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Banks Adapt to Compete in a Tough, New Market

By Hendrik Jauer. Head of Financial Lines, Switzerland

September 02, 2014

The global financial crisis shrank client assets and bank revenues. It also hit national economies so hard that many decided it was time to reclaim lost revenues. Few predicted how quickly this would erode the code of banking secrecy. In its absence, Swiss private bankers are confronted with challenges not just to growth, but possibly even to their survival.

Restricted Revenues

Fortunately, there are signs of a gradual economic recovery. Unfortunately, interest rates barely above zero continue to suppress net interest margins. Investor risk tolerance naturally suffered in the wake of the 2008 crisis. Many bank clients now shun risky or complex investments in favor of conservative portfolios, yielding lower returns and lower fees.

The regularization of offshore assets was another blow to Swiss banks, which had 27% of the global, offshore-market share in 2011. Without tax secrecy privileges, clients have less incentive to keep money offshore, and many are repatriating assets. Some nations are luring assets back to the homeland through tax amnesty. Other countries are demanding back taxes and penalties from clients and banks.

Stricter regulation has prompted some investors to turn to independent asset managers (IAMs), who are not bound by the same regulations as banks. Meanwhile, a recent Swiss High Court decision on retrocession requires comprehensive disclosure and client sign-off, putting a significant portion of IAM income in jeopardy.

New investors from Eastern Europe, Asia, and Latin America are replacing some of the lost clientele. However, without the secrecy advantage, Swiss private banks find themselves in a more competitive environment, compelled to reduce fees, or risk losing clients.

Rising Costs

From AML, FATCA, and MiFID II, to Basel III, regulatory reforms are raising costs and creating new challenges to profitability.

Anti-Money Laundering (AML) regulation compels banks to verify the identity, essentially monitor the intent of new and existing customers, especially foreign ones, and report suspicious activity to the authorities. Banks deemed negligent or complicit in money laundering face punishing fines, potentially in the billions.

Switzerlands cooperation with the new US Foreign Account Tax Compliance Act (FATCA) compels banks to disclose to US tax authorities the name, address, most account transactions, and taxpayer number of each US client.

The EUs Markets in Financial Instruments Directive (MiFID II) obliges banks in non-EU countries to implement equivalent standards to be permitted access to the EU market. It also requires banks to establish local branches in each client country. It may essentially eliminate the vestiges of client privacy in Europe, by requiring information exchange in tax matters, up to whatever level is deemed effective. Finally, it limits retrocessions to banks which have declared themselves dependent advisors. The Swiss Financial Market Supervisory (FINMA) has adopted the MiFID II, to ensure that Swiss banks can continue to operate in the EU market.

The Basel III Accord is a response to the financial crisis, aimed at making banks more resilient in high-stress markets. To comply, banks must increase capital and liquidity reserves, and reduce leverage (buying assets with borrowed funds), narrowing the income stream.

In fact, the cost of compliance is so high, some banks have had to refuse clients from certain countries. Other banks have added manpower, to help clients get compliant in their local countries. The cost of compliance personnel is largely responsible for slashing income per employee by 40% between 2007 and 2011.

Compulsory investment in IT is another expense. The Automated Exchange of Information and other laws are compelling banks to add expensive tax-reporting and compliance tools to IT platforms.

In short, costs are up, client volume and profitability are down, and Swiss private banks are redefining themselves to compete in a tough, new market.

Rediscovering the Swiss Advantage

Private banking in Switzerland goes back more than 200 years, long before secrecy was codified in 1934. Some of the first private banks are leading private banks today. The permanence of these banks is a statement in itself. The first step in redefining what it means to be a Swiss private bank involves a simple return to core strengths.

Switzerland continues to be a safe haven. Neutrality, internal political stability, and liberal financial markets foster prosperity; and the strong, stable currency offers foreign investors a shield against financial turbulence elsewhere.

Swiss private banks have also made an art form of VIP service. Highly educated, cultured, multilingual, and discreet, the Swiss are known for developing intimate, long-term relationships with bank clients from around the world.

In the words of Zurich private banker Hans J. Baer: Private banking is the full range of services that a client may wish to obtain and this therefore extends way beyond wealth management. Swiss private banking starts at the three international airports at Zurich, Geneva and Basel and continues via the railway stations and luxury hotels of our country right up to the doors of Sprnglis cake shop. Swiss private banking encompasses our hospitals, cultural institutions, media, lawyers, shops, schools, universities and, of course, our banks and asset managers.

Remodeling for Strategic Growth

Swiss private banks can build on this tradition of elite service by creating innovative, new financial solutions, tailored to individual clients or client segments. For example, banks could turn compliance from a burden to an advantage by applying trademark Swiss precision to tax-declaration services in each client country.

Banks can also trim expenses by outsourcing non-core services and automating processes. Offshoring can still save money, even with regulatory changes. It is clear, however, that efficiency alone will not supply the liquidity and manpower to enter new markets, where the real growth potential lies.

As China overtakes the US as the worlds biggest economy (based on purchasing-power parity), Asia offers enormous opportunity. With the increase in wealth, the prospective client base for private banks is growing. Latin America, Eastern Europe, and the Middle East are also underserved markets with a lot of room for growth. Of course, the investment in new branches offsets profits for several years, and if the client base is too small, it may never pay off.

The Basel III Accord is expected to make expansion even more challenging, by raising capital and liquidity requirements. In general, Swiss private banks will have to consolidate, to achieve the margins and liquidity to be able to enter new markets. Mergers and acquisitions can help banks reach critical mass and economy of scale, gain greater market visibility, and diversify client assets. However, banks will have to gauge the reputational risk, values, leadership, and national culture which each organization brings to the deal.

From regulation and costs, to new ventures and consolidation, Swiss private banks are confronting extraordinary challenges in a competitive, changing market.

Staying Resilient with Strong Partners

Insurers can be powerful partners, helping banks stay resilient as they move forward.

Ten Swiss banks still belong to the Swiss Private Bankers Association, where partners have traditionally assumed unlimited liability. However, leaders at any private bank face enough liability to inflict severe personal and family hardship. It drove four of those ten banks to incorporate, not least, because of the threat of US tax litigation. Directors and officers liability insurance has become a standard for good reason.

In fact, regulatory changes expose banks to a variety of potential complaints, which may or may not be valid. Professional indemnity covers a bank against claims for a broad range of errors, including wrongful investment advice, mismanagement of client assets, and trade-execution errors.

Crime insurance covers banks against losses from employee crimes such as embezzlement. It also covers third-party computer crime and forgery.

Cyber insurance has also become a mainstay, as banks are frequent targets of hacking attacks and phishing fraud. Standard bankers crime and professional indemnity insurance policies already cover certain cyber risks. But two significant exposures losses from a data breach and business interruption are generally not covered, and these exposures are being addressed in a separate cyber insurance policy. IT systems are becoming more sophisticated, with more connection points, including mounting mobile connections. As the number of data-input points grows, so does potential breach exposure. In addition, as customer preferences are shifting towards electronic banking, there is a potential for threats from unknown or untested sources.

As Swiss private banks consolidate to venture into new markets and create innovative, new products, insurers can use extensive claims experience to help banks identify and quantify new risks. A global insurer can also offer broad, flexible coverage, providing banks with adequate cover to account for regulatory differences in each new country.

The New Swiss Private Bank

Swiss private banks are on the verge of creating a new, more sustainable banking paradigm. Growth and even survival depend on it. To be strong partners, insurers should be attentive to evolving bank risk, actively looking ahead at how society, politics, and technology could influence the next round of change.