Swiss gnomes in cloud-cuckoo-land

ZURICH'S gnomes, those secretive fellows that former Labour Prime Minister Harold Wilson accused of almost bringing the British economy to its knees during the devaluation crisis of 1967, are emerging blinking from their marbled banking halls to discover the world has changed rather more than they suspected since they last took a peek.

Switzerland's asset management business looks after about a third of the billions of dollars of the world's offshore savings. The soaring stock markets of the 1990s were very good to its financial institutions, especially the private banks, a group that includes about 15 larger internationally active institutions (but not the two banking giants UBS and Credit Suisse Group) and specialises in providing haute couture asset management to the world's wealthy.

As the very rich got very much richer, private bankers could happily plump up their cushions and pat their wallets. Even five years ago, when awkward questions began to be asked about the way in which Swiss financial institutions had handled the assets of European Jews who had been victims of the Holocaust, many Swiss bankers responded initially with an insouciant shrug. Now, however, it is becoming clear that last year was a financial disaster which is exposing the fragility of the sector's underpinnings.

Last week, Julius Baer, the largest and best-known internationally of the group, shocked observers by cutting its dividend, disclosing that net profits had plunged 48% and revealing that assets under management had shrunk 11%. The tentative signs that a few well-heeled customers, who normally suffer from a mighty dose of inertia when it comes to changing bankers, could be starting to vote with their feet was particularly disconcerting.

A Deutsche Bank analyst even posed the question: 'Will these Baers ever get new money again?' before implicitly answering in the affirmative and putting a buy recommendation on the stock.

Most of Baer's rivals are suffering too. Bank Sarasin said this week that its profits slumped 57% last year and disclosed it is giving up its independence - selling an initial 28% stake to Holland's Rabobank, a co-operative.

And as its shares plunged, Vontobel Holdings said its profits for 2001 would halve. Meanwhile, Swiss Life has indicated it is anxious to be shot of its involvement with Banca del Gottardo, one of the real aristocrats of the sector. It only bought the bank in 1999.

Swiss Life's decision was accompanied by the news that Manfred Zobl, author of its aggressive expansion policies, was quitting. That followed the decision of Rolf Hueppi to step aside as chief executive of neighbouring Zurich Financial Services. It, too, has run into trouble with its international asset management expansion.

So what has gone wrong? In London last week, Jean-Pierre Roth, chairman of Switzerland's central bank, dropped a heavy hint that there is one issue to which all financial centres need to pay more attention. 'Reputational risk is the major challenge facing financial centres at the beginning of this century,' he argued.

Roth emphasised that Switzerland was well aware of the way in which drugs traffickers, weapons traders, terrorists, criminals in general and even modern slave traders, can misuse financial centres. And he stressed the positive steps that Switzerland is taking to reduce its vulnerability to such misuse. He even indicated that Switzerland is ready to reform its withholding tax regime so that it does not become 'a privileged haven for funds seeking to avoid European Union regulations'.

Critics of Swiss banking secrecy say they detect a change of mood. But financiers who know Switzerland well also argue that in the 1990s, as the volume of their assets under management soared along with their profits, too many bankers paid too little attention to the potential damage which financial scandals were doing to the nation's reputation.

'At first, they virtually ignored the reputational problem posed by these issues,' said Ray Soudah, founder of Millennium Associates, a merger and acquisitions adviser to the global wealth and asset management industry. 'Now, the Swiss are 100% serious about tackling money laundering, terrorism, tax evasion and corruption. But how do you recover a tarnished reputation?'

As the profits performance of the private banks shows, whatever damage has been done to reputations is being amplified by setbacks from ill-conceived business strategies. In the fat years, banks paid too little attention to costs and the fact too much of revenue streams was geared to fees based on asset values which can fall, as well as rise. In many cases they did not develop the specialist skills needed in the increasingly competitive global wealth management business. Or, flushed with profits and ambition, they diversified into businesses that they barely understood.

So today, as they set about trying to ensure they hold on to these funds and make profits managing them, observers are even beginning to anticipate a wave of mergers as, for the first time in decades, Zurich's gnomes wonder just how robust their business models really are.