negative interest in private banking - ey · negative interest in private banking. the mortgage-...

Negative interestin private bankingExistential threat to a venerabletradition or strategic opportunityfor the business model?

Increasing income in a negative interestenvironment

It is on account of their balance sheet structure that banks specialized in assetmanagement are hit particularly hard by negative interest compared with competitorswith other business models. As a result, negative interest can only partially be passedon to customers. Negative interest impacts fundamental components of a privatebank's service-rendering process. However, a range of effective short and medium-term countermeasures are available. In particular, measures such as activemanagement of the balance sheet structure and launching new services and productsfor customers can still give impulses with the desired effects. Owing to the highlydisparate alignment and situation of individual private banks, each institution has tofind its own solution. Tight integration of a bundle of operational and strategicmeasures is of central importance, while factoring in the long-term business strategy,the customer structure and the service packages currently offered.

We hope you enjoy reading our take on the subject and look forward to discussing itwith you. Please do not hesitate to contact us should you require additional backgroundinformation, or wish to ask any questions or discuss specific aspects in greater depth.

Negative interest in private banking

Dr. Peppi SchnieperPartnerLead Strategy Consulting FSO

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Increasing income in a negative interest environment 21. Private and foreign banks are especially affected by negative interest 42. Options for handling negative interest 6

Option 1: Keep cash in the vault 6Option 2: Convert CHF deposits into foreign currency 7Option 3: Prolong duration of CHF investments 8Option 4: Expand credit business, focusing on Lombard lending 9Option 5: Expand credit business, focusing on mortgage lending 10Option 6: Arrange credit for customers 11Option 7: Sell derivative financial products to customers 12

3. Summary 134. Conclusion 145. Contacts 15

Contents

3Negative interest in private banking

1. Private and foreign banks are especiallyaffected by negative interest

Private and foreign banks that specializein the private banking sector haveendured several negative market trendsover the last few years, such as thesoftening of bank secrecy, decreasingmargins in private banking and increasingcosts for regulatory compliance and legalprovisions.

These very banks found themselvesexposed to yet another adverse shockwhen the Swiss National Bank (SNB)announced on 15 January 2015 theintroduction of a negative interest rateof 0.75% on sight deposits.

This interest rate is binding for allbanks that hold sight deposits with theSNB. However, negative interest is onlyapplied on amounts in excess of20 times the legal minimum reserve.Despite the reduction in intererst rate,the change in sight deposits held bySwiss private banks has beennegligible, as can be seen in the figurebelow.

Figure 1: Development of sight deposits in 2015 (Source: Swiss National Bank)

4 Negative interest in private banking

202.6 201.2

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50.0

100.0

150.0

200.0

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January April

Sigh

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posi

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priv

ate

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CHF billion

Although the interest rate applies to allbanks, not all are equally affected.Because retail and wholesale bankshave to hold higher minimum reservesdue to their business models, they areallowed a higher exemption limit. Onlyfew of these banks exceed this exemptionlimit, and where it is exceeded, theamounts involved are small. Privatebanks, however, provide a contrastingpicture.

Because their activities mean that theyhave to hold lower minimum reserves,they also have a lower exemption limit.Due to the traditionally sizable sightdeposits held by private banks, mostexceed their exemption limit and aretherefore compelled to pay interest onthe surplus. Furthermore, a structuralincrease in liquidity is emerging asprivate customers in particular havesubstantially reduced their investments insecurities in response to the currentinterest situation, opting instead forliquidity.

In the private banking sector, privatebanks are in direct competition withretail and wholesale banks. The latter,are still able to keep their liquidity withthe SNB at a zero interest rate.Accordingly, these banks can take inliquidity at zero interest or low

negative interest, and do attractivebusiness with customers on top. Thismeans that private banks can only passon the negative interest to customersto a limited extent for real fear of losingtheir business. They bear a largeportion of the negative interestthemselves.

Some private banks are attempting topass on part of the negative interest.One major private bank, for instance,charges negative interest on deposits inexcess of a defined threshold, whileother private banks charge negativeinterest to institutional investors.However, it has not been possible sofar to pass on negative interest indis-criminately.

Based on current sight deposits,negative interest burdens private bankswith costs of CHF 680 million per annum,of which only a small portion can bepassed on to customers. Given that allprivate banks have together generatedprofit before tax of CHF 2.61 billion perannum on average over the last fouryears, negative interest poses asignificant threat to this bank cluster.


2. Options for handling negative interest

The first logical alternative is to storeand insure surplus liquidity as banknotes.Banknotes can be acquired from the SNBdirectly or through the money market.Many market participants are activelypursuing this course of action, despite itbeing in clear contravention of the SNB'sintent in its introduction of negativeinterest.

However, this is subject to a number ofproblems in practice. Firstly, acquiringbanknotes in the volumes required isproving difficult. Secondly, the acquisition,storage and insurance of cash is associatedwith costs estimated at 20 to 40 basispoints.

This approach therefore only helps reducethe core problem of negative interest butfails to resolve it.

Thirdly, even if it appears contradictoryat first glance, cash in large volumes isilliquid. If liquidity is needed, cash hasto be converted to book money, whichtakes time and involves transportcosts. This problem can be reducedthrough standardization, certificationand securitization of cash amounts, andtheir storage at an independent location.This would essentially permit the saleof the vault contents whenever liquidityis needed, thereby reducing transactioncosts.

These difficulties mean that the storageof cash can at most only serve asshort-term relief to the problem, butnot as a robust long-term solution. Inany event, securitization solutions shouldbe given preference over simply storingcash.

In the current competitive environment, it is not possible to indiscriminately pass onnegative interest to customers. This would only be possible if, for instance, the SNBwere to reduce the exemption limit. As a result, the sector is looking for alternatives.In the following, we present an overview and discussion of possible options:


Option 1: Keep cash in the vault

Option 2: Convert CHF deposits into foreign currency

By investing part of the sight deposits ina foreign currency that is subject to noor only a small negative interest (e.g.,euro or US dollar), it is possible toeffectively avoid the negative interestregime. This can either be done throughthe bank — i.e., the bank continues toaccept deposits in Swiss francs andinvests in euros, for instance — ordirectly by customers — who exchangetheir Swiss franc deposits for eurodeposits.

In practice, both approaches are onlypartial solutions. Customers choose aspecific currency based on their riskpreference.

So banks that pressure customers toexchange deposits to another currencyare not necessarily acting in theinterest of the customer and aretherefore failing to provide customer-centric advice.

At most, only those customers for whomexchange into a foreign currency makessense in view of their asset allocation canbe persuaded to convert their investments.Such customers will likely tend to be theexception.

The alternative — i.e., the bank investingcustomers' CHF deposits in a foreigncurrency — exposes the bank to a highcurrency risk. Such a risk would have tobe hedged in the interest of the bank'scustomers and owners. Owing to interestrate parity, however, the cost of completehedging would offset any interestadvantage from a foreign investment.

In other words, banks investing theircustomers' CHF deposits in foreigncurrency is an approach fraught withdifficulties in actual practice.


Another approach is to invest savings ininvestments with long terms and low-riskprofiles. This solution takes advantage ofthe currently steep yield curve. In fact, itis even possible to obtain positivenominal returns from low-risk SwissPfandbriefe with terms of five years ormore.

That said, this approach is not withouta number of difficulties. The CHF bondmarket is limited in size and illiquid.Indeed, the total volume of non-government bonds adds up to aboutCHF 390 billion, with Swiss Pfandbriefeaccounting for CHF 98.6 billion of thatamount. With that kind of market depth,even an investment of onlyCHF 20 billion in the bond market wouldcause major upheaval.

This problem could be mitigated byinvesting in the more liquid USD andEUR bond markets and hedging theseamounts using currency swaps.

However, private banks would therebyexpose the assets side of their balancesheets to high duration risks. Since theliabilities and equity side of a privatebank's balance sheet has a shorter termstructure than that of a retail bank,equity would be exposed to a very highinterest rate risk. This is not consistentwith low-risk governance.

Consequently, prolonging the durationof CHF investments is an optioninvolving substantial difficulties.

Option 3: Prolong duration of CHF investments


A sensible alternative could be to expandor establish the Lombard lending businesswith the aim of reducing liquidity. Theissue of (additional) Lombard loansreduces sight deposits. Some privatebanks with a very large Lombard creditbusiness are not or, at most barely,affected by negative interest. Manyprivate banks do not offer such a service,or only to a limited extent, despite thefact that wealthy customers frequentlyhave a clear need for this form of credit.

A successful and low-risk Lombardcredit business requires effective riskmanagement, robust risk systems and aqualified sales team. If these conditionsare satisfied, Lombard loans are a veryeffective means of placing liquidity whilecreating customer benefits.

Many banks are rethinking the strategicoptions in their business models andare currently considering establishingor expanding business with Lombardcredit facilities. There is an appreciableincrease in interest in the developmentof credit risk systems, provision ofwhite-label Lombard solutions and theirefficient integration in existing systems.In our experience, it is possible to buildup the technical and administrativeplatform for a rudimentary Lombardlending business within a few weeks.Greater effort is needed to secure ahigh level of operational efficiency andto build up effective risk managementas well as, in particular, to integrateLombard products in the advice processof sales staff.

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Option 4: Expand credit business, focusing on Lombard lending


The mortgage- and corporate-lendingbusiness is a market that is still largelyuntapped by Swiss private banks. Incontrast to other countries, such asGermany, where asset-managing banksextend significant loans to theircustomers, only very few Swiss privatebanks are active in the mortgagebusiness, or indeed, in commerciallending. However, mortgages in particularare very attractive at present, measuredby margin. Even in transactionsinvolving impeccable credit ratings andlarger volumes, it is possible to extractmargins to the SWAP/LIBOR of130 basis points (based on data as of20 August 2015), which translates to avery attractive risk-adjusted return onequity with favorable refinancing.

The problem here is mainly in the ambitof expertise: private banks typically lackemployees in front, middle and backoffice with experience in mortgagelending as well as correspondingsystems.

Several solutions are conceivable inpractice, however — from buying inexpertise and systems to joint effortsto build up solutions for several privatebanks. The latter factor is particularlyrelevant if the aim is to target not onlyown customers but also third-partycustomers.

Building up an in-house mortgage-lending solution can make sense in thecontext of a holistic customer strategy.Over the last several months, we haveseen a significant increase in interestfrom private banks in the mortgagebusiness and the correspondingoperational components needed. In ourexperience, it is possible to establisha mortgage business within anappealing time frame.

Option 5: Expand credit business, focusing on mortgage lending


Option 6: Arrange credit for customers

Apart from issuing loans, banks canplay the part of intermediary betweentheir customers and borrowers. Giventhe current, larger margins that can beobtained in the mortgage business,mortgage lending to institutional orwealthy private customers is veryattractive at present — be it throughsecuritized credit packages or 1:1securitization. This approach can alsobe used to reduce customers' liquidity,but without entailing a credit risk forthe bank.

The added income for banks taking thisapproach would essentially stem fromthe reduction of the negative interestpayable and the generation of fees forthe arrangement and management ofloans. This option again requiresinvestment in risk management, systemmodifications and coaching of customeradvisors. Additionally, in some cases itmay only be possible to reach requiredlending volumes in collaboration withpartners.


Option 7: Sell derivative financial products to customers

Another approach is to sell investmentproducts. Customers with a high amountof equity should be sold investmentproducts that are compatible with theirrisk appetite to the extent possible.Derivative products are a conceivablesolution here. Account products havecertain attributes as regards security,availability of liquidity and quality ofunderlying assets, particularly in risk-averse times. With derivatives, it ispossible to address specific risk profilesand develop bespoke pay-out scenarios.Although downside risks can be covered,it is generally not possible to replicatethe attributes of account products withnon-negative profitability, unlessadditional risk factors are accepted.

In addition, the choice of specificderivative financial products has to takeinto account several factors, includingthe risk profile of customers, theirunderstanding and knowledge of thechosen derivatives, the financial capacityto absorb potential losses as well as thestrategic asset allocation of customerportfolios. All of these considerationscombined mean that derivatives canonly ever serve as a partial substitutefor account products.


3. Summary

The figure below presents a comparisonof the options described before from fiveperspectives:

Income enhancement, the time neededto implement, the implementation costinvolved and suitability as a short-termor long-term measure.


Option Income enhancement Time to implement Cost to implement Fit for short-term Fit for long-term

Keep cash in thevault (withoutsecuritization)

Keep cash in the vault(with securitization)

Convert CHF depositsinto foreign currency

Prolong duration ofCHF investments

Expand creditbusiness, focusing

on Lombard lending

Expand creditbusiness, focusing

on mortgage lending

Arrange creditfor customers

Sellderivatives

+++

+

++

+++

++++++

4. Conclusion

Private banks face a tough task onaccount of the introduction of negativeinterest. The challenge can be masteredwith the right mix of the measuresdiscussed before. Lending should form acentral component of any solution,either acting as an intermediary ordirect lending. This approach can beflanked by the conversion of CHFdeposits and the sale of derivatives.

The unique particulars of each bankhave to be factored into the solutiondevelopment and implementationprocess. Such particulars include thelong-term business strategy, customerstructure and the currently offeredservice packages. Other parameterssuch as current risk management, ITsystems as well as the risk capacityand risk appetite also have to be takeninto account.


5. Contacts

Senior Manager+41 58 286 44 [email protected]


Dr. Roger StettlerDr. Peppi Schnieper

Partner+41 58 286 37 [email protected]

Andreas Wigger

Executive Director+41 58 286 42 [email protected]

Roger Disch

Executive Director+41 58 286 41 [email protected]

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