Valuations jump for banks without wealth arms

National Australia Bank and Australia and New Zealand Banking Group's move to flog off key parts of their wealth business is looking increasingly smart given the doom and gloom forecasts for the industry.

In a new report, Deutsche Bank said despite encouraging first quarter results, wealth managers will continue to face many structural headwinds that endanger revenue growth and threaten to erode profitability.

“Structural headwinds are set to intensify as cost pressures combine with even stronger fee compression. We therefore continue to believe that the industry will struggle to meet market expectations, despite benefiting from rising US interest rates.”

While acknowledging that the increases in US rates will fuel higher net interest margins, Deutsche analysts found forward rate projections have been revised up too much and, consequently, the projected uptick in net interest margin is also commensurately higher.

“Rising US rates represent cyclical upside, but growth in assets under management is expected to slow and structural industry challenges will persist: trading and managed account fee levels continue to be squeezed; lending growth is slowing down; and the onset of the tougher regulation in emerging markets, which many underestimate in terms of its impact," analysts noted.

Deposit beta

The upshot? Deutsche is forecasting annual growth in assets under management to slow from eight per cent to five per cent on the back of lower asset returns. Further, the bank is estimating an 11-percentage point drag on industry profitability over the next five years.

The bank is bearish partly because it expects higher deposit betas to partially offset the benefits of rising US interest rates.

Basically, deposit beta looks how much of the rise in interest rates the bank expects to pass on to those customers with interest-bearing accounts. So, while on the one hand, rising rates mean better investment opportunities for fund managers, on the other, it means hanging on to depositors becomes more expensive.

“Our assessment concludes that deposit betas over the next five years will likely be 10 percentage points higher than in the last rising rates cycle.”

Further, Deutsche argued that expectations that increasing market volatility will drive wealth managers’ trading revenues are likely wrong.  

“Historically, no correlation can be observed between the industry’s trading margins and market volatility.

“Trading activity does decline with economic policy uncertainty which we believe will not diminish in the near-term, further pressuring trading margins.”

Disruptive competition

To win in this environment, the analysts argued, wealth managers should double down on revenue initiatives whether in alternative assets, build onshore franchises or enhance digital capabilities - in addition to cutting costs to protect margins.

“With current business models unchanged, we expect wealth managers’ trading and fee margins to continue their decline, in light of greater transparency, disruptive competition, modest investment returns and a continued shift from active to passive strategies.”

At issue for Deutsche is that wealth management valuations have reached record highs.They have continued to increase by 7 per cent year-on-year even though the industry has made limited progress in improving profitability.

At the same time, valuations for their non-wealth management bank peers grew more quickly over the course of last year, rising 16 per cent on the back of strong wholesale and commercial banking performance as well as market expectations for an easing regulatory environment, lower taxes and higher interest rates, the report found.

Interestingly, wealth management units now account for 35 per cent of the-sum-of-the-parts valuations for the leading bank-owned businesses, down 2 percentage points compared to last year but still more than double the 16 per cent seen in 2007.

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