Julius Baer: how one banker laundered millions of 'dirty dollars' out of Venezuela

How to steal a billion dollars

It all started in December 2014, a time when Venezuela was one of the richest oil-producing countries of the world. Under Hugo Chavez and his successor Nicolas Maduro, the government had introduced its own brand of socialism, in which oil revenue was used to provide generous housing, food and healthcare subsidies for the population.

Such generosity was only possible as long as the price of oil stayed high, but it began to fall. As oil prices cratered, Venezuela staggered into chaos. Inflation jumped to over 60%.

In a futile attempt to restore stability, the government fixed the exchange rate of the bolivar, the main currency of Venezuela, against the US dollar, and established an official currency exchange mechanism, in which few people were allowed to participate. A parallel foreign exchange black market quickly sprang up to fill the void.

Matthias Krull was an employee of Julius Baer, attached to the Venezuelan branch of the Swiss private bank. Born in Germany, Krull spent his early years in Caracas after his father was asked to serve as a pastor for the Protestant community in the Venezuelan capital. Krull would go on to study in Switzerland, and after his graduation returned to Venezuela to work as a banker. In 2009, he helped Julius Baer open the bank's first office in Caracas.

A well-connected banker, Krull soon discovered that there was a group of fraudsters gaming Venezuela's fixed exchange rate mechanism. The model was simple enough. The fraudsters would purchase bolivars from the black market and extend loans to Petroleos de Venezuela ('PDVSA'), also in bolivars.

Because PDVSA was one of the few participants allowed to transact at the official exchange rate, it would repay the loans in euros, at the official rate. The fraudsters would then end up with more US dollars or Euros than they started with. The entire scheme, which included accomplices within PDVSA, allowed the fraudsters to amass a fortune that some observers placed at USD 1.2 billion.

Krull was in charge of the money-laundering part of the scheme. A canny operator, Krull employed a variety of models to avoid detection.

A significant amount went to Malta, wired to shell companies which had nominee shareholders, 'strawmen' which owned the companies only in name. Malta had been chosen as it was perceived to have weak banking supervision and more importantly, because it used the euro, a stable currency. Once received, some money was invested into different businesses and financial instruments : bonds issued by one company, real estate in Spain.

Funds were also wired from bank to bank, to the extent that the money trail became murky and the identity of the original sender impossible to be traced. It is estimated that Krull managed to personally launder at least USD 60 million, out of the alleged USD 1.2 billion stolen from PDVSA.

The scandal cast a long shadow over the operations of Julius Baer, particularly in Latin America. In the aftermath, Julius Baer closed its office in Panama, where Krull was based before he left the bank in June last year and was caught the next month. An extensive internal probe was initiated. The bank also decided to exit both Panama and Peru as part of a review into its regional operations.

The rogue banker is not unique to Julius Baer. Societe Generale had Jerome Kerviel and UBS Kweku Adoboli, whose unauthorised trading caused their employers to lose billions. In certain aspects, these banks have emerged from the crises stronger and more resilient than before.

In the case of Julius Baer, the bank never faced any criminal charges in relation to the affair, which has since faded into the background. In fact, shortly before Krull was sentenced in October to 10 years in prison for his involvement in the illicit scheme, Julius Baer announced that its first-half pre-tax profit had increased by 18%, demonstrating that the affair had little impact on the market's confidence in Julius Baer.

In the next section, we will discover Julius Baer, a truly venerable Swiss bank with a 129-year history. We invite you, the reader, to join us as we learn more about the bank and its businesses.

About Julius Baer

'If contact between people is based on trust and absolute integrity, then it is of benefit for both sides. '

Julius Baer (1857 – 1922), Founder of the Julius Baer Group

Many of the most successful businesses that we know of today had very humble beginnings, and Julius Baer was no different.

Julius (Isaac) Baer was born in Heidelsheim in the Grand Duchy of Baden (now part of modern-day Germany) on 2 January 1857. Named Isaac at birth, he later changed his name to Julius in 1897.

After moving to Zurich, Baer joined a partnership operating a bureau de change (exchange office) located along Bahnhofstrasse, the city's most famous thoroughfare. The bureau de change had been founded by two individuals, Ludwig Hirschhorn and Theodor Grob, who recognized early on the importance of Zurich as an international trade hub.

In 1902, Baer acquired control of the business. Under consolidated management, Julius Baer expanded into wealth management, FX trading and securities dealing, activities that remain mainstays of the Julius Baer Group today.

The advent of World War II put a pause on Baer's plans, but did little to throttle his ambitions for the business. After the war was over and peace restored, Baer immersed himself in building his business again. Indeed, the post-World War II period was one marked by strong economic growth and technological progress.

The business also began to expand its operations internationally, laying the initial building blocks for Julius Baer's global franchise. The success of the firm drew the attention of other members of the Baer family, and a rising number of family members joined the Julius Baer partnership.

Julius Baer was then a relatively small Swiss bank with limited resources. The partnership quickly realized that if it were to realize the full scale of its ambitions and make further inroads internationally, it would have to raise substantial external financing. Thus in 1980, the company made the momentous decision to issue shares to the public, becoming the first Swiss private bank to do so.

Interestingly, even though most of the group's shares were now in the hands of outsiders, the Baer family continued to exercise overwhelming control of the company's operations. The family had retained the majority of the voting rights from the public offering, even though the company had sold off the bulk of its economic interests. It was only in 2005, with the introduction of the 'one share, one vote' principle, that the Baer family gave up the control of the company.

In September 2005, Julius Baer signed a deal to acquire three private banks (Ferrier Lullin & Cie, Ehinger & Armand von Ernst, and Banco di Lugano) and an asset management firm (GAM Holding AG) from UBS AG, a transaction that thrust Julius Bar into the big league. As part of the deal, UBS acquired a 21% interest in Julius Baer, a stake that would eventually be divested by the Swiss banking giant to finance a share buyback.

The large purchases failed to permanently sate Julius Baer's appetite for acquisitions: the group was soon back on the acquisition track with a deal to acquire Merrill Lynch's International Wealth Management ('IWM') business located outside the US. At the point of acquisition, Merrill Lynch’s IWM business had USD 84 billion of assets under management ('AUM'), and was supported by approximately 2,000 employees and 500 dedicated relationship managers. The acquisition, valued at some CHF 860 million, resulted in Julius Baer’s AUM increasing by some 40%.

In November 2012, Julius Baer and Milan-based Kairos Investment Management SpA ('Kairos') teamed up in a joint venture to jointly run and coordinate their wealth management activities in Italy. As part of the deal, the companies’ respective wealth management operations in Italy were folded into a new group bearing the name Kairos Julius Baer. Julius Baer also acquired a 19.9% stake in Kairos.

Over the years, Julius Baer has forged a reputation as a best-in-class player in the field of wealth management, renowned for its commitment to distinctive service and client confidentiality. Unlike its larger Swiss counterparts, Julius Baer bills itself as a private bank that maintains an exclusive strategic focus on wealth management. Its offerings are carefully curated: services include investment management, real estate financing, wealth management and a limited selection of trading services (primarily in FX).

Julius Baer operates in 28 countries and employs almost 6,800 employees worldwide. It currently has a market capitalization of about CHF 8.20 billion.

A review of Julius Baer's financials

Despite weaker global economic conditions and political tensions resulting from the US-China trade dispute, Julius Baer posted solid financial results for the first half of 2019. Half-yearly operating income came in at CHF 1.70 billion, down 5.0% YoY but up 7.6% compared to the second half of 2018. With half-yearly adjusted operating expenses of CHF 1.23 billion, profit before tax for the first half of 2019 was CHF469.8m (1H18: CHF582.7m; 2H18: CHF394.4m).

For the first six months of 2019, the bank reported a cost-to-income ratio of 71.0%, a significant improvement from the 74.3% figure reported for the second half of 2018. A measure of operational efficiency, the cost-to-income ratio reflects a company's operating expenses in relation to its operating income. The lower the ratio, the more efficient the company is.

We pause here to make a brief observation about Julius Baer's cost-to-income ratio. A cost-to-income ratio in the low 70s for a Swiss private bank is considered to be relatively low. By way of comparison, the cost-to-income ratios of UBS and Credit Suisse were 77.4% and 77.5% respectively.

In terms of profitability, Julius Baer posted a return on tangible equity (annualized) of 25% in the period, some 3 percentage points higher than the 22% posted for the six months ended December last year. Tangible equity refers to the part of shareholders' equity that is not derived from goodwill and other intangible assets.

For the first half of this year, Julius Baer continued to maintain an excellent solvency profile. Its BIE core equity tier 1 ('CET1') ratio was 13.1%, up 30 bps from the 12.8% reported in December 2018.

The number of staff employed by the firm at the end of June 2019 was 6,768, some 1.1% higher YoY.

As expected from a pure-play wealth management firm, Julius Baer makes most of its money through commission and fee income derived from its suite of private banking services. For the first half of 2019, a full CHF955.9m, 56.3% of operating income, was categorized as net commission and fee income. 30.3% of total operating income came from net interest and dividend income. Net trading income made up 11.6% of the bank’s aggregate operating income.

Commission and fee income is especially valuable and important to a bank like Julius Baer. The value of this income lies in its recurring nature, and its intrinsic attribute of bearing lower correlation with macroeconomic factors, as compared to other sources of income for a bank. This stands in stark contrast to trading revenue (which is highly cyclical) and net interest income (which is significantly affected by central bank policies).

In this respect, we are heartened to observe that Julius Baer earns more than half of its operating profit from recurring sources. In the first half of 2019, the proportion of recurring income from commissions and fees was 56.2%.

An in-depth look at Julius Baer's wealth management business

Julius Baer currently employs 1,490 dedicated relationship managers. These individuals not only maintain existing client relationships, they also source for new business , developing new client relationships and attracting fresh funds. Collectively, the relationship managers play an integral role in the bank's success in the short and long term.

In the first half of 2019, these rainmakers brought in CHF 6.2 billion in net new money, bringing total AUM to CHF 412.3 billion. Net new money as a proportion of total AUM was 1.6% for the six-month period.

To understand how successful Julius Baer has been in attracting new money, all we need to do is to look at how UBS and Credit Suisse , banks with substantial wealth management businesses, performed. In the first half of the year, UBS reported net new money of CHF 20.6 billion, about 0.8% of its assets under management. Credit Suisse’s ratio was approximately 1.9%.

Considered in this context and bearing in mind that Julius Baer maintains a relatively lower cost/income ratio compared to its two larger counterparts, we cannot help but conclude it has been quite successful in its endeavors.

The incisive reader would recall that because Julius Baer is a pure-play wealth management group, the quantum of funds under management (and how it evolves) underpins and determines the present and future success of the group. The bank’s two main profit engines , fee income and interest income , bear a direct relationship with its AUM.

To see why this is the case, let us first consider fee income. Private banks and wealth management firms such as Julius Baer typically levy advisory fees on accounts, which vary as a function of AUM. In other words, the greater the amount of assets under the bank's supervision, the higher the fee income. In the report 'Paying for Investment Advice: A Private Banking Revolution' released by Deutsche Asset Management in February 2018, the authors found that for an account with five million Swiss francs on a balanced trading strategy, the average fee levied was approximately 87 basis points ('bps').

The relationship between interest income and AUM is not so direct, but the relationship between the two variables is positive nonetheless. In the case of Julius Baer, a significant part of its loan or interest income is derived from 'Lombard loans', loans secured by various types of assets. Of the CHF 46.7 billion in loans to customers that the bank had on its books as of 30 Jun 19, Lombard loans made up CHF 37.3 billion or almost 80%. One can imagine that with a larger asset pool under its care, there would be more room for such secured loans to be extended.

Some discussion about AUM is in order, for the benefit of readers who might not be familiar with terms used in the wealth management context. Essentially, the term refers to bankable assets managed by the bank. This usually includes portfolios of wealth management clients that are subject to discretionary or advisory mandates. Assets with discretionary mandate refer to assets for which investment decisions are made by the bank. For accounts subject to advisory mandates, investment decisions are made by the respective account holders.

Non-bankable assets such as art work and mortgages are not considered a part of the AUM pool. Such assets would be regarded as part of the bank’s pool of assets under custody, but they would not be included in the AUM pool.

An important point: Assets might be subject to more than one type of asset management service. Should this be the case, industry practice allows for the assets to be “double counted” in the calculation of total AUM. The underlying rationale is that each separate service provided generates additional fees and other non-tangible benefits.

Credit quality of loan assets

With about 52.5% of Julius Baer's loan book comprising of Lombard loans, it is beneficial for us to gather some information about their underlying credit quality. During the first half of the year, the amount of Lombard loans that were credit-impaired rose slightly, but still remained extremely low. CHF118.4m out of a total of CHF 37.3 billion of Lombard loans was reported credit-impaired : an impairment rate of 0.31%. In December 2018, only CHF48.3m of Lombard loans were impaired.

Mortgages also experienced a slightly higher impairment rate. The proportion of credit-impaired mortgages was 0.3%, versus 0.2% at the end of last year.

Julius Baer's trading operations

Much credit for the profitability of Julius Baer's trading division can be attributed to its foreign exchange department. Of the CHF197.1m in net trading income posted for the first half of 2019, foreign exchange trading activities contributed CHF304.3m. This implies, of course, that other types of trading activities were loss making.

Fixed income trading and equity trading reported losses of CHF39.5m and CHF67.7m respectively. In the same period last year, trading in debt instruments contributed CHF22.4m in net trading income, while equity trading reported losses of CHF53.3m. These losses are of smaller concern to us; their magnitude pales in comparison to profits recorded on the FX side. Besides, it is well known that fixed income and equities trading is cyclical in nature.

In contrast to the disappointing results from debt and equity trading activities, the FX department appears to have grown from strength to strength. The 1H19 net trading income of CHF304.3m represents a significant jump of 28.3% YoY.

As a whole, Julius Baer's performance on its trading portfolios appears to be sound, and is an essential contributor to the bank’s bottom line.

Debt profile

Julius Baer maintains an exceedingly conservative debt profile, with an overwhelming proportion of debt bearing no maturity i.e. they are perpetual. Of the CHF 1.88 billion in total debt issued, only CHF325.5m (carrying value) bears a fixed maturity date. It is this conservative profile that leads us to be positively predisposed towards Julius Baer bonds.

The table below provides an overview of outstanding debt issued by Julius Baer.

Figure 1: Debt issued (as of 30 Jun 19)

The CHF 200m (notional amount) bullet bond is denominated in CHF and matures only in Dec 2024. Due to its status as a senior unsecured issue (unlike the bank's perpetual bonds, which are ranked at the subordinated level) and the negative interest rate environment in Switzerland, the note bears a yield to maturity of negative 0.34%. Needless to say, we do not see any compelling reason for local investors to even contemplate this issue.

The best fixed income opportunities in Julius Baer

Julius Baer has a number of outstanding perpetual bonds. In this section, we will undertake a comprehensive analysis of these issues and consider whether current valuations provide any attractive investment opportunities.

A selected list of Julius Baer perpetual bonds may be found below in Figure 2.

Figure 2: Selected Julius Baer bonds

Julius Baer has two outstanding perpetual issues denominated in SGD. The BAERVX 5.900% Perpetual Corp (SGD) has a first call date in November 2020 and bears a yield to call ('YTC') of 3.50%. The BAERVX 5.750% Perpetual Corp (SGD) has a first call date of 20 Apr 22 and has a YTC of 4.30%.

At first glance, it might seem obvious that the BAERVX 5.75% perp is more attractive, given its higher yield. However, we need to be mindful that the issue has a first call date that is some 1.5 years later than that of the BAERVX 5.9% perp. Even if we assume that both perpetuals will be called on their respective first call dates, the fact that the BAERVX 5.750% Perpetual Corp (SGD) has a later call date means that it has greater duration risk. Thus, it is wholly normal for some yield premium to be ascribed to this risk.

Figure 3: Z-spreads on the Julius Baer perpetuals

Plotting the Z-spreads of the three perpetual bonds against their remaining years to first call informs us that the BAERVX 5.750% Perpetual Corp (SGD) might be more attractive relative to the other two bonds. In addition, with just 2.7 years before the first call date, investors can strike a balance between mitigating reinvestment risk and duration risk.

As tier 1 capital instruments, all three perpetuals are subject to the same write-down trigger event. What this means in practical terms is should the bank's CET1 ratio fall below 7%, the perpetual bonds shall be written down to the extent that allows the bank's CET1 ratio to be restored to a level above 7%. This is a remote possibility in the case of Julius Baer, whose CET1 ratio has been on an upward trend and currently stands in excess of 13%.

Our view on relative valuation

We would be remiss if we glossed over the issue of relative valuation, one which we feel is of significant importance to the fixed income investor. When we speak of relative valuation in the context of Julius Baer, we are referring to how the Julius Baer perpetuals are priced in relation to perpetual bonds issued by other Swiss banks.

An analysis of the perpetual bond landscape in the Swiss banking sector leads us to the conclusion that Julius Baer's perpetuals have been overlooked by investors and are attractively priced on a relative basis.

To see why this is the case, let us compare the bonds issued by Credit Suisse and Julius Baer : the CS 5.625% Perpetual Corp (SGD) and BAERVX 4.75% Perp (USD). Both perpetual bonds may be called by the issuer in 2024. The CS 5.625% perp has a YTC of 5.15%, while the BAERVX 4.75% perp has a YTC of 5.68%, which translates to an implied yield of 5.52% in SGD terms.

Even though both bonds have similar yields, our decision in favor of Julius Baer can be easily made on the basis of the bank's stronger fundamentals. We quickly grasp this reality when we compare the two banks’ solvency ratios. Credit Suisse, with a CET1 ratio of 12.5% in 2Q19, pales in comparison with Julius Baer, whose CET1 ratio is a full 60 bps higher.

Afterword

It is eight o' clock in the morning and the visitor steps out of the train at Hauptbahnhof, Zurich's main train station and one of the busiest in the world. The station has 26 train tracks, and a vast complex filled with shops and restaurants for every taste. But the visitor is on a mission, and there is little time for exploration today.

Leaving its vast concourse, he steps out into Bahnhofstrasse, where Julius Baer first established his fledging foreign exchange business some 120 years ago. These days, it is Zurich’s prime shopping district, one of the priciest in the world on a per square meter basis.

A city map in one hand and his favorite newspaper in the other, the visitor starts on the long stretch that is Bahnhofstrasse. It is early in the morning, and the street is relatively quiet. A tram glides silently past.

He passes the fabled Sprungli confectionery, the city's most well-known patisserie with a 175-year history. Its shelves are adorned with the most exquisite confectionary: pretty pralines in brownish hues, light fluffy macarons filled with cream. But the visitor is engrossed in his thoughts, and the delights fail to tempt.

At No. 36 Bahnhofstrasse, he stops abruptly. A sleek, elegant sign adorns the entrance. Julius Baer. He pauses a moment. It is his first time meeting his relationship manager. He takes a tentative step in.

In the marbled reception area, the banker, draped in a monotone three piece suit, is waiting. A discreet smile and a firm handshake convey the unspoken Swiss values of confidentiality, discretion and excellence.

It’s the start of a fruitful relationship.

Recommended Bond: BAERVX 5.750% Perpetual Corp (SGD)

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a principal position in UBS 5.875% Perpetual Corp (SGD) . The analyst who produces this report own none of the above mentioned securities.