Professional Documents
Culture Documents
08 March 2011
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
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
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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.
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.
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
4
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
5
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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.
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.
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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.
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).
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.
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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.
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
11
Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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.
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
• 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.
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
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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%
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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.
• 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
(44-20) 7325-1523 08 March 2011
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
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
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
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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.
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 Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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
(44-20) 7325-1523 08 March 2011
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
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
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 Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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Kian Abouhossein Global Equity Research
(44-20) 7325-1523 08 March 2011
kian.abouhossein@jpmorgan.com
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.
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
(44-20) 7325-1523 08 March 2011
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).
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
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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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
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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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 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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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.
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.
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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.
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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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.
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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.
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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 - - -
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.
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 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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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 - -
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
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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“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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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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Kian Abouhossein Global Equity Research
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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
• “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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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.
• 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.
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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• 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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• 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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Kian Abouhossein Global Equity Research
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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.
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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.
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• 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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• 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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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)
IB revenues (clean) (mn) 17,647 12,420 24,338 39,636 16,142 15,908 10,165 19,536
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Kian Abouhossein Global Equity Research
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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.
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Kian Abouhossein Global Equity Research
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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.
4
https://credit-suisse.com/news/en/media_release.jsp?ns=41668
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Kian Abouhossein Global Equity Research
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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.
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).
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Kian Abouhossein Global Equity Research
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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.
• 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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Kian Abouhossein Global Equity Research
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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 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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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
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.
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
5
CP 10/19 Revising the Remuneration Code
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Kian Abouhossein Global Equity Research
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“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.
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%
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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%
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.
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.
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:
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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.
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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.
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:
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.
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
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.
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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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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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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.
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.
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.
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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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.
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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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.
• 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.
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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• 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
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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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)
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