Alternative Assets May Threaten Private Banks’ Profitability

Stephen Harris

15 March 2007

The proportion of negotiable instruments in client portfolios has fallen dramatically since the 1990s, according to Nicholas Brewer, head of private and wealth management strategy at international banking technology company Temenos. According to Mr Brewer, ten years ago around 70 to 80 per cent of assets in private client portfolios were represented by conventional negotiable instruments. This percentage is now more likely to be in the region of 20 to 40 and the speed of change is accelerating, Mr Brewer told WealthBriefing. The figures, drawn from industry intelligence gathered by Temenos, indicate that a much higher percentage of client assets are now placed into alternative assets by wealth managers, including structured products, hedge funds and private equity funds. These assets can either be those which exhibit non-linear pricing, such as structured products, or can consist of funds and other collective investment schemes which have unusual pricing or liquidity patterns. “The worry is that it is often difficult to understand what the components of the structured products that find their way into client portfolios are, and consequently what the true asset position of the client is,” said Mr Brewer. “There may be a lot of accidental overlap which will skew the asset allocation, with unrecognised concentration risk arising,” he said. This kind of problem affects both the integrity of the asset management process, but also means it is becoming increasingly difficult to provide accurate client investment reports which reveal the real portfolio sensitivities and which contain up to date prices. This client reporting problem is particularly acute given the increasing trend for clients to use banks in advisory rather than mainly discretionary management roles. Although this growth has taken place on a worldwide basis, certain private banking centres have seen sharper growth in alternative assets, and hence have a more immediate need to address the resulting problems. The new instrument classes have proved to be particularly popular in centres in Asia Pacific. Possible future trends under which private banks will start to directly manufacture structured products, rather than merely distributing them, will add further complications to instrument handling. The focus on these same instruments can also lead to increased operational costs for private banks, according to Mr Brewer. The increased processing of alternative assets in client portfolios is leading to a less scaleable operational cost base. This can in part be attributed to the fact that the markets for these alternative instruments are less mature and thus greater manual intervention is required for transaction processing. However, some of the increased costs are due to the fact that private banks are inappropriately applying systems and procedures to these newer instruments, which were actually only designed for dealing with equity and bond assets. This mismatch creates a cost base which can rise in step with business volumes and hence erode profitability. “Given the operational situation in which many private banks find themselves, processing costs are bound to rise with the increased use of alternative assets, and these costs must be passed onto either the shareholders or to the customers. The only escape from this problem is for a bank to invest in changing how it operates by adopting a more robust and scaleable processing platform and procedure set.”