those shocks. Wealthy clients withdrew a net 239.2 billion francs, or 13 percent of total assets under management at the time, in the nine quarters ended on June 30, 2010, and UBS had to hand over data on about 4,700 accounts to the U.S., opening the floodgates for scrutiny of Swiss banking secrecy worldwide. Now, Credit Suisse and other banks in Switzerland are facing similar investigations. Credit Suisse says it’s cooperating.
“They’ve stormed the castle Switzerland when it comes to secrecy,” Gruebel, 69, says.
Secrecy, which made the country rich, financed the global expansion of banks and helped Swiss companies prosper internationally, is dead. The law, introduced in 1934 to stop a run on Swiss wealth managers after a clampdown on tax evaders by French authorities, was like discovering oil, says Tobias Straumann, a lecturer in economic history at Zurich University.
“Swiss banks enjoyed a kind of monopoly,” Straumann says. “Foreign clients who brought their untaxed funds to Switzerland were ready to pay higher fees in exchange for secrecy. Since the secrecy has gone, these fees are coming down dramatically.”
Swiss banks have also benefited from others’ misfortunes. Two world wars involving neighboring countries brought in billions from people seeking haven. The country’s stability will continue to attract funds as Europe’s sovereign-debt crisis rages, says Peter Kurer, a former UBS chairman.
“People are afraid of instability, expropriation, nationalization, extreme kinds of taxes,” he says. “They vote with their feet, and they come to Switzerland.”
Still, the profitability of wealth management is falling as banks attract more funds abroad than at home and costs rise from implementation of new rules and tax agreements. While Switzerland remains the biggest manager of offshore wealth in the world with $2.1 trillion, or 27 percent of the total, it experienced stagnation in 2011, according to the Boston Consulting Group Inc.’s Global Wealth 2012 report.
The extra costs and uncertainty are a drag on Credit Suisse’s wealth-management unit, which accounted for 30 percent of pretax profit in the first nine months of 2012, Dougan says. Although the bank hasn’t met its annual target of net new asset growth of more than 6 percent for the past four years, Dougan sees it as achievable after the economic environment improves.
Ermotti says UBS’s goal is to recoup assets lost in 2008 to 2009 by growing faster than the market, and he isn’t excluding acquisitions.
“They have to start offering private banking with high-quality investment advice,” MainFirst’s Esterer says. “You have many old relationship managers sitting on lots of client assets, whose know-how is actually not sufficient for the new environment. They have to manage to bring these people into the new world or replace them.”
UBS in 2012 started requiring client advisers to take a diploma course about markets and portfolio management. Credit Suisse made all client advisers go through certification over the past two years, testing their knowledge of markets and products, and is restricting bankers for offshore customers to a small number of countries to make sure they know all the relevant laws and restrictions.
At the same time, the banks are trying to be closer to clients. UBS in 2013 plans to introduce automated daily checks of customer portfolios for deviations from saved risk profiles and its house view on markets. Credit Suisse merged its asset-management and private-banking units to improve product offerings and brought the Swiss trading platform under the same roof to make execution more efficient.
Even with all of the challenges, the banks’ money-management units are “the stuff of dreams,” producing returns marred only by investment banking, says Huw van Steenis, a London-based analyst at Morgan Stanley.
Now, UBS and Credit Suisse have to prove they can create value for investors from their securities units while controlling risks enough to avoid running into trouble again.
For UBS, the execution risks are big: Will the bank be able to shut units without major losses? Will it be able to hold onto key employees and gain market share in areas it wants to keep? Will clients want an investment bank that isn’t using its balance sheet to muscle in on deals? Anyone who expects change in a couple of quarters will be disappointed, and it will take three to five years to fully transform the business, Orcel, brought in by Ermotti to run the shrunken unit, told staff in November town hall meetings.
Dougan says he’s about 80 percent finished adapting the investment bank to the new environment and that 2013 will be mostly about refinements.
The banks have placed their bets, and it will be easy for investors to keep score, says Gruebel, who is retired again and managing his own investments.
“As the banks’ strategies diverge, it gives observers the perfect opportunity to judge whether it was a good thing to stay or get out of fixed income,” he says. “You can judge that every quarter.”