Outlook for Wholesale and Investment Banking...merchant banking, direct lending, debt restructuring, proprietary trading, and parts of trading and structuring complex derivatives could

24 March 2011

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B L U E P A P E R

Wholesale & Investment Banking Outlook Reshaping the Model The market underestimates the potential for banks to reach mid-teens RoEs. This cannot happen without managements acting decisively to reshape the business model. New regulations will depress industry RoEs 4-6% in our analysis. But contrary to market perceptions, we find that three-quarters of banks’ revenues are already “fit” for the new environment. This includes most of equity trading, debt and equity underwriting, advisory, foreign exchange trading, and government bond trading; other categories are being much re-engineered. In the next two years, growing equities revenues, improving asset quality, efficiency programmes, and portfolio reshaping should support 13-15% returns.

The market also underestimates the knock-on impact of regulatory change on banking clients. Faced with higher capital and funding requirements, banks will respond by repricing and, failing that, shrinking credit provision in the business lines most affected by new regulation. Corporates hedging their exposures will feel the impact, as will pension funds/insurance hedging long-term liability with derivatives and users of long-dated lending (infrastructure, municipal finance). Asset managers, pension funds, and the non-bank sector should benefit from the new opportunities.

Regulation is changing the basis of competitive advantage. Infrastructure, client service, scale, and efficient use of capital become critical as automation lowers margins in trading and clearing of OTC derivatives, credit, and rates, and as funding costs hit financing activities. We estimate a global investment bank today faces $4 billion of quasi-fixed costs. Flowmonsters will gain greater advantage, mid-size firms will need outstanding strategic focus to outperform. Banks need to take hardheaded portfolio and investment decisions today, as well as become more efficient; we think banks have to take out 6-8% of costs in the next 12-18 months alone.

M O R G A N S T A N L E Y R E S E A R C H

G l o b a l

Banks Huw van Steenis1 +44 (0)20 7425 9747

Hubert Lam1 +44 (0)20 7425 3734

Betsy Graseck2 +1 212 761 8473

Cheryl Pate2 +1 212 761 3324

Michael Cyprys2 +1 212 761 7619

Ted Moynihan +44 (0)20 7852 7555

James Davis +44 (0)20 7852 7631

Lisa Draper +1 646 364 8673

Oliver Wyman is an international management consultancy firm. For more information, visit www.oliverwyman.com.

Part 2 of this report solely reflects the views of Morgan Stanley Research, not Oliver Wyman.

Oliver Wyman is not Authorised nor regulated by the FSA and as such is not providing investment advice. Oliver Wyman authors are not research analysts and are neither FSA nor FINRA registered. Oliver Wyman authors have only contributed their expertise on business strategy to the first part of this report. The second part of the report is the work of Morgan Stanley only and not Oliver Wyman. For disclosures specifically pertaining to Oliver Wyman please see the Disclosure Section, located at the end of this report.

1Morgan Stanley & Co. International plc+ 2Morgan Stanley & Co. Incorporated

2

24 March 2011 Wholesale & Investment Banking

Table of Contents

Part 1

Executive Summary ................................................................................................................................................................ 3

What the Market Is Missing ..................................................................................................................................................... 7

The Strategic Agenda.............................................................................................................................................................. 16

3


Executive Summary

There is a fundamental tension in the global securities markets. Numerous banks are sharing with investors the aspiration that their corporate and investment banking divisions will show returns on equity (RoE) in the mid-teens, and yet the market seems to believe that these divisions will make little more than their cost of equity (CoE). Investors are struggling to reconcile dramatically higher capital and liquidity requirements, a fast evolving industry structure, a very different opportunity set and, simply, a high level of uncertainty.

Our thesis is that – with strong management action – many wholesale and investment banks could earn RoE in the low to mid-teens (well above their cost of equity). We think the market is overlooking the fact that almost three-quarters of industry revenues are already or on track to be “fit” for the new industry regulations and ought to make respectable RoE – including most of banks’ equity trading, debt and equity underwriting, advisory, and foreign exchange and government bond trading businesses.

But the challenge for management teams is significant: Our analysis suggests that, prima facie, RoE in parts of fixed-income trading could fall by half under the new regulatory model. Banks will need relentless focus on execution, hard-headed portfolio decisions on what to shrink and what to grow, major investment in the “electronification” (the switch to electronic systems) of trading and clearing fixed-income securities, while also seizing opportunities in the growing non-bank sector. We map out what management action we think is critical and run scenarios on the regulatory and market outcomes that would allow the sector to generate returns investors would reward.

While the industry conclusions are largely joint, any stock-specific or valuation sections solely reflect the views of Morgan Stanley Research, not Oliver Wyman. We would like to express our thanks to the business leaders who engaged with us on the debates raised in this report.

What the market is overlooking

1. Banks should be able to generate acceptable returns in the next few years – albeit with much management action required. We believe the market may be underestimating the banks’ ability to generate acceptable returns over the next two years, as legacy portfolio issues unwind, cost controls kick in and the impact of regulatory change has yet to fully pass through. Our base case industry returns of 13-15% look achievable (vs ~14% in 2009 and ~13% in 2010) (exhibit 1). This said, our analysis suggest a prima facie (4)-(6)% impact of regulation on returns in our base case prior to management action. Once regulatory changes are in place, banks will have to act decisively to hit their RoE targets of 12-16% in wholesale banking – but much change is already under way. In this paper, we highlight

which businesses are already largely “fit” for new regulations or where, with greater efficiency, returns could be on track to be mid-teens. This said, the actual shape of regulations will be critical: our base case is anchored around our current best estimate of a considered calibration of new regulations consistent with credit intermediation. We run a range of scenarios for more adverse policy formulations.

Exhibit 1 Market is assuming corporate and investment banking divisions will fail to make management targets or what banks have made in 2009-10

9-12%

17.5%

13-14%

13-15%

12-16%

7-9%

3-4%

4-6%

0% 5% 10% 15% 20%

2000-06

2009-10

Reg impact

M itigants

M gmt action

Future returns

M anagement statedaspirations

Implied ROE fromvaluations

C

B

A

Historical structural shifts

Our view of industry potential

Significant gap between Management and Market

9-12%

17.5%

13-14%

13-15%

12-16%

7-9%

3-4%

4-6%

0% 5% 10% 15% 20%

2000-06

2009-10

Reg impact

M itigants

M gmt action

Future returns



C

B

A




Source: Oliver Wyman, Morgan Stanley Research, Company reports Management targets include: Barclays, Credit Suisse, HSBC, Standard Chartered, JPMorgan, Soc Gen

2. The spread between winners and losers is likely to remain wider for longer. Among the top 20 large and medium-sized firms, the wide spread of returns between best-positioned and potentially challenged banks will probably persist for far longer than it has after other asset-quality crises, given the scale of the shock, the size of legacy assets, and the nature of regulatory response, in our view. Banks with healthier balance sheets, better funding profiles, and operational scale should be able to make better use of today’s opportunities. The market may underestimate how much global banks have regrouped and how this regrouping has inhibited the growth of many regional players and boutiques, with the exception of a few with strong strategic clarity and a number of firms in the emerging markets.

3. The market underappreciates that as banks respond to the higher cost of capital and funding in the most

4


impacted businesses such as credit and long-dated structures, clients will really feel the impact. As banks respond to higher capital and funding requirements in the most impacted businesses such as credit and structured rates, they will respond by repricing and shrinking. Corporates hedging their exposures, pension funds/insurance hedging long-term liability with derivatives and users of long-dated lending (infrastructure, municipal finance) are likely to see material repricing and/or reduced provision. Other areas such as non-investment grade debt, proprietary trading, small and medium enterprises (SMEs), and illiquid fixed income are also impacted. At the margin, better funded banks will reap the rewards of supply constraints, but the nature of the advantage is still in flux.

4. Sizeable shift in business to the non-bank sector. Markets and regulators may underestimate how much business could move into hedge funds, private equity, asset managers, and other alternative sources of capital over the long term, as banks respond to the regulatory agenda. Whilst we do not expect change to happen overnight, parts of merchant banking, direct lending, debt restructuring, proprietary trading, and parts of trading and structuring complex derivatives could migrate out of the highly regulated deposit-supported banking sector. Opportunities will come in different shapes and sizes. We think the disintermediation trend for more European corporates to tap the markets will continue. We think long-dated lending will be impacted materially and infrastructure projects may seek to be funded directly by pension funds or in the markets as banks ration their activities. We also see a series of “niche” areas such as finance for SMEs (private equity, mezzanine), structured credit, commercial real estate, and some parts of shipping, infrastructure, and commodity finance. The challenge for the banks will be to make up for lost revenues over time, replace some of the key trading and advisory talent, which will migrate to the non-bank sector, and extract value from the shift in activity into this sector, which we estimate could possibly present a $5-9 billion revenue opportunity in the long term – still smaller than the profits lost and still far from clear if the banks will capture.

The strategic agenda

5. Adjusting to a more “beta-driven’’ portfolio. Investment banking is becoming more beta driven, with a shift to businesses with high market gearing (investment banking, equities) and, within fixed income, towards greater beta (by reducing the focus on alpha drivers like structuring, principal, and leverage). Our base case for the next two to three years assumes a material shift to equities and advisory (+10% CAGR base case) as cyclical growth kicks in. We forecast FICC is likely to shrink (5%)-(10%) in 2011, although falling legacy losses should support reported revenues. We run four scenarios: our base case (flat to down 5% overall); our bull case has industry revenues compounding +10%; and two bear cases – one focuses on economic stagnation, the second focuses on the risks of inflation, as we think FICC is far more heavily impacted by an inflationary environment as bonds fall in value and investors switch to real assets and equities (exhibits 3, 18 and 19).

6. Gaining share in equities and advisory. Equities and advisory will be prioritised at the expense of much of fixed income, given equities’ appealing 15-20% RoEs (even after an estimated regulatory impact of 2-4%). This is in contrast with fixed income, currencies, and commodities (FICC), where returns will prima facie feel more than double the impact at the RoE level. The importance of emerging markets looks set to intensify, but rising costs and falling yields will mean that less of the top-line growth comes through to the bottom line.

7. Reshaping the fixed-income portfolio. The market is right to be worried about FICC, but we think it underestimates how differently businesses will be affected. Regulation could halve underlying fixed-income returns before management action, but credit trading will take a much bigger hit than foreign exchange. We estimate that more than half of FICC revenues will be modestly affected by Basel III (exhibit 2). “Flowmonsters” – banks with high scale in a product or region – will be best placed, as FICC businesses undergo significant transformation from 2011 to 2012. Some of the globals, though, seem further ahead in reshaping their impacted businesses and so fro here should be less impacted.

5


Exhibit 2 About 75-80% of industry revenues are broadly “fit” for new regulatory regime 1 Incremental cost of equity and funding/revenue

0%

20%

40%

60%

80%

100%

120%

140%Capital Funding Leverage

Heavily impacted~20% of total revenue

Rest of FICC~35% of total revenue

Equities and IBD~45% of total revenue

Impact will be significantly reduced by

central clearing

Illustrative: Based on current business structures, before mitigation and management actions

Diverging impact across sub-

products

Stru

ctur

ed

cred

it

Sec

uriti

satio

n

Stru

ctur

ed

rate

s

Com

mod

ities EM

Fina

ncin

g

FX

Flow

Cre

dit

Prim

e br

oker

age

Flow

EqD

Stru

ctur

ed E

qD

F&O

Cas

h eq

uitie

s

EC

M,

DC

M, M

&A

Flow

Rat

es

0%

20%

40%

60%

80%

100%

120%






central clearing



products

Stru

ctur

ed

cred

it

Sec

uriti

satio

n

Stru

ctur

ed

rate

s

Com

mod

ities EM

Fina

ncin

g

FX

Flow

Cre

dit

Prim

e br

oker

age

Flow

EqD

Stru

ctur

ed E

qD

F&O

Cas

h eq

uitie

s

EC

M,

DC

M, M

&A

Flow

Rat

es

Source: Oliver Wyman data and analysis 1. “Funding” is the increase in term funding required; “RWA” is the impact of additional RWA requirements under Basel 2.5 and Basel 3, charged at a 10.5% cost of equity and assuming 12% regulatory capital (before and after Basel 3); “Leverage” is the additional capital required to meet the leverage ratio (if this were enforced at the product level), charged at 10.5% cost of equity

8. Scale, distribution, delivery of advice and technology/infrastructure will become more critical as banks focus on balance sheet velocity to improve returns. The strategic value of scale (in products or regions), distribution, delivery of advice and technology/infrastructure will grow dramatically, and banks will be forced to invest in these areas. For instance, we think the “platform costs” of running a global investment bank is approaching ~$4 billion for the top global players, underscoring the importance of scale and efficiency. The businesses which are most likely to be transformed are flow credit and rates, which potentially could become loss-making for mid-tier firms. Mid-sized firms will need to be very focussed on scalability in particular business lines or geographies or mine opportunities in adjacent businesses.

9. Banks need to rediscover cost flexibility and operational gearing. Banks will need to regain cost flexibility and operational gearing in 2011-12, given the high volatility of a client flow business model. We estimate banks need to take out 6-8% of the 2010 cost base before variable

compensation, which will contribute about 1-1.5% to the rebuild of decent RoEs. This is no mean feat, given investments needed in technology, risk management and compliance.

10. Navigating potential discontinuities in regulation or markets. With regulatory uncertainty and rebounding markets, banks have tried to keep as many options open as possible. Better visibility in 2011-13 could see more change in business models, but these also create risks of discontinuities. We see the three main risks of potential regulatory change as: 1) an unlevel playing field in required capital for too-big-to-fail firms in different countries; 2) how funding rules and costs evolve; and 3) “subsidiarisation”, which means banks being asked to have more dedicated capital and funding to different entities, rather than run the bank on a group basis. But to be clear, banks also need to manage funding and other market discontinuities, especially in the flow driven business models, which may see higher market volatility. Getting the right balance and stress testing business models for challenging markets will be critical.

6


Exhibit 3 We expect equities and IBD to outperform FICC in our 2011 base case Pre- and post-credit write-down revenues by product. Industry revenues 2004-11E, $bn

50

0

50

100

150

200

250

300

350

400

Volatility Credit Commods Equities EMG IBD

$115 BN

$220 BN

$35 BN

280

2006

300

20081 Net

205

2007Net 2009Net

315

G10 stagnation

2010

260 290

Bull

255

2004

215180

2005

225

Base

2011 scenarios

245

Inflationary50

0

50

100

150

200

250

300

350

400


$115 BN

$220 BN

$35 BN

280

2006

300

20081 Net

205

2007Net2007Net 2009Net2009Net

315

G10 stagnation

2010

260 290

Bull

255

2004

215180

2005

225

Base

2011 scenarios

245

Inflationary

Source: Oliver Wyman data and analysis, discussions with Morgan Stanley on forecasts 1.For 2008 credit revenues are negative, represented by the cross-shaded area: this should be added to the dark blue area to read the total volatility revenues.

Exhibit 4 RoE outcomes under different macro and regulatory scenarios Macro scenario

2013-14 return profiles Assumed regulatory impact Regulatory scenarios

More severe Less severe

Bull case

Banking sector seen as strong enough to withstand tougher implementationStronger implementation6% RoE drag

~15% Unlikely

Base case

Measured implementation, though with risks of failures in sequencing, international co-ordination and parameterisation5% RoE drag

~13% ~15%

Stagnation

Rebuilding the banking sector seen as a prerequisite for economic recoveryMore phased and softened implementation4% RoE drag

Unlikely ~15%

Inflation Bear case

Stronger implementation as part of wider monetary tighteningPotential negative feedback loop6% RoE drag

~9% Unlikely

2%

4%

5%

5%

RoE impact of management action

Assumed ROE drag

~17%

~15%

~13%

~11%

-8% -4%RoE drag across regulatory severity:

Macro scenario



Bull case


~15% Unlikely

Base case


~13% ~15%

Stagnation


Unlikely ~15%

Inflation Bear case


~9% Unlikely

Macro scenario



Bull case


~15% Unlikely

Base case


~13% ~15%

Stagnation


Unlikely ~15%

Inflation Bear case


~9% Unlikely

2%

4%

5%

5%

RoE impact of management action

Assumed ROE drag

~17%

~15%

~13%

~11%

-8% -4%RoE drag across regulatory severity:

Source: Oliver Wyman

7


What the Market Is Missing

1. Banks should be able to generate acceptable returns in the next few years.

We believe the market may be underestimating the banks’ ability to generate acceptable returns over the next two years, as legacy portfolio issues unwind and the regulatory program has yet to set in. As regulations are put in place, banks will have to act decisively to hit their RoE targets of 12-16% in wholesale banking. Much change is already under way but we think winners will be making decisions about leadership in change in 2011 and 2012.

The regulatory reform programme is likely to reduce industry RoEs by 4-6 percentage points, in our base case implementation scenario. Our bear case is -8%, and our bull case -4%. On our estimates, applying future regulations to current business structures takes 7-9% off returns, but this is partially offset by direct mitigants, such as current capital surpluses and scope for technical improvements to RWA calculations.

Exhibit 5 Rebuilding ROEs

9-12%

17.5%

13-14%

13-15%

12-16%

7-9%

3-4%

4-6%

0% 5% 10% 15% 20%

2000-06

2009-10

Reg impact

M itigants

M gmt action

Future returns



C

B

A




9-12%

17.5%

13-14%

13-15%

12-16%

7-9%

3-4%

4-6%

0% 5% 10% 15% 20%

2000-06

2009-10

Reg impact

M itigants

M gmt action

Future returns



C

B

A




Source: Oliver Wyman, Morgan Stanley Research, Company reports Management targets include: Barclays, Credit Suisse, HSBC, Standard Chartered, JPMorgan, Soc Gen

The biggest impact comes from capital and liquidity costs (about 3-4% in our base case), with over-the-counter (OTC) derivatives reform, the Volcker Rule, legal entity restructuring, subsidiarisation, and others making up the rest (exhibit 7). The range of possible outcomes is still very wide – but narrowing – and will hinge on the coordinated program of rules ultimately determined by the regulators.

Exhibit 6 RoE impact: (B) mitigating factors

Pre-mitigation impact 7-9% RoE reduction on current business

structures (ceteris paribus)

Capital Surplus 2-3% • Erosion of current surplus of capital over required minima

Risk models 0.5-1% • Risk management improvements (e.g. model approvals)

Total mitigation 3-4% Post-mitigation impact (pre-management action)

4-6% • Reduction in industry RoE before management action


How can management boost returns to the targeted 12-16% range? Many of the required changes are already under way, although regulatory uncertainty has meant options have been kept open. We see several main areas of management action (exhibit 8):

• Shift at the portfolio level towards the equities and advisory businesses and from G7 to emerging markets. We expect the impact on RoE to be relatively limited given the size differential of equities versus FICC and the drop in margins and yield in emerging markets.

• Restructuring FICC will be the key driver of change: Our base case assumes that material change in FICC drives a 3-4% uplift in FICC returns, or 1-2% on group returns. This will require significant management action, including: heavy restructuring of problematic businesses; a shift to a more capital light product mix; reducing counterparty risk through use of central counterparty clearing houses (CCPs); increased balance sheet velocity; strict client focus; fewer large consumers of funding and balance sheet, such as Repo books; and a major review of cost structure within the business.

• The shift towards higher velocity of balance sheet and focus on making more money on illiquid positions should push up return on assets (RoA) and return on risk-weighted assets (RoRWA). This will entail greater scrutiny on all held positions, wider distribution capture, and a focus on the multipliers between client financing and returns across the client portfolio.

• Major reviews of cost structures could add another 1-1.5% to RoEs in our base case, including restructuring back to front office staffing ratios in maturing flow businesses and reducing aggregate compensation ratios.

8


Exhibit 7 RoE impact: (A) Proposed regulations and their impact (pre-mitigation and management action)

ROE impact pre-mitigation1

Degree of certainty

Category Theme Key regulatory elementsMar. 2010

Mar. 2011

Basel 2.5Use of stressed VaR, incremental risk chargesTreatment of securitisation in Pillar 1

5-6% 3-5%

Basel 3

Improve quality of tier 1 capital; new gross leverage capLiquidity ratios: coverage, NSFRNew counterparty credit risk charges

SupervisionFinancial Stability Oversight Council (with OFR), European Systemic Risk Board

1-3% 2-4%

G-SIFIHeightened capital requirements for global systemically important institutions (G-SIFIs)

RRPs Resolution and recovery plans (“living wills”)

Narrow bankingUS: Swaps spin-off; Volcker ruleUK: IBC review (potential subsidiarisation / separation)

CompensationDeferred compensation requirements, structure, risk-adjustment and quantum

SEFs/OTFs

Execution shift of standardised OTC towards electronic trading on SEFs/OTFsPre-trade transparency that is more “equity like” – RFQ to 5, 15 second show

0-2% 0-1%Clearing

Mandatory central clearing for standardized OTC; capital punishment otherwise

Commodities regulations

Impose restrictions on investment bank ownership of commodities infrastructureAggregate position limits on contracts with same underlying; hedging restrictions

Short selling

Ban on naked short selling in France, ban under economic duress in Europe; short selling disclosure requirements

Consumer protection

Increase in credit rating agency transparency Duty of care regulations for some segments e.g. munisIn retail, fixed salesperson incentives, product standardization and transparency

0-1% 0-1%Solvency II

Levelling of playing field between banks and insurance with new capital requirements

Hedge Funds

Increased capital and reporting requirements for HFs MiFID in Europe drafting some HFs/HFTs under regulation

Tobin tax Transaction taxNA 0.5-1%

Balance sheet tax Levy / tax on bank balance sheets (UK, some EU)

Base case impact on RoE pre-mitigation ~10% 7-9%

Base case impact on RoE post-mitigation 4-6% 4-6%

Bull/Bear Range

4-8%

1. Solvency & liquidity

2. Systematic risk and bank structure

3. Market structure

4. Clients & adjacent industries

5. Tax

Impact pre-m

itigation and not additive across elements

ROE impact pre-mitigation1

Degree of certainty

Category Theme Key regulatory elementsMar. 2010

Mar. 2011

Basel 2.5Use of stressed VaR, incremental risk chargesTreatment of securitisation in Pillar 1

5-6% 3-5%

Basel 3

Improve quality of tier 1 capital; new gross leverage capLiquidity ratios: coverage, NSFRNew counterparty credit risk charges

SupervisionFinancial Stability Oversight Council (with OFR), European Systemic Risk Board

1-3% 2-4%

G-SIFIHeightened capital requirements for global systemically important institutions (G-SIFIs)

RRPs Resolution and recovery plans (“living wills”)

Narrow bankingUS: Swaps spin-off; Volcker ruleUK: IBC review (potential subsidiarisation / separation)

CompensationDeferred compensation requirements, structure, risk-adjustment and quantum

SEFs/OTFs

Execution shift of standardised OTC towards electronic trading on SEFs/OTFsPre-trade transparency that is more “equity like” – RFQ to 5, 15 second show

0-2% 0-1%Clearing

Mandatory central clearing for standardized OTC; capital punishment otherwise

Commodities regulations

Impose restrictions on investment bank ownership of commodities infrastructureAggregate position limits on contracts with same underlying; hedging restrictions

Short selling

Ban on naked short selling in France, ban under economic duress in Europe; short selling disclosure requirements

Consumer protection

Increase in credit rating agency transparency Duty of care regulations for some segments e.g. munisIn retail, fixed salesperson incentives, product standardization and transparency

0-1% 0-1%Solvency II

Levelling of playing field between banks and insurance with new capital requirements

Hedge Funds

Increased capital and reporting requirements for HFs MiFID in Europe drafting some HFs/HFTs under regulation

Tobin tax Transaction taxNA 0.5-1%

Balance sheet tax Levy / tax on bank balance sheets (UK, some EU)

Base case impact on RoE pre-mitigation ~10% 7-9%

Base case impact on RoE post-mitigation 4-6% 4-6%

Bull/Bear Range

4-8%

1. Solvency & liquidity

2. Systematic risk and bank structure

3. Market structure

4. Clients & adjacent industries

5. Tax

Impact pre-m

itigation and not additive across elements

Source: Oliver Wyman 1. Based on application of proposed regulations to 2010 business structures (inc. preserving current capital ratios) ROE impact are non-additive due to interactions between elements (e.g., OTC reform and Basel III have partially offsetting inputs on CCR RWA)

9


Exhibit 8 RoE impact: (C) Management response

Management action RoE

impact Requirements Portfolio shifts 0.5 -

1% • Relative Equities and IBD growth

FICC restructuring 1-2% • Product and activity reprioritisation within FICC

• Exit and run-down of non-core businesses

Financial resource efficiency

1-1.5% • Optimisation of liquidity, capital, balance sheet

• Pricing and governance structures to support

Front-to-back costs 1-1.5% • Re-engineering of business structures, front-to-back

• 7% cost reduction

ROE upside via Management Action

4-6% • Re-engineering of business structures, front-to-back


We think much of the global and national regulatory programme is addressing the right issues in response to the banking crisis: improving bank solvency; delivering more resilient funding profiles, addressing too big to fail and ensuring resolution and recovery can be managed smoothly; inserting circuit breaks in traded markets; reducing interconnectedness risk; improving quality of supervision; redefining the borders of banking, and so on. Where we have concerns, they revolve around calibration, impact assessment, international coordination and the impact on credit provision and economic growth. As examples: • We do not think the impact assessment on end-users

such as corporates, pension funds, insurance companies and municipals has been fully addressed yet, (as we argue later);

• Over-compression of the banking industry and under attention to the non-banking sector could potentially result in future bubbles being harder to identify and new under-regulated too-big-to-fail entities emerging;

• Understandable national response and compromises of international co-ordination could result in a variable set of rules;

• Potential that the overlapping impact of new rules or calibration of the overall programme could be so severe that it would impact the functioning of wholesale markets, credit extension and thereby be a drag on growth;

• Stable funding rules could impact lending practices in Europe and have second order issues such as deposit wars; and

• Phasing of new rules with policy exit is also critical, and there is a material risk new rules come quicker than policy support exited, notably in Europe.

On the whole, we think most policy makers are broadly seeking to get the right balance between stability and resilience and economic growth, but clearly until the calibration of the rules is set and with so many different overlapping national and international agendas, it is difficult for investors to get a really accurate read of the implications on banks’ earnings and knock-on impacts.

On the latter point, our base case for the impact of the full program industry-wide is (4%)-(6%). However, as the full regulatory programme reads today the downside could be as high as (12%). We think obvious sensible outcomes bring our bear case down to (8%); examples of key areas we assume in our base case that the regulators will settle will ultimately include funding ratios, CCR on non CCP, treatment of some types of securitisation, level of capital holdings for SIFIs, extent of leverage restrictions outside the US, and some elements of Basel lll in the US.

Phased implementation of regulatory reform will give banks time to adjust. Basel 2.5 is to be implemented in 2012, but most of Basel III is dovetailed over the following seven years, and this transition affords the industry time to respond (exhibit 35). We think 2011 and 2012 could be reasonable years for returns as industry revenues are reasonable, cost controls kick in after over-hiring, the legacy book drag diminishes, low tax rates continue from prior year losses, and the impact of regulatory change has yet to fully pass through. Our base case industry returns of 13-15% look achievable (versus about ~14% in 2009 and ~13% in 2010).

Management action is critical, but banks remain a geared play on market volumes and economic growth. We see plenty of scope for focused management action to rebuild capital and returns, but market volumes, economic growth, and the regulatory program are clear swing factors that could reduce industry returns to 9-11% in a bearish scenario or deliver 15-17% in our bullish scenario by 2013. Exhibit 4 shows a range of scenarios, building in a level of interplay between these two dimensions.

10


Exhibit 9 RoE for major investment banks Reported RoE, 1993-2010

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

'10'09'08'07'06'05'04'03'02'01'00'99'98'97'96'95'94'93

Maximum Median Minimum

Cycle ‘93-’99Avg RoE = 15.4%

Cycle ‘00-’06Avg RoE = 17.5%

-100%

//

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

'10'09'08'07'06'05'04'03'02'01'00'99'98'97'96'95'94'93

Maximum Median Minimum

Cycle ‘93-’99Avg RoE = 15.4%

Cycle ‘00-’06Avg RoE = 17.5%

-100%

//

Source: Company reports

Exhibit 10 RoE1 evolution drivers. RoE (%)

0% 5% 10% 15% 20%

Average RoE Negative driver Positive driver

Structural change

2009-10change

2009

Weaker H2 revenues

Reduction in credit losses

Costs and capital growth

2010

Improved BS efficiency

Weaker op. efficiency

Deleveraging

2004-2006

0% 5% 10% 15% 20%

Average RoE Negative driver Positive driver

Structural change

2009-10change

2009

Weaker H2 revenues



2010



Deleveraging

2004-2006

2009

Weaker H2 revenues



2010



Deleveraging

2004-2006

Source: Public data, Oliver Wyman analysis 1. RoE post tax, post provisions

2. The spread between winners and losers will remain wider for longer.

Among the top 20 large and medium-sized firms, the wide spread of returns between the best-positioned and potentially challenged companies will probably persist for far longer than it has after past asset quality crises, given the scale of the shock, the size of legacy assets, and the nature of regulatory reform. Those with healthier balance sheets and better funding profiles and operational scale should be able to make better use of today’s opportunities. The market may underestimate how much global banks have regrouped and how this regrouping has inhibited the growth of many regional players and boutiques, with the exception of a few with strong strategic clarity and a number of firms in the emerging markets.

A group of “super-global” banks is emerging that combine strong funding and balance sheet positions with scale in flow trading businesses. Interestingly, despite the huge problems in many banks, several global banks bounced back strongly in 2010 and have now stabilized and even won back market shares (exhibit 11), particularly amongst a handful of the universal banks. We expect the spread of returns between best positioned and potentially challenged in the top 15-20 banks to persist far longer than it has after past asset quality crises. Winners in the 2011-13 markets will excel in:

• Infrastructure and e-commerce as a means to win client share and make flow-trading gains.

• Responding quickly to regulatory change – shifting cost/capital/headcount across the portfolio to improve capital efficiency and adopting new regulatory-driven market structures in flow products.

• Portfolio focus – banks will need discipline to pull back from or ignore markets with poor returns or where they have no competitive advantage, rather than trying to keep their options open.

• Clients and content – ensuring coverage discipline on the issuer side and investor side of the business and increasing the quality and deployment of client-focused ideas and research.

• Portfolio balance – within FICC or across FICC / equities / IBD, or both, earning most revenues from capital-light businesses.

11


Exhibit 11 Competitive landscape in wholesale

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2007 2009 2010e

Mar

ket s

hare

Global winners

Globals looking to recommit

“Bank the profit”Domestics/ Regionals

Expanding Regionals

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2007 2009 2010e

Mar

ket s

hare

Global winners

Globals looking to recommit

“Bank the profit”Domestics/ Regionals

Expanding Regionals

Source: Oliver Wyman data and analysis Note: Excludes writedowns

Larger global banks may consolidate further, as scale, infrastructure, and distribution become more important – and so a greater challenge for the lower end of the top tier of global banks. This said, we do note there is likely to be an unlevel playing field in regulation, although it is not yet clear how this will play out. US players could well be disadvantaged in some areas if US regulation on market structure and scope of activities is more punitive. Some Swiss and UK banks could be disadvantaged if a materially higher bar of capital is required in these markets.

Outside of emerging markets, boutiques and regionals have struggled to continue to seize share as some of the globals have bounced back. One of the intriguing trends of the past two years is the failure of more than a handful of boutiques and regional banks to gain material market share in major markets outside emerging markets. As several of the globals have bounced back, several of the regionals have struggled to capitalise on the opportunities presented post-crisis. The significant gains made by this competitive segment of the market in 2009 have trailed off, partly as several of these firms were weighted towards some of the businesses that shrank the most in 2010. Asia and the Emerging Markets are an exception and we expect to continue to see ferocious competition in these markets.

Some regional banks could emerge as market leaders, with strategic clarity, strong local franchises in emerging markets, sticky corporate client franchises anchored in transaction banking, strong balance sheets or areas of deep product expertise. Returns for many regional banks will be boosted by cash and payments platforms but the corporate banking portfolio looks set to continue to drag on returns. However, we do see challenges for some regionals still following aggressive growth plans conceived under different conditions. For banks in this tier, we see it as essential to absorb the outlook and likely impact of regulatory change and changes in corporate banking and to focus strategies to deliver acceptable returns over the next two to four years.

Will the pressure on returns result in exits? We think not, as in the short term the RoE of the capital markets business for some of the disadvantaged firms is still higher than that for corporate lending or retail banking. In fact, regulatory changes in funding could mean more corporates go to the bond market in Europe, leading some corporate banks to invest in wholesale banking as a defensive measure. Finally, it is worth noting that several of the smaller ‘defensive’ domestic wholesale banks that focused on optimizing their client reach in their home markets which have fared relatively well in 2010.

Some boutiques have benefited from the fallout of the financial crisis but may struggle to grow from here. US-centric firms are pushing for more international business, advisory firms are building underwriting capabilities, and corporate financiers are looking to build out distribution models. Most are facing the same challenge – they are looking to broaden their offer as they start to hit a ceiling on a monoline offering. The risk of expansion should not be underestimated when the globals are fighting for every dollar.

12


Major Changes Ahead for Corporate Banking

Before the crisis, corporate banking generated low but relatively stable returns of 9-14% RoE (depending on the market and segment). Although a much lower-return business than sales and trading, it benefits from low client turnover, a captive audience for cross-selling once loan relationships are established, and limited earnings volatility pre-provisions.

Most loans to corporates in developed markets are priced below risk-adjusted cost of capital on the basis that returns can be made from cross-selling risk management, advisory and transaction banking services. The short-term spike in financing margins post-crisis has not structurally changed this model. However, as exhibit 12 shows, current Basel lll proposals will change the economic relationship between the corporate sector and the banks fundamentally, with fully risk-adjusted loan pricing and collateral financing at the centre of the new model. Proposed regulation will lead to sharply higher funding costs for unsecured financing lines and significantly higher margin and collateral required for derivative positions.

This is likely to result in one or more of the following:

• The client pays more – this looks almost certain across all segments, with potentially material effects on economic growth, particularly in small and midcap sectors.

• Bank returns deteriorate – also highly probable.

• New winners emerge – a small number of banks could win share in cross-selling low capital and funding product – such as securities financing, advisory, FX, flow rates, deposits, payments services – much of which is tied to basic treasury and transaction banking services.

How will this affect the banks?

• Domestic or smaller regional wholesale banks often derive >60% of revenues from corporate banking, with portfolios typically skewed to smaller client segments. The client base here is relatively uncontested, and it seems plausible that the additional costs of financing will be passed directly on to clients.

• Larger regional and global universal banks operate very differently, typically servicing their large corporate clients out of the investment bank and with a middle market corporate bank ring-fenced within the investment bank or as a separate division. We would expect these banks to use the transaction banking axis to capture flows and create capital-light income streams, particularly in their attempts to push onshore in emerging markets where the economics are highly attractive.

• The pure play or hybrid investment banks generally service large corporates only, and maintain small franchise loan books they already consider to be a cost centre. Assuming a limited transaction banking offering, returns will have to be generated through securities origination and derivative transactions, reinforcing the emphasis on content and distribution.

Exhibit 12 Impact of Basel III funding costs on global corporate banking economic profit

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

Pre-crisislending loss

x-sell pre-crisis

Total beforecrisis

Negativefundingeffect

Profitabilityloss in

cross-sell

Total post-crisis

Trxn banking

Corp. Finance

RiskManagement

Risk Mgmt

USD

BN

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

Pre-crisislending loss

x-sell pre-crisis

Total beforecrisis

Negativefundingeffect

Profitabilityloss in

cross-sell

Total post-crisis

Trxn banking

Corp. Finance

RiskManagement

Risk Mgmt

USD

BN

Source: Oliver Wyman analysis

3. Changes in liquidity / funding will have a bigger impact on clients as banks reprice and adjust than the market expects.

As banks respond to higher capital and funding requirements in the most impacted businesses such as credit and structured rates, they will respond by repricing and shrinking. Corporates hedging their exposures, pension funds/insurance hedging long-term liability with derivatives and users of long-dated lending (infrastructure, municipal finance) will be heavily impacted. At the margin, better-funded banks will reap the rewards of supply constraints, but the nature of that advantage is still in flux.

Greater impact on a wider range of offerings. The cost and scarcity of unsecured funding – alongside capital constraints – will drive banks to continue to shrink units that are heavy consumers of unsecured funding and balance-sheet intensive. The obvious units are warehouse lending, non-investment grade debt, proprietary trading, and illiquid fixed income – but we think the market is underestimating the impact on a wider range of offerings.

13


Exhibit 13 Industry client sales1 mix (IBD, equities, FICC) $bn, 2009

$95BN

$85BN

$40BN

Corporates

Banks & insurers

Public sector

Hedge funds

Asset managers

45% 31% 27%% Buyside2

Americas EMEA APAC

$95BN

$85BN

$40BN

Corporates

Banks & insurers

Public sector

Hedge funds

Asset managers

45% 31% 27%% Buyside2

Americas EMEA APACAmericas EMEA APAC

Source: Oliver Wyman proprietary data and analysis 1. Sales normalised to industry standard sales credit methodology 2. Buyside = Hedge Funds + Asset Managers

The need for collateral means hedging costs will move sharply higher for corporates. In the extreme, some markets could shift towards an Asian model, where many corporates have to manage foreign exchange (FX) and interest rate risk themselves. As corporate derivatives become more expensive, banks will need to reprice their loan portfolios, a scenario that could involve an annual profit and loss charge of about $20 billion to the corporate sector just to break even. This is more than large enough to hurt corporate profits for many segments.

Is more disintermediation in European debt markets and supply constraints possible? Changes in the stable funding ratio, for example, would make long-dated, low-margin municipal finance less attractive for banks, as well as businesses that do not generate liquid collateral (such as infrastructure finance, SMEs, micro-finance, etc.). This has

major implications for how municipals get funding and could lead to more disintermediation in European debt markets and/or supply constraints in some segments.

Synthetic swaps for liability-driven investing (LDI) will become far more expensive, threatening the model for asset managers doing synthetic LDI. We think $2 trillion more collateral may be needed in our base case, about half of which will be for asset managers. This additional collateral could undermine the LDI model emerging in these sectors.

But the implications could take time to feed through in practice. Liquidity rules are proving the trickiest to frame and implement at the Basel level (stable funding rules have already been revised twice and are still far from workable) and at the national level, where much room has been given for manoeuvre, alongside significant government involvement. So the real implications of funding could well take longer to come through as the implementation of liquidity rules are delayed until “policy exit” from central bank support for the economy and the banking sector is further advanced.

Cheaper funding and better funding profiles will be a major source of competitive advantage. Regulators are increasingly seeking to have more capital trapped in each major subsidiary; however, banks that are well-funded, diversified and capital generative will have a significant funding and pricing edge over a more skewed bank. Strategically, banks will need to address the funding and business balance question. Exhibit 14 shows the increase in funding costs passed through to different segments of wholesale banks based on the current reading of Basel lll. The larger European investment banks and the European regionals are most affected and will experience the largest increase in costs. By contrast, many US banks and emerging market banks start from a position of relative strength and will face much lower increases in funding costs at the divisional level.

14


Exhibit 14 Impact of Basel III regulations on key financial metrics1

% incremental Tier 1 capital required

% below liquidity coverage ratio of 100%

% below stable funding ratio of 100%

% increase in RWA

US Banks

Eur IBs

European Regionals

Emerging Market Majors

15-25%

20-50%

2-45%

0-20% 190%

200%

180%

0-5%

0-15%

0-15%

0-10%

0-15%

% increase in funding cost to wholesale bank2

5-35%

20-30%

10-35%

2-5%

Minimal impact

Minimal impact

Minimal impact180%

% incremental Tier 1 capital required

% below liquidity coverage ratio of 100%

% below stable funding ratio of 100%

% increase in RWA

US Banks

Eur IBs

European Regionals

Emerging Market Majors

15-25%

20-50%

2-45%

0-20% 190%

200%

180%

0-5%

0-15%

0-15%

0-10%

0-15%

% increase in funding cost to wholesale bank2

5-35%

20-30%

10-35%

2-5%

Minimal impact

Minimal impact

Minimal impact180%

Source: Oliver Wyman analysis based on publicly reported 2009 figures. Assumes capital required due to 7% CET1 ratio, 8% T1 ratio and 250% risk weighting 1. Bar represents the weighted average; lines represent ranges 2. Funding impact assumes increase in RWAs due to the BIII credit risk enhancements, B2.5 changes from May 2009, additional T1 requirements to meet new capital ratios and liquidity shortfalls

4. Sizeable shift in business to the non-bank sector

Markets and regulators may underestimate how much business could move into hedge funds, private equity, asset managers and other alternative sources of capital, over the long term, as banks respond to the regulatory agenda. We think the disintermediation trend for more European corporates to tap the markets will continue. We think long-dated lending will be impacted materially and infrastructure projects may seek to be funded directly by pension funds or in the markets as banks ration their activities. We also see a growing series of “niche” opportunities such as finance for SMEs (private equity, mezzanine), structured credit, commercial real estate, and some parts of shipping, infrastructure, and commodity finance. The challenge for the banks will be to make up for lost revenues, replace some of the key trading and advisory talent which will migrate to the non-bank sector and extract value from the shift in activity into this sector, which we estimate could present an $5-9 billion revenue opportunity – still smaller than the profits lost.

A change in capital rules and “demarcation” (e.g. Volcker rule) will push far more business into the asset management sector. Large parts of proprietary trading, direct lending, restructuring, and parts of complex derivatives could migrate out of the highly regulated deposit-supported banking sector. We also think banks contending with stable funding ratios will look to shed or ration some of their long-

dated assets such as longer municipal finance and project/infrastructure finance. Owners of long-term capital such as pension funds will increasingly be the source of the funding as well as equity for these types of projects, we think.

In the near term, the opportunities for funds will be in the niche categories such as finance for SMEs (private equity, mezzanine), structured credit, commercial real estate and some parts of shipping, infrastructure, and commodity finance. We also think more capital could be brought into market making/trading platforms.

We forecast hedge fund assets to grow at a 15% CAGR to $2.5 trillion by end 2012 (well above the 2007 peak). Policy makers are signaling more regulation of the non-bank sector, but bank deleveraging will shift activity into this segment. We note AUM invested in the alternatives sector has grown at a CAGR of 15% over the last ten years versus capital in the banking sector at 5% CAGR over the same period (exhibit 16).

The transition could be a $5-9 billion revenue opportunity for some firms – a helpful boost but not enough to offset lost revenues. The challenge for the banks is to extract maximum value from the transition. We

15


estimate the resulting opportunities – capital introduction services, private placements for direct credit investors, flow execution with non-bank market makers – could add $5-9 billion to industry revenues by 2013. This could soften the fall in revenues from reduced business lines, but the most nimble banks are likely to reap the lion’s share of new revenues. We see opportunities in the following areas:

• Execution and clearing services to new market makers, high frequency trading desks, and proprietary spin outs ($2-4 billion);

• Servicing new direct lenders, fixed income and credit funds that emerge to service the gap in credit provision ($1-2 billion);

• New profit-oriented capital-introductory type services that emerge to supply capital and leverage to the hedge fund community – where capital was formerly introduced for free and leverage was supplied by the banks ($1-3 billion); and

• Advisory services on portfolio divestments ($0.5-1.2 billion).

• But clearly the size and pace of these opportunities is subject to much uncertainty and we think this is still lower than lost revenues. From an operational point of view the banks would also have to replace lost talent – particularly trading and advisory (i.e. content) – which could move to the non-bank sector.

Exhibit 15 We expect 15% growth in hedge fund AUM in 2011

1,3301,430

1,105

1,4701,410

1,5351,600

1,668 1,648

1,769

1,9171,870

144

144

0%

3%2%

5%

-31%

13%11%

5%

-12%

3%

-8%

3%

500

700

900

1,100

1,300

1,500

1,700

1,900

2,100

2,300

2,500

2005 2006 2007 2008 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410 2011e Perf

2011e Flows

End2011e

Hed

ge F

und

Ass

ets

($bn

)

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Ann

ualis

ed F

low

Rat

e

Base 2,205

Bull 2,395

Bear 1,835

Source: Morgan Stanley Research

Exhibit 16 Evolution of hedge funds and wholesale banking capital, assets and returns 1990-2010E (1)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

1990-94 1995-98 1999-2002 2003-2006 2007-2010H

edge

fund

ass

ets

and

who

lesa

le b

anki

ng

capi

tal (

$ TN

)

0%

5%

10%

15%

20%

25%

Ret

urns

(%)

Bank allocated capital Hedge fund AUMWholesale bank RoE Hedge fund returns index

Source: HFR, SIFMA, Oliver Wyman analysis 1. Estimated total industry based on sample of banks

Exhibit 17 New opportunities in non-bank sector - $5-9bn possibly up for grabs

0

1

2

3

4

5

6

7

8

9

10

New Revenues from Shadow Banking

$BN

Servicing non bank market makers and risk takers

Servicing new direct Credit Funds

Direct capital and balance sheet to Alternatives

Advisory on divestiture

Perpetual revenue streams

One-off revenue streams

0

1

2

3

4

5

6

7

8

9

10

New Revenues from Shadow Banking

$BN

Servicing non bank market makers and risk takers

Servicing new direct Credit Funds

Direct capital and balance sheet to Alternatives

Advisory on divestiture

Perpetual revenue streams

One-off revenue streams


16


The Strategic Agenda

5. Adjusting to a more ‘beta-driven’ portfolio

Investment banking is becoming more ‘beta driven’ with a shift to businesses with high market gearing (investment banking, equities) and shift within fixed income towards greater beta (by reducing the focus on alpha drivers like structuring, principal and leverage). Our base case for the next two to three years assumes a material shift to equities and advisory (+10% CAGR base case) as cyclical growth kicks in. Fixed income credit commodities (FICC) is likely to shrink modestly again in 2011, although falling legacy losses should support reported revenues. For the industry at large in our base scenario, we see top line growth delivering minimal RoE improvement, though a bull scenario would significantly change that outcome.

More top-line volatility and balanced portfolios. We expect a shift to more beta-like businesses, which tend to have higher correlations with macro factors, such as investment banking, equities, and a shift within fixed income towards greater beta (by reducing the focus on alpha drivers like structuring, principal and leverage). As shown in exhibit 20, FICC was relatively correlated to the business cycle prior to 2003 and remained so in macro businesses (rates, FX). However, the growth in credit and securitisation in 2003-2007 decorrelated the overall portfolio from the business cycle, as structuring, principal positioning and leverage became more prominent growth drivers.

Ironically, the shift to flow in beta businesses could increase quarterly top-line volatility – despite the reduction in risk-taking – as revenues are no longer supported by positive balance sheet positions (e.g. carry trades) or risk taking, but should reduce tail risks. It also means that alpha generation will need to come from market share gains in core businesses, which implies greater focus on footprint and share of wallet, as well as scale, distribution and cost management. Volatility of returns could also drive banks to build and sustain more balanced portfolios.

We expect a cyclical upswing in equities and advisory on a two- to three-year view, but macro risks mean a moderate start in 2011. Our equities base case is for a ~10% CAGR in market activity over the next two years (bull +15% / bear -5%), driven by growth in Asia and Europe, improved market valuations, and increased M&A / event volume – but this assumes moderate outcomes on macro and sovereign risks. For investment banking, we expect steady refinancing activity to continue in debt capital markets, moderate growth in equity issuance (with a strong bias to emerging markets and European financial institutions) and M&A to rebound steadily, as we have seen in past cycles.

17


Exhibit 18 Revenue outlook for FICC Product 10/09 2010 performance drivers 11e/10 2011 performance drivers Rates $50 BN

-40% • Strong Q1, but rapid tail-off as bid-asks

narrowed vs. 2009, particularly in European flow

• Trading conditions less favourable – flat interest rates, yield curves more likely to flatten

• Euro crisis depressing volumes and causing some small losses

$45 BN -10%

• Continued weakening in trading conditions vs. q1 ‘10

• Some recovery in client volumes likely but continued intense competition in flow, pressuring margins

• Downside risks from exacerbated sovereign risk concerns, upside risks from volatility

FX $16 BN -10%

• Continuation of weak performance seen in 2009

$16 BN Flat

• Support from recovering global trade • Possibility of significant currency moves

Emerging Markets $24 BN -5%

• Continued strong results, but down slightly on a record 2009, with margins normalising and fewer one-off rebound effects

$25 BN +0-5%

• Local market economic growth, increasing client sophistication and continued investor flows driving fundamental growth story

• But competition and margin pressure intense• Potential risk of major correction and/or

restrictions in capital flows Credit & Securitisation $46 BN

-15% • Reduced activity in structured credit

repackaging • Continued strong client demand in flow

credit, but trading gains of ’09 not widely repeated

• Some strong results in distressed

$36 BN -20%

• Capital and funding pressures on securitisation and structured credit, combined with weak deal flow likely to drive renewed re-appraisals of these businesses at many banks

• Continued weakening in flow credit trading compared to recent records

Commodities $7 BN -50%

• Very weak trading opportunities in energy (oil, power and gas); some banks also recording losses in niche products

• Sales also down but more resilient than trading

• Forced sale of some commodities units incl. Phibro (Citi), Gaselys (SG) and Sempra (RBS)

$10 BN +30-45%

• Partial reversal of 2010 trading losses likely and some rebound in P&G, particularly NA, after a few bad years

• Supply side shocks (geo-political, climatic) likely to drive volatility and trading opportunities

• Increased volatility likely to see corporate sales growth with continued investor demand supported by inflationary expectations

FICC $143 BN ~-25 - -30%

$132 BN -5 - -10%

Bear/Bull range: $115 – $160 Bear/Bull range: -20% to +10%

Source: Underlying data based on Oliver Wyman proprietary data. Forecasts based on Oliver Wyman and Morgan Stanley

18


Exhibit 19 Revenue outlook for equities and investment banking Product 10/09 2010 performance drivers 11e/10 2011 performance drivers

Equities cash & prop $29 BN -10%

• Low volume growth (value traded up 2%) • Q2 dip driven by sovereign crisis-linked

volatility (up ~90%) • Several US banks exiting prop trading

activities

$31 BN +5-10%

• Cyclical growth supporting index and volume growth

• Pick up in client activity – HFs re-leveraging • EM (Asia & increasingly LatAm) capturing

retail investment flows • Some further withdrawals in prop

Equity derivatives $17 BN -20%

• Risk rally over on Q2 sovereign fears – softening in underlying demand

• Tightened margins in Asian flow/ delta 1 • Institutional demand (and supply) continued

to migrate away from complex products • Convertibles revenues/sales off double

digits on cyclical weakness

$19 BN +10 – 15%

• Cyclical uptick in FF&O with focus on Emerging Asia/India and commodities

• Retail structured product flows weak – consumer protection legislation pressuring distribution

• Upside from increased transparency remains outside 2011 forecasts

Prime Brokerage $13 BN -5%

• Funding pressures eased in US/EU, increased in EM

• Margins still strong though compressed from 2009 as supply side flattened

• Hedge fund flows remained positive though leverage ratios off 2007 highs

$14BN +5 - 10%

• Growth in balances driven by re-leveraging on more benign market and new activities (partially in substitution to banks); AUM up 15-20% for the HF industry

• Margins likely to come in as growth picks up

Total equities $59 BN ~-10%

$64 BN ~5-10%

Bear/Bull range: $55 - $70 Bear/bull range: -10% - +15%

Investment Banking $58 BN ~5%

• M&A recovery underway but still far below pre-crisis levels

• Record DCM origination as corporate, financial, and public issuers sought to lock in attractive long-term rates

• Sharp decline in ECM origination in the West offset by continuing strength of Asian growth markets

$60 BN +0-5%

• Strong cash balances and eventual return of private equity likely to spur M&A growth

• Asian ECM market almost certain to maintain its strong growth, driven primarily by mainland China

• Sovereign and quasi-sovereign issuance likely becoming a theme worldwide

• New regulations driving demand for (often local currency) financing to fund balance sheet restructuring, liquidity needs, and resolution plans

Total underlying income $260 BN -15 - -20%

$256 BN 0 - -5%

Bear/Bull range: $225 - $290 Bear/Bull range: -15% to +10%

Source: Underlying data based on Oliver Wyman proprietary data. Forecasts based on Oliver Wyman and Morgan Stanley

19


Exhibit 20 Drivers of wholesale banking revenues

0%

20%

40%

60%

80%

100%

1997 2000 2003 2006 2009

Equities FICC IBD

DriverCash equity EQD Prime

Rates & FX

Credit & ABS CTY EM M&A ECM DCM

MSCI worldEquity volumes

OECD GDP

EM GDP

Interest rates

Yield curve

TED spread

Credit spread

Oil price

R-Squared Equities: 75% FICC: 60% IBD: 90%

Strong positive Weak positive Strong negative Weak negativeRelationship:

Regression model factors Regression output1

Revenues, $BN

Pred

ictiv

enes

s

0%

20%

40%

60%

80%

100%

1997 2000 2003 2006 2009

Equities FICC IBD


Rates & FX



OECD GDP

EM GDP

Interest rates

Yield curve

TED spread

Credit spread

Oil price




Revenues, $BN

Pred

ictiv

enes

s


Rates & FX



OECD GDP

EM GDP

Interest rates

Yield curve

TED spread

Credit spread

Oil price




Revenues, $BN

Pred

ictiv

enes

s

Source: Public data, IMF, Dealogic, Global Insight, Oliver Wyman

1. Predictiveness calculated as regression error margin 1- (Historical data – model output)/Historical data

Our fixed income base case for 2011 is down ~5-10% underlying (i.e. prior to write downs) with our bull case at +10% and bear (15%)-(20%). We expect 2011 to be driven by the macro businesses (foreign exchange and rates)

helped by a rebound in commodities, while credit is likely to be much weaker than in 2010. Cyclical improvements and credit recovery should support FICC modestly into 2012/13, with headwinds from rising rates and inflation.

20


Exhibit 21 Pre- and post-credit write-down revenues by product Industry revenues 2004-11E, $bn

50

0

50

100

150

200

250

300

350

400


$115 BN

$220 BN

$35 BN

280

2006

300

20081 Net

205

2007Net 2009Net

315

G10 stagnation

2010

260 290

Bull

255

2004

215180

2005

225

Base

2011 scenarios

245

Inflationary50

0

50

100

150

200

250

300

350

400


$115 BN

$220 BN

$35 BN

280

2006

300

20081 Net

205

2007Net2007Net 2009Net2009Net

315

G10 stagnation

2010

260 290

Bull

255

2004

215180

2005

225

Base

2011 scenarios

245

Inflationary

1. For 2008 credit revenues are negative, represented by the cross-shaded area: this should be added to the dark blue area to read the total volatility revenues. Source: Oliver Wyman data and analysis, discussions with Morgan Stanley on forecasts

Recap of 2010

After the strong rebound in Q2 09, Q3 09 and Q1 10, business came back to earth in 2010.

• Fixed income was off ~25-30% overall in 2010, with rates, and commodities worst hit, down 40% and 50% respectively, while credit and FX were down a moderate ~15% and 10%.

• Equities down ~10% overall as low GDP growth and concerns over sovereign risk kept indices and client volumes at lows. Cash equities was down ~10%, with index volatility in Asia and disappointing client volumes in the US and Europe. Equity derivatives suffered a very difficult year down ~20% with tough trading conditions in Q2, and disappointing client activity in structured volumes and flow volatility. Relatively flat Prime Brokerage revenues – as some funds put marginal balances to work – did not make up the difference.

• IBD overall was down ~5%, as HG DCM fell off sharply. The promising M&A pipeline of Q4 2009 did not materialize, and G7 ECM was muted. The hotspots were China ECM, HY DCM, some Commodities and financial institutions (“FIG”.

• Overall RoEs were about ~13% (with our allocations).

6. Gaining share in equities and advisory, accessing growth in emerging markets

Equities and advisory will be prioritised at the expense of much of fixed income, given equities’ appealing 15-20% RoEs even post regulations – which could knock 2-4% off RoEs. This is in contrast to FICC where, returns are prima facie impacted by twice as much. The importance of emerging markets looks set to intensify, but rising costs and falling yields will mean less of the top-line growth comes through to the bottom line. Clearly, the focus on equities could put further pressure on margins. We see structural industry shifts towards equities and advisory and from G7 towards emerging markets unlikely to deliver more than 0.5-1% RoE improvement at industry level in our base case, though more for some firms.

Post tax RoEs in equities and advisory could significantly outstrip much of fixed income trading post Basel lll, on our analysis, leading banks to reshape portfolios and investment in 2011/12. We think equities – including equity underwriting –will deliver ~15-20% returns on allocated equity, even after a ~2-4% reduction from regulatory

21


change. In contrast, FICC is prima facie under the most pressure from Basel lll capital rules, with RoAE falling to about 7-9% prior to significant management action. We estimate FICC will see a >2.5x increase in risk weighted assets, and is also most exposed to other regulatory changes, notably derivative reforms. Banks will not be able to deliver the 13-15% returns expected by investors without significantly reshaping their portfolios.

Major global players should make RoAE well above CoE in equities. Equities is intensely competitive – the top nine players are tightly bunched and numerous players are trying to enter – but the highly scaled global players with strong electronic capabilities, derivative, research/advisory

capabilities, prime brokerage, risk management, and – critically – large underwriting activities should be able to make RoAE well above CoE. We think global reach and strong market shares will compound their competitive advantage, while the second tier face a tough challenge to deliver good portfolio economics without scale in cash, prime brokerage or flow derivatives. Asia is a particularly competitive environment in equities, as many regional firms look to build out their pan-Asian platforms and all of the global players converge around the China-led equity capital markets pipeline. This said, we clearly see the case for margins coming under pressure from the weight of competition but think they will not be crushed.

Exhibit 22 Possible impact of regulation on RoEs by division

Business area 2006 Avg. 09-10 2009 2010E

2010 on Post B3

Basis

Pot. 2013 on Post B3

basis Perspectives Legacy Drag1 -20%

-25%

-8% NA NA • Most of the legacy drag has been on FICC though some on EQD in 2009 in particular

Underlying FICC (incl DCM)

30-35% 30-35% 39% 18% 7-9% 10-14% • Peak FICC ROE was >30% • Regulations have specifically targeted complex/structured

FICC products in an attempt to reduce industry risk • Securitisation and structured rates worst hit • Credit flow and financing are not hit as severely

Underlying Equities (incl ECM)

15-20% 20-25% 32% 23% 15-18% 15-20% • Peak Equities ROE was 30-35% • Impact on equities is minimal compared to proposed FICC

regulations • Like FICC, regulations focus squarely on complex equity

and off-exchange derivatives • Prime Brokerage is significantly impacted by balance sheet

constraints Advisory1 >40% >35-40% >45% >35% >35% >30% • Advisory is minimally impacted by regulations due to limited

risk-taking in the business Total 25-30% 10-15% 14% 13% 9% 13-15% Source: Oliver Wyman data and analysis 1 Allocated RoE drag from excess equity, lending and legacy books allocated back out to the business lines. Corporate lending will be allocated to advisory – overall RoE will be significantly lower on a non-standalone basis.

Emerging market RoEs may be more modest than the market expects. Emerging markets drove ~20% of total revenues in 2010, but 50% of what growth there was in the market at the product level, with ~$5 billion of revenue growth up for grabs in equity trading and origination, advisory and parts of FICC EM. We expect the dichotomy to continue, with global industry growth in single digits in 2011 against double-digit growth in the emerging markets, driven by the rebound in FICC, search for yield, a strong origination pipeline, and GDP-led growth in the local client base. However, this raises a number of concerns:

• Capital inflows yields in many emerging markets have fallen sharply, in some cases to below developed markets levels.

• The cost of doing business locally has increased with the cost of trapped balance sheet (funding costs are up 20-30bps in many countries) and falling yields (down below investment grade in China).

• Emerging markets can be balance sheet consumptive, as banks historically have gone in and lent money to win market share. This is now inconsistent with the constraints on balance sheet and the need to access emerging market liabilities.

22


Exhibit 23 Developed markets versus emerging markets in 2010

Macro scenario Growing businesses

2009 Net Revenues

Revenue reduction in

2010 in shrinking

businesses

Revenue growth in

2010 in growing

businessesDeveloped Markets

High Yield, FX, Parts of Commodities, HG in some markets, sub-segments of equity derivatives

$220 BN Down ~$28 BN

Up ~$5 BN

Emerging Markets

Most businesses with some exceptions

$60 BN Down ~$1-2 BN

Up ~$5 BN


Global banks are less advantaged but will compete hard for share. Although capital inflows/outflows have remained an important driver of emerging market revenues, local client base, infrastructure, financial strength, local funding, and content have become pre-eminent. This means that significantly more of the growth has gone to emerging market regional and local banks in the last one to two years than to the global banks, bucking the general swing back to the global players in 2010.

A key battleground is the large industrialising emerging markets, which represent ~45% of total emerging market

revenues and are among the fastest growing. In these markets corporate lending and transaction banking remain key access points, as well as being significant revenue (and deposit-raising) opportunities in their own right for those with local balance sheet (exhibit 24).

Exhibit 24 Market Structure % wholesale and corporate banking revenues

5-10% 10% 70-75%10%

Number of countries: 115 6 12 34

Examples: ArgentinaNigeriaVietnam

BrazilChinaTurkey

KoreaMexicoMiddle East

N. America JapanW. Europe

0%

20%

40%

60%

80%

100%

Small EM /Frontier

Big industrial EM s Quasi-Developed Developed

Fixed income Equities IBD

Corporate Lending Transaction banking Structured financing

5-10% 10% 70-75%10%

Number of countries: 115 6 12 34

Examples: ArgentinaNigeriaVietnam

BrazilChinaTurkey

KoreaMexicoMiddle East

N. America JapanW. Europe

0%

20%

40%

60%

80%

100%

Small EM /Frontier

Big industrial EM s Quasi-Developed Developed

Fixed income Equities IBD

Corporate Lending Transaction banking Structured financing

Source: Oliver Wyman data and analysis

7. Reshaping the fixed income portfolio

The market is right to be worried about FICC, but we think it underestimates how differently businesses will be affected. Regulation could halve underlying fixed income returns before management action, but credit trading will take a much bigger hit than foreign exchange. We estimate that ~65% of FICC revenues are already or are on track to be broadly fit for purpose for regulatory change. Flowmonsters – banks with high scale in a product or region – will be best placed, and 2011/12 will see much business reshaping, which at the industry level we believe can deliver 1-2% improvement in RoEs.

FICC returns have been and will remain most subject to change in the next few years, as exhibit 22 shows. This analysis separates the underlying returns of the business from the return drag of the legacy portfolios: apparent RoE hit highs of 30-35% in 2006 (although this excluded financing costs and what turned into bad debts), and returns in 2009 hit 40% on the underlying business. However, allocating the drag from legacy portfolios has offset this heavily, reducing the fully loaded FICC RoE to ~14% on average in 2009/10.

Most worrying, we estimate FICC returns in 2010 on a post Basel lll basis fall to 7-9% fully loaded, as the sharp increase in RWAs hits the capital base and funding costs are fully passed through. Clearly, this is a somewhat ‘synthetic’ analysis, in that it disregards management action to improve RWA and balance sheet efficiency or indeed the potentially positive impact of OTC reform (see breakout box below). Building these in, we estimate the industry can generate FICC returns of 10-14% by 2013.

Distribution of FICC returns around these averages is likely to be wide with firms that reshape portfolios delivering acceptable returns, while others struggle. We therefore expect considerable pressure in FICC to clean up asset quality, reshape the product portfolio, refocus the cost structure, and build out distribution capture.

We think ~65% of FICC revenues are already broadly fit for purpose in the new regulatory regime, and some businesses will remain very attractive even under new regulatory constraints.

23


• Some businesses (~35% of FICC revenue base) attractive today (e.g. FX, government bonds, futures and options) that are likely to remain attractive in the near-term despite meaningful regulatory pressures. Foreign exchange is one of the businesses least affected, in part because it is already highly electronic and more driven by client flows. Indeed, market shares have become more stable since the market has become electronic, as scale economies have played a larger role – a possible role model for other businesses set to move to greater electronic trading

• Some businesses (~30% of FICC revenue base) in a process of major regulatory change but that should still remain attractive (e.g. flow rates and credit), and indeed will see some benefits from regulatory changes (e.g. reduced capital requirements on cleared business although the cost of collateral will be a key swing factor).

But ~35% of fixed income revenues are heavily pressured by new regulations – namely credit (particularly securitisation and structured credit), commodities, parts of emerging markets and structured rates. This is mainly due to increased capital requirements. All players will probably need to rethink their business models, and only the strongest players will see stable returns in the medium term. We think many players will look to reprice their offer in order to pass on the higher costs of regulation, change the way the business are run (e.g. through far greater use of clearing) and/or shrink the resources they deploy to these areas. We think the market has not fully worked through the impact of these changes on the clients and how banks will seek to respond to new regulatory standards. But we recognize from our meetings that a number of the global banks are further ahead in repricing and reshaping their business practices than others although the exact rules are still being refined.

Exhibit 25 About 75-80% of industry revenues are broadly “fit” for new regulatory regime 1 Incremental cost of equity and funding/revenue

0%

20%

40%

60%

80%

100%

120%






central clearing



products

Stru

ctur

ed

cred

it

Sec

uriti

satio

n

Stru

ctur

ed

rate

s

Com

mod

ities EM

Fina

ncin

g

FX

Flow

Cre

dit

Prim

e br

oker

age

Flow

EqD

Stru

ctur

ed E

qD

F&O

Cas

h eq

uitie

s

EC

M,

DC

M, M

&A

Flow

Rat

es

0%

20%

40%

60%

80%

100%

120%






central clearing



products

Stru

ctur

ed

cred

it

Sec

uriti

satio

n

Stru

ctur

ed

rate

s

Com

mod

ities EM

Fina

ncin

g

FX

Flow

Cre

dit

Prim

e br

oker

age

Flow

EqD

Stru

ctur

ed E

qD

F&O

Cas

h eq

uitie

s

EC

M,

DC

M, M

&A

Flow

Rat

es

Source: Oliver Wyman data and analysis 1. “Funding” is the increase in term funding required; “RWA” is the impact of additional RWA requirements under Basel 2.5 and Basel 3, charged at a 10.5% cost of equity and assuming 12% regulatory capital (before and after Basel 3); “Leverage” is the additional capital required to meet the leverage ratio (if this were enforced at the product level), charged at 10.5% cost of equity

24


Firms will start to take make clearer portfolio decisions in 2011/12 to boost RoE. Banks have kept many options open, given the highly uncertain environment, and have rebuilt key flow products to drive returns. As visibility on regulation and business economics improves, banks will make clearer portfolio decisions. All major FICC divisions are also likely to have to look at their cost base and capital consumption with an eye for tactical savings.

Flowmonsters with scale and diversified cross portfolio economics will retain the competitive advantage, and many are moving fast to change their business models, particularly around clearing, flow product, and capital and liquidity management.

Mid-tier players face the toughest challenge in a Basel lll world and will need to select and prioritise those businesses where they have an edge, ensuring a focus on profitable markets where top-5 status can be achieved and defended, while maintaining the coherence of the overall offering. Some of the smallest players may fare reasonably well, as their macro-oriented portfolios (FX/rates) are largely sold to related corporates/retail and are less affected by Basel lll

Legacy books should fade as an issue. Legacy books were still a major drag on FICC returns in 2010 (~300-400bps, we estimate). This drag should fade over the next three years, revealing the underlying new business margins.

Balance sheet velocity will be critical – which we discuss in the following section.

Derivatives markets Derivative market reform will alter the industry’s structure and competitive landscape fundamentally, but it is probably a 2012 event.

We expect significant change to this industry but anticipate this to start to take hold in 2012 – not 2011. The sheer volume of regulatory change is dramatic – there are some 200-300 rules under draft in the US alone related to Dodd Frank, and regulators also face the significant challenge of ensuring US and European markets evolve in a complementary way. Centralised clearing still requires significant operational change for the buy and sell side and market infrastructure, and to date there are still massive unknowns in terms of central clearing counterparty landscape, quantity of margin required, scope for netting, accounting treatment, and so on.

Although banks, their clients and the market infrastructure are responding to the likely change, the full response will depend on the finalised details of the reforms. This said, over the medium term, our research suggests that most buy-side clients of

banks are shifting attitudes towards being strongly in favour of the risk reducing aspects of centrally clearing transactions, assuming it is at worst cash flow and P&L neutral for them, albeit significant concerns persist around margining and collateral costs, plus loss of negotiating power on margins with banks, and in operational risk in the transition period.

Pricing structures have yet to be stabilised but it is highly likely that there will be significant downward pressure on margins which will be challenging for the banking community. However, we do expect a number of partial offsets in the form of new revenue streams:

• A new business to emerge around collateral transformation;

• Financing likely to become a more explicit part of the business e.g. collateral finance, margin finance;

• Margining become a major feature in the industry so that the ability to manage cash effectively for clients and extract income from this process becomes key;

• Clearing fees likely to emerge as a material source of value; and

• From a service perspective access to capital issuance and content are likely to take a more prominent role as they do today in the equities business, particularly in credit.

There is plenty of scope for competitive reshuffling here:

• An opportunity for market infrastructure players to take a significant share of the intermediation pie as clearing houses, trade repositories and other data and analytics providers, and electronic execution facilities emerge;

• Competition in electronic execution is likely to be particularly intense, as the IDBs, exchanges, and new entrants compete with the broker-dealers to gain share in SEF/OTF executed business (exhibit 26); and

• Complex interplay between clearing and execution as end-clients look to their key banking relationships to provide integrated post-trade services, and likely consolidate non-cleared business with these firms for efficient management of counterparty risk.

Critical areas of concern in the industry include the disruption to liquidity due to a one size fits all approach to OTC, which would remove valuable flexibility, plus the pace of rule making and implementation, which could fail to build in adequate time to evaluate potential unintended consequences. There are risks that increased transparency in certain areas of the market could lead to unintended consequences. For example, on large swap trades where a bank cannot remove the risk position from its balance sheet prior to trade reporting, the cost of hedging will likely be passed to the end user or banks may choose simply not to do the business. Equally the requirement for an end client to show a trade to multiple dealers could have damaging market impact implications for the client.

25


Exhibit 26 Impact on OTC execution venues Platform Example players Products Description Market dynamics and outlook Inter-dealer iSwap, BGC,

GFI, Millennium Rates • Inter-dealer electronic trading platform

• Often multi-asset, often integrated voice and electronic

• Some platforms include post-trade processing

• Primarily RfQ, some auctions and order books

• Will largely survive in existing form if separate inter-dealer market remains

• Some, limited adaptations will be required to comply with SEF requirements e.g. – Implementing RFQ or CLOB trading

systems – Changing access requirements e.g.

volume restrictions to expand access to broader range of dealers, including smaller ones

– Upgrade reporting capabilities Dealer-to-customer (multi-dealer)

Javelin, MarketAxess, Tradeweb

Rates, CDS • Often dealer backed or owned, multi-dealer electronic trading platforms

• Some on RFQ, some planning CLOBs

• Multi dealer-to-customer platforms are well placed to gain market share, particularly those that already utilise an RFQ pricing model

• Scope of players still reliant on hybrid or voice execution will require technological/operational improvements to become SEFs

Dealer-to-customer (single-dealer)

PRIMEtrade, eXpress, Autobahn, FXDealer

Multi-asset • Multi-asset, proprietary execution platforms • Institutional only (e.g. DB has separate retail

FX platform)

• SEFs must be multi-dealer platforms, therefore cannot survive in current form – can either expand to multi-dealer offering or compensate via participation in another SEF e.g. Barcap, Citi, CS, DB, MS consortium

• Significant adaptation required Source: Oliver Wyman

8. Distribution, delivery of advice, infrastructure and scaleability and will become more critical as banks focus on balance sheet velocity to improve returns.

The nature of competitive advantage is changing: the strategic value of scale (in products or regions), distribution and technology/infrastructure will grow dramatically, substituting for balance sheet and capital, and banks will need to find headroom to invest in these areas, as the margins come down. For the industry at large, we think improved RoA and RoRWA can deliver a further 1.3% RoE base case improvement though will require further change to the way financial resources are managed. However, most of the benefit will go to the few firms that win on distribution capture.

Distribution has gained in strategic importance. To gain scale and amortise the relatively ‘fixed’ cost execution platforms, firms must grow distribution to load the platforms, which requires regulatory and technology investment. In the institutional businesses, the focus will therefore be on depth of client relationships as well as extracting value across different business ‘silos’. In non-institutional, firms will look to extract maximum value from associated corporates and retail distribution channels. Across all client types, share of wallet will be a key metric. On the wholesale side, the same trend is likely to result in larger firms leveraging their infrastructure by providing more wholesale services to other banks – both in new areas, like client clearing services, and in mature businesses (for example, government bonds, cash equities or FX). We expect this to play out via renewed efforts to

extract value across business silos, and efforts to access distribution in wealth channels, SME and mid-sized corporates, and in the emerging markets. Exhibit 27 ~$4bn minimum infrastructure cost for a full scale investment bank1 2005 - 2010, US$ BN

0

5

10

15

20

25

30

35

5 15 25 35Revenue

Cos

t

Base

Breakeven

MedianBelow average C:I

Above average C:I

0

5

10

15

20

25

30

35

5 15 25 35Revenue

Cos

t

Base

Breakeven

MedianBelow average C:I

Above average C:I

Source: Public data, Oliver Wyman proprietary data and analysis 1. Wholesale banking defined as FICC, Equities, IBD Note: revenues have been adjusted for DVAs and writedowns

26


We expect to see a multi-year electronification of FICC, a process that will change the competitive landscape. We see the key risk in maturing businesses such as flow rates and flow credit. Exhibit 28 shows a comparison of margins across competitor tiers in two businesses – cash equities and FX. In equities, the barbell structure makes the economics very difficult for mid-tier firms carrying the full cost structure of the platform. This is primarily because the client base is largely institutional. By contrast, in FX most tiers make money, as high-margin distribution to sticky internal channels such as corporates, retail or custody is a larger part of the business mix for mid-tier firms.

• We suspect flow credit will follow the pattern of cash equities after 2000, with consolidation and challenges to mid-tier business models. The equivalent margin erosion and cost structure would hurt all market players, with profit and return consolidated at the top end.

• On the other hand, flow rates could be more like foreign exchange markets, where mid-tier players may be able to compete thanks to related non-institutional distribution channels (for example, corporates). An FX-like structure may maintain better economics for the market as a whole, albeit probably slightly better for the market leaders.

Exhibit 28 Case study: Comparison of competitor group economics of cash equities and FX

Cash Equities FX

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Top 5 Mid 10 Tail Top 5 Mid 10 Tail

Mar

gins

(%)

Cash Equities FX

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Top 5 Mid 10 Tail Top 5 Mid 10 Tail

Mar

gins

(%)


To offset shrinking margins and higher cost structures, velocity of capital will be key for driving returns in the trading businesses. Capital and balance sheet velocity has improved markedly since the crisis; however, we see further room for improvement as balance sheets become more focused on high velocity trading opportunities and more legacy assets are freed up year by year. This means banks will be far choosier on where they lend and face difficult decisions on pricing. It also – perversely – means the new regulation encourages lending to riskier areas, although we think this will be tempered by management teams and risk management.

• Businesses like flow rates and flow credit are still large consumers of balance sheet, which should be significantly changed by the reform of the OTC flow markets, driving RoA up further. Tying back to the analogies with FX and cash equities, the RoAs in these businesses today are several times higher than in flow fixed income (exhibit 29).

• Financing businesses like franchise lending, prime, and repo books will come under increasing scrutiny as banks will look to ensure multipliers are delivered into other businesses such as flow trading.

• Activities that tie down illiquid balance sheet, such as structured or emerging market lending and long-dated derivatives, will come under most pressure.

This will require further changes to industry practices. More balance sheet and capital fungibility across businesses, better metrics on multipliers between financing and execution businesses, more metrics and management pressure around balance sheet velocity, ensuring businesses avoid the trap of RoA up RoRWA down will all be key features of the winners over the coming two years, in our view.

27


Exhibit 29 Balance sheet velocity and RoA will come under huge scrutiny in businesses that are currently high consumers

Bubble = Size of the industry balance sheetUnder pressure by funding Under pressure by leverage caps Limited funding pressure

0%

20%

40%

60%

80%

100%

120%

Rev/Assets

Unf

unde

d pr

opor

tion

EM

Prop trading

Credit flow

IBD / Relationship lending

Flow rates

Commodities

Structured fixed incomePrime brokerage

Financing

Cash Equities

G10 FXEquity derivatives

Illiquid credit



0%

20%

40%

60%

80%

100%

120%

Rev/Assets

Unf

unde

d pr

opor

tion

EM

Prop trading

Credit flow


Flow rates

Commodities


Financing

Cash Equities


Illiquid credit

0%

20%

40%

60%

80%

100%

120%

Rev/Assets

Unf

unde

d pr

opor

tion

EM

Prop trading

Credit flow


Flow rates

Commodities


Financing

Cash Equities


Illiquid credit

Source: Oliver Wyman estimates

As part of this theme, we anticipate increasing upside from the integration of investment banking with infrastructure-like service offerings, both from increasing the stickiness of client flows and from a valuation perspective. Two areas, in particular, stand out:

• Bridging the value chain between prime and custody: Higher costs of balance sheet provision or risk intermediation make it more attractive to extract value and create client stickiness through the provision of middle office and post-trade services. Custodians will have an advantage here, and will look to prime and related execution businesses as a new opportunity. We think banks will seek to build out securities services offerings organically or via acquisitions or mergers.

• Integrating corporate investment and transaction banking: Again, balance sheet constraints may lead banks to seek new ways to create value from corporate relationships. The cash, payments and trade finance businesses offer new sources of value in themselves, while new services to bundle together with FX, treasury, and flow hedging offer ways to deepen client relationships.

Exhibit 30 Revenues – integration of banking and infrastructure services

Transaction Banking (Cash and Payments)

Investment Banking (M&A, ECM, DCM, Corporate Lending)

Total = $70 BN Total = $230 BN

Execution

Financing

Middle Office Services

Transaction Services

0%

20%

40%

60%

80%

100%

Buyside Value Chain Investment and TransactionBanking

Transaction Banking (Cash and Payments)

Investment Banking (M&A, ECM, DCM, Corporate Lending)

Total = $70 BN Total = $230 BN

Execution

Financing

Middle Office Services

Transaction Services

0%

20%

40%

60%

80%

100%

Buyside Value Chain Investment and TransactionBanking


28


FX as an analogue

The evolution of the foreign exchange (FX) markets could provide an analogue for the rate swaps and CDS markets

The FX market has undergone a massive “electronification” in the past decade, which has driven significant consolidation as firms needed to invest heavily in technology and infrastructure, and electronic flows clustered into a small number of liquidity pools, at the expense of regional and local players. However, profits have held up through the cycle, with FX generating among the highest returns in many FICC portfolios – as a highly scaled offering for the largest players has performed well.

The “corporate” business has seen less change than institutional business, as the electronification process was limited to the largest global corporates. As a result, the supply-side remains relatively fragmented, and regional / local players are still very competitive, thanks to lending provision and the strength of their local corporate coverage. Margins have therefore remained much higher in the corporate segment than the institutional segment.

New forms of competition have emerged on the supply-side. Most obviously, technology and infrastructure are now a key competitive advantage, but more profoundly a change in trading styles had led to greater focus on monetisation of client flows, netting, en-masse informational advantages, and the emergence of quasi-algo trading. In the flow business, advice still matters a lot, with research and content in particular growing in importance, as execution has become more commoditised. This said, in the “structured solutions” part of FX, there are still good margins in creating bespoke solutions for clients.

The economics of the FX business have remained among the most attractive in fixed income, and are far better than rates, for example, due to the low risk-weighted asset requirements. Even in FIG, the hit to deal-level margins has been more than offset by volume growth and market consolidation.

The FX business does face some regulatory challenges. For example, there is some pressure to move to a cash-equities-like execution model, as a result of Dodd-Frank and Mifid requirements, which could result in lower margins/netting efficiency, although at this stage we think this risk is modest, given the high transparency and thin margins.

We view the pattern of change in FX as an appropriate analogy for the rates swaps and (parts) of the CDS market today.

Exhibit 31 Summary FX market evolution, 2005-10 2005 2006 2007 2008 2009 2010eFX wholesale market revenues $BN 12 13 16 23 15 16% e-trading 28% 46% 48% 55% 58% 60%+Top-6 Euromoney market share 55% 60% 67% 66% 67% 61%Avg top-10 cost/revenue (2 year average) 55% 50% 40% 45% 55%Source: Oliver Wyman

9. Banks need to rediscover cost flexibility and operational gearing

Banks will need to regain cost flexibility and operational gearing in 2011/12, given the high volatility of a client flow business model. We estimate banks need to take out 6-8% of the 2010 cost base before variable compensation, which will contribute 1-1.5% ceteris paribus to the rebuild of RoEs.

Cost structures will be a major focus in 2011. In 2010 industry costs were broadly flat while revenues dropped ~20%. Industry headcount rose ~5%, while compensation per head dropped with most cost coming out of variable bonus. Many banks continued to hire aggressively into 1Q 2010 to avoid being left behind on the top line.

We think banks will seek to cut 2010 cost bases by 6-8% this year and next in anticipation of regulatory change and right sizing to today’s revenue opportunity. This will be tough, given the investments needed in risk/compliance and infrastructure upgrades. Reducing the breadth of the portfolio and headcount through technology are likely to be important drivers. We estimate this could boost banks’ RoEs by 1-1.5% ceteris paribus. Cost structures industry wide will have to respond to excessive hiring in 2009 and 1H 2010.

All banks will have to recreate operational gearing; scale is not the only answer, but mid-sized firms will be particularly challenged and need to respond with clear focus and outstanding execution. A fixed cost base of $4 billion needs to be amortized (exhibit 27) at a time when the shift in business model to client flow is creating higher volatility in quarterly revenues. Banks will need to regain cost flexibility to boost returns. Perversely, regulatory initiatives to reduce bonuses in lieu of base compensation have made the sector’s bottom line volatility higher. This should benefit larger firms though we note that today few firms have succeeded in delivering much scalability. However, mid-sized firms face a significant challenge to monetize the fixed costs.

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Strategic action on infrastructure base will be key in 2011. The ratio of full time employees in the support and front office ranges from 1:1 to 3:1 across the market, as some banks have continued to invest in technology and straight through processing through the last cycle. Some progress has been made in mature businesses. Exhibit 33 shows the cost structure of different businesses and the substitutional effect of technology for middle, back and front office. We continue to see front to back office cost alignment as the most powerful tool at the industry’s disposal, and it has yet to happen in some increasingly mature businesses such as flow fixed income and flow equity derivatives. Triaging, as shown in exhibit 34, we estimate that there could be overcapacity of around 20,000 employees in the middle and back offices of the top ~20 banks globally. Some functions such as risk management are structurally under-resourced given the regulatory program, which will place even greater pressure on other areas to deliver efficiencies. This is not going to come through tactical reductions, but will require medium-term structural change initiatives.

Front office cost structures will have to be further reshaped to create cost flexibility. Beyond reshaping infrastructure and reducing aggregate compensation, we see three cost control opportunities for the banks:

• Portfolio reshaping – again a 7-8% reduction of cost in aggregate in the front office is going to mean certain businesses come under much more pressure – we anticipate to rebuild returns the process of reshaping FICC and some origination businesses in particular will require a front office cost reduction of a further ~$2-3 billion over the next two to three years, with under pressure businesses having to restructure by significantly more than the average of 7%.

• Pyramid reshaping – getting the right balance of senior relationship offers with product experience and leverage, along with greater compensation skews.

• Organisational restructuring – often overlooked, we see significant scope to improve cost efficiency through better organizational design and improving the span of control in middle management layers, which has had inadequate management attention in recent years relative to many other industries.

Exhibit 32 Evolution of industry compensation. 2004-2010E

35%

31%

58%

42%45%45%46%

0%

15%

30%

45%

60%

75%

90%

2004 2005 2006 2007 2008 2009 2010E0

100

200

300

400

500

Comp/revenues Average comp. C:I

35%135%

31%

58%

42%45%45%46%

0%

15%

30%

45%

60%

75%

90%

2004 2005 2006 2007 2008 2009 2010E0

100

200

300

400

500

Comp/revenues Average comp. C:I

35%1

1 Based on 2009 revenue adjusted for publically announced write downs and DVAs Source: Company reports; sample banks, Oliver Wyman analysis

Exhibit 33 Cost structures by business type

Middle andBack Office

Front Office

IT

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Mature FactoryBusinesses (Spot FX,

Cash Equities)

Green FactoryBusinesses (Flow FICC,

Flow EQD)

Assembly Businesses(Structuring)

Advisory Businesses

Middle andBack Office

Front Office

IT

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Mature FactoryBusinesses (Spot FX,

Cash Equities)

Green FactoryBusinesses (Flow FICC,

Flow EQD)

Assembly Businesses(Structuring)

Advisory Businesses


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Exhibit 34 Cost cutting agenda

Segment % Infrastructure Cost % of Costs Business

aligned

Implications of ~7% reduction in Cost

Industry-wide Regulatory driven Cost Pressure IT 25-35% 50% 5-7K FTE

Risk infrastructure, Electronification

Ops 15-20% 90% 4-5K FTE

Collateral management Derivatives

Finance 10-15% 60% 1-3K FTE

Balance sheet management Treasury

Risk 10-15% 30% 2-4K FTE

Capital Risk Management

HR 3-7% 70% 0.5-1K FTE Restructuring

Legal, Compliance/ Audit 5-7% 20% 1-1.5K FTE

Regulatory compliance

Real Estate/. Corporate 4-8% 10% 0.5-1K FTE Restructuring

Total 100% 60% 15-20K FTE


10. Navigating potential discontinuities in regulation

With regulatory uncertainty and volatile markets in 2009/2010, banks have tried to keep as many options open as possible. Better visibility in 2011-13 could see more change in business models, but these also create risks of discontinuities should regulatory outcomes differ from expectations. We see the three main areas at risk of regulatory change as: 1) an unlevel playing field in the required levels of capital for too-big-to-fail firms in different countries (SIFI premium); 2) the evolution of funding rules; and 3) subsidiarisation. But we also do not underestimate market discontinuities, which could challenge funding markets or impact decisions on optimal business mix.

We note that in prior industrial crises both in and outside of Financial Services, often there has been a wave of restructuring three to five years after the initial crisis, as the period of remediation settles down and the longer-term new normal becomes clearer. There are three areas we are particularly focused on:

• SIFI – too-big-to-fail premiums. How much capital a systemically important financial institution (“SIFI”) needs in different markets is likely to be set in the next 18 months and could have far-reaching implications. We think European banks in countries that have ‘supersized’ banking systems will understandably face the largest capital requirements and lead to something of an unlevel playing field. Banking assets in countries such as Switzerland and the UK are 3-4x GDP (even on US GAAP basis) versus the US at less than 1x GDP. Should these banks need to carry more capital, all else equal they will generate lower returns, putting them at a competitive disadvantage to US, German and French

banks, where banking systems are less supersized relative to GDP.

• Funding. Funding rules will have a profound impact on industry structure at the product and company level. The funding markets will wish to see greater capital buffers from banks with more volatile earnings, which means banking groups where investment banking dominates could see lower RoEs, all else equal. This could drive a focus on broadening the portfolio through organic growth and small bolt-on deals, and over time to more radical reshaping of portfolios – notably for parts that are very capital heavy – or conceivably larger scale M&A.

• Subsidiarisation. A number of markets are thinking through whether banks should trap capital and funding into different subsidiaries for each country and for wholesale versus retail activities (known as “subsidiarisation”). This could add meaningfully to the effective capital and funding requirements that a global bank needs. The UK is at the vanguard of these moves. In our view, diversification is the key reason groups are bundled together, but subsidiarisation could reduce the attractiveness of certain businesses and certain countries and could increase the fixed costs in each market. It is likely to give an advantage to firms with large corporate activities alongside investment banking in the subsidiary of a given market.

• Beyond regulatory discontinuities, banks also need to manage funding and other market discontinuities, especially in the flow driven business models, which may see higher market volatility. The macro risk from Middle

31


East, Natural disasters and so forth impacting economic recovery and investor sentiment are clearly important. Getting the right business balance and stress testing business models for market and regulatory discontinuities

will be critical. Risks of further change in industry structure and consolidation should we get a prolonged period of weak volumes should not be ruled out.

Exhibit 35 Timelines for key legislation

Capital and liquidity

Phase in expected

Basel 2.5 end 2011

2013-2018 phase in, US Europe timelines vary

OTC Derivatives

Commodities

Planned 2012, likely 2013+

Clients

Investor protectionPortions as early as July 2011

National laws and transition

Implementation period TBD in final rules

Volcker Rule Oct 2011 July 2012 - 2014

Consultation period Implementation period

Recovery and resolution plans

Consultation & proposals

Implementation period TBD in final rule

Structural reform

July 2013

Compensation


N.B: Implementation periods subject to change pending publication of final rules

Compliance with disclosure requirements from Q3

Implementation period TBD


Securitization

July 2011

FIA Study on improving Insurance industry

Jan 2012

Swaps pushout

July 2011

July 2011

‘Skin in the game’ in transition to national law

Basel III YE2010

FSOC prudential YE 2011 / T1 & RWA Jan 2012

EMIR / MiFID

Solvency II

Jan 1, 2011

PRIPs, MAD, MiFID, short selling

Q2 2011 Planned 2012, likely 2013+

IBC consultation Sept 2011

Capital and liquidity

Phase in expected

Basel 2.5 end 2011

2013-2018 phase in, US Europe timelines vary

OTC Derivatives

Commodities

Planned 2012, likely 2013+

Clients

Investor protectionPortions as early as July 2011

National laws and transition


Volcker Rule Oct 2011 July 2012 - 2014

Consultation period Implementation period

Recovery and resolution plans

Consultation & proposals


Structural reform

July 2013

Compensation


N.B: Implementation periods subject to change pending publication of final rules

Compliance with disclosure requirements from Q3

Implementation period TBD


Securitization

July 2011

FIA Study on improving Insurance industry

Jan 2012

Swaps pushout

July 2011

July 2011

‘Skin in the game’ in transition to national law

Basel III YE2010

FSOC prudential YE 2011 / T1 & RWA Jan 2012

EMIR / MiFID

Solvency II

Jan 1, 2011

PRIPs, MAD, MiFID, short selling

Q2 2011 Planned 2012, likely 2013+

IBC consultation Sept 2011


32


PART 2 – Global Stock Implications of our Joint Findings

This valuation section solely reflects the views of Morgan Stanley Research, not Oliver Wyman.

This section is intentionally blank for this Oliver Wyman shortened version - please contact Morgan Stanley directly for this section.

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Ticker Company Close Price (03/22/2011)ALVG.DE Allianz €97.01 BAC.N Bank of America US$13.88 BMO.TO Bank of Montreal C$62.33 BNS.TO Bank of Nova Scotia C$59.21 BARC.L Barclays Bank 289p BNPP.PA BNP Paribas €52.57 CM.TO Canadian Imperial Bank of Commerce C$84.31 C.N Citigroup Inc. US$4.42 CAGR.PA Credit Agricole S.A. €11.8 CSGN.VX Credit Suisse Group SFr39.05 DBKGn.DE Deutsche Bank €41.13 HSBA.L HSBC 626p IAP.L ICAP 513p JPM.N J.P.Morgan Chase & Co. US$45.47 LLOY.L Lloyds Banking Group 61p 8411.T Mizuho Financial Group ¥149 8411.T Mizuho Financial Group ¥149 CNAT.PA Natixis €4.08 8604.T Nomura Holdings ¥455 PGHN.S Partners Group SFr167.8 RY.TO Royal Bank of Canada C$59.98 RBS.L Royal Bank of Scotland 42p SOGN.PA Societe Generale €48.35 SBKJ.J Standard Bank ZAc9,837 STAN.L Standard Chartered Bank 1,604p TD.TO Toronto Dominion Bank C$84.55 TLPR.L Tullett Prebon 408p UBSN.VX UBS SFr16.66 CRDI.MI UniCredit S.p.A. €1.76

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