Monday, November 5, 2012

UBS Throws in the IB Flag

UBS, the Zurich-based global financial institution, announced last week that it plans to dismiss 10,000 employees as it continues, like most big banks, to review, revamp and re-scale its business units around the world.  That's not an unusual news item. In financial services, that's a news blurb we see almost every other day.

UBS provided more details.  Most of the dismissals will come in its investment-banking group.  More specifically, its fixed-income businesses will suffer the most.  The dismissals, the down-scaling and shrinkage are unfortunate. The announcements are, nonetheless, not shocking, since they are a common event in the business press.

This might, however, be the first wave of dismissals in finance, where the bank stepped up to admit  blame solely on its inability to justify business lines because of hefty capital requirements from the new wave of regulation. UBS says new regulation (in Switzerland and from the reforms of Basel II, II.5, and III, and new Dodd-Frank and Volcker rules) will require substantial increases in its equity capital base just to continue doing existing business. And barring any spectacular periods of revenue growth, the increases in capital will push down returns on equity to levels that can't be explained to shareholders.  About as simple as that.

(See CFN on Basel III, 2010 for more background on Basel regulation. In effect, the combination of Basel and Dodd-Frank would virtually double the capital requirements at large banks (those commonly thought to be "too big to fail") between now and 2019. The requirements will step up in increments over the years.)

For all practical purposes, UBS has decided to withdraw from huge-scale investment banking after having decided years ago to attempt to be a bulge-bracket bank.  It has decided it can't make the numbers make sense for it to be a Top-10 investment bank.  Sure, it will continue in certain niches--equities, research, brokerage, and investment management.  But it will not try to compete head-to-head with Goldman Sachs, JPMorgan, Deutsche Bank, and Morgan Stanley.

UBS, through the years, had built up its investment-banking practice through acquisitions, corporate-banking relationships, the reputation of its investment-management and private-banking businesses and the heft of its capital base. Some may recall how in two decades it penetrated U.S. borders by acquiring the well-known retail brokerage Paine Webber and the boutique firm Dillon Read. It absorbed those operations years ago and used them as a base to compete in the U.S. in many areas.

UBS's rationale makes some sense.  It articulates that it seeks to generate a return on equity (ROE) from 12-17 percent. That varies with business cycles and market volatility. On average, it strives to seek returns of 15 percent.

New regulation throws a thorn into its side.  The bank must, as it has done the past year or so, reduce leverage, get rid of bad assets, and push costs down significantly. It also had to deal with the $2 billion loss of a rogue trader, repair risk management and trading operations and improve controls.  While sprucing up controls and balance sheet, new regulation comes along and adds the burden of boosting capital and taking leverage down even more.

If it decides that it must boost capital by 10-20 percent, then ultimately it would need to increase net earnings by 20 percent or more. Increasing net earnings in the current environment--one of uncertainty, volatility and fierce competition from the other big banks--might be near impossible, unless UBS decided to cut costs vigorously.

So where do you cut costs? You do so in businesses where regulation will require big increases in capital, where profit margins are already slim or vulnerable and where costs can be cut swiftly.  Its fixed-income businesses (corporate bonds, municipal bonds, government bonds, interest-rate derivatives, corporate lending) became the first target of deep cuts. This includes (within fixed-income units) corporate-advisory activity, underwriting, trading and market-making.

Senior management may have deduced that, at best, ROE would hover around 5-7 percent in those businesses. ROE in the range of 0-5 percent for a business that already uses up significant amounts of capital would be a certain drag on the bank's overall ROE.  An unsatisfactory result for shareholders, who too dream of earnings growth, stock-price increases and a nice, reliable dividend.

UBS Investment Banking won't go away. It requires a certain amount of investment banking (underwriting, market-making, securities distribution and equity research) to complement other profitable or growing business lines:  investment management, private banking, brokerage, and corporate banking. Yet with massive departures in London and in fixed-income activities, there will be minimal activity in corporate bonds, short-term instruments, mortgage securities, structured securities, private placements, subordinated debt, mezzanine debt, interest-rate swaps, and any of the products and activities that fall under the fixed-income spectrum.

UBS in its announcements hints this is not a cowardly business act. It claims to be making a tough business decision (at the expense, unfortunately, of thousands who must seek employment elsewhere) that all of its old peers must inevitably make over the next few years. It is patting itself for making that decision now.

Tracy Williams

See also:

CFN:  Basel III and Capital Cushion, 2010
CFN:  Big Banks and Dreadful Downgrades, 2012
CFN:  JPMorgan Chase and Regulatory Rants, 2012
CFN:  Big Banks and Where Do We go from Here? 2010

CFN:  The Volcker Rule, 2010
CFN:  The Volcker Rule, Part 2, 2011

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