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Tuesday, 24 October 2017

RoE of 26%? UBS returns methodology under scrutiny

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UBS’s strategy of allocating billions of francs of equity to its corporate centre is being criticised by rivals and analysts, who say it makes UBS’s investment bank and other businesses appear to be doing far better than they are.

Banks calculate return on equity (RoE) for individual business lines based on the equity held in each. By allocating half of its equity to the corporate centre, UBS flatters the returns in all other areas, critics say.

UBS reported a return on equity of 25.9% for its investment bank last year, the best of all major firms. It reported even higher returns for all other businesses, including 77.4% in wealth management. Its group RoE was a far more modest 11.8%.

“We believe that the group under-allocates capital to its operating divisions, particularly its investment bank, because a large part of the total assets of the group are in corporate centre,” said Alastair Ryan, analyst at Bank of America Merrill Lynch.

“The IB receives less than half the allocated equity a fully-weighted leverage-based analysis would demand. There are no material earnings in corporate centre, so this inflates IB RoE accordingly,” Ryan said.

UBS allocates SFr25.8bn of equity to its corporate centre, or 49% of group equity. Another SFr7.8bn is not allocated to any business line, which means only 36% of group equity is directly allocated to its business areas. All UBS units hold sufficient levels of capital to satisfy regulatory requirements.

All banks calculate equity allocation in different, often complex ways. For example, SFr2.9bn of UBS’s corporate centre equity is for its non-core assets, which many banks allocate separately.

Credit Suisse allocates just SFr387m of equity to its corporate centre, or 1% of group equity. It attributes SFr4.8bn to its non-core arm, taking the total for the corporate centre and non-core to 15% of group equity.

Barclays allocates 7% of its equity to its head office, which rises to 23% with the addition of equity for its non-core unit. Deutsche Bank does not allocate any equity to its corporate centre and attributes 10% of group equity to non-core.

Bankers said firms generally allocate equity to the corporate centre to cover operational risk, Treasury functions, treatment of deferred tax and other functions, but the scale at UBS is far higher than elsewhere.

UBS says it is transparent on how its equity is allocated. It revised its equity allocation framework in late 2012, at the time it restructured and drastically shrank its investment bank.  

People familiar with the matter said the higher amount in its corporate centre reflected its centralised operating model, where the HQ holds a higher amount of resources and assets. UBS’s corporate centre holds equity for non-core, goodwill on PaineWebber, deferred tax assets and asset liability management. It also holds excess group capital, which is significant given the group’s common equity Tier 1 ratio is 14.5%, one of the highest in the industry.

UBS has SFr60bn of risk-weighted assets in its corporate centre, much more than most rivals. Critics say that includes assets that benefit the investment bank.

In its 2015 annual report UBS said equity was attributed to divisions by a weighted approach that combined regulatory capital rules with internal models “to determine the amount of capital required to cover each business division’s risk”.

It allocated SFr7.3bn of equity to its investment bank at the end of last year, or 14% of group equity. Before its 2012 reorganisation it allocated SFr21.9bn of equity to its larger investment bank, or 46% of group equity.

BAML analysts estimated if the investment bank operated as a standalone entity it would need SFr12.6bn of equity to surpass regulatory requirements because it would lack the financial clout of the parent company.

“Parked conveniently”

The returns delivered by banks and their units is under increasing scrutiny from investors and executives as banks restructure in the face of tougher regulations and weak revenue growth. Their decisions on future shape and size are based on whether they can deliver returns above their cost of equity, estimated at 10%–12%.

That has left banks axing capital intensive and unprofitable areas and trying to see where rivals are getting an edge.

UBS shares trade at a premium to almost all its rivals, helped by its strong and stable wealth business and also the strong recovery in its investment bank. The bank says its bold overhauls in 2012 have left its investment bank with a fraction of the balance sheet of rivals, which allows it to deliver higher returns. 

The RoE for its investment bank in 2015 was better than all rivals based on adjusted profits, and almost double the 13% reported by JP Morgan and Goldman Sachs and well above the 8% at Credit Suisse and 7% at Deutsche Bank, Barclays analyst Jeremy Sigee said in a recent report.

But Sigee said adjusting for more consistent equity allocations, the RoE of UBS’s investment bank would be 9%, in line with most rivals, which ranged between 7% and 10%. Goldman stood at 13%.

“If we adjust to take account of disclosed one-off items in the P&Ls, and to ensure that group tangible common equity is fully allocated out rather than leaving large chunks parked conveniently in the corporate centre, then we get a surprisingly consistent 7%–10% range across all of the European and US banks,” Sigee said.

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