McKinsey Banking Practice

McKinsey Private Banking Survey 2012 Finding a new footing

July 2012

Contents

05

Introduction

19

06 12

Middle East: Attractive but increasingly competitive

Western Europe: Fighting for sustainable profits

21

Priorities for finding a new footing

North America: Expanding profitability, but no growth

26 27

Disclaimer

16

Authors

Asia: Growing fast but at a cost

McKinsey Private Banking Survey 2012 Finding a new footing

5

Introduction
Private banking may be one of the most attractive segments within financial services in 1 terms of profitability, but it has not emerged unscathed from 4 years of financial crisis. Not only did the crisis hit the economics of the industry by slowing net inflows and squeezing margins, it has also led to structural changes. Following a difficult year in 2009, when net inflows in developed markets were negligible and margins and profits hit record lows, a modest improvement was seen in 2010. It seemed at first that this recovery would continue in 2011. But, after a good start, the industry suffered from a difficult second half: markets fell and profits stagnated at low levels. The situation has not yet improved in 2012; another good start was wiped out in the second quarter. Given the continued growth in global wealth, this implies that private banks are failing to capture their fair share of the market. The longer-term structural changes caused by the crisis are creating a much more demanding environment for private banks. Slower wealth generation in developed markets means that the growth momentum on- and offshore is shifting to clients in developing markets. Offshore growth has stabilized thanks to ultra high-net-worth (UHNW) and emerging markets clients. To maintain their position, let alone embark on a quest for growth, banks will need to adapt traditional investment and product strategies to a world that has higher capital markets volatility and in which clients have less appetite for risk. The crisis has also pushed regulation to the fore and it has become a major force shaping the industry. Cross-border rules and regulation on investment products and advice now affect all parts of the business model across the globe. Initially, many industry observers hoped that these changes would be cyclical and reverse as soon as the market recovered. It is now widely accepted that the crisis has triggered lasting change. In its wake, the banking industry has lost the trust of clients, employees, regulators, and the general public. Such trust will be hard to regain. Private banks should expect that both regulatory pressures and more critical and demanding clients are here to stay. Inevitably, not all banks will be able to adapt. This report looks at the context in which private banking now operates, with a regional overview of Western Europe and North America as well as the dynamic emerging markets of Asia and the Middle East. We conclude with a selection of the strategic and operational levers that will allow private banks to find their footing in this more demanding environment.

1

Private banks are defined as any financial institution or unit within a larger financial institution whose main source of business comes from individuals with at least USD or EUR 1 million to invest.

6

Western Europe: Fighting for sustainable profits
ƒ ƒ ƒ ƒ ƒ Assets down; profitability stagnant at 30 percent below pre-crisis levels Traditional investment revenues hit, offset by banking-related activities Cost containment efforts struggling at a time when scale is increasingly important Offshore under pressure, but matches onshore net inflows for first time in 8 years Universal banks’ private banking units in their home markets displayed the highest resilience

Private banking has long been one of the most attractive sectors within European financial services. It enjoyed healthy pre-tax profit margins of 35 basis points (bp) of assets, attractive growth rates, limited capital requirements, and significant excess liquidity. Then came the financial crisis. As if a torch had been lit to banks’ assets, they fell 15 percent in 2008, triggering a 30 percent drop in profits. There was something of a recovery over the next 2 years but, in 2011, a combination of poor market performance, shifting customer preferences, and increasing regulatory demands maintained the pressure on the industry, which saw virtually no net inflows and flat profits.

Industry economics: Battered, bruised, but not yet down and out
Assets under management (AuM) in private banks in Western Europe fell by 3 percent in 2011. Net inflows stood at just 1 percent – half the 2010 level. This was not enough to offset the poor market performance of the second half of 2011. Total profits were stagnant, and still 30 percent below their pre-crisis peak level in 2007 (Exhibit 1). Inflows have struggled due to limited wealth creation since 2008, renewed investor interest in real estate and other tangible assets, and the slow pace at which consumer trust in financial institutions is returning. With net inflows of 2 percent, advisory mandates sustained their relative attractiveness for customers seeking independent guidance, and represented 17 percent of total private banking AuM in 2011. Execution-only accounts (1 percent net inflows) and discretionary mandates (zero net flows) represented 61 percent and 22 percent of invested assets respectively. Eurozone capital markets performed badly in 2011, especially in the third quarter, which contributed to the poor performance of invested portfolios in 2011. The picture is far from healthy even from a long-term perspective: over the past 5 years, private banking portfolios have been under significant pressure from market volatility, and total asset volumes have barely changed over this period, demonstrating the need for private banks to rethink investment strategies and products. Profit margins remained stable at 24 bp in 2011, still 12 bp below the highs of 2005–2007. The cost/income ratio reached 72 percent, in line with 2010. Revenue margins were stable at 83 bp, but this is still 17 bp below the peak of 2005 and we expect pressure to continue in the near term given the evolving regulatory and competitive landscape, and changing customer preferences in Western Europe (Exhibit 2).

McKinsey Private Banking Survey 2012 Finding a new footing

7

Western Europe: Profit margins flat and ~30% below historical levels
Net inflow Performance impact Cost-income ratio (percent)

Profit margin Basis points

34

35

37

35

35 26 20 24 24

Profit pool Indexed at 2003

100

112

136

147

159 112 113 113 84 f() 2003 04 66 64

05 63

06 64

07 64

08 71

09 10 2011 76 71 72

Asset growth Percent 16 10 2011 6 0 6 9 4 5 7 9 14 8 6 8 8 3 10 1 9 -18 -15 2003 04 05 06 07 08 09 9 2 7 -4 -3 10 2011

2003 04

05

06

07

08

09

1

0

Exhibit 1

Western Europe: Revenue margins flat and ~15% below the peak
2005-2011, bp
Percentage change from previous year

Revenue margin

100

98

96

90

84

83

83

Profit margin 2005 21 06 12 07 8 08 -10 09 -10 10 8 2011 3

37

35

35

26

20

24

24

Cost margin

2005 21

06 7

07 10

08 -29

09 -26

10 35

2011 0

63

63

61

64

64

59

59

2005 21

06 15

07 7

08 1

09 -3

10 0

2011 4

Exhibit 2

8

If we compare the revenue margins from different sources of income, a clear picture emerges. Revenue margins from traditional investment-related activities (e.g., mandates, advisory, and brokerage) dropped from 97 bp to 82 bp in the last 5 years. Our survey suggests three root causes of this drop. ƒ Customer risk-aversion and flight to safety have led to an unprecedented demand for cash and fixed-income, which generate lower revenue margins. Their share of total assets rose to 59 percent in 2011 whilst equity’s share fell 2 percentage points to 24 percent, in line with 2008–2009 levels (Exhibit 3). Customer reluctance to trade actively and a more complex regulatory environment have pushed the brokerage contribution to revenues down from 22 percent in 2010 to 20 percent in 2011. Mutual fund penetration has slightly decreased within portfolios, which are increasingly invested in lower-margin ETFs and index/passive funds.

ƒ

ƒ

In 2011, revenue margins from banking-related activities, which accounted for 31 percent of total revenues, offset the drop in investment revenues: deposit margins grew from 48 bp in 2010 to 59 bp in 2011, and lending margins remained stable at 91 bp (lending volumes rose 1 percentage point to reach 11 percent of AuM) . However, the rise in deposit margins may be temporary. It stems not only from a change in interest rates, but also from the liquidity premium paid by banks’ central treasury function to their private banking arms. Deposit margins are still below their 2007 level, and are responsible for a decline of 5 bp in the total private banking revenue margin in Europe since then. As banks continue to search for liquidity and capital, it is unlikely that this trend will reverse in the near-term. Western Europe: Asset allocation still focused on less risky products
2005-2011, percent

Alternatives

7

10

11

10 20 10

10 25 8 26

9 26 9 26

8 24 9 28

Equities

34

34

28

Other/balanced

12

7 25

11 25 21

Fixed income

26

Cash and equivalent

21
2005

24
06

29

35

31

30

31

07

08

09

10

2011

Exhibit 3

McKinsey Private Banking Survey 2012 Finding a new footing

9

The new lower level of profitability appears to have become the norm for private banks. Nor are the prospects overwhelmingly positive in light of the uncertainty in the global economy, upcoming regulation, and the increased cost of compliance. If private banks are to have any hope of restoring profitability they will have to revisit costs. Cost containment has proven to be a challenge. Revenues rose 3 percent in 2011, but absolute costs rose 4 percent, tracking the rise in AuM in the first 6 months, but then not falling, as AuM did, in the second half of the year. Costs in back-office, IT, and overhead (45 percent of the total cost base) rose 7 percent, partly because of higher compliance and risk requirements. Sales and marketing costs remained almost stable despite falling AuM. Despite this growth of absolute cost on average, one-third of private banks managed to cut costs by an average of 6 percent thanks to a focus on operational excellence, platform optimization, and – in particular – staff costs, which fell by 3 percent for these cost-cutters. Scale is becoming increasingly important: between 2007 and 2011, the cost margin of banks with more than EUR 10 billion AuM in a booking center fell from 53 to 52 bp. Banks with less than EUR 5 billion in assets, however, reported an average cost margin of 87 bp. Comparison with the industry’s average revenue margin of 84 bp reveals that these cost margins are unsustainable . These banks will have to work on their operating model to capture synergies across markets, or with third-party providers (via outsourcing, for example), or consider both organic and inorganic growth options.

Market structure: Offshore under pressure, but matches onshore net inflows for first time in 8 years
Offshore private banking has come under significant pressure in recent years from stricter cross-border and domestic regulation. Double taxation agreements and tax information exchange agreements that seek to increase transparency in the banking industry have started shaping a new operating environment for offshore banks. Although 2011 was still challenging for offshore markets, they registered – for the first time in 8 years – almost the same net inflows as onshore markets (almost 1 percent net inflows for offshore and only slightly above 1 percent for onshore). Offshore markets have also recovered since 2009 (from net outflows of 2 percent in 2009 to inflows of almost 1 percent in 2011), while onshore net inflows fell from 3 percent to 1 percent on average (Exhibit 4). The improved resilience of European offshore centers is the result of continued efforts to develop a more viable and sustainable proposition. Switzerland continues to attract significant flows from emerging markets, while Luxembourg retains its appeal for UHNW clients in Europe. These two offshore centers promote diversification, and offer highquality services, strong capabilities, discretion, and safety. Meanwhile, as the traditional tax rationale for offshore markets comes into question, customers with less than EUR 1 million of invested assets continue to return onshore, and now account for only 16 percent of assets in offshore private banks (vs. 24 percent for onshore private banks). If onshore/offshore convergence on net flows was one conspicuous trend in 2011, another was the widening gap between leaders and laggards. For the second consecutive year, the modest increase in net flows across the region masked stark differences between those private banks leading the charge for new money (top-quartile

10

Western Europe: Onshore inflows remain low, offshore showing positive signs
2005-2011, net flows, percent of assets at start of year

5 2

5 2 0

Offshore

1

-2

9

9

9

Onshore

3

3

3

1

2005

06

07

08

09

10

2011

Exhibit 4 banks had average net inflows of 10 percent) and those that struggled in the tough environment (bottom-quartile banks suffered from average net outflows of 6 percent). The total number of private banks that experienced outflows rose to 40 percent in 2011. One bank in ten registered an actual loss in 2011, as in 2010, raising the question of whether these players can survive. Against this background we expect a continuation of the mergers and acquisitions activity that has increased since the outbreak of the financial crisis. Onshore universal banks have proved more resilient to the crisis and were more profitable than boutiques in their home markets, as the latter suffered heavily from poor market performance and lower brokerage revenues. Universal bank-based private banks are in a better position to offer deposits and loans, and many benefit from higher internal transfer pricing for the excess liquidity from deposits. Hence in 2011, universal private banks actually saw profit margins rise (from 32 bp to 34 bp), while boutiques witnessed a drop (from 32 bp to 26 bp). On the other hand, boutiques demonstrated the highest net inflow growth (4 percent) in the industry, benefiting from the investor perception that they are more independent and resilient. At the other end of the spectrum, many of the foreign onshore ventures continued to struggle in 2011 as in previous years, reporting slight outflows on average, and profit margins at low levels (8 bp vs. 6 bp in 2010).

McKinsey Private Banking Survey 2012 Finding a new footing

11

* * * Under the challenging conditions we see today and expect for tomorrow, the gap between leaders and laggards in Western Europe is only likely to widen. Banks that want to grow their profits in a sustainable way will have to differentiate their value proposition, offering, and client service model in line with evolving client needs (e.g., advice seekers vs. self-directed), and adapt it to the new regulatory environment (e.g., tailoring solutions in light of tax compliance rules for each customer domicile). They will also have to adjust their operating models to become much more efficient and flexible while gaining scale, and finally, carefully choose in which markets to operate and on which customer segments to focus. The final chapter of this report will address some of the actions private banks should take to cope with these challenges.

12

North America: Expanding profitability, but no growth
ƒ Zero asset growth and third straight year of flat flows as local and alternative wealth managers capture the net new money Private banks’ focus on UHNW comes at the expense of the faster-growing “core millionaire” segment In spite of low growth, total profits are up 13 percent due to higher revenue margins in all product categories and flat costs – even though talent is becoming more expensive ƒ

ƒ

North American private banks experienced a third consecutive year of flat flows, but signs indicate that they are finally coming to terms with their new environment. Banks’ efforts to re-focus on core clients are beginning to pay off through higher revenues and profits. The industry’s recovery does remain tenuous: recent profit growth has been highly dependent on pricing and interest margin improvements rather than on sustainable broad-based asset accumulation. Moreover, increased competitive intensity from alternative and local wealth management players, and changes to consumer preferences will continue to challenge the sector. Private banks will need to find new pathways to growth to build on this year’s foundation.

Industry economics: Expanding profits despite zero growth
Overall AuM remained flat in 2011 as banks struggled to gather new assets – total net flows were just 1 percent of asset levels at the start of the year.2 There was no relief from market performance, which completely neutralized those inflows. As in Western Europe, a strong gain in the first half of the year was completely wiped out in the third and fourth quarters, as the effect of the European sovereign debt crisis took hold. Although assets were flat overall, the asset mix did shift as investors reacted to market swings. Equity investments fell slightly, to 36 percent of total assets. Balanced mandates were the biggest gainers – up 15 percent and accounting for 9 percent of assets. Alternative classes also grew strongly – up 8 percent – with that growth concentrated in hedge funds and structured products (each of which grew by 20 percent). Fixed-income investments saw a stable allocation of 26 percent of client assets whilst cash and cash equivalent investments rose by 11 percent, to reach 24 percent of total assets. Three important trends contributed to the overall flat flows, which have persisted since 2008. First, non-traditional players have invested heavily in the wealth management market and attracted clients with less than USD 10 million. Regional retail banks, independent financial advisors, and online players still hold less than 20 percent of total client assets but they have been capturing annual positive net flows of 5–8 percent since 2008. Given the flat flows for private banks, and negative flows for national brokerage firms, this means that alternative and local players have taken all the net flows over the past 3 years. Second, private banks are losing the “core millionaire” opportunity. In the wake of the financial crisis, private banks have focused on the very rich (>USD 10 million) to improve profitability. For the third consecutive year, these UHNW households have contributed positive net flows (1 percent in 2011 and 17 percent since 2008). But this focus has caused the banks to lose ground in the less wealthy segments. A small fraction of the
2 North American data is not yet completely collated, but is correct as of July 18th 2012.

McKinsey Private Banking Survey 2012 Finding a new footing

13

loss is due to an intentional purge of customers with less than USD 1 million, but 95 percent of the drop is due to outflows from the “core millionaire” segment, who hold USD 1 million-10 million in assets (down 4 percent in 2011). Ignoring these clients means missing an important growth opportunity. The core millionaires are projected to generate 60 percent of asset growth among all households with more than USD 1 million through to 2015. They also have investment revenue margins on average two to three times higher than the UHNW segment, and they make greater use of banking and lending products. Private banks will need to adapt their 3 business model in order to recapture this business. The third cause of flat flows was increased consumer consideration for “lighter” advisory models. The lack of consistently positive returns combined with low interest rates on deposits, has raised investor awareness of the high costs of private banks’ “full service” model. This is especially true for younger households that are entering private banking wealth bands for the first time. According to the Federal Reserve’s recently released Survey of Consumer Finance data, 80 percent of families headed by someone 35 or younger use the Internet for financial services. The full impact of this behavioral shift has yet to be felt fully, due to demographic trends. The same Federal Reserve survey also found that, for the first time, U.S. households headed by those 75 or older have the highest median net worth of any age cohort. Increasingly, the old and the wealthy are becoming one and the same, and these investors remain more likely to use advisors than their children or grandchildren. Nevertheless banks need to adapt their models to capture younger households today, or they will face a structural disadvantage as this generation comes to control a larger share of wealth. Despite little to no asset growth, private banks displayed impressive resilience in 2011. Total profits jumped 13 percent, the first significant increase since the financial crisis, and evidence that efforts to adjust business models are finally paying off. Profits are still 45 percent below pre-crisis levels, but this year’s results represent a meaningful step forward (Exhibit 5). The majority of this profit growth was generated by a 6 percent increase in revenue margins, a substantial increase given a stagnant asset base. Two factors drove most of the revenue improvement: improved pricing on investment assets, and higher income from banking and lending. Investment management revenue rose 7 percent in 2011. Considering lower total assets, the shift out of equity, and the stable share of managed assets, this rise could be an indication of better pricing discipline. Such an improvement is particularly impressive given that banks have essentially been replacing assets from the core millionaire segment referred to above, with assets from UHNW clients who tend to exert more pressure on banks’ pricing structures. Total interest-related income rose 4 percent, with the majority of growth coming from deposit interest revenues, which grew 9 percent. This reflected clients’ flight to the safety of cash deposits, as well as a slight improvement in deposit spreads. Lending volumes in 2011 remained flat, although net revenue from lending increased by 3 percent, primarily due to the lower fund transfer pricing required to finance loans.
3 See “A Tale of Two Millionaires,” McKinsey 2012, for more detail on how banks can approach this opportunity.

14

North America: Profits up 13%, but still far from pre-crisis levels
Net inflow Performance impact Cost-income ratio (percent)

Revenue margin Basis points

Profit margin Basis points

81

77

75

77

82

34
Profit pool Indexed at 2007

29

24
09 68

25
10 68

28
11 67

2007 08 Cost margin Basis points

09

10

11

2007 08 58 62 f()

100

64

47
09

49
10

55
11

Asset growth Percent 5 1 4 -25 2007 08 09 10 11 6 0 6 0 1 -1

47

48

51
09

52
10

53
11

2007 08

2007 08

Exhibit 5 Alongside the revenue growth, private banks’ shift to a leaner operating model began to pay off in 2011. Total operating expenses rose 1 percent (not including loan loss provisions), well below revenue growth. Compensation costs, of course, are a big part of the story. Private banks’ increased focus on UHNW households led to a 11 percent reduction in client-facing staff. However, increased competition between banks for these customers drove up the price of top talent and the average compensation costs of frontline roles increased by 11 percent. The net result was virtually no change in total frontline compensation. Revenue growth came without banks adding significant numbers of middle- and back-office staff. Total non-client-facing staff declined by less than 1 percent, while compensation costs edged up 1 percent. For the second consecutive year, management and functional headcount experienced relatively flat growth. Although non-compensation costs grew in line with the overall cost base, private banks significantly reduced costs in categories that indicate investment in growth: sales and marketing costs fell by 6 percent and IT costs by nearly 15 percent. Conversely, expenses grew in indirect cost areas – particularly non-IT back-office functions, corporate functions, and indirect allocated costs. These trends are worrying, as they suggest a significant expansion of expenses in functions and roles not directly related to revenue growth, at the expense of investment in the next wave of growth.

Market structure: A call for growth
The product margin improvements achieved in 2011 may be impressive, but they are not sufficient to sustain profit growth. Private banks are expected to return to addressing asset growth explicitly over the next 2 years. More than 85 percent of executive teams say they expect net flows to be the primary driver of revenue growth over the next 2 years, and the number of private banking customers to increase by 5 to 6 percent each year.

McKinsey Private Banking Survey 2012 Finding a new footing

15

To achieve sustained profit growth, North American private banks will need to innovate their business models to compete with other wealth managers. The overall market remains highly fragmented with classic private banks holding on to about 20 percent of the market as they have for a decade. Retail brokerages have seen their share gradually decline from 33 percent in 2001 to 27 percent in 2011, as problems in investment banking have led to ownership changes, new wealth management joint ventures, and the departure of some senior, high-value advisors. Most prominently, local and alternative wealth managers are gaining share at the expense of traditional providers, particularly among clients holding less than USD 10 million in assets. Three classes of wealth management players bear closer scrutiny: ƒ By 2015, independent advisors are expected to be managing USD 2.5 trillion in total assets, nearly twice the USD 1.3 trillion they managed in 2005, despite the financial crisis in the intervening decade. Consumers increasingly prefer such independent advice, as large banks’ reputation continues to suffer, and more and more third-party services are replicating the capabilities of large institutions. We also see the gradual consolidation of these independent advisors into a smaller number of large registered investment advisors (RIAs) that can effectively replicate the capabilities of larger institutions. A shift to self-directed wealth management services has been observed. Many clients, even in higher-income brackets, do not want a high-touch experience and many are willing to use self-service applications for simple tasks. Roughly half of U.S. investor households consider themselves “self-directed” and these households invest very substantial assets via direct channels. Attracted by fee-based wealth management revenues, regional banks have invested heavily in advisory offerings and are using their substantial branch networks and existing relationships with high-net-worth (HNW) clients to attract assets. These regional offerings are particularly strong outside the top 10 major financial centers, which are home to most private banks but only to one-third of HNW households. * * * North American banks seeking profit growth face four strategic imperatives. First, banks will need to consolidate profitability gains achieved in 2011 by exploring additional tactical revenue drivers (e.g., value-based pricing, banking product revenue growth). Second, banks need to focus on developing targeted value propositions and service models geared to specific behavioral client segments within the wealth bands they are targeting. Given the competitive and fragmented landscape, banks will need to be selective in terms of where to compete based on their natural strengths. Third, banks will need to focus on improving the relationship manager (RM) talent proposition without forfeiting recent profitability gains. Three-quarters of private bank executives say that frontline talent is their top priority for the next 2 years, which suggests an impending war for talent. Fourth, U.S. banks will need to control indirect costs and direct savings towards targeted investments in capabilities that differentiate them in the eyes of advisors and clients. Banks that can attract and retain relationship managers in a costefficient manner will be best positioned for profitable growth.

ƒ

ƒ

16

Asia: Growing fast but at a cost
ƒ ƒ Continued strong net inflows Profit margins drop to record lows due to high cost, but top players still extract very healthy margins Business and operating models need to differ substantially from those in the U.S. and Europe

ƒ

Asia is a high-growth region and thus represents a significant opportunity for local, regional, and international private banks. Because of its high potential, Asia has become a fiercely competitive market, and success will require banks to understand how to serve entrepreneurs and business owners effectively as well as to adopt innovative approaches towards attracting, developing and retaining top talent.

Industry economics: Heightened competition but highly varying performance
Asia (excluding Japan) is already a significant market, with more than USD 8 trillion in HNW personal financial assets (PFA) in 2011, equivalent to about 14 percent of the global total. It is also expected to be the fastest-growing region over the next 5 years, with HNW assets growing at 13–17 percent; China alone will contribute more than half of this growth. Private banking is only beginning to take hold in the region, managing about 20 percent of all HNW assets, but prevailing levels of wealth creation suggests strong growth potential. Asian private banking centers are benefiting from the re-allocation of international clients’ assets due to increasing customer interest in Asian markets and, to some extent, Asia: Profit margins continue to decline
Net inflow Performance impact Cost-income ratio (percent)

Revenue margin Basis points

109
Profit margin Basis points 35 20 Profit pool Indexed at 2007

99

88

84

78

15
9 83

14
10 84

2007

8

9

10

11

11
11 86

100

64

56
9

65

57

f()

2007 8 68 80

Cost margin Basis points

74

79

73

70

67

Asset growth Percent 24

2007

8

10

11

1 23

29 7

3
-26 -23

22 8 14

2007 2 9

8

9

10

11

22

-7

2007 08

09

10

11

Exhibit 6

McKinsey Private Banking Survey 2012 Finding a new footing

17

to the recent introduction of more stringent regulations in Europe and the U.S. There has been a large mutual fund inflow from developed markets to Asia since 2008, while the U.S. flow to Asia-related funds has doubled over the past 3 years. Asian private banks enjoyed 7–9 percent net inflows over this period. Many customers today see Hong Kong and Singapore as natural alternatives to the more traditional offshore private banking centers. Despite the growth rates, average profit margins in Asia continue to decline. They dropped from 14 bp in 2010 to 11 bp in 2011. This is primarily due to the drop in revenue margins, which fell significantly from 84 bp in 2007 to 78 bp in 2011, as private banking clients simplified their product portfolios and reduced their trading activity. Cost margins, although lower than in previous years, remain high at 67 bp. It is important to note that performance varies enormously, and the best-performing players have been able to achieve very healthy profit margins, in excess of 30 bp, by successfully differentiating their offering by segment and having the scale to serve the HNW segment cost-effectively. Overall, total profits in 2011 are only 58 percent of what they were in 2007, although they are marginally up on the 2009 total (Exhibit 6).

Market structure: Time to invest in the potential of onshore
The onshore market generates lower returns on assets than the offshore model. Nevertheless, its potential – especially in the HNW segment – is much larger over time. A private bank investing in key Asian onshore markets (e.g., Taiwan or China) could see a positive knock-on effect, as onshore customers spill over to the more profitable offshore business. The result could be similar revenue levels off- and onshore in 8 to 10 years, depending on regulatory trends. The challenge for private banks is to balance lower short-term returns with the high up-front investment needed to capture this longer term potential revenue. A prime driver for affluent and HNW individuals to move assets offshore is a specific business need. Most Asian HNW customers have more than three wealth management relationships and place increasing importance on having a relationship manager who understands their needs (Exhibit 7). These factors suggest that banks need to address both personal and business needs more systematically. Many banks have a pool of highpotential customers whose wealth they do not fully capture. These customers appear as affluent or even mass affluent in the bank, but in fact have total wealth that would reach the HNW threshold. The cost-to-serve has increased significantly as both RM compensation and compliance costs have risen. Despite these rising costs, RMs are becoming less productive in the face of less entrenched client relationships, which make it harder for them to capture client assets. The average AuM per RM in Asia is about 20 percent below the European average. Banks targeting the fast-growing Asian market need to decide which segments to target, which markets to operate in, and how to make the economics work. Trying to be everything to everyone is not a sustainable model. Segments could be divided by wealth band (e.g., UHNW with >USD 30m or HNW with USD 1m to 30m); by origin of flows (e.g., Chinese, Southeast Asian, non-resident Indian, or Middle Eastern flows); or by their special requirements (e.g., small business owners, large family offices).

18

Asia: Investment services and relationship manager quality are key
What is most important factor when choosing a wealth manager? Percent; n = 112 Within investment services, what is most important to you? Percent (multiple answers allowed); n = 73

Investment services Institutional characteristics Product offering Value-added planning Access 7

37

RM who thoroughly understands customer needs Professional product and service specialists

70

22

51

21
Integrated investment solutions

49

13

Wide range of research

47

Exhibit 7 The natural geographic markets for a new entrant would be the offshore centers of Hong Kong and Singapore. But banks may want to target select onshore markets to tap into the higher growth rates in domestic wealth. Shrinking profit margins require banks to be particularly adroit in designing an operating model that is effective and efficient in deepening client relationships and delivering profitability. This means thinking about whether to adopt a high-touch or a more handsoff model; whether to be advisory-focused or product-driven; what type of relationship managers are needed, and how to train them; and determining what type of platform (product platform, compliance, etc.) would work. These decisions are especially important in Asia, where clients tend to be more transaction-focused, so classic hightouch private banking may not be the most appropriate model. In addition, given the variety of product needs of Asian clients, the development of an efficient platform (in compliance and product manufacturing) will determine how smooth client interactions are, and will drive a lot of a bank’s costs.

McKinsey Private Banking Survey 2012 Finding a new footing

19

Middle East: Attractive but increasingly competitive
ƒ ƒ ƒ Double-digit net inflows and healthy margins Regional players moving from “red carpet” offers to full private banking Onshore delivery becoming increasingly important

The Middle East has historically been a very attractive market for private banks. Particularly attractive are the six countries that form the Gulf Cooperation Council (GCC) – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. The GCC countries have enjoyed double-digit growth over the past few years both in terms of investible assets, as well as in the number of HNW and UHNW households. Investible assets for both segments in Saudi Arabia, the UAE, Kuwait and Qatar are expected to grow at 12-15 percent from 2012 to 2015. Government coffers have swelled thanks to high oil prices and increased production volumes. A growing share of this national wealth is being invested in developing the local economies, which in turn raises the incomes of the population at large, and affluent segments in particular.

Industry economics: Continuing to offer healthy margins
Total investible assets for the HNW and UHNW segments (excluding wealth locked into family-owned businesses) across the four countries mentioned above can be estimated at USD 850 billion. Around half of this is kept offshore, with that figure rising to 80 percent for Kuwait. Such wealth typically generates approximately USD 10 billion in revenues, split equally between invested assets and cash and cash equivalents. Although profit margins fell in 2009 as a result of the higher cost of deposits during the liquidity crisis, McKinsey data suggests that they recovered in 2010 to 60 bp and remained at that level in 2011. Middle Eastern margins are therefore significantly higher than in the rest of the world. The difference is driven by two factors. ƒ Local and regional players, which share a similar universal banking business model, benefited from the higher revenue margins associated with cash and lending. During 2010 HNW and UHNW investors in the region shifted back to cash and away from investment products, and banks started lending again to the most prominent families, without too much competition from international banks. In late 2009, the same local and regional private banks started reviewing their cost structures and focusing on improving efficiency, particularly in the middle and back office. The impact of such programs brought cost margins down from 47 bp in 2009 to 40 bp in 2010, although they have since crept up again in line with revenue margins.

ƒ

The average numbers mask significant differences between individual players, especially on the revenue side. Private banks have benefited over the past 12 to 18 months from an increase in lending to HNW investors, while pressures to reduce costs have eased. AuM growth has fallen slightly from its 2010 level, but net inflows are still at double-digit levels. Some of these inflows are the result of the more stringent regulatory environment in Europe, but repatriation and conversion of AuM held in investment portfolios offshore into more liquid alternatives onshore has also occurred. These moves reflect lower risk appetite among investors but also their desire to take advantage of attractive investment opportunities in the region.

20

Market structure: Competition intensifies
The dynamics of wealth management in the GCC are creating opportunities that private banks should capture whether they are established local players or international banks striving to establish a presence. Over the next 10 years, we expect intergenerational wealth transfer to continue, encompassing both family-owned businesses as well as managed wealth. This trend may lead not only to assets becoming fragmented as they are divided between heirs, but also to a fundamental shift in the needs and preferences of clients as the younger, more financially sophisticated generation begins dealing with private banks. Already more offices have been established that professionally manage the wealth of the most prominent families and there is stronger demand for better frontline skills and service delivery. Both local and regional banks are rising to the challenge of serving private banking clients, making the Middle East a much more competitive region. Traditionally, most of these banks would capture client business in cash and cash equivalents, and focus on providing a “red carpet” service to HNW and UHNW clients (i.e., basic banking with a limited wealth management offering). This approach is rapidly changing. A number of local players, mostly the large universal banks, have started to assemble sizeable private banking teams and their offers are based on their deep knowledge of the region, longstanding relationships, and their lending capabilities. The Middle East remains a classic offshore private banking market served primarily out of London and Switzerland. However, some HNW and UHNW investors are starting to look for private banking services from alternative centers such as Singapore and Hong Kong, particularly given the uncertainty regarding regulation and the impact it may have on private banks operating in traditional European offshore booking centers. Within the region, the Arab Spring has also led to money moving from North Africa and the Levant to regional safe havens such as Dubai. In fact, Dubai is gradually emerging as an offshore center able to attract funds beyond the Gulf. Meanwhile, onshore operations are becoming more important, especially for players wanting to serve the lower wealth segments (between USD 1 million and 10 million in PFA). These players need a team of relationship managers who are deeply rooted in these markets.

McKinsey Private Banking Survey 2012 Finding a new footing

21

Priorities for finding a new footing
Private banking has become more demanding and banks need to secure their foothold in this competitive market. Those that fail risk slipping further and further down, and the indications are that the summit of sustainable success no longer has room for everyone. Private banks that aspire to become (or remain) leaders need to adapt their offering and delivery model, increase efficiency, and carefully choose both the markets and customer segments they serve. We see three priorities for banks: ƒ ƒ ƒ Capture the emerging markets opportunity Rethink the value proposition in the context of the new regulatory environment Take operational initiatives to restore profitability

Capture the emerging markets opportunity
We have already seen that Asia and the Middle East are two markets of critical importance for private banking. Both are attractive in terms of existing and expected wealth, and thus are crucial for banks seeking growth and profitability. The same rationale applies to Latin America and Eastern Europe. They all have different market dynamics, but Asia and the Middle East in particular share two challenges: serving the needs of the business owner/entrepreneur segment, and attracting and retaining top talent, particularly in the front line. Business owners and entrepreneurs typically have personal financial needs that are intertwined with those of their businesses. Private banks will therefore need to develop solutions that combine personal wealth management with the growth of these entrepreneurs’ businesses. Local banks have tended to focus on high-touch service for these clients, but have only offered them basic banking services. International players, meanwhile, have pushed their full spectrum of wealth management services but have failed to address their critical business needs. Recently, we have seen more integrated “merchant private banking” business models emerging, which offer a full suite of products and services targeted at entrepreneurs and family business owners, and include lending, corporate restructuring, and access to co-investment opportunities. For such a business model to work, banks must break down the barriers that often exist between corporate and private banking, and establish an effective coverage model that uses the knowledge and expertise of both units. Both local and international players in emerging markets struggle to attract and retain top talent, particularly at the front line. Given the relationship-driven model prominent in both Asia and the Middle East, private banks need to invest in defining a talent program (including development opportunities as well as an appropriate set of incentives and a performance management framework) that can appeal to top-caliber relationship managers and provide them with attractive long-term careers. The talent pool is limited and large variations in relationship manager performance are observed (according to previous survey data, significantly greater performance variations are present than in

22

developed markets). To address these factors, banks will have to institutionalize frontline capabilities to achieve improved consistency and effectiveness.

Rethink the value proposition in the context of the new regulatory environment
Today’s regulatory wave seems the most stringent the industry has had to face. Previously, private banking had to address one issue at a time, and typically at a local level. Now, regulatory initiatives are affecting many different aspects of how banks operate regionally and globally. Some banks, notably in the U.S., will see benefits; others may find the new environment challenging. Uncertainty remains around the final impact and timeline of the latest initiatives, but they can be grouped into three types: ƒ Consumer protection. These initiatives seek to increase transparency around fees and the risks associated with investment products. They include both local (e.g., RDR) and international (e.g., MiFID 2) regulations. The expected impact on private banks is a drop in profit margin related to the potential ban of inducements, as well as an increased cost-of-sales. It seems at the moment as though the decision to ban inducements will remain a local issue, although several countries are already moving in that direction. Bank stability. Initiatives such as Basel III aim to reinforce banks’ balance sheets. In the quest for more liquidity and capital, private banks that are part of universal banks will suffer from a distorted asset allocation (fewer investments, more cash holdings) leading to overall lower revenues, despite the liquidity premiums paid to some private banking units by the group’s treasury function. Tax compliance. Government deficits have accelerated the hunt for non-taxcompliant customers. Double-taxation agreements will lead to clients moving assets out of high-margin offshore locations, while regulations such as FATCA will raise costs. This would become more challenging if countries outside the U.S. pushed similar initiatives.

ƒ

ƒ

Banks need to go beyond simply complying with the new regulations. They need to consider how to redefine their value proposition in this regulatory environment. We see three approaches: ƒ Review the booking center set-up and geographic footprint. Our survey shows that a booking center with assets of more than EUR 10 billion has a cost margin 30 percent lower than one with assets of less than EUR 5 billion. In Western Europe, this gap has widened since 2007. Regulatory changes are likely to drive up the minimum scale at which private banks can operate, given increasing capital requirements and the cost of ensuring regulatory compliance. To ensure sufficient scale in selected regions, while of course guaranteeing that individual relationship managers have the local knowledge they need, private banks will have to review which clients they serve with which teams. Redefine the advisory model. Regulatory changes may also hurry in pricing schemes that favor the investor paying advisory fees for access to research,

ƒ

McKinsey Private Banking Survey 2012 Finding a new footing

23

investment advice, and regular reporting. This will require banks to rethink (or in some cases set up) their advisory process, and to deploy the required skills, internal organization and advisory tools that will let them truly differentiate themselves. A stronger investment function is needed, with a more direct link to relationship managers and clients. The focus of product management will also have to shift toward the creation of solutions that fit client needs. Some countries have anticipated the move towards fee-based advisory services, such as India and the Netherlands, but it is still unclear whether this model can compensate for the loss of inducements or will even be accepted by investors in the first place. ƒ Change frontline management. Relationship managers need to be more knowledgeable about investment restrictions and understand how to serve different types of clients in different markets. Given the higher compliance risks, it is essential that desk heads manage their teams more closely, both in terms of pushing for more active client servicing as well as in managing the risks associated with implementing new regulations. The new environment will definitely require more coaching and collaboration.

Take operational initiatives to restore profitability
If today’s revenue margins are the “new normal,” as the authors of this paper believe, then banks will be forced to work on restoring profitability. There are two important ways to achieve this: adapt pricing to strengthen revenues; and deliver operational excellence. Pricing Boosting profitability in the short term Many banks have already undertaken pricing efforts – some under regulatory pressure (e.g., RDR in the U.K.), some under margin pressure. Pricing might look like an easy fix, but few banks deliver its full potential. Obvious actions, such as changing the price list or targeting commercial and technical leakages, are not as simple to implement as banks initially think. They hope to see a 10-15 bp impact on revenue margins, but frontline resistance and limitations in establishing transparency frequently hamper such efforts. It is also difficult to maintain momentum in pricing projects: banks start enthusiastically but the energy can soon dissipate. In McKinsey’s experience, success in pricing projects involves rethinking the pricing strategy along with the target value proposition of the bank, focusing on five actions: ƒ Involve frontline and other stakeholders (finance, operations) from the outset to ensure buy-in for the overall project. Model the impact of pricing changes on individual clients to anticipate the real cumulative effect. Typically, the impact is very different from one client to another so this modeling is key to decide whether or not the pricing strategy is realistic and sustainable, at both the overall and client level. Rigorously plan implementation to maintain momentum, track progress, and ensure quick wins to help celebrate success.

ƒ

ƒ

24

ƒ

Extensively train and support the frontline to ensure the impact is realized (explain the new price list and how to present it to clients, answer their questions, and fix objectives in terms of rebates with the team leader). During the whole process, ensure sufficient commitment and attention from management to emphasize the importance of the project and communicate to the whole bank that it is a priority.

ƒ

Operational excellence Drive longer-term profitability and growth Private banks have plenty of room for improvement in the front, middle, and back office, both in terms of operations and people. The level of sales and advisory skills as well as overall RM performance varies enormously from bank to bank and within banks. Some clients have less than one contact with their RM per year; RMs tend to spend too much time on administrative tasks; they waste time on unnecessary tasks; fail to follow standard processes (if they even exist); and performance management as well as coaching are underdeveloped. Best practices are little shared, even within the same team. With so much room for improvement, banks should start by focusing on measures with the greatest impact. ƒ Eliminate waste in end-to-end processes, shorten lead times, standardize operating procedures and tighten performance management; typical impact: 15–30 percent in efficiency gains. Double client-facing time by reducing waste and administrative tasks in the front office, standardize the advisory processes, upgrade RM skills and, improve the way people work together; typical impact: 15–20 percent revenue increase per RM. Treble RMs’ time with prospective clients by segmenting the value propositions and client service models, and upgrading acquisition skills through extensive coaching; typical impact: 5–15 percent net new assets increase per RM.

ƒ

ƒ

The journey to operational excellence is about initiating a cultural change revolution at the front-line and throughout the entire bank. To realize the full potential, banks need to focus on several areas simultaneously: (i) always have the voice of the customer in mind; (ii) perform efficient advisory and service processes; (iii) manage staff performance; (iv) organize and improve staff skills, and (v) align organizational mindsets and behaviors (Exhibit 8). Alongside these pricing and operational excellence initiatives, leading private banking groups have started to prepare for a more permanent low margin environment by considering more structural levers including the optimization of their platforms across markets and the value chain.

McKinsey Private Banking Survey 2012 Finding a new footing

25

Five elements for bringing operational excellence to the frontline
B Perform efficient advisory and service processes ▪ Actively advise on broad mix of products and services in line with needs and customer potential ▪ Perform service processes to meet customer needs, as needed, with relevant quality and at lowest possible cost D Organize and up-skill staff Optimize roles and responsibilities as well as capability building to meet customer needs at the lowest possible cost Manage staff performance Continuously coach, challenge and improve delivery of customer services through structured and focused approach A Voice of the customer Align mindset and behaviors Work individually and collectively to put the customer at the heart of the business E C

Understand and deliver to the true needs of the customers in each interaction

Exhibit 8

* * * In 2011, private banks faced yet another difficult year with low margins and negative market performance. The road to profitability and growth will likely remain bumpy due to a wide range of present and arising challenges. The new footing that private banks will need to attain success can only be achieved by those willing to invest in addressing the challenges and adapting accordingly.

26

Disclaimer
McKinsey & Company’s annual Private Banking Survey, first launched in 2002, seeks to provide comprehensive information on the industry. The survey now covers all of Europe, the Middle East, Asia and North America. The total number of banks participating in the survey has increased to more than 160. This document gives an overview of the latest survey’s key findings. The issues it raises are discussed in more detail in other McKinsey publications and at regular events held by McKinsey’s Private Banking practice. The participating banks cover a range of sizes and business models, and all regions are well represented. Three-quarters are private banking units of universal banks, and the remainder are specialist players. Approximately 70 percent operate onshore and 30 percent are based in offshore centers. The banks provided detailed economic data based on their 2011 results, as well as qualitative data on their organization, product and service offering, delivery model, risk management procedures, and cost-management efforts. Players allocate revenues and costs within their private banking operations and between their private banking activities and parent companies in different ways. These differences have been clarified as much as possible through interviews with the participants, but some variations may nevertheless remain and may distort the final results. The increased number of participants this year may also induce a slight sample bias on occasion, affecting the comparability of this year’s results with those of previous years. Sample comparisons have been made where appropriate. Survey participants are entitled to customized benchmarking and feedback sessions and have access to more detailed information than that presented here, but within the bounds of confidentiality governing the data supplied by individual participants. McKinsey would like to thank everyone who has participated in the 2012 survey for their valuable contributions, which will help us to gain a better understanding of the economics surrounding the private banking industry. The survey will run again in 2013.

McKinsey Private Banking Survey 2012 Finding a new footing

27

Authors
EUROPE Frédéric Vandenberghe Director, Brussels +32 (2) 645 4189 frederic_vandenberghe@mckinsey.com Felix Wenger Director, Zurich +41 (44) 876 8444 felix_wenger@mckinsey.com Jens Hagel Partner, Vienna +43 (1) 5370 6102 jens_hagel@mckinsey.com Sébastien Lacroix Partner, Paris +33 (1) 4069 9325 sebastien_lacroix@mckinsey.com MIDDLE EAST Hans-Martin Stockmeier Director, Dubai +971 (4) 312 4568 hans-martin_stockmeier@mckinsey.com Gemma D’Auria Partner, Dubai +971 (4) 389 9256 gemma_dauria@mckinsey.com NORTH AMERICA Salim Ramji Director, New York +1 (212) 446 7393 salim_ramji@mckinsey.com Pooneh Baghai Director, Toronto +1 (416) 313 3939 pooneh_baghai@mckinsey.com Jill Zucker Partner, New York +1 (212) 446 7989 jill_zucker@mckinsey.com ASIA Naveen Tahilyani Director, Mumbai +91 98201 45651 naveen_tahilyani@mckinsey.com Kenny Lam Partner, Hong Kong +85 (22) 846 2011 kenny_lam@mckinsey.com Jared Shu Associate Partner, Hong Kong +85 (22) 846 2073 jared_shu@mckinsey.com

* * * For their valuable contributions to this global survey, our special thanks go to the following colleagues: Thomas Briot, Aastha Chandhok, Erwin Daems, Daniel Gourvitch, Owen Jones, Paul Midy, Luigi Moriconi, Michael Rogenmoser, David Ryan, Sofia Santos, Saurabh Trehan, Lukas Vogt, and Christina Widmer. * * * For any queries regarding this publication, you can contact the members of McKinsey’s Private Banking Survey team through Private_Banking_Survey@mckinsey.com

McKinsey Banking Practice July 2012 Copyright © McKinsey & Company www.mckinsey.com