The 20% rally in UBS’s share price in the month to late-November, after the announcement at the end of October of a severe reduction in capital allocated to the fixed-income business, presents a challenge to other large banks.
UBS has transformed its story to investors. This group was dominated by its large, troubled investment bank, with a strong wealth management business attached, but now it will look more like a large global wealth manager and asset manager, with a trimmed down investment bank – two-thirds smaller than it was – attached.
Analysts love the idea of the new UBS. Jeremy Sigee and Kiri Vijayarajah, European banks analysts at Barclays, note: "It is a big change and it prompts a big change in our view too, from underweight to overweight. UBS’s new business model should be able to generate near-20% returns on tangible equity and justify a price/book multiple up to 1.5 to two times."
|Sergio Ermotti, chief executive of UBS|
What the market most likes is that the investment bank will be small. It will have just SFr7 billion ($7.5 billion) of attributed equity in 2015, supporting SFr70 billion of Basle III risk-weighted assets, down from SFr22 billion of equity in the third quarter of 2012, supporting SFr162 billion of risk-weighted assets. From accounting for 46% of UBS Group’s attributed equity today, the investment bank will account for just 16% in three years.
A London-based investment banker mocks: "I see UBS is targeting a 15% return on equity. I’m not sure that’s so ambitious: 15% of fuck all surely can’t be that hard."
However, Ermotti warns rivals that UBS intends forcefully to compete for increased market share in its core businesses, saying it has SFr1.5 billion to invest during the next two years across UBS, including the investment bank, and that from 2015 it will not only deliver that return on equity of 15% but also continue to grow its business organically, while maintaining a 50% pay-out ratio to shareholders.
Investors want to hear exactly this kind of talk, and to see large complex banks shrink back and concentrate more on a few core strengths. However, does all this chest-beating sound a bit too good to be true?
The businesses that will now dominate the investment banking division, equities and advisory, might well consume less capital than the FICC businesses UBS is exiting, but equities has suffered from persistently low customer volumes amid continuing concerns about the weak global economy. Similarly, access to cheap funding has not prompted companies to grow through acquisition, given the macro uncertainties. And even during equity market rallies, that business and M&A advisory exhibit high cost/income ratios.
The good news is that marginal players are exiting the equity business, especially in Europe, where UBS is particularly strong. Crédit Agricole, for example, is selling its equity brokerage Cheuvreux to Kepler. UniCredit has also outsourced it equity brokerage to Kepler, and RBS has quit equities. If more large universal banks give up on equities, UBS could pick up some share.
Is there any element of attempted market timing in UBS’s decision to fall back on its equity business? It might be that a business built on equity and advisory with plain-vanilla flow credit, rates and debt capital market (DCM) will be a good one in a slow grinding recovery from here. Certainly, UBS will hope that secondary volumes and the equity-capital-market fee pool can get no lower from here and will eventually rebound, and similarly M&A.
Fixed-income investors have benefited in most years since the financial crisis from one or both of rallying rates or rallying credit spreads. But with some debt markets now in clear bubble territory, investors might reallocate into equity. Even the most conservative investors are worrying about the potential for capital loss on good-quality safe-haven bonds now offering negative yields.
UBS has the natural advantage of gaining customer flow from its large wealth management and asset management businesses. It would be a geared play on rallying equity markets. The group has set out a wide range for the cost/income ratio in its stated financial targets for the investment bank of between 65% and 85%.
Equity will be the driver. In rallying equity markets with good volumes, the bank hopes to hit 65%. Amid lower equity volumes, it will be closer to 85%. UBS will have to spend plenty of its investment dollars keeping in the front ranks of electronic trading and brokerage in equity.
It has a strong equity business in Asia and plans to grow in the Americas not just in cash equities but also in plain-vanilla corporate equity derivatives, in equity swaps linked to its financing business and in listed derivatives. It will hope that strong earnings and capital generation can improve its credit fundamentals and attraction as a counterparty.
Meanwhile, even though the bank has cut most savagely on the debt side, it has not abandoned DCM completely. At its big annual conference at the Savoy in London last month, UBS’s DCM bankers were busily pitching to banks and corporates very much as usual.
Deals in the first week of November provided a reminder of what UBS can do. It was a bookrunner on the first Portuguese financial bond since March 2010, a €750 million senior unsecured deal for Banco Espírito Santo; it led the largest yankee deal of the week, a three-tranche $3 billion offering from BP; and it won a first bookrunner mandate from Microsoft, for a three-tranche $2.25 billion bond offering.
Can it sustain this business? UBS has quit the sovereign, supranational and agency bond business, where it was a leader. Unfortunately, it had tied up large amounts of capital supporting much higher RWAs from counterparty exposure on long-dated derivatives than it envisaged when it first wrote a flurry of those trades in an effort to gouge revenue from those clients.
The so-called profit on those derivatives trades has long since been taken and no doubt paid out in bonuses. Many were written with one-way-only collateral support annexes that UBS has struggled to renegotiate, novate or otherwise hedge while still competing for new business from those clients. Shorn of the profit from associated derivatives trades, now with multiples of the RWAs originally associated, that DCM business does not offer much return on its own.
The bank has lost its appetite for unhedgeable exposure on RWA-intense business that can no longer make a return above cost of capital. The other big FICC business it is exiting is credit correlation trading, which similarly has been rendered uneconomic by new RWA calculations and associated capital requirements. Having taken these two big decisions, UBS is still combing through the FICC businesses, selecting what to retain and what to manage down.
It is worth remembering this drag on the old UBS investment banking business was already consuming capital that the bank could not devote to other core investment banking clients. The effect of exiting the SSA and correlation business might be modest on its continuing effort in DCM and flow rates and credit trading.