Global Equity Research 08 March 2011 Global Investment Banks Regulatory Arbitrage series: OW European over US IBs Banks Kian Abouhossein AC (44-20) 7325-1523 [email protected]Jerzy Kot (44-20) 7325-9729 [email protected]Amit Ranjan (44-20) 7325-4780 [email protected]Delphine Lee (44-20) 7325-3971 [email protected]J.P. Morgan Securities Ltd. See page 78 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Transcript
Global Equity Research 08 March 2011
Global Investment Banks
Regulatory Arbitrage series: OW European over US IBs
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.
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
Portfolio Snapshot Following our two reports on Volcker limits and EU compensation rules, we complete our Regulatory Arbitrage series today with our analysis of the third key regulatory issue opposing the US vs. Europe: Section 716 of the Dodd-Frank bill.
Relative to US Investment Banks, European IBs are overall “winners” from regulatory arbitrage opportunities, based on our analysis of the three key regulatory issues: 1) Volcker prop trading limits, 2) EU compensation rules, 3) Section 716 or swap push out provision.
Regulating IB comp structures has been a key element of financial reform in Europe to limit risk taking, while in the US the approach is more direct through the Volcker rule and the segregation of part of the derivatives activities from the bank. The financial implications of changes in EU compensation structures are significantly less material for European IB profitability than the two key constraints for US IBs in the Dodd-Frank bill – Volcker limits (Section 619) and to a lesser extent the swap push out rules (Section 716). Hence, European IBs could benefit from regulatory arbitrage opportunities and gain market shares in market making and some of the derivatives activities.
• Volcker rule could hit not only US IB ‘pure’ prop trading but also their market making activity earnings. European IBs would be the relative “winners” as Volcker rule provisions are unlikely to be implemented by the EU/Swiss.
• EU compensation rules could threaten the competitiveness of European Investments Banks as employers, through higher bonus retention and deferral rates, however, the rules only affect the top 200-400 employees.
• Section 716 or the swap push out provision requires the segregation of some of the derivatives activities from the banking entity. In our universe all major European banks (except from HSBC) will be unaffected whilst US banks would have to set up a new swap entity to comply with Section 716.
We remain OW IBs over traditional credit banks, which in our view have limited earnings momentum, and stick to our preference for European IBs over US IBs, with the Swiss banks as our top picks ticking all the right boxes. Our pecking order is UBS, CSG, MS, BNPP, SG, BARC, GS and DB.
• European IBs continue to trade at more attractive multiples compared to US IB peers. Despite recent underperformance of US IBs, US IBs still trade at 1.1x tangible book value 2012E, vs. European IBs at 0.9x NAV (excluding the WM business at 10x PE).
• We prefer Swiss IBs’ business mix and equity gearing, with i) relatively resilient private banking exposure at average 32% of 2012E earnings, and ii) equity gearing over fixed income within IB – we expect equities revenues to grow 8% CAGR 10E-12E vs. fixed income to decline -3%.
• European IBs could benefit from regulatory arbitrage opportunities: We believe that the tougher Volcker and swap push out rules in the Dodd-Frank bill for US IBs could represent a material revenue opportunity for European IBs.
Investment Case and Valuation We remain OW IBs over Traditional Credit Banks We are OW IBs as a sub-sector within our Banking universe as i) despite our expected decline in FICC revenues of -3% p.a., we forecast that for FICC, ongoing market volatility, strong refinancing schedule, and ongoing steep Yield Curve for 2011E will keep overall FICC at a level in-line with 2006-07, ii) in Equities, pickup in both client flow revenues and ECM/M&A over the next two years are expected to lead to 8% p.a. revenue growth assuming 5% p.a. equity market performance, and iii) we feel Basel 3 capital impacts are priced in. Overall, we expect IB revenues to grow 4% p.a. for the IB industry with equity geared IBs outperforming. Clearly, there remain material regulatory headwinds but we feel IBs have the opportunity through compensation ratio adjustments to create shareholder returns in the long-term.
Overall, European IBs reflect our preference for i) well capitalised banks with attractive valuation, ii) relatively resilient private banking exposure, iii) equity gearing over fixed income within IBs and, iv) European IBs best positioned on an overall basis for US vs. Europe “regulatory arbitrage” opportunities as we outline in our regulatory arbitrage sections below.
We prefer equity gearing over credit as we see limited upside in traditional credit banks compared to equity geared IBs with an improving provision trend already discounted, especially in Europe. We expect European loan growth to remain muted at 3.5% p.a. for the next two years.
Table 2: Swiss IBs preferred stocks due to attractive valuation and preferred business mix
Valuation Capital
Business Mix (prefer Private Banking
exposure) IB revenue mix (prefer
Equity gearing) Regulatory Arbitrage Number of Positives UBS √ √ √ √ √ 5 Credit Suisse √ - √ √ √ 4 Morgan Stanley √ √ - √ X 3 BNP Paribas √ √ - X √ 3 Société Générale √ X - √ √ 3 Barclays √ √ X X √ 3 Deutsche Bank √ X - X √ 2 Goldman Sachs X √ X X X 1 Source: J.P. Morgan estimates.
Preference for Euro over US IBs in a New Regulatory World In our report “Global Investment Banks: Portfolio Snapshot: Switching OW from US IBs to Europe IBs - Downgrading GS to N” on 12th January 2011 we switched within Global IBs our preference from US IBs to Europeans IBs with a preference for the Swiss IBs UBS and CS. We maintain our preference for the European IBs over US IBs, despite recent underperformance of the US IBs.
Why do we maintain OW European IBs over US IBs today? In our view, i) European IBs continue to trade at more attractive multiples compared to US IB peers, ii) the market has largely priced in a share buyback scenario for US IBs, particularly GS post the details of the Fed Stress Test results which are expected on 21st March 2011, and iii) based on our analysis European IBs (DB, SG) have priced in now potential EPS dilution from capital issuance to offset the JPM capital deficit methodology.
Table 1: IB revenue growth rates
12E/11E 10E-12E
CAGR Equities 8% 8% Fixed Income -4% -3% IBD 8% 8% Total IB 3% 4% Source: J.P. Morgan estimates, Company data.
European IBs the overall ‘winners’ in Regulatory Arbitrage Our analysis regarding regulatory changes for the IB sector leads us to conclude that European IBs will be the overall winners due to regulatory arbitrage opportunities. We discussed in our series of notes on regulatory arbitrage published over the last couple of months, the three key regulatory arbitrage scenarios between Europe and the US, in our view. Our analysis suggests that overall taking into account the 3 key regulatory issues, the US IBs have more potential earnings at risk and could actually lead to earnings opportunities for European IBs.
Table 3: Regulatory Arbitrage: European IBs at an overall advantage compared to US IBs US IBs European IBs
Tougher than expected Volcker rules X √ EU Compensation rules √ X Section 716 X √ Overall X √
Source: J.P. Morgan estimates.
1.) Volcker Rule: Section 619 of the Dodd-Frank Act, also known commonly as the Volcker Rule, prohibits banking entities from engaging in proprietary trading. Initial interpretation suggested that only pure proprietary trading activities of the banks would be impacted by the Volcker rule. The key issue coming out of recent communication between lawmakers, SIFMA and FSOC is the possibility of market making related activities of banks being impacted by the Volcker rules. This possibility has arisen because of different interpretation of the phrase “selling in the near term” when used in the context of a trading account and when used in the context of “market making related permitted activities”.
In our view, European IBs would be the likely “winners” in a scenario where “market making related” revenues of US IBs are impacted by the provisions as the EU has not shown willingness to adopt a similar provision in Europe. Hence, US IB revenues will be negatively impacted, but will overall benefit European IBs running their market making and prop positions out of Europe. Large European IBs such as DB, Barclays especially in Fixed Income (and especially in the derivative parts) would be the “winners” with French Banks BNP and SG also benefiting in their Equity Derivatives business at the cost of the US IBs in our view – stepping into the ‘liquidity void’ created by the Volcker rule impacting US IBs. For details, please refer to the section below on page 22.
2.) EU Compensation analysis: According to new EU compensation rules, key IB staff in Europe would at best receive 20% of their cash upfront, 20% retained for an estimated 6 months to 2 years, and an estimated 60% deferred between 3-5 years in our view.
We believe the EU compensation rules will lead to regulatory arbitrage risk with the European IB industry becoming less competitive than other Global IBs which are only impacted in Europe in their ability to attract and retain top/key talent. In addition, comp regulation is likely to reduce cost flexibility as fixed salaries will be increased further in Europe to offset the higher bonus deferral, which will likely put pressure on Tier II/III IB players – especially in weaker markets. For details, please refer to the sections below on page 42.
3.) Section 716 of the Dodd-Frank Act will require banks to separate their derivative business from those banking entities that are able to tap Federal Reserve credit facility. BofA, Citi and HSBC appear to be most impacted by the provisions of the bill, but the impact will be relatively muted with a 5-10bps decrease in Core Tier 1 ratios. In our view these banks will need to set up a new swap entity (or adopt the existing one), change documentation with clients as trading will be executed from a different entity, inject capital and arrange funding to the new entity. GS will be largely unaffected as most operations carried out of its 'bank' are in exempted areas. MS already conducts most of its derivatives activities outside of the deposit bank, hence we also envisage no impact. However, US Money Centred Banks are expected to be materially negatively impacted by section 716, in our view, compared to European Banks where we do not expect section 716 to be implemented in Europe.For details, please refer to the section below on page 62.
Hence, we maintain our preference for European IBs over US IBs, with preference for Swiss names UBS and CS: Our pecking order is 1) UBS (OW), 2) Credit Suisse (OW), 3) MS (OW), 4) BNPP (OW), 5) Société Générale (OW), 6) Barclays (N), 7) GS (N) and 8) Deutsche Bank (N).
Stock selection rationale Global IB top picks - UBS and CSG: own both in 2011 In our view, both UBS and CS tick the right boxes in terms of i) excellent entry point in terms of valuation (see below sections), ii) the right business mix in terms of our preferred business segment Asset Gathering accounting for 42% of 2012E group earnings on average and high Equity gearing within the IBs of average 37% compared to 27% for global peers in 2012E. One key issue is clearly the weak Fixed Income business – however we see material restructuring potential leading to potential capital release.
The high equity gearing of Swiss banks provides potential upside from a pickup in Equity markets, not only in terms of gearing through Wealth Management Invested assets but also from Equity revenues in the IB.
In addition, from a European perspective, Swiss Banks have material potential (and highest potential within Europeans) to be “winners” in case of a US vs. Europe regulatory arbitrage scenario on an overall basis, as outlined in our series of 3 regulatory notes. We do not see Swiss bank strategy being positioned to such opportunities – however, we believe Swiss banks will shortly seize the earnings potential.
We prefer UBS over CS due to its stronger capital position, with a Basel 3 Equity Tier 1 ratio of 13.8% in 2012E compared to 8.6% for CS.
MS – retain preference for cheap valuation, FICC turnaround still holds the key We like MS for its cheap valuation; however FICC turnaround still holds the key for the stock in the long-term. Whilst MS management believes it has gained market share in key Fixed Income product areas, we are yet to see the market share gains being reflected in revenues. FICC remains a key focus area for MS management with headcount in Fixed Income up significantly through 2010, particularly FX (+40%) and Rates (+20%), and we would expect the associated revenues to “come through” in 2011E. MS management has set a key performance goal to drive 2% market share increase in Fixed Income. We do not believe MS will be able to close the Fixed Income gap and hence market share gains are undiscounted upside in our forecast. MS also meets our criteria of preference for Equity gearing, through its strong Wealth Management franchise generating 28% of 2012E pre-tax earnings, and management targeting a 20%+ PBT margin in GWM. Please see our report “Global Investment Banks: Investment Banking wallet outlook - all eyes on equity derivatives”, published on 8th September, 2010.
With a 2012E Basel 3 Tier 1 ratio of 9.4% and undemanding valuation at just 0.9x diluted tangible BV 2012E ex DVA, there is upside potential. In our view, material valuation will be unlocked in the long term through its high equity gearings.
GS – strong FICC in Q1 11E, Fed Stress test results could provide short-term boost We downgraded GS from OW to N in our report, “Global Investment Banks: Portfolio Snapshot: Switching OW from US IBs to Europe IBs - Downgrading GS to N” on 12th January 2011. Our downgrade was purely valuation driven.
In addition, our regulatory arbitrage analysis illustrates that within US IBs, GS will be materially affected. We are convinced that GS will adjust to the challenges put forward in respect to regulatory changes in the Dodd-Frank bill, nevertheless overall earnings impact will be material as discussed in our note, “Global Investment Banks: Regulatory Proposal Analysis: Structural IB Profitability Decline”, published 9th September, 2009.
We continue to maintain our Neutral rating on the stock, as longer-term we do not find GS valuation attractive and see limited upside to our $175 price target. However, short-term going into Q1 11 results we now prefer GS over MS due to i) its strong FICC gearing with Q1 likely to surprise positively as credit hedging losses in Q4 come back in Q1 11 and a strong performance in commodities, driven by price movements in key commodities, particularly Oil, ii) Fed Stress test results which are expected on March 21st could also provide short-term boost to the stock, with the strong capital position of GS putting it as a frontrunner to buy back shares even after buyback of the Berkshire Hathaway preferreds. We note, on the purchase of Berkshire Hathaway preferred stock, GS would have to make a one-time preferred dividend payment of $1.64bn which would be recorded as a reduction to its net earnings and common shareholder’s equity, however it would save on annual preferred dividend payments of $500mn going forward.
French Banks more attractive than DB and Barclays - top pick BNPP At similar valuations to DB and Barclays, our preference would be for French Banks BNPP and SG, considering i) more stable cash flow mix with 55-62% of group profits from retail, and ii) less fixed income and more equity gearing through Equity Derivative businesses within CIB. In addition in a world of regulatory arbitrage, we see French banks in Equity derivatives having the potential to gain ground in the US, and expand their presence in Europe further, please see the section on Volcker rule on page 22 below.
Our preference is for BNPP over SG mainly due to capital position – we estimate BNPP capital deficit at €1bn vs. SG €5bn based on our JPMC divisional capital methodology. More generally, we continue to prefer BNPP vs. other traditional credit banks in Europe: i) better positioned for growth with lower risk to revenues, remaining a counterparty of choice with strong cash flow generation, ii) high gearing to a recovery in the credit cycle with exposures to more resilient retail markets, mainly France and Belgium, and iii) relatively solid capitalisation levels with Common Equity Tier I of 8.4% end 2012E.
We see the potential for further re-rating in Société Générale shares from asset disposals. In our estimates, SG Common Equity could improve by €5.4bn or 120bp to 8.8% end 2012E by selling 1) insurance, 2) securities services, 3) TCW (US fixed income asset manager), and 4) 50% stake in Newedge. The potential for disposals makes SG very attractive; however, the market environment has to be right and the regulatory environment clearer, which could take 12-18 months.
Preference for Barclays over DB due to valuation Within the UK domestic banks Barclays (Neutral TP 320p) is our preferred bank. The stock trades at a discount to NAV (0.8x 2011E) as the market struggles to understand how the group will earn returns greater than cost of equity in the medium term, given a c.2/3 IB 1/3 retail mix, and as c.35% of Barclays business does not achieve returns greater than the cost of equity. Based on our estimates we see the group earning an 11% RoNAV 2012E, in line with our longer term CoE expectations, justifying our Neutral recommendation. Note that we have not accounted for any losses related to the Lehman lawsuit where we believe that the downside risk has increased post the ruling. Further clarifications on the Lehman lawsuit and any details pertaining to their restructuring and disposal plans should act as a catalyst for the stock.
DB: Impressive FICC franchise but prefer better capitalised/cheaper valuation IBs, maintain Neutral In Q1 11 we expect DB to benefit from the ongoing market volatility, strong refinancing schedule and ongoing steep yield curve for 2011E, however we would prefer FICC gearing through better capitalised (GS in US) /cheaper valuation banks such as Barclays in the UK.
We welcome DB management’s initiative towards cost synergies through complexity reduction programs with 2011 exit rate of €1.1bn and also the IBIT impact through cost and revenue synergies which the management aims to achieve through CIB integration of €0.35bn and €0.3bn respectively. However, even with cost savings in our opinion it is unlikely DB is able to achieve its €10bn pre-tax target for 2011E on a divisional basis compared to JPMCe forecast of €7.8bn.
We upgraded DB from UW to N, “Deutsche Bank: Upgrade from Underweight to Neutral - it's good to be German,” on 1st December, 2010 as sovereign & senior debt capital at risk looks limited for DB with banking book exposures of €9.3bn to stressed sovereigns, with our base case haircut scenario leading to -12bps Basel 3 Tier I loss to Tier 1 of 6.7% in 2012E.
DB trades at 1.1x 12E P/NAV compared to Barclays at 0.8x12E P/NAV which is better capitalised at 9.0% 12E Basel 3 Equity Tier 1 ratio compared to DB at 6.8%. In our view, DB should trade in a range €43-€48 as its ongoing capital deficit will not allow any material re-rating. Capital at risk remains with €26.6bn in carrying value of structured credit assets with pre-tax mark-to-model losses of €2.6bn at YE2010. Also, long-term DB does not tick our preference for equity gearing over Fixed Income as discussed in our report, “Global Investment Banks: Investment Banking wallet outlook - all eyes on equity derivatives”, published on 8th September, 2010.
IB division at 1.0x P/BV implies 14% upside for Swiss IBs With ongoing regulatory uncertainty, we value the IB divisions of global investment banks on average at 1.1x P/BV in our 2012E SOP valuation, however current market prices imply the IB business is valued at 0.9x P/BV based on our SOP valuation. Valuing the IB divisions at 1x BV would imply 2% upside to current prices in our estimates.
• UBS and CS trade at 0.6x implied P/BV on average for the IB division, compared to 1.0x for the rest of the IB peers. This is unwarranted in our view and implies the market does not believe in an IB turnaround for the Swiss IBs and does not factor in the high Equity gearing of the Swiss IBs. Valuing the IB divisions at 1x BV would imply 15% upside for UBS followed by 13% for CS.
• In contrast, GS trades at 1.2x 2012E implied P/BV while the rest of the IBs trade at 1.0x 2012E implied P/BV.
We note, our analysis is simplistic and ongoing negative regulatory newsflow is of concern – however, we believe over time the value of the IBs should be re-confirmed at 1x at least in our view – offering material upside for the Swiss IBs in our estimates.
Table 5: Global Investment Banks: P/BV of the SOP Investment Banking division and sensitivity to group valuations 2012E local ccy GS MS DB CS UBS BARC Avg. Current share price 164.5 29.3 46.1 41.4 18.2 3.2 - SOP TP group 175 30 41 50 22 3.2 - SOP Value CIB 137 18 30 23 6 2.2 - Implied SOP value rest 37 12 10 27 15 1.0 - SOP P/BV CIB 1.4 1.0 0.8 1.1 1.1 1.0 1.1 SOP PE CIB 10.3 8.0 9.0 8.0 6.0 7.7 8.2 Implied P/BV of IB at current prices 1.2 1.0 1.0 0.7 0.5 1.0 0.9 SOP value CIB at 1x BV 95.0 18.2 36.9 19.9 5.7 2.2 - Implied SOP value rest 37 12 10 27 15 1.0 - Implied SOP group 132 30 47 47 21 3.2 - Upside -19% 3% 2% 13% 15% 0% 2% Source: J.P. Morgan estimates, Priced from Bloomberg 4th March, 2011 (intraday).
Share Buyback: GS remains fully valued post buyback – but buyback newsflow short-term catalyst We still believe that US IBs Goldman Sachs and Morgan Stanley could do a share buyback. We estimate GS and MS have excess capital of $15bn and $2bn respectively, which they could use to repurchase shares. We run a sensitivity scenario assuming US IBs use their respective excess capital to buy back shares at current share prices, in Table 6 below. Assuming both banks use all their excess capital for a share buyback, they would remain well capitalised with Basel 3 equity Tier1 ratios of 9.9% and 9.0% respectively in 2012E post the assumed buyback.
• For GS a share buyback scenario is already reflected in current valuation in our view. GS would trade at 8.7x 2012E earnings, 1.2x NAV for an RoNAV ex own debt of 14.2%, post our assumed buyback of $15.4bn or 17% of market cap
• MS on the other hand still trades at just 0.9x diluted tangible BV 2012E ex DVA, for an RoNAV ex own debt of 9.6%, post our assumed buyback of the $1.6bn of excess capital.
Table 6: US IBs: GS appears fully valued after assumed share buyback scenario $ million, % GS MS Capital Surplus 15,364 1,639 Current Market Cap 92,094 45,302 Share Buyback 15,359 1,639 Buyback as % Market Cap 17% 4% Old EPS 16.40 3.05 New EPS 18.99 3.14 % change 16% 3% Risk weighted Assets 707,435 469,560 Basel 3 Equity Tier 1 (old) 85,278 44,040 Basel 3 Equity Tier 1 (new) 69,914 42,401 Basel 3 Equity Tier 1 (old) 12.1% 9.4% Basel 3 Equity Tier 1 (new) 9.9% 9.0% Old NAV/share 138.2 32.4 New NAV/share 133.4 32.5 Old RoNAV ex own debt 11.9% 9.4% New RoNAV ex own debt 14.2% 9.6% PE (old) 10.0 9.6 PE (new) 8.7 9.3 P/NAV (old) 1.2 0.9 P/NAV (new) 1.2 0.9 Source: J.P. Morgan estimates, priced from Bloomberg 4th Mar 2011 (intraday).
...Swiss IBs at 0.8x P/NAV 2012E ex WM valued at 10x P/E UBS and CS trade at 1.3x and 1.6x NAV ex own debt 2012E for RoNAV of 18.7% and 23.4% respectively. However, we believe these multiples are not entirely comparable to other IB peers owing to the large Wealth Management exposure of the Swiss IBs. Excluding the Wealth Management business which we value at 10x PE, CS would trade at 0.8x NAV for RoNAV of 14.4% for CS and UBS would trade at 0.9x NAV for RoNAV of 13.0%.
If we value the Wealth Management business of the Swiss IBs at PE multiples of 13.1x which is in line with the US peers, both UBS and CS would be trading at very attractive multiples of average 0.6x 2012E P/NAV.
Table 7: Swiss IBs at 0.8x 2012E Implied P/NAV ex Wealth Management Local currency
CS UBS
SoP basis WM U.S. peer
group basis SoP basis WM U.S. peer
group basis Group net income 7,069 7,069 9,223 9,223 WM 2011E net income 2,622 2,622 2,419 2,419 Ex WM net income 4,447 4,447 6,805 6,805 Share price 41.4 41.4 18.2 18.2 NOSH 1,230 1,230 3,847 3,847 Group market cap 50,852 50,852 70,022 70,022 Assumed WM PEx 10.0 13.1 10.0 13.1 PE implied WM mkt value 26,219 34,279 24,186 31,621 Ex WM group mkt value 24,633 16,573 45,837 38,401 Group NAV 32,939 32,939 53,984 53,984 o/w WM capital 2,107 2,107 1,707 1,707 Ex WM group NAV 30,832 30,832 52,277 52,277 Ex WM Implied P/NAV (x) 0.8 0.5 0.9 0.7 Ex WM RoNAV 14.4% 14.4% 13.0% 13.0% Ex WM PE (x) 5.5 3.7 6.7 5.6 Source: J.P. Morgan estimates, Bloomberg (based on prices at 4th Mar 2011 (intraday)).
For the Swiss IBs we value the Wealth Management business at 10x PE 2012E, below the average 13.1x for US peers or 11.2x for Global peer group.
Table 8: Private bank peer group 2012E P/E multiples Local currency Share price EPS 2012E P/E 2012E Blackrock 207.1 16.2 12.8 T-Rowe Price 67.6 4.5 15.1 Janus Group 13.3 1.2 11.4 US Peer Group 13.1 Julius Baer 41.6 3.8 11.0 Van Lanshot 31.2 3.6 8.8 EFG Group 13.6 1.7 8.2 Average 11.2 Source: Bloomberg (based on prices at 4th March 2011 (intraday)).
UBS and US IBs well Capitalised under Basel 3 We would seek exposure to banks with high levels of capitalisation, enabling them to improve returns for shareholders.
• UBS capital position remains solid in our estimates with 2012E Basel 3 equity Tier 1 ratio of 13.8% while CS reaches a Basel 3 Equity Tier 1 ratio of 8.6% end 2012E. Note that we do not account for any dividend payouts for UBS in 2010E-012E, whilst we estimate DPS of SF1.30 in both 2011E and 2012E for CS.
• GS and MS remain amongst the best capitalised banks with Basel 3 Equity Tier 1 ratios of 12.1% and 9.4% respectively end 2012E. We estimate that GS has significant excess capital of $15bn – which it could use to buy back shares.
• Deutsche Bank Basel 3 Equity Tier 1 ratios look relatively low vs. other IB peers, with 6.8% for DB. We estimate capital deficit of €10.7bn for DB, compared to our minimum capital required based on our divisional capital allocation. Our
€10.7bn estimated capital deficit also factors in the IAS 39 reclassified assets of €26.6bn carrying value, with €2.6bn of mark-to-model fair value risk as of 31st December, 2010 – assuming ongoing high annual provision accruals in our CB&S estimates. For details on our allocated capital calculation, please refer to our note “Global Investment Banks: Market RWA consistency questioned: DB downgrade to UW, upgrade GS to OW” published on 6 July 2010. In our view, DB should continue to trade in the €43-€48 price range due to business mix but more importantly capital positioning.
Table 9: Global Investment Banks – Basel 3 Equity Tier 1 ratios (end 2012E) Local currency (millions) CS UBS DB GS MS BNP SG BARC Tier 1 Capital end 2012E 45,400 51,557 50,321 90,066 61,921 80,403 43,778 61,574 Hybrids - deducted -14,448 -4,903 -12,400 -5,000 -13,439 -11,655 -6,600 -10,685 Preference shares - deducted - - - -3,097 -9,597 -1,445 -1,000 Core Tier 1 30,952 46,654 38,456 81,969 38,885 67,303 36,178 50,889 Deferred Tax Assets (timing) - - -5,000 -1,700 -4 Deferred Tax Assets (other) -2,300 -4,200 -2,200 -3,000 -1,800 -2,194 Minority Interests (allowing 80% in capital) - - -300 - - -3,000 -1,600 -523 Shortfall of provisions to expected losses -488 - -1,700 - - 0 0 0 AFS reserves - gains or losses included - - - - - 0 0 -340 100% Insurance subsidiaries - - - - - -3,600 -2,800 Unconsolidated Investments -700 - -2,600 - - -1,146 -950 -5,352 Add back 1st loss securitisation deductions 3,227 2,385 5,000 - - 0 2,320 2,360 pension fund assets -2,500 -3,000 -400 - - 0 0 -1,913 Other Deductions - -735 -700 - - 0 0 -2,250 Core Tier 1 before capital addition limits 28,191 41,104 35,021 81,969 38,885 51,557 29,648 40,673 Maximum allowed aggregate recognition - - - - - 9,098 5,232 7,178 DTAs at 40% cap - - - - - 5,000 1,700 4 Unconsolidated Investments & Insurance subsidiary - - - - - 5,892 4,700 5,352 Max Allowed Individual Inclusion - - - - - DTAs at 40% cap - - - - - 5,000 1,700 4,519 Unconsolidated Investments & Insurance subsidiary - - - - - 5,729 3,294 4,519 Final inclusion DTAs at 40% cap - - - - - 5,000 1,700 4 Unconsolidated Investments & Insurance subsidiary - - - - - 5,729 3,294 4,519 Aggregate Capital addition - - - - - 9,098 4,994 4,523 Basel 3 Equity Tier 1 28,191 41,104 35,021 85,278 43,881 60,655 34,642 45,196 Risk Weighted Assets 247,636 268,875 418,984 560,570 377,757 671,869 398,774 470,754 Adjustment for CVA 89,500 20,000 24,000 45,402 Adjustment for Securitisation exposures 62,500 0 58,000 59,000 Other adjustments 10,000 0 11,308 Additional RWAs due to CVA+Securitisation 152,000 130,000 185,000 200,000 190,000 30,000 82,000 115,713 Adjustment for mitigation -70,000 -100,000 -90,000 -54,415 -100,000 0 -25,000 -84,000 Revised Risk Weighted Assets 329,636 298,875 513,984 706,155 467,757 701,869 455,774 502,464 Additional RWAs - - - - - 22,746 12,485 - Total Risk Weighted Assets under Basel 3 329,636 298,875 513,984 706,155 467,757 724,615 468,259 502,464 Basel 3 Common Equity Tier I new 8.6% 13.8% 6.8% 12.1% 9.4% 8.4% 7.4% 9.0% Source: J.P. Morgan estimates. Company data. Note: Basel 3 common Equity Tier 1 estimates end 2012E not assuming any phase-in of Basel 3 deductions nor progressive phasing out of other common Equity Tier 1 instruments
Prefer Wealth Management exposure: UBS, CS Private banking/brokerage provides a source of relatively stable cash flow generation across the cycle, and overall, remains one of the most profitable banking businesses with limited capital consumption in our view. We believe that private banking has more limited regulatory risk, and the main players would reap most of the benefits from improving equity markets.
UBS and Credit Suisse have material Wealth Management exposures accounting for c.26% and c.38% of group net profits in 2012E respectively, providing a source of more stable cash flow generation with limited credit risk and long term growth (despite currently difficult market conditions), in our view. Despite its gearing to equity markets, and regulatory risk surrounding offshore private banking, we believe private banking remains the most profitable banking business overall in the current environment. We view the offshore banking concerns as overdone and believe they are already discounted within the Swiss banks, with newsflow to slow.
Looking at the business mix for the Global Wholesale and Investment Banks, Swiss banks Credit Suisse and UBS have the highest gearing to asset gathering accounting for 43% and 41% of group net income in 2012E.
• For GS and MS, IB division contributes 73%-90% of group net income in 2012E. Morgan Stanley also has gearing to Wealth Management with its JV, however with Global WM accounting for 19% of group earnings, exposure to asset gathering/private banking is less significant than the two Swiss banks.
• Within the European IBs, DB has the highest gearing to Investment Banking activities with CB&S accounting for 61% of 2012E group net income followed by CS and UBS at average 47%.
• French banks BNP and SG derive relatively lower share of net income at 40% and 35% from IB division in 2012E, with retail and financial services contributing 58% on average to the 2012E group net income.
Table 10: Global Investment Banks – Split of group net income by divisions 2012E %
Prefer equity gearing over fixed income: UBS, CS, MS Within the more pure-play IBs, we prefer banks with higher equity gearing as we see growth in IB revenues coming from Equities. For more details, please refer to our note, “Global Investment Banks: Investment Banking wallet outlook - all eyes on equity derivatives”, published on 8th September, 2010.
• Credit Suisse and UBS are amongst the highest geared to equities accounting for c.37% of total Investment Banking revenues in 2012E. At group level, equities account for 20% of group revenues for CS and 15% for UBS. These banks are thus likely to benefit the most from any improvement in the equities environment.
• Morgan Stanley and Goldman Sachs are also geared to equities which accounts for c.31% of total IB revenues in 2012E, and 15% of group revenues for MS. For GS, 29% of 2012E group revenues come from Equities, GS is however even more geared to Fixed Income which accounts for 44% of IB revenues and 36% of group revenues in 2012E.
• Barclays and Deutsche Bank are mainly fixed income houses with FICC accounting for 63% and 53% of total IB revenues and 26% of 2012E group revenues. These two banks are the most exposed to a decline in fixed income revenue in our view.
• Société Générale is mainly an equity derivatives house in its CIB business, with equities accounting for 37% of total 2012E CIB revenues. However, as the business mix is more diversified with higher gearing to retail activities, equities only account for 11% of 2012E group revenues.
Table 11: Global Investment Banks - Fixed Income and Equities as % of Group 2012E revenues Local ccy in millions, %
Regulatory Arbitrage I: Tougher than expected Volcker rules undiscounted What is Section 619 of the Dodd-Frank Act or Volcker Rule? Section 619 of the Dodd-Frank Act, also known commonly as the Volcker Rule prohibits banking entities from engaging in proprietary trading. Initial interpretation suggested that only pure proprietary trading activities of the banks would be impacted by the Volcker rule. The key issue coming out of recent communication between lawmakers, SIFMA and FSOC is the possibility of market making related activities of banks being impacted by the Volcker rules. This possibility has arisen because of different interpretation of the phrase “selling in the near term” when used in the context of a trading account and when used in the context of “market making related permitted activities”. In this report, we try to analyze the impact on U.S. IBs from a more strict interpretation of the Volcker rule and the relative advantage it provides to European IBs where a similar provision is unlikely to be implemented.
1. We have focused on the impact from Volcker rule on Pure Proprietary trading in the past; however the impact on market making related activities if included within the scope of the Volcker rule would be significant in terms of earnings impact and is highly likely for the U.S. IBs in our view.
2. We believe Section 619 if applied to market making related activities of the banks would negatively impact liquidity and volumes with the end users of derivatives ultimately bearing the increased cost.
3. In our view, European IBs would be the likely “winners” in a scenario where “market making related” revenues of U.S. IBs are impacted by the provisions as EU has not shown willingness to adopt a similar provision in Europe. Hence, US IB revenues will be negatively impacted, but will overall benefit European IBs running their market making and prop positions out of Europe. Large European IBs such as DB, Barclays especially in Fixed Income (and especially in the derivative parts) would be the “winners” with French Banks BNP and SG also benefiting in their Equity Derivatives business at the cost of the U.S. IBs in our view – stepping into the ‘liquidity void’ created by the Volcker rule impacting US IBs.
Why unprohibited market making is good for markets in our view: In a world where more derivatives are to be traded on SEF platforms increasing transparency, the importance of using the IBs’ capital to offer liquidity in size becomes more and more important in our view.
The best example is Cash Equity block trades for mainly Hedge Funds – taking a position at risk for an equity client leading generally to a trader’s views and hence prop positions. Generally we estimate for the large prime brokerage firms such as GS, MS and CSG hedge fund block losses to account for 20-30% of overall HF revenues. Overall, we believe Hedge Funds will want to trade the majority of their business with liquidity providers and will pay firms offering liquidity (and IBs willing to put capital at risk) from an overall wallet perspective.
It is our clear view; the winners in the IB business are the capital at risk liquidity providers with GS historically being best in class across asset classes. Hence, we believe GS has potentially most to lose from the new rules. We expect US IBs to react by aggressively investing in technology to retain their position as liquidity providers through highly electronic platform offering (i.e. Algo).
Timeline of Volcker Rule Implementation Volcker Rule is to be effective by July 21, 2012 at the latest. The FSOC would be completing its study on the Volcker rule in January, 2011 and the rulemaking is expected to be completed by regulators by October 2011. Banks will have to be fully compliant by July 2014 (within two years after the rules are effective) although this deadline may be extended under certain cases.
Table 13: Statutory deadlines for the study and rulemaking process Statutory deadline FSOC Study January 21,2011 Agency Rulemaking October 21,2011 Volcker Rule become effective July 21, 2012 or one year after the issuance of final agency regulations Full Compliance with Volcker Rule July 21, 2014 Source: http://www.treasury.gov/initiatives/Documents/FSOC%20Integrated%20Roadmap%20-%20October%201.pdf
Pure Prop trading vs. Market making related activities We have estimated the impact of Volcker rule on “pure” proprietary trading activities in the past. However, we did not focus on the likely impact of Volcker rule on “market making related activities” of the banks. Recent Communication between lawmakers and industry bodies with the Financial Stability Oversight Council (FSOC) seems to suggest that market making related activities of the banks could also be impacted by a more strict interpretation of the Volcker rule provisions.
The key area of concern for U.S. IBs in our view is related to the usage of the term “near term” when used in the context of a “trading account” and when used in the context of “market making related permitted activities”.
• In the context of a trading account, banking entities are not allowed to acquire or take positions to sell in the near term.
• The difference between “market-making related activities” and proprietary transactions is in terms of the period of time a firm is allowed to hold the position on its books. Currently the rules permit activities which are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties. Clearly if the final provisions do not allow firms to hold inventories for long-term periods, IBs’ trading activities are likely to be impacted materially. Both SIFMA and Senators Merkley and Levin, in separate letters to the FSOC have expressed their views on the issue (see page 34)
• The rule in its current form allows banks to engage in risk-mitigating hedging activities which reduce specific risk associated with individual or aggregated positions, contracts, or other holdings.
• Also it is interesting to note that activities related to the U.S. government or government agencies such as Ginnie Mae, FHLB etc. and states or political subdivisions are included within the scope of permitted activities. The government is concerned about the likely impact of provisions on volumes and liquidity on these activities in our view and has thus permitted banking entities to continue with their activities in relation to government agencies. We question the fact that some government related activities are treated differently from private activities in respect to the Volcker rule.
• Section 619 also excludes from permitted activities any transaction, class of transaction or activity which would result, directly or indirectly, in a material exposure by the banking entity to high-risk assets or high-risk trading strategies.
US IBs GS and MS have disclosed the impact from the Dodd-Frank Act and in particular from the proposed limits on proprietary trading activities on their profitability in their regulatory filings (For details see Table 19). GS in its 10-K filing said, “ …however, we expect that there will be two principal areas of impact for us: the prohibition on “proprietary trading” and the limitation on the sponsorship of, and investment in, hedge funds and private equity funds by banking entities, including bank holding companies…” MS also stated in its 10K filing, “A provision of the Dodd-Frank Act (the “Volcker Rule”) will, over time, prohibit the Company and its subsidiaries from engaging in “proprietary trading,” as defined by the regulators…”
On the other hand, ECB members have said at numerous forums that they are not in favour of adopting the Volcker rule provisions in Europe. European Central Bank council member Axel Weber said, “A complete prohibition of certain activities -- activities that are perhaps more risky but not necessarily economically inefficient -- is a very far-reaching market intervention,” The Volcker rule “might have unintended and unfavorable consequences” including “undesirable effects on the transmission of monetary policy,” he said, without elaborating.1
European Central Bank Executive Board Member Jose Manuel Gonzalez-Paramo in his speech “Reform of the architecture of the financial system” on 21 June 2010 said: “In general terms, there are two ways to address ex ante the problems that SIFIs pose: you can restrict the scope of their activities or force them to internalise the costs they pose to the system. The clearest illustration of the first approach is the discussion on the “Volcker rule” in the United States. Under this rule, banks that receive deposits would be prevented from engaging in proprietary trading, and investing in or sponsoring hedge funds and private equity funds. I do not believe this is the most fruitful way to pursue in Europe, given the traditional strength of the universal banking model in a number of Member States. Also, there may be challenges associated with defining the borderline between the proprietary trading and servicing clients. But more importantly, the activities that are seen as deserving special attention may move outside the intensively regulated and supervised banking business, but stay within the same group.”2
We agree with the views expressed by some members of the Senate on the potential negative impact the restrictions on market making related activities rules might have on the competitiveness of the U.S. Financial Services sector.
Spencer Bachus, who is an Alabama Republican and new Chairman of the House Financial Services Committee, had sent a letter to the Financial Stability Oversight Council (FSOC) on November 3, 2010 warning them that a ban on proprietary trading “will undermine competitiveness of US Financial Service Sector”. He further added that “the rule-making agencies must give to the international financial regulatory context as they begin crafting regulations to implement the Volcker rule.”
Unilateral adoption of the rules by U.S. would benefit European IBs in our view, with ECB members expressing their unwillingness for a Volcker Rule like provision in Europe. Also, the limits on market making related activities would bring down liquidity in the instruments, with potential increase in costs for end-users.
The final interpretation of the provisions of the Volcker Rule related to “Proprietary Trading” might have a significant impact on U.S. IBs trading revenues. In a scenario where the Volcker Rule is extended to include “Market Making” (which is likely in our opinion) related proprietary trading activities, large European IBs such as DB, Barclays would be the “winners” with French Banks BNP and SG also benefiting in their Equity Derivatives business at the cost of the U.S. IBs in our view.
How to measure the difference between market making vs. prop business – recent FSOC study sheds some light We believe the devil will be in the details in the rule on how US IB businesses will be impacted. The recent report by FSOC shed some light on how the regulator may attempt to differentiate between prop and market making.
The FSOC study includes a detailed summary of the potential types of metrics that the Council believes regulators may find useful to consider implementing to differentiate between prop and market-making activity. We would make two main observations on proposed indicators.
Firstly, we believe it is reasonable to assume that if these indices make it to the final document, regulators will have a fair chance of identifying proprietary activity, especially once benchmark levels are established for various asset classes across the industry.
Secondly, the process of monitoring and adjusting limits to these ratios may prove quite onerous. This is because each metric is likely to display a different level, not only for different asset classes, but also at an asset level. Different levels of the underlying liquidity will potentially drive the trading profile. For example, trading an illiquid bond will have a trading profile more akin to prop trading and a blue chip stock more similar to market making. On top of that, any derivative transaction would need to be monitored with respect to various sensitivities, complicating the process even further.
We highlight again that all these quant measures as well as process controls are parts of the FSOC proposal and may be reshaped in the final rulemaking by the Fed and the CFTC.
FSOC proposed four categories of metrics: 1) Revenue-Based Metrics: These metrics would attempt to measure daily revenue
and revenue from specific trades relative to historical revenue and similar data for other banks (i.e., horizontal comparison). Revenues and losses for market making and certain other permitted activities principally derive from both spreads and price movement in the inventory held, while impermissible proprietary trading revenue is generated principally from price movements. An analysis of revenue may allow a determination that a particular trade or activity was proprietary in nature.
a) Historical Revenue Comparison: This measure compares a particular period’s revenue to historical trends. If a trading desk’s revenue from a particular day, month or quarter is outsized relative to recent trends, that desk could be implementing strategies that include impermissible proprietary trading.
b) Day One Profit & Loss: This measure compares the profitability of positions on the first day they are taken with the profitability of all positions held that day. This metric seeks to address the challenge of discerning the source of a firm’s profitability. Day One Profit & Loss is likely to be higher for market makers that profit immediately from capturing the spread upfront than for proprietary traders that seek to profit from asset appreciation in the near term.
c) Bid-Offer Pay-to-Receive Ratio: This measure compares the profitability of positions on the first day they are taken with the total trading activity on that day. The metric seeks to approximate whether a trader is more likely to be purchasing securities at the bid, or offer, even in the absence of continuously quoted markets.
2) Revenue-to-Risk Metrics: These metrics would attempt to measure revenue generated per unit of risk assumed. Market makers and underwriters endeavor to mitigate risk by quickly reselling or hedging positions that are acquired, whereas proprietary traders actively seek to assume risk by holding positions with the expectation that they will appreciate. Consequently, permitted activities are likely to have greater revenue-to-risk ratios than impermissible proprietary trading.
a) Profitable Trading Days as a Percentage of Total Days: Market makers will tend to evidence more consistent daily profitability than proprietary from high turnover of a position rather than appreciation in the position, while the opposite is true of proprietary traders. Market makers seek to price into each transaction an appropriate spread and manage inventory tightly. By design, proprietary traders tend to seek exposure to market fluctuations, which do not follow a defined day-to-day pattern.
b) Sharpe Ratios: This measure compares the annualized total revenue or excess return of the firm or trading desk to the annualized standard deviation of revenue or standard deviation of the portfolio (i.e., how much the firm’s trading profit varies from day-to-day) or how much excess return is earned for every unit of risk taken. Similar to the measure of profitable trading days as a percentage of total days, established proprietary trading activities will generally have a lower Sharpe ratio, as proprietary trading generally results in higher earnings volatility.
c) Revenue-to-Value at Risk: This measure evaluates the revenue per dollar of value-at-risk in the firm. For a given level of profitability, market making should entail less aggregate risk than proprietary trading as market makers retain the risk for a shorter period of time.
d) Value at Risk: Standard value at risk (VaR) metrics may also provide Agencies with a helpful guide for areas that bear further scrutiny. We note, even with these measures a lot of questions remain such as the calculation on VAR based models are all using different inputs and calculation methodologies as illustrated in Table 14 below. Hence are not comparable across US IBs as discussed in our note “Global Investment Banks: Market RWA consistency questioned: DB downgrade to UW, upgrade GS to OW” published on 6 July 2010.
Table 14: VaR & IRC related market risk vs. total market risk Local currency, Q4 2009 CS UBS DB GS MS BNP SG BARC Avg Reported 1-day avg VaR (m) 114 51 127 181 132 63 30 77 Confidence level 99% 95% 99% 95% 95% 99% 99% 95% Observation period (years) 3 5 1 N/A 4 N/A 1 2 2.7 Regulator FINMA FINMA BaFIN FED* FED* FR Reg FR Reg FSA 1-day 99% avg VaR (m) 114 87 126.8 308 224 63 30 131 10-day 99% avg VaR (m) 360 274 401 973 710 199 96 415 Source: Company reports and J.P. Morgan estimates. *GS and MS are currently regulated under Fed Basel 1 as BHC. GS exponentially weighted VaR methodology with 20% per month decay rate- equivalent to 5.5 month observation period on a weighted basis.
3) Inventory Metrics: Inventory turnover compares the asset value that is transacted each day to the value of assets that are held in inventory. This measure takes into account the need for market makers to hold inventory, but relates it to observed customer demand. A market maker that retains risk well in excess of customer demand is more likely to be holding an impermissible proprietary position in that risk
a) Inventory Turnover: This metric calculates the ratio of assets that are transacted each day to assets that are retained in inventory. The metric takes into account the need for market makers to hold inventory (volume of retained assets), but relates it to the asset’s observed customer demand (volume of transacted assets). For highly liquid financial instruments, inventory turnover and aging are relatively straightforward to measure as banking entities will have both significant daily volume and measurable inventories of each discrete asset. Such financial instruments include most cash equities, high volume foreign exchange rate pairs, commercial paper, and other financial instruments for which risk can be offloaded quickly. For such assets, banking entities may compare the gross notional value traded each day against the amount retained in inventory.
Less-liquid or more complex financial instruments may necessitate a more nuanced measure of inventory turnover. While such financial instruments may be correlated or hedged with other financial instruments, they may be individually distinct in the way in which they are valued.
b) Inventory Aging: Inventory aging measures how long inventory has resided on the balance sheet rather than simply how large it is. Retaining inventory when near-term customer demand fails to appear rather than selling such inventory could indicate impermissible proprietary trading.
4) Customer-Flow Metrics: These metrics evaluate the volume of customer-initiated orders on a market-making desk against those orders that are initiated by a trader for the purposes of building inventory or hedging. Significant trader-initiated, rather than customer-initiated, order volume could indicate that impermissible proprietary activity has occurred.
a) Customer-Initiated Trade Ratio: This metric compares the amount of customer-initiated flow relative to trader-initiated flow. Trader-initiated flow should be closely correlated with customer-initiated flow, as trader-initiated positions should be established primarily to hedge positions acquired from customers, or to manage inventory to appropriate levels such as in anticipation of customer demand.
b) Customer-Initiated Flow to Inventory: This calculates the volume of a desk’s inventory relative to the desk’s average customer-initiated trades. Inventory should remain in proportion to customer-initiated trades in most instances.
c) Revenue to Customer-Initiated Flow Ratio: This ratio measures the trading desk’s revenue to the proportion of customer-initiated flow. There should be a strong relationship between the customer-initiated flow on the desk and the revenue it generates.
Enforcement of the compliance with the restrictions on proprietary activities within market making FSOC made a significant step forward towards implementation of limits on market making that may be considered proprietary trading by proposing a comprehensive framework for monitoring, assessment and enforcement of compliance with the Volcker rule. FSOC recommended in particular:
• bank entities develop internal operational controls (internal policies and procedures, programs to monitor trading activity, creation of recordkeeping and reporting systems, internal compliance oversight, public attestation of compliance with Volcker rules by the CEO).
• supervisory review and oversight up to investigating specific trading activity on a position level
• enforcement actions for violations could include increased oversight, reduction in risk limits, increased capital charges or monetary penalties.
The proposed range of quantitative indicators that are comparable across assets, time periods and unified across the industry together with a set of processes designed to enforce compliance with them is a powerful tool to limit potential proprietary activities in our view.
Impact from Prohibiting Pure Prop Trading Section 619 of the Dodd-Frank Act has clear language related to the prohibition on “pure proprietary trading” operations of banks as compared to the limits on “market making related activities.” In Table 15 below, we show the comments made by the Global IBs on their activities related to pure proprietary trading.
Table 15: Global Investment Banks – comments on proposed limits in “pure” prop trading/private equity/hedge funds Local currency in million Bank Comments Goldman Sachs Pure prop trading (non-client) accounts for c.10% (+/- a couple of %) of total firm revenues, depending on the revenues of other divisions of the firm. Credit Suisse Prop accounts for:
• Less than 10% of Equity revenues in 2009, vs. 10-20% previously. • 0% of Fixed income in 2009, vs. high single digits previously.
Credit Suisse has SF4bn of own money invested in their Private equity and principal investment business within Asset Management.
UBS UBS has virtually no Private Equity activity currently. In the IB, UBS only has segregated prop trading in Equities and revenues per annum amount to Sfr0.4- Sfr1.6bn per annum. There is also some prop within the Asset Management business.
Deutsche Bank 5% of revenues in 2009. Barclays Pure prop is less than 3% of group revenues in 2009 and less than 5% of BarCap topline income.
Barclays does not seed or own hedge funds. PE business is small, loss making in 2009 and for sale. Morgan Stanley n.a. Société Générale Limited prop trading. BNP Paribas Prop trading is very limited.
BNP Paribas Capital manages the group's prop portfolio of unlisted investments; and the value of the portfolio was €3.3bn end 2008. The group made no revenues in BNP Paribas Capital in 9m 09.
Citigroup Citigroup generates less than 2% of its revenues from prop trading Bank of America Bank of America also, generates less than 2% of its revenues from prop trading Source: Company reports and J.P. Morgan estimates, Citigroup and Bank of America based on press articles, “Senators Prepare A Citigroup-Sized Hole In Volcker Rule”, CNBC, 23 June 2010.
We estimate the impact from proposed limits on “pure Proprietary trading” on the 2012E EPS for Global IBs in Table 16 below. For US IBs GS and MS, we estimate average -14% impact on 2012E EPS from the limits on “proprietary trading”, based on pure prop trading revenues in a “normal year”.
For GS, we estimate 10% of 2012E Group revenues to be related to pure prop trading, i.e. non client related while for MS we estimate 5% of 2012E group revenues to be “pure prop” related. Our calculation is based on a simplistic approach, using 40% Cost/Income ratio for the prop trading operations. We note, the Cost/Income ratio for prop trading business is lower than IB, as a pure prop trader utilizes the bank infrastructure, with limited fixed cost.
We assume no impact from the “proprietary trading” limits on the European IBs, as the EU has not indicated any plans to implement the Volcker rule in Europe. Thus the European IBs are at an advantage compared to US IBs in our view, with little or no impact from the proposals to limit “proprietary trading”. U.S. subsidiaries of the European IBs might be impacted by the limits on Prop trading, but we believe the business written out of the U.S. subsidiaries would be moved to Europe in such a scenario, thus limiting the impact in our view.
Table 16: Global Investment Banks: 2012E EPS Sensitivity to Section 619 limits on “PURE Proprietary trading” local currency millions GS MS CSG UBS DBK Pure Prop Trading Revenues 3,722 1,733 1,800 1,000 1,608 Pure Prop Trading Revenues impacted by Section 619 3,722 1,733 - - - Assumed Cost/Income ratio 40% 40% 40% 40% 40% Cost Impact 1,489 693 - - - Pre-tax impact 2,233 1,040 - - - Impact on Net Income 1,518 728 - - - EPS Impact from limits on "Proprietary Trading" 14.8% 13.4% - - - Source: J.P. Morgan estimates.
Impact from restrictions on Market making related activities Section 619 of the Dodd-Frank Act which proposes limits on “proprietary trading”, if applied to the market making related activities of the IBs would have significant negative impact on IB revenues in our view, as market making forms a very significant part of both Fixed Income and Equity Sales and Trading revenues (especially Derivatives) for the IBs in our view as well as Equity Derivative business. Limits on market making would also bring down liquidity in the instruments; the revenue impact on IBs would partly be offset by increase in margins in our view and the increased cost would be paid by the end users.
We start our analysis of the impact from Volcker rule provisions with the 2011E IB revenue split by product for the different IBs, as shown in Table 12. We have looked at the derivative notional outstanding data provided by OCC on a quarterly basis, and based on that made assumptions on the amount of revenues in each product line which might be impacted by an extension of the Volcker rule to include “market making related activities.”
If Section 619 of the Dodd-Frank Act is interpreted in a way which affects the market-making activities of the IBs, the impact would be much higher in our view. It is very difficult to differentiate the pure market making activity in derivatives, and Equity derivatives in particular from proprietary position taking.
• We estimate market making to contribute c.80% of all Fixed Income revenues and c.60% of Equity derivative revenues.
• Cash Equities which is mostly order-book driven would be less impacted in our view and we estimate c.15% of cash equity revenues to be impacted from this interpretation of Section 619 of the Dodd-Frank Act.
• Based on our estimates, 52% of 2011E IB revenues for GS and 40% of 2011E IB revenues for MS would be impacted by the more stringent interpretation of limitations on market making related activities.
• At the Group level, GS would be most impacted with 46% of 2011E revenues likely to be affected by the rules followed by MS at 20%. The impact for U.S. Large Cap banks Citi and BofA would be average 13% in 2011E in our estimates.
At this point, looking at the proposals in Section 619 of the Dodd-Frank Act, we do not have clarity on the final likely impact on market-making related activities of the banking entities.
Key terms from Dodd-Frank Act on “Proprietary Trading” The Dodd-Frank Act was enacted on July 21, 2010. Under section 619 of the Dodd- Frank Act, banking entities are prohibited from engaging in proprietary trading and from maintaining certain relationships with hedge funds and private equity funds. These prohibitions and other provisions of section 619 are commonly known, and referred to herein, as the “Volcker Rule”.
“Banking entity” is defined as any insured bank or thrift, any company that controls an insured bank or thrift, any company that is treated as a bank holding company under Section 8 of the International Banking Act of 1978, and any affiliate or subsidiary of such an entity.
(4) Proprietary Trading – The term ‘proprietary trading’, when used with respect to a banking entity or nonbank financial company supervised by the Board, means engaging as a principal for the trading account of the banking entity or nonbank financial company supervised by the Board in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract or sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures trading commission may, by rule as provided in subsection (b) (2), determine.
Trading Account: The term ‘trading account’ means any account used for acquiring or taking positions in the securities and instruments described in paragraph (4) principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts as the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures trading commission may, by rule as provided in subsection (b) (2), determine.
Permitted activities 1. The purchase, sale, acquisition, or disposition of securities and other instruments
described in subsection (h)(4) in connection with underwriting or market-making-related activities, to the extent that any such activities permitted by this subparagraph are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties
2. The purchase, sale, acquisition, or disposition of the United States or any agency thereof, obligations issued by the Government National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), and obligations of any State or of any political subdivision thereof;
3. Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings ;and
4. The purchase, sale acquisition, or dispose of securities and other instruments on behalf of customers.
Interpretation of Prop Trading and Market Making: Responses to the FSOC Section 619 of the Dodd-Frank Act bans proprietary trading but includes an exemption for market-making trades with the limitation that these trades do not exceed the reasonable expected near term demand of clients, customers or counterparties.
In separate responses to FSOC, there have been references on the likely interpretation of Section 619 of the Dodd-Frank Act, especially on the terms market-making and near term demand, with Senators Merkley and Levin and the SIFMA expressing their views on the issue.
Senators Merkley and Levin response to FSOC Senators Jeff Merkley and Carl Levin, co-sponsors of the Volcker rule, in a letter, dated 4th November 2010, to Financial Stability Oversight Council (FSOC) commented: “Some firms seem to assert that entering into any transaction with a client or counterparty is somehow market-making. That view, however, would expand the definition of market-making to include all proprietary trading-because every trade has at least two parties-and would thus render the statutory protections against high-risk proprietary trading meaningless.”
SIFMA response to FSOC SIFMA in its letter to FSOC, dated 5th November 2010, highlighted the fact that Section 619 expressly permits activities that are crucial to functioning of US and Global markets which includes market making: “SIFMA views the market making-related permitted activity as a crucial component of Section 619. Market making is a core function of banking entities and provides liquidity needed by all market participants, resulting in better pricing. The Study should support the design of a sensible framework of regulations and policies and procedures that preserve the effective functioning of markets and the current role of market making within those markets, and at the same time achieve the objectives of the statute. SIFMA supports a robust discussion of this topic, especially in light of possible confusion regarding the activities involved in market making.”
Further, the rule related to market making activities states that these activities are permissible only if they do not exceed the reasonably expected near term demands of clients, customers, or counterparties implies that there is a time limitation for these market making activities.
The phrase “near term” is used in both the definition of “trading account” and in describing the “market making-related” permitted activities. In the definition of “trading account,” the phrase “near term” defines the nature of the seller’s selling activity, and when used to describe a “market making–related” permitted activity, the phrase defines the nature of the demand of clients, customers and counterparties.
SIFMA and Committee on capital market regulation in their comments submitted to FSOC pointed out that the phrase “near term” need not be defined the same way in both places and have recommended the “FSOC to encourage regulators when writing regulations to apply a meaning to the words “near term” that is appropriate to the context in which they appear.” “The regulators should take care not to define the term in such a way as to prohibit either long-term investments or market making.”
SIFMA in its letter to FSOC dated 5th November 2010 highlighted that: Section 619 uses the words “near term” in the definition of “trading accounts” and in describing the “market making-related” permitted activity. In the definition of “trading account,” the phrase "near term" defines the nature of the seller’s selling activity, and when used to describe a “market making–related” permitted activity, the phrase defines the nature of the demand of clients, customers and counterparties. The FSOC should encourage regulators to view the phrase in its defining context. The FSOC also should recognize that any definitions in this area should be sufficiently flexible to account for differences among asset classes and markets. The FSOC should encourage regulators when writing regulations to apply a meaning to the words “near term” that is appropriate to the context in which they appear
Committee on capital market regulation response to FSOC Committee on capital markets regulation sent a letter to FSOC on November 5, 2010 expressing its views on the terms near term and selling in the near term, stressing on the fact that the rulemaking should identify the differences in the definition of the terms.
• “Selling in the near term.”: Under the Dodd-Frank Act, a “trading account” used for proprietary trading is defined to be used principally with the intent to “sell in the near term (or otherwise with the intent to resell in order to profit from short-term price movements).” This implies that the motives of the banking entity when initially acquiring the security or instrument are highly relevant in determining whether impermissible proprietary trading is occurring.
• The phrase “near term,” however, is also used in the exception allowing for market making “for the reasonably expected near term demands of clients.” The phrase need not be defined the same way in both places. Although there is an important temporal aspect in both uses, the regulators should take care not to define the term in such a way as to prohibit either long-term investments or market making.
Recent developments • On 17th November, Fed opened up the public comment period on proposed rules
that would implement the conformance period during which banking entities and non-bank financial companies, supervised by the board, must bring their activities into compliance with the rules.
According to Bloomberg article “Derivatives, ‘Volcker’ Rules Might Be Targets of House Republican Tactics”, dated 19th November 2010: “Republicans, who will take power in the House in January, have already voiced concerns with the so-called Volcker rule to bar banks trading on their own accounts and new derivatives rules designed to push the $615 trillion over-the-counter market onto regulated clearinghouses and exchanges -- two issues that have garnered much attention from Goldman Sachs Group Inc., JPMorgan Chase & Co. and Bank of America Corp., according to meetings posted on the Web sites of the federal regulators.”
“One procedure being considered by House Republicans is a little used “resolution of disapproval” through the 1996 Congressional Review Act, which can be deployed to target a specific regulation”
“We are committed to conducting aggressive oversight to bring the Administration’s actions to light,” said Spencer Bachus. “The Congressional Review Act should be a tool for Congress to use to demand greater efficiency and accountability throughout the federal bureaucracy”
• SIFMA (The Securities Industry and Financial Markets Association (SIFMA) is an organization that brings together the shared interests of hundreds of securities firms, banks and asset managers) issued a study in January 2011 highlighting the importance of liquidity provisioning by market makers and its impact on the general economy.
• FSOC issued on 18th January 2011, where the committee put forward recommendations designed to comprehensively implement the Volcker rule (we have discussed the proposed quantitative indicators as well as new control processes in the previous sections as well as in separate report Volcker Rule - Clear quantitative indicators for market making by FSOC: Remain OW Euro IBs.
Concerns on impact of Section 619 on U.S. Financial Sector The Volcker rule limits proprietary trading activities of the US IBs, giving a competitive advantage to European Banks in our view. This might lead to some clients moving out from US banks to European banks, leaving the US banks at a competitive disadvantage. Republican Senators have already voiced concerns over the proposed “Proprietary Trading” limits on US banks.
Spencer Bachus, who is an Alabama Republican and new Chairman of the House Financial Services Committee, had sent a letter to the Financial Stability Oversight Council (FSOC) on November 3, 2010 warning them that a ban on proprietary trading “will undermine competitiveness of US Financial Service Sector” He further added that “the rule-making agencies must give to the international financial regulatory context as they begin crafting regulations to implement the Volcker rule.”
• 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.
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
What is the Financial Stability Oversight Council? Financial Stability Oversight Council (“FSOC”) is the body which will study and make recommendations on implementing the Volcker Rule and the various government agencies must consider the recommendations of the FSOC study in developing and adopting regulations to implement the Volcker Rule.
Financial Stability Oversight Council (FSOC) is made up of ten voting members – nine federal financial regulatory agencies and an independent member with insurance expertise – and five nonvoting members
• Voting Members: The Secretary of the Treasury, who serves as the Chairperson of the FSOC, the Chairman of the Board of Governors of the Federal Reserve System, the Comptroller of the Currency, the Director of the Consumer Financial Protection Bureau, the Chairman of the Securities and Exchange Commission, the Chairperson of the Federal Deposit Insurance Corporation, the Chairperson of the Commodity Futures Trading Commission, the Director of the Federal Housing Finance Agency, the Chairman of the National Credit Union Administration Board, and an independent member with insurance expertise that is appointed by the President and confirmed by the Senate for a six year term.
• Nonvoting Members:-Who Serve in an Advisory Capacity: The Director of the OFR, the Director of the Federal Insurance Office, a state insurance commissioner selected by the state insurance commissioners, a state banking supervisor chosen by the state banking supervisors, and a state securities commissioner designated by the state securities supervisors. The state nonvoting members have two year terms.
Regulatory Arbitrage II: EU compensation analysis – favors Global IBs over EU IBs, winners AM & HFs Overview Based on the EU regulation on compensation, we see risk for regulatory arbitrage with the European IB industry becoming less competitive relative to Global IBs in their ability to attract and retain top/key talent.
In our base case assumption, key IB staff in European IBs would receive at best 20% of their bonuses in cash upfront, 20% retained for 6 months to 2 years and an estimated 60% deferred between 3-5 years (more likely 3 years in our view). Overall 50% of total bonuses will be paid in equity-linked instruments, in our view.
Who is impacted: limited staff numbers, but key revenue generators... We note that the EU compensation rules would only affect the top 200-400 employees per bank for Investment Banks operating in the EU in our view, equivalent to about 2% of total IB staff globally. It is, however, important to note that employees affected include key revenue contributors. We believe there is a 20%-80% rule in investment banking with 20% of staff generating 80% of revenues. We believe these key staff are greater revenue generators and will be part of the 20% most productive employees.
Whilst the EU compensation rules could be seen as an improvement in Europe vs. the past one to two years when 60-100% of variable compensation was deferred for key staff between 3-5 years, we believe these rules are harsher for IBs operating in Europe than US compensation guidelines. Long-term deferral plans used to be between 40-60%, and going forward, are expected to be 50-60% in a normal year for key staff.
Table 20: Group number of employees - Geographical distribution - 2009 CS UBS DB GS MS Total employees 47,600 65,233 77,053 32,500 61,388 o/w in EMEA 29,700 34,573 49,391 8,160 6,463 o/w in Asia Pacific 6,400 6,849 16,489 5,440 4,386 o/w in Americas 11,500 23,810 11,173 18,900 49,682 Total employees (IB) 19,400 15,666 20,000 24,500 17,000 Source: Company reports and J.P. Morgan estimates; 2009 data Note: 1.For GS and MS number of employees estimates are based on the geographical revenue breakdown 2.For CS and UBS EMEA also includes employees in Switzerland
...local regulators driving even tougher compensation rules in Europe We note that under pressure from local regulators, some banks have gone one step further, increasing the proportion of employees covered by highly defined remuneration structures: lowering the threshold for deferred compensation and increasing rates of deferrals. Below, we give examples of plans implemented by CSG and BNPP/SG:
• Close to 45% of IB staff for Credit Suisse in 2010 will see bonuses deferred for four years: We estimate that 9,000-10,000 FTE in CS’s Investment Bank (majority of front office staff) would fall within the scope of the new remuneration policy. For all IB staff with variable comp of at least SF50k, 35%-70% of bonuses would be deferred over 4 years. For executive management, MDs and Directors, deferred cash based comp would account for 50% of deferred comp and could be adjusted based on CS’s ROE - even if group ROE is positive, as long as the division is loss making, cash based deferred comp would decreaseWe assume UBS will have to implement similar rules to CSG, given that both are regulated by FINMA.
• In the Netherlands, Dutch banks adopted a voluntary code of conduct in September 2009, which included capping bonuses at 100% of salary and limiting pay to one year’s salary in the event of dismissal of a member of the executive board.
• 20-25% of CIB staff within French banks in 2009: For financial market professionals whose activities have a significant impact on the group's risk, French banks have already agreed to ban guaranteed bonuses longer than 1 year; defer at least 50% of bonuses (and 60% for the highest compensation levels) for at least three years, with at least 50% of the variable compensation paid in securities or equivalent instruments, retention period of at least 2 years for shares/equivalent instruments.
Table 21: French banks – 2009 remuneration for financial market professionals € million
Number of people Fixed
Variable paid in Mar 10
Deferred Variable* 2011
Deferred Variable* 2012
Deferred Variable* 2013
Other Deferred Variable
SG 2,600 260 223 114 114 114 7 BNP 3,972 356 508 161 225 258 0 Source: J.P. Morgan estimates, Company data. *Deferred Variable Remuneration paid in shares or share equivalents.
What’s harsher: Volcker rule or EU compensation? EU regulators have so far been more proactive on compensation than their US counterparts, with US regulators favoring the prohibition or limitation of riskier activities (e.g. Sections 619 or Volcker rules, Section 716 of the Dodd Frank bill). Whilst US regulators are reviewing compensation rules for executive management, we do not expect the same level of constraints with fewer employees impacted.
In the broader context of regulatory changes, the EU and Swiss compensation rules are significantly less punitive than the Volcker rule with its potential impact on US IBs' market making activities - for more details, please refer to our report published on 12 Jan 2011 “Regulatory Arbitrage I: Tougher than expected Volcker rules undiscounted”. Hence, in the overall regulatory context, European IBs could still benefit from regulatory arbitrage overall.
For more details, please refer to our note:
“Global Investment Banks: Regulatory Arbitrage I: Tougher than expected Volcker rules undiscounted - OW Euro IBs
Disadvantage for European IBs and generally Tier II/III IBs New restrictions on compensation would apply to EU-based banks, both the parent company and foreign subsidiaries globally. For Global IBs, it impacts key staff in EU subsidiaries. Interestingly, the FINMA rules based on CSG disclosure are even harsher than EU rules as discussed below on page 48. This would likely have a more significant impact on European IBs, effectively reducing their competitiveness and attractiveness as employers for top key employees. The overall result could be:
• Potentially less top talent moving to European IBs globally and European countries: New EU compensation rules create disincentives for top talent from US, Asia, and non Swiss Banks in Switzerland to move to European countries or Europe based IBs. As EU compensation rules would apply not only to the EU based parent institution but also to its foreign subsidiaries and branches (i.e. globally), European IBs would be less competitive in the US, Asia and other Emerging Markets. In addition, as there is scope for interpretation of the EU compensation rules by local regulators, creating potential regulatory arbitrage opportunities between EU banks based on their home country interpretation of the EU rules such in the case of retained part of the bonus (up for interpretation by the local regulator).
• Less industry cost flexibility due to increased fixed salaries: Base salaries will likely rise further to retain talent – especially driven by EU/Swiss banks to compensate for more stringent bonus rules compared to US IB peers globally. Coupled with higher salaries and in addition to more deferred compensation expenses, IBs' fixed cost will rise for key employees which would limit the cost flexibility of the IB industry in our view.
• EU Tier II/III IBs - competitive disadvantage to attract and retain talent: EU/Swiss comp rules would make it very difficult for Tier II/III IBs that do not operate a pure agency model to retain and attract talent in our view. We believe with salaries expected to increase for top employees due to new compensation rules, cost flexibility for Tier II/III IBs declines on a smaller revenue base. In a downturn this will be difficult to absorb for Tier II/III IBs in our view. In addition, with bonus guarantees limited to one year (vs. multi year guarantees), Tier II and III firms will have difficulty to attract talent to their franchise in the future.
• EU and compensation rules would also affect EU-based employees of Global IBs, however we expect Global IBs to remain relatively better positioned than European peers. Global IBs in the UK would be subject to limitations on compensation, however, Global IBs will likely still fare better than EU IBs (and Swiss), mainly due to their ability to grow aggressively in Asia and Emerging Markets where all IBs have an expansion strategy and competition for the limited talent pool will remain fierce. As employees of global IBs would not be impacted by these rules it will be easier for them to retain and attract top staff.
The ultimate winners of top talent: ‘agency’ only boutiques, and asset gatherers and in particular Hedge Funds We potentially see more opportunities for financial institutions not impacted by the new EU compensation rules such as small boutiques, niche players and asset managers, and in particular hedge funds. EU compensation rules introduce a “proportionality” provision that implies that not all institutions and staff members need to comply with the compensation rules to the same extent.
• Small positive for small IBs and organizations that use the agency model: we believe that only small IBs and organisations that use the agency model would increase in number as these can pay 100% bonus in cash and would not be impacted to the same extent by the compensation rule.
• Asset managers (solely investing client money) would be the most likely winners in our view as they can pay 100% bonus in cash and would not have the specific requirements to defer remuneration and pay bonuses in shares. A similar compensation level to top employees with no restrictions is positive for asset management firms in our view. We believe this could trigger migration of some top staff into 3rd party AM businesses. Asset Management firms could become employers of choice in our view, in particular asset managers independent from larger bank holdings.
• Hedge funds could also benefit as the EU compensation regulation makes it clear that rules should be applied proportionately to investment firms and the dividends payments to partners as owners of an institution are not covered by the guidelines. This would mean that these rules are not applicable to partners in hedge funds and therefore we believe there could be a migration of talent from banks to these less regulated entities. Hedge funds as such will be subject to separate legislation - the alternative investment fund managers’ directive (‘AIFMD’). CEBS guidelines further states that depending on the legal structure of the institution or entity, some of the remuneration requirements may not be applicable to staff at such ownerships or partnerships. The underlying principle is that when investors' money is put at risk, the investing firm's incentives should be aligned with theirs.3 Overall, hedge fund due to their highly flexible and focused cost structure will always be able to move relatively easily to jurisdictions that have limit impacts on compensations. Hence, further stringent hedge fund guidelines could drive HF firms out of the EU, especially UK in our view.
3 Frequently Asked Questions on the Capital Requirements and Bonuses Package (CRD3)
Compensation Regulation and disclosure creates an equal level playing field Compensation overview – no clarity today by IB industry As we discuss below, compensation ratios vary materially. It is unclear, however, how decisions are made between shareholder returns and retaining top talent, with compensation ratios varying between 34% and 57% for 2010E. The compensation details given by banks so far are too subjective. As a result, one could argue FINMA, EU compensation rules as well as Basel CRD3 guidelines (especially in respect to disclosure) should create a more harmonized playing field with improved comparability in compensation levels. As an example, other than CSG, no other global IB discloses its deferred compensation level. This, in our view should be unacceptable to shareholders and will be addressed through CRD3.
Table 22: Global Investment Banks: IB division 2010E $ millions CS UBS DB GS group MS BNPP SocGen Barclays Total number of employees IB 21,200 17,006 24,088 35,400 18,000 17,319 11,728 23,896 Total IB cost (clean) (mn) (13,280) (10,157) (15,653) (24,896) (11,004) (8,434) (5,982) (12,112) o/w compensation cost (clean)(mn) (8,224) (7,050) (10,103) (14,950) (6,325) (5,482) (3,888) (8,115) o/w non compensation cost (clean)(mn) (5,056) (3,107) (5,550) (9,946) (4,679) (2,952) (2,094) (3,997) Cost/Income 75% 82% 65% 63% 68% 53% 59% 62% Comp ratio (clean) 47% 57% 42% 38% 39% 34% 38% 42% Non comp ratio (clean) 29% 25% 23% 25% 29% 19% 21% 20% IB revenues (clean) (mn) 17,647 12,420 24,338 39,636 16,142 15,908 10,165 19,536 Revenues/head 832,416 730,317 1,010,361 1,119,674 896,805 918,503 866,703 817,552 Cost/head 626,415 597,275 649,824 703,271 611,359 486,973 510,076 506,882 Compensation cost/head 387,925 414,569 419,438 422,321 351,393 316,533 331,550 339,611 Non-compensation cost/head 238,490 182,706 230,386 280,950 259,966 170,441 178,527 167,271 Source: J.P. Morgan estimates, Company data. Note: We estimate CB&S comp ratio for DB as compensation expense not disclosed; Institutional securities compensation ratio for MS; GS group level Assumed 65% of CIB expenses attributable to Investment Banking for BNP and SocGen. Barcap clean annual compensation is 67% of the total Barcap cost in 2010; GS are group nos. Note Comp ratios are calculated excluding UK bonus tax.
Less competition with less top talent/performer turnover Some Top Tier IBs with strong compensation and rules management culture would argue that most of the EU compensation rules are already implemented. However, many firms pre-crisis, did not operate with compensation structure similar to those outlined in the EU compensation rules. Hence, one of the consequences of the rules is a more harmonized level playing field - not just for Code Staff in the EU, but more generally on the wider principles of risk adjustment of bonus pools, the link to profitability and governance.
Overall, the new environment and rules should mean banks are only allowed to pay their staff what the results can justify. The consequence of that, coupled with the ban on guarantees except in exceptional circumstances for one year of new hires, should be to make the Top Tier IBs stronger and Tier II/III IBs weaker, because the pay gap between the two will get wider as regulators/shareholders will refuse to allow the weaker ones to pay more than their results justify. As we outlined above the US IBs will have a relative advantage in hiring top talent and HFs/Asset managers will be absolute 'winners', but overall, in the long-term these results could result in the best talent of Tier II/III leaving for stronger competitors, especially in Europe. You could also argue that it will reduce competition in the long-run despite the US and Europe compensation regulatory arbitrage opportunity. It is certainly likely to make it very difficult for new entrants to the IB market.
Market rationally has to be questioned so…at least in the short-term as salaries increase We believe that the aforementioned view above is quite a rational way of looking at compensation behavior. Clearly, Tier II/III IBs could (and currently are in our view) increasing salaries above Tier I levels in order attract and retain talent (ie "overpay”). This is a concern as it reduces cost flexibility whilst increasing the additional deferred expense level. However, in the next downturn, Tier II/III firms may well be "caught out" with this strategy as their revenue pool is smaller and hence will likely lead to material staff reduction in order to generate a shareholder return (ie reduce fixed costs). Such a material market downturn would likely trigger a re-thinking of strategy for Tier II/II IBs from an institutional business competing with Tier I IBs to an agency only business, in our view.
CSG – toughest compensation rules so far Whilst FINMA guidance on remuneration schemes is less detailed than the EU compensation rules, the Swiss regulator seems to take a tougher stance, based on what Credit Suisse implemented, in our opinion.
FINMA guidance applies to all financial institutions in Switzerland required to maintain equity capital of at least SF2bn, which implies that most foreign subsidiaries of non Swiss based IBs would not be subject to these restrictions.
Credit Suisse compensation structure from 2010 is one of the most stringent compensation rules globally considering i) material deferral rates and relatively low deferral threshold, and ii) deferrals of up to 70%, and iii) vesting period of four years whereas most EU regulators are focusing on 3 years, and iv) awards are reduced for employees if their division is loss making.
We note the key points:
• Increase in number of employees receiving deferred variable compensation
• Significant decrease in the threshold for deferred compensation programs from CHF 125,000 to CHF 50,000 in variable awards. This implies that now more employees will have part of their bonuses deferred.
• Increase in the deferral rates to a range of 35% to 70%
• Deferred variable awards granted to members of the Executive Board, Managing Directors and Directors will be in the form of (1) Share awards (shares granted as part of 2010 variable awards will vest and be delivered over four years on a pro-rata basis between 2012 and 2015) and (2) Adjustable Performance Plan Awards (cash-based awards that will vest and be delivered over four years on a pro-rata basis). Outstanding awards will be adjusted upwards or downwards based on Credit Suisse’s return on equity (ROE) each year from 2011 to 2014 However, should a division be loss-making in one or more years between 2011 and 2014 outstanding awards for employees of that division will be adjusted downwards even if Credit Suisse's ROE is positive. The maximum upside of the proportion of variable awards granted in APPA will be the cumulative return on equity over the vesting period. The maximum downside is 100%.4
Basel 3 framework -“Building buffers through capital conservation” Bonus and dividends payout subject to the conservation capital requirement from 1 Jan 2016 Besides the EU, there are clear compensation payout rules set by Basel. The Basel Committee on Banking Supervision will require banks to have a minimum common Equity Capital of at least 7%, including a 2.5% conservation buffer to withstand future periods of stress. The conservation buffer will be phased in from 1 Jan 2016 to 1 Jan 2019. Banks that fail to meet the conservation buffer would be subject to constraints on discretionary distributions of earnings (dividends and bonuses).
According to the Basel 3 rules on the capital conservation buffer – “Basel III: A global regulatory framework for more resilient banks and banking systems” published on 16 Dec 2010, the maximum allowed earnings distribution would then be determined according to a defined table. The Basel Committee published the required levels shown in Table 23.
Table 23: Basel proposed capital conservation range %
Common Equity Tier 1 Ratio Minimum Conservation ratio
While banks are allowed to draw on the buffer during periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. For example: if a bank suffers losses such that its Common Equity Tier 1 capital ratios fall in the range of 5.75% - 6.375%, then the bank would be required to conserve 60% of its earnings in the subsequent financial year (i.e. payout no more than 40% in terms of dividends, share buybacks and discretionary bonus payments).
Increased disclosure requirements The Basel Committee on Banking Supervision has issued “Pillar 3 disclosure requirements for remuneration” seeking detailed disclosure on remuneration practices and policies on 27th Dec, 2010 for consultation. Under new proposals, banks would be required to disclose qualitative and quantitative information about their remuneration practices. Banks would, at a minimum, be expected to publish the disclosures on an annual basis and also need to disclose the number, total amount of guaranteed bonuses paid during the financial year and the total amount of outstanding deferred compensation. Remuneration disclosure tables includes complete breakdown in cash and equity, deferred and non deferred, fixed and variable etc to be completed separately for (a) senior management, (b) other material risk takers, and (c) financial and risk control staff. This would increase transparency, allowing shareholders to assess the real compensation paid out in a year compared to peers as well as comp flexibility. The consultation period closes on Friday, 25 February 2011.
Key Points from the EU Compensation Regulation At best 20% of bonuses paid upfront in cash, with the rest deferred for at least 6 month to 2 years in our view The key constraint from new EU compensation regulation is the limitation of upfront bonuses in cash to at best 20%-30% of total variable compensation, as i) 40-60% of bonuses must be deferred (60% for large bonuses), and ii) 50% of the total bonus paid (whether paid upfront or deferred) must be paid in "equity-linked instruments". CEBS guidance does not, however, specify the minimum retention period or the ratio of fixed to variable component.
In our view, as bonuses for the employees affected by the rules would fall into the higher range within the bank, at least 60% of bonuses will be deferred for them, which would imply that at best 20% of bonuses can be paid in cash upfront.
• Between 40-60% of bonus must be deferred over at least 3-5 years (depends on category of staff); for the managers should be longer. We would however expect 60% of bonuses to be deferred given that bonuses of identified staff would fall within the top of the bank's range. Payments should not take place more frequently than on a yearly basis.
• 50% of bonus must be paid in the form of “equity-linked instruments” and there shall be an appropriate balance of shares and contingent capital instruments. This provision is applicable to both deferred and non deferred components. Therefore in effect amounts to 20% cap (50% of 40%) or a 30% cap (50% of 60%) on upfront cash bonus. Over 50% of bonuses could be paid in equity-linked instruments, however we do not expect firms to go beyond that minimum and assume 50% of deferred bonuses would be paid in cash.
• There is a minimum retention period for the instruments that has already been vested or paid out. The retention period should be determined by the institutions. CEBS doesn't provide any specific period but provides certain examples (which we have discussed below) on how a minimum retention period should be sought. We expect the retention period to be between 6 months and 2 years, at the discretion of the regulator.
• Remuneration should be an appropriate balance of fixed and variable proportion; institutions should set a maximum appropriate ratio of fixed to variable component for different classes of identified staff. However, there is no range set.
Other requirements include:
• No multi-year guarantees.
• No personal hedging on deferred and retained bonus; no rewarding of failure in case of severance payments.
• Shareholders must be given more information on staff pay in order to increase transparency allowing shareholders to assess the real compensation paid out in a year compared to peers as well as comp flexibility in our view.
• Government supported institutions could also be required not to award any bonus as long as the government support is not yet paid back, or until a recovery plan for the institution is implemented/accomplished.
• Regulators should intervene if they think bonuses are detrimental to the maintenance of a sound capital base.
Scope of application: key staff – the revenue generators EU compensation rules are applicable to senior management, risk takers, heads of control functions, and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers and whose activities mean that they could have a material impact on the firm’s risk profile. It is for the institution to determine its own scope of Identified Staff.
These rules apply to all EU banks whether they are based inside or outside the EU and only to the European arms of non-EU banks. For EU-based banks, compensation rules would apply not only to the parent institution, but also to foreign subsidiaries globally.
EU compensation rules introduce a “neutralization” provision which implies that identified staff does not need to comply if the subsidiary doesn’t have a material impact on the risk of the firm or if the firm has a lower prudential risk profile.
• The neutralization provision allows EEA parent to ‘neutralise’ the pay requirements in relation to a non-EEA subsidiary if the subsidiary has a different business model and as long as the subsidiary doesn't have a 'material impact' on the risk of the whole firm.
• Further, CEBS states that in order to meet a proportionality principle, firms and staff members can "neutralize" some requirements if they have a lower prudential risk profile. This means that some firms, either for all or some of their staff can put aside the requirements on bonus in equity linked instruments, retention or deferral. CEBS did not provide any such guidelines in its previous draft guidelines. The revised guidelines have included further neutralization of some requirements and therefore we believe that these guidelines are much better than expected and are going to impact only key people who have a material impact on the risk profile of the institution.
EU compensation rules introduce a “proportionality” provision which implies that not all institutions and staff members need to comply with the compensation rules to the same extent.
• EU comp rules apply to all credit institutions and investment firms, with “proportionality” provisions depending on size and complexity of the institution. It is for the institutions to identify staff that has a “material impact” on risk.
• Proportionality applies in principle to all remuneration provisions, proportionality amongst different kinds of institutions and different category of staff which implies that not all institutions and staff members need to comply with these rules to the same extent.
Who’s impacted? 200-300 key employees per IB, in our view In our view, these rules are not going to affect a significant number of employees although it does impact key people. We believe out of several thousands of employees only 200-300 key people such as risk takers are going to be impacted by these rules. However, these key people play an important role in generating revenues for the firm.
Table 24: Number of employees - Geographical distribution - 2009 CS UBS DB GS MS Total employees 47,600 65,233 77,053 32,500 61,388 o/w in EMEA 29,700 34,573 49,391 8,160 6,463 o/w in Asia Pacific 6,400 6,849 16,489 5,440 4,386 o/w in Americas 11,500 23,810 11,173 18,900 49,682 Total employees (IB) 19,400 15,666 20,000 24,500 17,000 Source: Company reports and J.P. Morgan estimates; 2009 data Note: 1.For GS and MS number of employees estimates are based on the geographical revenue breakdown 2.For CS and UBS EMEA also includes employees in Switzerland
We note that these numbers are quite small as compared to the number of employees who were affected by the FSA code in 20095 . The FSA reviewed its last year’s policy on the deferral arrangements covered by its code for the following two groups
• major wholesale/investment banks – includes UK based staff of seven major international banking groups; and
• major UK banking groups − includes six major UK banks. In most cases, these figures cover staff in global operations, including investment banking.
Over 3,900 employees were identified as “P8 employees” by the 13 firms in the above two main peer groups. Almost 2,800 of them came under the code because they earned at least £1m and remaining 1,100 were in Significant Influence Function (SIFs) and firm designated risk takers.
Figure 1: Breakdown of employees impacted by FSA code
0
500
1000
1500
2000
7 Major Wholesale/Inv estment banks 6 Major UK Banking Groups
Significant Influence Function and firm designated risk takers Earnings abov e £1m
Source: FSA; CP 10/19 Revising the Remuneration Code
Also, as reported in Deutsche Bank Group Remuneration Report 2009 where it discloses as per the voluntary self-commitment referencing the BaFin Circular 22/2009 & the Financial Stability Board (FSB) Principles for Sound Remuneration:
“For the financial year 2009 the identified risk taker population in all divisions globally received fixed pay of €367m and variable components consisting of €921m cash paid in February 2010 and deferred awards. Therein, as per the BaFin requirements, are a population of 28 so called “Geschäftsleiter” which are the members of the Group Executive Committee (GEC) and the Management Board members and “Geschäftsführer” of selected German subsidiaries. Specific clawback provisions have been introduced for the group of the “Geschäftsleiter”. The deferred awards are all subject to the Banks future performance. €961m of the deferred awards were granted in the form of restricted equity awards which are deferred over 3.75 years and tied to the future share price of DB. €317m of the deferred awards were granted in the form of restricted incentive awards deferred over 3 years and tied to the Group NIBT and a Variable Adjustment based on RoE less cost of funds. For the population above, on average nearly 60% of the variable compensation is deferred and subject to future performance and clawback – this is compliant with BaFin and FSB requirements”.
As some of these requirements were already there in the previous codes such as FSA (PS09/15 Reforming remuneration practices in financial services) and BaFin Circular 22/2009, we believe that as new EU rules are not going to impact significant number of employees. We assume the new EU compensation rules impacts about 5-10 times as many people as were impacted by the BaFin Circular 22/2009 which is limited in our view.
Key Requirements At best 20% of bonuses paid upfront in cash At least 40 % of the bonus (60% for large bonus) should be deferred over minimum of 3-5 years and correctly aligned with the nature of the business, its risks and the activities of the member of staff; and is paid or vests only if it is sustainable according to the financial situation of the credit institution as a whole, and justified according to the performance of the credit institution, the business unit and the individual concerned. This measure leaves it to the national supervisory authorities to decide what a "large" bonus means in their economies for this purpose based on the CEBS guidelines.
At least 50% of any variable remuneration should be paid in equity linked instruments consisting of an appropriate balance of:
• shares (or equivalent ownership interests) or share-linked instruments (or equivalent non-cash instruments (alternative instruments) , in the case of a non-listed institution) and
• other instruments reflecting the credit quality of the credit institution as a going concern (refers to a specific subset of so-called Tier 1 hybrid instruments; interpreted as some form of contingent capital or subordinated debt)
And this 50% threshold for instruments must be applied equally to the non-deferred and the deferred part. Further, national supervisory authorities may place restrictions on certain instruments as appropriate.
This would imply that at best 20% of bonuses are paid in cash upfront for large bonuses received by the identified staff: bonuses that fall into the scope of the rules are likely to be at the higher range within the bank, and as a result, would incur the higher deferral rate, i.e. 60%. This would imply that at best 20% of bonuses are paid in cash upfront, in our view.
We provide two examples to explain how the upfront and the deferred component could be paid out in cash and instruments. In the first example we assume the cash/instruments ratio as 50/50 for three different deferral schemes. In the second example we assume the cash/instruments ratio as 40/60.
Table 25: Payout process for cash/instruments ratio 50/50 with different deferral schemes % Upfront 60% 40% 30% o/w cash 30% 20% 15% o/w instruments 30% 20% 15% Deferred 40% 60% 70% o/w cash 20% 30% 35% o/w instruments 20% 30% 35% Source: CEBS.
Table 26: Payout process for cash/instruments ratio 40/60 with different deferral schemes % Upfront 60% 40% 30% o/w cash 24% 16% 12% o/w instruments 36% 24% 18% Deferred 40% 60% 70% o/w cash 16% 24% 28% o/w instruments 24% 36% 42% Source: CEBS
In our view, the deferred component of the compensation is most likely to be paid 50% in cash, unless stipulated by national regulators. CEBS requirement is that a minimum of 50% is paid in stock, which means 50% cash. Firms could pay beyond 50% in stock for deferred bonuses, but we would not expect that. The cash will get very low interest income in our view, due to the CEBS guidelines prohibiting ex-post upward revision of deferred cash awards.
Deferral period of 3-5 years The minimum deferral period is 3-5 years, depending on the potential impact of the staff on the risk profile of the institution. CEBS requires institutions to consider longer deferral periods at least for the members of the management body in its management function. However, we assume that the deferral period would be 3 years for the majority of the identified staff.
Deferral payment can be done once at the end of the deferral period or may be spread out over several payments during the deferral period. The first vested amount should not be sooner than 12 months, vesting can take place on a yearly basis as shown in Figure 2, but no faster than annually.
Figure 2: Payout schedule deferred equally over a period of three years
Source: CEBS, Note: Assumptions Deferred/Non deferred: 60/40; deferred equally over a deferral period of three years
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
rate Deferral Period n n+1 n+2 n+3 n+4 n+5 n+6 n+7
40% 3 years Cash 30% Instruments* 30%
Cash 20% Instruments* 20%
60% 5 years Cash 20 % Instruments* 20%
Cash 30% Instruments* 30%
70% 7 years** Cash 15% Instruments* 15%
Cash 35% Instruments* 35%
Source: CEBS. Note -1) * Instruments paid out or vested subject to minimum retention period. ** Estimated longer deferral period for the members of the management body in its management function. Assumption: Cash/Instruments ratio 50/50.2) ‘n’ represents the one year accrual period during which the performance of the staff member is assessed and measured for the purposes of determining its remuneration.
Further, if institutions decide to determine the proportion that is being deferred by cascade of absolute amounts (rather than percentages of the total variable remuneration - e.g. part between 0 and100: 100% upfront, part between 100 and 200: 50% upfront and rest is deferred, part above 200: 25% upfront and rest is deferred ...), supervisors will review that on an average weighted basis such institutions respect the 40 to 60 % threshold.
Retention Period – 6 months to 2 years in our view Further, there should be a minimum retention period determined by the institution during which any bonus that has been paid out or vested in the form of instruments cannot be sold. This minimum retention period is independent from the deferral period and can be shorter or longer than the deferral period. The retention period should be determined by the institution. Supervisors shall then determine whether the retention periods proposed by the institution are deemed to be sufficient and appropriate.
We would expect that the retention period would be in the range of six months to two years, at the discretion of local regulators.
In Figure 3 it is assumed that the payment is made once at the end of the deferral period.
Figure 3: Payout process for 40 % bonus deferred over a period of three years
Source: CEBS, Note: Assumptions: 50/50% cash/instruments ratio; Deferred/Non deferred: 40/60; Deferral payment done once at the end of the deferral period
As shown in Figure 3, the retention period for the deferred instruments comes after every vested portion. CEBS does not provide any specific duration for the retention period. However, it provides certain examples on how the appropriate retention period should be sought.
For example:
• Shorter retention period could be considered: when there is a deferral period of five years or more, or where institutions measure the performance of their staff over multi-year accrual periods, On the other hand, a longer period may be considered in cases where the risks underlying the performance can materialize beyond the end of the minimum retention period. Furthermore, it would be appropriate to apply longer retention periods for staff with the most material impact on the risk profile of the institutionl.
• It is possible that a retention period lasts for a shorter period than the deferral period of minimum three to five years applied to the instruments that are not paid up front as shown in Figure 4 below. However, as an example of proportionality, for their most senior staff, large and complex institutions should consider the use of a retention period for upfront paid instruments that goes beyond the deferral period for the deferred instruments.
Figure 4: Payout process for 40 % bonus deferred over a period of three years
Source: CEBS, Note: Assumptions: 50/50% cash/instruments ratio; Deferred/Non deferred: 60/40; deferred equally over a deferral period of three years
In Figure 4, CEBS assume a base case where a total bonus €100,000 is paid with an assumption of 50/50 cash/instruments, 40% deferral bonus deferred over a period of three years for a certain category of “identified staff”. In its base case, CEBS assume the retention period for the bonus paid in instruments for upfront to be 2 years and for deferred to be 1 year. So, the staff would receive €30,000 in upfront cash and €30,000 in upfront instruments and the amount paid in upfront instrument would have a retention period of two years. Similarly, the deferred part of the compensation would be €20,000 in cash and €20,000 in instruments. Again, the bonus paid in instruments would be further subjected to one year retention period during which one cannot sell these instruments.
It is important to note that the upfront payment of instruments with a minimum retention period of 3 years is not equivalent to deferred instruments. Deferred instruments are subject to an ex-post risk adjustment by means of malus arrangement or clawback clauses. While in case of upfront paid instruments, although the staff cannot sell the instruments for the given retention period but the institution cannot change the number of instruments it has granted. A retention period is not a substitute for a longer deferral period. CEBS, in its revised guidelines, have further emphasized the difference between deferral and retention periods and have added some further proportionality for retention periods of deferred instruments.
Fixed vs variable There is no limitation to the fixed component of the remuneration but the fixed and the variable components should be appropriately balanced; fixed components should be sufficiently high to allow the operation of a fully flexible variable remuneration policy, including the possibility to pay no bonus. This would lead to higher salaries. Press reports seem to suggest that some banks like HSBC and Barclays have already begun adjusting base salaries up in view of the bonus curbs6.
An explicit appropriate maximum ratio on the variable remuneration compared to the fixed remuneration should be set by an institution; may vary across the staff, according to market conditions and the specific context in which the financial undertaking operates. However, CEBS doesn’t prescribe the ratio but criteria to determine this ratio; it is for the institutions to set this ratio. Nevertheless, CEBS indicates that the separation between the fixed and variable components must be absolute. There must be no leakage between these two components.
The ratio between fixed and variable remuneration must be determined at the moment of initial performance measurement, independent of any future ex-post risk adjustments or fluctuation in the price of instruments. The appropriate balance is to depend on:
• the quality of performance measurement and associated risk adjustments;
• the length of the deferral and retention periods;
• the legal structure of the institution, kinds and scope of the activities;
• business types and which risks are involved;
• category and level of staff.
We believe that this will have an adverse impact on the cost flexibility of the banks. The new EU rules would further increase pressure on the cost base and make it more rigid. In our view, in order to retain talent, banks will pay higher salaries and hence increase fixed cost. Deferred expenses related to prior year compensation would also rise which would in turn further push up the fixed costs. Increasing fixed costs would increase pressure on the cost base; an institution will not be able to reduce or cut expenditure in a poor financial year which would lead to an unacceptable cost/income ratio in our view.
Although according to the CEBS guidelines, it is up to the institutions to determine the appropriate maximum ratio on the bonus compared base salary. We note that in the Netherlands, Dutch banks adopted a voluntary code of conduct in September 2009, which included capping bonuses at 100% of salary and limiting pay to one year’s salary in the event of dismissal for members of the executive board. 7 The Banking Code applies to all activities in the Netherlands performed by banks that are in possession of a banking licence granted under the Financial Supervision Act (Wet op het financieel toezicht (Wft), irrespective of whether they perform their activities in the Netherlands or in another Member State, and irrespective of whether those activities are performed by a branch.
6 Source: Reuters Article: “Some bankers may escape EU cash bonus limit” dated on Dec 10, 2010. http://uk.reuters.com/article/idUKTRE6B93F220101210 7Code Banken published on 9th Sep 2009 http://www.nvb.nl/scrivo/asset.php?id=534018
Scope of Application Institutions Applies to all credit institutions and investment firms falling within the scope of MiFID, with “proportionality” provisions depending on size and complexity of the institution
Credit Institutions Defined in Article 4(1) of Directive 2006/48/EC as undertakings whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account
Investment firms Defined in Article 4 (1)(1) of Directive 2004/39/EC on markets in financial instruments (MiFID) and to which the MiFID requirements apply with respect to any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis. However, certain exemptions apply and these are specified in Directives 2004/39/EC and 2006/49/EC. These exemptions can include institutions which are only authorized to provide the service of investment advice and/or receive and transmit orders from investors without holding money or securities belonging to their clients
Applies to all firms within an EEA consolidation group, any subsidiary of an EEA parent institution that is located offshore, including in a non-EEA jurisdiction and at the solo or EEA-based level, where the EEA subsidiary is part of a wider non-EEA group.
Additionally, where staff members are formally employed by a parent company based in a non-EEA jurisdiction, but perform duties/services for an EEA-based institution, then the remuneration requirements of the EEA jurisdiction where the staff member is actually working should be followed for the remuneration paid to these staff members.
Identified staff The Commission’s intention is that the rules apply to anyone whose professional activities have a material impact on the institution’s risk profile. It is primarily the responsibility of institutions to identify the members of staff whose professional activities have a material impact on the institution’s risk profile according to CEBS guidelines and any other guidance or criteria provided by supervisors.
As given by CEBS following categories of staff, unless it is demonstrated that they have no material impact on the institution’s risk profile to whom the specific remuneration principles apply, must include:
• Executive members of the credit institution or investment firms’ corporate bodies, depending on the local legal structure of the institution,
• Senior Management responsible for day-to-day management, such as: the members of the management committee not included in the category above;
• Staff responsible for independent control functions.
Regulatory Arbitrage III: Section 716, pushing part of derivatives out of the US depositary bank What is section 716 Section 716 of the Dodd-Frank Act will require banks to separate their derivative business from those banking entities that are able to tap Federal Reserve credit facility or discount window, usually the one with the word ‘bank’ in its name. It will require creation of a swap entity (or use of a current non-bank entity such as e.g. broker-dealer) that will need to be capitalised and funded outside of the US bank entity. The main motivation behind the swap push-out was to prevent the risk of committing taxpayers’ money to bail out banks’ derivatives trading operations. However, the new entity can still be debt financed by the group holding – in our view this would have to be done at a relative high cost-of-funding.
In terms of product reach, Section 716 exempts interest rates, FX, centrally cleared CDS on investment grade names, bullion and base (physical) commodities. All remaining asset classes would fall under the scope. It includes in particular equity derivatives business, high yield or non CCP cleared credit, CDS on emerging markets underlyings and the part of commodity business that does not fall into exemption mentioned above. Finally only new business will need to comply with the new rules.
Figure 5: Exemplar structure of the universal bank pre and post implementation of Section 716
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.
Section 716 – pushing part of derivatives business out of the US depositary bank. The motivation behind the regulation is that taxpayers’ funds are not used to support potentially distressed derivative businesses. Historically, global universal banks used their balance sheets’ strength (funding and capital) to serve both their retail/commercial and investment banking arms.
As a result investment banking divisions often enjoyed lower funding costs of the retail bank and relatively low capital adequacy requirement which was calculated on the group level, rather than on the division level.
Pure investment banks such as e.g. Goldman Sachs or Morgan Stanley became FED regulated (rather than SEC regulated) during the recent financial crisis in order to obtain FED funding. However, they retained a structure which separates their investment banking from retail/commercial banking.
Section 716 therefore impacts those banks that carry derivatives activity out of the banking entity - BofA, Citi, Goldman Sachs and to some extent HSBC, according to the OCC (Office of the comptroller of the currency) data. In this case derivative activities will need to be segregated into a separately funded and higher capitalised entity. It is worth noting that in terms of the notional, only a relatively small proportion of the derivative activities will fall under Section 716. The largest derivative transactions are concentrated in the area of rates and fx, that are entirely outside of the scope of Section 716. This is important for Goldman Sachs with almost 99% of derivatives trades notional that is carried out from the banking entity belongs to the out of scope assets.
The remaining areas that fall into the scope of our analysis on Section 716 include equity derivatives, credit derivatives and part of commodity derivatives with BofA, Citi and HSBC most impacted, in our view.
Implementation deadlines Although the law is now final, the rules are in the process of being consulted with relevant organizations and the banking community. Compared to other acts such as e.g. Volcker rule, prohibition of assistance to swaps entities has a reasonably long agency rulemaking period of 24-months ending in October 2012. In case an insured depositary institution is considered a swap entity, it will have another 2-year period to divest its swap activities or cease activities that require separation, hence the final implementation deadline is likely going to be October 2014.
Regional scope – will European IBs have an advantage? Most likely yes, at least initially In terms of the regional impact of the regulation two main issues remain unclear. First, who will be impacted by the bill? It seems unavoidable that US banks on US transactions will be affected. However, the act does not specify if foreign banks with US FDIC insured entities would fall under similar treatment. We take a view that Section 716 will impact those entities that run insured depositary operations in the US on all transactions booked in the insured depositary institution in the US. For example, a European bank with a banking entity in the US (such as e.g. BNPP, HSBC, RBS) will be impacted by the new regulation on derivatives contracts written out of this particular entity.
Secondly, the question remains of what type of activities are likely to fall under the scope of Section 716. Are these activities with the US clients only or all derivative activities internationally in the case of US depositary institutions? For the purpose of our analysis we assume that international business that is ultimately booked in the depositary institution will be impacted. We do believe that the regulation will become global because otherwise it would create regulatory arbitrage opportunities as US banks would simply write derivatives out of e.g. their London branches. Our interpretation of the rules means that US banks will be at a disadvantage compared to, for example, their European peers. We also take a view that the playing field will be not leveled at least in the nearest future as we are still yet to hear about similar regulations implemented for other regions.
Therefore for the time being the US banks running derivatives business out of the US banks such as BoA, Citi and HSBC are facing a real risk of lower competitiveness, in our view. The impact is likely going to be more of a qualitative than quantitative nature and will depend on the approach banks will adopt in order to deal with the new requirements of Section 716. Below we present several options in detail.
Various implementation solutions possible for those impacted Those banks that operate a derivatives business out of the insured depositary entity will have at least three potential solutions at hand. Each option carries significant amount of operational burden as clients will need to change the entity with which they are dealing with. This can potentially lead to lost revenue in the transition period as well as a permanent loss of customers that will not be happy to take the extra burden of documentation work.
1. First, banks may choose to move only impacted derivatives trades into the entity that is outside of the bank. For example a bank may decide to set up a separate entity that will serve as a counterparty only in affected transactions. This would clearly create additional operational burden as customers would need to trade with different entities when dealing with in-scope and out-of-scope products. This solution creates a number of other internal issues, for example, trading derivatives in one entity and hedging them in another one, risk management of separate entity, IT systems complexity etc, that may convince the bank to adopt other approaches outlined below.
2. Second, banks may choose to separate parts of business that are most impacted by the bill. For example banks may decide to push out the US equity derivatives business to become an affiliate company to the bank, but keep the cash equity business in the bank entity. The extent to which the business is viewed as impacted will vary from bank to bank.
3. The third option would be to separate the entire investment banking activities from those of the commercial bank. This solution, whereas desirable from an organisational point of view as it keeps most of the interrelated business together is clearly the most cost intensive one in terms of potential financing cost.
We expect that banks are most likely going to adopt option 1.
The structure of a bank defines the potential impact – universal banking model most affected As mentioned earlier, Section 716 requires the separation of depository banking activities from derivatives activities. The impact on banks that already operate their derivatives business outside of the insured depositary operations will be negligible, compared to banks that operate the universal banking model out of a single entity.
The latter ones will need to set up a new swap entity to carry derivatives operations or to move them to other existing non FDIC entities. An example of how such entity would be structured/financed is depicted inFigure 5. We assume that the new entity will be an affiliate of the member bank and therefore will operate within the trading restrictions as defined in Section 23a) and 23b) of the Federal Reserve Act. These regulations limit the ability of a US depositary institution to transact with its affiliates. The new swap entity will be able to obtain the funding from the holding company, however in our view this would have to be done at close to market cost-of-funding levels. The purpose is to protect banks, which have their deposits insured by the FDIC, from suffering losses on transactions they engage in with their affiliates.
Section 716 impact on capital requirement vs funding needs The new entity will have to be financed in the form of both equity and short term funding or long term debt. Firstly, the new entity will need to be highly capitalized, most likely above the 10% often assumed for the investment banking activities. Additional capital charge will be required to obtain desirable rating in order to secure market funding at acceptable cost.
We assumed that this will be achieved through a 15% core tier 1 capital ratio as derivatives operations are relatively risky compared to other banking activities. It is in fact a justifiable question for investors to ask what cost of equity should derivatives business be charged at. This also translates into the cost of debt issued by the entity that conducts derivatives business but does not have the safety net of obtaining funding from FED. Highly balance sheet intensive operations may no longer provide return on capital above the cost of equity and hence may be discontinued. Almost surely though US banks will be disadvantaged compared to their European peers due to higher cost of funding.
In normal market conditions highly capitalized entity should be able to obtain funding in the uncollateralized CP or debt market or collateralized via repo transactions. It can still be funded from the parent company, however in such case the funding rate should be at the market level. The swap entity will not be able to use Fed discount window lending through the bank though (as highlighted in Section 716).
With respect to the funding, not all assets will need to be funded externally as part of the business often provides desirable sources of funding. For example, capital protected equity derivatives business is a relatively stable source of long term funding as these products are net long cash for the issuer.
Which banks run derivatives business out of their US bank entity? In order to assess the impact of Section 716 on each individual bank we look at the size of the derivatives business done within its US bank entity compared to the holding company. Whether a bank does its derivatives business out of the US bank is the single most important differentiating factor because the act applies to entities having a status of a ‘bank’ rather than other operations conducted in the holding company outside of the bank.
In Table 28 and Table 29we present the breakdown of derivatives business of the top 25 holding companies as well as the top 25 banks in the US at the end of the third quarter 2010. This data proves very useful for our analysis as it allows us to calculate whether derivatives operations are being run from the bank (and therefore impacted by Section 716) or the holding company (not impacted).
• The derivatives business appears heavily concentrated with the biggest 4 players - make up $220Trn, or nearly 95% of the derivatives covered in the report.
• The amount of business run from the banking entity (and therefore impacted by Section 716) varies greatly from 100% for Citi, 88% for Goldman, 70% for BoA and negligible amount in the case of Morgan Stanley.
Table 28 and Table 29also provide the breakdown of the derivatives business by the type of instruments with biggest notional coming from OTC contracts such as swaps (most likely interest rate swaps), forwards, options and credit derivatives. The relatively small notional are traded on exchange in the form of futures and options.
The following are the key conclusions from the data provided in Table 28 and Table 29:
• European banks do not run their businesses out of their US entities, or their derivatives operations are immaterial which makes them immuned to Section 716. This is because they either feature low in the ranking or do not appear in the table at all. The lack of a derivatives presence in the US banking entities is perhaps not surprising given their headquarters and IB operations are in Europe. Most derivative contracts will be written out of the legal entity that holds capital, which, in the case of European banks, will almost certainly be based and regulated in Europe.
• Bank of America, Goldman Sachs, Citigroup and HSBC conduct the majority of their holding operations in terms of notional out of their bank entities (Bank of America NA, Citibank National and Goldman Sachs Bank USA, HSBC Bank USA National, respectively) and are therefore affected by Section 716. We have also adjusted by the approximate proportion of the revenues derived from the US to calculate the RWA exposure.
• Goldman Sachs’s operations are mainly out-of-scope interest rate products and HSBC’s derivatives business is relatively small in the US. Morgan Stanley does almost all of its business outside of the Morgan Stanley Bank entity, therefore remains largely unaffected in the bank.
• Finally, we envisage that there will be a shift in terms of regulatory focus putting pressure on banks to move away from a branch network system to a legal entity system.
Derivative assets impacted: equity and part of credit are in, but rates and fx stay out of the final version of the bill. Although Section 716 is often called a swap push-out bill, it refers to a broad definition of swaps that encapsulates most derivative contracts. According to the final version of Section 716 there is going to be no impact in swaps on the following underlyings: interest rates, FX, centrally cleared CDS on investment grade names, bullion and base (physical) commodities.
• Excluded business lines are flow and exotic rates and currency markets, developed world flow CDS (as EM credit is unlikely going to be cleared) as well as part of the commodity business.
• The areas impacted by the bill include: equity derivatives business: delta -1 swaps, flow derivatives, exotics and hybrids. In credit, exotic and hybrid business, high yield or non CCP cleared CDS, CDS on EM underlyings and the part of commodity business that does not fall into exemption mentioned above.
Finally transactions used as derivative hedging will also be excluded from the reach of Section 716, however what constitutes a hedging activity still remains unclear.
It is worth noting that Section 716 applies to new transactions only. Therefore existing ones will be grandfathered.
Table 30 provides some insight into the product split of the US biggest 25 banks in derivatives.
• Overwhelming majority of transactions is transacted over the counter with exchange traded products accounting for less than 10% of business in most cases.
• Moreover if US banks engage in derivatives they trade mostly interest rates derivatives that comprise around 84% of total derivative notional followed by foreign exchange 8% and credit derivatives 6%, all outside of scope of Section 716.
The top 4 US banks with the highest derivative exposure in products other than rates and foreign exchange are Bank of America, Citibank, HSBC Bank USA and Goldman Sachs Bank. Notional exposures amount to $5.0Trn, $2.8Trn, $0.8Trn and $0.5Trn, respectively, providing the upper limit to the amount of assets impacted by Section 716. This is because the break-down provided by OCC (Office of the comptroller of the currency) does not account for the fact that, among others, cleared high grade CDS or certain commodity derivatives fall outside of the scope. On average this upper limit is around 8.3% of all derivative assets for the top 25% banks, with the median of 4.45%.
Assessing the final impact – manageable capital shortfalls Our analysis shows that most banks in our global investment and wholesale banking universe will not be materially impacted by the introduction of Section 716. The only three banks with material asset impact are BofA, Citi and HSBC with RWA in the impacted businesses of around $39Bn, $10Bn and $16Bn, respectively (Table 31).
We estimated these exposures in a four step procedure
• Firstly, we estimated investment banking revenues per business line (Table 12)
• Secondly we calculated RWA exposures in different derivatives businesses by distributing the total amount of RWA according to revenues generated in each investment banking business line (assuming constant IB Revenues/RWA across businesses) except from cash equities that we assumed to carry no RWA.
• Thirdly, in each business line we subjectively applied proportions of assets impacted by Section 716. For example, we assume 80% of equity derivatives impacted compared to only 30% of global emerging markets (GEM).
• Finally, using the data on the notional of derivative business presented in Table 28, Table 29 and Table 30we calculated the upper limit of the derivative business falling under the scope of Section 716 (non rates and non fx derivatives run out of the bank).
As mentioned in earlier sections, the new entity will need to be well capitalized before it becomes a self-funded entity. Therefore we envisage that the swap entity will require around 15% of core tier one capital and hence there will be a capital shortfall of around $2.0Bn, $0.5Bn and $0.8Bn for BofA, Citi and HSBC, respectively (Table 31). In terms of the impact on 2012 Core Tier 1 ratios on these three companies, these are likely to drop by around 0.1% as a result of the introduction of Section 716, based on our assumptions.
Health warning. Calculations on the capital impact presented above have been performed making several relatively strong assumptions. We assumed that global risk weighted assets are distributed according to revenues generated in each business segment. Therefore we believe that especially equity derivative exposures can be distorted. Secondly OCC data that we use do not have enough granularity to assess exactly what proportion of assets falls in scope of Section 716 and we used the upper limit in the calculation. As a result the overall impact might be overestimated.
Table 31: Global investment and wholesale banks RWAs and capital impact $ million
GS MS UBS CS DB BNP SocGen Barclays HSBC RBS Citi BofA
Non-rates non-fx derivatives business, carried out of the US entity as % of global revenues 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 4.2%* 0.0% 3.0%* 8.0%*
Fixed Income Markets % of business impacted SPG 40% 0 0 0 0 0 0 0 0 1,312 0 2,524 13,035 Credit Trading 40% 0 0 0 0 0 0 0 0 3,759 0 1,431 10,267 FX & Rates 0% 0 0 0 0 0 0 0 0 0 0 0 0 GEM 30% 0 0 0 0 0 0 0 0 7,675 0 2,595 4,487 Commodities 40% 0 0 0 0 0 0 0 0 0 0 379 688 Prop trading/hedge gains/others 0% 0 0 0 0 0 0 0 0 0 0 0 0 Total Fixed Income Markets RWA impacted 0 0 0 0 0 0 0 0 12,745 0 6,929 28,477 Equity Markets Equity Derivatives 80% 0 0 0 0 0 0 0 0 1,851 0 2,483 10,002 Cash equities 0% 0 0 0 0 0 0 0 0 0 0 0 0 Prime brokerage 10% 0 0 0 0 0 0 0 0 1,279 0 218 796 Prop trading/other equity-related 0% 0 0 0 0 0 0 0 0 0 0 0 0 Total equities RWA impacted 0 0 0 0 0 0 0 0 3,130 0 2,701 10,798 Total bank RWA impacted 0 0 0 0 0 0 0 0 15,875 0 9,630 39,274 Capital charge at 15% Core Tier 1 ratio 15% 0 0 0 0 0 0 0 0 2,381 0 1,445 5,891 Current charge at 10% Core Tier 1 ratio 0 0 0 0 0 0 0 0 1,588 0 963 3,927 Capital shortfall 0 0 0 0 0 0 0 0 -794 0 -482 -1,964 Basel 3 Core Tier 1 capital before Section 716 85,240 43,880 41,104 28,191 35,021 60,655 34,642 44,993 141,411 54,633 163,572 161,427 Basel 3 Core Tier 1 capital after Section 716 85,240 43,880 41,104 28,191 35,021 60,655 34,642 44,993 140,617 54,633 163,090 159,464 Basel 3 Core Tier 1 ratio before Section 716 12.1% 9.4% 13.8% 8.6% 6.8% 8.4% 7.4% 9.0% 11.01% 8.4% 12.31% 8.41% Basel 3 Core Tier 1 ratio after Section 716 12.1% 9.4% 13.8% 8.6% 6.8% 8.4% 7.4% 9.0% 10.95% 8.4% 12.27% 8.31% Source: J.P. Morgan estimates. Note: 1. RoRWA is estimated on the group level over the last 9M Revenues/RWA (cash equities are assumed to carry no RWA risk). 2. We adjust for the proportion of US derived revenues to total revenues
Valuation Methodology and Risks Barclays (Neutral; Price Target 320p) Valuation Methodology Our Dec-11 target price of 320p is based on our sum of the parts analysis. Risks to Our View We believe the key risks that could prevent our price target and rating from being achieved are regulatory risks. Barclays has lower exposure to UK mortgages than UK peers and potentially better customer asset quality. Nevertheless, through Barclays Capital, it is significantly exposed to the fixed income cycle and the corporate credit cycle while Barclaycard gives high exposure to consumer credit. Given the high dependence on investment banking activities Barclays is vulnerable to a slowdown in volumes and/or further deterioration in the economic environment which could result in higher writedowns. Barclays is also exposed to the economic cycle through its lending exposure in particular to the UK credit cycle, South Africa and Spain. Being a retail bank it is also exposed to the interest rate environment.
Goldman Sachs (Neutral; Price Target $175.00) Valuation Methodology Our Dec 2011E sum-of-the-parts based price target for Goldman Sachs is $175. Note that our SoP multiples are differentiated by business and franchise quality, and the IB multiple is adjusted for regulatory uncertainty. Risks to Our View We believe the key risks (both on the upside and downside) that could keep our rating and target price from being achieved include the following: · The performance of the capital markets , impacting both the investment banking capital markets business (especially fixed income) as well as the performance of Goldman Sachs’ assets under management. · Despite decent risk reductions, liquidity and mark-to-market risk remains in Goldman Sachs’ legacy assets such as leverage finance, residential and commercial real estate and other structured credit assets. In addition, other assets such as credit card loans, consumer finance and other ABS could potentially become an issue. · Funding risk with Goldman Sachs being predominantly wholesale funded could become a material issue should credit markets freeze up. · The US, as well as global economies could experience a 'double dip’ with a corresponding deterioration in credit quality and weaker revenues, impacting Goldman Sachs profitability. · Legal risk coming out from the structured credit and financial market crisis could become a material issue both from a financial and reputational perspective. · Regulatory risk with the proposed changes in Basel rules and financial reform in OTC derivatives could significantly reduce profitability of the group.
Companies Recommended in This Report (all prices in this report as of market close on 04 March 2011) Barclays (BARC.L/313p/Neutral), BNP Paribas (BNPP.PA/€53.21/Overweight), Credit Agricole (CAGR.PA/€11.99/Neutral), Credit Suisse Group (CSGN.VX/SF 40.92/Overweight), Deutsche Bank (DBKGn.DE/€44.66/Neutral), Goldman Sachs (GS/$161.00/Neutral), Morgan Stanley (MS/$28.44/Overweight), Société Générale (SOGN.PA/€47.52/Overweight), UBS (UBSN.VX/SF 17.96/Overweight)
Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.
Important Disclosures
Important Disclosures for Equity Research Compendium Reports: Important disclosures, including price charts for all companies under coverage for at least one year, are available through the search function on J.P. Morgan’s website https://mm.jpmorgan.com/disclosures/company or by calling this U.S. toll-free number (1-800-477-0406)
Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] J.P. Morgan Cazenove’s UK Small/Mid-Cap dedicated research analysts use the same rating categories; however, each stock’s expected total return is compared to the expected total return of the FTSE All Share Index, not to those analysts’ coverage universe. A list of these analysts is available on request. The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication. See below for the specific stocks in the certifying analyst(s) coverage universe.
Coverage Universe: Kian Abouhossein: Barclays (BARC.L), Credit Suisse Group (CSGN.VX), Deutsche Bank (DBKGn.DE), Deutsche Postbank (DPBGn.DE), Goldman Sachs (GS), Lloyds Banking Group (LLOY.L), Morgan Stanley (MS), Natixis (CNAT.PA), Royal Bank of Scotland (RBS.L), UBS (UBSN.VX)
J.P. Morgan Equity Research Ratings Distribution, as of December 31, 2010
Overweight (buy)
Neutral (hold)
Underweight (sell)
J.P. Morgan Global Equity Research Coverage 46% 42% 12% IB clients* 53% 50% 38% JPMS Equity Research Coverage 43% 49% 8% IB clients* 71% 63% 59%
*Percentage of investment banking clients in each rating category. For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.
Valuation and Risks: Please see the most recent company-specific research report for an analysis of valuation methodology and risks on any securities recommended herein. Research is available at http://www.morganmarkets.com , or you can contact the analyst named on the front of this note or your J.P. Morgan representative.
Analysts’ Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.
Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMS, are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of JPMS,
and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.
Other Disclosures
J.P. Morgan ("JPM") is the global brand name for J.P. Morgan Securities LLC ("JPMS") and its affiliates worldwide. J.P. Morgan Cazenove is a marketing name for the U.K. investment banking businesses and EMEA cash equities and equity research businesses of JPMorgan Chase & Co. and its subsidiaries.
Options related research: If the information contained herein regards options related research, such information is available only to persons who have received the proper option risk disclosure documents. For a copy of the Option Clearing Corporation’s Characteristics and Risks of Standardized Options, please contact your J.P. Morgan Representative or visit the OCC’s website at http://www.optionsclearing.com/publications/risks/riskstoc.pdf.
Legal Entities Disclosures U.S.: JPMS is a member of NYSE, FINRA and SIPC. J.P. Morgan Futures Inc. is a member of the NFA. JPMorgan Chase Bank, N.A. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. U.K.: J.P. Morgan Securities Ltd. (JPMSL) is a member of the London Stock Exchange and is authorized and regulated by the Financial Services Authority. Registered in England & Wales No. 2711006. Registered Office 125 London Wall, London EC2Y 5AJ. South Africa: J.P. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. Hong Kong: J.P. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission in Hong Kong. Korea: J.P. Morgan Securities (Far East) Ltd, Seoul Branch, is regulated by the Korea Financial Supervisory Service. Australia: J.P. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188) is regulated by ASIC and J.P. Morgan Securities Australia Limited (ABN 61 003 245 234/AFS Licence No: 238066) is a Market Participant with the ASX and regulated by ASIC. Taiwan: J.P.Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Bureau. India: J.P. Morgan India Private Limited, having its registered office at J.P. Morgan Tower, Off. C.S.T. Road, Kalina, Santacruz East, Mumbai - 400098, is a member of the National Stock Exchange of India Limited (SEBI Registration Number - INB 230675231/INF 230675231/INE 230675231) and Bombay Stock Exchange Limited (SEBI Registration Number - INB010675237/INB010675237) and is regulated by Securities and Exchange Board of India. Thailand: JPMorgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission. Indonesia: PT J.P. Morgan Securities Indonesia is a member of the Indonesia Stock Exchange and is regulated by the BAPEPAM LK. Philippines: J.P. Morgan Securities Philippines Inc. is a member of the Philippine Stock Exchange and is regulated by the Securities and Exchange Commission. Brazil: Banco J.P. Morgan S.A. is regulated by the Comissao de Valores Mobiliarios (CVM) and by the Central Bank of Brazil. Mexico: J.P. Morgan Casa de Bolsa, S.A. de C.V., J.P. Morgan Grupo Financiero is a member of the Mexican Stock Exchange and authorized to act as a broker dealer by the National Banking and Securities Exchange Commission. Singapore: This material is issued and distributed in Singapore by J.P. Morgan Securities Singapore Private Limited (JPMSS) [MICA (P) 025/01/2011 and Co. Reg. No.: 199405335R] which is a member of the Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (MAS) and/or JPMorgan Chase Bank, N.A., Singapore branch (JPMCB Singapore) which is regulated by the MAS. Malaysia: This material is issued and distributed in Malaysia by JPMorgan Securities (Malaysia) Sdn Bhd (18146-X) which is a Participating Organization of Bursa Malaysia Berhad and a holder of Capital Markets Services License issued by the Securities Commission in Malaysia. Pakistan: J. P. Morgan Pakistan Broking (Pvt.) Ltd is a member of the Karachi Stock Exchange and regulated by the Securities and Exchange Commission of Pakistan. Saudi Arabia: J.P. Morgan Saudi Arabia Ltd. is authorized by the Capital Market Authority of the Kingdom of Saudi Arabia (CMA) to carry out dealing as an agent, arranging, advising and custody, with respect to securities business under licence number 35-07079 and its registered address is at 8th Floor, Al-Faisaliyah Tower, King Fahad Road, P.O. Box 51907, Riyadh 11553, Kingdom of Saudi Arabia. Dubai: JPMorgan Chase Bank, N.A., Dubai Branch is regulated by the Dubai Financial Services Authority (DFSA) and its registered address is Dubai International Financial Centre - Building 3, Level 7, PO Box 506551, Dubai, UAE.
Country and Region Specific Disclosures U.K. and European Economic Area (EEA): Unless specified to the contrary, issued and approved for distribution in the U.K. and the EEA by JPMSL. Investment research issued by JPMSL has been prepared in accordance with JPMSL's policies for managing conflicts of interest arising as a result of publication and distribution of investment research. Many European regulators require a firm to establish, implement and maintain such a policy. This report has been issued in the U.K. only to persons of a kind described in Article 19 (5), 38, 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (all such persons being referred to as "relevant persons"). This document must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. In other EEA countries, the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction. Australia: This material is issued and distributed by JPMSAL in Australia to “wholesale clients” only. JPMSAL does not issue or distribute this material to “retail clients.” The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. For the purposes of this paragraph the terms “wholesale client” and “retail client” have the meanings given to them in section 761G of the Corporations Act 2001. Germany: This material is distributed in Germany by J.P. Morgan Securities Ltd., Frankfurt Branch and J.P.Morgan Chase Bank, N.A., Frankfurt Branch which are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may be based on the month end data from two months’ prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider/market maker for derivative warrants, callable bull bear contracts and stock options listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website:
http://www.hkex.com.hk. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a loss may occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules.
General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.
“Other Disclosures” last revised January 8, 2011.
Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan.#$J&098$#*P
![[JP Morgan] Variance Swaps](https://static.documents.pub/doc/80x56/551e53714a795970108b4afb/jp-morgan-variance-swaps.jpg)
