Outlook for Global Wholesale and Investment Banking - BlackRock ...

March 16, 2010Banks4) Regulatory Change – significant impact by 2012, but range ofoutcomes is wideThere is a raft of regulatory change under consideration.Although the terms of engagement are now set, there is still ahigh degree of uncertainty around the outcome. Somechanges are likely to hit 2011 (for example, taxes, IRC,progression derivatives moves) although many may notactually bite until 2012-14. Regulation will drive higher capitallevels, and the growing desire to ring-fence capital andfunding (rather than separate) should reinforce this. Our basecase suggests regulation could take ~4% off returns on equity(~8% in our bear case, ~2% in our bull case). This is prior tomanagement reaction, which will need to be decisive to drivehealthy returns.Exhibit 16Estimated impact of regulatory scenarios on ROE0%-2%-4%Punitive Measured Incremental3. Structural reform: Regulations could limit the risktakingactivities of the banks and force banks torestructure to allow resolution in case of failure. Theseeffects generally reduce cost, balance sheet andcapital efficiency, but will be the least significant of thethree, in our view, although they will generatesignificant management distraction.4. Adjacent industries: Regulation of the alternativesand insurance sectors could impact the banks inserving these customer groups.5. Tax: We also believe a balance sheet tax is likely.Although we think the basis and rate for the USproposal is being reconsidered, post IMF discussionsin April, we believe a bank tax, probably based onRWAs or loans, looks likely to be adopted by manyWestern markets (Morgan Stanley has arguedelsewhere that this could result in an extra ~2% on theeffective tax rate).-6%-8%We outline three scenarios to bound the scale of regulatoryimpact on returns (see Exhibit 17).Solvency & Liquidity Structural reform Market profileSource: Oliver Wyman, Morgan Stanley Research estimatesWe group the range of regulatory proposals into five distinctareas, where regulatory change will affect bank financialperformance.1. Solvency and capital: The main regulatory vehiclesare increased capital, narrower definitions of Tier I,leverage caps, funding ratio targets; Basel III (to beimplemented by 2012) and enhancements to Basel II.These changes directly affect ROE and ROA. Weestimate these effects will be most significant, with adrag of 2-4% under our three scenarios.2. Market profile: Markets that will be materially affectedby new proposals include OTC derivatives, CDSreforms, securitization, retail structured products andcommodities. These changes generally limit marketsizes, though in several cases (e.g. OTC) wouldimprove balance sheet efficiency. In our base case,these effects are bounded with a ~2% drag on returns.‘Punitive’ scenario – parameterisation of existingregulatory proposals generates a ~8% drag onnormalised ROEs. This includes, for example, a highlydraconian implementation of Basel III, full implementationof reforms along the lines of Volcker, very restrictiveLiving Wills causing substantial trapped liquidity andcapital, and significant limitations imposed on derivativeand securitization markets. We see this ‘worst of allworlds’ combination as highly unlikely.Our base case of ‘Measured’ implementation leads toa ~4% drag on ROEs. This is the scenario we expectand believe to be most sensible. It assumesimplementation of all the elements of Basel III but underreasonable parameterization and elements of theObama-Volcker proposals (i.e. applied only to ring-fencedproprietary desks and stakes in alternatives held withinsecurities divisions). Living wills are implemented, butwith a view to balance sheet fungibility. OTC shifts toCCP structures, but not to exchange on the executionlayer.15