Competition escalates

Private and investment banks are pursuing lucrative high-net-worth structured products business in an increasingly competitive market. Even so, some have developed mutually beneficial distribution relationships. Christopher Jeffery reports

Investment banks and private client advisers have seen their profit margins hammeredby the equity market’s ongoing malaise and the overall sluggishness ofthe leading economies. But there remains at least one business where both typesof institutions have benefited: the distribution of structured products to high-net-worthindividuals (HNWIs).

The joint Merrill Lynch/Cap Gemini Ernst & Young World Wealth Report 2002 – theannual ‘bible’ for the wealth management industry – says HNWIfinancial assets under management hit $26.2 trillion in 2001. The US investmentbank and French consultancy predict this figure will rise to $38.5 trillion bythe end of 2006. While it is difficult to assess the size of the structured productsmarket, as many instruments are over-the-counter, a number of participants estimatethey could account for up to 10% of that figure by that time.

Most investment banks can structure the types of derivatives-based, capital-protectedinvestment products investors have embraced, especially in Europe. Some – includingUBS, SG, BNP Paribas, Deutsche Bank and US investment banks such as Merrill Lynch,Goldman Sachs, Salomon Smith Barney and Morgan Stanley – have made significantinroads into this area.

Rivalry is also growing among distributors. Private banks face severe competitionfrom asset managers such as London-based Schroders and New York-based LazardAsset Management in the ultra-HNWI segment, where clients need to hold a minimumof $5 million in investable assets, although some institutions place the cut-offat $15 million. Insurers with strong risk management skills, such as France’sW Finance and Guardian Vie, are also targeting this segment. Private banks arealso being squeezed in the mass-affluent and lower-HNWI segments by retail banks,which have significantly improved their client segmentation by pushing HNWIsfrom their retail business into specialised mass-affluent and private-bankingunits and increasingly powerful independent financial adviser (IFA) networks,particularly in Italy, Germany and the UK.

Meanwhile, other international private banks, universal banks and US bulge-bracketbrokerage houses are seeking to cash in on this business. This has caused a financialsqueeze at a number of prominent institutions such as Switzerland’s Sarasinand even the world’s third-largest private bank, Credit Suisse (accordingto figures compiled by UK wealth consultancy boutique Scorpio Partnership – seefigure 1).

As a result, almost all private banks have adapted their business models by decoupling,at least in part, their manufacture of products and their client advisory business – typicallytheir most profitable area. A JP Morgan Chase analysis of Boston Consulting Group’sRicher Prospects in Wealth Management study last year found that 78% of a privatebank’s profits stem from this front-office advisory. While a number ofprivate banks still attempt to manufacture the majority of their products in-house,most have embraced a so-called ‘open architecture’ approach, sellingthird-party products, either in the third party’s name or on a white-labelbasis (where the distributor places its name on a product developed elsewhere).

In theory, this means any investment bank with a strong structuring capabilitycan tap into this market. But there is still some resistance to a fully openapproach, with a number of private-banking networks opting to use their own in-housestructuring teams where possible. The private-banking arm of American Express,for example, structures almost everything in-house, except in areas where itrequires third-party money managers, according to Richard Holmes, president ofAmerican Express Bank in New York. The situation is similar at Dutch bank ABNAmro. “We embraced ‘open architecture’ two years ago. We arepretty balanced, but clients have a preference for ABN Amro products,” saysWalter Kiceleff, director of funds and structured products for internationalprivate banking at ABN Amro in Zurich. Kiceleff says ABN Amro’s investmentbanking staff typically structure equity-linked and credit-linked derivativesproducts, but it also turns to third parties to select and advise on activelymanaged portfolios.

Even market leader – in terms of assets under management – UBS, adoptedan open architecture after purchasing multi-manager GAM in 1999, says Marco Schaller,head of equity product development at UBS wealth management and the businessbanking unit in Switzerland. Although Schaller says UBS Warburg remains the bank’spreferred provider, the pre-screened offering of selected third-party products – UBSdoes not white label – is central to its client-retention strategy of providingunbiased advice.

As assets under management at the leading private banks decline – Scorpioestimates the top 26 private banks saw assets under management tumble 8% lastyear mainly due to declines in asset values – offering attractive new structuredproducts is seen as critical to maintain competitive advantage. Add in that privatebanks earn 75–200 basis points for distributing structured products – comparedwith 30bp for time deposits and 50–75bp for advisory mandates – andthe rationale becomes compelling.

Some market incumbents, such as UBS, Société Généraleand BNP Paribas, have already built strong businesses and, importantly, strongdistribution relationships, over the course of the past five to 10 years. SG,Société Générale’s investment banking subsidiary – withabout a 20% market share – now sells more than 90% of its 1,000 or so newstructured products each year to several hundred third-party distributors, withthe rest destined for its own distribution network. The figures are not dissimilarat BNP Paribas and UBS.

Deutsche Bank, meanwhile, has created Xavex, a unit that offers customised structuredproducts, including index-linked investments that may be periodically restructured.

Split business
Major houses have split their businesses into flow and structured product divisions. Flow deals are simple on-demand structures that typically deal with one asset class, for example call options or call spreads based on a single underlying equity index. They can produce these for anyone interested in investing $500,000 or more. The market is estimated to be worth hundreds of billions of dollars, with most major equities houses, such as Goldman Sachs and Salomon Smith Barney, active in it.

Investment banks typically need an annual flow of $20 billion-plus in notional volumes to achieve a profit-generating critical mass for such business lines. This means they need significant access not only to private banks but also to insurers, asset managers, retail banks and other distribution networks. “On the flow side, it is a very competitive business, and the margins have shrunk very significantly,” says Bernard Desforges, global head of equity derivatives sales and structuring at SG. “Still, if you are able to provide a very good quality service to private banks that are happy to trade very significant amounts within a global flow sales desk… you get something that is quite significant, and it is worth building up a team.”

Most profits are generated within specific structured product groups that deal with more complex exposures than the simple options used in flow products. Overall, the market for these products is around $75 billion–80 billion a year. They are built on the basis that investors will buy a minimum of $15 million–20 million. Market participants say the cost of structuring, maintaining secondary market pricing, generating customer reports and so on would otherwise be prohibitive.

Banks such as BNP Paribas, SG and UBS create the product, the wrapper and the marketing documents, train distributors’ sales forces and make a secondary market in the products. “Many of the private banks we work with have strong selling capabilities. In many cases it is quite feasible to create the nice innovative types of products that are very popular in many countries,” says Desforges. “Often it has to be white labelled,” he adds. The bank can also make money providing just one part of a deal, such as the hedge for a complex equity-linked swap, he notes.

Although the structured product market appears mutually beneficial for both private bankers and dealers, there remain some sticky issues between the two groups. Distributors complain about the complexity and appropriateness of some dealers’ products. ‘Mass affluent’ clients have a low tolerance for complexity, and distributors often wonder whether dealers are stuffing structured products with risks they simply want off their books (see page 10).

“ There are always new structures and opportunities and that’s fine. But we need to ensure the end-investor understands the risks, either if they are not structured correctly or there are embedded risks of which they are not aware,” says Amex’s Holmes.

The battle over credit

The current shift in assets – from equity markets that have declined precipitously in the past two years into cash, commodity, foreign exchange and fixed-income instruments – has given investment houses traditionally weaker in equities, such as JP Morgan Chase, an opportunity to tap into the structuring market. “Most investor portfolios are under-allocated in credit,” says Stephen Stonberg, a London-based managing director in JP Morgan Chase’s credit and rates division. “And clients looking for credit exposure find the cash bond markets expensive due to a lack of supply,” he adds. Often, high-net-worth individuals (HNWIs) opt for government bonds or cash deposits as a safe haven from equities, but investment-grade bonds offer a halfway house from a risk-reward standpoint. Stonberg believes capital-protected credit-linked notes based on a pool of credit derivatives offer a significant premium over cash bonds. Combined with range accrual, callable range accrual and step-up callable notes, these could prove a valuable tool to HNWI investors. JP Morgan Chase is already offering such products on a white-label basis to a range of distributors. The bank’s ability to quickly create complex correlation products may leave many of its competitors, at least in the fixed-income area, struggling. But SG’s global head of equity derivatives sales and structuring, Bernard Desforges, says it is often important that structures are wrapped as a mutual fund rather than as bonds – an area in which he believes SG maintains a key competitive advantage through its Lyxor Asset Management unit. Stonberg says JP Morgan Chase can convert synthetic pools of credit into insurance and fund products, but believes that the key to selling highly complex credit structures to HNWIs lies in education, adding that the process could take time. The other issue is distribution. Market leaders already have hundreds of relationship managers dealing with hundreds of distributors apiece. But with private banks and other distributors eager to shore-up flagging assets under management, the market is likely to remain open to new entrants.