Europe Equity Research 27 May 2010

Global Investment Banks

US Derivative Regulation - better for European IBs

• The Senate reform bill is going to be reconciled with the House version. We Banks estimate global IB ROEs could decline from 19% to 11% based on the Kian AbouhosseinAC Senate bill, and Basel II changes introduced in 3Q2011E. Currently, the (44-20) 7325-1523 attention is focused on section 716 which could make US Bank IB [email protected] operations uncompetitive versus Europeans peers, due to two drivers: J.P. Morgan Securities Ltd. • US IBs uncompetitive vs. European peers due to higher financing costs and capital return hurdle: The Lincoln provision (Section 716) would Delphine Lee (44-20) 7325-3971 result in limited capital deficits for US banks and brokers of less than $2bn [email protected] by 2012, in order to recapitalize the IB subsidiary with a 15% core Tier I to J.P. Morgan Securities Ltd. maintain single A rating and rest of business at 8% core T1. Ironically, we estimate European IBs would have a material deficit of close to $60bn on Amit Ranjan the same basis, however, we understand the EU does not appear to (91-22) 6157 3257 [email protected] support section 716. Hence, European IBs BARC, CSG, UBS and DB without US retail operations would be the likely winners from the J.P. Morgan India Private Limited potential regulatory arbitrage – gaining market share in the US where the For more details Please refer to end user account for a material 41% of transactions, thanks to their our Notes: lower financing cost and return requirements. • Staffing re-allocation from US to Europe IBs in US and out of US: "UBS: Gruebel's 'make or break' Governments underestimate IB staff mobility with staffing attracted to year: Remain OW on risk reward growing revenue market share of European IBs (i.e. European IBs in US, analysis", Published on 15th April, were US section 716 to be adopted) and low personal tax locations (i.e. HK, 2010 Singapore, Switzerland, Ireland). With shareholders demanding acceptable returns, CEOs could find it hard to generate IB ROEs of 15%. With IB “Credit Suisse: Blue Sky analysis returns declining from 19% to 12%, IB Comp ratio would have to decline to – Sfr90: Remain OW” ", Published 35% to get back to a 15% ROE ex section 716. Due to Section 716, GS and on 15th April, 2010 MS would lose 3% ROE due to additional capital and derivative revenues triggering staff reductions, making European IB market share "Regulatory Proposal Analysis: winners and employers of choice for potentially 275,000 US broker and structural IB profitability decline", security employees. In addition for Tier II/III IBs regulation will trigger a Published on 09th Sept, 2009 strategic review of a spin-off or closure of IB businesses. • Section 716 makes the outlook for US IBs highly uncertain at this point, and with investor consensus expecting it not to pass we see downside risk: within global IBs, we prefer Swiss geared private banks CS and

UBS. Within the US we prefer MS at 1x tangible BV over GS on valuation.

Our global IB pecking order remains: CS, UBS, MS, GS, BARC and

DB. Table 1: Global Investment Banks: Summary Valuation Ratios lcl currency/share Rec Price PT* Upside EPS 2010E EPS 2011E NAV**11E RoNAV** 2011E Core Tier I 2011E Credit Suisse OW 43.9 70 58% 5.8 6.8 27.8 26.3% 11.1% UBS OW 15.0 23 53% 1.6 2.2 11.2 22.4% 13.6% Deutsche Bank N 46.3 61 32% 7.0 8.0 49.8 17.1% 7.7% Goldman Sachs N 142.6 180 26% 16.3 16.3 125.8 13.8% 14.4% Morgan Stanley OW 26.1 36 37% 3.2 3.7 27.1 14.7% 12.3% Société Générale OW 33.0 59 80% 3.0 6.4 45.8 14.8% 8.2% BNP Paribas OW 45.3 65 44% 5.3 6.8 46.3 15.4% 8.5% Barclays N 2.84 3.1 7% 35.88 41.64 3.85 11.3% 9.6%

Source: J.P. Morgan estimates, Bloomberg (priced as of COB 25 May 2010). Note: EPS on a fully diluted basis. *SOP Dec-2010 based. **Ex own debt gains/losses.

See page 12 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

Capital Impact Analysis – US Banks uncompetitive

Section 716, which proposes “prohibition against Federal Government bailouts of swaps entities” is still a part of the bill approved by the Senate, despite concerns raised by FDIC Chairman Sheila Bair and the OCC. (Source: “FDIC concerned with swaps rules in Democrats' bill”, Reuters, May 1 2010)

Section 716, which would lead to the segregation of swaps activities, is effectively similar to the Glass Steagall Act. The Federal Reserve and FDIC will be prohibited from providing any federal funds to bail out firms that engage in swap activities. In our view, this measure could effectively see the split of IB operations and commercial banking into separate entities.

According to this section, no Federal Assistance (which includes the Federal Reserve’s credit facility, discount lending window, emergency lending functions and FDIC’s insurance and guarantees) may be provided to any swaps entity with respect to any swap, security based swap or other activity of the swaps entity. The term swaps entity means “any swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, swap execution facility, designated contract market, national securities exchange, central counterparty, clearing house, clearing agency, or derivatives clearing organization that is registered under- (A) the Commodity Exchange Act; (B) the Securities Exchange Act of 1934; or (C) any other Federal or State law (including regulations).”

Federal Assistance cannot be used for the purpose of:

(A) making any loan to, or purchasing any stock, equity interest, or debt obligation of, any swaps entity; (B) purchasing the assets of any swaps entity; (C) guaranteeing any loan or debt issuance of any swaps entity; or (D) entering into any assistance arrangement (including tax breaks), loss sharing, or profit sharing with any swaps entity. In our view, section 716 could have significant implications for the industry and is very challenging to price in terms of valuation considering its different impacts on the IB sector as well as the commercial banking world.

We run a very simplistic exercise to illustrate the potential impact on the US banks and brokers. For the US banks and brokers combined, all the major banks and brokers would have capital surplus by 2012E, with small deficits of $0.5bn-$0.6bn for FITB, STI and RF. In our sensitivity scenario, we calculate capital surplus of $10.6bn for GS and MS, assuming the firms have to increase minimum capital requirements for their Investment Banking businesses to 15% of RWAs in order to retain a single A rating on a stand-alone basis, from 10% currently, and maintain at least 8% of RWAs for the rest of the group.

2 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

In our analysis we assume that the IB operations in their entirety would be split from the commercial banking business rather than just Swap business, given the challenges of splitting the cash business from derivatives, as they are closely interlinked in terms of IT platforms, cross-client business and hedging purposes. Though the language of the Dodd/Lincoln bill is not clear on the issue, we assume that Section 716 would apply to all businesses of the US banks like GS and MS and would not be limited to their US operations alone. The language of the Dodd/Lincoln bill is also not clear on whether Banks would be allowed to retain the swap trading desk as an affiliate or if they will have to spin it off completely. However, in our view Banks would not be able to retain their swap trading desks as an affiliate within the bank holding company structure. Overall though, it makes limited difference in terms of capital allocation considering the subsidiary is financed 100% separate from holding. Actually, we think the argument could be made that in case Bank Holdings are unable to use their overall group capital strength to support the IB business, it is in shareholders’ interests to spin it off - rather than valuing a Holding at a ‘holding discount’. We think in this scenario Tier II/III IBs would need to consider closing their IB operations and returning capital to shareholders to maximize their returns.

In our sensitivity analysis, we estimate capital surplus of $1.7bn at Morgan Stanley and $8.9bn for Goldman Sachs, in a scenario where the banks would have to set aside minimum capital requirement equal to 15% of RWAs for their Investment Banking businesses and 8% for the rest of the group. The impact is limited because of their already high levels of capitalisation with Core Tier I of 16.3% and 14.1% for Goldman Sachs and Morgan Stanley respectively in 2012E.

Our US bank analysts have run a similar analysis for the US banks, assuming a 15% Tier 1 common ratio to the broker-dealer subsidiary and an 8% ratio to the core bank. Our analysts estimate that the Large Cap US Banks like Citi, Bank of America, and Wells Fargo would be easily able to meet the new capital requirements through retained earnings by 2012E as shown in Table 2, while there would be small deficits of $0.5bn-$0.6bn for FITB, STI and RF.

However, derivative trading liquidity would become very expensive, as the NewCo will not be able to use its balance sheet in size, and volumes would dry-up in our view. We think derivative end users would consider moving to European counterparts offering cheaper derivative financing.

Overall, Banking CEOs might decide with section 716 that it is in shareholders’ interest to unwind the IB operation and pay back the capital to shareholders at 1x BV.

For more details on the calculation for US banks, please refer to Vivek Juneja’s report “Large Cap Banks: Regulatory Spotlight: Separation of Broker-Dealer - Capital Raises Unlikely But Reduced Excess Capital”, published 19th May, 2010

3 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

Table 2: US Banks/brokers – Capital sensitivity to a change in required capital for the IB business 2012E $ in millions GS MS BAC BBT C FITB PNC RF STI USB WFC Core Tier 1 Capital 85,772 53,425 169,649 14,046 163,282 8,828 27,180 8,449 12,143 28,512 114,162 Group RWA 527,490 379,813 1,595,945 137,976 1,033,430 115,701 241,815 111,171 154,099 263,756 1,114,863 Core Tier 1 Ratio 16.3% 14.1% 10.6% 10.2% 15.8% 7.6% 11.2% 7.6% 7.9% 10.8% 10.2%

IB RWA 495,468 305,354 306,362 541 178,650 1,142 3,840 1,162 6,358 1,160 51,080 IB Core Tier I Capital Required 74,320 45,803 45,954 81 26,798 171 576 174 954 174 7,662 Core Tier I Capital Group ex IB 11,452 7,622 123,695 13,965 136,485 8,657 26,604 8,275 11,189 28,338 106,500 Core Tier I Group ex IB 35.8% 10.2% 9.6% 10.2% 16.0% 7.6% 11.2% 7.5% 7.6% 10.8% 10.0% Shortfall of the Group ex IB 8,890 1,666 20,528 2,970 68,102 -508 7,566 -526 -630 7,330 21,397 vs. Tier I of 8.0% Shortfall ($m) 8,890 1,666 20,528 2,970 68,102 -508 7,566 -526 -630 7,330 21,397 Source: Company reports and J.P. Morgan estimates. Note: Pro forma for PNC to reflect sale of Global Investment Servicing business in 3Q10.

We have run the same simplistic exercise to estimate the potential impact of Section 716 on European IBs. Ironically, we find the impact is much more negative for the European Banks compared to their US counterparts. We estimate a shortfall of $59bn for the European IBs within our coverage assuming Section 716 is applied globally as shown in Table 3. However, we understand that the implementation of Section 716 is unlikely for the European IBs. We see European IBs as the “winners” on this basis.

Table 3: European Investment Banks – Capital sensitivity to a change in required capital for the IB business 2012E (Basel II change adjusted) $ in millions CS UBS DB SG BNP Barclays Tier 1 Capital 51,006 53,635 43,465 42,465 78,068 64,477 Core Tier 1 Capital 38,611 46,473 32,576 34,865 64,768 53,277 Group RWA 299,954 266,660 373,658 393,333 699,007 514,781 Tier 1 Ratio 17.0% 20.1% 11.6% 10.8% 11.2% 12.5% Core Tier 1 Ratio 12.9% 17.4% 8.7% 8.9% 9.3% 10.3%

IB RWA 212,435 176,713 268,835 156,042 279,924 299,633 IB Core Tier I Capital Required 31,865 26,507 40,325 23,406 41,989 44,945 Core Tier I Capital Group ex IB 6,746 19,966 -7,749 11,458 22,779 8,332 Core Tier I Group ex IB 7.7% 22.2% -7.4% 4.8% 5.4% 3.9% Shortfall of the Group ex IB vs. Tier I of 8.0% -256 12,771 -16,135 -7,525 -10,748 -8,880 Shortfall ($m) -236 11,763 -21,292 -9,930 -14,183 -13,517 Source: J.P. Morgan estimates, Company data.

Funding Costs and Counterparty of Choice due to section 716 – European Banks the winners Section 716 would require the US banks to hold more capital in order to retain a single A credit rating which is necessary to write long-term derivatives business as discussed above, and hence their financing costs would increase in our view, with the result that more and more end-users would probably prefer to have an international bank as their counterparty offering cheaper derivative transactions, thus benefiting the European IBs in our view.

4 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

Table 4: Current Long Term Rating of major US banks Bank S&P Moody Golman Sachs A A1 Morgan Stanley A A2 Bank of America A A2 Citi A A3 JP Morgan A+ Aa3 Source: Bloomberg

If we look at the main counterparties to US commercial banks' net current credit exposure in Table 5 below, banks and securities firms account for 53% of the Net current credit exposure. Corporates and other counterparties also account for 41% of the net current credit exposure, thus making them an important source of revenue from derivative transactions.

Any downgrade in credit rating resulting from the absence of access to Federal Assistance as defined in the Lincoln provision, would lead to banks having to post higher collateral with their counterparties, thus increasing their financing costs. This could lead to end-users preferring to deal with international banks which we think would have better financing, would require less collateral and would be considered “safer” in our view.

S&P's latest comments on the potential impact of financial reform suggest that it might not complete its review until end 2010 or 2011. This clearly reduces the risk of a credit rating downgrade and alleviates concerns on the impact on US banks’ short term ratings and repo books in the short term. However, whilst there is no immediate risk with the potential rating actions postponed to next year, we still view US banks as being more exposed to that risk, relative to European banks.

Table 5: Net Current Credit Exposure By Counterparty Type as a % of Total Net Current Credit Exposure % Banks & Monoline Hedge Sovereign Corp and All Total Securities Firms Financial Firms Funds Governments Other Counterparties Total insured US-chartered Commercial Banks 53% 1% 2% 4% 41% 100% Top 5 Commercial Banks 55% 1% 2% 4% 39% 100% Source: OCC. Note: data based on Call Report information provided by all insured US commercial banks and trust companies; data only refers to US operations.

We believe, in the event of a credit rating downgrade, the Fair Value of Collateral to Net Current credit exposure which Banks and Securities firms post with commercial banks would go up from the present level of 95%, though it would not touch the high levels required for Hedge Funds (217%). Goldman Sachs and Morgan Stanley discuss the impact of a one-notch and two-notch downgrade on collateral and additional payments.

As per GS 10-Q, “As of March 2010, additional collateral or termination payments pursuant to bilateral agreements with certain counterparties of approximately $1.51 billion and $2.77 billion could have been called by counterparties in the event of a one-notch and two-notch reduction, respectively, in the firm’s long-term credit ratings.”

As per MS 10-Q, “At March 31, 2010 and December 31, 2009, the amount of additional collateral or termination payments that could be called by counterparties under the terms of such agreements in the event of a one-notch downgrade of the

5 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

Company’s long-term credit rating was approximately $938 million and $717 million, respectively. Additional collateral or termination payments of approximately $998 million and $975 million could be called by counterparties in the event of a two-notch downgrade at March 31, 2010 and December 31, 2009, respectively.”

Table 6: FV of Collateral to Net Current Credit Exposure % Banks & Securities Monoline Financial Hedge Sovereign Corp and All Other Overall Firms Firms Funds Governments Counterparties FC/NCCE Total Commercial Banks 95% 1% 217% 2% 31% 67% Source: OCC. Note: data based on Call Report information provided by all insured US commercial banks and trust companies; data only refers to US operations.

The impact of the provisions on the US banks would be very concentrated in our view, with the Top 5 US commercial banks accounting for c.97% of the total derivative contracts outstanding in the US and for which data is filed by the banks through call reports. These banks are likely to lose material end-user business in our view, which would impact their return generation. In addition, European Bank counterparties would become the preferred choice for trading in our view.

Table 7: US Commercial Banks: Concentration of Derivative Contracts ($ Billions) $ billion, %, Q4 09 Top 5 Bks Tot Derivs (%) Non-Top 5 Bks Tot Derivs(%) All Bks Tot Derivs(%) Futures & Fwrds 24,573 11.5 1,921 0.9 26,493 12.4 Swaps 139,056 65.3 2,955 1.4 142,011 66.7 Options 29,338 13.8 929 0.4 30,267 14.2 Credit Derivatives 13,215 6.2 821 0.4 14,036 6.6 TOTAL 206,182 96.9 6,626 3.1 212,808 100.0 Source: Office of Comptroller of the Currency (OCC). Note: In billions of dollars, notional amount of total: futures, exchange traded options, over the counter options, forwards, and swaps. Note: data based on Call Report information provided by all insured US commercial banks and trust companies; data only refers to US operations.

Table 8: Credit equivalent exposures of major US Commercial Banks and Trust Companies in Derivatives $ million, Dec 31,2009 BANK NAME TOTAL TOTAL TOTAL BILATERALLY POTENTIAL TOTAL (%) TOTAL ASSETS DERIVATIVES RISK NETTED FUTURE CREDIT CREDIT BASED CURRENT EXPOSURE EXPOSURE EXPOSURE CAPITAL CREDIT FROM ALL TO EXPOSURE CONTRACTS CAPITAL JPMORGAN CHASE BANK NA 1,627,684 78,545,384 136,646 149,444 212,449 361,893 265 BANK OF AMERICA NA 1,465,221 44,315,928 148,811 56,154 168,128 224,282 151 GOLDMAN SACHS BANK USA 91,016 41,595,932 22,154 52,681 117,118 169,799 766 CITIBANK NATIONAL ASSN 1,161,361 37,546,159 110,625 63,838 135,019 198,857 180 WELLS FARGO BANK NA 1,118,861 4,178,720 118,863 28,304 42,986 71,290 60 HSBC BANK USA NATIONAL ASSN 167,165 2,894,963 19,532 11,185 26,264 37,449 192 RBS CITIZENS NATIONAL ASSN 116,921 48,105 10,331 839 351 1,191 12 MORGAN STANLEY BANK NA 66,159 41,467 8,880 63 0 63 1 DEUTSCHE BANK TR CO AMERICAS 45,875 21,994 8,502 2,027 799 2,826 33

TOP 25 COMMERCIAL BANKS & TCs 7,917,784 212,466,466 790,769 392,631 720,354 1,112,985 141 WITH DERIVATIVES OTHER COMMERCIAL BANKS & TCs 2,446,650 341,162 290,111 5,822 2,840 8,662 3 WITH DERIVATIVES TOTAL AMOUNT FOR COMMERCIAL 10,364,434 212,807,628 1,080,880 398,453 723,194 1,121,647 104 BANKS & TCs WITH DERIVATIVES Source: Office of Comptroller of the Currency. Note : Total credit exposure is defined as the credit equivalent amount from derivative contracts (RC-R line 54) or the sum of netted current credit exposure and PFE .The total credit exposure to capital ratio is calculated using risk based capital (tier one plus tier two capital). Data based on Call Report information provided by all insured US commercial banks and trust companies; data only refers to US operations.

6 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

Impact on IB profitability – European IBs employer of choice

We highlight the four key proposals in the Dodd/Lincoln bill that could have implications for the viability of the IB industry: 1) Lincoln provision (Section 716) leading to the segregation of swaps activities, 2) Volcker rule; 3) Central clearing of OTC derivatives for material SWAP participant end users leading to significantly lower liquidity in derivatives, and most importantly; 4) Real time public reporting as soon as technologically practicable – looks unrealistic, in our view, for most single name CDSs and SWAPs which are mainly illiquid. In addition, it would also negatively impact liquidity in derivative markets, making, end user hedging more expensive.

In respect to the Volcker rule, one option could be for shareholders to press for private equity and HF assets spin-off to shareholders directly and give them full control.

In our sensitivity analysis, we estimate that investment banking businesses’ ROE could decline from 19% to 11% on average in 2011E. We expect the main impact to come from: i) Basel related changes in higher market risk requirements (Stressed Value at Risk (VaR), Incremental Risk Charge, Securitisation) which shave off 3.9% on average, followed by ii) OTC derivatives regulation (mandatory trading on swap execution facilities, and post trade transparency proposals) with a 2.5% negative impact on ROE on average, iii) Section 716 reducing returns by 1.5% on average (assuming only the US brokers are impacted) and iv) Obama proposed limits on prop trading with 1.2% negative impact on ROE.

Note that we have assumed that:

• Section 716 would only be implemented by US banks and brokers, and would affect their OTC derivatives activities globally, whilst European IBs would not be subject to similar measures. • 5% of sales & trading revenues would be at risk from the Volcker proposals on prop trading. The impact is still material, as we assume a marginal cost/income ratio of just 20% for Prop related activity. Our analysis does not assume a sale of private equity and hedge fund activity, which in our view would most significantly impact GS due to its material principal investment. Under this scenario, the US brokers would be the most impacted by regulatory changes with ROE halving from 20% to 10% on average, mainly driven by Section 716 which would lead to higher capital requirements with a Tier I of 15% vs. 10% previously.

European IBs would be less affected, with Credit Suisse and Barclays being the most profitable with ROEs of 13% and 12% respectively post regulatory changes.

Our estimates are conservative in our view, as our sensitivity analysis is based on the pessimistic assumption that margins would not increase. In our view, IBs would need to reprice transaction margins upwards to make an acceptable ROE,

7 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

especially considering less liquidity in the market and hence greater risk for the IBs, which we have not factored in the analysis. For more details on our methodology, please refer to our Sept 09 report “Global investment banks: Regulatory proposal analysis: Structural IB profitability decline”.

Table 9: Global Investment banks – 2011E ROE in the investment banks – pre and post regulation changes** % Credit UBS Deutsche Goldman Morgan BNP Société Barclays Average Suisse Bank Sachs Stanley Paribas Générale Impact on IB profitability IB ROE 2011E 23.5% 17.5% 20.3% 20.7% 18.9% 15.0% 17.1% 18.2% 18.9% 1. Clearing via CCP 1.5% 2.7% 2.5% 2.2% 1.8% 0.2% -0.2% 1.0% 1.5% 2. Moving CDS & Rates Deriv. to SEF trading -3.3% -1.5% -3.0% -2.2% -0.6% -0.5% -0.8% -1.4% -1.6% 3. OTC post trade transparency -0.8% -0.7% -0.9% -0.8% -0.8% -0.5% -1.2% -0.8% -0.8% 4. Stressed VaR capital buffer Basel -1.9% -0.9% -1.0% -1.8% -2.0% -0.6% -0.7% -1.3% -1.3% 5. Incremental Risk Charge Basel -2.7% -1.7% -2.3% -1.1% -0.8% -1.3% -1.4% -1.6% -1.6% 4&5. Management guidance Basel -3.7% -3.8% -4.0% - - -2.5% -3.9% 0.0% -3.0% 6. Securitization Basel -1.0% -1.4% -1.1% -0.8% -0.7% -0.3% -0.7% -1.1% -0.9% 7. Higher capital on non CCP clearing -2.2% -2.6% -2.5% -2.2% -1.9% -0.5% -0.9% -1.2% -1.8% 8. Obama proposed limits on prop trading* -1.8% -1.2% -1.7% -1.4% -1.1% -0.6% -1.1% -0.6% -1.2% 9. Section 716 US reg - segregation IB -6.3% -5.8% -1.5% Total impact -10.0% -7.5% -9.4% -10.9% -9.1% -4.3% -7.2% -5.9% -8.0% % change in IB ROE -43% -43% -46% -53% -48% -29% -42% -32% -42% Resulting IB ROE 2011E 13.4% 10.0% 10.9% 9.8% 9.8% 10.7% 9.9% 12.3% 10.9% Source: J.P. Morgan estimates, Company data. Notes: i) BNP Paribas CIB estimates including Fortis; ii) Morgan Stanley Institutional Securities estimates, and iii) Goldman Sachs Global Capital Markets excluding any principal investment revenues; iv) our ROE estimates are based on allocated capital as disclosed by the company or JPM alllocated capital (Tier I of 8%-11%), whichever the highest for European IBs; v) For Deutsche Bank, we have normalized provisions in 2011E. * limits on prop trading (pure prop), vi) note that percentages cannot be added up as both numerators and denominators are changing. ** Proposed OTC derivatives regulation, higher market risk requirements, Obama/Volcker rules for prop trading.

Although regulatory changes should significantly decrease IB returns, we think most investment banks could still achieve a 15% IB ROE if they make the necessary adjustments to IB comp costs per head.

Given the political pressures in various geographies, we believe IB compensation reduction will be a key driver of this road back to 15% RoE generation.

Excluding Section 716, we estimate investment banks would need to reduce 2011E IB comp costs/head by -22% on average vs. 2009E. This would lead to structural reduction in comp ratio declining from 44% to 35% on average. Overall, we see the adjustment as manageable excluding Section 716.

However, if US brokers have to comply with section 716, the IB comp adjustment would be much more significant.

Banking CEOs could decide with section 716 that it is in shareholders’ interests to unwind IB operations and pay back the capital to shareholders at 1x BV.

Table 10: Global investment banks –Reaching 15% IB ROE by adjusting IB comp/head ex section 716 impact Credit UBS Deutsche Goldman Morgan BNP Société Barclays Average Suisse Bank Sachs Stanley Paribas Générale Excluding Section 716 for US brokers Cut in IB Comp/head 2011E vs. 2009E -17% -14% -16% -26% -16% -45% -44% 4% -22% Resulting IB comp ratio* 44% 33% 40% 40% 37% 23% 25% 35% 35% IB ROE 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% Source: J.P. Morgan estimates, Company data. For Barclays, please note the compensation ratio in 2009 was significantly lower on a clean basis due to significant writedowns.

8 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

In our view, should section 716 be implemented for US banks and brokers, the US industry would become less competitive in terms of revenue and ROE generation due to counterparty risk to end-users and ability of pricing derivative contracts compared to peers. We would expect US Banks to lose market share in derivative revenues with European IBs being the winners. US banks would reduce staffing levels with lower revenues. European IBs would become employers of choice winning market share, not being captured by section 716, and employment in the US security brokerage industry would decline more sharply in our view from current levels of about 275,000 and European IBs in the US.

According to the US Bureau of Labor Statistics, the number of employees has already declined by -9% vs. 2007 levels. We think Section 716 would make the US securities brokerage industry less attractive, potentially leading to a further drop in employment as staff would likely move out of the US.

Table 11: Highest Rates Figure 1: Number of employees in the US Security brokerage industry of Personal Income Tax - Thousands 2009 310 % Country Tax Rate 305 US 35% UK 40% 300 Germany 45% France 40% 295 Switzerland 25% 290 HK 15% Singapore 20% 285 Ireland 46% Source: KPMG's Individual Tax 280 and Social Security Tax Rate Survey 2009. JPM estimates. 275

270

265

260 Jul-07 Jul-08 Jul-09 Jan-07 Jan-08 Jan-09 Jan-10 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Nov-07 Nov-08 Nov-09 May-07 May-08 May-09

Source: Bureau of Labor Statistics, US Department of Labor.

Next steps for the derivative bill to become law

1.) House passes the Senate bill or Senate Passes the House bill: Does not seem possible as there are significant differences between the versions passed by the House and the Senate

2.) House and Senate send the bill back and forth, making amendments until there is a final agreement on the bill which both chambers can pass: not

9 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

suggested by either House Financial Services Committee Chairman Barney Frank or Senate Banking Committee Chairman Christopher Dodd till now.

3.) The third route which is happening at the moment, is that the House and Senate create a “Conference Committee”, composed of “Conferees”, both Democrats and Republicans, from both the Senate and the House.

The House and the Senate have already named some of the participants of the conferencing committee: Rep. Barney Frank, Dem Senators Dodd, Lincoln and Rep Senators Shelby and Chambliss.

• The Senate picked its 12 members, seven of which will be democrats, all coming from the banking and agriculture committees: Christopher J. Dodd (Conn.), Sen. Blanche Lincoln (Ark.), Tim Johnson (S.D.), Charles E. Schumer (N.Y.), Tom Harkin (Iowa), Patrick J. Leahy (Vt.) and Jack Reed (R.I.). The Republican Senators appointed are: Richard C. Shelby (Ala.), Judd Gregg (N.H.), Bob Corker (Tenn.), Michael D. Crapo (Idaho), and Saxby Chambliss (Ga.). • On the House side, there will be eight Democratic members vs. 5 GOP ones: Joining Barney Frank as House Democrat conferees are Democrat reps Carolyn Maloney (N.Y.), Paul Kanjorski (Pa.), Luis Gutierrez (Ill.), Maxine Waters (Calif.), Melvin Watt (N.C.), Dennis Moore (Kans.) and Gregory Meeks (N.Y.). On the GOP side, likely House conferees include Spencer Bachus (Ala.), Jeb Hensarling (Texas), Scott Garrett (N.J.), all to be named by minority leader John Boehner of Ohio (CNBC, 26 May 2010). Barney Frank commented that the Senate and the House will be able to merge financial regulation bill by early July in his opinion (25 May 2010, Bloomberg).

How does the Conference Committee work?1 Conferees are appointed by the Senate and the House, with the number of Conferees from each House not making a difference in the voting, since conferees of each House vote as a unit.

Once the House and the Senate go in conference, the Conferees negotiate to resolve the matters. After an agreement has been reached, it is embodied in a Conference report, signed by a majority of Senate Conferees and House Conferees.

If there are amendments upon which the conferees were unable to agree, a statement to this effect is included in the report. If these amendments are not agreed upon by the chambers, a further conference may be requested on the amendments. The bill cannot be sent to the President until both the houses reconcile the amendments in disagreement.

Conference Reports are not open to amendment, although there can be extended debate on it. They must be voted on in their entirety.

The Conference report must then be agreed to by both the House and the Senate before being sent to the President for consideration.

1 http://thomas.loc.gov/home/enactment/confcomm.html

10 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

11 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

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Coverage Universe: Kian Abouhossein: BNP Paribas (BNPP.PA), Credit Agricole (CAGR.PA), Credit Suisse Group (CSGN.VX), Deutsche Bank (DBKGn.DE), Goldman Sachs (GS), Morgan Stanley (MS), Natixis (CNAT.PA), Société Générale (SOGN.PA), UBS (UBSN.VX)

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12 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

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13 Kian Abouhossein Europe Equity Research (44-20) 7325-1523 27 May 2010 [email protected]

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