Bloomberg News

UBS’s Ermotti to Woo Investors by Shrinking Investment Bank

November 18, 2011

(Updates with Kurer commentary in 10th paragraph.)

Nov. 16 (Bloomberg) -- Sergio Ermotti won over UBS AG’s board to get the chief executive officer post. Now he has to convince investors that the fifth reorganization of the firm’s investment bank in six years will succeed.

Ermotti, 51, who took over after a $2.3 billion loss from unauthorized trading led CEO Oswald Gruebel to quit, will lay out the bank’s strategy to investors at a meeting in New York tomorrow. Analysts predict deeper cuts in assets and jobs at the investment bank, especially in fixed-income trading, where rising capital requirements are eroding profitability.

“They’ve got to scale down the fixed-income business, otherwise they die,” said Christopher Wheeler, a London-based analyst at Mediobanca SpA. “Nobody has voluntarily shrunk their investment bank to the extent that they’ll have to do. It is a very tricky job and execution is what worries me most.”

The shift in strategy coincides with another round of management upheaval at Zurich-based UBS, which was ravaged by more than $57 billion of credit-related losses during the financial crisis of 2008. Mediobanca’s Wheeler cut his rating on UBS to “underperform” from “outperform” after the September departure of Gruebel, 67. Chairman Kaspar Villiger is leaving in 2012, a year earlier than planned, to make way for former Bundesbank President Axel Weber in the role.

Question of Communication

Tom Naratil became chief financial officer in June, replacing John Cryan, after serving as CFO and chief risk officer of UBS’s wealth management Americas unit. Maureen Miskovic, a former risk officer at Boston-based State Street Corp. and Lehman Brothers Holdings Inc. of New York, took over as group chief risk officer in January.

“It’s more a question of how they communicate rather than what they communicate” at the investor day, said Matthew Clark, a London-based analyst at Keefe, Bruyette & Woods Ltd. “There have been a lot of senior management changes. It’s more important for the management to convince the market of their authority.”

UBS shares rose 0.8 percent to 10.71 francs by 10:29 a.m. in Swiss trading. They have declined 30 percent this year, compared with a 33 percent drop in the 46-company Bloomberg Europe Banks and Financial Services Index. The stock gained 5.8 percent since Gruebel’s departure.

Ermotti, who was confirmed in the CEO post yesterday after serving in an interim role since September, told reporters the bank’s strategy “will be centered on our leading wealth management businesses and our position as the strongest universal bank in Switzerland.” The investment bank will be “focused, less complex and less capital intensive,” he added.

He declined to be interviewed for this article.

Split-Up?

Former UBS Chairman Peter Kurer, in a commentary for Bloomberg View today, said UBS and Credit Suisse Group AG should split off their investment banks to regain the trust of investors and clients.

“The only way to regain trust on a sustainable basis, is to separate the investment bank from the retail and private-banking units,” wrote Kurer, 62. He said investment-banking units need to be “independently governed, funded and capitalized.”

The $2.3 billion trading loss the bank discovered in September heightened investors’ impatience with the securities business. Ermotti may tell investors Zurich-based UBS will slash the investment bank’s risk-weighted assets by 70 billion francs ($76.5 billion), on top of 100 billion francs in cuts already announced, and reduce staff at the unit, according to the average estimate of analysts at Morgan Stanley, JPMorgan Chase & Co., Mediobanca and Citigroup Inc.

Higher Profitability

Asset cuts on that scale, together with a further 1,700 job reductions, may enable the bank to raise the unit’s return on equity to 17 percent by 2013, JPMorgan analyst Kian Abouhossein estimated. Without such a reorganization, the unit’s ROE, a measure of profitability, may fall as low as 7 percent that year, according to his estimates.

The bank, which announced 3,500 job cuts in August, including about 1,575 at the securities unit, will maintain “cost control,” Villiger, 70, said in an interview yesterday, adding he can’t rule out further reductions in staff levels. UBS wants to maintain top positions in foreign exchange, equities, underwriting and merger advice, while it may exit or scale down some other businesses, he said.

UBS may shrink its rates and structured credit units to one-third of their current size, exit the commodities business and slim the credit trading unit by about 20 percent, Abouhossein said. UBS is unlikely to reorganize its equities business, which is where the trading loss occurred, he said.

Repeated Restructurings

“Ultimately the more aggressive in cutting fixed income you are, the better,” said Abouhossein, who has an “overweight” rating on UBS. “I don’t believe that you really need a big fixed-income business to support the private bank.”

About three-quarters of risk-weighted assets by business under the new Basel III rules resided at the investment bank, according to a pro-forma calculation for June 30. That portion will be reduced to about half of the company’s total, Naratil’s presentation slides showed last month.

The investment bank has gone through repeated expansions and contractions since 2006, when under the leadership of Huw Jenkins -- who replaced John Costas as the latter went to start an internal hedge fund -- the company decided to expand its fixed-income business and invest in, among other things, U.S. mortgage securities and collateralized debt obligations. That strategy backfired as the contagion from the U.S. subprime crisis spread, leaving UBS with record writedowns and losses.

Lehman Collapse

In August 2007, UBS replaced Simon Bunce as head of fixed income with Andre Esteves, who previously ran Latin America. In October of that year, Jenkins stepped down, leaving the investment bank in the hands of then-CEO Marcel Rohner, who announced a plan to shrink the securitization businesses in the U.S. and 1,500 job cuts.

UBS hired Jerker Johansson the following year to lead the investment bank, and he initiated another reorganization and further staff reductions, also taking over the fixed-income business from Esteves. His target was to return the investment bank to a pretax profit of about 4 billion francs in 2009 -- a goal that was buried when the bankruptcy of Lehman Brothers shook markets in September 2008.

Gruebel, who joined UBS out of retirement in February 2009, replaced Johansson in April of that year with Carsten Kengeter, who had just been hired as co-head of fixed-income from Goldman Sachs Group Inc., and UBS veteran Alexander Wilmot-Sitwell. More jobs were eliminated before they embarked on an expansion aimed at boosting the unit’s pretax profit to 6 billion francs by 2014. UBS abandoned the target in July.

Kengeter, 44, who’s now sole head of the investment bank, will present the unit’s strategy in New York tomorrow.

Stretched Ambitions

“UBS’s ambitions had clearly been stretched,” Citigroup analysts led by Kinner Lakhani said in a note. As UBS scales back in fixed income the key risk is “execution and retaining the right talent to see the process through,” they said.

UBS isn’t alone in shrinking is securities arm. Zurich- based Credit Suisse Group AG, Switzerland’s second-largest bank, said earlier this month it will eliminate about 1,500 positions, in addition to 2,000 announced in July, and trim risk-weighted assets by 110 billion francs, including almost 100 billion francs at the fixed-income unit, by the end of 2014.

‘Painful’ Journey

“Until now, at many firms, a lot of investment bankers have been convinced that we are living now in a limited period where things are a bit more difficult and afterwards the old world will come back,” Villiger said. “This illusion has now vanished, and our people and at other banks feel that something has changed and we have to tackle that. Execution will be key.”

European banks may seek to shrink assets by 1.5 trillion euros ($2 trillion) to 2.5 trillion euros over the next 18 months, making UBS’s plan more difficult to execute, Morgan Stanley analysts Huw van Steenis and Hubert Lam said in a note.

“Although investors should like the destination, the pathway could be painful in a challenging market,” wrote the analysts, who have an “equal-weight” rating on UBS. “Downsizing the investment bank will be a multi-year process, risking staff and further cost cuts, hitting both revenues and restructuring charges. The execution risk may be underestimated.”

Credit Suisse said it expects to lose about 1.1 billion francs in annual revenue by cutting about 100 billion francs of risk-weighted assets at the investment bank. Exit costs, including legal and administrative expenses for renegotiating contracts, may amount to another 1.5 percent of risk-weighted assets, said Dirk Becker, a Frankfurt-based analyst at Kepler Capital Markets.

“Downsizing is certainly easier than building, but I think many underestimate how long something like that takes and how expensive it is,” said Becker, who has a “hold” rating on UBS. “If you count the exit costs, revenue loss, plus possibly unfavorable trading environment, it could well be that there won’t be enough left for a profit at UBS’s investment bank. That’s the price you pay for getting out of businesses.”

--With assistance by David Henry in Frankfurt. Editors: Frank Connelly, Stephen Taylor

To contact the reporter on this story: Elena Logutenkova in Zurich at elogutenkova@bloomberg.net

To contact the editor responsible for this story: Frank Connelly at fconnelly@bloomberg.net


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