Credit Suisse Group AG
Q2 2014 Earnings Call Transcript

Published: 22 Jul 2014

Christian Stark:

Good morning and welcome to our second quarter results call. Before we begin, let me remind you to take note of the important disclaimer on slide 2, including the statements on non-GAAP measures and Basel III disclosures. I now turn it over to Brady Dougan, our CEO.
Brady Dougan:

Great. Thank you very much Christian. Welcome everybody and thanks for joining our second quarter 2014 earnings call. I'm joined by David Mathers, our CFO, who's going to deliver the results portion of today's discussion. Second quarter was a period of substantial progress for Credit Suisse. In addition to resolving our most significant and long-standing legacy litigation issue we saw continued strong momentum with clients and made progress in winding down our non-strategic portfolio. We maintained a resilient capital base and leverage ratio, despite the impact of the settlement of the U.S. cross-border matter and we remain on track to reach our cost reduction targets. On a reported basis we recorded a net loss attributable to shareholders of CHF700 million for the second quarter and net income of CHF159 million for the first half of the year. Our reported results were impacted by the CHF1.6 billion charge relating to the final settlement of the U.S. cross-border matter as announced on May 19. I want to reiterate that we deeply regret the past misconduct that led to this settlement and that we take full responsibility for it. When looking at our strategic businesses, results across both of our divisions were solid. We reported strategic net income of CHF1.3 billion for the second quarter and a return on equity of 13%. The performance of our strategic businesses demonstrates the resilience of our business model and the strength and diversity of our client franchise across both divisions. These solid results were achieved even with subdued client trading activity in certain areas, which impacted both private banking and wealth management and investment banking. Turning to private banking and wealth management, while the division's reported result in the second quarter was impacted by the U.S. settlement, our strategic businesses generated pretax income of CHF882 million and a continued high return on capital of 28%. We further improved the efficiency of our strategic businesses with operating expenses down 8% compared to last year's second quarter. This substantial progress on costs helped us to mitigate the impact on our margins of higher levels of assets under management, a change in asset mix, subdued transaction activity and the continued low interest rate environment. We were able to sustain our net margin in wealth management clients at 28 basis points while our gross margin decreased by 5 basis points to 99 basis points due to the factors just mentioned. We saw strong net new assets of CHF11.8 billion during the quarter from our strategic businesses with particularly strong growth in Asia Pacific and Switzerland. In our strategic businesses we achieved an annualized net new asset growth rate of 4%, despite CHF2.9 billion of outflows from our Western European cross-border business. Including the non-strategic portion, these outflows totaled CHF4.1 billion and were driven by our proactive measures to regularize our asset base in Western Europe. We consider this regularization a necessary step in the secular transformation of the global cross-border banking industry. We also made further progress with our lending initiatives for ultra-high net worth clients during the second quarter, particularly in Asia Pacific. Looking now at the investment bank. We generated pretax income of CHF1 billion for our strategic businesses in investment banking. We saw a strong close to the second quarter and achieved a solid return on capital of 18%, demonstrating the stability of our diversified franchise. We saw strong underwriting results, driven by robust equity and fixed income origination activity across all regions. Our high-returning fixed income yield franchises delivered another good performance. We saw continued momentum in our U.S. and European credit businesses, with strong origination and secondary trading activity across both leveraged finance and investment grade. We also saw strong results from our diversified securitized products platform with a fairly balanced contribution across non-agency and agency RMBS, asset finance and mortgage servicing. Emerging markets results improved, driven by recovering industry trends and in particular, higher financing activity in EMEA and Asia Pacific. As we move forward we intend to continue to diversify our yield franchises across regions and products to create a more balanced and non-correlated business mix. The strong results of our fixed income yield franchises were partly offset by less favorable trading conditions in equities and continued weakness in macro products. The restructuring of our macro business, combined with infrastructure savings, will drive further cost efficiencies in the investment bank. This macro restructuring will also drive further capital and leverage reductions, in line with our strategy of rebalancing resources toward growth in private banking and wealth management. It includes the exit from our commodities trading business in order to reallocate resources to more profitable businesses. David will provide more detail about our planned exit from commodities trading shortly. Looking at our non-strategic portfolio, we are ahead of schedule in winding down positions and losses in our non-strategic units. We've reduced risk weighted assets by $6 billion and our leverage exposure by $3 billion in the non-strategic unit of the investment bank since the end of the first quarter. We've also made significant progress in resolving key legacy litigation issues in 2014 to date. In the second quarter the most significant item in the non-strategic unit was the settlement charge relating to the U.S. cross-border matter. This settlement, along with the FHFA settlement in March, brought to a close the most significant outstanding litigation issues for Credit Suisse. This brings me to capital. We're executing the capital measures we announced on May 19 to fully mitigate the impact of the litigation settlement. At the end of the second quarter our look-through CET1 ratio stood at 9.5%. I would note that this includes a continued accrual for cash dividend for 2014 and compares to 9.3% at the end of the first quarter adjusted for the settlement. We are continuing to execute on the previously announced sale of real estate and non-core assets. This is likely to yield between CHF400 million and CHF500 million. Also the reduction of risk weighted assets to end 2013 levels is proceeding as planned. With these measures, along with organic capital generation through retained earnings, we remain on track to improve our look-through Basel III CET1 ratio to above 10% by the end of this year. Once we reach 10% and as we continue to accrete capital towards our 11% long-term target, we intend to return approximately half our earnings to shareholders through our annual distributions. And finally, our look-through leverage ratio stood at 3.7% at the end of the second quarter compared to the 4% requirement applicable in 2019. So to sum up, while our second quarter results were impacted by the U.S. settlement charge, we continue to see good momentum with clients while at the same time making further progress in winding down our non-strategic units. Our strategic businesses delivered a solid performance in the quarter, demonstrating the resilience of our business model, the trust and support of our clients helped us mitigate the impact of the settlement on our business. I'd like to thank all of our employees for their contributions as we work to resolve our legacy litigation issues and for their continuous outreach to clients. It is because of their efforts and professionalism that our clients regard Credit Suisse as their partner. The implementation of our capital measures is on track and our intention remains to deliver cash returns to our shareholders at or above 2013 levels. With that I'll hand it over to David who'll discuss the results in more detail.
David Mathers:

Thank you Brady. Good morning. I'd like to start on slide 7 with an overview of the financial results. In the second quarter we achieved revenues of CHF6.3 billion and pre-tax income of CHF1.8 billion from our strategic businesses with a cost to income ratio of 72%. The after-tax return on equity was 13% in strategic businesses and the net new asset inflows CHF11.8 billion. On a total basis we reported a pretax loss of CHF370 million for the second quarter and a net after-tax loss of CHF700 million, reflecting the impact of the U.S. cross-border settlement of CHF1.6 billion that we've announced previously. Excluding the impact of the settlement and fair value adjustments due to movements in credit spreads, we achieved an after-tax return of 8% in the second quarter. Slide 8, on this slide we show the quarter's results measured against the various Group and divisional KPIs we've set. Our Group strategic return on equity of 13% compares to our target of 15% and the strategic cost to income ratio of 72% is now approaching our target of 70%. In private banking and wealth management the division's cost to income ratio of 69% was relatively stable compared to the first quarter this year. Net new assets in wealth management clients grew at an annualized rate of 4% in the second quarter, in line with our guidance. The investment banking division achieved a strategic cost to income ratio of 70% in the second quarter, similar to that achieved in the first quarter of the year. Let's now turn to the private banking and wealth management division in more detail on slide 9. In the second quarter our strategic businesses achieved a pre-tax income of CHF0.9 billion, reflecting a more difficult trading environment. Recurring revenues were stable in the second quarter, however performance fees decreased, client FX trading declined due to reduced currency volatility and brokerage fees were also depressed. These weaker revenue results though were partly mitigated by further progress on cost reductions. In the second quarter we reduced expenses in the strategic business lines by 8% compared to the second quarter of 2013, reflecting significant restructuring across the portfolio as well as the exit from lower returning businesses. These expense reductions were achieved notwithstanding continued growth in our business in emerging markets. Slide 10. Net new assets in second quarter for strategic businesses remained strong at CHF11.8 billion after Western European cross-border outflows of CHF2.9 billion in the second quarter. Our wealth management client business saw strong inflows of CHF10.3 billion while asset management reported net new asset inflows of CHF4.1 billion, driven by inflows in emerging markets, index, hedge fund and credit products. Slide 11. The wealth management client business achieved pretax income of CHF569 million in the second quarter. This was broadly in line with results in the first quarter but down by 8% compared to the second quarter of 2013. Net revenues were 10% lower compared to the strong second quarter in 2013 but the adverse impact on profits was largely offset by a further 10% reduction in expenses. For the first half of this year pretax income increased by 7% to CHF1.15 billion compared to the first half of last year. This was driven by a 9% reduction in expenses, more than offsetting the decline in revenues. Slide 12. Our net margin on assets under management improved in the first half of this year to 28 basis points, up from 27 basis points in the first half of last year, reflecting a significantly lower expense base. In terms of the revenue composition for the quarter, recurring fees were slightly lower than in the second quarter of 2013, reflecting the impact of the cross-border outflows. The decline in net interest income was in line with guidance, driven by the continued impact of the low interest rate environment on the replication portfolio. And as we said before, we continue to expect this trend to level off in the second half of 2014. Transaction and performance-based revenues though were adversely affected by a number of factors, including lower client FX trading on reduced currency volatility, lower brokerage fees, the absence of performance fees from our Brazilian business Hedging Griffo, as well as non-repetition of the special dividend that we received in 2013 for our ownership interest in the Swiss stock exchange SIX. Just to be clear on the Hedging Griffo point, due to the difficult market conditions in Brazil, whilst the performance of the Hedging Griffo funds was in line with peers, this year-to-date performance fell short of the high watermark which would otherwise have triggered performance fee crystallization. Finally I'd like to point out that our ultra-high net worth share of assets under management has increased to 47% in the second quarter, in line with our general strategy for this business. Slide 13. On this slide we show the trends in gross and net margins on assets under management in the first half of the year. If we start with gross margins, a number of factors have contributed to the decline from 110 basis points in the first half of last year to 101 in the first half of this year. Increases in assets under management and adverse change in client mix have impacted our gross margins by approximately 3 basis points. If we were to assume a stable level of assets under management, our gross margins were also negatively impacted by approximately 5 basis points from lower net interest income, reduced client FX trading and the reduced brokerage fees that I previously mentioned. And looking forward to the remainder of this year, we'd expect gross margins to be in line with those for the first half of 2014, subject of course to the performance of client assets. Turning to net margins in the graph on the right-hand side, we already discussed the improvement in net margins so far this year and given the continued progress we're making in delivering cost efficiencies, we'd expect net margins to continue at or around current levels in the second half of 2014. Slide 14. Let's now look at the details of net new asset inflows in the wealth management client business. Asset inflows from emerging markets remain strong with inflows in the Asia Pacific region growing at annualized rate of 16%. We also saw continued momentum in Switzerland in the second quarter. Within the EMEA region we continue to see good inflows in the Middle East and in the Western European onshore business, focused on the ultra-high net worth client segment. Total West European cross-border outflows though stood at CHF4.1 billion in the second quarter of which CHF2.9 billion was reported in the strategic businesses and a further CHF1.2 billion in the non-strategic unit. Credit Suisse continues to believe that it's vital for the industry to regularize client assets and this remains a core focus of our strategy. Given the outflows that we've seen in Western Europe so far in the first half of 2014, we would now expect total outflows to reach CHF10 billion to CHF15 billion in 2014 and continue at a similar level into 2015. However, please note that notwithstanding this focus on the regularization of client assets, annualized net new asset growth was 4% in the second quarter after these outflows and this particularly reflects the strength of the business in emerging markets and in the Asia Pacific region. And even with the flows from regularization we continue to reiterate a target of 3% to 4% of annualized net new asset growth in the near term, post these outflows. Slide 15. On this slide we provide an update of our strategy of expanding the lending business in the ultra-high net worth client segment. In the first quarter we talked about the strength of this initiative when we increased lending by CHF2.2 billion compared to the first quarter of 2013. We've continued to make progress on this in the second quarter, albeit at a slower pace in the emerging markets of Europe. In the first half of the year we've increased our lending to the segment by CHF2.8 billion, almost double the level achieved in the first half of 2013. Loan growth has been particularly pronounced in Asia Pacific with net new lending of CHF1.1 billion so far this year. And as we've mentioned before, the interest margin on these ultra-high net worth client loans exceeds 100 basis points. Slide 16. Pretax income of CHF211 million in the second quarter was solid for the corporate and institutional clients business, albeit lower than in the second quarter of 2013. Results reflect stable recurring fees, partly offset by fair value changes on asset securitizations of CHF16 million which is recorded in the other revenue line on this slide, a reduction in transaction-based revenues of CHF9 million due to lower sales and trading income and a reduction in net interest income due to the decline in eligible deposits, which we mentioned late last year as being a factor. Slide 17. Our asset management pretax income of CHF102 million in the second quarter was lower compared to the second quarter of 2013, mainly due to reduction in carried interest on realized private equity gains of CHF28 million and the absence of the performance fees from Hedging Griffo funds in Brazil, which as a reminder contributed CHF28 million in the second quarter of 2013. Just to be clear though, year-to-date our uncrystallized performance fees, primarily for York Capital, are actually higher so far than in 2013, but I caution the full-year outturn for when we record these fees in the fourth quarter will depend on the investment results for the remainder of this year both in York and in Hedging Griffo. Nonetheless, operating expenses were slightly lower than the second quarter of 2013, reflecting the implementation of a number of efficiencies within the businesses. Slide 18. We continue to make progress in winding down the non-strategic portfolio within the private banking and wealth management division. Results in the second quarter were lower compared to second quarter of 2013, reflecting the ongoing wind-down of the non-strategic portfolio. And to the operating expenses include here the settlement regarding the U.S. cross-border matter which we previously announced. The total amount of the settlement was CHF2.5 billion of which CHF1.6 billion was recorded in the second quarter earnings. Let's now turn to the investment bank on slide 19. In the second quarter we achieved a return on capital of 18% in the strategic businesses within the investment banking division with solid revenues at CHF3.4 billion and pre-tax income of CHF1 billion. In the first half of this year our strategic businesses delivered a strong return on capital of 20% and overall return on capital of 13%, including the losses from the non-strategic unit. We saw strong performances in our credit and securitized product franchises, as well as across our underwriting businesses, with origination activity remaining very robust in the quarter. In addition, we saw some improvement in the emerging market businesses and solid results from Prime Services. However our macro, derivatives and cash equity businesses were adversely impacted by significantly lower client activity and lower trading volumes, driven by low volatility compared to the prior year. In the second quarter expenses in the strategic business lines increased by 4% in U.S. dollar terms compared to the second quarter of 2013. This primarily reflects the changes in the compensation accruals that we discussed, as you may recall, in the first quarter. These are resulting in a higher proportion of variable compensation to be accrued in the first half of this year, as well as higher deferred compensation costs from prior year awards amortized through the first half of this year. The impact of these higher compensation costs was offset by substantial progress though in infrastructure and shared service initiatives and by the depreciation of the U.S. dollar against the Swiss franc. Overall therefore you can see that total expenses declined by 3% in Swiss franc terms. We continue to focus on capital efficiency, reductions in leverage exposure and are on track to achieve the further reduction in risk weighted assets by the end of this year to support the Group's target. Slide 20. In fixed income we had revenues of CHF2 billion with continued strength in credit and securitized products. We maintained our top three position in leveraged finance and are ranked number two in asset finance. Furthermore, after a disappointing 2013 which continued into the first quarter of this year, we've now seen improvement in revenues in emerging markets, driven by higher financing activity, particularly in the EMEA and the Asia Pacific regions. Revenues from our macro product areas remain very challenged, albeit that our European rates business was more resilient in the quarter. Slide 21. So I'd just like to take a few moments discussing the broader strength across the fixed income franchise and also a number of the measures that we're taking to rationalize the macro business. Let's talk first about the core businesses in the fixed income portfolio. If we look at the securitized product business, this is a very broadly diversified portfolio of businesses, encompassing mortgage servicing, asset finance, agency and non-agency trading in both the United States and in Europe. In the top right-hand charts we show both the growth in revenues over the last year and the diversification in these revenues. We continue to believe that there remain opportunities to expand and diversify this business further, particularly if securitization investment activity continues to expand in Europe. If we turn now to the credit business, I think you know we have a very strong position in leveraged finance which has continued to perform extremely strongly in the first half of 2014. What is perhaps less well known has been the expansion of this business in Europe where we're seeing much greater interest in bank balance sheet restructuring and capital market funding of corporate credit. This trend is likely to be further encouraged by the direction of regulation in Europe and we remain well placed to continue to expand this business and replicate the strength of our U.S. franchise. Let me just complete now with a few words regarding the emerging market business. As you know, we have a strong emerging market business across Brazil, Eastern Europe, India, China, South Korea and Mexico, focused on both financing and trading. One point to note is this is not very well correlated to securitized product or credit. For example, since the second quarter of last year to the first quarter of this year this business suffered from the adverse trend in investor sentiment towards the emerging markets, which has only started to recover in the current quarter. Emerging markets remain a very strong component of the fixed income franchise and we aim to leverage our strength in financing by diversifying into new markets. And just to conclude, the returns on capital we have invested in these businesses continues to substantially exceed the Group target. Slide 22. Let me turn now to the macro business, where continued central bank intervention and low interest rates across the curve are depressing client activity. This has been further exacerbated by structural changes encompassing both new regulatory developments, such as the Basel III leverage rules, as well as the introduction of different trading platforms and pricing requirements. This area has been a continued focus for us, which we have been restructuring for several years. We've reduced the expenses by CHF0.5 billion over the last three years and at the same time cut risk weighted assets from CHF34 billion to CHF20 billion. In terms of our strategy for this business, we're announcing today that we will be exiting our small commodities trading business, which will contribute CHF75 million in expense savings, a CHF2 billion reduction in risk weighted assets, and a CHF5 billion reduction in leverage exposure. The trading book of the commodity business will be transferred to the non-strategic unit in the third quarter of 2014. If we turn to the other businesses within macro, to address the low levels of volatility we'll also be refocusing our FX business more heavily towards electronic trading whilst selectively maintaining voice offerings for key clients and traders. We'll also simplify the rates product further, focusing primarily on satisfying client liquidity needs in cash products and derivatives. Overall the implementation of the change in the macro business is targeted to deliver approximately $200 million of expense savings and reductions in risk weighted assets and leverage exposure of $8 billion and $25 billion respectively. This will clearly help the investment banking division to achieve the cost targets set for the end of 2015, as well as contributing towards the Group's longer-term capital target. Slide 23. Equity revenues in the second quarter declined by 6% in U.S. dollar terms compared to the strong levels in the second quarter of 2013. We experienced a significant decrease in market volatility which adversely impacted volumes and client activity in our trading businesses. This was, however, offset by robust primary underwriting activity. Equity sales and trading revenues declined by 13% in U.S. dollar terms, but this was offset by a 38% increase in equity underwriting revenues. In terms of the performance of the different business lines, we experienced difficult trading conditions in derivatives compared to the strong performance in the second quarter of 2013. Lower cash equity revenues primarily reflected reduced commissions in Asia and the United States. Our Prime Services revenues though were solid and consistent, reflecting continued market leadership, increased activity in Europe and growth in client clearing services. Slide 24. In underwriting and advisory we achieved solid revenues of CHF912 million compared to CHF907 million in the second quarter of 2013, a 7% increase in U.S. dollar terms. Equity underwriting results increased by 38% compared to the second quarter of 2013, driven by growth in EMEA and APAC. Advisory revenues were stable compared to the second quarter of 2013, but based on the existing pipeline of transactions; we would expect to see growth in the revenue of this business during the remainder of this year. Finally results in debt underwriting reflected market share gains and higher volumes in leveraged finance and investment grade businesses, offset by weaker structured lending results in emerging markets. Slide 25. So consistent with prior quarters, we've included the usual bubble chart which includes the relative market shares of each of our business lines and the return in capital usage for each of these businesses. And just to remind you, the measure of capital that we use here is based on risk weighted assets and leverage exposure by business line. As you can see from this chart, the returns are broadly stable compared to the numbers we reported at the end of the first quarter, with the exception of the macro business. Particularly we saw extremely strong returns in our credit business and our securitized product business. In macro, given the combination of market and structural changes, it's no surprise that returns remained low, and well below our requirements, reflecting the very depressed market environment we've discussed. However, as we show in this graph, the restructuring we've just outlined should significantly improve the returns from this franchise. Slide 26. In the non-strategic unit of the investment bank pretax losses of CHF282 million in the second quarter were in line with those of the last quarter, as reduced losses on position sales was offset by higher litigation expenses. Our funding costs in the non-strategic unit decreased significantly compared to the second quarter of 2013, due to proactive portfolio management of both our legacy debt instruments and our trading assets as well as net valuation gains across the remainder of the portfolio. We succeeded in accelerating the wind-down of our capital positions in the second quarter, reducing risk weighted assets by $6 billion. We also reduced leverage exposure by $3 billion since the first quarter. Slide 27. The waterfall chart in this slide highlights the strong returns generated by the strategic investment banking businesses. For the first half of this year these strategic businesses achieved a solid after-tax return on allocated capital of 20%, reflecting continued momentum in high market share, high return businesses, as well as improved capital efficiency. As I mentioned before, the increase in U.S. dollar expenses was driven by higher variable and deferred compensation expenses, which offset the reduction in infrastructure and commission expenses we achieved in the quarter. Given the measures we've announced today in terms of restructuring our macro business, we would expect further capital and cost reductions to benefit returns, complementing the further cost savings from other efficiency measures. Let's turn to the next section to discuss the divisional non-strategic units in more detail. Slide 29 please. As already noted, we've made substantial progress in reducing the amount of capital we have tied up in the risk weighted assets of the non-strategic unit of the investment bank, as well as the gradual run-off of the amount of capital in the non-strategic unit of the private banking business. And we'd expect to continue this momentum in the second half of the year. The reductions in the first half were focused more heavily on risk weighted assets, but as we move forward over the next 6 to 12 months we will focus more on trade compression in collapsing some of the leverage-heavy but risk-light positions that were transferred from the rates business. This will drive the leverage exposure down towards the target of CHF26 billion for the end of 2015. Slide 30. This slide provides a breakdown of the components contributing to the non-strategic pretax loss of CHF2.1 billion in the second quarter. In the corporate center we have CHF217 million of restructuring expenses taken in connection with both the ongoing reduction in headcount and the re-engineering of our infrastructure. Clearly though the largest contributor to our non-strategic pretax loss this quarter was the CHF1.6 billion U.S. cross-border settlement that was recorded in the non-strategic unit of the private banking and wealth management division. The remaining non-strategic drag is driven primarily by legacy litigation costs of approximately CHF143 million, together with losses on the fixed income wind-down portfolio and the legacy rates business in investment banking of approximately CHF100 million. The remaining pretax drag is expected to reduce by a further CHF38 million of incremental quarterly expense savings, as well as the resolution of the remaining legacy litigation issues. Let's turn to the next section where we discuss the continued Group-wide progress on cost and capital. Slide 32 please. In the second quarter our total cost savings stood at CHF3.4 billion. We achieved further progress with our infrastructure and private banking initiatives, albeit offset by some increase of costs within the investment banking division. This was primarily driven by an increase in mortgage-related legal fees that we took in the first half of 2014. The restructuring in the macro business announced today and the expected cost savings from this of approximately CHF200 million puts us back on target to achieving CHF1.85 billion in cost savings in the investment bank by the end of next year. We will continue to achieve further efficiencies beyond that as the macro business restructuring progresses. Let's now turn to the capital slides, 33 please. As you can see from the chart, our look-through Basel III risk weighted assets stood at CHF279 billion at the end of the quarter. We continued to wind down capital in non-strategic units and to shift the risk weighted asset allocation from the investment bank to the private bank and wealth management division. During the quarter strategic risk weighted assets in the private banking division increased by CHF1.9 billion, a trend we expect to continue. Risk weighted assets in the strategic investment banking businesses declined, despite moderate increases in credit and securitized product businesses in response to the market conditions. Slide 34. Our look-through Swiss total capital ratio increased to 15.3% at the end of the second quarter, compared to 15% that we reported at the end of the first quarter or 14.4% adjusted for the May litigation settlement. This improvement compared to the first quarter reflects both organic earnings generation and the issuance of a further $2.5 billion of low trigger tier one capital during the quarter. Our look-through BIS CET1 ratio also improved from 9.3% adjusted for the settlement to 9.5% at the end of the second quarter. And as we said before, we've put in place capital measures aimed at restoring our look-through CET1 ratio of an excess of 10% by the end of 2014 towards our long-term target of 11%. Slide 35. The expected reductions in risk weighted assets will be mainly achieved within the investment bank, offsetting a planned increase in the private banking and wealth management businesses. Our plans to increase capital include real estate sales and other non-core business disposals which are expected to release approximately CHF0.4 billion to CHF0.5 billion capital. And overall, as we said before, we would expect our CET1 ratio to exceed 10% by the end of this year, even before taking into account organic capital generation. Slide 36. At the end of the second quarter our leverage exposure stood at CHF1.16 trillion, a cumulative reduction of CHF249 billion or 18% since the third quarter of 2012. You'll note that the small increase since the first quarter primarily reflects the increased seasonal usage within credit in the investment banking division. Including full implementation of the BCBS proposals, together with the ongoing mitigation efforts and the run-off of our non-strategic portfolio, we remain on track to achieve our long-term leverage exposure target of approximately CHF1 trillion for the Group. Slide 37. Our look-through BIS total capital ratio increased at 3.8% at the end of the second quarter from 3.6% at the end of the first quarter, again adjusted for the impact of the U.S. cross-border settlement. I think it's clear from this chart that once we achieve our long-term leverage exposure target of CHF1 trillion our look-through Swiss total capital leverage ratio, even on current capital levels, would exceed 4%. And with that I'd like to conclude the results portion and pass back to Brady. Thank you.
Brady Dougan:

Thanks a lot David. I think with that we're going to open it up for Q&A.
Operator:

(Operator Instructions). And your first question comes from the line of Daniele Brupbacher.
Daniele Brupbacher:

I had a couple of questions. First of all, could you again confirm that you don't expect the U.S. settlement to have any material negative impact on all your businesses? You made quite reassuring statements in that context a few months ago. And also there, basically the 99 basis point gross margin was not driven by pricing rebates or any (technical difficulty) measures in relation to the U.S. settlement. If you could just confirm that? And then secondly, the macro business. The question there is really why now is it compared to previous expectations even worse returns or is it also partly linked to the capital rebuild plan? And also what do you mean by ends date; should we read 2015 into this? And a very small number question. CHF3.4 billion cost cutting achieved in the second quarter. I think that looks unchanged versus Q1. Could you talk again through a bit where that is, why we haven't seen progress in the second quarter and why you now include the CHF200 million from the macro reduction which I understand previously was not in there, which makes me believe that you probably reduced your cost-cutting expectations elsewhere. Thank you.
Brady Dougan:

Okay Daniele. Thanks. Maybe I'll try to take the first two and David can address the cost-cutting issue. I'd say just in general obviously the U.S. settlement process and getting that issue behind us did have an impact on the business, there's no question. I think that the best indicator though of how we were able to manage through that is clearly the numbers that you see for the full second quarter where obviously if you look at for instance the net new asset number, CHF11.8 billion was a very strong second quarter number for us. So I think, as we said, we appreciated the support that we saw from clients. I think what we have continued to – what we said at the time and what we've continued to say is that there are no impacts on our capability so there's no licensing capability issues that have any material impact on our business. So from that point of view we clearly have all of our capabilities. And again, if you look at the second quarter again results and the continued momentum we've had on the client side, I think you can see that I think we actually managed through it reasonably well. There's certainly no – in terms of the gross margin there are certainly no specific pricing rebates or anything like that. Obviously it's hard for us to judge whether or not the transactional activity may have been impacted by that period, particularly the period leading up to and around the settlement. That's something that is very, very difficult for us to make a judgment on. But there certainly were no – there are no – there's nothing specific, no specific actions that we undertook, nor do we see any ongoing impact from that. Again, whether or not transactional volumes were somehow impacted is something that is hard for us to comment on. I think with regard to the macro business, I think it's just we believe that we've been very responsive to changes in regulations, changes in market structure. I think our view is not so much that it's worse but that our view is that we believe that we can reallocate this capital to the private banking and wealth management side and make good use of it there. We believe that it does contribute – leading to your third question, it does help us to contribute to continuing and in fact furthering over time our cost efficiency goals as well. And we think that this is a business where there really is going to be a required movement much more to electronic, to the agency side of the business, which is what we're doing in foreign exchange, and also focusing on our largest clients on the rates business. So I think it's just a – we think we've been pretty proactive about it, responding to the changes in the regulatory backdrop but also what we see as the transactional opportunities and the market structural issues there. So I think it's really more just continuing to in our view be proactive about properly allocating our capital and making sure we're being as efficient as possible.
David Mathers:

I think there's probably three points, Daniele, I'd make on the macro changes, just following up from Brady's points really. Firstly I think we have perhaps slightly conservatively defined the ends date as being 2017, not 2015, although I think clearly, as with the NSU, that's a target we'd hope to beat and get to as quickly as possible. Clearly a lot will depend on how fast we can exit for example from the commodities book which, as I said before, will be transferred into the non-strategic unit in the third quarter. But I think it's unlikely we will achieve all of those CHF200 million of cost savings by the end of 2015. So I think if you're thinking about that CHF200 million, is that incremental or is that – and how much is factored in, I think you really should consider a large chunk of that, probably more than 50%, will fall after 2015 and beyond the cost targets we've actually given on slide 17 of the decs which run through to 2015. So that's really why we've not changed the end 2015 target because it's, as you might say, the benefits will be beyond 2015. Just in terms of those specific cost targets, if you compare to the slides we gave in the first quarter, you can see there that the total, as you said, is unchanged at CHF3.4 billion. Within that the shared service or infrastructure functions have increased the savings from CHF1.3 billion to CHF1.35 billion, the private banking number has nudged up from CHF0.63 billion to CHF0.65 billion and the investment bank number has dropped from CHF1.46 billion to CHF1.4 billion. So basically private banking and shared service infrastructure have increased cost savings and the investment bank slipped slightly. That really reflects, as I mentioned, the increase in legal costs relating to some of our mortgage settlements. That actually has boosted the run rate by about CHF160 million compared to the first half of last year. So if it wasn't for that, the investment bank number would improve to something like CHF1.55 billion or CHF1.6 billion rather than the CHF1.4 billion you see here. So that's really what's actually caused that standstill as you might say in the cost progress so far in 2015. Nonetheless clearly this – we're very much committed to the goal of CHF4.5 billion and it's certainly true that at least some of the macro savings should help us to actually reach that target, even if the fall-off in mortgage litigation costs doesn't come down to as low a level as you'd like it to be over the next 18 months.
Operator:

Thank you. Your next question comes from the line of Kinner Lakhani from Citi.
Kinner Lakhani:

My first question was on the SNB report which was published I think back in June. And I just wanted to understand what impact, if any, are you seeing or are you expecting in terms of the RWA review that I understand, been most conducting [ph] and whether that's part of the model adjustment that we're seeing through your risk weighted asset (technical difficulty)? And also any thoughts on the leverage ratio given that the SNB report yet again flagged this issue as Swiss banks being below international peers? Secondly, I was interested in why your Group RWA and leverage exposure target to remain unchanged despite the additional restructuring that we're doing in global macro? Is that just a timing thing or something else? And finally on litigation, we clearly see that the boundaries are now closing in which is clearly positive. But I wanted to understand what your thoughts are on the non-agency RMBS issue that some of your U.S. peers have been experiencing, some settlements that have come through recently? That would be great. Thank you.
David Mathers:

Just on the Swiss National Bank financial stability review, which as you say, came out in the middle of June. There are a number of points in the SNB review separate from the mortgage market. Firstly I think they acknowledge that both us and UBS have increased our capital position. I think it also acknowledged that both banks I think now provide the comprehensive roll-forward analysis in terms of the composition of RWA that I think we actually included in these slides and was also included in our full quarterly report. So I think the main point which the SNB raised essentially is the question of whether or not the Swiss banks should be required to also produce risk weighted assets on the old standards model type base. And I think that's been something that's been discussed now for a couple of years; it's not a new request so far. And I think the discussions which we've had with our regulators and I think is understood is that the standard models they're referring to in many cases do date back to the late 1990s and are based on the old Basel I regime and are not really that appropriate in terms of risk management. They're very broad buckets. So I think that's always been our reservation around the standard model approach and that very much remains the case and that's not a change in our stance. I think looking forward though, I think the issue will probably move forward somewhat in the sense the Basel Committee obviously is conducting its own review of risk-weighted asset measures and I think is looking to improve transparency and consistency with measures such as the SACCR proposals, which we'll look to see coming out over the next two to three years. So I think that's more likely to be the way in which we see the RWA models develop there afterwards. So those are the only really reviews in terms of risk-weighted assets. The marginal changes that you see relating to this quarter are mostly data setup changes. There weren't any particularly material methodology changes in the second quarter to actually be aware of. I think in terms of the leverage ratio discussion, I think, as the FSR acknowledges, we've certainly significantly improved our leverage ratio. It's up at 3.8% at the end of the second quarter, which is obviously substantially ahead of where it was one year ago or two years ago, and that's notwithstanding the cost of the U.S. settlement. I think in terms of the Swiss discussion around that, I think, as you know, there is the Brunetti Commission, which is looking at Swiss banking law and is due to report later this year, I think probably late this year, to the Swiss parliament in due course. So we'll see what comes out at that point in terms of what that means for the leverage ratio. I think it's probably fair to say that clearly at the moment we have a target of 4%, which is generally in line with the European levels of leverage ratios, but it clearly is lower than the U.S., where the market structure is radically different with the different agencies and how that U.S. market is actually structured. But I think it's difficult to comment further on the Brunetti Commission at this point. Brady, do you want to pick on the litigation point?
Brady Dougan:

Well, I guess the second question was on why our Group RWA and leverage targets are unchanged despite the changes in global macro. I think our general view is, again, this a – in terms of our overall firm-wide goals, as you know, one of our important goals is to shift capital into the private banking wealth management business. You saw we did some of that during the course of the second quarter. We're going to continue to do that. So again, I think the global macro is part of freeing up and meeting our investment – meeting our goals on the RWA and the leverage side in investment banking in order to be able to reallocate that into the higher-returning private banking wealth management side. So I'd say that's why our overall targets are not changed, but it allows us to do reallocation. I think your last question on litigation, as you say, we're obviously – the U.S. cross-border matter was probably our longest-standing and largest issue that we had out there, so getting that resolved was good. We also, as you mentioned, on the mortgage side, did – I'll remind you, did resolve the FHFA matter earlier this year, and we've continued to address and resolve mortgage matters and obviously smaller matters on an ongoing basis. But there are still a number of matters out there. As you say, we we'll obviously continue to work through those. And you can see obviously in our possible-losses-above-reserves number, which has come down from I think CHF2.4 billion to CHF1.0 billion this quarter, that obviously is an attempt that's trying to reflect some of the – obviously some of the settlements, some other changes as well. But obviously that's not an exact science. So yes, I'm not sure we can comment on any specific issues, but we obviously continue to try to work through our mortgage issues and other issues on an ongoing basis and we hope we're – we hope we do have most of the major issues behind us. Clearly, we don't have issues on the Libor side, we don't, at this point, have any material issues on the FX side as well, though that's a process that continues. So our hope is that we have been making progress and working through these, but it obviously is a dynamic area and we'll have to continue to work through issues.
Operator:

Thank you. Your next question comes from the line of Michael Helsby, Bank of America.
Michael Helsby:

I've got a couple of – or a few questions just related to the investment bank, if that's okay. Firstly, just on the fixed-income performance, I think we all expect fixed income to be volatile, but I think what happened in Q2 was pretty striking. You were clearly guiding the market to down 20% at the end of May and you've come in at plus 4%. So I was wondering if you could give us some more color on what happened in June. It can't be all about client flows, so what positions are you running there? Secondly, again on fixed income, $1.6 billion of FICC revenue in Q2. Can you give us a sense of the proportion of that now which is coming from the high yield and securitization franchise and how that's changed relative to maybe last year? And then I guess wrapping into that, more of a Group question, I think, Brady, right at the top of the call you said that you were pleased with the progress in the second quarter. But if we strip out the swing in the fixed-income revenues, which you clearly weren't expecting at May, then actually you'd have missed consensus by about 18%. Gross margin is a lot weaker – and that's at a Group level. Gross margin's a lot weaker than clearly you envisaged as recently as Q1. Balance sheet's flat up versus the first quarter. So I can see that you're clearly relieved that you've had a monster fixed-income performance, but I'm just a bit confused why you're taking as much comfort away from that as you seem to be – as implied by your comments. Thank you.
Brady Dougan:

David, you want to try to address the first couple of points and I'll --?
David Mathers:

Shall I start that? So just to be clear, I don't think we gave guidance actually that that would be – that's not what we did. What we said was that the revenues were down in trading in I think May 18 actually when we actually announced the settlement and I think subsequently at a couple of conferences a few weeks later. And that was the case, basically, for both April and May. We did not give a forecast for the whole of the second quarter and nor would I have ever done so. And I think the point about that clearly is that June in 2013 was extremely weak across credit, securitized products and emerging markets, and it's certainly true that June in 2014 was considerably stronger across all those three businesses. And I would say that the positive surprise we saw was probably the strength within that of the emerging market franchise, which definitely did pick up reasonably strongly towards the end of the second quarter. But I can certainly assure you that the trading revenues for the investment bank were definitely down by the mid-teens for April and May. And I think what that shows, essentially, is the strength of June in credit and securitized products, which is perhaps less of a surprise, but also the momentum we actually saw in the emerging markets business in June itself. And to answer the question, I would say approximately 60% to 65% of the revenues of the fixed-income number you're referring to are actually coming from the credit and securitized products businesses in the second quarter, if that's helpful.
Brady Dougan:

Do you want to – so you've basically addressed the first two questions I guess. I guess my perspective, the reason why I would say that we were – I think it was a solid quarter from the point of view of – as you said, certainly performance in the investment bank was good. I think overall, I think our client franchise had very good momentum, so, for instance, the net new assets, close to CHF12 billion. That's a really good result for a second quarter. So I think particularly when we had obviously the disruption of the settlement in the middle of that process, I think that's actually something that's encouraging. That's actually I think one of our stronger second quarters in some time. Yes, obviously not everything was good and obviously the reduction in gross margin is something that we have obviously talked about. It's something that – where we were – things – there clearly are explanations for it, but we also continue to work very hard on doing everything we can to try to increase and to offset those reductions in gross margin and increase it. So that's something that we are very focused on and clearly that's an area that we do need to work on. I think though if you look at the capital progression as well in the quarter, ending the quarter at 9.5% CET1, including the accrual for the dividend, I think that's actually quite good. So I think that was something that – we were pleased about the progress we made there. We made good progress on the NSU. I think if you look at what we did in the NSU in the quarter, I think that was something that was good. I view that as a positive. So having our strategic businesses make a 19% ROE in a quarter where we clearly had a lot of preoccupation with getting this cross-border settlement done and behind us is – I think that's actually something that – yes, I think that is something that was actually a good result. So I think on most fronts I think we actually made good progress. And again, that was in the context of a period where we obviously were getting one of our large litigation matters behind us. So yes, I think actually, looking at the result, I think it's something that's actually – I am pleased with. Yes.
Operator:

The next question comes from the line of Fiona Swaffield, RBC.
Fiona Swaffield:

I have questions in three areas. The first was coming back to David's comment on variable compensation, particularly in investment bank. But looking at the variable compensation that you give at the back I think in the cost reconciliation, it's obviously running up half on half, while revenues are down. Is that really solely due to the change in accrual methodology that you mentioned? How should we think about the second half? Is there some kind of true up? Is that a Q4 event? Just how should we think about compensation going forward in terms of the variable amount? The second issue is just generally a follow-up on electronic business within equities. Obviously this was something we talked about in the last call, but where are we in terms of percentage of revenues? Have you seen any change in appetite from clients given what's been going on at some of your peers and what's – if there's any change in strategy on that business? And then the third is just a very small number question. Just on WMC, on Hedging-Griffo, is there – should I assume that was a similar number that's fallen out to the one in asset management, so something like a basis point of gross margin? Thank you.
David Mathers:

So perhaps if I start then with the variable compensation point, so, Fiona, there's probably three factors driving the variable compensation – the compensation numbers. Firstly, I think as we said in the first quarter, we felt that our practice of accruing 25% per quarter, which is what we did up until the end of 2013, was unusual compared to industry practice and was not that closely associated with the seasonal recognition of revenues, although the seasonal recognition of revenues is not always the easiest task. So I think it's certainly true to say that the accrual we've made for the first two quarters this year is significantly higher than it would be on a straight-line basis, so in that sense that increases the variable comp number you see here and reduces the profits accordingly for the first six months. Secondly, as we've said before, I think it is our intention to reduce the amount of deferral that we award to employees to basically improve the flexibility of our cost structure going forward. So that's a further factor in that. That was true in the first quarter and it's true in the second quarter. We've not changed that policy. So what you're seeing in terms of the disclosure on page 45 really reflects those two factors. Clearly, the full-year variable compensation will depend on I guess the full-year results and the view of the Compensation Committee at that time, but it's certainly therefore conservatively stated, given that shift in terms of both the pattern of recognition and the amount of deferral we're actually planning to award in 2014. Now, clearly that therefore should, everything else being equal, Fiona, result in the variable compensation accrual being lower in the second half of this year. And we'll see how the quarters actually develop as we go through the balance of 2014. I think the second point was on the amount of the Hedging-Griffo contribution within the wealth management division. It was CHF28 million in asset management and it was CHF12 million in the second quarter of 2013 last year. So it's not as big as it is in asset management, but it obviously does have some impact, adverse impact on the gross margin of the wealth management division in the quarter. So CHF40 million for the PB division as a whole, split CHF12 million into wealth management, CHF28 million into asset management.
Brady Dougan:

Yes. And I think with regard to your question on the electronic business within equities, I would say the answer to your specific questions is no, we haven't really seen any particular change in volumes there one way or another. It's obviously a very small part of our revenue base there, but we haven't really seen any changes there. Obviously on the broader matter, we have obviously developed our electronic business over time. We've worked closely with the regulators on that. We've tried to – we obviously see a lot of benefits from that business, but we also know that there are potential abuses there as well and we've tried to work hard with our clients and with the regulators to ensure that we try to avoid as many of those potential abuses in the business as possible. And we're obviously dealing with a lot of enquiries on it, don't really see any particular issues right now, but we'll obviously continue to work through that. It is a – it is – we're really in the process on that. But we haven't – your specific question, we haven't seen any real change in the transactional volume or the revenues from them.
David Mathers:

And just to be clear, it's not an – it's about – the revenues in the business are about CHF30 million in Crossfinder, just for everyone's – just for the record for everybody. And one just follow-up point basically, I think I did mention it in the course of the presentation, the second quarter of 2013, in regard to the wealth management business, also included a large dividend from Six, the Swiss Stock Exchange, which was in reflect of the sale of their derivatives exchange, which they completed before and which they actually paid out to the Six shareholders, which is us and UBS and a number of other Swiss financial institutions, in the second quarter of last year. So between the non-repetition of that special dividend – there was a Six dividend and it was smaller – and the absence of that CHF12 million relating to the Hedging-Griffo fees, that was worth about 2 basis points on the gross margin in the second quarter.
Operator:

Your next question comes from the line of Stefan Stalmann, Autonomous U.S.
Stefan Stalmann:

Three questions, please. First, Julius Baer talked yesterday about noticing a rise in client risk appetite since April in their wealth management business. Is there anything of that order that you have seen in your business? The second question, it looks as if almost all of your new money flows in the wealth management business in the second quarter came from the ultra-high-net-worth business and I think there was only about CHF0.5 billion of flows from the rest of the business. Is that just within your normal range of quarterly fluctuation or was there something more going on? And the final question, going back to the risk-weighted asset development, David, you briefly touched on that when you discussed the changes in the second quarter. But we have now seen two quarters where methodology changes and policy changes have actually added quite noticeably to your risk-weighted assets. Is that pure coincidence? Have we just had two quarters where things worked against you on modeling and methodology or is there more to this? Is there a trend that we should expect to continue? Thank you.
Brady Dougan:

I think maybe I'll try to answer the first couple of questions and then David can address the RWA or add to my responses as well if he'd like. I think with regard to client risk appetite, I think it's, I'd say, very slightly probably increased second quarter over first quarter, so you had a slight decrease in cash balances, a slight increase in equity allocation. But to be honest, those things change relatively slowly from quarter to quarter, so we don't typically see rapid moves in that. So I'd say on the margin, yes, a slight movement, but I wouldn't say that we've seen a – anything dramatic. And I think in terms of the net new money, obviously some of that will be different from quarter to quarter, but I do think that there are a couple of things. One is obviously we do have a real focus on the ultra-high and really trying to drive our increases and our market share there. We think that's very good business and business that we're extremely suited towards, so that's part of the strategy overall. I also do think that some of the other flows are impacted by the regularization, the cross-border flows that we've seen. With over CHF4 billion going out in terms of the Western European flows, that obviously has some impact on that. And that probably tends to be not the ultra-highs, but smaller-type clients, so that's probably had some impact as well. David, do you want to --?
David Mathers:

So I think in terms of the disclosure we show on page 33, which is non-position-related impact, just to be clear, there were no significant changes in methodology from the FINMA, which actually drove this. It was a number of relatively small changes, and you would note compared to the first quarter that the number was much smaller than what we saw in the first quarter, where we did see some external change as well as internal data updates. I can give you come color on this. So if you look at page 33, you can see it was an add-on of about CHF3.7 billion, of that, about CHF700 million was actually FX movements, for example, and then there was about a similar order of magnitude, which reflected the updating within our off-risk model for the fact we obviously had the DoJ settlement in the quarter. So that was about another CHF600 million, CHF700 million risk-weighted assets. That's just the updating of the dataset. And that's because we – I think you could say that we still have then a double count for off risk because I think you may know that we also have this litigation buffer related to our reasonably possible litigation exposure, which is not – does not come down to the one bid [ph] number see before. It's actually flawed. So there is a degree of double count coming from that. So that's about CHF700 million, and there's about CHF700 million from FX. And then the rest is in the same kind of ilk. It's CHF200 million – CHF300 million type numbers throughout it. So I think, generally speaking, I probably would confirm your thesis. I think as you see models updated, fine tuning, guidance externally, there does tend to be some upwards creep in risk-weighted assets. But I think, at least in this quarter, there's nothing particularly material that's come through. It's really small updates. And I'm not really expecting much really in the second half, and certainly nothing on the order of what we saw in the first quarter, which I think – when it was much more material, Stefan.
Operator:

Your next question comes from the line of Jeremy Sigee, Barclays.
Jeremy Sigee:

I just wanted to follow up on wealth management clients and particularly the cost reduction in the quarter. Costs were down about CHF50 million from 1Q to 2Q, and obviously that was pretty crucial in offsetting the revenue decline that you suffered. So I just wondered if you could talk a bit more about what drove that cost saving and how sustainable it is because it's a bigger reduction than is indicated by your cost-saving slide, which, as you say, has moved I think from CHF0.63 billion – from CHF0.65 billion – to CHF0.65 billion [ph]. So what was the driver of that wealth management and is it sustainable on the cost line?
David Mathers:

Well, it is sustainable actually, Jeremy, and we would expect to see further progress in the second half and certainly moving forward in 2015 to the CHF950 billion there afterwards. I think it does reflect a number of measures across the business, including both reductions in the ongoing businesses and also the sale of some of the weaker-performing assets in the business, which you know we've announced the disposal of. It's a mixture of non-compensation reductions, reductions in expense related to revenue and also a reduction in our compensation expense because obviously, as you can see from our disclosure, we also do – there are less people actually involved in the business. So it's everything you would expect. It's – and it's a number of different sources.
Jeremy Sigee:

So in that sense, we can focus on the fact that the pre-tax margin was reasonably stable even though the gross margin was weaker?
David Mathers:

Well, it's really in line with the cost plan we have, in that sense. I think that's all I can really say. But there is nothing particularly extraordinary in it. It's a number of components that have actually driven that.
Operator:

Your next question comes from the line of Jon Peace with Nomura.
Jon Peace:

I had a question on your distribution policy because you said that you plan to move to a 50% payout once you reach a 10% CET1, which you're on track to do certainly before the end of 2014. But I notice also that you stressed you expect the dividend to be at or above last year's levels. And I just wonder whether you're leaving the door open that you may need to introduce a leverage test as well on dividend policy, especially in light of the too-big-to-fail commission's deliberations, and whether we ought therefore to continue to model the dividend fairly cautiously. Thanks.
David Mathers:

I think just to be clear what we have said, I think, firstly, this is just for the record, we have not committed to a formal dividend level for 2014 and the Board has not made such a recommendation to shareholders, so just formally. What we have said though is that we understand and recognize that cash dividends for our shareholders are important and that when we actually set the level of CHF0.7 in respect to 2013 it was with a weather eye [ph] both to market conditions and to litigation settlements which we could see happening in 2014. So not a complete surprise in terms of what we were expecting. And clearly, we've also made clear today that in respect to both the first quarter and the second quarter we have continued to make a full accrual for our dividend in 2014. So – but just formally, the Group has not committed nor forecast a CHF0.7 in respect to 2014, but that said, I think you can see the analysis we've gone through in terms of our thinking. Thereafter, clearly we've also said then as we move through the 10% mark we intend to distribute half of our earnings and accrete towards an 11% mark. I don't think you should necessarily read into it that there'll be a leverage test in terms of that. I think our dividend policy is what it is. I think, clearly, if we were to see a significant change in the leverage ratio for Swiss banks as a consequence of legislative change in 2015 we'll look at that then, but I think we've also made clear that we will look at any business's viability on the basis of any revised capital test and you should not necessarily assume that you would not see further adjustments to our business portfolio in the event of a significant change in the leverage ratio. So I think our dividend policy I think very much remains as we laid it out, basically, on May 18. Is that --?
Brady Dougan:

Yes. I guess so.
David Mathers:

Yes.
Operator:

Your next question comes from the line of Christopher Wheeler, Mediobanca.
Christopher Wheeler:

A couple of questions. First of all, perhaps we can return to the subject we has at the Q1, where obviously dark pools became very popular, and perhaps talk a little bit more about what you think is going on there given the news on Barclays' decline in trading volumes. Perhaps against that background, could you give us some clue as to the extent of your equity trading revenues which emanate from your dark pool and also, perhaps more interesting, just give us a view on what you think is going to happen there because there's some people saying – oh, the trading's just shifting to other dark pools? The other view is of course that dark pools are obviously losing credibility and we're going to see a marked decline. So I'm interested in your philosophy around that as well as trying to put some numbers on that topic. The second thing is on the gross margin again. On the first page of the earnings release you talk about why the gross margin fell and you talk about change in client mix. And I get what's going on, on ultra-high net worth. We all do I think. But I'm just wondering whether or not this is more of a long-term issue because the 3-basis-point drop in transaction activity doesn't seem to me to be necessarily something to do with the ultra-high-net-worth segment. And perhaps just get a better feel for what really you think was the main drivers in that perhaps surprising decline in the gross margin in the quarter. And then finally, very interesting comments you gave on how fixed income picked up and also the comparison against the weak June 2013. But one thing Jeremy Diamond said was – when he also said how pleased he was they'd had the uptick at the end of the quarter, he then basically said I think, or that's the way I read it, that everything went back to normal after June and that July was not following through. Is that the way you see it? Thanks very much.
Brady Dougan:

I guess the first question with regard to the electronic trading, as you said, I guess it's hard to say right now what directions that may go in. I think, as we mentioned before, we haven't really seen any material changes in volumes in any aspect of our electronic trading at this point. So as you say, I guess you'd have to draw your own conclusions about if others are having decreases in transaction volume or revenues, is that going to other players in the same area or to a different type of execution? I don't think we really have a good explanation for that. We haven't really seen much in the way of change in transactional activity or volumes. I think from our point of view, we have – we offer light pools as well as dark pools. As I said, we've tried to work pretty hard to make sure that we have a resilient platform that offers various different execution experiences for people. And we'll have to see how that develops, both, as you say, from a market involvement, but also the regulatory – as regulatory prescriptions around the business, maybe that will change as well. And as you know, some aspects, for instance, there's now – we were I think one of the first to start reporting on terms of trade volumes, on some of our exchange and some of our processes there. So I think that's something where there'll probably be more – we'll see more developments over time. I think it's a little bit hard to predict right now. Just to make it clear though, I think David mentioned before, but just to reiterate, our total revenue from this area is about $30 million, which is a very small percentage. I think a couple of percent of our equity revenues overall. So it's actually relatively small, not a material part of the business. So that's on that issue. I think on the fixed-income issue, and then I'll let David come back to maybe the gross margin issue, but on the fixed-income issue, I guess what we've said is that it's obviously still early in July, and it was I guess even earlier probably when some of the other people reported. But our view is that July has continued to be relatively consistent with the first half as a whole, is what we're saying. But it's obviously very early to be able to make any judgments about how that may continue. But there certainly continues to be a strong backlog of business to do on the underwriting side, as well as on the advisory side. There's a lot out there to be done. We'll obviously at some point see a pause here for some of the seasonal influences in August, I'm sure, but there's a lot to be done. So I just think it's probably a bit early to predict what direction that may go in.
David Mathers:

Well, and my only add really, which I think – just to Michaels's comment before just in terms of not getting drawn into making forecasts, I would – but I would make the point that if you look back at 2013, what we actually saw was very strong markets through to the end May and then significantly weaker activity from June really through to about the middle of November. So the comparables for the third quarter and at least part of the fourth quarter are obviously softer than what we saw in the first five months. So we'll see how it pans out, but just to make that point that essentially, as Brady said, conditions so far have been broadly similar with what we've seen so far this year. But the comparables of last year were much more volatile, very strong for the first five months, then weaker and then a relatively strong close to 2013. I think on the gross margin, I think there's a couple of points to make though. Firstly, there's no doubt that the combination of regularization and the shift to ultra-high-net-worth clients is structurally dilutive to the gross margin because – but not just in terms of the mix, but also the product penetration in the sense the type of business our ultra-high-net-worth clients does, does tend to be more transactionally biased. It's large transactions. It's often more sophisticated products. And therefore, as I think we've actually warned before but I would reiterate today, ultra-high-net-worth business does tend to be more volatile and more transactional than what you actually see in other client segments. Now, in fairness, for overall profitability it's also higher, but it is larger and more lumpy in terms of its nature. So therefore, a shift in our business mix as we regularize the Western European positions towards the ultra-high-net-worth clients would be expected to have this kind of impact in terms of the gross margin shift, albeit I think it's clear that the cyclical factors we saw in the second quarter made that more pronounced than we otherwise would have been expecting in terms of our transactional activity. But we do point out that regularization flows were CHF4.1 billion in the second quarter and that we have increased our guidance for regularization outflows for 2014 from CHF6 billion to CHF10 billion up to CHF10 billion to CHF15 billion and expecting a similar level for 2015. So you will see this continued shift towards ultra-high net worth, and that business is more lumpy and more volatile because it is more transactionally biased in terms of its mix. But I think that's really why I think --
David Mathers:

We're guiding really much more towards the net margin being sustained around the 28 basis points, and that does obviously require some re-engineering in the business with the cost measures we've talked about already.
Brady Dougan:

But it is also fair to say that we do expect the second half of the year gross margin to be similar to what we've seen in the first half at the CHF101 million type (multiple speakers).
Operator:

Your next question comes from Jernej Omahen from Goldman Sachs.
Jernej Omahen:

I just have a couple of short questions left. So firstly, this revenue from Hedging-Griffo, can you just clarify why does it make sense to book part of that in the private bank revenue? Why is that booked in your private bank, the result of Hedging-Griffo?
David Mathers:

As I said, so last year the Hedging-Griffo performance fees were CHF40 million in the second quarter of 2013, and that was booked CHF28 million asset management and CHF12 million within the wealth management business. Now, clearly the recognition is biased towards the asset management segment rather than to the wealth management business, but the distribution was actually sourced from the private bank. And therefore, under the usual market agreements, and that would apply for Hedging-Griffo and for a number of other type funds, the PB will get some share of the performance fees related to that. It's not unique to Hedging-Griffo and nor is it unique to Credit Suisse.
Brady Dougan:

Yes. Just to make it clear, the Hedging-Griffo as a business included both the asset management piece, but also a private banking portion of that. So that business is our private banking, wealth management business in Brazil is effectively – Hedging-Griffo was part of that and included both portions. It wasn't just the fund part of it, but also a private banking business.
Jernej Omahen:

All right. And then my second question would be on the development of the total balance sheet this quarter. So the assets, total assets, U.S. GAAP assets at least, were actually up CHF13 billion, and obviously the Group is still targeting to reduce the leverage exposure by more than 10% from here. I was just wondering how we tally the two, i.e. why do you think the assets were up and was there anything specific in this quarter for this to be the case?
David Mathers:

It was mostly seasonal. We saw a pickup in the balance sheet usage by the credit business. It does tend to be slightly seasonal in terms of our balance sheet utilization tends to be higher in end of the first quarter, at the end of the second quarter and then drop in the balance this year. But I think given the strength of our credit business in the second quarter, I think it seemed appropriate to allow that business to deploy some more balance sheet in the second quarter. So that was most of it, frankly.
David Mathers:

It's not a long-term trend, but I think it does – but it definitely was the right thing to do this quarter.
Jernej Omahen:

Right. And then just finally, two very brief questions, so firstly, on litigation, so is it correct from my end to summarize your comments on litigation by saying that Credit Suisse sees very limited risk from FX litigation from here? And the same, if I understood the CEO's – Dougan's comments here on the dark pools, you also see the dark pools as a very limited risk from a litigation perspective? And the final question is on capital. I think whichever way we cut this, now Credit Suisse now has the lowest capital position of any European investment bank. And I think you're also targeting a lower capital position than most of the other investment banks, actually all for that matter. So you're targeting 11% and the others are at 12%. Why is that – why do you remain comfortable with the current capital position and why is 11% the right target versus everybody else, who's aiming for a higher figure? Thanks a lot.
David Mathers:

Well, I'm not going to get into a discussion about what other banks target and don't target, although I'm not sure I necessarily agree with your comment that everybody else is aiming for more than 11%. I would point out one small point of fact really around the structure of the Swiss capital regime, which is that it is intended to encourage the use of high-trigger CoCos, where we have approximately 3% further in terms of loss-absorbing capital in the extent of that, as well as the use of low-trigger CoCos. So if you look at Credit Suisse's capital position you have to look at the total capital position, which is over 15%, even today, basically. And clearly, as we move up towards our 11% target that's going to move up to more like the 17% mark. And that obviously is split between and 11% CET1, 3% high trigger, and the balance in low trigger. So I think any analysis of our capital position has to reflect the very substantial buffer to our capital which actually comes from that. And I think just to underline that point, that was something that was actually reiterated in the Swiss National Bank's financial stability report last month as well. So those are the points I would make. I think quite clearly, in terms of the capital progression, I think we've laid out the targets. I think it's right and appropriate, the capital strategy we're actually following, which is to look to achieve the risk-weighted asset reductions we intend to, to CHF65 billion or less for the end of this year, to sell off the surplus businesses and real estate and generate between CHF0.4 billion and CHF0.5 billion over the course of the next six to nine months to actually get that because I think that will actually boost our capital position back through the 10% mark, on track to 11%, without imposing any dilution of our shareholders in respect to the DoJ settlement, which otherwise I think would be a drag in terms of book value or earnings per share for our shareholders. But I think the capital point I would just reiterate, there is a very substantial buffer now in terms of high- and low-trigger CoCos, which also protects the creditors of Credit Suisse.
Brady Dougan:

I think as to your litigation question, obviously these questions are always hard to be too precise on. I think on the foreign exchange side there have been a lot of enquiries, I think starting about nine months ago. So there've been – it's been going on for a long time. I think to date we don't see any material issues, but obviously as those enquiries continue it's not impossible that there could be issues somewhere. But as of right now, we don't see any material issues. So that's probably the most accurate statement we can make there. And I'd say on the dark pool issue or the high-frequency trading issue, that's obviously a more recent thing. It's – obviously there's been a significant increase in a lot of the enquiries there. And so we're obviously cooperating in those and we'll continue to. Again, they're – it's much earlier in the process, but we don't see a lot of issues there. We've tried to be responsive and responsible around how we've actually run that business, so our hope is that we won't see issues there. But that's probably earlier in the process, so it's a little bit harder to be as definitive about it. But – so we'll have to see how both of those issues continue to develop, but I think as of right now we don't see any material issues.
Operator:

Your next question comes from the line of Dirk Becker from Kepler. Dirk Becker – Kepler Cheuvreux Dirk Becker from Kepler Cheuvreux. I have a couple of questions on your new guidance about the Western European offshore business. You said CHF10 billion to CHF15 billion this year and next year. And I always thought that the whole process of regularization would be completed by the end of this year, so I don't understand why you still see outflows next year. And then can you remind us of the total amount of outflows that you've seen so far? And then I guess we would have to add up another CHF20 billion to CHF30 billion until the end of next year. So what is the total amount of outflows? And then the margin impact of this, I think when the whole process started your margin was at 120 basis points. It's now at 100 basis points. So I was wondering how much of this margin decline came from the demise of the offshore business, please.
David Mathers:

Great. Well, I'd just start in terms of the outflows issue, so I think the – obviously there is actually amnesties extent in Germany and France at this point. I think we've talked about Germany before. And that's clearly quite vast in terms of the regularization process. France is active now. And we certainly think that it's likely that there will be one in Italy over the course of next 15 months. So that's the basis in terms of our expected regularization flows over the next couple of years, the CHF10 billion to CHF15 billion per annum. I think year to date or, sorry, in terms of the regularization we've seen over the last couple of years, we've seen about CHF30 billion of outflows so far. So that would be what we've seen so far. And I think another CHF10 billion to CHF15 billion over the course of the whole of this year and the whole of next year. Dirk Becker – Kepler Cheuvreux And the margin impact, please?
David Mathers:

We'd have to get back to you in terms of that. It's quite an – it's not, by no means, the only factor in terms of the gross margin impact. The interest rates were obviously substantially higher several years ago and that would have had a large impact all by itself. Dirk Becker – Kepler Cheuvreux Okay. And the outlook in 2015, I always thought that the process of regularization would be triggered by you and not by your clients, so I thought you would be closing all accounts by the end of 2014, where it's not clear whether the money is declared or not. And now you're telling us that it's driven by the amnesties in the other countries, so it's still driven by your customers then. Right?
Brady Dougan:

Well, it's a combination really. I think with regard to, for instance, Germany, we do believe that that'll be substantially complete by the end of this year, but it's at different paces in different countries. And I think, as David mentioned, obviously different countries have different timetables and different probabilities around it. I think our general view is that probably by the end of 2015 basically all of Western Europe will basically be complete, at least materially complete. So it's just – it's a little hard to say. It's hard to predict exactly how these things will run. So I think we're trying to give you a feel for how we see things right now, but you're right, things obviously do adjust as different policies are adopted in different countries.
Operator:

Your next question comes from the line of Andrew Lim from Societe Generale.
Andrew Lim:

I've got three questions, firstly on the leverage ratio, just more clarity on the discussion right now. I'm just wondering how you're thinking about the introduction of an equity minimum leverage ratio. I think this is a discussion taking off in the UK. And I'm just wondering whether it's something that Swiss politicians and Swiss regulators are talking about right now. Secondly, we've seen of course Citi take a $7 billion fine and the angle there I think is that their CDO exposure, more than anything was the concern. So perhaps you could give us some color on what your relevant CDO exposure is with respect to what's been investigated by the U.S. regulators. And then thirdly, I know you're reiterating your guidance on the NII components of the gross margin bottoming out in the second half, and I'm just wondering whether the ECB rate cut has a bearing on that. I know it was relatively small, but are you saying there that it hasn't really had an impact on your – in your guidance there and we should still see that bottoming-out process in the second half? Many thanks.
David Mathers:

Okay. So just starting off with the leverage ratio point, I think to be clear, under the existing Swiss rules there is already an equity leverage ratio. You may recall, for us it's 2.4%, is the CET1 requirement. 0.7% is the component that'd be satisfied, either in the form of high trigger or in terms of incremental equity. And the balance to 4% is satisfied in the form of low-trigger CoCos. So I guess the question actually is, is what changes would you see as part of the Swiss regime? I think there's two things, one which is there's no – currently no formal Tier 1 requirement under the Swiss rules, whereas I think you know that Basel has a minimum of 3%. I think that seems likely, and it's one reason why if you actually look at our CoCo issuance, we've generally issued recently more in Tier 1 format than anything else, so already in excess of that 3% level. But I guess it's not entirely implausible you could see the equity level increased from 2.4% to 3% depending on how the Swiss political discussions actually develop. And that clearly would be perfectly manageable within our current capital plan. After all, at 11% we'd be at 2.7% equity leverage ratio in any sense. So I think worth watching, but a little bit speculative at this point. But it's not – it is – there is already an equity leverage ratio under the Swiss rules as we actually stand today, basically. I think on the net interest income guidance, it's not really based on the short-rate curve. It's based on the curve three to five years out in Swiss franc, dollar and euros. So therefore it reflects – so all you really need to do to actually project the replication portfolio is to actually look at where the curve actually shifts, three to five out. So therefore we can speak with some confidence that we know it stabilizes in the second half of this year. That said, so if you want me to think 18 months away, which is what the other – there's no doubt that the flattening of the long end of the curve has reduced the upside we'd otherwise expect to see. You've seen that in the first half of this year. But that doesn't really impact on the net interest income in the second half of this year. It probably does dilute the upside we'd otherwise expect to see over the following 12 months there afterwards. But realistically, it is purely mathematically based. Just watch the curve for the three main currencies about 18 months out and you'll get a pretty good idea of what the replication portfolio does. We simply just roll it forward mathematically. I think on the legal settlement terms of the Citi exposure, yes, I find it difficult to really comment because in terms of the CDO exposure I'm not quite sure if that really was the basis of the settlement, and it's difficult for us to comment on Citi's settlement in that sense. So not much I can add I'm afraid.
Andrew Lim:

Can you say what your CDOs were, let's say, leading up to the credit crisis?
Brady Dougan:

I don't – to be honest, I'm not sure. I know we were a less active player. If you think about the 2003 to 2007 period, we were a less active player. But to be honest with you, I'm not that up to speed on exactly where we were on that. I think our league table positions were much lower, but I don't know for sure.
Operator:

Your next question comes from the line of Andrew Simpson, Bank of America.
Andrew Simpson:

Most of them have been answered, so just two from me, one on the private bank and then one on the IB. On the private bank, just going back to the ultra-high-net-worth segment, so clearly many of your competitors are also seeking that business. So I'm just wondering how much of the gross margin impact has come from a deliberate pricing policy that presumably will unwind at some point rather than just the transactional and mix effect. And then just a clarifying number, which I might have misheard. You said the dark pools business is contributing CHF30 million in revenues. Is that for Q2 2014 or is that a rough annual number? It just sounded very low for a number one player. Thanks.
Brady Dougan:

I think on the first question, no, I don't think there's any – there's certainly no – there's no pricing policy in terms of somehow trying to use lower pricing to increase market share. I think we believe that we're very well positioned to actually gain market share there with our product mix in private banking, wealth management, but also with the ability to cross sell into the investment banking capability. So our view is actually that that should be pretty good. And I think in general, obviously again the gross margin clearly in ultra-high is lower than in our average gross margin, but I'm not sure that that has had – I think it's been relatively stable. Maybe it's been going down a little bit, but relatively stable.
David Mathers:

Yes. I think also our gross margin is around the 50 basis point mark I think is very similar to what I've seen quoted for other peers in terms of the numbers. So I don't think it's out of order. It simply reflects the mix of the business, the fact it's more transactional than the classic high-net-worth or affluent type segment. As we've said before, just to be clear, a lower gross margin of 50 basis points results in a higher net margin though because clearly the size of the revenues on the transactions is much higher, but the percentage you're actually paying is lower. And I think, just formally to confirm it, the revenues from the Crossfinder product are $30 million per annum.
Operator:

Thank you. That was your final question, sir. Thank you.
Brady Dougan:

Very good. Well, thank you all for listening in on the call and thanks for all our questions. Thank you very much.
Operator:

(Technical Difficulty) today's conference. An email will be sent out shortly advising how to access the replay of this conference. Thank you for joining the call today, and you may all disconnect.

Credit Suisse Group AG Q2 2014 Earnings Call Transcript

Other Credit Suisse Group AG earnings call transcripts:

Credit Suisse Group AG
Q2 2014 Earnings Call Transcript