The private banking sector has had a roller-coaster ride over the last couple of years. Long a stable, predictable and relatively obscure pa...

The private banking sector has had a roller-coaster ride over the last couple of years. Long a stable, predictable and relatively obscure part of the financial sector, it has experienced a massive surge of clientele, the consequent gold rush to supposed easy pickings, an unprecedented global drive towards transparency resulting in a flight to new locations and, critically, unimpressive or negative asset growth. On top of what was largely unimaginable has been grafted an ambition so far unrequited.

Against this backdrop, the private bank scene is clearly changing. Clients are either dying off or skipping down a generation, in many cases to more attentive, more knowledgeable and more demanding sons and (less often) daughters. Providers see more-complex instruments and alternative investments post 9/11 as the key to unlocking elusive wallets. Brasher (often US-based) competitors are more open about services, more aggressive in promoting them without the conventional distaste for advertising and more experimental with multi-provider aggregation and performance-related (and downright lower) fees.

And, of course, there is technology and the internet.

Private banking economics 2002: the squeeze

A large part of many private banks' revenue is an openly advertised percentage of each client's assets under management. This is fine for a rising market. It ensures good revenue flow for the bank and, long term, more than counterbalances inflation. A neat trick. But of course, when AUM falls, revenues fall.

Revenue growth through expansion is no easier. Organic growth is blocked by the difficulties of acquiring clients and by private bankers being not so easy to find, or rear, or even keep. Merger and acquisition opportunities are scarcer than in other industries and recent consolidation shows the ripest cherries have been picked.

Costs are doing what they do best: rising. The primary cost to a private bank is its precious private bankers — not only salaries (rarely low) but also the associated travel, entertaining, and the support infrastructure of juniors and assistants.

Add to these rising costs, the cost of compliance. In the UK, the Centre for Study of Financial Innovation complains that the City has been 'sold a pup' — i.e., the massive upheaval and a huge increases in costs caused by new compliance regimes for banks. Globally, groups such as Transparency International and the Financial Action Task Force and the resultant Wolfsberg anti-money laundering principles have effectively created what may be the first worldwide (albeit voluntary) regulatory body. Not all banks subscribe, but those that do so have to apply the principles within all countries they operate in. They will then put pressure on the less-regulated countries to level up.

Late in 1999, one private bank's Miami operation had to all but suspend operations for a year in order to satisfy Federal requirements. This included dispatching private bankers to Colombia to photograph clients' cows! I know of private banks in the UK who even resorted to private investigators to verify the source of prospective clients' monies. Even though it's a little while since Abacha, Houphouet and Babangida reputedly laundered more than $10bn through the system between them, the costly dirty image persists.

I asked a private banker in July 2002 if paperwork was breaking his back. "It's broken," he said.

The industry effect of this is not just an inconvenience and cost to recruiting new clients but a clear transfer of money away from the 'big' centres in Switzerland, Luxembourg, London and various sunny islands towards the Far East and smaller centres. Presumably clients, whether their money is 'funny' or not, suppose the regulatory environment will change more slowly.

Fingers burnt by technology's white heat

Around 1999 many retail banks looked for a way to reduce volatility and improve their capital adequacy. Fee-based income is more valuable than loan-based income. They quickly turned to their sleepy private banking operations to balance their mainstream lending. They also glimpsed a wider market: asset management for their best retail customers and for corporate clients in a personal capacity, flatteringly rebadged 'wealth' management for the punters, but called 'mass affluents' inside the industry.

The first beneficiaries, as usual, were the consultants. Their impact on the banks was an overhaul of organisational structure and investment in IT. Against the drama of the ballooning internet global village (tragedy or comedy?) private banks' IT operations were to converge with, and gain benefits from, their central IT operation. Convergence in many places, however, means culture clash. The central departments, used to mass retail banking, had been using technology for years to (supposedly) reduce unit costs through standardisation. Any 'benefits' to customers were provided whether they wanted them or not. Private banks' IT staff, however, knew the strength of local custom and practice, the difficulty of segmenting the market and the impossibility of forcing service changes on clients.

Vision was not the hard part. The simplest idea was the internet as (finally) somewhere to advertise without being tacky. For actual clients, a 360-degree view of all their assets and services was assumed to be just the start. The more tantalising fantasy was of complementary internet-based reporting, but this carried the opposite worries of: overdo it: dilute valued personal relationships underdo it: be left behind as other providers get internet servicing right.

Temptingly around the corner was delivery of service by mobile telephone and interactive TV. Do you remember when WAP was king and SMS (now the fastest growing payment mechanism) old hat? And, of course, 2000/1 was when the rising asset stocks were ones in this very field.

In practice, of course, it was all that many organisations could do to deploy technology to create the reporting at all — never mind use the internet, whether in plain or fancy ways. Some organisations, especially the smaller and 'Swisser' ones, either could not or would not jump on the bandwagon, proclaiming the virtues of tradition. A certain smugness is now detectable.

In others, rising new appointees were pitched in. Amid radical organisational change and forgetting the disparate and largely manual existing systems, they announced wide-ranging plans and projects. Some succeeded, whether by luck or good management, and these are the providers who lead the field in functionality today. Many, however, did not.

Whether in a private bank heading downmarket or mass retailer climbing upmarket, failures litter the marketplace, especially the cyberspace. Nor did the often-cited new clicks-only entrants make the desired impression.

These mass affluent embarrassments have undermined many private banks' business cases for technology investments — whether internet or not — which were in the first place built mostly on faith.

The gold is there but the cupboard is bare

In a world where the disposable income of the private bank is being squeezed and technology investment is looking decidedly 'volatile' (both in the markets and as internal projects), private banks are reassessing their options.

Yet the market for private banking services is massive.

There are still more than 8,000 decamillionaires in the UK, almost eight per cent of the UK population have liquid assets of £30,000 to £200,000 and almost 5m people are forecast to have large cash reserves by 2004.

Worldwide, in households with net assets in excess of $250,000, the recession has destroyed an estimated $3trn of privately held assets, leaving total AUM at a mere $37trn.

The bottom line is that with a predicted annual growth for the wealth management industry of seven per cent and revenue of up to $600bn by 2006, no-one is likely to exit this market voluntarily, whatever the current difficulties, and the correct investment, including investment in technology, will reap rich rewards.

Global instability, though currently unremitting, is not permanent, though you may not think so to hear some commentators. 'Good times' will return, even if not for a year or more and not as good. Certain pockets of the market look almost promising: as an FT journalist put it recently, quite seriously, "there has been no sign of a financial crisis in Mexico for months".

Cost, maybe risk, maybe not-so-much income

The visionaries who upset the apple cart over the last few years focused, being visionaries, on income generation. They told of the brand new world, with new-economy enriched clients flocking to the hi-tech, hi-touch multi-channel private bank. Nothing much wrong with this as a vision, save not matching the world we became.

Therefore today's news is consolidation and cost cutting, with layoffs in private banking now being common — and not just for administrative staff.

The mantra to gain new clients and (more likely) attempt to retain clients is "improve front-end service". But it is dangerous to interpret this as meaning adding new functionality. Much as they would like this, more likely they mean getting the ones that are supposed to be there to work properly. Budget holders are spending — if at all — on operating procedures correctly. The concept of 'discipline' is emerging.

In terms of systems, the emphasis is on infrastructure plumbing and ensuring the back office is right. The front office is still seen as key but organisations are wary of investing further there — so far. Therefore, the conclusion is that, like almost every other industry in 2002, the drivers are cost and (to a lesser degree) risk, rather than income.

The basic equation for a private bank is:

profit = revenue-per-client x clients-per-PB x number-of-PBs — (costs-per-PB x number-of-PBs + back-office-costs)

Revenue-per-client is under competitive pressure and in the current market is unlikely to increase unless wallet share can be gained.

Most private banks' instincts are to reduce the number of clients-per-private-banker in order to increase service levels, so no fruit here: hope instead for better private banker productivity

The number-of-private-bankers is hard to increase, and many are actively decreasing it; costs-per-private-banker tend, similarly, to come with the territory. This leaves: back-office-costs.

Financial institutions are also increasingly concentrating on risk, as a result partly of recession but mostly of regulation. For private banks, however, the situation is in many ways simple and encouraging. Market risk? Credit risk? Not convinced.

Operational risk, however, is a real concern and it is vital to get the workflow and auditing right, to avoid jail terms under the most recent anti-terrorism and anti-money laundering rules. Even if we are less keen to invest for growth as our pockets are empty, new clients are always worth wooing and finding, and preventing defections is vital. Similarly, increasing share of wallet and stemming loss of wallet are key drivers. What can we do?

When the graphs point upwards, it is not so hard to convince a prospective client that putting (more of) his or her assets with your bank might be worth a shot. This year, many private bankers have had, perhaps for the first time, unhappy experiences of presenting less than exciting graphs to existing customers with explanations of apparent asset underperformance, and discovering the pain of trying to rope new clients in using sad-looking performance curves.

Aside from rushing into hedge funds (attractive now but will they seem so attractive if markets begin to rise again?), the best performing wealth institutions are also looking for ways to market their funds and capabilities more effectively, with smarter comparisons against benchmarks to show that the funds may be going down, but going down less fast than everyone else's!

In conclusion, although budgets may be tight, the industry needs to regain confidence and start investing for the future growth that is clearly there. Careful use of technology should be deployed to reduce costs (and probably increase service at the same time), possibly with payback within a single year. Risk management is not as important an issue as it is for many financial services organisations, but compliance is, and operational risks need to be managed as a part of business-as-usual, not piecemeal. The face to the client must be upgraded to reflect current concerns and so generate new income while protecting existing income.

Finally, and most importantly, when the good times return, investment will again lag the market. By all means, let us adjust to the current climate and cut the cloth (and costs) accordingly. But this time next year the priorities will be different. Winners are those who anticipate change, and the same will be true when the upturn comes. If you believe the three-to-five year forecasts (or even anything like them), then planning now for capturing market share is vital. The worst response would be to cut the cloth so no coat can ever again be made.