Inflated earnings due to the windfall of higher interest margins are driving up valuations of private banks and external asset managers beyond historical averages, making buyers reluctant to pay for temporary situations, Ray Soudah, Chairman at Millenium Associates, writes in his article for finews.com.

The majority of M&A, strategy, auditing, and accounting advisers in Switzerland have long predicted large numbers of M&A transactions leading to an overdue consolidation. The reasoning behind this prediction is sound; higher compliance and technology costs, intense competition, lack of economies of scale, and new licensing requirements, especially for external asset managers (EAMs), have all had an influence. But consolidation has not happened at the rate expected, surprising advisers and regulators alike.

Indeed, the Swiss Financial Market Supervisory Authority’s (Finma) incremental licensing requirements (a process still not fully completed for EAMs) have not led to any significant flow of mergers and or acquisitions from firms struggling to meet expectations. The regulators, in particular, had hoped, and still hope, for a reduction in the large number of private banks and wealth managers still operating in the sector.

Equally, the continued existence and a large number of smaller private banks still operating have continued to defy regular predictions of a flurry of mergers or sales. In fact, in 2023, almost no private banks were sold or bought (with the notable exception of the forced takeover of huge wealth manager Credit Suisse by its rival UBS).

Invisible Barrier to Consolidation

Ironically, the authorities, regulators, and central banks are the primary cause of the lag or lack of consolidation. Furthermore, the culture of the clients and operating participants in the sector is an invisible barrier to consolidation.

Many central banks, including the Swiss National Bank (SNB), dramatically and drastically reduced interest rates to support their economies before, during, and as a reaction to the pandemic. Additionally, finance ministries provided fiscal stimulus through the financial support granted to companies, especially small and medium enterprises (SMEs) and individuals.

But such help ironically also indirectly supported smaller institutions and their clients. In addition, stock markets generally held up well during the pandemic, and as a result, earnings in the financial sector did well, in some cases surprising even the shareholders and management of private banks and wealth managers.

Saving Grace

In fact, lower interest rates effectively subsidized private banks’ and wealth managers’ funding costs and excused them from paying their depositors fairly; many clients were charged negative interest rates for placing their cash funds with banks for custody.

Unknown to the authorities, and even the management of the wealth sector, this was the saving grace and invisible helping hand that kept many afloat. «We do not want your cash, but please buy funds or securities from us,» was the message from independent asset managers and private banks. Some private banks limited the size of deposits they would accept from any client, in most major currencies to boot. This era of cheap money was another example of authorities and central banks ‘doing whatever it takes and for however long is necessary’ to hold up their economies and financial institutions.

Monetary Shock

It could be argued, therefore, that central banks, including the highly respected SNB, were, in effect, responsible for partially being the cause of the lack of consolidation in the Swiss financial sector.

But all that changed, and forecasters again announced the imminent wave of M&A when inflation raised its ugly head following the end of the pandemic and then the impact of the Russian invasion of Ukraine on energy and food prices.

Central banks, including the SNB, rushed to raise interest rates to extremely high levels, moving from negative real rates to almost positive real rates. In fact, they announced they were now suddenly doing «whatever it takes, for however long it takes» to lower inflation through monetary tools. They essentially curtailed credit extension and encouraged deposit flows into the banking sector. However, private banks and wealth managers took advantage of the monetary shock to consumers and did not pass on the higher cost of funds to their depositors, resulting in huge windfall profits almost by accident to the sector, which did nothing to deserve such enrichment.

Another Irony

Indeed, analysis of the earnings during 2023 shows huge profit increases – primarily due to the wider interest margins enjoyed, and at the expense of their clients who were told, «Stay more in cash, it is safer for you in this dangerous geopolitical high-inflation environment». In another irony, stock markets held up and even gained, further increasing revenue fees of private banks and independent asset managers and giving more power to their bottom lines. Clients lost out for sure again.

Consequently, consolidation did not materialize as the earnings of the sector improved. Again, central banks had rescued the sector – there was no motivation to merge or sell when enjoying wonderful earnings!

The strength of the franc (CHF) and its lower interest margins was not enough to stop these phenomena, and in fact, a huge portion of assets under management (AUM) in Switzerland were, and continue to be, in non-CHF major currencies whose interest margins are greater than those in Switzerland, further supporting the sector.

Facing Reality

However, central banks are not the only actors indirectly blocking M&A activity in Switzerland. Cultural issues and financial rewards in the sector continue to cause hesitation. In particular, the attitudes of owners and management of firms and private banks, especially EAMs (who are often said to face succession issues), are to blame. Enjoying a relatively free and profitable lifestyle, essentially an elite in the financial sector compared to commercial and retail banking, the associated executives and relationship managers cherish their independence, high earnings, and lack of bureaucracy found in the larger institutions.

Even in Credit Suisse before its demise, the management and board hesitated to face reality as they cherished their independence, overlooking their exposure to external events that were impacting their survival chances. Ironically UBS, which was itself rescued by the SNB, was the only one to come to the rescue. Credit Suisse itself had declined government help during the previous financial crisis.

In many attempted M&A cases, such barriers occurred and continue to occur due to the fear of losing such elite status and lifestyle benefits. Some owners simply expect to be overpaid and left alone. Furthermore, the currently inflated earnings due to the windfall of higher than historical interest margins, inflate the valuations of private banks and independent asset managers beyond historical averages, thus causing buyer hesitation to pay up for temporary situations.

Superior to the Others

Looking ahead, what can be expected in the sector? The majority of private banks and wealth managers proudly announce that they are ready, willing, and able to buy their rivals because they have platforms with surplus capacity and surplus capital to employ. They assume they are superior to the others and deserve to be the ones to buy up and consolidate. This one-sided market is somewhat a fiction as when it comes to actual, albeit few, opportunities; the devil is in the details, and most deals fail to materialize due to a variety of structural and cultural issues as well as overpriced valuation expectations of the sellers.

Furthermore, digital entrants are nibbling away at traditional banks’ business, pressuring the banks to want to acquire their rivals. Even the cantonal banks are increasing their desire to grow private banking businesses. All these factors induce further demand to buy, but sellers are unwilling to sell as they see no reason to unless a stupidly high price is offered.

Ray Soudah founded Millenium Associates in 2000, an independent firm specializing in M&A and strategic advice for the global financial services industry focusing on wealth management. He held various senior positions within Citigroup and Midland Montagu Investment Banking. Subsequently, he was with the National Bank of Bahrain and Cedel Bank (renamed Clearstream). Later, from 1998 to 2000 he was a Managing Director and member of the Private Banking Management Board for SBC/UBS. There he created and led the corporate strategic acquisition and development team in asset/wealth management and private banking. He is a Harvard Business School & INSEAD Alumnus.