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Maybe UBS shouldn't have cut its fixed income trading business so enthusiastically after all?

Upset at UBS's investment bank as 2016 turns sour

Last time UBS reported, we suggested things were looking a little off at the investment bank, and that Andrea Orcel's July 2016 promise to stop cutting costs (and by implication, jobs) looked a rash. Three months on, and UBS seems to have reached the same conclusion.

There were big job cuts at the investment bank in the fourth quarter 

To be clear, UBS hasn't stopped cutting jobs at its investment bank. In the fourth quarter of 2016 alone, 4% of headcount or 193 people were cut. Because of the way UBS allocates headcount between its divisions now, these layoffs were likely all in the front office.

As the chart below shows, it's a while since UBS cut headcount to this extent in Q4. The last time it happened was 2012, when UBS expedited its big restructuring programme. Back then, headcount figures applied to the whole investment bank and cuts therefore included people in the back office. This time, it looks like UBS has slashed a lot of disappointing revenue generators before bonus time.

Costs are rising as a percentage of revenues 

UBS's target is for costs to eat up between 70% and 80% of revenues in its investment bank. Unfortunately, this isn't happening. Worse: in 2016 costs moved in the wrong direction. The unadjusted cost income ratio in the investment bank went from 78% to 87%; the adjusted cost income ratio went from 74% to 81%. By its own reckoning, UBS's investment bank is failing on a cost basis.

UBS still needs to cut costs, therefore. Deferred bonuses at the investment bank are likely to be a lot lower this year: CFO Kirt Gardner said the bank has made "material" reductions to variable compensation which were not reflected in 2016 figures.

Return on allocated equity is falling  

Return on attributed equity at UBS's investment bank is also moving in the wrong direction. In 2015 it was 26% (unadjusted); last year it was 13%. Basel IV changes are partly to blame: changing regulatory requirements have compelled UBS to allocate an additional CHF1.9bn of equity to the investment bank in the past year. Long term, UBS aims to generate a RoAE of more than 15% from the business, implying that equity-hungry desks in fixed income might have to be pared back further...

The shrivelled fixed income trading business is seriously losing out

Except that the cuts UBS made four years ago to its fixed income trading business to bolster returns are starting to look like a bad idea. While banks like Goldman Sachs and Morgan Stanley benefited from 78% and 219% year-on-year increases in their fixed income sales and trading revenues respectively in the fourth quarter, revenues in UBS's fixed income business only rose by 8% over the period.

What went so wrong? Gardner blamed the fact that UBS's fixed income trading business had a stronger fourth quarter in 2015 than U.S. rivals, making comparables more challenging. However, he also said that the new fundamental structure of UBS's fixed income trading business meant it was excluded from the fourth quarter party. Other banks' fixed income trading desks benefited from curve steepening and a narrowing of credit spreads in the fourth quarter, but UBS's structured credit and rates businesses are now too small for this to be significant. Equally, Gardner said that because UBS's trading "inventory" is now less than peers, it wasn't positioned to benefit from market shifts after the U.S. election.

Either way, it looks like UBS won't participate in any revival in fixed income trading in 2017. And while banks like Goldman Sachs are congratulating themselves on maintaining their fixed income sales and trading businesses throughout the tough years, it's starting to look like UBS cut too zealously. Credit Suisse might want to take note.

Something's wrong in Asia 

During today's call, analysts also queried what looks like problems in UBS's Asian business. Historically, UBS's Asian investment bank has been one of the jewels in its crown, but in 2016 it started to look more like a pebble. Unsurprisingly, the bank began cutting headcount at its Asian investment bank in December, but more cuts are almost certainly on the cards unless revenues in the region recover in 2017. The U.S. market, on the other hand, looks ripe for expansion.

But, the advisory and capital markets businesses are doing fine...

As the chart below (from Bernstein Research) shows, while UBS's sales and trading businesses had a feeble fourth quarter, its investment banking division excelled. This follows years of investment in senior M&A bankers by investment bank CEO Andrea Orcel, himself an M&A banker by trade. It was the debt capital markets business rather than M&A that really soared in Q4 though: revenues in the division were up 50% year-on-year, while M&A and ECM revenues rose by 7% and 4% respectively. At Goldman Sachs, M&A revenues were down 19% y-o-y in Q4; ECM revenues were down 7% and DCM revenues were up 28%.

UBS bernstein Q4

 Source: Bernstein Research

And UBS is paying people more 

The other silver lining to UBS's investment banking cloud is that it appears to be paying more in the investment bank. Thanks to the big layoffs in the fourth quarter and a headcount cut of 10% for 2016 as a whole, pay per head rose from CHF614k ($614k) in 2015 to CHF651k ($651k) last year. Of course, this might be diluted by promised reductions to deferred bonuses, but sometimes pre-bonus layoffs make good sense.


Photo credit: ubs by Martin Abegglen is licensed under CC BY 2.0.

AUTHORSarah Butcher Global Editor

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