jpm-global banks-too big to fail-running the numbers-100217.pdf

Europe Equity Research 17 February 2010 Global Banks Too Big to Fail? Running the Numbers J.P. Morgan Global Research Nick ODonohoe Global Head of Research nick.odonohoejpmorgan.com J.P. Morgan Securities Ltd. Banks Carla Antunes da SilvaAC (44-20) 7325-8215 carla.antunes-silvajpmorgan.com Amit Goel, CFA (44-20) 7325-6924 amit.x.goeljpmorgan.com J.P. Morgan Securities Ltd. See page 41 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. In this document we run a scenario analysis to see what the impact would be in a scenario where all the regulatory proposals currently being discussed were to become a reality. On our estimates, the sum of the current proposals would see RoE for global banks drop from 13.3% to 5.4% in 2011E with the UK banks being the most impacted, followed by the Europeans and then the US banks. Whilst investment banking has been one of the main focuses of regulation, it appears that returns for retail banks may be impacted to the same extent. At these levels of return, we believe that it would be difficult to attract private capital to fund growth, and so product pricing would have to increase substantially. The rising cost of doing business could have significant negative ramifications on the global economy. In order to return to similar levels of profitability as per current forecasts we estimate that pricing on all products (retail banking, commercial banking and investment banking) would have to go up by 33%. If we were to see the sector RoE at 15%, this would imply that pricing of financial product including fees and interest income would have to increase by 39% across the board. The European IBs would have to increase pricing the most, whereas retail banks with their higher cost efficiency would see a lower impact. Capital needs for the global banks in our report would be approximately $221bn higher on the back of the new measures which is equivalent to 19% of our estimated tangible equity in 2011E. Geographically the higher capital needs would be split 41% for the UK with $91bn of additional capital needs and 39% for Europe with $86bn, followed by the US with $44bn additional need. The banks with significant investment banking operations that have moved to a Basel II standard would be the most impacted, as well as those with substantial insurance subsidiaries. Limited offset from reduced compensation we model the extreme case where employee variable costs are cut to zero in IB operations (implied 35% compensation revenue ratio average vs. 45-50% historically). Even in this scenario, product pricing would still need to increase by 26% to achieve constant RoEs, or 35% to achieve 15% RoEs. Costs could be reduced by $19bn compared to $110bn gross loss of earnings from all of the regulatory proposals. Furthermore, this would benefit investment banks relative to retail banks as retail banks have more fixed costs, implying pricing increases in retail/commercial banking would have to be disproportionately larger. 2 Europe Equity Research 17 February 2010 Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silvajpmorgan.com Table of Contents Executive Summary .3 Putting It All Together6 Impact on Capital11 Product Pricing Impact12 How much can compensation offset this?.15 J.P. Morgan Methodology22 1. Separation of Activities23 2. Increasing Capital Requirements26 3. Increasing Liquidity Requirements.29 4. Gross leverage ratios.31 5. Accounting33 6. Taxes.34 7. Recovery and Resolution Planning 36 3 Europe Equity Research 17 February 2010 Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silvajpmorgan.com Executive Summary How to reshape the worlds banks and ensure financial stability has taken centre stage, and will likely continue to dominate the debate over the foreseeable future as we emerge into the reconstruction phase post the financial crisis of the last couple of years. In this third and final report of the series of Too Big to Fail (TBTF) we have tried to estimate the potential financial impact of the current proposals on global banks as we believe it is important to have a holistic and cumulative view of the measures being discussed, rather than merely a piecemeal approach, especially given the fact that there are several different regulators, each of them trying to address the same issue from a slightly different angle. On our estimates, the sum of the current proposals as they stand would see RoE for global banks drop from 13.3% to 5.4% in 2011E. Geographically, we see the UK banks being the most impacted, followed by the Europeans and then the US banks. Whilst investment banking has been one of the main focuses of regulation, it appears that returns for retail banks may be impacted just as much. At these levels of return, we believe that it would be difficult to attract private capital to fund growth, and so product pricing would have to increase. The rising cost of doing business could have significant negative ramifications on the global economy, depending on the elasticity of demand. On a bank specific level, we see biggest decline in the UK banks, in particular RBS and Lloyds Banking Group, which would see negative returns largely a function of increased funding costs from the removal of implicit government guarantees and extension of funding duration. On our analysis, the least impacted would be the US banks as they appear to have less of an impact from BIS III, they already operate with leverage limits and, accounting wise, they have higher NPL coverage levels. Santander would also be one of the least impacted, on our estimates. In order to return to the same levels of profitability in current estimates we estimate that pricing on all products (retail banking, commercial banking and investment banking) would have to go up by 33%. If we were to see the sector RoE at 15% this would imply that pricing of financial product including fees and interest income would have to increase by 39% across the board. For a 15% RoE we estimate the European IBs and UK banks would have to increase pricing the most at 60-80%. Capital needs for the global banks in our report would be approximately $221bn higher on the back of the new measures which is equivalent to 19% of our estimated tangible equity in 2011E. Geographically the higher capital needs would be split 41% for the UK with $91bn of additional capital needs and 39% for Europe with $86bn, followed by the US with $44bn additional need. The banks with significant investment banking operations that have moved to a Basel II standard would be the most impacted, as well as those with substantial insurance subsidiaries. 4 Europe Equity Research 17 February 2010 Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silvajpmorgan.com The most meaningful impact in terms of regulation appears to be the area surrounding taxes. On our estimates, the Tobin tax, whilst having a negative impact on the banks profitability, does not translate into greater tax receipts for governments we see the primary impact on transaction volumes. We think some variation of the liability tax is likely, and this could also be seen as the means to create an insurance fund for systemic risk. Resolution is the single largest area of earnings impact. We think that big banks should be allowed to fail and so this is a crucial part of the regulation ensuring sustainable financial stability. Interestingly, we find that some of the larger banks are unlikely to benefit as much from this guarantee as we had expected. We suspect that this is because the market believes the probability of failure is low for these institutions, and hence ascribes little incremental value to the guarantee. The separation of activities is also a major area in particular, the narrow banking measure would have a significant impact on retail banks with large deposit bases, and have very little impact on the likes of the broker dealers, whereas the Volcker proposal works in exactly the opposite way. There would be some potential offset from reduced compensation for IBs but much less so for retail/commercial banks we model the extreme case where employee variable costs are cut to zero in the IB operations. At these levels, the implied sector average compensation to revenue ratio would be 35% compared to a historic average of 45-50%. We find however that even in the extreme case, even with a 100% reduction in variable compensation, product pricing would still need to increase by c.26% to achieve constant RoEs, and increase by 35% to achieve 15% sector RoEs. Reducing compensation benefits the investment banks disproportionately relative to the retail banks as the retail banks have more fixed costs, which also implies that pricing increases in retail and SME would likely be disproportionately more significant. When regulators have presented new proposals they have generally allowed for lengthy implementation periods to reduce the impact on short term profitability. Whilst this appears sensible it may only serve to make the landscape more opaque, as it hides the cumulative impact, and ultimately there will be several proposals being implemented simultaneously. Furthermore, the duration of the downturn will be extended if banks are always running to stand still with regards to capital adequacy and regulation. In the table overleaf we have summarised the results for the Global banks in our universe from our analysis of the regulatory proposals. 5 Europe Equity Research 17 February 2010 Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silvajpmorgan.com Table 1: Global Banks: Summary of Analysis Base Case $ million BoA Citi GSMSCSUBSDBBarcHSBCLloyds RBSSTANBNPSoc GenSantanUCGAvgTotal Abs. Changes to Earnings Estimates (pretax) -9,100 -8,114 -5,334-3,311-4,841-4,374-5,055-9,346-8,956-9,669 -13,104-2,017-7,867-5,236-7,326-6,134-6,862-109,785 Tax Benefit 3,185 2,840 1,8671,1599688751,5172,6642,0602,756 3,7354642,3601,4662,1981,8401,99731,952 Abs. Change in Net Income -5,915 -5,274 -3,467-2,152-3,873-3,499-3,539-6,683-6,896-6,913 -9,370-1,553-5,507-3,770-5,128-4,294-4,865-77,833 2011E Net Income before regs 18,825 12,886 10,2286,9867,7907,3186,7308,61117,6416,492 5,9843,99110,8426,50313,7397,3799,497151,946 2011E Net Income after regs 12,910 7,612 6,7614,8343,9173,8193,1911,92910,745-422 -3,3852,4385,3352,7338,6113,0854,63274,113 % Change -31% -41% -34%-31%-50%-48%-53%-78%-39%-106% -157%-39%-51%-58%-37%-58%-51%-51% 2011E Tang Equity pre regs 147,053 148,122 80,40754,01333,34638,48544,61875,807118,10457,728 76,22422,30271,29744,35570,06756,78871,1701,138,715 Capital Requirement 23,235 6,071 7,9996,5949,3626,10718,22814,59216,03123,367 35,2881,74924,71518,4011,6157,90813,829221,264 2011E Tang Equity post regs 170,288 154,192 88,40560,60742,70844,59262,84690,399134,13581,095 111,51224,05196,01262,75671,68364,69684,9991,359,978 % Change 16% 4% 10%12%28%16%41%19%14%40% 46%8%35%41%2%14%19%19% 2011E RoE pre regs 12.8% 8.7% 12.7%12.9%23.4%19.0%15.1%11.4%14.9%11.2% 7.9%17.9%15.2%14.7%19.6%13.0%13.3%13.3% 2011E RoE post regs 7.6% 4.9% 7.6%8.0%9.2%8.6%5.1%2.1%8.0%-0.5% -3.0%10.1%5.6%4.4%12.0%4.8%5.4%5.4% % Change -41% -43% -40%-38%-61%-55%-66%-81%-46%-105% -139%-43%-63%-70%-39%-63%-59%-59% 2011E Adj Assets pre regs 2,396,643 1,733,955 849,000773,420962,692685,803 1,309,486 1,447,960 2,447,883 1,450,163 1,638,371529,428 1,931,541 1,171,419 1,553,577 1,352,283 1,389,60122,233,623 Reduction 0 0 00-119,062-20,521-13,71200-32,212 00-29,405-25,01900-14,996-239,931 2011E Adj. Assets post regs 2,396,643 1,733,955 849,000773,420843,630665,283 1,295,774 1,447,960 2,447,883 1,417,951 1,638,371529,428 1,902,136 1,146,400 1,553,577 1,352,283 1,374,60621,993,692 % Change 0.0% 0.0% 0.0%0.0%-12.4%-3.0%-1.0%0.0%0.0%-2.2% 0.0%0.0%-1.5%-2.1%0.0%0.0%-1.1%-1.1% 2011E RoA pre regs 0.79% 0.74% 1.20%0.90%0.81%1.07%0.51%0.59%0.72%0.45% 0.37%0.75%0.56%0.56%0.88%0.55%0.68%0.68% 2011E RoA post regs 0.54% 0.44% 0.80%0.63%0.46%0.57%0.25%0.13%0.44%-0.03% -0.21%0.46%0.28%0.24%0.55%0.23%0.34%0.34% % Change -31% -41% -34%-31%-43%-46%-52%-78%-39%-107% -157%-39%-50%-57%-37%-58%-51%-51% Const. RoE Implied change in product pricing 16% 15% 31%34%63%35%57%40%32%51% 51%21%42%46%5%14%33%33% Const RoE Delta in asset yield 0.85% 0.72% 1.65%1.79%2.19%1.75%1.85%1.43%0.88%1.38% 1.31%0.65%1.25%1.47%0.18%0.41%1.23%1.23% 15% RoE Implied change in product pricing 25% 56% 51%49%14%13%56%62%32%74% 109%8%41%48%-8%24%39%39% 15% RoE Delta in asset yield 1.28% 2.60% 2.67%2.59%0.47%0.66%1.83%2.20%0.89%1.99% 2.80%0.24%1.22%1.53%-0.30%0.72%1.46%1.46% Source: J.P. Morgan estimates. RoE refers to return on tangible common equity. 6 Europe Equity Research 17 February 2010 Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silvajpmorgan.com Putting It All Together In this report we have provided a framework to model and apply the main regulatory proposals currently on the table, and we have applied this framework to the global banks featured in this report. We highlight that this is a sensitivity exercise and we have modeled the impact for the case where all of the proposals are implemented, which could be seen as extreme. Nevertheless, we believe it is a useful exercise as it tries to illustrate the potential cumulative impact of the measures. We think it is important to look at the holistic impact as while the effects of individual regulatory changes may be manageable, the whole is likely to be much more difficult. Impact on Return Potential On our estimates, the cumulative impact of the current regulatory proposals would have the following impact: Global banks sector return on tangible equity would virtually disappear, contracting by 59% from a current estimated 13.3% for 2011E to 5.4%; From a return on assets perspective this would see global banks sector return on assets drop from 0.68% in our 2011E estimates to 0.34% which compares to an average of c.0.80% for this group of banks in the period 2000-08. The table below summarises the potential impact on returns from the regulations reviewed. Table 2: Global Banks: Potential Impact on Returns from Regulation Addressing TBTF Return Analysis - RoE and RoA BoA Citi GS MS CSUBSDBBarcHSBC LloydsRBSSTANBNP Soc Gen SantanderUCGAvgTotal Current Estimates 2011E RoE 12.8% 8.7% 12.7% 12.9% 23.4%19.0%15.1%11.4%14.9%11.2%7.9%17.9%15.2% 14.7% 19.6%13.0%13.3%13.3% 2011E RoA 0.79% 0.74% 1.20% 0.40% 0.81%1.07%0.51%0.59%0.62%0.43%0.45%0.75%0.53% 0.55% 0.97%0.58%0.69%0.69% Adjusted Earnings Estimates 2011E RoE 7.6% 4.9% 7.6% 8.0% 9.2%8.6%5.1%2.1%8.0%-0.5%-3.0%10.1%5.6% 4.4% 12.0%4.8%5.4%5.4% 2011E RoA 0.54% 0.44% 0.80% 0.63% 0.46%0.