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Global Equity Research

08 March 2011

Global Investment Banks


Regulatory Arbitrage series: OW European over US
IBs

Banks
AC
Kian Abouhossein
(44-20) 7325-1523
kian.abouhossein@jpmorgan.com

Jerzy Kot
(44-20) 7325-9729
jerzy.s.kot@jpmorgan.com

Amit Ranjan
(44-20) 7325-4780
amit.x.ranjan@jpmorgan.com

Delphine Lee
(44-20) 7325-3971
delphine.x.lee@jpmorgan.com

J.P. Morgan Securities Ltd.

See page 78 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

Table of Contents
Portfolio Snapshot ...................................................................3
Investment Case and Valuation...............................................6
Regulatory Arbitrage I: Tougher than expected Volcker
rules undiscounted ................................................................22
Key terms from Dodd-Frank Act on “Proprietary Trading” 33
Regulatory Arbitrage II: EU compensation analysis – favors
Global IBs over EU IBs, winners AM & HFs .........................42
Compensation Regulation and disclosure creates an equal
level playing field....................................................................46
CSG – toughest compensation rules so far .........................48
Basel 3 framework -“Building buffers through capital
conservation” .........................................................................49
Key Points from the EU Compensation Regulation ............50
Key Requirements ..................................................................54
Scope of Application..............................................................60
Regulatory Arbitrage III: Section 716, pushing part of
derivatives out of the US depositary bank ...........................62
Section 716 – pushing part of derivatives business out of
the US depositary bank..........................................................64
Valuation Methodology and Risks ........................................77

2
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

Portfolio Snapshot
Following our two reports on Volcker limits and EU compensation rules, we
complete our Regulatory Arbitrage series today with our analysis of the third key
regulatory issue opposing the US vs. Europe: Section 716 of the Dodd-Frank bill.

Relative to US Investment Banks, European IBs are overall “winners” from


regulatory arbitrage opportunities, based on our analysis of the three key
regulatory issues: 1) Volcker prop trading limits, 2) EU compensation rules, 3)
Section 716 or swap push out provision.

Regulating IB comp structures has been a key element of financial reform in Europe
to limit risk taking, while in the US the approach is more direct through the Volcker
rule and the segregation of part of the derivatives activities from the bank. The
financial implications of changes in EU compensation structures are significantly less
material for European IB profitability than the two key constraints for US IBs in the
Dodd-Frank bill – Volcker limits (Section 619) and to a lesser extent the swap push
out rules (Section 716). Hence, European IBs could benefit from regulatory
arbitrage opportunities and gain market shares in market making and some of
the derivatives activities.

• Volcker rule could hit not only US IB ‘pure’ prop trading but also their market
making activity earnings. European IBs would be the relative “winners” as
Volcker rule provisions are unlikely to be implemented by the EU/Swiss.
• EU compensation rules could threaten the competitiveness of European
Investments Banks as employers, through higher bonus retention and
deferral rates, however, the rules only affect the top 200-400 employees.
• Section 716 or the swap push out provision requires the segregation of some
of the derivatives activities from the banking entity. In our universe all major
European banks (except from HSBC) will be unaffected whilst US banks would
have to set up a new swap entity to comply with Section 716.

We remain OW IBs over traditional credit banks, which in our view have
limited earnings momentum, and stick to our preference for European IBs over
US IBs, with the Swiss banks as our top picks ticking all the right boxes. Our
pecking order is UBS, CSG, MS, BNPP, SG, BARC, GS and DB.

• European IBs continue to trade at more attractive multiples compared to US


IB peers. Despite recent underperformance of US IBs, US IBs still trade at 1.1x
tangible book value 2012E, vs. European IBs at 0.9x NAV (excluding the WM
business at 10x PE).
• We prefer Swiss IBs’ business mix and equity gearing, with i) relatively
resilient private banking exposure at average 32% of 2012E earnings, and ii)
equity gearing over fixed income within IB – we expect equities revenues to
grow 8% CAGR 10E-12E vs. fixed income to decline -3%.
• European IBs could benefit from regulatory arbitrage opportunities: We
believe that the tougher Volcker and swap push out rules in the Dodd-Frank bill
for US IBs could represent a material revenue opportunity for European IBs.

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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

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4
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

Investment Case and Valuation

5
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

Investment Case and Valuation


We remain OW IBs over Traditional Credit Banks
Table 1: IB revenue growth rates We are OW IBs as a sub-sector within our Banking universe as i) despite our
10E-12E expected decline in FICC revenues of -3% p.a., we forecast that for FICC, ongoing
12E/11E CAGR market volatility, strong refinancing schedule, and ongoing steep Yield Curve for 2011E
Equities 8% 8% will keep overall FICC at a level in-line with 2006-07, ii) in Equities, pickup in both
Fixed Income -4% -3%
IBD 8% 8% client flow revenues and ECM/M&A over the next two years are expected to lead to 8%
Total IB 3% 4% p.a. revenue growth assuming 5% p.a. equity market performance, and iii) we feel Basel
Source: J.P. Morgan estimates, Company data. 3 capital impacts are priced in. Overall, we expect IB revenues to grow 4% p.a. for
the IB industry with equity geared IBs outperforming. Clearly, there remain
material regulatory headwinds but we feel IBs have the opportunity through
compensation ratio adjustments to create shareholder returns in the long-term.

Overall, European IBs reflect our preference for i) well capitalised banks with
attractive valuation, ii) relatively resilient private banking exposure, iii) equity
gearing over fixed income within IBs and, iv) European IBs best positioned on an
overall basis for US vs. Europe “regulatory arbitrage” opportunities as we outline in
our regulatory arbitrage sections below.

We prefer equity gearing over credit as we see limited upside in traditional


credit banks compared to equity geared IBs with an improving provision trend
already discounted, especially in Europe. We expect European loan growth to
remain muted at 3.5% p.a. for the next two years.

Table 2: Swiss IBs preferred stocks due to attractive valuation and preferred business mix
Business Mix (prefer
Private Banking IB revenue mix (prefer
Valuation Capital exposure) Equity gearing) Regulatory Arbitrage Number of Positives
UBS √ √ √ √ √ 5
Credit Suisse √ - √ √ √ 4
Morgan Stanley √ √ - √ X 3
BNP Paribas √ √ - X √ 3
Société Générale √ X - √ √ 3
Barclays √ √ X X √ 3
Deutsche Bank √ X - X √ 2
Goldman Sachs X √ X X X 1
Source: J.P. Morgan estimates.

Preference for Euro over US IBs in a New Regulatory World


In our report “Global Investment Banks: Portfolio Snapshot: Switching OW from US
IBs to Europe IBs - Downgrading GS to N” on 12th January 2011 we switched
within Global IBs our preference from US IBs to Europeans IBs with a preference
for the Swiss IBs UBS and CS. We maintain our preference for the European IBs
over US IBs, despite recent underperformance of the US IBs.

Why do we maintain OW European IBs over US IBs today?


In our view, i) European IBs continue to trade at more attractive multiples compared to US
IB peers, ii) the market has largely priced in a share buyback scenario for US IBs,
particularly GS post the details of the Fed Stress Test results which are expected on 21st
March 2011, and iii) based on our analysis European IBs (DB, SG) have priced in now
potential EPS dilution from capital issuance to offset the JPM capital deficit methodology.

6
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

European IBs the overall ‘winners’ in Regulatory Arbitrage


Our analysis regarding regulatory changes for the IB sector leads us to conclude that
European IBs will be the overall winners due to regulatory arbitrage opportunities.
We discussed in our series of notes on regulatory arbitrage published over the last
couple of months, the three key regulatory arbitrage scenarios between Europe and
the US, in our view. Our analysis suggests that overall taking into account the 3 key
regulatory issues, the US IBs have more potential earnings at risk and could actually
lead to earnings opportunities for European IBs.

Table 3: Regulatory Arbitrage: European IBs at an overall advantage compared to US IBs


US IBs European IBs
Tougher than expected Volcker rules X √
EU Compensation rules √ X
Section 716 X √
Overall X √
Source: J.P. Morgan estimates.

1.) Volcker Rule: Section 619 of the Dodd-Frank Act, also known commonly as
the Volcker Rule, prohibits banking entities from engaging in proprietary
trading. Initial interpretation suggested that only pure proprietary trading
activities of the banks would be impacted by the Volcker rule. The key issue
coming out of recent communication between lawmakers, SIFMA and
FSOC is the possibility of market making related activities of banks being
impacted by the Volcker rules. This possibility has arisen because of different
interpretation of the phrase “selling in the near term” when used in the context
of a trading account and when used in the context of “market making related
permitted activities”.

In our view, European IBs would be the likely “winners” in a scenario where
“market making related” revenues of US IBs are impacted by the provisions as
the EU has not shown willingness to adopt a similar provision in Europe. Hence,
US IB revenues will be negatively impacted, but will overall benefit
European IBs running their market making and prop positions out of
Europe. Large European IBs such as DB, Barclays especially in Fixed Income
(and especially in the derivative parts) would be the “winners” with French
Banks BNP and SG also benefiting in their Equity Derivatives business at the
cost of the US IBs in our view – stepping into the ‘liquidity void’ created by the
Volcker rule impacting US IBs. For details, please refer to the section below on
page 22.

2.) EU Compensation analysis: According to new EU compensation rules, key IB


staff in Europe would at best receive 20% of their cash upfront, 20% retained for
an estimated 6 months to 2 years, and an estimated 60% deferred between 3-5
years in our view.

We believe the EU compensation rules will lead to regulatory arbitrage risk with
the European IB industry becoming less competitive than other Global IBs
which are only impacted in Europe in their ability to attract and retain top/key
talent. In addition, comp regulation is likely to reduce cost flexibility as fixed
salaries will be increased further in Europe to offset the higher bonus deferral,
which will likely put pressure on Tier II/III IB players – especially in weaker
markets. For details, please refer to the sections below on page 42.

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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

3.) Section 716 of the Dodd-Frank Act will require banks to separate their
derivative business from those banking entities that are able to tap Federal
Reserve credit facility. BofA, Citi and HSBC appear to be most impacted by the
provisions of the bill, but the impact will be relatively muted with a 5-10bps
decrease in Core Tier 1 ratios. In our view these banks will need to set up a new
swap entity (or adopt the existing one), change documentation with clients as
trading will be executed from a different entity, inject capital and arrange
funding to the new entity. GS will be largely unaffected as most operations
carried out of its 'bank' are in exempted areas. MS already conducts most of its
derivatives activities outside of the deposit bank, hence we also envisage no
impact. However, US Money Centred Banks are expected to be materially
negatively impacted by section 716, in our view, compared to European Banks
where we do not expect section 716 to be implemented in Europe.For details,
please refer to the section below on page 62.

Hence, we maintain our preference for European IBs over US IBs, with
preference for Swiss names UBS and CS: Our pecking order is 1) UBS (OW), 2)
Credit Suisse (OW), 3) MS (OW), 4) BNPP (OW), 5) Société Générale (OW), 6)
Barclays (N), 7) GS (N) and 8) Deutsche Bank (N).

Stock selection rationale


Global IB top picks - UBS and CSG: own both in 2011
In our view, both UBS and CS tick the right boxes in terms of i) excellent entry point
in terms of valuation (see below sections), ii) the right business mix in terms of our
preferred business segment Asset Gathering accounting for 42% of 2012E group
earnings on average and high Equity gearing within the IBs of average 37%
compared to 27% for global peers in 2012E. One key issue is clearly the weak Fixed
Income business – however we see material restructuring potential leading to
potential capital release.

The high equity gearing of Swiss banks provides potential upside from a pickup in
Equity markets, not only in terms of gearing through Wealth Management Invested
assets but also from Equity revenues in the IB.

In addition, from a European perspective, Swiss Banks have material potential (and
highest potential within Europeans) to be “winners” in case of a US vs. Europe
regulatory arbitrage scenario on an overall basis, as outlined in our series of 3
regulatory notes. We do not see Swiss bank strategy being positioned to such
opportunities – however, we believe Swiss banks will shortly seize the earnings
potential.

We prefer UBS over CS due to its stronger capital position, with a Basel 3 Equity
Tier 1 ratio of 13.8% in 2012E compared to 8.6% for CS.

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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

MS – retain preference for cheap valuation, FICC turnaround still holds the key
We like MS for its cheap valuation; however FICC turnaround still holds the key for
the stock in the long-term. Whilst MS management believes it has gained market
share in key Fixed Income product areas, we are yet to see the market share gains
being reflected in revenues. FICC remains a key focus area for MS management with
headcount in Fixed Income up significantly through 2010, particularly FX (+40%)
and Rates (+20%), and we would expect the associated revenues to “come through”
in 2011E. MS management has set a key performance goal to drive 2% market share
increase in Fixed Income. We do not believe MS will be able to close the Fixed
Income gap and hence market share gains are undiscounted upside in our forecast.
MS also meets our criteria of preference for Equity gearing, through its strong
Wealth Management franchise generating 28% of 2012E pre-tax earnings, and
management targeting a 20%+ PBT margin in GWM. Please see our report “Global
Investment Banks: Investment Banking wallet outlook - all eyes on equity
derivatives”, published on 8th September, 2010.

With a 2012E Basel 3 Tier 1 ratio of 9.4% and undemanding valuation at just 0.9x
diluted tangible BV 2012E ex DVA, there is upside potential. In our view, material
valuation will be unlocked in the long term through its high equity gearings.

GS – strong FICC in Q1 11E, Fed Stress test results could provide short-term
boost
We downgraded GS from OW to N in our report, “Global Investment Banks:
Portfolio Snapshot: Switching OW from US IBs to Europe IBs - Downgrading GS to
N” on 12th January 2011. Our downgrade was purely valuation driven.

In addition, our regulatory arbitrage analysis illustrates that within US IBs, GS will
be materially affected. We are convinced that GS will adjust to the challenges put
forward in respect to regulatory changes in the Dodd-Frank bill, nevertheless overall
earnings impact will be material as discussed in our note, “Global Investment Banks:
Regulatory Proposal Analysis: Structural IB Profitability Decline”, published 9th
September, 2009.

We continue to maintain our Neutral rating on the stock, as longer-term we do


not find GS valuation attractive and see limited upside to our $175 price target.
However, short-term going into Q1 11 results we now prefer GS over MS due to
i) its strong FICC gearing with Q1 likely to surprise positively as credit hedging
losses in Q4 come back in Q1 11 and a strong performance in commodities, driven
by price movements in key commodities, particularly Oil, ii) Fed Stress test results
which are expected on March 21st could also provide short-term boost to the stock,
with the strong capital position of GS putting it as a frontrunner to buy back shares
even after buyback of the Berkshire Hathaway preferreds. We note, on the purchase
of Berkshire Hathaway preferred stock, GS would have to make a one-time preferred
dividend payment of $1.64bn which would be recorded as a reduction to its net
earnings and common shareholder’s equity, however it would save on annual
preferred dividend payments of $500mn going forward.

9
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

French Banks more attractive than DB and Barclays - top pick BNPP
At similar valuations to DB and Barclays, our preference would be for French Banks
BNPP and SG, considering i) more stable cash flow mix with 55-62% of group
profits from retail, and ii) less fixed income and more equity gearing through Equity
Derivative businesses within CIB. In addition in a world of regulatory arbitrage, we
see French banks in Equity derivatives having the potential to gain ground in the US,
and expand their presence in Europe further, please see the section on Volcker rule
on page 22 below.

Our preference is for BNPP over SG mainly due to capital position – we estimate
BNPP capital deficit at €1bn vs. SG €5bn based on our JPMC divisional capital
methodology. More generally, we continue to prefer BNPP vs. other traditional credit
banks in Europe: i) better positioned for growth with lower risk to revenues,
remaining a counterparty of choice with strong cash flow generation, ii) high gearing
to a recovery in the credit cycle with exposures to more resilient retail markets,
mainly France and Belgium, and iii) relatively solid capitalisation levels with
Common Equity Tier I of 8.4% end 2012E.

We see the potential for further re-rating in Société Générale shares from asset
disposals. In our estimates, SG Common Equity could improve by €5.4bn or 120bp
to 8.8% end 2012E by selling 1) insurance, 2) securities services, 3) TCW (US fixed
income asset manager), and 4) 50% stake in Newedge. The potential for disposals
makes SG very attractive; however, the market environment has to be right and the
regulatory environment clearer, which could take 12-18 months.

Preference for Barclays over DB due to valuation


Within the UK domestic banks Barclays (Neutral TP 320p) is our preferred bank.
The stock trades at a discount to NAV (0.8x 2011E) as the market struggles to
understand how the group will earn returns greater than cost of equity in the medium
term, given a c.2/3 IB 1/3 retail mix, and as c.35% of Barclays business does not
achieve returns greater than the cost of equity. Based on our estimates we see the
group earning an 11% RoNAV 2012E, in line with our longer term CoE
expectations, justifying our Neutral recommendation. Note that we have not
accounted for any losses related to the Lehman lawsuit where we believe that the
downside risk has increased post the ruling. Further clarifications on the Lehman
lawsuit and any details pertaining to their restructuring and disposal plans should act
as a catalyst for the stock.

DB: Impressive FICC franchise but prefer better capitalised/cheaper valuation


IBs, maintain Neutral
In Q1 11 we expect DB to benefit from the ongoing market volatility, strong
refinancing schedule and ongoing steep yield curve for 2011E, however we would
prefer FICC gearing through better capitalised (GS in US) /cheaper valuation banks
such as Barclays in the UK.

We welcome DB management’s initiative towards cost synergies through complexity


reduction programs with 2011 exit rate of €1.1bn and also the IBIT impact through
cost and revenue synergies which the management aims to achieve through CIB
integration of €0.35bn and €0.3bn respectively. However, even with cost savings in
our opinion it is unlikely DB is able to achieve its €10bn pre-tax target for 2011E on
a divisional basis compared to JPMCe forecast of €7.8bn.

10
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

We upgraded DB from UW to N, “Deutsche Bank: Upgrade from Underweight to


Neutral - it's good to be German,” on 1st December, 2010 as sovereign & senior debt
capital at risk looks limited for DB with banking book exposures of €9.3bn to
stressed sovereigns, with our base case haircut scenario leading to -12bps Basel 3
Tier I loss to Tier 1 of 6.7% in 2012E.

DB trades at 1.1x 12E P/NAV compared to Barclays at 0.8x12E P/NAV which is


better capitalised at 9.0% 12E Basel 3 Equity Tier 1 ratio compared to DB at 6.8%.
In our view, DB should trade in a range €43-€48 as its ongoing capital deficit
will not allow any material re-rating. Capital at risk remains with €26.6bn in
carrying value of structured credit assets with pre-tax mark-to-model losses of
€2.6bn at YE2010. Also, long-term DB does not tick our preference for equity
gearing over Fixed Income as discussed in our report, “Global Investment Banks:
Investment Banking wallet outlook - all eyes on equity derivatives”, published on 8th
September, 2010.

11
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

Table 4: Global wholesale and Investment Bank Valuation Table 2011E-2012E


Lcl currency
P/NAV P/NAV RONAV RONAV Basel 3
NAV ex NAV ex ex own ex own ex own ex own Equity
NAV NAV own debt own debt PE PE P/NAV P/NAV debt debt RONAV RONAV debt gain debt gain Tier I
Price TP Rec 2011E 2012E 2011E 2012E 2011E 2012E 11E 12E 11E 12E 11E 12E 11E 12E 12E* (%)
UBS 18.5 22 OW 11.7 14.1 11.6 14.0 8.8 7.7 1.6 1.3 1.6 1.3 19.7% 18.6% 19.8% 18.7% 13.8%
CSG 42.1 50 OW 23.2 27.6 22.3 26.8 8.4 7.3 1.8 1.5 1.9 1.6 21.5% 20.8% 24.4% 23.4% 8.6%
DB 46.2 41 N 38.3 42.4 38.2 42.2 9.3 8.4 1.2 1.1 1.2 1.1 13.0% 12.9% 13.8% 13.6% 6.8%
Euro IBs - - - 8.8 7.8 1.5 1.3 1.6 1.3 18.1% 17.4% 19.2% 18.4% 10.1%

SG 48.8 58 OW 44.4 47.6 44.1 47.3 7.5 6.8 1.1 1.0 1.1 1.0 15.9% 15.7% 15.9% 15.7% 7.4%
BNPP 54.2 65 OW 46.2 51.4 46.0 51.2 7.9 7.2 1.2 1.1 1.2 1.1 15.7% 15.4% 15.8% 15.4% 8.4%
CASA 12.1 14 N 10.8 12.3 10.6 12.1 7.6 6.2 1.1 1.0 1.1 1.0 15.2% 16.7% 15.4% 16.9% 6.0%
French Banks - - - 7.7 6.9 1.1 1.0 1.2 1.0 15.7% 15.8% 15.8% 15.9% 7.6%

Barclays 3.15 3.20 N 3.76 4.12 3.71 4.07 9.4 7.8 0.8 0.8 0.8 0.8 9.9% 11.0% 10.1% 11.1% 9.0%

GS 164.5 175 N 123.6 138.8 123.0 138.2 10.4 10.0 1.3 1.2 1.3 1.2 13.6% 12.5% 13.7% 12.6% 12.1%
MS 29.3 30 OW 29.6 32.4 29.7 32.5 10.8 9.6 1.0 0.9 1.0 0.9 9.5% 9.8% 9.5% 9.8% 9.4%
US IBs - - - 10.5 9.9 1.2 1.1 1.2 1.1 12.3% 11.6% 12.3% 11.6% 11.2%

Total - - - 8.7 7.8 1.2 1.1 1.3 1.1 15.3 15.0 15.7 15.4 9.6%
Source: J.P. Morgan estimates, Company data. Priced from Bloomberg as of COB 3rd March 2011. *including mitigation initiatives. Basel 3 common equity Tier I estimate assuming no phasing-in of capital deductions nor progressive phasing out of other common
Equity Tier 1 instruments.

12
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

IB division at 1.0x P/BV implies 14% upside for Swiss IBs


With ongoing regulatory uncertainty, we value the IB divisions of global investment
banks on average at 1.1x P/BV in our 2012E SOP valuation, however current
market prices imply the IB business is valued at 0.9x P/BV based on our SOP
valuation. Valuing the IB divisions at 1x BV would imply 2% upside to current
prices in our estimates.

• UBS and CS trade at 0.6x implied P/BV on average for the IB division,
compared to 1.0x for the rest of the IB peers. This is unwarranted in our view
and implies the market does not believe in an IB turnaround for the Swiss IBs and
does not factor in the high Equity gearing of the Swiss IBs. Valuing the IB
divisions at 1x BV would imply 15% upside for UBS followed by 13% for CS.
• In contrast, GS trades at 1.2x 2012E implied P/BV while the rest of the IBs
trade at 1.0x 2012E implied P/BV.

We note, our analysis is simplistic and ongoing negative regulatory newsflow is


of concern – however, we believe over time the value of the IBs should be re-
confirmed at 1x at least in our view – offering material upside for the Swiss IBs
in our estimates.

Table 5: Global Investment Banks: P/BV of the SOP Investment Banking division and sensitivity to group valuations 2012E
local ccy
GS MS DB CS UBS BARC Avg.
Current share price 164.5 29.3 46.1 41.4 18.2 3.2 -
SOP TP group 175 30 41 50 22 3.2 -
SOP Value CIB 137 18 30 23 6 2.2 -
Implied SOP value rest 37 12 10 27 15 1.0 -

SOP P/BV CIB 1.4 1.0 0.8 1.1 1.1 1.0 1.1
SOP PE CIB 10.3 8.0 9.0 8.0 6.0 7.7 8.2

Implied P/BV of IB at current prices 1.2 1.0 1.0 0.7 0.5 1.0 0.9

SOP value CIB at 1x BV 95.0 18.2 36.9 19.9 5.7 2.2 -


Implied SOP value rest 37 12 10 27 15 1.0 -
Implied SOP group 132 30 47 47 21 3.2 -
Upside -19% 3% 2% 13% 15% 0% 2%
Source: J.P. Morgan estimates, Priced from Bloomberg 4th March, 2011 (intraday).

Share Buyback: GS remains fully valued post buyback –


but buyback newsflow short-term catalyst
We still believe that US IBs Goldman Sachs and Morgan Stanley could do a
share buyback. We estimate GS and MS have excess capital of $15bn and $2bn
respectively, which they could use to repurchase shares. We run a sensitivity scenario
assuming US IBs use their respective excess capital to buy back shares at current
share prices, in Table 6 below. Assuming both banks use all their excess capital for a
share buyback, they would remain well capitalised with Basel 3 equity Tier1 ratios of
9.9% and 9.0% respectively in 2012E post the assumed buyback.

13
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

• For GS a share buyback scenario is already reflected in current valuation in


our view. GS would trade at 8.7x 2012E earnings, 1.2x NAV for an RoNAV ex
own debt of 14.2%, post our assumed buyback of $15.4bn or 17% of market cap
• MS on the other hand still trades at just 0.9x diluted tangible BV 2012E ex
DVA, for an RoNAV ex own debt of 9.6%, post our assumed buyback of the
$1.6bn of excess capital.

Table 6: US IBs: GS appears fully valued after assumed share buyback scenario
$ million, %
GS MS
Capital Surplus 15,364 1,639
Current Market Cap 92,094 45,302
Share Buyback 15,359 1,639
Buyback as % Market Cap 17% 4%

Old EPS 16.40 3.05


New EPS 18.99 3.14
% change 16% 3%

Risk weighted Assets 707,435 469,560

Basel 3 Equity Tier 1 (old) 85,278 44,040


Basel 3 Equity Tier 1 (new) 69,914 42,401

Basel 3 Equity Tier 1 (old) 12.1% 9.4%


Basel 3 Equity Tier 1 (new) 9.9% 9.0%

Old NAV/share 138.2 32.4


New NAV/share 133.4 32.5

Old RoNAV ex own debt 11.9% 9.4%


New RoNAV ex own debt 14.2% 9.6%

PE (old) 10.0 9.6


PE (new) 8.7 9.3

P/NAV (old) 1.2 0.9


P/NAV (new) 1.2 0.9
Source: J.P. Morgan estimates, priced from Bloomberg 4th Mar 2011 (intraday).

...Swiss IBs at 0.8x P/NAV 2012E ex WM valued at 10x P/E


UBS and CS trade at 1.3x and 1.6x NAV ex own debt 2012E for RoNAV of 18.7%
and 23.4% respectively. However, we believe these multiples are not entirely
comparable to other IB peers owing to the large Wealth Management exposure of the
Swiss IBs. Excluding the Wealth Management business which we value at 10x PE,
CS would trade at 0.8x NAV for RoNAV of 14.4% for CS and UBS would trade at
0.9x NAV for RoNAV of 13.0%.

If we value the Wealth Management business of the Swiss IBs at PE multiples of


13.1x which is in line with the US peers, both UBS and CS would be trading at very
attractive multiples of average 0.6x 2012E P/NAV.

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Kian Abouhossein Global Equity Research
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Table 7: Swiss IBs at 0.8x 2012E Implied P/NAV ex Wealth Management


Local currency
CS UBS
WM U.S. peer WM U.S. peer
SoP basis group basis SoP basis group basis
Group net income 7,069 7,069 9,223 9,223
WM 2011E net income 2,622 2,622 2,419 2,419
Ex WM net income 4,447 4,447 6,805 6,805

Share price 41.4 41.4 18.2 18.2


NOSH 1,230 1,230 3,847 3,847
Group market cap 50,852 50,852 70,022 70,022
Assumed WM PEx 10.0 13.1 10.0 13.1
PE implied WM mkt value 26,219 34,279 24,186 31,621
Ex WM group mkt value 24,633 16,573 45,837 38,401

Group NAV 32,939 32,939 53,984 53,984


o/w WM capital 2,107 2,107 1,707 1,707
Ex WM group NAV 30,832 30,832 52,277 52,277

Ex WM Implied P/NAV (x) 0.8 0.5 0.9 0.7


Ex WM RoNAV 14.4% 14.4% 13.0% 13.0%
Ex WM PE (x) 5.5 3.7 6.7 5.6
Source: J.P. Morgan estimates, Bloomberg (based on prices at 4th Mar 2011 (intraday)).

For the Swiss IBs we value the Wealth Management business at 10x PE 2012E,
below the average 13.1x for US peers or 11.2x for Global peer group.

Table 8: Private bank peer group 2012E P/E multiples


Local currency
Share price EPS 2012E P/E 2012E
Blackrock 207.1 16.2 12.8
T-Rowe Price 67.6 4.5 15.1
Janus Group 13.3 1.2 11.4
US Peer Group 13.1
Julius Baer 41.6 3.8 11.0
Van Lanshot 31.2 3.6 8.8
EFG Group 13.6 1.7 8.2
Average 11.2
Source: Bloomberg (based on prices at 4th March 2011 (intraday)).

UBS and US IBs well Capitalised under Basel 3


We would seek exposure to banks with high levels of capitalisation, enabling them to
improve returns for shareholders.

• UBS capital position remains solid in our estimates with 2012E Basel 3 equity
Tier 1 ratio of 13.8% while CS reaches a Basel 3 Equity Tier 1 ratio of 8.6%
end 2012E. Note that we do not account for any dividend payouts for UBS in
2010E-012E, whilst we estimate DPS of SF1.30 in both 2011E and 2012E for CS.
• GS and MS remain amongst the best capitalised banks with Basel 3 Equity
Tier 1 ratios of 12.1% and 9.4% respectively end 2012E. We estimate that GS
has significant excess capital of $15bn – which it could use to buy back shares.
• Deutsche Bank Basel 3 Equity Tier 1 ratios look relatively low vs. other IB peers,
with 6.8% for DB. We estimate capital deficit of €10.7bn for DB, compared to
our minimum capital required based on our divisional capital allocation. Our

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Kian Abouhossein Global Equity Research
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kian.abouhossein@jpmorgan.com

€10.7bn estimated capital deficit also factors in the IAS 39 reclassified assets
of €26.6bn carrying value, with €2.6bn of mark-to-model fair value risk as of
31st December, 2010 – assuming ongoing high annual provision accruals in our
CB&S estimates. For details on our allocated capital calculation, please refer to
our note “Global Investment Banks: Market RWA consistency questioned: DB
downgrade to UW, upgrade GS to OW” published on 6 July 2010. In our view,
DB should continue to trade in the €43-€48 price range due to business mix but
more importantly capital positioning.

Table 9: Global Investment Banks – Basel 3 Equity Tier 1 ratios (end 2012E)
Local currency (millions)
CS UBS DB GS MS BNP SG BARC
Tier 1 Capital end 2012E 45,400 51,557 50,321 90,066 61,921 80,403 43,778 61,574
Hybrids - deducted -14,448 -4,903 -12,400 -5,000 -13,439 -11,655 -6,600 -10,685
Preference shares - deducted - - - -3,097 -9,597 -1,445 -1,000
Core Tier 1 30,952 46,654 38,456 81,969 38,885 67,303 36,178 50,889

Deferred Tax Assets (timing) - - -5,000 -1,700 -4


Deferred Tax Assets (other) -2,300 -4,200 -2,200 -3,000 -1,800 -2,194
Minority Interests (allowing 80% in capital) - - -300 - - -3,000 -1,600 -523
Shortfall of provisions to expected losses -488 - -1,700 - - 0 0 0
AFS reserves - gains or losses included - - - - - 0 0 -340
100% Insurance subsidiaries - - - - - -3,600 -2,800
Unconsolidated Investments -700 - -2,600 - - -1,146 -950 -5,352
Add back 1st loss securitisation deductions 3,227 2,385 5,000 - - 0 2,320 2,360
pension fund assets -2,500 -3,000 -400 - - 0 0 -1,913
Other Deductions - -735 -700 - - 0 0 -2,250
Core Tier 1 before capital addition limits 28,191 41,104 35,021 81,969 38,885 51,557 29,648 40,673
Maximum allowed aggregate recognition - - - - - 9,098 5,232 7,178
DTAs at 40% cap - - - - - 5,000 1,700 4
Unconsolidated Investments & Insurance subsidiary - - - - - 5,892 4,700 5,352

Max Allowed Individual Inclusion - - - - -


DTAs at 40% cap - - - - - 5,000 1,700 4,519
Unconsolidated Investments & Insurance subsidiary - - - - - 5,729 3,294 4,519

Final inclusion
DTAs at 40% cap - - - - - 5,000 1,700 4
Unconsolidated Investments & Insurance subsidiary - - - - - 5,729 3,294 4,519
Aggregate Capital addition - - - - - 9,098 4,994 4,523

Basel 3 Equity Tier 1 28,191 41,104 35,021 85,278 43,881 60,655 34,642 45,196

Risk Weighted Assets 247,636 268,875 418,984 560,570 377,757 671,869 398,774 470,754
Adjustment for CVA 89,500 20,000 24,000 45,402
Adjustment for Securitisation exposures 62,500 0 58,000 59,000
Other adjustments 10,000 0 11,308
Additional RWAs due to CVA+Securitisation 152,000 130,000 185,000 200,000 190,000 30,000 82,000 115,713
Adjustment for mitigation -70,000 -100,000 -90,000 -54,415 -100,000 0 -25,000 -84,000
Revised Risk Weighted Assets 329,636 298,875 513,984 706,155 467,757 701,869 455,774 502,464

Additional RWAs - - - - - 22,746 12,485 -

Total Risk Weighted Assets under Basel 3 329,636 298,875 513,984 706,155 467,757 724,615 468,259 502,464

Basel 3 Common Equity Tier I new 8.6% 13.8% 6.8% 12.1% 9.4% 8.4% 7.4% 9.0%
Source: J.P. Morgan estimates. Company data. Note: Basel 3 common Equity Tier 1 estimates end 2012E not assuming any phase-in of Basel 3 deductions nor progressive phasing out of other
common Equity Tier 1 instruments

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Kian Abouhossein Global Equity Research
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kian.abouhossein@jpmorgan.com

Prefer Wealth Management exposure: UBS, CS


Private banking/brokerage provides a source of relatively stable cash flow generation
across the cycle, and overall, remains one of the most profitable banking businesses
with limited capital consumption in our view. We believe that private banking has
more limited regulatory risk, and the main players would reap most of the benefits
from improving equity markets.

UBS and Credit Suisse have material Wealth Management exposures


accounting for c.26% and c.38% of group net profits in 2012E respectively,
providing a source of more stable cash flow generation with limited credit risk and
long term growth (despite currently difficult market conditions), in our view. Despite
its gearing to equity markets, and regulatory risk surrounding offshore private
banking, we believe private banking remains the most profitable banking business
overall in the current environment. We view the offshore banking concerns as
overdone and believe they are already discounted within the Swiss banks, with
newsflow to slow.

Looking at the business mix for the Global Wholesale and Investment Banks,
Swiss banks Credit Suisse and UBS have the highest gearing to asset gathering
accounting for 43% and 41% of group net income in 2012E.

• For GS and MS, IB division contributes 73%-90% of group net income in


2012E. Morgan Stanley also has gearing to Wealth Management with its JV,
however with Global WM accounting for 19% of group earnings, exposure to
asset gathering/private banking is less significant than the two Swiss banks.
• Within the European IBs, DB has the highest gearing to Investment Banking
activities with CB&S accounting for 61% of 2012E group net income followed
by CS and UBS at average 47%.
• French banks BNP and SG derive relatively lower share of net income at
40% and 35% from IB division in 2012E, with retail and financial services
contributing 58% on average to the 2012E group net income.

Table 10: Global Investment Banks – Split of group net income by divisions 2012E
%
Goldmans Morgan Deustche Credit Société BNP
Sachs Stanley Bank Suisse UBS Générale Paribas Barclays
Retail Financial Services 0% 0% 26% 11% 20% 62% 55% 48%
Asset gathering 12% 27% 5% 43% 41% 9% 19% 7%
IB 90% 73% 61% 49% 45% 35% 40% 68%
Transaction banking 0% 0% 12% 0% 0% 0% 0% 0%
Other -2% 0% -3% -4% -6% -6% -14% -23%
Total 100% 100% 100% 100% 100% 100% 100% 100%
Source: J.P. Morgan estimates.

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kian.abouhossein@jpmorgan.com

Prefer equity gearing over fixed income: UBS, CS, MS


Within the more pure-play IBs, we prefer banks with higher equity gearing as
we see growth in IB revenues coming from Equities. For more details, please refer
to our note, “Global Investment Banks: Investment Banking wallet outlook - all eyes
on equity derivatives”, published on 8th September, 2010.
• Credit Suisse and UBS are amongst the highest geared to equities accounting
for c.37% of total Investment Banking revenues in 2012E. At group level,
equities account for 20% of group revenues for CS and 15% for UBS. These
banks are thus likely to benefit the most from any improvement in the equities
environment.
• Morgan Stanley and Goldman Sachs are also geared to equities which
accounts for c.31% of total IB revenues in 2012E, and 15% of group revenues for
MS. For GS, 29% of 2012E group revenues come from Equities, GS is however
even more geared to Fixed Income which accounts for 44% of IB revenues and
36% of group revenues in 2012E.
• Barclays and Deutsche Bank are mainly fixed income houses with FICC
accounting for 63% and 53% of total IB revenues and 26% of 2012E group
revenues. These two banks are the most exposed to a decline in fixed income
revenue in our view.
• Société Générale is mainly an equity derivatives house in its CIB business,
with equities accounting for 37% of total 2012E CIB revenues. However, as the
business mix is more diversified with higher gearing to retail activities, equities
only account for 11% of 2012E group revenues.

Table 11: Global Investment Banks - Fixed Income and Equities as % of Group 2012E revenues
Local ccy in millions, %
Credit Deutsche Goldman Morgan BNP Société
Suisse UBS Bank Sachs Stanley Paribas Générale Barclays
Group revenues 34,250 37,644 35,317 40,683 36,613 45,905 28,281 31,491
IB revenues 18,080 15,831 17,051 33,093 17,981 12,024 8,100 12,836

Fixed Income clean 6,530 6,437 9,116 14,720 6,648 4,500 2,100 8,083
Equities clean 6,921 5,765 3,485 11,802 5,634 2,494 3,000 2,158

Fixed Income clean % clean IB revenues 36% 41% 53% 44% 37% 37% 26% 63%
Equities clean % clean IB revenues 38% 36% 20% 36% 31% 21% 37% 17%

Fixed Income clean % clean group revenues 19% 17% 26% 36% 18% 10% 7% 26%
Equities clean % clean group revenues 20% 15% 10% 29% 15% 5% 11% 7%
Source: J.P. Morgan estimates, Company data.

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Kian Abouhossein Global Equity Research
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kian.abouhossein@jpmorgan.com

Table 12: Global Wholesale & Investment Banks - 2012E detailed IB revenues split
$ in millions
GS MS UBS CS DB BNPP SG BARC HSBC RBS Citi BofA
IB Fees
Advisory 2,985 1,860 1,068 1,348 901 232 110 1,481 1,869 779 871 1,233
Equity Underwriting 1,973 1,839 1,755 1,114 1,133 170 130 1,122 748 623 1,134 1,814
Debt Underwriting 1,613 1,750 957 2,495 1,764 798 400 1,473 1,122 1,713 2,627 3,953
Other - - - - - - - 411 - - - -
Total 6,571 5,449 3,781 4,958 3,799 1,201 640 4,487 3,739 3,114 4,632 7,000

Fixed Income Markets


SPG 669 162 321 1,632 829 284 99 528 491 18 1,032 1,651
Credit Trading 2,880 257 2,288 858 2,333 241 245 1,432 -373 3,166 1,851 2,636
FX 1,753 1,056 1,536 707 2,739 1,196 715 873 1,548 901 1,558 1,335
Rates 4,562 2,082 1,007 2,177 3,095 2,529 1,165 4,753 640 686 3,709 4,225
GEM 598 382 748 1,070 1,589 394 179 2,244 2,568 734 3,863 1,330
Commodities 4,073 2,407 226 255 944 272 139 927 - - 1,113 542
Prop trading/hedging gains/other 184 150 578 104 473 210 222 317 860 1,835 564 692
Total Fixed Income Markets 14,720 6,495 6,705 6,802 12,002 5,126 2,765 11,073 5,735 7,341 13,690 12,412

Equity Markets
Equity Derivatives 3,900 1,600 1,972 2,167 1,705 2,807 3,417 1,550 320 546 1,448 1,630
Cash equities 3,864 1,423 2,193 2,928 1,273 90 229 487 457 624 1,307 2,007
Prime brokerage 1,838 2,011 1,267 1,655 938 182 - 1,235 1,828 156 1,049 1,067
Prop trading/other equity-related 2,200 750 573 458 672 204 303 172 137 234 516 496
Total equities 11,802 5,784 6,005 7,210 4,588 3,284 3,950 3,445 2,742 1,561 4,320 5,201

Credit Portfolio - - - - 2,060 6,219 3,310 1,150 1,175 - - -


Underlying - - - - 2,060 6,219 3,310 1,150 1,175 - - -
CVA - - - - - - - - - - - -
Other - - - - - - - - - - - -

Total Revenue 33,093 17,728 16,491 18,969 22,447 15,830 10,664 20,155 13,391 12,016 22,642 24,613
Source: J.P. Morgan estimates. Note: i.) most of the French banks’ commodities-related revenues are not reported in the capital markets Sales & Trading but in Financing, unlike European IBs, ii)
BNP Paribas "cash equities" include advisory revenues; iii) Barclays Currencies includes commodities; iv) RBS IB Fees includes portfolio management revenues; v) Citi and BofA revenue
estimates using weighted average growth rates for the rest of the IB universe.

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kian.abouhossein@jpmorgan.com

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Regulatory Arbitrage I: Volcker Rule

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Regulatory Arbitrage I: Tougher than


expected Volcker rules undiscounted
What is Section 619 of the Dodd-Frank Act or Volcker Rule?
Section 619 of the Dodd-Frank Act, also known commonly as the Volcker Rule
prohibits banking entities from engaging in proprietary trading. Initial interpretation
suggested that only pure proprietary trading activities of the banks would be
impacted by the Volcker rule. The key issue coming out of recent communication
between lawmakers, SIFMA and FSOC is the possibility of market making
related activities of banks being impacted by the Volcker rules. This possibility
has arisen because of different interpretation of the phrase “selling in the near
term” when used in the context of a trading account and when used in the context of
“market making related permitted activities”. In this report, we try to analyze the
impact on U.S. IBs from a more strict interpretation of the Volcker rule and the
relative advantage it provides to European IBs where a similar provision is
unlikely to be implemented.

1. We have focused on the impact from Volcker rule on Pure Proprietary trading in
the past; however the impact on market making related activities if included
within the scope of the Volcker rule would be significant in terms of earnings
impact and is highly likely for the U.S. IBs in our view.
2. We believe Section 619 if applied to market making related activities of the
banks would negatively impact liquidity and volumes with the end users of
derivatives ultimately bearing the increased cost.
3. In our view, European IBs would be the likely “winners” in a scenario where
“market making related” revenues of U.S. IBs are impacted by the
provisions as EU has not shown willingness to adopt a similar provision in
Europe. Hence, US IB revenues will be negatively impacted, but will overall
benefit European IBs running their market making and prop positions out of
Europe. Large European IBs such as DB, Barclays especially in Fixed Income
(and especially in the derivative parts) would be the “winners” with French
Banks BNP and SG also benefiting in their Equity Derivatives business at
the cost of the U.S. IBs in our view – stepping into the ‘liquidity void’ created
by the Volcker rule impacting US IBs.

Why unprohibited market making is good for markets in our view:


In a world where more derivatives are to be traded on SEF platforms increasing
transparency, the importance of using the IBs’ capital to offer liquidity in size
becomes more and more important in our view.

The best example is Cash Equity block trades for mainly Hedge Funds – taking a
position at risk for an equity client leading generally to a trader’s views and hence
prop positions. Generally we estimate for the large prime brokerage firms such
as GS, MS and CSG hedge fund block losses to account for 20-30% of overall
HF revenues. Overall, we believe Hedge Funds will want to trade the majority of
their business with liquidity providers and will pay firms offering liquidity (and IBs
willing to put capital at risk) from an overall wallet perspective.

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Kian Abouhossein Global Equity Research
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kian.abouhossein@jpmorgan.com

It is our clear view; the winners in the IB business are the capital at risk
liquidity providers with GS historically being best in class across asset classes.
Hence, we believe GS has potentially most to lose from the new rules. We
expect US IBs to react by aggressively investing in technology to retain their
position as liquidity providers through highly electronic platform offering (i.e.
Algo).

Timeline of Volcker Rule Implementation


Volcker Rule is to be effective by July 21, 2012 at the latest. The FSOC would be
completing its study on the Volcker rule in January, 2011 and the rulemaking is
expected to be completed by regulators by October 2011. Banks will have to be
fully compliant by July 2014 (within two years after the rules are effective)
although this deadline may be extended under certain cases.

Table 13: Statutory deadlines for the study and rulemaking process
Statutory deadline
FSOC Study January 21,2011
Agency Rulemaking October 21,2011
Volcker Rule become effective July 21, 2012 or one year after the issuance of final agency regulations
Full Compliance with Volcker Rule July 21, 2014
Source: http://www.treasury.gov/initiatives/Documents/FSOC%20Integrated%20Roadmap%20-%20October%201.pdf

Pure Prop trading vs. Market making related activities


We have estimated the impact of Volcker rule on “pure” proprietary trading
activities in the past. However, we did not focus on the likely impact of Volcker
rule on “market making related activities” of the banks. Recent
Communication between lawmakers and industry bodies with the Financial
Stability Oversight Council (FSOC) seems to suggest that market making
related activities of the banks could also be impacted by a more strict
interpretation of the Volcker rule provisions.

The key area of concern for U.S. IBs in our view is related to the usage of the
term “near term” when used in the context of a “trading account” and when
used in the context of “market making related permitted activities”.

• In the context of a trading account, banking entities are not allowed to acquire
or take positions to sell in the near term.
• The difference between “market-making related activities” and proprietary
transactions is in terms of the period of time a firm is allowed to hold the
position on its books. Currently the rules permit activities which are
designed not to exceed the reasonably expected near term demands of clients,
customers, or counterparties. Clearly if the final provisions do not allow firms to
hold inventories for long-term periods, IBs’ trading activities are likely to be
impacted materially. Both SIFMA and Senators Merkley and Levin, in separate
letters to the FSOC have expressed their views on the issue (see page 34)
• The rule in its current form allows banks to engage in risk-mitigating hedging
activities which reduce specific risk associated with individual or aggregated
positions, contracts, or other holdings.

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kian.abouhossein@jpmorgan.com

• Also it is interesting to note that activities related to the U.S. government or


government agencies such as Ginnie Mae, FHLB etc. and states or political
subdivisions are included within the scope of permitted activities. The
government is concerned about the likely impact of provisions on volumes
and liquidity on these activities in our view and has thus permitted banking
entities to continue with their activities in relation to government agencies.
We question the fact that some government related activities are treated
differently from private activities in respect to the Volcker rule.
• Section 619 also excludes from permitted activities any transaction, class of
transaction or activity which would result, directly or indirectly, in a
material exposure by the banking entity to high-risk assets or high-risk
trading strategies.

US IBs GS and MS have disclosed the impact from the Dodd-Frank Act and in
particular from the proposed limits on proprietary trading activities on their
profitability in their regulatory filings (For details see Table 19). GS in its 10-K
filing said, “ …however, we expect that there will be two principal areas of impact
for us: the prohibition on “proprietary trading” and the limitation on the
sponsorship of, and investment in, hedge funds and private equity funds by banking
entities, including bank holding companies…” MS also stated in its 10K filing, “A
provision of the Dodd-Frank Act (the “Volcker Rule”) will, over time, prohibit the
Company and its subsidiaries from engaging in “proprietary trading,” as defined by
the regulators…”

On the other hand, ECB members have said at numerous forums that they are
not in favour of adopting the Volcker rule provisions in Europe. European
Central Bank council member Axel Weber said, “A complete prohibition of certain
activities -- activities that are perhaps more risky but not necessarily economically
inefficient -- is a very far-reaching market intervention,” The Volcker rule “might
have unintended and unfavorable consequences” including “undesirable effects
on the transmission of monetary policy,” he said, without elaborating.1

European Central Bank Executive Board Member Jose Manuel Gonzalez-Paramo in


his speech “Reform of the architecture of the financial system” on 21 June 2010 said:
“In general terms, there are two ways to address ex ante the problems that SIFIs
pose: you can restrict the scope of their activities or force them to internalise the
costs they pose to the system. The clearest illustration of the first approach is the
discussion on the “Volcker rule” in the United States. Under this rule, banks that
receive deposits would be prevented from engaging in proprietary trading, and
investing in or sponsoring hedge funds and private equity funds. I do not believe this
is the most fruitful way to pursue in Europe, given the traditional strength of the
universal banking model in a number of Member States. Also, there may be
challenges associated with defining the borderline between the proprietary trading
and servicing clients. But more importantly, the activities that are seen as deserving
special attention may move outside the intensively regulated and supervised banking
business, but stay within the same group.”2

1
http://www.businessweek.com/news/2010-03-10/ecb-s-weber-says-volcker-rule-has-
significant-shortcomings.html
2
http://www.bis.org/review/r100624f.pdf

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Kian Abouhossein Global Equity Research
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kian.abouhossein@jpmorgan.com

We agree with the views expressed by some members of the Senate on the
potential negative impact the restrictions on market making related activities
rules might have on the competitiveness of the U.S. Financial Services sector.

Spencer Bachus, who is an Alabama Republican and new Chairman of the House
Financial Services Committee, had sent a letter to the Financial Stability Oversight
Council (FSOC) on November 3, 2010 warning them that a ban on proprietary
trading “will undermine competitiveness of US Financial Service Sector”. He further
added that “the rule-making agencies must give to the international financial
regulatory context as they begin crafting regulations to implement the Volcker rule.”

Unilateral adoption of the rules by U.S. would benefit European IBs in our view,
with ECB members expressing their unwillingness for a Volcker Rule like
provision in Europe. Also, the limits on market making related activities would
bring down liquidity in the instruments, with potential increase in costs for end-
users.

The final interpretation of the provisions of the Volcker Rule related to


“Proprietary Trading” might have a significant impact on U.S. IBs trading
revenues. In a scenario where the Volcker Rule is extended to include “Market
Making” (which is likely in our opinion) related proprietary trading activities,
large European IBs such as DB, Barclays would be the “winners” with French
Banks BNP and SG also benefiting in their Equity Derivatives business at the
cost of the U.S. IBs in our view.

How to measure the difference between market making vs.


prop business – recent FSOC study sheds some light
We believe the devil will be in the details in the rule on how US IB businesses
will be impacted. The recent report by FSOC shed some light on how the
regulator may attempt to differentiate between prop and market making.

The FSOC study includes a detailed summary of the potential types of metrics that
the Council believes regulators may find useful to consider implementing to
differentiate between prop and market-making activity. We would make two main
observations on proposed indicators.

Firstly, we believe it is reasonable to assume that if these indices make it to the final
document, regulators will have a fair chance of identifying proprietary activity,
especially once benchmark levels are established for various asset classes across the
industry.

Secondly, the process of monitoring and adjusting limits to these ratios may prove
quite onerous. This is because each metric is likely to display a different level, not
only for different asset classes, but also at an asset level. Different levels of the
underlying liquidity will potentially drive the trading profile. For example, trading an
illiquid bond will have a trading profile more akin to prop trading and a blue chip
stock more similar to market making. On top of that, any derivative transaction
would need to be monitored with respect to various sensitivities, complicating the
process even further.

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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

We highlight again that all these quant measures as well as process controls are parts
of the FSOC proposal and may be reshaped in the final rulemaking by the Fed and
the CFTC.

FSOC proposed four categories of metrics:


1) Revenue-Based Metrics: These metrics would attempt to measure daily revenue
and revenue from specific trades relative to historical revenue and similar data
for other banks (i.e., horizontal comparison). Revenues and losses for market
making and certain other permitted activities principally derive from both
spreads and price movement in the inventory held, while impermissible
proprietary trading revenue is generated principally from price movements. An
analysis of revenue may allow a determination that a particular trade or activity
was proprietary in nature.

a) Historical Revenue Comparison: This measure compares a particular


period’s revenue to historical trends. If a trading desk’s revenue from a
particular day, month or quarter is outsized relative to recent trends, that
desk could be implementing strategies that include impermissible
proprietary trading.

b) Day One Profit & Loss: This measure compares the profitability of
positions on the first day they are taken with the profitability of all positions
held that day. This metric seeks to address the challenge of discerning the
source of a firm’s profitability. Day One Profit & Loss is likely to be higher
for market makers that profit immediately from capturing the spread upfront
than for proprietary traders that seek to profit from asset appreciation in
the near term.

c) Bid-Offer Pay-to-Receive Ratio: This measure compares the profitability of


positions on the first day they are taken with the total trading activity on
that day. The metric seeks to approximate whether a trader is more likely to
be purchasing securities at the bid, or offer, even in the absence of
continuously quoted markets.
2) Revenue-to-Risk Metrics: These metrics would attempt to measure revenue
generated per unit of risk assumed. Market makers and underwriters endeavor
to mitigate risk by quickly reselling or hedging positions that are acquired,
whereas proprietary traders actively seek to assume risk by holding positions
with the expectation that they will appreciate. Consequently, permitted activities
are likely to have greater revenue-to-risk ratios than impermissible proprietary
trading.

a) Profitable Trading Days as a Percentage of Total Days: Market makers


will tend to evidence more consistent daily profitability than proprietary
from high turnover of a position rather than appreciation in the position,
while the opposite is true of proprietary traders. Market makers seek to
price into each transaction an appropriate spread and manage inventory
tightly. By design, proprietary traders tend to seek exposure to market
fluctuations, which do not follow a defined day-to-day pattern.

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(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com

b) Sharpe Ratios: This measure compares the annualized total revenue or


excess return of the firm or trading desk to the annualized standard
deviation of revenue or standard deviation of the portfolio (i.e., how much
the firm’s trading profit varies from day-to-day) or how much excess return
is earned for every unit of risk taken. Similar to the measure of profitable
trading days as a percentage of total days, established proprietary trading
activities will generally have a lower Sharpe ratio, as proprietary trading
generally results in higher earnings volatility.

c) Revenue-to-Value at Risk: This measure evaluates the revenue per dollar


of value-at-risk in the firm. For a given level of profitability, market making
should entail less aggregate risk than proprietary trading as market makers
retain the risk for a shorter period of time.

d) Value at Risk: Standard value at risk (VaR) metrics may also provide
Agencies with a helpful guide for areas that bear further scrutiny. We note,
even with these measures a lot of questions remain such as the calculation
on VAR based models are all using different inputs and calculation
methodologies as illustrated in Table 14 below. Hence are not comparable
across US IBs as discussed in our note “Global Investment Banks: Market
RWA consistency questioned: DB downgrade to UW, upgrade GS to OW”
published on 6 July 2010.
Table 14: VaR & IRC related market risk vs. total market risk
Local currency, Q4 2009
CS UBS DB GS MS BNP SG BARC Avg
Reported 1-day avg VaR (m) 114 51 127 181 132 63 30 77
Confidence level 99% 95% 99% 95% 95% 99% 99% 95%
Observation period (years) 3 5 1 N/A 4 N/A 1 2 2.7
Regulator FINMA FINMA BaFIN FED* FED* FR Reg FR Reg FSA

1-day 99% avg VaR (m) 114 87 126.8 308 224 63 30 131
10-day 99% avg VaR (m) 360 274 401 973 710 199 96 415
Source: Company reports and J.P. Morgan estimates. *GS and MS are currently regulated under Fed Basel 1 as BHC. GS exponentially weighted VaR methodology with 20% per month decay
rate- equivalent to 5.5 month observation period on a weighted basis.

3) Inventory Metrics: Inventory turnover compares the asset value that is


transacted each day to the value of assets that are held in inventory. This
measure takes into account the need for market makers to hold inventory, but
relates it to observed customer demand. A market maker that retains risk well in
excess of customer demand is more likely to be holding an impermissible
proprietary position in that risk

a) Inventory Turnover: This metric calculates the ratio of assets that are
transacted each day to assets that are retained in inventory. The metric
takes into account the need for market makers to hold inventory (volume of
retained assets), but relates it to the asset’s observed customer demand
(volume of transacted assets). For highly liquid financial instruments,
inventory turnover and aging are relatively straightforward to measure as
banking entities will have both significant daily volume and measurable
inventories of each discrete asset. Such financial instruments include most
cash equities, high volume foreign exchange rate pairs, commercial paper,
and other financial instruments for which risk can be offloaded quickly. For
such assets, banking entities may compare the gross notional value traded
each day against the amount retained in inventory.

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Kian Abouhossein Global Equity Research
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Less-liquid or more complex financial instruments may necessitate a more


nuanced measure of inventory turnover. While such financial instruments
may be correlated or hedged with other financial instruments, they may be
individually distinct in the way in which they are valued.

b) Inventory Aging: Inventory aging measures how long inventory has resided
on the balance sheet rather than simply how large it is. Retaining inventory
when near-term customer demand fails to appear rather than selling such
inventory could indicate impermissible proprietary trading.

4) Customer-Flow Metrics: These metrics evaluate the volume of customer-


initiated orders on a market-making desk against those orders that are initiated
by a trader for the purposes of building inventory or hedging. Significant trader-
initiated, rather than customer-initiated, order volume could indicate that
impermissible proprietary activity has occurred.

a) Customer-Initiated Trade Ratio: This metric compares the amount of


customer-initiated flow relative to trader-initiated flow. Trader-initiated
flow should be closely correlated with customer-initiated flow, as trader-
initiated positions should be established primarily to hedge positions
acquired from customers, or to manage inventory to appropriate levels such
as in anticipation of customer demand.

b) Customer-Initiated Flow to Inventory: This calculates the volume of a


desk’s inventory relative to the desk’s average customer-initiated trades.
Inventory should remain in proportion to customer-initiated trades in most
instances.

c) Revenue to Customer-Initiated Flow Ratio: This ratio measures the


trading desk’s revenue to the proportion of customer-initiated flow. There
should be a strong relationship between the customer-initiated flow on the
desk and the revenue it generates.

Enforcement of the compliance with the restrictions on


proprietary activities within market making
FSOC made a significant step forward towards implementation of limits on market
making that may be considered proprietary trading by proposing a comprehensive
framework for monitoring, assessment and enforcement of compliance with the
Volcker rule. FSOC recommended in particular:

• bank entities develop internal operational controls (internal policies and


procedures, programs to monitor trading activity, creation of recordkeeping and
reporting systems, internal compliance oversight, public attestation of compliance
with Volcker rules by the CEO).
• supervisory review and oversight up to investigating specific trading activity on
a position level
• enforcement actions for violations could include increased oversight, reduction
in risk limits, increased capital charges or monetary penalties.

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Kian Abouhossein Global Equity Research
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The proposed range of quantitative indicators that are comparable across


assets, time periods and unified across the industry together with a set of
processes designed to enforce compliance with them is a powerful tool to limit
potential proprietary activities in our view.

Impact from Prohibiting Pure Prop Trading


Section 619 of the Dodd-Frank Act has clear language related to the prohibition on
“pure proprietary trading” operations of banks as compared to the limits on “market
making related activities.” In Table 15 below, we show the comments made by the
Global IBs on their activities related to pure proprietary trading.

Table 15: Global Investment Banks – comments on proposed limits in “pure” prop trading/private equity/hedge funds
Local currency in million
Bank Comments
Goldman Sachs Pure prop trading (non-client) accounts for c.10% (+/- a couple of %) of total firm revenues, depending on the revenues of other divisions of the firm.
Credit Suisse Prop accounts for:
• Less than 10% of Equity revenues in 2009, vs. 10-20% previously.
• 0% of Fixed income in 2009, vs. high single digits previously.

Credit Suisse has SF4bn of own money invested in their Private equity and principal investment business within Asset Management.
UBS UBS has virtually no Private Equity activity currently.

In the IB, UBS only has segregated prop trading in Equities and revenues per annum amount to Sfr0.4- Sfr1.6bn per annum.
There is also some prop within the Asset Management business.
Deutsche Bank 5% of revenues in 2009.
Barclays Pure prop is less than 3% of group revenues in 2009 and less than 5% of BarCap topline income.
Barclays does not seed or own hedge funds. PE business is small, loss making in 2009 and for sale.
Morgan Stanley n.a.
Société Générale Limited prop trading.
BNP Paribas Prop trading is very limited.

BNP Paribas Capital manages the group's prop portfolio of unlisted investments; and the value of the portfolio was €3.3bn end 2008. The group made
no revenues in BNP Paribas Capital in 9m 09.

Citigroup Citigroup generates less than 2% of its revenues from prop trading
Bank of America Bank of America also, generates less than 2% of its revenues from prop trading
Source: Company reports and J.P. Morgan estimates, Citigroup and Bank of America based on press articles, “Senators Prepare A Citigroup-Sized Hole In Volcker Rule”, CNBC, 23 June 2010.

We estimate the impact from proposed limits on “pure Proprietary trading” on the
2012E EPS for Global IBs in Table 16 below. For US IBs GS and MS, we estimate
average -14% impact on 2012E EPS from the limits on “proprietary trading”,
based on pure prop trading revenues in a “normal year”.

For GS, we estimate 10% of 2012E Group revenues to be related to pure prop
trading, i.e. non client related while for MS we estimate 5% of 2012E group
revenues to be “pure prop” related. Our calculation is based on a simplistic
approach, using 40% Cost/Income ratio for the prop trading operations. We note, the
Cost/Income ratio for prop trading business is lower than IB, as a pure prop trader
utilizes the bank infrastructure, with limited fixed cost.

We assume no impact from the “proprietary trading” limits on the European


IBs, as the EU has not indicated any plans to implement the Volcker rule in Europe.
Thus the European IBs are at an advantage compared to US IBs in our view, with
little or no impact from the proposals to limit “proprietary trading”. U.S. subsidiaries
of the European IBs might be impacted by the limits on Prop trading, but we believe
the business written out of the U.S. subsidiaries would be moved to Europe in such a
scenario, thus limiting the impact in our view.

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Kian Abouhossein Global Equity Research
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kian.abouhossein@jpmorgan.com

Table 16: Global Investment Banks: 2012E EPS Sensitivity to Section 619 limits on “PURE Proprietary trading”
local currency millions
GS MS CSG UBS DBK
Pure Prop Trading Revenues 3,722 1,733 1,800 1,000 1,608
Pure Prop Trading Revenues impacted by Section 619 3,722 1,733 - - -

Assumed Cost/Income ratio 40% 40% 40% 40% 40%


Cost Impact 1,489 693 - - -

Pre-tax impact 2,233 1,040 - - -


Impact on Net Income 1,518 728 - - -
EPS Impact from limits on "Proprietary Trading" 14.8% 13.4% - - -
Source: J.P. Morgan estimates.

Impact from restrictions on Market making related activities


Section 619 of the Dodd-Frank Act which proposes limits on “proprietary trading”, if
applied to the market making related activities of the IBs would have significant
negative impact on IB revenues in our view, as market making forms a very
significant part of both Fixed Income and Equity Sales and Trading revenues
(especially Derivatives) for the IBs in our view as well as Equity Derivative business.
Limits on market making would also bring down liquidity in the instruments; the
revenue impact on IBs would partly be offset by increase in margins in our view and
the increased cost would be paid by the end users.

We start our analysis of the impact from Volcker rule provisions with the 2011E IB
revenue split by product for the different IBs, as shown in Table 12. We have looked
at the derivative notional outstanding data provided by OCC on a quarterly
basis, and based on that made assumptions on the amount of revenues in each
product line which might be impacted by an extension of the Volcker rule to
include “market making related activities.”

If Section 619 of the Dodd-Frank Act is interpreted in a way which affects the
market-making activities of the IBs, the impact would be much higher in our view. It
is very difficult to differentiate the pure market making activity in derivatives,
and Equity derivatives in particular from proprietary position taking.

• We estimate market making to contribute c.80% of all Fixed Income revenues


and c.60% of Equity derivative revenues.
• Cash Equities which is mostly order-book driven would be less impacted in our
view and we estimate c.15% of cash equity revenues to be impacted from this
interpretation of Section 619 of the Dodd-Frank Act.
• Based on our estimates, 52% of 2011E IB revenues for GS and 40% of 2011E IB
revenues for MS would be impacted by the more stringent interpretation of
limitations on market making related activities.
• At the Group level, GS would be most impacted with 46% of 2011E revenues
likely to be affected by the rules followed by MS at 20%. The impact for U.S.
Large Cap banks Citi and BofA would be average 13% in 2011E in our estimates.

At this point, looking at the proposals in Section 619 of the Dodd-Frank Act, we
do not have clarity on the final likely impact on market-making related
activities of the banking entities.

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Table 17: US Investment Banks: 2011E Revenue Impact from “market-making” limitations under Section 619 of Dodd-Frank Act
$ million
% of revenues Bank of
impacted GS MS Citigroup America
Fixed Income Markets
SPG 80% 564 139 2,223 3,120
Credit Trading 80% 3,310 273 1,259 2,455
FX 80% 1,292 833 872 991
Rates 80% 3,616 1,742 3,102 3,343
GEM 80% 643 333 2,790 1,311
Commodities 80% 3,387 1,765 323 159
Prop trading/hedge gains/others 80% 1,870 526 1,272 684
Total Fixed Income Markets 14,681 5,610 11,840 12,063

Equity Markets
Equity Derivatives 60% 2,142 842 790 889
Cash equities 15% 432 187 179 275
Total Equity Markets 2,574 1,029 968 1,164

Total Revenues Impacted 17,256 6,639 12,808 13,227

Total Revenues Impacted as % of IB Revenues 2011E 52% 40% - -

Total Revenues Impacted as % of Group Revenues 2011E 46% 20% 15% 12%
Source: J.P. Morgan estimates. Note: Citi and BofA revenue estimates using weighted average growth rates for the rest of the IB universe

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Kian Abouhossein Global Equity Research
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Table 18: Global Wholesale & Investment Banks - 2011E detailed IB revenues split
$ in millions
GS MS UBS CS DB BNPP SG BARC HSBC RBS Citigroup BofA
IB Fees
Advisory 2,371 1,562 967 1,137 836 192 80 1,181 1,423 622 - -
Equity Underwriting 1,402 1,255 1,588 916 766 130 100 895 569 498 - -
Debt Underwriting 1,463 1,471 866 2,242 1,667 712 370 1,146 854 1,369 - -
Other 357 - -
Total 5,237 4,288 3,421 4,294 3,269 1,034 550 3,580 2,847 2,490 - -

Fixed Income Markets


SPG 705 173 299 810 872 313 99 546 382 25 2,778 3,900
Credit Trading 4,137 341 2,563 1,422 2,998 395 355 1,482 1,082 3,788 1,574 3,068
FX 1,616 1,041 1,250 1,385 2,896 1,196 700 980 1,095 859 1,090 1,238
Rates 4,520 2,178 909 2,644 3,259 2,719 1,200 5,336 1,030 645 3,877 4,179
GEM 803 416 647 711 1,362 358 163 1,540 3,004 830 3,487 1,639
Commodities 4,234 2,207 235 323 988 216 111 1,041 0 404 199
Prop trading/hedging gains/other 2,337 657 957 417 702 410 269 881 1,163 2,149 1,590 855
Total Fixed Income Markets 18,351 7,013 6,860 7,713 13,077 5,607 2,896 11,806 7,756 8,597 14,800 15,079

Equity Markets
Equity Derivatives 3,571 1,403 1,922 2,073 1,594 2,552 3,048 1,902 275 564 1,316 1,482
Cash equities 2,879 1,247 1,826 2,711 1,224 82 205 597 393 644 1,192 1,830
Prime brokerage 1,857 1,762 1,008 1,547 910 170 0 429 1,521 161 966 983
Prop trading/other equity-related 1,500 650 625 391 516 363 564 325 118 242 748 883
Total equities 9,806 5,062 5,381 6,721 4,244 3,167 3,818 3,253 2,306 1,610 4,221 5,178

Credit Portfolio 0 0 0 0 2,316 5,937 3,070 1,850 135 0 - -


Underlying 0 0 0 0 2,316 5,937 3,070 1,850 135 - - -
CVA 0 0 0 0 0 0 0 0 0 0 - -
Other 0 0 0 0 0 0 0 0 0 0 - -

Total Revenue 33,395 16,363 15,662 18,729 22,906 15,745 10,335 20,489 13,044 12,698 - -
Source: J.P. Morgan estimates, Company data. Note: i.) most of the French banks’ commodities-related revenues are not reported in the capital markets Sales & Trading but in Financing, unlike European IBs, ii) BNP Paribas "cash equities" include advisory revenues;
iii) Barclays Currencies includes commodities; iv) RBS IB Fees includes portfolio management revenues; v) Citi and BofA revenue estimates using weighted average growth rates for the rest of the IB universe

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kian.abouhossein@jpmorgan.com

Key terms from Dodd-Frank Act on


“Proprietary Trading”
The Dodd-Frank Act was enacted on July 21, 2010. Under section 619 of the Dodd-
Frank Act, banking entities are prohibited from engaging in proprietary trading and
from maintaining certain relationships with hedge funds and private equity funds.
These prohibitions and other provisions of section 619 are commonly known, and
referred to herein, as the “Volcker Rule”.

“Banking entity” is defined as any insured bank or thrift, any company that
controls an insured bank or thrift, any company that is treated as a bank holding
company under Section 8 of the International Banking Act of 1978, and any affiliate
or subsidiary of such an entity.

(4) Proprietary Trading – The term ‘proprietary trading’, when used with respect to a
banking entity or nonbank financial company supervised by the Board, means
engaging as a principal for the trading account of the banking entity or nonbank
financial company supervised by the Board in any transaction to purchase or sell, or
otherwise acquire or dispose of, any security, any derivative, any contract or sale of a
commodity for future delivery, any option on any such security, derivative, or
contract, or any other security or financial instrument that the appropriate Federal
banking agencies, the Securities and Exchange Commission, and the Commodity
Futures trading commission may, by rule as provided in subsection (b) (2), determine.

Trading Account: The term ‘trading account’ means any account used for
acquiring or taking positions in the securities and instruments described in
paragraph (4) principally for the purpose of selling in the near term (or otherwise
with the intent to resell in order to profit from short-term price movements), and any
such other accounts as the appropriate Federal banking agencies, the Securities and
Exchange Commission, and the Commodity Futures trading commission may, by rule
as provided in subsection (b) (2), determine.

Permitted activities
1. The purchase, sale, acquisition, or disposition of securities and other instruments
described in subsection (h)(4) in connection with underwriting or market-
making-related activities, to the extent that any such activities permitted by this
subparagraph are designed not to exceed the reasonably expected near term
demands of clients, customers, or counterparties
2. The purchase, sale, acquisition, or disposition of the United States or any agency
thereof, obligations issued by the Government National Mortgage Association,
the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the
Federal Agricultural Mortgage Corporation, or a Farm Credit System institution
chartered under and subject to the provisions of the Farm Credit Act of 1971 (12
U.S.C. 2001 et seq.), and obligations of any State or of any political subdivision
thereof;
3. Risk-mitigating hedging activities in connection with and related to individual or
aggregated positions, contracts, or other holdings that are designed to reduce the
specific risks to the banking entity in connection with and related to such
positions, contracts, or other holdings ;and

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4. The purchase, sale acquisition, or dispose of securities and other instruments on


behalf of customers.

Interpretation of Prop Trading and Market Making:


Responses to the FSOC
Section 619 of the Dodd-Frank Act bans proprietary trading but includes an
exemption for market-making trades with the limitation that these trades do not
exceed the reasonable expected near term demand of clients, customers or
counterparties.

In separate responses to FSOC, there have been references on the likely


interpretation of Section 619 of the Dodd-Frank Act, especially on the terms market-
making and near term demand, with Senators Merkley and Levin and the SIFMA
expressing their views on the issue.

Senators Merkley and Levin response to FSOC


Senators Jeff Merkley and Carl Levin, co-sponsors of the Volcker rule, in a letter,
dated 4th November 2010, to Financial Stability Oversight Council (FSOC)
commented: “Some firms seem to assert that entering into any transaction with a
client or counterparty is somehow market-making. That view, however, would
expand the definition of market-making to include all proprietary trading-because
every trade has at least two parties-and would thus render the statutory protections
against high-risk proprietary trading meaningless.”

SIFMA response to FSOC


SIFMA in its letter to FSOC, dated 5th November 2010, highlighted the fact that
Section 619 expressly permits activities that are crucial to functioning of US and
Global markets which includes market making: “SIFMA views the market making-
related permitted activity as a crucial component of Section 619. Market making is a
core function of banking entities and provides liquidity needed by all market
participants, resulting in better pricing. The Study should support the design of a
sensible framework of regulations and policies and procedures that preserve the
effective functioning of markets and the current role of market making within those
markets, and at the same time achieve the objectives of the statute. SIFMA supports a
robust discussion of this topic, especially in light of possible confusion regarding the
activities involved in market making.”

Further, the rule related to market making activities states that these activities are
permissible only if they do not exceed the reasonably expected near term demands of
clients, customers, or counterparties implies that there is a time limitation for these
market making activities.

The phrase “near term” is used in both the definition of “trading account” and in
describing the “market making-related” permitted activities. In the definition of
“trading account,” the phrase “near term” defines the nature of the seller’s selling
activity, and when used to describe a “market making–related” permitted activity, the
phrase defines the nature of the demand of clients, customers and counterparties.

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SIFMA and Committee on capital market regulation in their comments submitted to


FSOC pointed out that the phrase “near term” need not be defined the same way in
both places and have recommended the “FSOC to encourage regulators when
writing regulations to apply a meaning to the words “near term” that is appropriate
to the context in which they appear.” “The regulators should take care not to define
the term in such a way as to prohibit either long-term investments or market
making.”

SIFMA in its letter to FSOC dated 5th November 2010 highlighted that: Section 619
uses the words “near term” in the definition of “trading accounts” and in describing
the “market making-related” permitted activity. In the definition of “trading
account,” the phrase "near term" defines the nature of the seller’s selling activity,
and when used to describe a “market making–related” permitted activity, the
phrase defines the nature of the demand of clients, customers and counterparties.
The FSOC should encourage regulators to view the phrase in its defining context.
The FSOC also should recognize that any definitions in this area should be
sufficiently flexible to account for differences among asset classes and markets. The
FSOC should encourage regulators when writing regulations to apply a meaning to
the words “near term” that is appropriate to the context in which they appear

Committee on capital market regulation response to FSOC


Committee on capital markets regulation sent a letter to FSOC on November 5, 2010
expressing its views on the terms near term and selling in the near term, stressing on
the fact that the rulemaking should identify the differences in the definition of the
terms.

• “Selling in the near term.”: Under the Dodd-Frank Act, a “trading account” used
for proprietary trading is defined to be used principally with the intent to “sell in
the near term (or otherwise with the intent to resell in order to profit from short-
term price movements).” This implies that the motives of the banking entity when
initially acquiring the security or instrument are highly relevant in determining
whether impermissible proprietary trading is occurring.
• The phrase “near term,” however, is also used in the exception allowing for
market making “for the reasonably expected near term demands of clients.” The
phrase need not be defined the same way in both places. Although there is an
important temporal aspect in both uses, the regulators should take care not to
define the term in such a way as to prohibit either long-term investments or
market making.

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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
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Recent developments
• On 17th November, Fed opened up the public comment period on proposed rules
that would implement the conformance period during which banking entities and
non-bank financial companies, supervised by the board, must bring their activities
into compliance with the rules.

According to Bloomberg article “Derivatives, ‘Volcker’ Rules Might Be Targets of


House Republican Tactics”, dated 19th November 2010: “Republicans, who will take
power in the House in January, have already voiced concerns with the so-called
Volcker rule to bar banks trading on their own accounts and new derivatives rules
designed to push the $615 trillion over-the-counter market onto regulated
clearinghouses and exchanges -- two issues that have garnered much attention from
Goldman Sachs Group Inc., JPMorgan Chase & Co. and Bank of America Corp.,
according to meetings posted on the Web sites of the federal regulators.”

“One procedure being considered by House Republicans is a little used “resolution


of disapproval” through the 1996 Congressional Review Act, which can be deployed
to target a specific regulation”

“We are committed to conducting aggressive oversight to bring the Administration’s


actions to light,” said Spencer Bachus. “The Congressional Review Act should be a
tool for Congress to use to demand greater efficiency and accountability throughout
the federal bureaucracy”

• SIFMA (The Securities Industry and Financial Markets Association (SIFMA) is


an organization that brings together the shared interests of hundreds of securities
firms, banks and asset managers) issued a study in January 2011 highlighting the
importance of liquidity provisioning by market makers and its impact on the
general economy.

• FSOC issued on 18th January 2011, where the committee put forward
recommendations designed to comprehensively implement the Volcker rule (we
have discussed the proposed quantitative indicators as well as new control
processes in the previous sections as well as in separate report Volcker Rule -
Clear quantitative indicators for market making by FSOC: Remain OW Euro IBs.

Concerns on impact of Section 619 on U.S. Financial Sector


The Volcker rule limits proprietary trading activities of the US IBs, giving a
competitive advantage to European Banks in our view. This might lead to some
clients moving out from US banks to European banks, leaving the US banks at a
competitive disadvantage. Republican Senators have already voiced concerns
over the proposed “Proprietary Trading” limits on US banks.

Spencer Bachus, who is an Alabama Republican and new Chairman of the House
Financial Services Committee, had sent a letter to the Financial Stability Oversight
Council (FSOC) on November 3, 2010 warning them that a ban on proprietary
trading “will undermine competitiveness of US Financial Service Sector” He further
added that “the rule-making agencies must give to the international financial
regulatory context as they begin crafting regulations to implement the Volcker rule.”

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Key points he raised concern about were:

• Other countries have not embraced and will not embrace the Volcker rule
• Unilaterally imposed restrictions on Bank Activities promote regulatory arbitrage
• EU countries have rejected the Volcker rule and have no plans to adopt its
provisions.
• May “mark a spark of mass exodus of clients” from US banks to banks based
abroad.
• Banks may move its operations abroad where these restrictions are not there.
• Volcker Rule will constrict capital and lending, unnecessarily hobbling the
provision of credit necessary for economic recovery in the U.S and abroad.

He pointed out that “prop trading is a primary source of income diversification for
US banks; a ban will undermine their competitive position globally. Trading and
fee income derived from a diverse set of financial products and services can help
make banking entities less risky and more stable. During financial crisis, firms with
significant trading operation fared batter than firms that concentrated their exposure
in real estates which need capital injections to keep from collapsing,”

He concluded by saying “If the Volcker rule's prohibition are expansively interpreted
and rigidly implemented against US institutions while other nation refuse to adopt
them, the damage to U.S. competitiveness and job creation could be substantial. It is
therefore critical that the regulatory agencies represented on the FSOC carefully
consider these unintended consequences before moving with the Rule’s
implementation.”

U.S. IBs GS and MS have also talked about the impact on their proprietary trading
operations from Volcker rule provisions in their regulatory filings.

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Table 19: US IBs: Comments from SEC filings on impact of Dodd-Frank Act
GS • On July 21, 2010, the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was enacted. The Dodd-Frank Act significantly
restructures the financial regulatory regime under which we operate. The implications of the Dodd-Frank Act for our businesses will depend to a large extent
on the provisions of required future rulemaking by the Board of Governors of the Federal Reserve System (Federal Reserve Board), the Federal Deposit
Insurance Corporation (FDIC), the SEC, the U.S. Commodity Futures Trading Commission (CFTC) and other agencies, as well as the development of
market practices and structures under the regime established by the legislation and the rules adopted pursuant to it. However, we expect that there will be
two principal areas of impact for us: the prohibition on “proprietary trading” and the limitation on the sponsorship of, and investment in, hedge funds and
private equity funds by banking entities, including bank holding companies; and increased regulation of and restrictions on over-the-counter (OTC)
derivatives markets and transactions
• In light of the Dodd-Frank Act, during 2010, we liquidated substantially all of the positions that had been held within Principal Strategies in our former
Equities operating segment, as this was a proprietary trading business. In addition, during the first quarter of 2011, we commenced the liquidation of the
positions that had been held by the global macro proprietary trading desk in our former Fixed Income, Currency and Commodities operating segment. Net
revenues from Principal Strategies and our global macro proprietary trading desk were not material for the year ended December 2010. The full impact of
the Dodd-Frank Act and other regulatory reforms on our businesses, our clients and the markets in which we operate will depend on the manner in which
the relevant authorities develop and implement the required rules and the reaction f market participants to these regulatory developments over the next
several years. We will continue to assess our business, risk management, and compliance practices to conform to developments in the regulatory
environment.

MS • Activities Restrictions under the Volcker Rule. A provision of the Dodd-Frank Act (the “Volcker Rule”) will, over time, prohibit the Company and its
subsidiaries from engaging in “proprietary trading,” as defined by the regulators. The Volcker Rule will also require banking entities to either restructure or
unwind certain relationships with “hedge funds” and “private equity funds,” as such terms are defined in the Volcker Rule and by the regulators. Regulators
are required to issue regulations implementing the substantive Volcker Rule provisions during the course of 2011. The Volcker Rule is expected to become
effective in July 2012, and banking entities will then have a two-year transition period to come into compliance with the Volcker Rule, subject to certain
available extensions. While full compliance with the Volcker Rule will likely only be required by July 2014, subject to extensions, the Company’s business
and operations are expected to be impacted earlier, as operating models, investments and legal structures must be reviewed and gradually adjusted to the
new legal environment. The Company has begun a review of its private equity fund, hedge fund and proprietary trading operations; however, it is too early
to predict how the Volcker Rule may impact the Company’s businesses.
BofA • We anticipate that the final regulations associated with the Financial Reform Act will include limitations on certain activities, including limitations on the use
of a bank’s own capital for proprietary trading and sponsorship or investment in hedge funds and private equity funds (Volcker Rule). Regulations
implementing the Volcker Rule are required to be in place by October 21, 2011, and the Volcker Rule becomes effective 12 months after such rules are final
or on July 21, 2012, whichever is earlier. The Volcker Rule then gives banking entities two years from the effective date (with opportunities for additional
extensions) to bring activities and investments into conformance. In anticipation of the adoption of the final regulations, we have begun winding down our
proprietary trading line of business. The ultimate impact of the Volcker Rule or the winding down of this business, and the time it will take to comply or
complete, continues to remain uncertain. The final regulations issued may impose additional operational and compliance costs on us.
Source: GS 10K filings page - 59; MS page 10 of 10K filing , Bank of America 10K 2010 filings page 4

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What is the Financial Stability Oversight Council?


Financial Stability Oversight Council (“FSOC”) is the body which will study and
make recommendations on implementing the Volcker Rule and the various
government agencies must consider the recommendations of the FSOC study in
developing and adopting regulations to implement the Volcker Rule.

Financial Stability Oversight Council (FSOC) is made up of ten voting members –


nine federal financial regulatory agencies and an independent member with insurance
expertise – and five nonvoting members

• Voting Members: The Secretary of the Treasury, who serves as the Chairperson
of the FSOC, the Chairman of the Board of Governors of the Federal Reserve
System, the Comptroller of the Currency, the Director of the Consumer
Financial Protection Bureau, the Chairman of the Securities and Exchange
Commission, the Chairperson of the Federal Deposit Insurance Corporation, the
Chairperson of the Commodity Futures Trading Commission, the Director of the
Federal Housing Finance Agency, the Chairman of the National Credit Union
Administration Board, and an independent member with insurance expertise that
is appointed by the President and confirmed by the Senate for a six year term.
• Nonvoting Members:-Who Serve in an Advisory Capacity: The Director of the
OFR, the Director of the Federal Insurance Office, a state insurance
commissioner selected by the state insurance commissioners, a state banking
supervisor chosen by the state banking supervisors, and a state securities
commissioner designated by the state securities supervisors. The state nonvoting
members have two year terms.

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Regulatory Arbitrage II:


EU compensation rules

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Regulatory Arbitrage II: EU compensation


analysis – favors Global IBs over EU IBs,
winners AM & HFs
Overview
Based on the EU regulation on compensation, we see risk for regulatory
arbitrage with the European IB industry becoming less competitive relative to
Global IBs in their ability to attract and retain top/key talent.

In our base case assumption, key IB staff in European IBs would receive at best 20%
of their bonuses in cash upfront, 20% retained for 6 months to 2 years and an
estimated 60% deferred between 3-5 years (more likely 3 years in our view). Overall
50% of total bonuses will be paid in equity-linked instruments, in our view.

Who is impacted: limited staff numbers, but key revenue


generators...
We note that the EU compensation rules would only affect the top 200-400
employees per bank for Investment Banks operating in the EU in our view,
equivalent to about 2% of total IB staff globally. It is, however, important to note
that employees affected include key revenue contributors. We believe there is a
20%-80% rule in investment banking with 20% of staff generating 80% of
revenues. We believe these key staff are greater revenue generators and will be part
of the 20% most productive employees.

Whilst the EU compensation rules could be seen as an improvement in Europe


vs. the past one to two years when 60-100% of variable compensation was
deferred for key staff between 3-5 years, we believe these rules are harsher for
IBs operating in Europe than US compensation guidelines. Long-term deferral
plans used to be between 40-60%, and going forward, are expected to be 50-60% in a
normal year for key staff.

Table 20: Group number of employees - Geographical distribution - 2009


CS UBS DB GS MS
Total employees 47,600 65,233 77,053 32,500 61,388
o/w in EMEA 29,700 34,573 49,391 8,160 6,463
o/w in Asia Pacific 6,400 6,849 16,489 5,440 4,386
o/w in Americas 11,500 23,810 11,173 18,900 49,682

Total employees (IB) 19,400 15,666 20,000 24,500 17,000


Source: Company reports and J.P. Morgan estimates; 2009 data Note: 1.For GS and MS number of employees estimates are based
on the geographical revenue breakdown 2.For CS and UBS EMEA also includes employees in Switzerland

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...local regulators driving even tougher compensation rules


in Europe
We note that under pressure from local regulators, some banks have gone one
step further, increasing the proportion of employees covered by highly defined
remuneration structures: lowering the threshold for deferred compensation and
increasing rates of deferrals. Below, we give examples of plans implemented by CSG
and BNPP/SG:
• Close to 45% of IB staff for Credit Suisse in 2010 will see bonuses deferred for
four years: We estimate that 9,000-10,000 FTE in CS’s Investment Bank (majority
of front office staff) would fall within the scope of the new remuneration policy. For
all IB staff with variable comp of at least SF50k, 35%-70% of bonuses would be
deferred over 4 years. For executive management, MDs and Directors, deferred cash
based comp would account for 50% of deferred comp and could be adjusted based
on CS’s ROE - even if group ROE is positive, as long as the division is loss making,
cash based deferred comp would decreaseWe assume UBS will have to implement
similar rules to CSG, given that both are regulated by FINMA.
• In the Netherlands, Dutch banks adopted a voluntary code of conduct in
September 2009, which included capping bonuses at 100% of salary and
limiting pay to one year’s salary in the event of dismissal of a member of the
executive board.
• 20-25% of CIB staff within French banks in 2009: For financial market
professionals whose activities have a significant impact on the group's risk,
French banks have already agreed to ban guaranteed bonuses longer than 1 year;
defer at least 50% of bonuses (and 60% for the highest compensation levels) for
at least three years, with at least 50% of the variable compensation paid in
securities or equivalent instruments, retention period of at least 2 years for
shares/equivalent instruments.

Table 21: French banks – 2009 remuneration for financial market professionals
€ million
Variable Deferred Deferred Deferred Other Deferred
Number of people Fixed paid in Mar 10 Variable* 2011 Variable* 2012 Variable* 2013 Variable
SG 2,600 260 223 114 114 114 7
BNP 3,972 356 508 161 225 258 0
Source: J.P. Morgan estimates, Company data. *Deferred Variable Remuneration paid in shares or share equivalents.

What’s harsher: Volcker rule or EU compensation?


EU regulators have so far been more proactive on compensation than their US
counterparts, with US regulators favoring the prohibition or limitation of riskier
activities (e.g. Sections 619 or Volcker rules, Section 716 of the Dodd Frank bill).
For more details, please refer
Whilst US regulators are reviewing compensation rules for executive management,
to our note:
we do not expect the same level of constraints with fewer employees impacted.
“Global Investment Banks:
Regulatory Arbitrage I: In the broader context of regulatory changes, the EU and Swiss compensation
Tougher than expected rules are significantly less punitive than the Volcker rule with its potential impact
Volcker rules undiscounted - on US IBs' market making activities - for more details, please refer to our report
OW Euro IBs published on 12 Jan 2011 “Regulatory Arbitrage I: Tougher than expected Volcker
rules undiscounted”. Hence, in the overall regulatory context, European IBs
could still benefit from regulatory arbitrage overall.

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Disadvantage for European IBs and generally Tier II/III IBs


New restrictions on compensation would apply to EU-based banks, both the
parent company and foreign subsidiaries globally. For Global IBs, it impacts key
staff in EU subsidiaries. Interestingly, the FINMA rules based on CSG disclosure are
even harsher than EU rules as discussed below on page 48. This would likely have a
more significant impact on European IBs, effectively reducing their competitiveness
and attractiveness as employers for top key employees. The overall result could be:

• Potentially less top talent moving to European IBs globally and European
countries: New EU compensation rules create disincentives for top talent from
US, Asia, and non Swiss Banks in Switzerland to move to European countries or
Europe based IBs. As EU compensation rules would apply not only to the EU
based parent institution but also to its foreign subsidiaries and branches (i.e.
globally), European IBs would be less competitive in the US, Asia and other
Emerging Markets. In addition, as there is scope for interpretation of the EU
compensation rules by local regulators, creating potential regulatory arbitrage
opportunities between EU banks based on their home country interpretation of
the EU rules such in the case of retained part of the bonus (up for interpretation
by the local regulator).
• Less industry cost flexibility due to increased fixed salaries: Base salaries will
likely rise further to retain talent – especially driven by EU/Swiss banks to
compensate for more stringent bonus rules compared to US IB peers globally.
Coupled with higher salaries and in addition to more deferred compensation
expenses, IBs' fixed cost will rise for key employees which would limit the cost
flexibility of the IB industry in our view.
• EU Tier II/III IBs - competitive disadvantage to attract and retain talent:
EU/Swiss comp rules would make it very difficult for Tier II/III IBs that do not
operate a pure agency model to retain and attract talent in our view. We believe
with salaries expected to increase for top employees due to new compensation
rules, cost flexibility for Tier II/III IBs declines on a smaller revenue base. In a
downturn this will be difficult to absorb for Tier II/III IBs in our view. In
addition, with bonus guarantees limited to one year (vs. multi year guarantees),
Tier II and III firms will have difficulty to attract talent to their franchise in the
future.
• EU and compensation rules would also affect EU-based employees of Global
IBs, however we expect Global IBs to remain relatively better positioned
than European peers. Global IBs in the UK would be subject to limitations on
compensation, however, Global IBs will likely still fare better than EU IBs (and
Swiss), mainly due to their ability to grow aggressively in Asia and Emerging
Markets where all IBs have an expansion strategy and competition for the limited
talent pool will remain fierce. As employees of global IBs would not be impacted
by these rules it will be easier for them to retain and attract top staff.

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The ultimate winners of top talent: ‘agency’ only boutiques,


and asset gatherers and in particular Hedge Funds
We potentially see more opportunities for financial institutions not impacted by the
new EU compensation rules such as small boutiques, niche players and asset
managers, and in particular hedge funds. EU compensation rules introduce a
“proportionality” provision that implies that not all institutions and staff
members need to comply with the compensation rules to the same extent.

• Small positive for small IBs and organizations that use the agency model: we
believe that only small IBs and organisations that use the agency model would
increase in number as these can pay 100% bonus in cash and would not be
impacted to the same extent by the compensation rule.
• Asset managers (solely investing client money) would be the most likely
winners in our view as they can pay 100% bonus in cash and would not have the
specific requirements to defer remuneration and pay bonuses in shares. A similar
compensation level to top employees with no restrictions is positive for asset
management firms in our view. We believe this could trigger migration of some
top staff into 3rd party AM businesses. Asset Management firms could become
employers of choice in our view, in particular asset managers independent from
larger bank holdings.
• Hedge funds could also benefit as the EU compensation regulation makes it
clear that rules should be applied proportionately to investment firms and the
dividends payments to partners as owners of an institution are not covered by the
guidelines. This would mean that these rules are not applicable to partners in
hedge funds and therefore we believe there could be a migration of talent
from banks to these less regulated entities. Hedge funds as such will be subject
to separate legislation - the alternative investment fund managers’ directive
(‘AIFMD’). CEBS guidelines further states that depending on the legal structure
of the institution or entity, some of the remuneration requirements may not
be applicable to staff at such ownerships or partnerships. The underlying
principle is that when investors' money is put at risk, the investing firm's
incentives should be aligned with theirs.3 Overall, hedge fund due to their
highly flexible and focused cost structure will always be able to move
relatively easily to jurisdictions that have limit impacts on compensations.
Hence, further stringent hedge fund guidelines could drive HF firms out of
the EU, especially UK in our view.

3
Frequently Asked Questions on the Capital Requirements and Bonuses Package (CRD3)

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Compensation Regulation and disclosure


creates an equal level playing field
Compensation overview – no clarity today by IB industry
As we discuss below, compensation ratios vary materially. It is unclear, however,
how decisions are made between shareholder returns and retaining top talent,
with compensation ratios varying between 34% and 57% for 2010E. The
compensation details given by banks so far are too subjective. As a result, one could
argue FINMA, EU compensation rules as well as Basel CRD3 guidelines (especially
in respect to disclosure) should create a more harmonized playing field with
improved comparability in compensation levels. As an example, other than CSG,
no other global IB discloses its deferred compensation level. This, in our view should
be unacceptable to shareholders and will be addressed through CRD3.

Table 22: Global Investment Banks: IB division 2010E


$ millions
CS UBS DB GS group MS BNPP SocGen Barclays
Total number of employees IB 21,200 17,006 24,088 35,400 18,000 17,319 11,728 23,896

Total IB cost (clean) (mn) (13,280) (10,157) (15,653) (24,896) (11,004) (8,434) (5,982) (12,112)
o/w compensation cost (clean)(mn) (8,224) (7,050) (10,103) (14,950) (6,325) (5,482) (3,888) (8,115)
o/w non compensation cost (clean)(mn) (5,056) (3,107) (5,550) (9,946) (4,679) (2,952) (2,094) (3,997)

Cost/Income 75% 82% 65% 63% 68% 53% 59% 62%


Comp ratio (clean) 47% 57% 42% 38% 39% 34% 38% 42%
Non comp ratio (clean) 29% 25% 23% 25% 29% 19% 21% 20%

IB revenues (clean) (mn) 17,647 12,420 24,338 39,636 16,142 15,908 10,165 19,536

Revenues/head 832,416 730,317 1,010,361 1,119,674 896,805 918,503 866,703 817,552


Cost/head 626,415 597,275 649,824 703,271 611,359 486,973 510,076 506,882
Compensation cost/head 387,925 414,569 419,438 422,321 351,393 316,533 331,550 339,611
Non-compensation cost/head 238,490 182,706 230,386 280,950 259,966 170,441 178,527 167,271
Source: J.P. Morgan estimates, Company data. Note: We estimate CB&S comp ratio for DB as compensation expense not disclosed; Institutional securities compensation ratio for MS; GS group
level Assumed 65% of CIB expenses attributable to Investment Banking for BNP and SocGen. Barcap clean annual compensation is 67% of the total Barcap cost in 2010; GS are group nos. Note
Comp ratios are calculated excluding UK bonus tax.

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Less competition with less top talent/performer turnover


Some Top Tier IBs with strong compensation and rules management culture
would argue that most of the EU compensation rules are already implemented.
However, many firms pre-crisis, did not operate with compensation structure
similar to those outlined in the EU compensation rules. Hence, one of the
consequences of the rules is a more harmonized level playing field - not just for
Code Staff in the EU, but more generally on the wider principles of risk
adjustment of bonus pools, the link to profitability and governance.

Overall, the new environment and rules should mean banks are only allowed to
pay their staff what the results can justify. The consequence of that, coupled with
the ban on guarantees except in exceptional circumstances for one year of new hires,
should be to make the Top Tier IBs stronger and Tier II/III IBs weaker, because the
pay gap between the two will get wider as regulators/shareholders will refuse to
allow the weaker ones to pay more than their results justify. As we outlined above
the US IBs will have a relative advantage in hiring top talent and HFs/Asset
managers will be absolute 'winners', but overall, in the long-term these results could
result in the best talent of Tier II/III leaving for stronger competitors, especially
in Europe. You could also argue that it will reduce competition in the long-run
despite the US and Europe compensation regulatory arbitrage opportunity. It
is certainly likely to make it very difficult for new entrants to the IB market.

Market rationally has to be questioned so…at least in the


short-term as salaries increase
We believe that the aforementioned view above is quite a rational way of
looking at compensation behavior. Clearly, Tier II/III IBs could (and currently
are in our view) increasing salaries above Tier I levels in order attract and
retain talent (ie "overpay”). This is a concern as it reduces cost flexibility whilst
increasing the additional deferred expense level. However, in the next
downturn, Tier II/III firms may well be "caught out" with this strategy as their
revenue pool is smaller and hence will likely lead to material staff reduction in
order to generate a shareholder return (ie reduce fixed costs). Such a material
market downturn would likely trigger a re-thinking of strategy for Tier II/II IBs
from an institutional business competing with Tier I IBs to an agency only
business, in our view.

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Kian Abouhossein Global Equity Research
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CSG – toughest compensation rules so far


Whilst FINMA guidance on remuneration schemes is less detailed than the EU
compensation rules, the Swiss regulator seems to take a tougher stance, based on
what Credit Suisse implemented, in our opinion.

FINMA guidance applies to all financial institutions in Switzerland required to


maintain equity capital of at least SF2bn, which implies that most foreign
subsidiaries of non Swiss based IBs would not be subject to these restrictions.

Credit Suisse compensation structure from 2010 is one of the most stringent
compensation rules globally considering i) material deferral rates and relatively
low deferral threshold, and ii) deferrals of up to 70%, and iii) vesting period of
four years whereas most EU regulators are focusing on 3 years, and iv) awards
are reduced for employees if their division is loss making.

We note the key points:

• Increase in number of employees receiving deferred variable compensation


• Significant decrease in the threshold for deferred compensation programs from
CHF 125,000 to CHF 50,000 in variable awards. This implies that now more
employees will have part of their bonuses deferred.
• Increase in the deferral rates to a range of 35% to 70%
• Deferred variable awards granted to members of the Executive Board, Managing
Directors and Directors will be in the form of (1) Share awards (shares granted
as part of 2010 variable awards will vest and be delivered over four years on a
pro-rata basis between 2012 and 2015) and (2) Adjustable Performance Plan
Awards (cash-based awards that will vest and be delivered over four years on a
pro-rata basis). Outstanding awards will be adjusted upwards or downwards
based on Credit Suisse’s return on equity (ROE) each year from 2011 to 2014
However, should a division be loss-making in one or more years between 2011
and 2014 outstanding awards for employees of that division will be adjusted
downwards even if Credit Suisse's ROE is positive. The maximum upside of the
proportion of variable awards granted in APPA will be the cumulative return on
equity over the vesting period. The maximum downside is 100%.4

4
https://credit-suisse.com/news/en/media_release.jsp?ns=41668

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Basel 3 framework -“Building buffers


through capital conservation”
Bonus and dividends payout subject to the conservation
capital requirement from 1 Jan 2016
Besides the EU, there are clear compensation payout rules set by Basel. The Basel
Committee on Banking Supervision will require banks to have a minimum common
Equity Capital of at least 7%, including a 2.5% conservation buffer to withstand
future periods of stress. The conservation buffer will be phased in from 1 Jan 2016 to
1 Jan 2019. Banks that fail to meet the conservation buffer would be subject to
constraints on discretionary distributions of earnings (dividends and bonuses).

According to the Basel 3 rules on the capital conservation buffer – “Basel III: A
global regulatory framework for more resilient banks and banking systems”
published on 16 Dec 2010, the maximum allowed earnings distribution would then
be determined according to a defined table. The Basel Committee published the
required levels shown in Table 23.

Table 23: Basel proposed capital conservation range


%
Minimum Conservation ratio Dividend and staff
Common Equity Tier 1 Ratio (expressed as % of earnings) bonus payout ratio
4.5% - 5.125% 100% 0%
>5.125% - 5.75% 80% 20%
>5.75% - 6.375% 60% 40%
>6.375% - 7.0% 40% 60%
>7% 0% 100%
Source: BIS

While banks are allowed to draw on the buffer during periods of stress, the closer their
regulatory capital ratios approach the minimum requirement, the greater the constraints
on earnings distributions. For example: if a bank suffers losses such that its Common
Equity Tier 1 capital ratios fall in the range of 5.75% - 6.375%, then the bank would be
required to conserve 60% of its earnings in the subsequent financial year (i.e. payout no
more than 40% in terms of dividends, share buybacks and discretionary bonus payments).

Increased disclosure requirements


The Basel Committee on Banking Supervision has issued “Pillar 3 disclosure
requirements for remuneration” seeking detailed disclosure on remuneration
practices and policies on 27th Dec, 2010 for consultation. Under new proposals,
banks would be required to disclose qualitative and quantitative information
about their remuneration practices. Banks would, at a minimum, be expected to
publish the disclosures on an annual basis and also need to disclose the number,
total amount of guaranteed bonuses paid during the financial year and the total
amount of outstanding deferred compensation. Remuneration disclosure tables
includes complete breakdown in cash and equity, deferred and non deferred, fixed
and variable etc to be completed separately for (a) senior management, (b) other
material risk takers, and (c) financial and risk control staff. This would increase
transparency, allowing shareholders to assess the real compensation paid out in a
year compared to peers as well as comp flexibility. The consultation period closes on
Friday, 25 February 2011.

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Key Points from the EU Compensation


Regulation
At best 20% of bonuses paid upfront in cash, with the rest
deferred for at least 6 month to 2 years in our view
The key constraint from new EU compensation regulation is the limitation of upfront
bonuses in cash to at best 20%-30% of total variable compensation, as i) 40-60% of
bonuses must be deferred (60% for large bonuses), and ii) 50% of the total bonus
paid (whether paid upfront or deferred) must be paid in "equity-linked instruments".
CEBS guidance does not, however, specify the minimum retention period or the ratio
of fixed to variable component.

In our view, as bonuses for the employees affected by the rules would fall into the
higher range within the bank, at least 60% of bonuses will be deferred for them,
which would imply that at best 20% of bonuses can be paid in cash upfront.

• Between 40-60% of bonus must be deferred over at least 3-5 years (depends
on category of staff); for the managers should be longer. We would however
expect 60% of bonuses to be deferred given that bonuses of identified staff would
fall within the top of the bank's range. Payments should not take place more
frequently than on a yearly basis.
• 50% of bonus must be paid in the form of “equity-linked instruments” and
there shall be an appropriate balance of shares and contingent capital instruments.
This provision is applicable to both deferred and non deferred components.
Therefore in effect amounts to 20% cap (50% of 40%) or a 30% cap (50% of
60%) on upfront cash bonus. Over 50% of bonuses could be paid in equity-linked
instruments, however we do not expect firms to go beyond that minimum and
assume 50% of deferred bonuses would be paid in cash.
• There is a minimum retention period for the instruments that has already been
vested or paid out. The retention period should be determined by the institutions.
CEBS doesn't provide any specific period but provides certain examples
(which we have discussed below) on how a minimum retention period should be
sought. We expect the retention period to be between 6 months and 2 years, at the
discretion of the regulator.
• Remuneration should be an appropriate balance of fixed and variable proportion;
institutions should set a maximum appropriate ratio of fixed to variable
component for different classes of identified staff. However, there is no range
set.

Other requirements include:

• No multi-year guarantees.
• No personal hedging on deferred and retained bonus; no rewarding of failure in
case of severance payments.
• Shareholders must be given more information on staff pay in order to increase
transparency allowing shareholders to assess the real compensation paid out
in a year compared to peers as well as comp flexibility in our view.

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• Government supported institutions could also be required not to award any


bonus as long as the government support is not yet paid back, or until a recovery
plan for the institution is implemented/accomplished.
• Regulators should intervene if they think bonuses are detrimental to the
maintenance of a sound capital base.

Scope of application: key staff – the revenue generators


EU compensation rules are applicable to senior management, risk takers, heads
of control functions, and any employee receiving total remuneration that takes
them into the same remuneration bracket as senior management and risk takers
and whose activities mean that they could have a material impact on the firm’s
risk profile. It is for the institution to determine its own scope of Identified Staff.

These rules apply to all EU banks whether they are based inside or outside the
EU and only to the European arms of non-EU banks. For EU-based banks,
compensation rules would apply not only to the parent institution, but also to foreign
subsidiaries globally.

EU compensation rules introduce a “neutralization” provision which implies that


identified staff does not need to comply if the subsidiary doesn’t have a material
impact on the risk of the firm or if the firm has a lower prudential risk profile.

• The neutralization provision allows EEA parent to ‘neutralise’ the pay


requirements in relation to a non-EEA subsidiary if the subsidiary has a
different business model and as long as the subsidiary doesn't have a 'material
impact' on the risk of the whole firm.
• Further, CEBS states that in order to meet a proportionality principle, firms and
staff members can "neutralize" some requirements if they have a lower
prudential risk profile. This means that some firms, either for all or some of
their staff can put aside the requirements on bonus in equity linked
instruments, retention or deferral. CEBS did not provide any such guidelines
in its previous draft guidelines. The revised guidelines have included further
neutralization of some requirements and therefore we believe that these
guidelines are much better than expected and are going to impact only key
people who have a material impact on the risk profile of the institution.

EU compensation rules introduce a “proportionality” provision which implies


that not all institutions and staff members need to comply with the
compensation rules to the same extent.

• EU comp rules apply to all credit institutions and investment firms, with
“proportionality” provisions depending on size and complexity of the
institution. It is for the institutions to identify staff that has a “material
impact” on risk.
• Proportionality applies in principle to all remuneration provisions, proportionality
amongst different kinds of institutions and different category of staff which
implies that not all institutions and staff members need to comply with these
rules to the same extent.

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Who’s impacted? 200-300 key employees per IB, in our view


In our view, these rules are not going to affect a significant number of employees
although it does impact key people. We believe out of several thousands of
employees only 200-300 key people such as risk takers are going to be impacted by
these rules. However, these key people play an important role in generating revenues
for the firm.

Table 24: Number of employees - Geographical distribution - 2009


CS UBS DB GS MS
Total employees 47,600 65,233 77,053 32,500 61,388
o/w in EMEA 29,700 34,573 49,391 8,160 6,463
o/w in Asia Pacific 6,400 6,849 16,489 5,440 4,386
o/w in Americas 11,500 23,810 11,173 18,900 49,682

Total employees (IB) 19,400 15,666 20,000 24,500 17,000


Source: Company reports and J.P. Morgan estimates; 2009 data Note: 1.For GS and MS number of employees estimates are based
on the geographical revenue breakdown 2.For CS and UBS EMEA also includes employees in Switzerland

We note that these numbers are quite small as compared to the number of employees
who were affected by the FSA code in 20095 . The FSA reviewed its last year’s
policy on the deferral arrangements covered by its code for the following two
groups

• major wholesale/investment banks – includes UK based staff of seven major


international banking groups; and
• major UK banking groups − includes six major UK banks. In most cases, these
figures cover staff in global operations, including investment banking.

Over 3,900 employees were identified as “P8 employees” by the 13 firms in the
above two main peer groups. Almost 2,800 of them came under the code because
they earned at least £1m and remaining 1,100 were in Significant Influence Function
(SIFs) and firm designated risk takers.

Figure 1: Breakdown of employees impacted by FSA code


2000

1500

1000

500

0
7 Major Wholesale/Inv estment banks 6 Major UK Banking Groups

Significant Influence Function and firm designated risk takers Earnings abov e £1m

Source: FSA; CP 10/19 Revising the Remuneration Code

5
CP 10/19 Revising the Remuneration Code

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Also, as reported in Deutsche Bank Group Remuneration Report 2009 where it


discloses as per the voluntary self-commitment referencing the BaFin Circular
22/2009 & the Financial Stability Board (FSB) Principles for Sound Remuneration:

“For the financial year 2009 the identified risk taker population in all divisions
globally received fixed pay of €367m and variable components consisting of €921m
cash paid in February 2010 and deferred awards. Therein, as per the BaFin
requirements, are a population of 28 so called “Geschäftsleiter” which are the
members of the Group Executive Committee (GEC) and the Management Board
members and “Geschäftsführer” of selected German subsidiaries. Specific clawback
provisions have been introduced for the group of the “Geschäftsleiter”. The deferred
awards are all subject to the Banks future performance. €961m of the deferred
awards were granted in the form of restricted equity awards which are deferred
over 3.75 years and tied to the future share price of DB. €317m of the deferred
awards were granted in the form of restricted incentive awards deferred over 3
years and tied to the Group NIBT and a Variable Adjustment based on RoE less cost
of funds. For the population above, on average nearly 60% of the variable
compensation is deferred and subject to future performance and clawback – this is
compliant with BaFin and FSB requirements”.

As some of these requirements were already there in the previous codes such as FSA
(PS09/15 Reforming remuneration practices in financial services) and BaFin
Circular 22/2009, we believe that as new EU rules are not going to impact significant
number of employees. We assume the new EU compensation rules impacts about 5-
10 times as many people as were impacted by the BaFin Circular 22/2009 which is
limited in our view.

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Key Requirements
At best 20% of bonuses paid upfront in cash
At least 40 % of the bonus (60% for large bonus) should be deferred over
minimum of 3-5 years and correctly aligned with the nature of the business, its risks
and the activities of the member of staff; and is paid or vests only if it is sustainable
according to the financial situation of the credit institution as a whole, and justified
according to the performance of the credit institution, the business unit and the
individual concerned. This measure leaves it to the national supervisory
authorities to decide what a "large" bonus means in their economies for this
purpose based on the CEBS guidelines.

At least 50% of any variable remuneration should be paid in equity linked


instruments consisting of an appropriate balance of:

• shares (or equivalent ownership interests) or share-linked instruments (or


equivalent non-cash instruments (alternative instruments) , in the case of a non-
listed institution) and
• other instruments reflecting the credit quality of the credit institution as a going
concern (refers to a specific subset of so-called Tier 1 hybrid instruments;
interpreted as some form of contingent capital or subordinated debt)

And this 50% threshold for instruments must be applied equally to the non-
deferred and the deferred part. Further, national supervisory authorities may place
restrictions on certain instruments as appropriate.

This would imply that at best 20% of bonuses are paid in cash upfront for large
bonuses received by the identified staff: bonuses that fall into the scope of the rules
are likely to be at the higher range within the bank, and as a result, would incur the
higher deferral rate, i.e. 60%. This would imply that at best 20% of bonuses are paid
in cash upfront, in our view.

We provide two examples to explain how the upfront and the deferred component
could be paid out in cash and instruments. In the first example we assume the
cash/instruments ratio as 50/50 for three different deferral schemes. In the second
example we assume the cash/instruments ratio as 40/60.

Table 25: Payout process for cash/instruments ratio 50/50 with different deferral schemes
%
Upfront 60% 40% 30%
o/w cash 30% 20% 15%
o/w instruments 30% 20% 15%

Deferred 40% 60% 70%


o/w cash 20% 30% 35%
o/w instruments 20% 30% 35%
Source: CEBS.

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Table 26: Payout process for cash/instruments ratio 40/60 with different deferral schemes
%
Upfront 60% 40% 30%
o/w cash 24% 16% 12%
o/w instruments 36% 24% 18%

Deferred 40% 60% 70%


o/w cash 16% 24% 28%
o/w instruments 24% 36% 42%
Source: CEBS

In our view, the deferred component of the compensation is most likely to be


paid 50% in cash, unless stipulated by national regulators. CEBS requirement is
that a minimum of 50% is paid in stock, which means 50% cash. Firms could pay
beyond 50% in stock for deferred bonuses, but we would not expect that. The cash
will get very low interest income in our view, due to the CEBS guidelines prohibiting
ex-post upward revision of deferred cash awards.

Deferral period of 3-5 years


The minimum deferral period is 3-5 years, depending on the potential impact of
the staff on the risk profile of the institution. CEBS requires institutions to consider
longer deferral periods at least for the members of the management body in its
management function. However, we assume that the deferral period would be 3 years
for the majority of the identified staff.

Deferral payment can be done once at the end of the deferral period or may be spread
out over several payments during the deferral period. The first vested amount
should not be sooner than 12 months, vesting can take place on a yearly basis as
shown in Figure 2, but no faster than annually.

Figure 2: Payout schedule deferred equally over a period of three years

Source: CEBS, Note: Assumptions Deferred/Non deferred: 60/40; deferred equally over a deferral period of three years

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In Table 27 we analyze three scenarios with different deferral rates and periods with
an assumption of 50/50 cash/instruments ratio for different categories of staff. i) 40%
deferral bonus deferred over a period of three years, ii) 60% deferral bonus deferred
over a period of five years and for members of management body 70% deferral
bonus over a period of seven years.

Table 27: Payout schedule with different deferral schemes and deferral periods
Deferral Deferral
n n+1 n+2 n+3 n+4 n+5 n+6 n+7
rate Period
Cash 30% Cash 20%
40% 3 years
Instruments* 30% Instruments* 20%
Cash 20 % Cash 30%
60% 5 years
Instruments* 20% Instruments* 30%
Cash 15% Cash 35%
70% 7 years**
Instruments* 15% Instruments* 35%
Source: CEBS. Note -1) * Instruments paid out or vested subject to minimum retention period. ** Estimated longer deferral period for the members of the management body in its management
function. Assumption: Cash/Instruments ratio 50/50.2) ‘n’ represents the one year accrual period during which the performance of the staff member is assessed and measured for the purposes of
determining its remuneration.

Further, if institutions decide to determine the proportion that is being deferred by


cascade of absolute amounts (rather than percentages of the total variable
remuneration - e.g. part between 0 and100: 100% upfront, part between 100 and
200: 50% upfront and rest is deferred, part above 200: 25% upfront and rest is
deferred ...), supervisors will review that on an average weighted basis such
institutions respect the 40 to 60 % threshold.

Retention Period – 6 months to 2 years in our view


Further, there should be a minimum retention period determined by the
institution during which any bonus that has been paid out or vested in the form of
instruments cannot be sold. This minimum retention period is independent from
the deferral period and can be shorter or longer than the deferral period. The
retention period should be determined by the institution. Supervisors shall then
determine whether the retention periods proposed by the institution are deemed to be
sufficient and appropriate.

We would expect that the retention period would be in the range of six months
to two years, at the discretion of local regulators.

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In Figure 3 it is assumed that the payment is made once at the end of the deferral
period.

Figure 3: Payout process for 40 % bonus deferred over a period of three years

Source: CEBS, Note: Assumptions: 50/50% cash/instruments ratio; Deferred/Non deferred: 40/60; Deferral payment done once at the
end of the deferral period

As shown in Figure 3, the retention period for the deferred instruments comes after
every vested portion. CEBS does not provide any specific duration for the
retention period. However, it provides certain examples on how the appropriate
retention period should be sought.

For example:

• Shorter retention period could be considered: when there is a deferral period of


five years or more, or where institutions measure the performance of their staff
over multi-year accrual periods, On the other hand, a longer period may be
considered in cases where the risks underlying the performance can materialize
beyond the end of the minimum retention period. Furthermore, it would be
appropriate to apply longer retention periods for staff with the most material
impact on the risk profile of the institutionl.
• It is possible that a retention period lasts for a shorter period than the deferral
period of minimum three to five years applied to the instruments that are not paid
up front as shown in Figure 4 below. However, as an example of proportionality,
for their most senior staff, large and complex institutions should consider the use
of a retention period for upfront paid instruments that goes beyond the deferral
period for the deferred instruments.

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Figure 4: Payout process for 40 % bonus deferred over a period of three years

Source: CEBS, Note: Assumptions: 50/50% cash/instruments ratio; Deferred/Non deferred: 60/40; deferred equally over a deferral
period of three years

In Figure 4, CEBS assume a base case where a total bonus €100,000 is paid with an
assumption of 50/50 cash/instruments, 40% deferral bonus deferred over a period of
three years for a certain category of “identified staff”. In its base case, CEBS assume
the retention period for the bonus paid in instruments for upfront to be 2 years and
for deferred to be 1 year. So, the staff would receive €30,000 in upfront cash and
€30,000 in upfront instruments and the amount paid in upfront instrument would
have a retention period of two years. Similarly, the deferred part of the compensation
would be €20,000 in cash and €20,000 in instruments. Again, the bonus paid in
instruments would be further subjected to one year retention period during which one
cannot sell these instruments.

It is important to note that the upfront payment of instruments with a minimum


retention period of 3 years is not equivalent to deferred instruments. Deferred
instruments are subject to an ex-post risk adjustment by means of malus arrangement
or clawback clauses. While in case of upfront paid instruments, although the staff
cannot sell the instruments for the given retention period but the institution cannot
change the number of instruments it has granted. A retention period is not a
substitute for a longer deferral period. CEBS, in its revised guidelines, have
further emphasized the difference between deferral and retention periods and
have added some further proportionality for retention periods of deferred
instruments.

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Fixed vs variable
There is no limitation to the fixed component of the remuneration but the fixed
and the variable components should be appropriately balanced; fixed components
should be sufficiently high to allow the operation of a fully flexible variable
remuneration policy, including the possibility to pay no bonus. This would lead to
higher salaries. Press reports seem to suggest that some banks like HSBC and
Barclays have already begun adjusting base salaries up in view of the bonus curbs6.

An explicit appropriate maximum ratio on the variable remuneration compared to the


fixed remuneration should be set by an institution; may vary across the staff,
according to market conditions and the specific context in which the financial
undertaking operates. However, CEBS doesn’t prescribe the ratio but criteria to
determine this ratio; it is for the institutions to set this ratio. Nevertheless, CEBS
indicates that the separation between the fixed and variable components must be
absolute. There must be no leakage between these two components.

The ratio between fixed and variable remuneration must be determined at the moment of
initial performance measurement, independent of any future ex-post risk adjustments or
fluctuation in the price of instruments. The appropriate balance is to depend on:

• the quality of performance measurement and associated risk adjustments;


• the length of the deferral and retention periods;
• the legal structure of the institution, kinds and scope of the activities;
• business types and which risks are involved;
• category and level of staff.

We believe that this will have an adverse impact on the cost flexibility of the
banks. The new EU rules would further increase pressure on the cost base and make
it more rigid. In our view, in order to retain talent, banks will pay higher salaries and
hence increase fixed cost. Deferred expenses related to prior year compensation
would also rise which would in turn further push up the fixed costs. Increasing fixed
costs would increase pressure on the cost base; an institution will not be able to
reduce or cut expenditure in a poor financial year which would lead to an
unacceptable cost/income ratio in our view.

Although according to the CEBS guidelines, it is up to the institutions to determine


the appropriate maximum ratio on the bonus compared base salary. We note
that in the Netherlands, Dutch banks adopted a voluntary code of conduct in
September 2009, which included capping bonuses at 100% of salary and limiting
pay to one year’s salary in the event of dismissal for members of the executive
board. 7 The Banking Code applies to all activities in the Netherlands performed by
banks that are in possession of a banking licence granted under the Financial
Supervision Act (Wet op het financieel toezicht (Wft), irrespective of whether they
perform their activities in the Netherlands or in another Member State, and
irrespective of whether those activities are performed by a branch.

6
Source: Reuters Article: “Some bankers may escape EU cash bonus limit” dated on Dec 10, 2010.
http://uk.reuters.com/article/idUKTRE6B93F220101210
7
Code Banken published on 9th Sep 2009 http://www.nvb.nl/scrivo/asset.php?id=534018

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Scope of Application
Institutions
Applies to all credit institutions and investment firms falling within the scope of
MiFID, with “proportionality” provisions depending on size and complexity of
the institution

Credit Institutions Defined in Article 4(1) of Directive 2006/48/EC as undertakings whose business is to receive
deposits or other repayable funds from the public and to grant credits for its own account
Investment firms Defined in Article 4 (1)(1) of Directive 2004/39/EC on markets in financial instruments (MiFID)
and to which the MiFID requirements apply with respect to any legal person whose regular
occupation or business is the provision of one or more investment services to third parties
and/or the performance of one or more investment activities on a professional basis. However,
certain exemptions apply and these are specified in Directives 2004/39/EC and 2006/49/EC.
These exemptions can include institutions which are only authorized to provide the service of
investment advice and/or receive and transmit orders from investors without holding money or
securities belonging to their clients

Applies to all firms within an EEA consolidation group, any subsidiary of an


EEA parent institution that is located offshore, including in a non-EEA
jurisdiction and at the solo or EEA-based level, where the EEA subsidiary is
part of a wider non-EEA group.

Additionally, where staff members are formally employed by a parent company


based in a non-EEA jurisdiction, but perform duties/services for an EEA-based
institution, then the remuneration requirements of the EEA jurisdiction where
the staff member is actually working should be followed for the remuneration
paid to these staff members.

Identified staff
The Commission’s intention is that the rules apply to anyone whose professional
activities have a material impact on the institution’s risk profile. It is primarily
the responsibility of institutions to identify the members of staff whose
professional activities have a material impact on the institution’s risk profile
according to CEBS guidelines and any other guidance or criteria provided by
supervisors.

As given by CEBS following categories of staff, unless it is demonstrated that they


have no material impact on the institution’s risk profile to whom the specific
remuneration principles apply, must include:

• Executive members of the credit institution or investment firms’ corporate bodies,


depending on the local legal structure of the institution,
• Senior Management responsible for day-to-day management, such as: the
members of the management committee not included in the category above;
• Staff responsible for independent control functions.

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Section 716 (Derivative Push-out)


Regulatory Arbitrage III:

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Regulatory Arbitrage III: Section 716,


pushing part of derivatives out of the US
depositary bank
What is section 716
Section 716 of the Dodd-Frank Act will require banks to separate their derivative
business from those banking entities that are able to tap Federal Reserve credit
facility or discount window, usually the one with the word ‘bank’ in its name. It will
require creation of a swap entity (or use of a current non-bank entity such as e.g.
broker-dealer) that will need to be capitalised and funded outside of the US bank
entity. The main motivation behind the swap push-out was to prevent the risk of
committing taxpayers’ money to bail out banks’ derivatives trading operations.
However, the new entity can still be debt financed by the group holding – in our view
this would have to be done at a relative high cost-of-funding.

In terms of product reach, Section 716 exempts interest rates, FX, centrally cleared
CDS on investment grade names, bullion and base (physical) commodities. All
remaining asset classes would fall under the scope. It includes in particular equity
derivatives business, high yield or non CCP cleared credit, CDS on emerging
markets underlyings and the part of commodity business that does not fall into
exemption mentioned above. Finally only new business will need to comply with the
new rules.

Figure 5: Exemplar structure of the universal bank pre and post implementation of Section 716

The Group
The Group
Capital injection (what cost of
Funding capital?)
Broker dealer
Funding, Broker Other Section 716 Other
The US bank The US bank deriv. push-out
capital dealer subsidiaries subsidiaries
New Swap entity
Short term funding (what cost?)
Debt (what cost?)
Fed Fed Capital markets

Source: JPMorgan

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Key conclusions
• Globally Section 716 will only impact the US banking industry. This is primarily
because it applies to the US banking entities that carry out derivatives operations.
In our universe most European banks and traditional broker - dealers remain
largely unaffected. Biggest areas of concern - interest rates and FX derivatives -
remain outside of the scope of Section 716. For most institutions active in the US
derivative market, 90% of derivatives trading is concentrated in these two areas,
hence eliminating them from the scope of the bill significantly reduces potential
implementation burden for most US banks.
• BofA, Citi and HSBC appear to be most impacted by the provisions of the bill,
but the impact will be relatively muted with a 5-10bps decrease in Core Tier 1
ratios.. The impact of Section 716 will be of a more qualitative than quantitative
nature. This is because these banks will need to a) set up a new swap entity (or
adopt the existing one) which will be used for out-of-scope derivatives trading, b)
change trading documentation with clients, c) inject capital into the swap entity,
d) arrange funding.
• The adoption of Section 716 will therefore create regulatory disadvantage to US
banks compared to e.g. their European counterparts and also other US banks
(such as Goldman Sachs or Morgan Stanley) that already operate in a structure
mostly compliant with the upcoming requirements.
• We see Section 716 as a regulation that is still relatively unclear in several key
areas such as scope of the operations of US banks that will be affected that need
clarification.
• Implementation deadline is defined as 2 years from the date Section 716 becomes
effective. Our estimate is that the bill will be finalized earliest in H2 2011, so the
implementation deadline will be somewhere in H2 2013.

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Section 716 – pushing part of derivatives


business out of the US depositary bank.
The motivation behind the regulation is that taxpayers’ funds are not used to support
potentially distressed derivative businesses. Historically, global universal banks used
their balance sheets’ strength (funding and capital) to serve both their
retail/commercial and investment banking arms.

As a result investment banking divisions often enjoyed lower funding costs of the
retail bank and relatively low capital adequacy requirement which was calculated on
the group level, rather than on the division level.

Pure investment banks such as e.g. Goldman Sachs or Morgan Stanley became FED
regulated (rather than SEC regulated) during the recent financial crisis in order to
obtain FED funding. However, they retained a structure which separates their
investment banking from retail/commercial banking.

Section 716 therefore impacts those banks that carry derivatives activity out of the
banking entity - BofA, Citi, Goldman Sachs and to some extent HSBC, according to
the OCC (Office of the comptroller of the currency) data. In this case derivative
activities will need to be segregated into a separately funded and higher capitalised
entity. It is worth noting that in terms of the notional, only a relatively small
proportion of the derivative activities will fall under Section 716. The largest
derivative transactions are concentrated in the area of rates and fx, that are entirely
outside of the scope of Section 716. This is important for Goldman Sachs with
almost 99% of derivatives trades notional that is carried out from the banking entity
belongs to the out of scope assets.

The remaining areas that fall into the scope of our analysis on Section 716 include
equity derivatives, credit derivatives and part of commodity derivatives with BofA,
Citi and HSBC most impacted, in our view.

Implementation deadlines
Although the law is now final, the rules are in the process of being consulted with
relevant organizations and the banking community. Compared to other acts such as
e.g. Volcker rule, prohibition of assistance to swaps entities has a reasonably long
agency rulemaking period of 24-months ending in October 2012. In case an insured
depositary institution is considered a swap entity, it will have another 2-year period
to divest its swap activities or cease activities that require separation, hence the final
implementation deadline is likely going to be October 2014.

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Regional scope – will European IBs have an advantage?


Most likely yes, at least initially
In terms of the regional impact of the regulation two main issues remain unclear.
First, who will be impacted by the bill? It seems unavoidable that US banks on US
transactions will be affected. However, the act does not specify if foreign banks with
US FDIC insured entities would fall under similar treatment. We take a view that
Section 716 will impact those entities that run insured depositary operations in the
US on all transactions booked in the insured depositary institution in the US. For
example, a European bank with a banking entity in the US (such as e.g. BNPP,
HSBC, RBS) will be impacted by the new regulation on derivatives contracts written
out of this particular entity.

Secondly, the question remains of what type of activities are likely to fall under the
scope of Section 716. Are these activities with the US clients only or all derivative
activities internationally in the case of US depositary institutions? For the purpose of
our analysis we assume that international business that is ultimately booked in the
depositary institution will be impacted. We do believe that the regulation will
become global because otherwise it would create regulatory arbitrage opportunities
as US banks would simply write derivatives out of e.g. their London branches. Our
interpretation of the rules means that US banks will be at a disadvantage compared
to, for example, their European peers. We also take a view that the playing field will
be not leveled at least in the nearest future as we are still yet to hear about similar
regulations implemented for other regions.

Therefore for the time being the US banks running derivatives business out of
the US banks such as BoA, Citi and HSBC are facing a real risk of lower
competitiveness, in our view. The impact is likely going to be more of a qualitative
than quantitative nature and will depend on the approach banks will adopt in order to
deal with the new requirements of Section 716. Below we present several options in
detail.

Various implementation solutions possible for those


impacted
Those banks that operate a derivatives business out of the insured depositary entity
will have at least three potential solutions at hand. Each option carries significant
amount of operational burden as clients will need to change the entity with which
they are dealing with. This can potentially lead to lost revenue in the transition period
as well as a permanent loss of customers that will not be happy to take the extra
burden of documentation work.

1. First, banks may choose to move only impacted derivatives trades into the
entity that is outside of the bank. For example a bank may decide to set up a
separate entity that will serve as a counterparty only in affected transactions. This
would clearly create additional operational burden as customers would need to
trade with different entities when dealing with in-scope and out-of-scope
products. This solution creates a number of other internal issues, for example,
trading derivatives in one entity and hedging them in another one, risk
management of separate entity, IT systems complexity etc, that may convince the
bank to adopt other approaches outlined below.

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2. Second, banks may choose to separate parts of business that are most
impacted by the bill. For example banks may decide to push out the US equity
derivatives business to become an affiliate company to the bank, but keep the
cash equity business in the bank entity. The extent to which the business is
viewed as impacted will vary from bank to bank.
3. The third option would be to separate the entire investment banking
activities from those of the commercial bank. This solution, whereas desirable
from an organisational point of view as it keeps most of the interrelated business
together is clearly the most cost intensive one in terms of potential financing cost.

We expect that banks are most likely going to adopt option 1.

The structure of a bank defines the potential impact –


universal banking model most affected
As mentioned earlier, Section 716 requires the separation of depository banking
activities from derivatives activities. The impact on banks that already operate their
derivatives business outside of the insured depositary operations will be negligible,
compared to banks that operate the universal banking model out of a single entity.

The latter ones will need to set up a new swap entity to carry derivatives operations
or to move them to other existing non FDIC entities. An example of how such entity
would be structured/financed is depicted inFigure 5. We assume that the new entity
will be an affiliate of the member bank and therefore will operate within the trading
restrictions as defined in Section 23a) and 23b) of the Federal Reserve Act. These
regulations limit the ability of a US depositary institution to transact with its
affiliates. The new swap entity will be able to obtain the funding from the holding
company, however in our view this would have to be done at close to market cost-of-
funding levels. The purpose is to protect banks, which have their deposits insured by
the FDIC, from suffering losses on transactions they engage in with their affiliates.

Section 716 impact on capital requirement vs funding


needs
The new entity will have to be financed in the form of both equity and short term
funding or long term debt. Firstly, the new entity will need to be highly capitalized,
most likely above the 10% often assumed for the investment banking activities.
Additional capital charge will be required to obtain desirable rating in order to secure
market funding at acceptable cost.

We assumed that this will be achieved through a 15% core tier 1 capital ratio as
derivatives operations are relatively risky compared to other banking activities. It is
in fact a justifiable question for investors to ask what cost of equity should
derivatives business be charged at. This also translates into the cost of debt issued by
the entity that conducts derivatives business but does not have the safety net of
obtaining funding from FED. Highly balance sheet intensive operations may no
longer provide return on capital above the cost of equity and hence may be
discontinued. Almost surely though US banks will be disadvantaged compared to
their European peers due to higher cost of funding.

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In normal market conditions highly capitalized entity should be able to obtain


funding in the uncollateralized CP or debt market or collateralized via repo
transactions. It can still be funded from the parent company, however in such case
the funding rate should be at the market level. The swap entity will not be able to use
Fed discount window lending through the bank though (as highlighted in Section
716).

With respect to the funding, not all assets will need to be funded externally as part of
the business often provides desirable sources of funding. For example, capital
protected equity derivatives business is a relatively stable source of long term
funding as these products are net long cash for the issuer.

Which banks run derivatives business out of their US bank


entity?
In order to assess the impact of Section 716 on each individual bank we look at the
size of the derivatives business done within its US bank entity compared to the
holding company. Whether a bank does its derivatives business out of the US bank is
the single most important differentiating factor because the act applies to entities
having a status of a ‘bank’ rather than other operations conducted in the holding
company outside of the bank.

In Table 28 and Table 29we present the breakdown of derivatives business of the top
25 holding companies as well as the top 25 banks in the US at the end of the third
quarter 2010. This data proves very useful for our analysis as it allows us to calculate
whether derivatives operations are being run from the bank (and therefore impacted
by Section 716) or the holding company (not impacted).

• The derivatives business appears heavily concentrated with the biggest 4 players -
make up $220Trn, or nearly 95% of the derivatives covered in the report.
• The amount of business run from the banking entity (and therefore impacted by
Section 716) varies greatly from 100% for Citi, 88% for Goldman, 70% for BoA
and negligible amount in the case of Morgan Stanley.

Table 28 and Table 29also provide the breakdown of the derivatives business by the
type of instruments with biggest notional coming from OTC contracts such as swaps
(most likely interest rate swaps), forwards, options and credit derivatives. The
relatively small notional are traded on exchange in the form of futures and options.

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Table 28: Derivatives operations of the US top 25 holding companies, Q3 2010


$ million
% of Total Total Total Total credit
Total derivatives futures Total option forwards Total swaps options derivatives
Top 25 Holding companies Total assets derivatives in the bank (exch TR) (exch TR) (OTC) (OTC) (OTC) (OTC) Spot FX
BANK OF AMERICA CORPORATION 2,341,160 72,310,369 70% 3,623,451 1,675,520 11,950,524 44,456,997 5,870,800 4,733,076 298,855
CITIGROUP INC. 1,983,280 49,512,642 104% 1,006,510 2,531,247 7,596,714 28,518,161 7,214,524 2,645,486 632,329
GOLDMAN SACHS GROUP, INC., THE 908,860 48,458,241 88% 1,241,495 2,106,866 4,604,659 27,387,998 8,641,808 4,475,415 251,428
MORGAN STANLEY 841,372 41,830,849 0% 136,531 961,944 6,349,774 25,589,601 3,933,649 4,859,350 409,555
HSBC NORTH AMERICA HOLDINGS INC. 350,102 3,845,104 101% 103,937 129,645 869,339 1,872,308 129,319 740,557 86,354
WELLS FARGO & COMPANY 1,220,784 3,811,249 101% 204,289 47,349 1,121,288 1,861,578 475,164 101,581 13,115
BANK OF NEW YORK MELLON CORPORATION, THE 254,352 1,567,584 101% 27,113 80,403 518,004 554,123 387,190 751 46,178
TAUNUS CORPORATION 389,993 1,146,446 86,093 273,183 524,236 188,641 19,957 54,336 787
STATE STREET CORPORATION 171,494 767,580 100% 30,697 0 601,122 41,469 94,137 155 37,797
BARCLAYS GROUP US INC. 383,955 730,446 0 213,946 457,114 43,884 15,042 460 5
ALLY FINANCIAL INC. 173,191 458,040 11% 10,143 280 65,866 316,569 65,127 55 0
PNC FINANCIAL SERVICES GROUP, INC., THE 260,174 388,211 101% 57,592 83,800 15,446 189,075 38,528 3,770 1,630
SUNTRUST BANKS, INC. 174,726 336,481 99% 41,908 11,282 60,209 177,467 43,575 2,040 589
NORTHERN TRUST CORPORATION 80,723 237,506 100% 0 0 229,749 7,494 129 135 21,151
METLIFE, INC. 617,254 227,256 15,856 0 37,637 70,176 93,334 10,254 0
REGIONS FINANCIAL CORPORATION 133,555 132,624 100% 1,525 0 34,005 90,970 5,547 578 92
U.S. BANCORP 290,654 110,221 98% 1,193 1,500 51,383 44,251 9,791 2,103 1,340
TD BANK US HOLDING COMPANY 174,985 94,106 38% 0 0 14,033 77,867 2,023 183 2
KEYCORP 94,074 85,586 95% 3,788 12 5,409 60,991 11,838 3,549 793
FIFTH THIRD BANCORP 112,322 78,221 95% 174 899 12,187 43,550 20,487 924 1,755
BB&T CORPORATION 157,230 67,274 5,095 0 19,144 34,581 8,453 0 52
CITIZENS FINANCIAL GROUP, INC. 136,118 50,950 0 0 6,658 40,225 2,883 1,184 262
CAPITAL ONE FINANCIAL CORPORATION 196,933 49,165 385 0 2,725 46,040 15 0 0
UNIONBANCAL CORPORATION 79,828 41,874 1,784 0 2,041 29,232 8,816 0 408
Source: Office of the comptroller of the currency

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Table 29: Derivatives operations of the US top 25 banks, Q3 2010


$ millions
Total credit
Total Total futures Total option Total forwards Total swaps Total options derivatives
Top 25 commercial banks and trusts Total assets derivatives (exch TR) (exch TR) (OTC) (OTC) (OTC) (OTC) Spot FX
CITIBANK NATIONAL ASSN 1,209,221 51,410,415 762,516 1,133,535 7,061,217 32,792,408 7,088,089 2,572,650 687,250
BANK OF AMERICA NA 1,489,198 50,467,838 2,737,593 793,862 7,842,908 30,278,389 3,883,873 4,931,212 384,679
GOLDMAN SACHS BANK USA 96,105 42,777,908 691,459 596,925 3,180,533 30,908,135 6,895,759 505,097 1,455
HSBC BANK USA NATIONAL ASSN 189,731 3,872,488 88,129 119,425 869,497 1,925,571 129,099 740,767 86,378
WELLS FARGO BANK NA 1,070,489 3,863,602 196,502 39,859 1,111,601 1,922,556 480,308 112,776 13,115
BANK OF NEW YORK MELLON 190,875 1,583,045 27,113 80,403 518,796 568,792 387,190 751 46,214
STATE STREET BANK&TRUST CO 167,877 767,554 30,691 0 601,103 41,469 94,137 155 37,797
PNC BANK NATIONAL ASSN 251,297 391,035 57,269 83,800 15,237 192,353 38,605 3,770 1,630
SUNTRUST BANK 164,557 334,120 41,908 11,282 60,209 177,467 41,214 2,040 589
NORTHERN TRUST CO 67,513 236,903 0 0 229,749 6,894 126 135 21,151
REGIONS BANK 129,068 132,933 1,525 0 34,005 92,056 4,770 578 92
U S BANK NATIONAL ASSN 285,762 107,540 1,193 1,500 51,383 41,573 9,791 2,100 1,340
KEYBANK NATIONAL ASSN 90,251 81,286 3,649 12 5,409 58,150 10,518 3,549 793
FIFTH THIRD BANK 110,197 74,116 174 899 12,187 39,445 20,487 924 1,755
BRANCH BANKING&TRUST CO 151,545 68,583 5,095 0 19,144 35,530 8,813 0 52
TD BANK NATIONAL ASSN 167,648 58,456 0 0 4,838 51,413 2,023 183 2
ALLY BANK 66,152 50,396 0 0 22,032 12,471 15,894 0 0
RBS CITIZENS NATIONAL ASSN 114,465 42,498 0 0 6,658 32,251 2,600 988 262
UNION BANK NATIONAL ASSN 79,356 41,874 1,784 0 2,041 29,232 8,816 0 408
TD BANK USA NATIONAL ASSN 10,614 35,650 0 0 9,196 26,454 0 0 0
BANK OF OKLAHOMA NA 17,611 31,566 382 919 23,028 3,814 3,423 0 2
MORGAN STANLEY BANK NA 65,518 29,818 0 0 0 6,701 0 23,117 0
HUNTINGTON NATIONAL BANK 52,704 28,487 90 0 2,138 23,028 2,910 322 4
DEUTSCHE BANK TR CO AMERICAS 45,915 26,890 0 0 303 21,777 498 4,312 0
Source: Office of the comptroller of the currency

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The following are the key conclusions from the data provided in Table 28 and Table
29:

• European banks do not run their businesses out of their US entities, or their
derivatives operations are immaterial which makes them immuned to Section
716. This is because they either feature low in the ranking or do not appear in the
table at all. The lack of a derivatives presence in the US banking entities is
perhaps not surprising given their headquarters and IB operations are in Europe.
Most derivative contracts will be written out of the legal entity that holds capital,
which, in the case of European banks, will almost certainly be based and
regulated in Europe.
• Bank of America, Goldman Sachs, Citigroup and HSBC conduct the majority of
their holding operations in terms of notional out of their bank entities (Bank of
America NA, Citibank National and Goldman Sachs Bank USA, HSBC Bank
USA National, respectively) and are therefore affected by Section 716. We have
also adjusted by the approximate proportion of the revenues derived from the US
to calculate the RWA exposure.
• Goldman Sachs’s operations are mainly out-of-scope interest rate products and
HSBC’s derivatives business is relatively small in the US. Morgan Stanley does
almost all of its business outside of the Morgan Stanley Bank entity, therefore
remains largely unaffected in the bank.
• Finally, we envisage that there will be a shift in terms of regulatory focus putting
pressure on banks to move away from a branch network system to a legal entity
system.

Derivative assets impacted: equity and part of credit are in,


but rates and fx stay out of the final version of the bill.
Although Section 716 is often called a swap push-out bill, it refers to a broad
definition of swaps that encapsulates most derivative contracts. According to the
final version of Section 716 there is going to be no impact in swaps on the following
underlyings: interest rates, FX, centrally cleared CDS on investment grade names,
bullion and base (physical) commodities.

• Excluded business lines are flow and exotic rates and currency markets,
developed world flow CDS (as EM credit is unlikely going to be cleared) as well
as part of the commodity business.
• The areas impacted by the bill include: equity derivatives business: delta -1
swaps, flow derivatives, exotics and hybrids. In credit, exotic and hybrid
business, high yield or non CCP cleared CDS, CDS on EM underlyings and the
part of commodity business that does not fall into exemption mentioned above.

Finally transactions used as derivative hedging will also be excluded from the reach
of Section 716, however what constitutes a hedging activity still remains unclear.

It is worth noting that Section 716 applies to new transactions only. Therefore
existing ones will be grandfathered.

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Table 30 provides some insight into the product split of the US biggest 25 banks in
derivatives.

• Overwhelming majority of transactions is transacted over the counter with


exchange traded products accounting for less than 10% of business in most cases.
• Moreover if US banks engage in derivatives they trade mostly interest rates
derivatives that comprise around 84% of total derivative notional followed by
foreign exchange 8% and credit derivatives 6%, all outside of scope of Section
716.

The top 4 US banks with the highest derivative exposure in products other than rates
and foreign exchange are Bank of America, Citibank, HSBC Bank USA and
Goldman Sachs Bank. Notional exposures amount to $5.0Trn, $2.8Trn, $0.8Trn and
$0.5Trn, respectively, providing the upper limit to the amount of assets impacted by
Section 716. This is because the break-down provided by OCC (Office of the
comptroller of the currency) does not account for the fact that, among others, cleared
high grade CDS or certain commodity derivatives fall outside of the scope. On
average this upper limit is around 8.3% of all derivative assets for the top 25% banks,
with the median of 4.45%.

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Table 30: A breakdown of US banks’ derivatives operations (Q3 2010) – upper limit to the assets impacted by Section 716
$ millions
Upper limit in
scope of
Section 716 % other
% foreign % other contracts +
Total % exchange % OTC % rate exch % other % credit contracts + credit derivs
Top 25 commercial banks and trusts Total assets derivatives traded contracts contracts contracts contracts derivatives credit derivs (notional)
CITIBANK NATIONAL 1,209,221 51,410,415 3.7 96.3 84.4 10.1 0.5 5 5.5 2,827,573
BANK OF AMERICA NA 1,489,198 50,467,838 7 93 82.2 7.9 0.2 9.8 10 5,046,784
GOLDMAN SACHS BANK USA 96,105 42,777,908 3 97 95 3.7 0 1.2 1.2 513,335
HSBC BANK USA NATIONAL 189,731 3,872,488 5.4 94.6 62 17.1 1.7 19.1 20.8 805,478
WELLS FARGO BANK 1,070,489 3,863,602 6.1 93.9 88.6 4.7 3.8 2.9 6.7 258,861
BANK OF NEW YORK MELLON 190,875 1,583,045 6.8 93.2 78.2 21.3 0.5 0 0.5 7,915
STATE STREET BANK&TRUST 167,877 767,554 4 96 8 85.6 6.4 0 6.4 49,123
PNC BANK NATIONAL 251,297 391,035 36.1 63.9 97.1 1.8 0.1 1 1.1 4,301
SUNTRUST BANK 164,557 334,120 15.9 84.1 93.6 1.6 4.1 0.6 4.7 15,704
NORTHERN TRUST 67,513 236,903 0 100 2.5 97.5 0 0.1 0.1 237
REGIONS BANK 129,068 132,933 1.1 98.9 98.9 0.7 0 0.4 0.4 532
U S BANK NATIONAL 285,762 107,540 2.5 97.5 83.3 14.7 0 2 2 2,151
KEYBANK NATIONAL 90,251 81,286 4.5 95.5 86.2 8.5 0.8 4.4 5.2 4,227
FIFTH THIRD BANK 110,197 74,116 1.4 98.6 72.4 22.3 4 1.2 5.2 3,854
BRANCH BANKING&TRUST 151,545 68,583 7.4 92.6 99.3 0.7 0 0 0 0
TD BANK NATIONAL 167,648 58,456 0 100 87.6 12.1 0 0.3 0.3 175
ALLY BANK 66,152 50,396 0 100 95.8 0 4.2 0 4.2 2,117
RBS CITIZENS NATIONAL 114,465 42,498 0 100 85.8 11.9 0 2.3 2.3 977
UNION BANK NATIONAL 79,356 41,874 4.3 95.7 84 5.1 10.9 0 10.9 4,564
TD BANK USA NATIONAL 10,614 35,650 0 100 70.8 29.2 0 0 0 0
BANK OF OKLAHOMA NA 17,611 31,566 4.1 95.9 83.5 0.3 16.2 0 16.2 5,114
MORGAN STANLEY BANK 65,518 29,818 0 100 22.3 0 0.2 77.5 77.7 23,169
HUNTINGTON NATIONAL BANK 52,704 28,487 0.3 99.7 97.9 0.8 0.1 1.1 1.2 342
DEUTSCHE BANK TR CO AMERICAS 45,915 26,890 0 100 63.3 20.7 0 16 16 4,302
Source: Office of the comptroller of the currency

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Assessing the final impact – manageable capital shortfalls


Our analysis shows that most banks in our global investment and wholesale banking
universe will not be materially impacted by the introduction of Section 716. The only
three banks with material asset impact are BofA, Citi and HSBC with RWA in the
impacted businesses of around $39Bn, $10Bn and $16Bn, respectively (Table 31).

We estimated these exposures in a four step procedure

• Firstly, we estimated investment banking revenues per business line (Table 12)
• Secondly we calculated RWA exposures in different derivatives businesses by
distributing the total amount of RWA according to revenues generated in each
investment banking business line (assuming constant IB Revenues/RWA across
businesses) except from cash equities that we assumed to carry no RWA.
• Thirdly, in each business line we subjectively applied proportions of assets
impacted by Section 716. For example, we assume 80% of equity derivatives
impacted compared to only 30% of global emerging markets (GEM).
• Finally, using the data on the notional of derivative business presented in Table
28, Table 29 and Table 30we calculated the upper limit of the derivative business
falling under the scope of Section 716 (non rates and non fx derivatives run out of
the bank).

As mentioned in earlier sections, the new entity will need to be well capitalized
before it becomes a self-funded entity. Therefore we envisage that the swap entity
will require around 15% of core tier one capital and hence there will be a capital
shortfall of around $2.0Bn, $0.5Bn and $0.8Bn for BofA, Citi and HSBC,
respectively (Table 31). In terms of the impact on 2012 Core Tier 1 ratios on these
three companies, these are likely to drop by around 0.1% as a result of the
introduction of Section 716, based on our assumptions.

Health warning. Calculations on the capital impact presented above have been
performed making several relatively strong assumptions. We assumed that global risk
weighted assets are distributed according to revenues generated in each business
segment. Therefore we believe that especially equity derivative exposures can be
distorted. Secondly OCC data that we use do not have enough granularity to assess
exactly what proportion of assets falls in scope of Section 716 and we used the upper
limit in the calculation. As a result the overall impact might be overestimated.

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Table 31: Global investment and wholesale banks RWAs and capital impact
$ million
GS MS UBS CS DB BNP SocGen Barclays HSBC RBS Citi BofA
Non-rates non-fx derivatives
business, carried out of the US
entity as % of global revenues 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 4.2%* 0.0% 3.0%* 8.0%*
Fixed Income Markets % of business impacted
SPG 40% 0 0 0 0 0 0 0 0 1,312 0 2,524 13,035
Credit Trading 40% 0 0 0 0 0 0 0 0 3,759 0 1,431 10,267
FX & Rates 0% 0 0 0 0 0 0 0 0 0 0 0 0
GEM 30% 0 0 0 0 0 0 0 0 7,675 0 2,595 4,487
Commodities 40% 0 0 0 0 0 0 0 0 0 0 379 688
Prop trading/hedge gains/others 0% 0 0 0 0 0 0 0 0 0 0 0 0
Total Fixed Income Markets RWA impacted 0 0 0 0 0 0 0 0 12,745 0 6,929 28,477

Equity Markets
Equity Derivatives 80% 0 0 0 0 0 0 0 0 1,851 0 2,483 10,002
Cash equities 0% 0 0 0 0 0 0 0 0 0 0 0 0
Prime brokerage 10% 0 0 0 0 0 0 0 0 1,279 0 218 796
Prop trading/other equity-related 0% 0 0 0 0 0 0 0 0 0 0 0 0
Total equities RWA impacted 0 0 0 0 0 0 0 0 3,130 0 2,701 10,798

Total bank RWA impacted 0 0 0 0 0 0 0 0 15,875 0 9,630 39,274

Capital charge at 15% Core Tier 1 ratio 15% 0 0 0 0 0 0 0 0 2,381 0 1,445 5,891
Current charge at 10% Core Tier 1 ratio 0 0 0 0 0 0 0 0 1,588 0 963 3,927
Capital shortfall 0 0 0 0 0 0 0 0 -794 0 -482 -1,964
Basel 3 Core Tier 1 capital before Section 716 85,240 43,880 41,104 28,191 35,021 60,655 34,642 44,993 141,411 54,633 163,572 161,427
Basel 3 Core Tier 1 capital after Section 716 85,240 43,880 41,104 28,191 35,021 60,655 34,642 44,993 140,617 54,633 163,090 159,464
Basel 3 Core Tier 1 ratio before Section 716 12.1% 9.4% 13.8% 8.6% 6.8% 8.4% 7.4% 9.0% 11.01% 8.4% 12.31% 8.41%
Basel 3 Core Tier 1 ratio after Section 716 12.1% 9.4% 13.8% 8.6% 6.8% 8.4% 7.4% 9.0% 10.95% 8.4% 12.27% 8.31%
Source: J.P. Morgan estimates. Note: 1. RoRWA is estimated on the group level over the last 9M Revenues/RWA (cash equities are assumed to carry no RWA risk). 2. We adjust for the proportion of US derived revenues to total revenues

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Figure 6: HSBC Holdings plc: Organisational structure

Source: Company reports

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Figure 7: Citigroup: Organizational structure

Source: Company reports

Figure 8: Bank of America Corporation: Organizational structure (Select Major Subsidiaries)

Source: Company reports

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Valuation Methodology and Risks


Barclays (Neutral; Price Target 320p)
Valuation Methodology
Our Dec-11 target price of 320p is based on our sum of the parts analysis.

Risks to Our View


We believe the key risks that could prevent our price target and rating from being
achieved are regulatory risks. Barclays has lower exposure to UK mortgages than
UK peers and potentially better customer asset quality. Nevertheless, through
Barclays Capital, it is significantly exposed to the fixed income cycle and the
corporate credit cycle while Barclaycard gives high exposure to consumer credit.
Given the high dependence on investment banking activities Barclays is vulnerable
to a slowdown in volumes and/or further deterioration in the economic environment
which could result in higher writedowns. Barclays is also exposed to the economic
cycle through its lending exposure in particular to the UK credit cycle, South Africa
and Spain. Being a retail bank it is also exposed to the interest rate environment.
Goldman Sachs (Neutral; Price Target $175.00)
Valuation Methodology
Our Dec 2011E sum-of-the-parts based price target for Goldman Sachs is $175.
Note that our SoP multiples are differentiated by business and franchise quality, and
the IB multiple is adjusted for regulatory uncertainty.

Risks to Our View


We believe the key risks (both on the upside and downside) that could keep our
rating and target price from being achieved include the following:
· The performance of the capital markets , impacting both the investment banking
capital markets business (especially fixed income) as well as the performance of
Goldman Sachs’ assets under management.
· Despite decent risk reductions, liquidity and mark-to-market risk remains in
Goldman Sachs’ legacy assets such as leverage finance, residential and commercial
real estate and other structured credit assets. In addition, other assets such as credit
card loans, consumer finance and other ABS could potentially become an issue.
· Funding risk with Goldman Sachs being predominantly wholesale funded
could become a material issue should credit markets freeze up.
· The US, as well as global economies could experience a 'double dip’ with a
corresponding deterioration in credit quality and weaker revenues, impacting
Goldman Sachs profitability.
· Legal risk coming out from the structured credit and financial market crisis
could become a material issue both from a financial and reputational perspective.
· Regulatory risk with the proposed changes in Basel rules and financial reform
in OTC derivatives could significantly reduce profitability of the group.

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Companies Recommended in This Report (all prices in this report as of market close on 04 March 2011)
Barclays (BARC.L/313p/Neutral), BNP Paribas (BNPP.PA/€53.21/Overweight), Credit Agricole
(CAGR.PA/€11.99/Neutral), Credit Suisse Group (CSGN.VX/SF 40.92/Overweight), Deutsche Bank
(DBKGn.DE/€44.66/Neutral), Goldman Sachs (GS/$161.00/Neutral), Morgan Stanley (MS/$28.44/Overweight), Société
Générale (SOGN.PA/€47.52/Overweight), UBS (UBSN.VX/SF 17.96/Overweight)
Analyst Certification:
The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily
responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with
respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report
accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research
analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst(s) in this report.
Important Disclosures

Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies
under coverage for at least one year, are available through the search function on J.P. Morgan’s website
https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406)

Explanation of Equity Research Ratings and Analyst(s) Coverage Universe:


J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the
average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve
months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s)
coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of
the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] J.P. Morgan Cazenove’s UK Small/Mid-Cap dedicated research
analysts use the same rating categories; however, each stock’s expected total return is compared to the expected total return of the FTSE
All Share Index, not to those analysts’ coverage universe. A list of these analysts is available on request. The analyst or analyst’s team’s
coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying
analyst(s) coverage universe.

Coverage Universe: Kian Abouhossein: Barclays (BARC.L), Credit Suisse Group (CSGN.VX), Deutsche Bank
(DBKGn.DE), Deutsche Postbank (DPBGn.DE), Goldman Sachs (GS), Lloyds Banking Group (LLOY.L), Morgan Stanley
(MS), Natixis (CNAT.PA), Royal Bank of Scotland (RBS.L), UBS (UBSN.VX)

J.P. Morgan Equity Research Ratings Distribution, as of December 31, 2010


Overweight Neutral Underweight
(buy) (hold) (sell)
J.P. Morgan Global Equity Research Coverage 46% 42% 12%
IB clients* 53% 50% 38%
JPMS Equity Research Coverage 43% 49% 8%
IB clients* 71% 63% 59%
*Percentage of investment banking clients in each rating category.
For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold
rating category; and our Underweight rating falls into a sell rating category.

Valuation and Risks: Please see the most recent company-specific research report for an analysis of valuation methodology and risks on
any securities recommended herein. Research is available at http://www.morganmarkets.com , or you can contact the analyst named on
the front of this note or your J.P. Morgan representative.

Analysts’ Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon
various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which
include revenues from, among other business units, Institutional Equities and Investment Banking.

Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US
affiliates of JPMS, are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of JPMS,

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kian.abouhossein@jpmorgan.com

and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public
appearances, and trading securities held by a research analyst account.

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Kian Abouhossein Global Equity Research
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kian.abouhossein@jpmorgan.com

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“Other Disclosures” last revised January 8, 2011.

Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or
redistributed without the written consent of J.P. Morgan.#$J&098$#*P

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