Moats Surround Swiss Banks

UBS has been more successful than Credit Suisse in rearranging its business model. However, we see many more similarities than differences between the two. Substantial write-downs and legal costs have obscured Credit Suisse's true profitability; consequently, we believe the market overestimates the company's future exposure to volatile sales and trading.

Both Credit Suisse and UBS target ultra-high-net-worth individuals. We believe that complexity supports moats in wealth management and catering to ultra-high-net-worth individuals constitutes a much moatier business than the mass affluent market. The needs of ultra-high-net-worth individuals and family offices are as complex as those of institutional investors. Credit Suisse and UBS have deep relationships with their clients, spanning various investment, transactional, and lending products--often integrated--which makes pricing opaque. Products are often tailor-made to the client’s needs, so it is impossible for a client to easily compare pricing. Credit Suisse has confirmed our view on the moatiness of ultra-high-net-worth clients. At a recent investor day, the company showed that typical returns on risk-adjusted capital in its ultra-high-net-worth segment exceed 30%, while returns in the mass affluent market are 10%-15%.

Credit Suisse's True Profitability Obscured The profitability of Credit Suisse's core businesses comfortably exceeds its cost of capital; we estimate a midcycle return on equity of 13% compared with our cost of capital estimate of 10%. A few issues have concealed the company's true profitability. As part of the process of derisking the business away from volatile sales and trading, Credit Suisse has run down a massive noncore book of EUR 126 billion to EUR 45 billion over the past four years, incurring cumulative before-tax losses of EUR 16 billion in the process. To add insult to injury, Credit Suisse has incurred legal expenses of CHF 7 billion over the past four years.

Credit Suisse has often been criticized that it was behind UBS in adapting its strategy to the new requirements for Swiss private banks. The market has hounded Credit Suisse to reduce its exposure to risky sales and trading and replicate UBS’ business mix, where wealth management dominates. However, there are many more similarities between Credit Suisse and UBS than there are differences. We believe that losses booked out of the noncore portfolio have led investors to overestimate the importance of sales and trading to Credit Suisse. Sales and trading contributed 27% to Credit Suisse’s revenue in 2017 compared with 23% to UBS’ revenue.

The path to success for Credit Suisse lies with its wealth management business. Therefore, it worries us that the company has by own admission been giving up market share in wealth management inflows over the past five years. Although the past two quarters have been much better, it is vital to our investment case that Credit Suisse executes its strategy well in wealth management.

UBS Is Undisputed Global Leader in Wealth Management UBS was ahead of the curve in anticipating what a global bank should look like in the post-crisis world, and its shareholders are benefiting from its early and decisive actions. Since 2012, UBS has acknowledged that some businesses have become less structurally attractive and reduced its focus on investment banking while eliminating legacy assets.

Sergio Ermotti, CEO since late 2011, is instead focusing on UBS' core strengths--its moaty private bank, large asset manager, Swiss retail and commercial divisions, investment banking advisory business, and a handful of successful execution, distribution, and trading businesses.

We believe that UBS offers good exposure to some good secular growth stories, such as the increased concentration of wealth, the growth of high-net-worth individuals in emerging markets, and an aging population. Globally, wealth is becoming more concentrated, and the assets of ultra-high-net-worth individuals are growing substantially ahead of global GDP. The growth in wealth will increasingly come from emerging markets, where competition is less intense, and the safety and diversification offered by a Swiss private banking account present an attractive option for investors from volatile regions. An aging population will increase the number of individuals looking for advice on preserving and transferring wealth to the next generation.

The rapid advances in artificial intelligence and the explosion of fintech disruptors pose less of a risk to UBS than to most other global banks. Offering advice to ultra-high-net-worth individuals is not a commodified business with generic solutions. The complexity of ultra-high-net-worth individuals’ needs makes it unlikely that robo-advisors will be able to replicate the benefits of having a relationship manager.

Switzerland Boasts Robust Banking System An evaluation of the banking system that a bank operates in is critical for us to have a high level of conviction in the moats we find for an individual bank. We define a banking system in broader terms than merely the regulatory environment in a particular jurisdiction. Competitive, political, and economic elements also contribute to the robustness of a system to withstand banking crises. Overall, we assign ratings to banking systems in four buckets: very good, good, fair, and poor. We view the Swiss banking system as very good. Globally, it is only the Australian and Canadian banking systems that we view equally positively.

The Swiss regulatory environment is exceptionally strong, and the Swiss National Bank’s requirements often exceed those of the Basel accord and the European Banking Authority. Switzerland is one of the world’s most stable democracies, and its devolved, cantonal system of government limits the potential of populist extremist parties.

Competition in Switzerland is also less intense and more rational than in most other European jurisdictions. UBS and Credit Suisse dominate the Swiss banking sector, holding 50% of all Swiss banking assets. Partially state-owned cantonal banks and mutually owned Raiffeisen account for 25% of Swiss banking assets, but we believe that in contrast to some other jurisdictions in Europe, the cantonal banks are much more rational in its pricing and there is a desire to cover its cost of capital; in fact the cantonal banks are more profitable than the pure commercial banks.

Switzerland has a long history as the banker to the world, and 25% of cross-border assets around the world are managed there. Historically, Swiss banking was best known for its fabled numbered of anonymous accounts--the numbered account and indeed any amount of privacy over financial matters. The global consensus seems to be that the right of the majority to have unfettered access to data trumps the right of privacy of the individual. The U.S. clampdown on offshore tax structures and antiterrorism measures further eroded the Swiss reputation for guardians of financial information.

The bailout of UBS by the Swiss government in 2009 did damage to the popular image of the inviolable stability of Swiss banks. However, we believe that Swiss banks remain attractive to the world’s elite for two main reasons: Swiss neutrality and the Swiss franc.

Both factors speak to downside protection and safeguarding of wealth. Switzerland has been neutral since 1815 and escaped the ravages of both world wars. Switzerland is also not aligned to any power bloc; it is not a member of the European Union nor is it a member of NATO. Even for wealthy citizens of stable democracies in the rest of Europe or North America, Switzerland represents a safe haven that provides diversification and liquidity to their portfolios. The Swiss franc has long been seen as an alternative for gold. During the 2008 and 2011 financial crises, the franc appreciated against both the U.S. dollar and the euro, illustrating this concept. The removal of the franc’s peg against the euro in 2015 enhanced the attraction of the franc as portfolio diversification tool to minimize risk. The franc also serves as protection against any debasement of other major currencies by loose monetary policies.