Wholesale & Investment Banking Outlook - Morgan Stanley

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compliance. 10. Navigating potential discontinuities in regulation or markets. With regulatory uncertainty and reboundin
23 March 2011 MORGAN STANLEY BLUE PAPER MORGAN ST ANLEY RESEARCH

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Wholesale & Investment Banking Outlook

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The market underestimates the potential for banks reaching 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 nonbank 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 quasifixed 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.

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. 1 2

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23 March 2011 Wholesale & Investment Banking

Table of Contents Part 1 Executive Summary ................................................................................................................................................................

3

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

7

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

16

Part 2 Global Stock Implications of Our Joint Findings ......................................................................................................................

34

We Think the Market Is Underestimating Potential for Returns...............................................................................................

39

What’s in the Price? Investors Struggle to Value Investment Banking Divisions – Most at 0.7 - 1.1x Book ............................

40

Spread of Returns Likely to Remain Wider for Longer ............................................................................................................

44

Funding to Transform Industry Practices.................................................................................................................................

46

Value Shift to the Non-Bank Sector.........................................................................................................................................

47

Industry Revenue Outlook.......................................................................................................................................................

49

Impact of Basel lll on Investment Banking Divisions................................................................................................................

52

Impact of Regulation on FICC .................................................................................................................................................

56

Sources of Competitive Advantage .........................................................................................................................................

58

Improving Returns Through Cost Cutting ................................................................................................................................

63

Potential Discontinuities of Future Change .............................................................................................................................

64

Appendix I: Tracker of Q1 Revenues ......................................................................................................................................

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Appendix II: Market Shares in Investment Banking .................................................................................................................

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Appendix III: Morgan Stanley Global Banks Exposure Basket Constituents (Bloomberg ticker: ) ...................

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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 midteens (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 0%

5%

10%

17.5%

2000-06

M itigants

7-9%

3-4%

Our view of industry potential

C

13-15%

Future returns

Implied ROE fro m valuations

Historical structural shifts

A

B

4-6%

M gmt actio n

M anagement stated aspiratio ns

20%

13-14%

2009-10

Reg impact

15%

12-16%

9-12%

Significant gap between Management and Market

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 assetquality 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

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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.

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Exhibit 2

About 75-80% of industry revenues are broadly “fit” for new regulatory regime 1 Incremental cost of equity and funding/revenue 140%

Capital

120%

Funding

Leverage

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

100% 80%

Diverging impact across subproducts

60%

Impact will be significantly reduced by central clearing

40% 20%

Heavily impacted ~20% of total revenue

Rest of FICC ~35% of total revenue

ECM, DCM, M&A

Cash equities

F&O

Structured EqD

Flow EqD

Prime brokerage

Flow Credit

Flow Rates

FX

Financing

EM

Commodities

Structured rates

Securitisation

Structured credit

0%

Equities and IBD ~45% of total revenue

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.

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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 2011 scenarios

400 350

180

280

2005

2006

300

205

315

300 $115 BN

250

260

245

225

255

290

Base

Bull

$35 BN

215

200 $220 BN

150 100 50 0 50

2004

2007Net

Volatility

20081 Net

Credit

2009Net

2010

Commods

Inflationary G10 stagnation Equities EMG

IBD

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



2% ~17%

Bull case

  

4%

Base case

~15%  

Stagnation

5%

~13%

  

Inflation Bear case

5%

~11%

 

RoE impact of management action

Regulatory scenarios More severe

Less severe

Banking sector seen as strong enough to withstand tougher implementation Stronger implementation 6% RoE drag

~15%

Unlikely

Measured implementation, though with risks of failures in sequencing, international co-ordination and parameterisation 5% RoE drag

~13%

~15%

Rebuilding the banking sector seen as a prerequisite for economic recovery More phased and softened implementation 4% RoE drag

Unlikely

~15%

~9%

Unlikely

Stronger implementation as part of wider monetary tightening Potential negative feedback loop 6% RoE drag RoE drag across regulatory severity:

-8%

-4% Assumed ROE drag

Source: Oliver Wyman

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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.

Exhibit 6

RoE impact: (B) mitigating factors Pre-mitigation impact

Capital Surplus Risk models

7-9%

2-3% 0.5-1%

Total mitigation

3-4%

Post-mitigation impact (pre-management action)

4-6%

RoE reduction on current business structures (ceteris paribus)

 Erosion of current surplus of capital over required minima  Risk management improvements (e.g. model approvals)  Reduction in industry RoE before management action

Source: Oliver Wyman

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 0%

5%

10%

2000-06

17.5%

M itigants

7-9%

3-4%

M gmt action

Implied ROE fro m valuatio ns

Our view of industry potential

C

13-15%

12-16%

9-12%

 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 Historical structural shifts

A

B

4-6%

Future returns M anagement stated aspirations

20%

13-14%

2009-10

Reg impact

15%

How can management boost returns to the targeted 1216% 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):

Significant gap between Management and Market

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.

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 riskweighted 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 11.5% to RoEs in our base case, including restructuring back to front office staffing ratios in maturing flow businesses and reducing aggregate compensation ratios.

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Exhibit 7

RoE impact: (A) Proposed regulations and their impact (pre-mitigation and management action) ROE impact premitigation1 Category

1. Solvency & liquidity

Theme

Key regulatory elements

Basel 2.5

 

Use of stressed VaR, incremental risk charges Treatment of securitisation in Pillar 1



Improve quality of tier 1 capital; new gross leverage cap Liquidity ratios: coverage, NSFR New counterparty credit risk charges

Basel 3

1-3%

2-4%

0-2%

0-1%

0-1%

0-1%

NA

0.5-1%

Base case impact on RoE pre-mitigation

~10%

7-9%

Base case impact on RoE post-mitigation

4-6%

4-6%

 

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



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

RRPs



Resolution and recovery plans (“living wills”)

Narrow banking

 

US: Swaps spin-off; Volcker rule UK: IBC review (potential subsidiarisation / separation)



Deferred compensation requirements, structure, riskadjustment and quantum



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

G-SIFI

Compensation

SEFs/OTFs

3. Market structure

3-5%

Clearing

Commodities regulations

 

Mandatory central clearing for standardized OTC; capital punishment otherwise



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

 

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

  

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



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

 

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

Tobin tax



Transaction tax

Balance sheet tax



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

Short selling

4. Clients & adjacent industries

Consumer protection Solvency II

Hedge Funds 5. Tax

Impact pre-mitigation and not additive across elements

2. Systematic risk and bank structure

Mar. 2011

5-6%



Supervision

Mar. 2010

Degree of certainty

Bull/Bear Range 4-8%

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)

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Exhibit 8

RoE impact: (C) Management response Management action

Portfolio shifts FICC restructuring

Financial resource efficiency

Front-to-back costs

ROE upside via Management Action

RoE impact

0.5 1% 1-2%

Requirements

 Relative Equities and IBD growth  Product and activity reprioritisation within FICC  Exit and run-down of non-core businesses

1-1.5%  Optimisation of liquidity, capital, balance sheet  Pricing and governance structures to support 1-1.5%  Re-engineering of business structures, front-to-back  7% cost reduction 4-6%

 Re-engineering of business structures, front-to-back

Source: Oliver Wyman

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.

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Exhibit 9

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

RoE for major investment banks Reported RoE, 1993-2010 40%

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.

30% 20% 10% 0% -10% -20% -30%

Maximum

Median

Minimum

// -40% -100% '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 Cycle ‘93-’99 Avg RoE = 15.4%

Cycle ‘00-’06 Avg RoE = 17.5%

Source: Company reports

Exhibit 10

RoE1 evolution drivers. RoE (%)

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

2004-2006

share and make flow-trading gains.

Deleveraging Weaker op. efficiency

 Responding quickly to regulatory change – shifting

Structural change

cost/capital/headcount across the portfolio to improve capital efficiency and adopting new regulatory-driven market structures in flow products.

Improved BS efficiency 2010

 Portfolio focus – banks will need discipline to pull back

Costs and capital growth Reduction in credit losses

from or ignore markets with poor returns or where they have no competitive advantage, rather than trying to keep their options open.

2009-10 change

Weaker H2 revenues

 Clients and content – ensuring coverage discipline on the

2009

0%

5% Average RoE

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

10% Negative driver

15%

20%

Positive driver

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.

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23 March 2011 Wholesale & Investment Banking

Exhibit 11

Competitive landscape in wholesale 100% Expanding Regionals

90% 80%

“Bank the profit” Domestics/ Regionals

Market share

70% 60% 50%

Globals looking to recommit

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.

40% 30% 20% Global winners

10% 0% 2007

2009

2010e

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.

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. UScentric 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.

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.

11

23 March 2011 Wholesale & Investment Banking

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.

Exhibit 12

Impact of Basel III funding costs on global corporate banking economic profit 30 25 20

Risk Mgmt Corp. Finance

15

USD BN

10

Most loans to corporates in developed markets are priced below riskadjusted 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.

5

Trxn banking

0 -5 Risk Management

-10 -15 -20 -25 Pre-crisis x-sell pre- Total before lending loss crisis crisis

Negative funding effect

Profitability loss in cross-sell

Total postcrisis

Source: Oliver Wyman analysis

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.

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 balancesheet 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.

12

23 March 2011 Wholesale & Investment Banking

Exhibit 13

Industry client sales1 mix (IBD, equities, FICC) $bn, 2009 % Buyside2

45%

31%

27%

$95BN Public sector

$85BN

Hedge funds

Asset managers

$40BN Banks & insurers

Corporates

Americas

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, lowmargin 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.

13

23 March 2011 Wholesale & Investment Banking

Exhibit 14

Impact of Basel III regulations on key financial metrics1 % incremental Tier 1 capital required

% below liquidity coverage ratio of 100%

15-25%

US Banks

0-20%

Eur IBs

20-50% Minimal impact

European Regionals

2-45%

Emerging Market Majors

0-15%

0-5%

0-15%

% below stable % increase in RWA funding ratio of 100%

% increase in funding cost to wholesale bank2

Minimal impact

190%

5-35%

0-10%

200%

20-30%

0-15%

Minimal impact

180%

10-35%

180%

2-5%

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

14

23 March 2011 Wholesale & Investment Banking

Exhibit 16

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:

Evolution of hedge funds and wholesale banking capital, assets and returns 1990-2010E (1) 2.0

25%

 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

1.6

20%

1.4 1.2

15%

1.0 0.8

10%

0.6 0.4

5%

0.2 0.0

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

Returns (%)

Hedge fund assets and wholesale banking capital ($ TN)

1.8

0% 1990-94

1995-98

1999-2002 2003-2006 2007-2010

Bank allocated capital

Hedge fund AUM

Wholesale bank RoE

Hedge fund returns index

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

 Advisory services on portfolio divestments ($0.5-1.2

Exhibit 17

billion).

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

 But clearly the size and pace of these opportunities is

10

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.

9

$BN

6

We expect 15% growth in hedge fund AUM in 2011 11%

13%

5%

3%

Hedge Fund Assets ($bn)

1,900

3%

5% 2%

0%

1,870

1,769 -8% 1,470

1,330

10%

1,600

1,668 1,648

0% -5% -10%

-12%

-15%

1,105

One-off revenue streams

Perpetual revenue streams

Servicing non bank market makers and risk takers

2

5%

Bear 1,835

1,430

1,410

1,300 1,100

1,535

3%

144

Base 2,205

1,917

1,700 1,500

3

15% 144

2,100

Servicing new direct Credit Funds

5 4

20%

Annualised Flow Rate

2,300

Bull 2,395

Direct capital and balance sheet to Alternatives

7

Exhibit 15 2,500

Advisory on divestiture

8

1 0

New Revenues from Shadow Banking

Source: Oliver Wyman

-20%

900

-25%

700

-30% -31%

500 2005

2006

2007

2008

Q109 Q209

-35% Q309 Q409 Q110

Q210 Q310

Q410 2011e 2011e End Perf Flows 2011e

Source: Morgan Stanley Research

15

23 March 2011 Wholesale & Investment Banking

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.

16

23 March 2011 Wholesale & Investment Banking

Exhibit 18

Revenue outlook for FICC Product

10/09

2010 performance drivers

11e/10

2011 performance drivers

 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  Continuation of weak performance seen in 2009

$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

$16 BN Flat

$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%

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%

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)

 Support from recovering global trade  Possibility of significant currency moves  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  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  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 Bear/Bull range: $115 – $160 Bear/Bull range: -20% to +10%

Rates

$50 BN -40%

FX

$16 BN -10%

Emerging Markets

FICC

$143 BN ~-25 - -30%

$10 BN +30-45%

$132 BN -5 - -10%

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

17

23 March 2011 Wholesale & Investment Banking

Exhibit 19

Revenue outlook for equities and investment banking Product

10/09

2010 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

Equity derivatives

$17 BN -20%

Prime Brokerage

$13 BN -5%

Total equities

$59 BN ~-10%

Investment Banking

$58 BN ~5%

Total underlying income

$260 BN -15 - -20%

11e/10

2011 performance drivers

$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

 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

 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

$64 BN ~5-10%

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

$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

$256 BN 0 - -5%

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

 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

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

18

23 March 2011 Wholesale & Investment Banking

Exhibit 20

Drivers of wholesale banking revenues Regression output1

Regression model factors

Revenues, $BN Driver

Cash Rates Credit equity EQD Prime & FX & ABS

CTY

EM

M&A

ECM

100%

DCM

MSCI world

80%

Equity volumes

Predictiveness

OECD GDP EM GDP Interest rates Yield curve TED spread

60%

40%

Credit spread Oil price R-Squared

20%

Equities: 75%

FICC: 60%

IBD: 90%

0% 1997

Relationship:

Strong positive

Weak positive

Strong negative

2000

2003

2006

2009

Weak negative Equities

FICC

IB D

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.

19

23 March 2011 Wholesale & Investment Banking

Exhibit 21

Pre- and post-credit write-down revenues by product Industry revenues 2004-11E, $bn 2011 scenarios

400 350

180

280

2005

2006

300

205

315

300 $115 BN

250

260

245

225

255

290

Base

Bull

$35 BN

215

200 $220 BN

150 100 50 0 50

2004

Volatility

2007Net

20081 Net

Credit

2009Net

Commods

2010

Inflationary G10 stagnation Equities EMG

IBD

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

20

23 March 2011 Wholesale & Investment Banking

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.

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 Exhibit 22

Possible impact of regulation on RoEs by division Business area

2006

Legacy Drag1

2010 on Pot. 2013 Post B3 on Post B3 Basis basis Perspectives

Avg. 09-10

2009

2010E

-20%

-25%

-8%

NA

Underlying FICC (incl DCM)

30-35%

30-35%

39%

18%

7-9%

Underlying Equities (incl ECM)

15-20%

20-25%

32%

23%

15-18%

>40%

>35-40%

>45%

>35%

>35%

25-30%

10-15%

14%

13%

9%

Advisory1 Total

NA  Most of the legacy drag has been on FICC though some on EQD in 2009 in particular 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 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 >30%  Advisory is minimally impacted by regulations due to limited risk-taking in the business 13-15%

Source: Oliver Wyman data and analysis 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. 1

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 2030bps 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.

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23 March 2011 Wholesale & Investment Banking

Exhibit 23

Developed markets versus emerging markets in 2010 Macro scenario

Developed Markets

Emerging Markets

Growing businesses

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

Revenue reduction in 2010 in shrinking businesses

Revenue growth in 2010 in growing businesses

$220 BN Down ~$28 BN

Up ~$5 BN

2009 Net Revenues

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 $60 BN

Down ~$12 BN

Up ~$5 BN

Source: Oliver Wyman

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

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.

100%

5-10%

10%

10%

70-75%

80% 60% 40% 20% 0%

Number of countries:

Small EM / Fro ntier 115

Big industrial EM s Quasi-Developed

Examples:  Argentina  Nigeria  Vietnam

6  Brazil  China  Turkey

12

Develo ped

34

 Korea  Mexico  Middle East

 N. America  Japan  W. Europe

Fixed inco me

Equities

IB D

Co rpo rate Lending

Transactio n banking

Structured financing

Source: Oliver Wyman data and analysis

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.

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23 March 2011 Wholesale & Investment Banking



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 nearterm 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

140%

Capital

120%

Funding

Leverage

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

100% 80%

Diverging impact across subproducts

60%

Impact will be significantly reduced by central clearing

40% 20%

Heavily impacted ~20% of total revenue

Rest of FICC ~35% of total revenue

ECM, DCM, M&A

Cash equities

F&O

Structured EqD

Flow EqD

Prime brokerage

Flow Credit

Flow Rates

FX

Financing

EM

Commodities

Structured rates

Securitisation

Structured credit

0%

Equities and IBD ~45% of total revenue

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

23

23 March 2011 Wholesale & Investment Banking

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 (~300400bps, we estimate). This drag should fade over the next three years, revealing the underlying new business margins.

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;



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 endclients look to their key banking relationships to provide integrated post-trade services, and likely consolidate noncleared business with these firms for efficient management of counterparty risk.

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

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

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.

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23 March 2011 Wholesale & Investment Banking

Exhibit 26

Impact on OTC execution venues Platform

Example players

Inter-dealer

iSwap, BGC, Rates GFI, Millennium

Products

Description

 Inter-dealer electronic trading platform  Will largely survive in existing form if separate inter-dealer market remains  Often multi-asset, often integrated voice and electronic  Some, limited adaptations will be required to comply with SEF requirements e.g.  Some platforms include post-trade – Implementing RFQ or CLOB trading processing systems  Primarily RfQ, some auctions and order – Changing access requirements e.g. books volume restrictions to expand access to broader range of dealers, including smaller ones – Upgrade reporting capabilities

Market dynamics and outlook

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

Dealer-to-customer (single-dealer)

PRIMEtrade, eXpress, Autobahn, FXDealer

Multi-asset

 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  Multi-asset, proprietary execution platforms  SEFs must be multi-dealer platforms, therefore cannot survive in current form – can  Institutional only (e.g. DB has separate retail either expand to multi-dealer offering or FX platform) 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.

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 Breakeven

35 30

Below average C:I

25 20 Cost

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

Median

Above average C:I

15 10

Base

5 0 5

15

25 Re ve nue

35

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

25

23 March 2011 Wholesale & Investment Banking

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.

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.

 We suspect flow credit will follow the pattern of cash



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.

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

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.

50% 45% 40% Margins (%)

35% 30% 25% 20%

   

15% 10% 5% 0% Top 5

Mid 10 Cash Equities

Tail

Top 5

Mid 10

Tail

FX

Source: Oliver Wyman

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23 March 2011 Wholesale & Investment Banking

Exhibit 29

Balance sheet velocity and RoA will come under huge scrutiny in businesses that are currently high consumers 120%

Illiquid credit

Unfunded proportion

100% IBD / Relationship lending

80%

60%

EM Prime brokerage

Structured fixed income

40%

Cash Equities

Credit flow Flow rates

20%

Equity derivatives

G10 FX

Commodities

0%

Prop trading

Financing Rev/Assets Bubble = Size of the industry balance sheet Under pressure by funding

Under pressure by leverage caps

Limited funding pressure

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:

Exhibit 30

Revenues – integration of banking and infrastructure services Total = $70 BN

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

80%

 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.

Transaction Services

60% Middle Office Services Financing

40%

20%

Transaction Banking (Cash and Payments)

Execution

0% Buyside Value Chain

 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.

Total = $230 BN

100%

Investment and Transaction Banking

Source: Oliver Wyman

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23 March 2011 Wholesale & Investment Banking

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 supplyside. 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 cashequities-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

FX wholesale market revenues $BN % e-trading Top-6 Euromoney market share Avg top-10 cost/revenue (2 year average)

2006

2007

2008

2009

2010e

12

13

16

23

15

16

28%

46%

48%

55%

58%

60%+

55%

60%

67%

66%

67%

61%

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, midsized firms face a significant challenge to monetize the fixed costs.

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23 March 2011 Wholesale & Investment Banking

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 underresourced 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.

Exhibit 32

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:

Source: Company reports; sample banks, Oliver Wyman analysis

Evolution of industry compensation. 2004-2010E 500

90%

75%

400 58%

60%

300 45%

46%

45%

45%

42%

35%1 30%

35%

200

31% 100

15%

0

0% 2004

2005

2006

2007

Comp/revenues

2008

2009

Average comp.

2010E C:I

1 Based on 2009 revenue adjusted for publically announced write downs and DVAs

Exhibit 33

Cost structures by business type 100% 90%

 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.

80% 70%

Front Office

60% 50% 40% 30% Middle and Back Office

20% 10%

IT

0% Mature Factory Businesses (Spot FX, Cash Equities)

Green Factory Businesses (Flow FICC, Flow EQD)

Assembly Businesses (Structuring)

Advisory Businesses

Source: Oliver Wyman

 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.

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23 March 2011 Wholesale & Investment Banking

Exhibit 34

Cost cutting agenda Implications of ~7% reduction in Cost Industry-wide Regulatory driven Cost Pressure

% Infrastructure Cost

% of Costs Business aligned

IT

25-35%

50%

5-7K FTE

Risk infrastructure, Electronification

Ops

15-20%

90%

4-5K FTE

Finance

10-15%

60%

1-3K FTE

Risk

10-15%

30%

2-4K FTE

HR

3-7%

70%

0.5-1K FTE

Collateral management Derivatives Balance sheet management Treasury Capital Risk Management 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

Segment

Source: Oliver Wyman

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

30

23 March 2011 Wholesale & Investment Banking

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.

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 Exhibit 35

Timelines for key legislation

Basel 2.5 end 2011 Capital and liquidity

2013-2018 phase in, US Europe timelines vary

Basel III YE2010 FSOC prudential YE 2011 / T1 & RWA Jan 2012

OTC Derivatives

EMIR / MiFID

Phase in expected

Planned 2012, likely 2013+

July 2011 Implementation period TBD in final rules IBC consultation Sept 2011 Structural reform

Volcker Rule Oct 2011

July 2012 - 2014

Swaps July 2013 pushout Recovery and resolution plans

Consultation & proposals

Implementation period TBD Jan 2012 Implementation period TBD in final rule

Q2 2011

Planned 2012, likely 2013+

Commodities July 2011

Implementation period TBD in final rules

‘Skin in the game’ in transition to national law Securitization July 2011 Compliance with disclosure requirements from Q3 Jan 1, 2011 Compensation Implementation period TBD in final rule

Investor protection

PRIPs, MAD, MiFID, short selling Portions as early as July 2011 Solvency II

Clients

Consultation period

National laws and transition

FIA Study on improving Insurance industry Implementation period

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

Source: Oliver Wyman

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23 March 2011 Wholesale & Investment Banking

PART 2 – Global Stock Implications of our Joint Findings

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

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23 March 2011 Wholesale & Investment Banking

Morgan Stanley Global Banks Team Contributors to this Report European Banks Huw van Steenis1 Hubert Lam1 Chris Manners, ACA1 Steven Hayne1 Thibault A Nardin1 Francesca Tondi1 Alice Timperley, CFA1

+44 (0)20 7425 9747 +44 (0)20 7425 3734 +44 (0)20 7425 3917 +44 (0)20 7425 8332 +44 (0)20 7425 3787 +44 (0)20 7425 9721 +44 (0)20 7425 9094

[email protected] [email protected] [email protected] [email protected] [email protected] [email protected] [email protected]

+44 (0)20 7425 3933 +27 11 282-4228

[email protected] [email protected]

+1 212 761 8473 +1 212 761 3324 +1 212 761 7619

[email protected] [email protected] [email protected]

+81 (0)3 5424 5349 +81 (0)3 5424 5381

[email protected] [email protected]

+44 (0)20 7425 7597 +44 (0)20 7425 8828

[email protected] [email protected]

EMEA Banks Magdalena L Stoklosa1 Greg Saffy4

North American Banks Betsy L. Graseck, CFA2 Cheryl M. Pate, CFA2 Michael J. Cyprys, CFA, CPA2

Japan Banks Graeme D Knowd3 Hideyasu Ban3

European Diversified Financials Bruce Hamilton1 Anil Sharma, CFA1

1

Morgan Stanley & Co. International plc

3

Morgan Stanley MUFG Securities Co., Ltd.

2

Morgan Stanley & Co. Incorporated

4

RMB Morgan Stanley (Proprietary) Limited

See page 72 for recent Blue Paper reports.

33

23 March 2011 Wholesale & Investment Banking

Global Stock Implications of Our Joint Findings This valuation section solely reflects the views of Morgan Stanley Research, not Oliver Wyman.

Key stock ideas – Europe/EMEA Top picks Barclays (Overweight) – Chris Manners UBS (Overweight) – Huw van Steenis/Hubert Lam Soc Gen (Overweight) – Thibault Nardin ICAP (Overweight) – Bruce Hamilton Partners Group (Overweight) – Bruce Hamilton/Hubert Lam

Key stock ideas – North America Top picks Bank of America (Overweight) – Betsy Graseck JP Morgan (Overweight) – Betsy Graseck Bank of Nova Scotia (Overweight) – Cheryl Pate Toronto Dominion (Overweight) – Cheryl Pate

Key stock ideas – Japan Top picks Nomura (Equal-weight) – Hideyasu Ban

three quarters of industry revenues are already or approaching being “fit” for new regulations – including much of equity trading, underwriting, advisory, FX trading, and government bond trading. Not only do we think these businesses will be strategically reprioritised, but they should provide earnings support when other areas transition to the new regulatory framework. If our view proves correct, there could be material valuation upside for a number of our stocks over the coming years as investors gain more comfort and clarity on capital levels, top line, regulations, and earnings power. Below we give a thumbnail sketch of how we overlay the banks in our coverage universe onto the themes and identify potential winners and losers. Exhibit 36

Market is assuming corporate and investment banking divisions will fail to make management targets or even what banks have made in 2009-10 0%

5%

10%

15%

20%

Implied RoE from market MS-OW RoE 2011-13 Management targets Average RoE 2009-10 MSe bottom up RoE 12e

Our core thesis is that corporate and investment banks have a lot more freedom to respond to changing regulation and the market environment than current valuations suggest. Today the market is pricing that corporate and investment banking (CIB) returns will struggle to make their CoE given tighter regulation, increased competition, changed environment and the electronification of FICC. Our reverse sum-of-the-parts analysis suggests that most CIB divisions are valued at 0.71.1x book value (exhibit 36), implying 9-12% returns on equity. In contrast, we think the wholesale banks have the ability to generate 12-16% returns on tangible equity in 2012-2013 – despite all the uncertainty – but every year banks will have to work harder to offset the ratchet driven by electronification of FICC and regulatory change. To be clear, this is still slightly below the 15% return on stated equity at a group level that banks have committed to the market (typically 15-19% on tangible equity). Our joint analysis with Oliver Wyman suggests that almost

Average RoE 1993-99 Average RoE 2000-06 Source: Oliver Wyman, Morgan Stanley Research, Company reports Management targets include: Barclays, Credit Suisse, HSBC, Standard Chartered, JPMorgan, Soc Gen

Theme 1: Banks should be able to generate acceptable mid-teen returns in the next few years – albeit with much management action required. Advantaged: We think Canadian banks (Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, Toronto Dominion, Royal Bank of Canada) will be at the higher end of RoEs followed by US banks (Bank of America, JPMorgan) and French banks (BNP Paribas, Soc Gen). Potentially challenged: Banks with a bigger skew to those areas more heavily impacted by new regulation (such as credit) could face challenges (Credit Suisse, Bank of

34

23 March 2011 Wholesale & Investment Banking

America, Barclays, Royal Bank of Scotland, Natixis, Deutsche). Given higher capital requirements, UK (Royal Bank of Scotland, Barclays) and Swiss banks (UBS, Credit Suisse) could be relatively disadvantaged in some businesses and have lower returns in their CIB divisions. This said, market valuations for this group suggest only 912% returns, which we think is too low. We also see Nomura and Citigroup yielding returns below the group average. Theme 2: The spread between winners and losers is likely to remain wider for longer. Advantaged: Highly scaled banks in equity and FICC trading (JPMorgan, Deutsche). Also, banks in countries with lower banking assets/GDP (US, Germany, France, Canada) where capital ratios to address ‘too-big-to-fail’ will be less challenging (BNP Paribas, Soc Gen, Deutsche). In the US, money center banks are better off than regional banks given their larger scale and distribution platform (Bank of America, Citigroup, JPMorgan). Potentially challenged: Sub-scale regionals (Natixis, Unicredit, Credit Agricole), some specialists, banks where capital requirements are materially higher (such as the UK and Swiss). Theme 3: The market under-appreciates that as banks respond to the higher cost of capital and funding in the most affected businesses, such as credit and long-dated structures, clients will really feel the impact. Advantaged: We think all banks will look to pass on higher funding costs, although those with the lowest funding costs will be most advantaged, such as JPMorgan, with a higher credit rating or Deutsche or BNP Paribas in Europe. Potentially challenged: Corporates, asset managers active in LDI, European municipals will feel the biggest impact from re-pricing. With a 154% loan-to-deposit ratio at December 2010, Lloyds still has some way to go in re-balancing its funding profile. We think margins will be at best flat this year on 2010 as government supported funding (£97bn at December 10) is replaced by expensive market funding.

Paribas are two of the banks that could most benefit most from greater disintermediation into the debt markets. Potentially challenged: US banks that are more impacted by demarcation rules (e.g. Bank of America, Citigroup, JPMorgan); European banks as they shrink from certain segments due to capital/funding pressures (e.g. Royal Bank of Scotland). Theme 5: Adjusting to a more “beta-driven’’ portfolio – with growth in equities, underwriting and advisory offsetting near-term shrinkage in FICCC. Advantaged: Banks with FICC exposure where our estimates are higher than street estimates (Deustche, Barclays, UBS). Equities exposed banks where we expect continued solid growth (UBS, Soc Gen, Credit Suisse, Nomura). Bank of America in the US as it regains lost market share. Potentially challenged: Players who are underweight equities/advisory (Deutsche, Bank of America, Royal Bank of Scotland, Barclays), although depends on business mix and growth initiatives. Theme 6: Gain share in equities and advisory, as RoEs are likely to remain 15-20%, ahead of many parts of FICC and the broader portfolio. Emerging markets will grow in importance, but higher costs will mean not much outsized returns. Advantaged: UBS (51% of revenues in equity and advisory), Soc Gen (49%), Credit Suisse (48%), Nomura (51%). For the US banks, JPMorgan (30%) has one of the strongest equity and advisory franchises, although a smaller proportion of group earnings. Potentially challenged: Most US banks' IB businesses are skewed to fixed income (~70% is FICC, ~26% is equities, and 4% is advisory). Canadian banks are also heavily skewed to FICC (~69% is FICC, ~31% in equities/advisory). In Europe Barclays (29% of revenues in equity and advisory), Deutsche (25%) and Royal Bank of Scotland (28%) are far less balanced.

Theme 4: Sizeable shifts to the non-bank sector. Advantaged: Corporates, asset managers active in LDI, European municipals from re-pricing, supporting Partners Group and a range of alternative managers and global fixed income houses (e.g. Pimco with Allianz) due to regulatory pressure on banks. In the Eurozone, Deutsche and BNP

On the emerging markets, higher costs will be felt broadly. We think this is why costs have been drifting up for Standard Chartered and HSBC and why they need to be more cost focused. It will also affect private banking at Credit Suisse and UBS. We also think this is why Standard Bank has revisited its ambitious emerging market strategy.

35

23 March 2011 Wholesale & Investment Banking

Theme 7: Reshaping the fixed-income portfolio – while fixed income will be challenged, we think the market is underestimating the very different impact of regulation by business and degrees of freedom to respond. Advantaged: Banks most heavily geared to FX (Deutsche, UBS) and areas within FICC that are less impacted by new regulation (Citigroup, BNP Paribas, Bank of Nova Scotia, Mizuho). Potentially challenged: Banks more exposed to credit/structured credit and lighter on FX and rates (Credit Suisse, Bank of America, Unicredit). Theme 8: Scale, distribution, and technology/ infrastructure will become more important as trading margins narrow. Advantaged: Flowmonsters, especially in FICC, such as JPMorgan, Bank of America, Citigroup, Deutsche, Barclays. In market infrastructure ICAP stands out with leadership and scale. Potentially challenged: Some mid-size players which will attempt to build a global platform (such as UBS, Nomura). Theme 9: Banks need to rediscover cost flexibility and operational gearing. Advantaged: Ongoing cost cutting initiatives at some banks appear somewhat underestimated by the market – Deutsche (€0.5bn alone in CIB), Barclays, HSBC, Mizuho and UBS stand out. Bank of America has the most potential among US banks. Potentially challenged: Banks that are subscale globally or do not focus on particular regional or product niches will find it more challenging to cut costs. Also, those firms who want to continue to invest for share gains in a reasonable but not outstanding year (Credit Suisse). Theme 10: Navigating potential discontinuities in regulation or markets: 1) an unlevel playing field in required capital for too-big-to-fail firms in different countries; 2) how funding rules and costs evolve; 3); “subsidiarisation” or 4) market discontinuities Advantaged: US, French, German, and Canadian banks are likely to be advantaged in the debate on global SIFIs. We expect US banks to go with a 100-200bps “SIFI premia” and

not get any tougher on liquidity and funding. We think France, Germany, Canada, and Japan will move to ratios very similar to the US. Potentially challenged: The Swiss and UK banks will likely be disadvantaged versus the US. The top five US banks are ~60% of US GDP compared to the top two Swiss banks, which are ~420% of GDP and top five UK banks, which are ~315% of GDP (both adjusted to US GAAP). Therefore, we think the SIFI requirement is likely to be ~300bps plus a further co-co buffer in these markets (i.e. 10% plus cocos/novel hybrids).

Key stock ideas – Europe/Asia Barclays (OW): Trading at 0.9x 11e TNAV, we see nervousness on the earnings power of the investment bank as one of the key drags on the stocks. We see a new focus on group cost, partial success in the high RoTE equities / M&A build out and an underestimated credit improvement as enough to allow Barclays to deliver a 13% RoTE in 2012. UBS (OW): Our thesis is UBS generates far higher tangible book value creation than the market expects (2x most European banks) driven by the strong capital generation of the retail, asset and wealth management units alongside replenishment of DTAs. UBS fits with a number of the positives of this note such as top five global equities player; top five FX player and strong skew to emerging markets and equities. However, this work has also reinforced our view on why we think UBS will have to make tough portfolio decisions in 2011 and is on the cusp of a shift in strategy. For instance, we think it will redouble efforts to be a category leader in FX – which we think is relatively untouched by regulation, but deprioritise some of the more capital and funding consumptive parts of FICC. Given the tension between restarting the dividend versus rebuilding out FICC, and our view of the industry change, we think UBS may start to err on the side of moderating its FICC ambitions in so many areas that require more capital and start to focus on stronger returns. Soc Gen (OW): Soc Gen is one of the highest equity-geared banks with ~50% of revenues in equities (including ECM) in 2010. We also forecast it to be one of the banks with the highest growth in equity trading given lackluster equity derivatives in Q2 and Q3 2010. This supports our broader view that the declining legacy asset drag will allow Soc Gen to make mid-teen RoE in 2012 in the investment bank. Clearly, perceptions on the European periphery (Greece,

36

23 March 2011 Wholesale & Investment Banking

Romania) are key drivers of the stock too, but we think the market has been somewhat too harsh on this, given the group has lower exposure to the region than peers. Partners Group (OW): We see top quartile fund raising supported by a diversified global multi-asset (private equity, debt, infrastructure) offering and strong performance. As banks shrink lending activities due to regulatory pressures, we see attractive return opportunities across mezzanine, real estate re-financing, and small and mid-cap private equity. We expect that this will support further asset gathering and drive material upside risk from performance fees over the coming years. ICAP (OW): We see the migration of OTC to electronic as the key structural growth opportunity for the market infrastructure players as regulations accelerate the pace of electronification. We see ICAP's electronic credentials (established EBS and Brokertec offerings) and ability to build consensus with key clients as critical sources of competitive advantage. With the re-launch of the iSwap platform for trading European interest rate swaps in September 2010 we believe that ICAP has established valuable early mover advantage and expect that growth in electronic can drive above sector growth and operational leverage.

Other key European stocks impacted by the key themes in this report Deutsche (EW): We have a moderately positive view on the top line, and given potential significant cost cuts as the bank combines its corporate and investment bank we are ~5% ahead of consensus on earnings for 2011. Deutsche has a €10bn target for all business units this year and we are currently ahead at €9bn (consensus €8.6bn). We think Deutsche could deliver ~20%+ post tax returns on capital in the investment bank in 2011 falling to ~15% in 2012, as Basel 2.5 is implemented. If Deutsche can hit its targets, it should approach near 8% Basel lll look through core Tier 1 at end 2012, although this would still put it below average. BNP Paribas (EW): BNP Paribas is well placed to benefit from the new banking regulation. The Group's client driven activity, strong DCM franchise and low exposure to credit/securitisation and other heavily capital consuming activities should allow it to maintain a decent RoE in the investment bank even under Basel lll. The Group has announced no mitigation factor as it hopes to grow underlying RWA to take advantage of weaker peers downsizing in FICC. Royal Bank of Scotland (EW): We expect faster non-core rundown than priced in currently and we note the success

seen in 2010 with £63bn of non-core third party assets shed, although we note that the RWAs did not fall as quickly as the total asset balance. We also have stressed the balance sheet and see a trough TNAV of 44p/share even with 47% cumulative loss on non-core commercial real estate, which provides some confidence. We also are cautious on Irish losses and note Royal Bank of Scotland i-bank revenues are running 20% below the target rate of £2bn/quarter. Standard Chartered (EW): Whilst we like Standard’s focus on Asia, we feel emerging markets are a more nuanced call as inflation would impact earnings expectations and, inline with our thesis in this note, costs would drift up too. We see much appeal in strong capital (11.8% core tier 1 ratio) and an enviable funding position with an excess of deposits, but valuation at 2.0x 2011e TNAV and 12x 2012e EPS look expensive given 16.5% RoTE in 2012e. Tullett Prebon (EW): Recent negative guidance on operating margins and earnings growth into 2011 spoke to Tullett's need to invest in its e-broking capabilities given the potential for migration of interest rate swaps to electronic. Whilst we expect that Tullett will launch an electronic offering in interest rate swaps later in 2011 given its JV with MillenniumIT, we are nevertheless nervous that Tullett has ceded ground to competitors who already have offerings operational. HSBC (EW): Our earnings estimates for HSBC are now about 10% above the street, as we expect faster US credit normalization, sharper management of costs and rising rates to benefit the deposit franchise. However, HSBC’s revenue growth remains low given the US run-down offsetting growth in Asia. Basel lll will lead to structurally lower RoEs though HSBC has already cut the RoE target so we do not expect a surprise from this.

Key stock ideas – North America Bank of America (OW): The stock is cheap at 1x 11e TNAV as we expect the group will make 16% RoTE in 2012. Global markets is a key contributor to this outcome and we see the potential for 25%+pre-tax RoAE in 2012 as profitability continues to improve and legacy assets fade. JPMorgan (OW): Trading at 1.6x 2011 TNAV, JPMorgan looks cheap given 18% RoTE in 2012. We think JPMorgan should be able to make ~15% RoAE in the investment bank in 2012 and as one of the winners should generate stronger returns than many given its scale.

37

23 March 2011 Wholesale & Investment Banking

Toronto Dominion (OW): Trading at 2.9x 2011e TBV (12x 2011e EPS), we see the most upside to Toronto Dominion based on our estimate of 23% RoTE in 2011. Capital markets is less of a driver for Toronto Dominion than peers, given its higher retail skew; however, we believe Toronto Dominion should be able to generate ~20% RoAE in the investment bank in 2012 (down from ~30% in 2009-10) given its diversified business mix and scale domestically. Bank of Nova Scotia (OW): Bank of Nova Scotia’s wholesale strategy centers around a full service model within Canada and Mexico, offering a wide range of products in the US and Latin America and a niche market strategy in Europe and Asia. We believe Bank of Nova Scotia should be able to make ~18% RoAE in the investment bank in 2012 given its higher skew to FX and commodities versus Canadian peers (~48% of FICC trading), and higher emerging markets exposure. Bank of Nova Scotia is trading at 2.7x 2011e TBV (12.5x 2011e EPS).

Other key North American stocks impacted by the key themes in this report Citigroup (EW): To get more interested in the stock, we need faster than expected asset sales out of Holdings, faster Holdings asset roll off and better top-line growth, likely sourced from non-US businesses. Citigroup is trading at 1.0x 11e TNAV against a 10% RoTE in 2012.

Royal Bank of Canada (UW): Trading at 3.1x 2011e TBV (13.4x 2011e EPS), Royal Bank of Canada looks expensive relative to peers. Royal Bank of Canada has a clear advantage of scale within its domestic capital markets franchise; however, with its higher skew to rates/credit (~61% of trading), particularly outside of Canada, we believe regulatory changes may prove a bigger headwind to Royal Bank of Canada’s wholesale business versus peers.

Key stock ideas – Asia/Japan Nomura (EW): In Asia-Pacific we would highlight Nomura from a mid-term perspective. Nomura is one of the few “equity” houses, which will be less affected by the potential decline in trading margins in FICC. In addition, the firm is building its franchise in the US and Asia while keeping tight cost control, which we believe will pay off in the next few quarters. It may take a few quarters for Japanese companies to normalize operations after the tragic event on March 11, but many of them are eager to expand overseas and as such will be beneficial to Nomura’s global IBD/equity businesses. The absolute level of RoE is lower than that of global peers, but we believe the excess return over CoE in FY12 and beyond will be comparable to global peers’ given lower CoE in Japan.

38

23 March 2011 Wholesale & Investment Banking

We think the market is underestimating potential for returns Debate: What are the long-term RoEs for wholesale banks likely to be, and how should they be valued? Market view: Investment banks will not be able to generate acceptable returns over CoE given tighter regulation, increased competition, and electronification of FICC. Our view: The market is underestimating the banks’ ability generate 12-16% returns near term – despite all the uncertainty – but every year banks will have to work harder to offset the ratchet driven by electronification of FICC and regulatory change. Two-year forward RoEs are still a good proxy for valuation. In Japan, excess returns over CoE should be lower but should start to improve from current zero or negative levels. Advantaged: We think Canadian banks (Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, Toronto Dominion, Royal Bank of Canada) will be at the higher end of RoEs followed by US banks (Bank of America, JPMorgan) and French banks (BNP Paribas, Soc Gen). Potentially challenged: Banks with a bigger skew to those areas more heavily impacted by new regulation (such as credit) could face challenges (Credit Suisse, Bank of America, Barclays, Royal Bank of Scotland, Natixis, Deutsche). Given higher capital requirements, UK (Royal Bank of Scotland, Barclays) and Swiss banks (UBS, Credit Suisse) could be relatively disadvantaged in some businesses and have lower returns in their CIB divisions. This said, market valuations for this group suggest only 9-12% returns, which we think is too low. We also see Nomura and Citigroup yielding returns below the group average. On our estimates, investment banks are implicitly valued at 0.7-1.1x allocated equity, suggesting that the market is questioning whether investment banks can generate acceptable returns over CoE, given tighter regulation, increased competition, and electronification of FICC. For the investment banks to achieve a higher valuation, we think the market needs to get a clearer view of stable returns on capital in 2012-15 as our work shows that two-year forward returns remain the best proxy for valuation for wholesale banks. We think this implies the market is penciling in 9-12% on tangible versus management teams hoping for 15-19% on tangible.

more fragmented market and lower increase in RWA relative to the European banks. Citigroup is well-positioned, given its very strong emerging market position but starts from a relatively low RoE. Factoring in valuation, we think Bank of America is in the best spot, given its low current RoE and the progress in place to raise it. We expect Canadian banks’ wholesale RoEs will be in the mid- to high teens, post-Basel lll (high teens to low 20s in 2012, including Basel 2.5). While the Japanese banks may exhibit lower absolute return on tangible common equity (RoTE), when the returns are looked at relative to CoE, they are closer to global peers. Exhibit 37

Market is assuming corporate and investment banking divisions will fail to make management targets or even what banks have made in 2009-10 0%

5%

10%

15%

20%

Implied RoE from market MS-OW RoE 2011-13 Management targets Average RoE 2009-10 MSe bottom up RoE 12e Average RoE 1993-99 Average RoE 2000-06 Source: Oliver Wyman, Morgan Stanley Research, Company reports Management targets include: Barclays, Credit Suisse, HSBC, Standard Chartered, JPMorgan, Soc Gen

In the midst of the current sovereign concerns and uncertainty about the impact of Basel lll and other regulations, it is not surprising that investors do not want to pay up. However, our fundamental work suggests banks like BNP Paribas and the Canadian banks can deliver strong RoAE. We expect US banks to drive strong relative RoE due to a

39

23 March 2011 Wholesale & Investment Banking

What’s in the Price? Investors Struggle to Value Investment Banking Divisions – Most at 0.7 - 1.1x Book Exhibit 38

What’s in the price? The market is differentiating between group returns, once again using estimated RoE two years out at a group level to drive valuations

3.5 x

RY BNS

Price/ 2011e Tangible Eq

3.0 x

TD CM

BMO

2.5 x

NA

2.0 x

Mizuho

1.0 x

JPM

GS* BNPP

1.5 x C

SocGen

Nomura

0.5 x

BAC

DBK

BARC

CSG

UBS

0.0 x 5%

7%

9%

11%

13%

15%

17%

19%

21%

23%

2012e Return on Tangible Equity Source: Morgan Stanley Research estimates,*GS based on FactSet estimates

Exhibit 39

“Excess Return” (2012e RoE - CoE) versus Price/2011e TNAV

Price/ 2011e Tangible Eq

3.5 x

RY BNS

3.0 x BMO

2.5 x 2.0 x 1.5 x

C RBS

1.0 x

BNPP DBK

JPM

NA

CM CSG

BAC Mizuho BARC Nomura

0.5 x 0.0 x -5%

SocGen

UBS

TD

-3%

-1%

1%

3%

5%

7%

9%

11%

13%

15%

2012e Excess Return on Tangible Equity above Cost of Equity Source: Morgan Stanley Research estimates

Royal Bank of Scotland uses more normalized ROTNAV of 2013

40

23 March 2011 Wholesale & Investment Banking

Exhibit 40

But investors are putting most investment banks at 0.7-1.1x, if we use a reverse sum of the parts with only modest differentiation

Implied IB P/B

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

SG BAC UBS CS BNPP DBK C JPM Source: Morgan Stanley Research estimates

Note Soc Gen includes legacy assets

41

23 March 2011 Wholesale & Investment Banking

Exhibit 41

Global Valuation Comparables Company

Rating

Ccy

EPS

P/E (x)

EPS

22/03/2011

Price

EPS 2010

P/E (x) 2010

2011e

2011e

2012e

P/E (x) BVPS, Last Reported 2012e

Stated

P/ TNAV (x)

Tangible Latest 2011e

2012e Core RoE (%) Stated

Dividend

Tangible 2011e Yield (%)

UBS

OW CHF

16.7

1.33

12.5

1.88

8.9

2.35

7.1

12.3

9.6

1.7

1.5

16%

19%

0.20

1%

CSG

EW CHF

39.0

4.42

8.8

4.53

8.6

5.41

7.2

28.4

19.6

2.0

1.7

17%

22%

1.29

3%

DBK

EW EUR

40.9

5.94

6.9

6.01

6.8

6.51

6.3

52.4

34.3

1.2

1.0

11%

15%

0.75

2%

1.6

1.4

15%

19%

European IB

9.4

8.1

6.9

BARC

OW

p

288.1

34.0

8.5

35.1

8.2

48.1

6.0

417

346

0.8

0.8

11%

13%

7.4

3%

RBS

EW

p

41.6

1.07

-

2.82

14.7

5.10

8.1

64.3

51.1

0.8

0.8

6%

8%

0.0

0%

0.8

0.8

9%

11%

UK Wholesale

8.5

11.5

7.1

SocGen

OW EUR

47.9

5.84

8.2

5.93

8.1

7.09

6.8

53.8

41.4

1.2

1.1

12%

15%

1.9

4%

BNPP

EW EUR

52.5

6.52

8.0

6.84

7.7

7.87

6.7

55.7

44.1

1.2

1.1

12%

14%

2.2

4%

French Wholesale

8.1

7.9

6.7

1.2

1.1

12%

15%

European Average

8.8

9.0

6.9

1.3

1.1

12%

15%

GS*

NR USD

8.5

128.7

118.6

1.4

1.2

-

-

1.4

1%

BAC

OW USD

160.8 13.18 13.9

0.98

14.2

1.32

10.5

2.45

5.7

21.0

13.0

1.1

1.0

11%

16%

0.1

1%

C

EW USD

4.4

0.36

12.3

0.39

11.3

0.49

9.0

5.6

4.5

1.0

0.9

8%

10%

0.0

1%

JPM

OW USD

45.5

3.96

11.5

4.51

10.1

5.70

8.0

43.0

30.3

1.5

1.4

12%

18%

0.8

2%

1.2

1.1

10%

14%

US Average

12.2 16.82

12.3

9.6 18.88

10.3

8.0

BMO

EW CAD

62.3

4.81

13.0

5.50

11.3

6.15

10.1

34.2

30.5

2.0

2.3

15%

18%

2.8

5%

BNS

OW CAD

59.2

4.03

14.7

4.67

12.7

5.41

10.9

23.0

19.6

3.0

2.8

19%

20%

2.1

4%

CM

EW CAD

84.3

6.46

13.1

7.60

11.1

8.45

10.0

33.0

26.7

3.2

2.8

22%

22%

3.5

4%

NA

EW CAD

76.6

6.25

12.2

7.00

10.9

7.60

10.1

38.5

33.9

2.3

2.1

18%

18%

2.7

4%

RY

UW CAD

60.0

3.62

16.6

4.46

13.4

4.97

12.1

24.8

16.8

3.6

3.2

18%

21%

2.1

3%

TD

OW CAD

84.6

5.82

14.5

6.95

12.2

7.93

10.7

43.2

24.5

3.5

3.0

15%

22%

2.6

3%

2.9

2.7

18%

20%

Canadian Average

14.0

11.9

10.6

Nomura

EW

JPY

455.0

9.35

48.7 16.19

28.1 59.32

7.7

573.0

541.0

0.8

0.8

10%

10%

8.0

2%

Mizuho

UW

JPY

149.0 24.08

6.2 17.72

8.4 15.72

9.5

182.0

162.0

0.9

0.8

7%

7%

6.0

4%

9%

9%

Japan Average

27.4

18.3

8.6

0.9

0.8

Total Average

13.3

11.1

8.5

1.7

1.5

Source: FactSet, Morgan Stanley Research estimates (e) NM = Not meaningful Note: Tangible calculations for UBS, CSG, and DBK exclude accumulated fair-value gains on own liabilities. *GS based on FactSet consensus estimates; GS TBVPS as reported for 3Q10.

What could the banks be worth? Price to tangible book versus two-year forward RoE has been the best predictor of bank stock prices historically, as investors use RoEs two years out as a proxy for long-term returns. This has had an R2 of 0.84 2004–1H07 for US investment banks and 0.82 for the key European capital market banks. While CoE and growth expectations have flexed enormously and the market is now assuming RoEs similar to CoEs, we still think this the best proxy to value the stocks going forward.

of equity – we can estimate the implicit cost of equity and long-term growth that the market has been using. 

This suggests that prior to the crisis the market was looking at roughly a CoE of ~10% and growth of ~4% on average.



In the first year of the crisis, this shifted to CoE of 12-14% and 0-1% growth. This relationship became much looser, but we can still sketch out some bands, with CoEs from 12-20%, growth at 0-1%, and tangible books needing to be diluted to get to the proper capital basis.

Using a simple Gordon Growth model – price/book = ((RoE g) / (CoE - g)), where g is long-term growth and CoE is cost

42

23 March 2011 Wholesale & Investment Banking





Today we think we are back to CoE of near 11-12% and growth of 1-4%. The issue driving valuation today is once again longer-term RoE and book value growth.

Exhibit 42

Longer term, as delevered banks find their footing and regulation becomes clearer, we think the betas could fall, CoEs narrow (to 10-11%) and growth expectations rise (to 3-5%), and returns on equity could be in the 14-16% range. If this is correct, this would imply 1.3-1.7x – a 5075% premium to implied valuations today.

P/B

European wholesale bank valuation Higher valuation could come from higher sustainable RoEs but also from perception of higher growth or lower risk

4.0 3.5 3.0

Pre-crisis period r2 = 0.8

2.5 2.0 1.5 1.0 0.5 0.0

2-yr forward ROE

0%

5%

12% and 14% CoE

10%

15%

Post-crisis (dotted line)

20%

25%

Source: FactSet, Morgan Stanley Research Note: Regression for UBS, CSG, Deutsche Bank and BARC

43

23 March 2011 Wholesale & Investment Banking

Spread of Returns Likely to Remain Wider for Longer Debate: How large will the spread of returns between best-positioned and worst-positioned be? Market view: Unclear, market largely assuming winners and losers stable but with modest valuation differentiation Our view: The spread between winners and losers will remain wider for longer: with returns disappointing for some regionals and some boutiques/specialists stalling. Advantaged: Highly scaled banks in equity and FICC trading (JPMorgan, Deutsche). Also, banks in countries with lower banking assets/GDP (US, Germany, France, Canada) where capital ratios to address ‘too-big-to-fail’ will be less challenging (BNP Paribas, Soc Gen, Deutsche). In the US, money center banks are better off than regional banks given their larger scale and distribution platform (Bank of America, Citigroup, JPMorgan). Potentially challenged: Sub-scale regionals (Natixis, Unicredit, Cred Ag), some specialists, banks where capital requirements are materially higher (such as the UK and Swiss).

Exhibit 43

2009 investment banking pre-tax ROEs showed wide dispersal -30%

-20%

-10%

0%

10%

20%

30%

40%

50%

BNPP TD RY JPM CSG GS BARC HSBC BNS Group Median BMO DBK Group Average BAC RBS Nomura CM UBS Soc Gen Source: Company data, Morgan Stanley Research

Exhibit 44

We believe that there will continue to be a wide spread between the best- and worst-positioned banks, with returns disappointing mostly for smaller regionals, boutiques, and specialists. Only the highly scaled banks will be profitable, we think. Banks in countries with lower banking assets/GDP, such as the US, Germany, France, and Canada will face less regulatory pressure and hence will see less harsh regulation on capital. The Swiss banks, for example, face tougher capital requirements, which makes them less competitive in more capital-intensive businesses and requires them to use capital more quickly. In light of higher capital needs, Credit Suisse recently downgraded its RoE target from >18% to >15%. We also believe regionals and specialists will suffer, as they lack the scale and distribution to compete against larger scale flowmonsters. In the US, we expect US money center returns to be better than regional banks over time, given the wider product set and anticipated Basel lll optimization strategies. Hence, we think the larger players will continue to get larger.

2010 pre-tax RoE 0%

10%

20%

30%

40%

50%

TD SG CM BNPP BNS DBK RY BMO HSBC Group Median JPM BAC RBS BARC GS Group Average CSG C UBS Nomura Source: Company data, Morgan Stanley Research

44

23 March 2011 Wholesale & Investment Banking

Exhibit 45

2012 pre-tax RoE 0%

5%

10%

15%

20%

25%

30%

35%

TD BMO CM RY BAC HSBC BNS BNPP JPM SG Group Median DBK BARC Group Average RBS CSG Nomura C UBS Source: Morgan Stanley Research estimates

Exhibit 46

2012e Basel lll “look through” Core Tier 1 ratios (%, ex-deferred tax assets)

14% 12% 10% 8% 6%

12.5%

11.5% 11.3%

10.4% 10.3% 10.3% 8.5%

4%

8.7% 9.2%

9.6% 9.2%

8.8% 8.5%

7.8% 7.5%

7.2% 6.8%

2% 0% SEB STAN

UBS HSBC Nomura BARC JPM

Basel 3 Core Tier 1 Ratio

BAC

C

RBS

MB

CSG

BNP Natixis DBK

GLE Mizuho

Incl. Backs

Source: Morgan Stanley Research estimates

45

23 March 2011 Wholesale & Investment Banking

Funding to Transform Industry Practices Debate: How much will funding transform industry practices? Market view: Capital is the most important driver and funding rules will get diluted down. Our view: We think the market is underestimating the impact of changes in liquidity and funding for both banks and users of banks. Corporate hedging, derivative-based liability management for pension funds and insurance, and long-dated finance (infrastructure, municipal finance) will see the biggest impact. Advantaged: We think all banks will look to pass on higher funding costs, although those with the lowest funding costs will be most advantaged, such as JPMorgan, with a higher credit rating or Deutsche or BNP Paribas in Europe. Potentially challenged: Corporates, asset managers active in LDI, European municipals will feel the biggest impact from re-pricing. With a 154% loan-to-deposit ratio at December 2010, Lloyds still has some way to go in re-balancing its funding profile. We think margins will be at best flat this year on 2010 as government supported funding (£97bn at December 10) is replaced by expensive market funding. Whilst much analysis has focused on capital, liquidity rules may have just as profound an impact on returns. A key risk for the wholesale banks is the impact of being required to hold term funding for short-dated assets and the impact on margins; however, our concerns go way beyond banks’ profits, to how these regulations will change the structure of the banking system. Fundamentally, more capital and less maturity transformation has hit hardest areas such as securitization, as well as project and trade finance. For instance, municipal finance will be less attractive for banks, as will businesses that do not generate liquid collateral (such as SMEs). One implication is that bond funding could remain quite a lot cheaper than bank funding, giving the advantage to the largest companies and leading to more disintermediation, but hurting the midcaps on a relative basis.

It is not clear to us that all policymakers have fully taken these challenges and trade-offs into account, and we would expect more change in the draft rules on implementation. We also think securitization will be far more challenging, leaving the US tied in to funding mortgages almost exclusively via the agencies and risking mortgage finance in Europe; again, these are risks that have yet to be ironed out. We thought the first draft of the net stable funding ratio was flawed in calibration (see our note Banks Regulation: European Banks Most Challenged – Dividends at Risk, January 27, 2010). Whilst it has been revised twice since then, we think there is still more work to be done. Politicians and policymakers are likely to continue to tweak the new rules and so it is impossible to work out the overall impact at this stage, and this uncertainty has clearly been in the investment banks’ prices. We also see a tremendous shift to secured funding such as covered bonds. Overall, we see this as a healthy trend, but we think this means that users of unsecured funding will be rationed. Wholesale banks’ ability to fund loans with illiquid collateral will be curtailed, particularly for long-dated lending (e.g., infrastructure). We have argued elsewhere that we think this could drive more disintermediation in Europe. Players such as BNP Paribas and Deutsche Bank are likely to be among those who would benefit more from this trend. As an aside, though, we do think unsecured debt is becoming very subordinated. Whilst we understand why so much funding is now on a secured basis, this, plus deposits becoming explicitly senior, could mean the resulting unsecured segment has a much weaker support base.

46

23 March 2011 Wholesale & Investment Banking

Value Shift to the Non-Bank Sector Debate: How much value will move into the non-bank sector? Market view: Signals from policymakers on regulating the non-bank sector will restrict its ability to benefit from bank deleveraging. Our view: Regulators underestimate how much business could move into hedge funds, private equity, asset managers, and other alternative sources of capital, which will have the advantage as banks delever and reduce the scope of their activities. Advantaged: Corporates, asset managers active in LDI, European municipals from re-pricing, supporting Partners Group and a range of alternative managers and global fixed income houses (e.g. Pimco with Allianz) due to regulatory pressure on banks. In the Eurozone, Deutsche and BNP Paribas are two of the banks that could most benefit most from greater disintermediation into the debt markets. Potentially challenged: US banks that are more impacted by demarcation rules (e.g. Bank of America, Citigroup, JPMorgan); European banks as they shrink from certain segments due to capital/funding pressures (e.g. Royal Bank of Scotland). We see attractions in diversified alternative business models that are able to tap into opportunities arising from banks capital withdrawal. Opportunities look most compelling in financing for SMEs (private equity, mezzanine, etc.), commercial real estate and in infrastructure. We do wonder if more longer dated opportunities will gravitate from banks to owners of long-term assets such as pension funds and insurance companies as banks seek to respond to stable funding rules and the need for liquid collateral. For example, the reduced level of competition from banks, combined with the upcoming wall of maturing leveraged loans, amounting to ~€440bn globally in 2013-16, will provide significant opportunities for mezzanine providers, in our view. Equally, we estimate $1.5 trillion of US and European commercial mortgages due for re-financing by year-end 2012, suggesting deleveraging and restructuring pressures remain material, which we expect will present significant opportunities for mezzanine providers, notwithstanding some sequential improvement in bank activity in the senior debt tranches. Partner’s group for example anticipates mid-teen returns on its recent mezzanine investment in the refinancing of a property complex in Canary Wharf.

We expect that the winning models in the alternative space will be those able to offer sufficient diversity of product by asset class and geography to allow them to benefit from some of these key investment trends. 3i’s move into debt management through the Mizuho Debt Finance acquisition mirrors moves by some of the larger global private equity players who have developed strong credentials across asset classes (e.g., Blackstone’s offerings across private equity, hedge fund of funds, and credit management). In Europe, we view Partners Group as the best positioned, given its established footprint across private equity, debt, and real estate. This positioning supports the top-quartile assetgathering momentum for the group. In the US, we expect the market to fragment as non-banks compete for business with higher profitability (they have to hold less capital and are less restricted by the new regulatory environment). We also think hedge fund assets should grow at a CAGR of 15% over the next two years. We believe the market may be underestimating the potential for shifting market share within the industry, as stronger players tap into the following key themes: Demand for absolute return product as private clients and smaller institutions look to access strong risk-adjusted returns in onshore (UCITS III) format. We also see these funds picking up a fair share of the upside that French banks and others would have hoped would go to retail equity derivative products. Institutional flow dynamics to pension funds, sovereign wealth funds, and foundations are set to overtake high-networth and endowments as key allocators, providing opportunity for those able to offer institutional scale and risk management. Demand for liquid, transparent strategies with road-tested risk management should drive flows to equity long/short, macro, CTAs (and with growing interest in emerging markets, distressed debt, and event-driven funds). We expect rotation away from funds that gated or suffered reputational damage.

47

23 March 2011 Wholesale & Investment Banking

Exhibit 47

Turnaround in hedge fund flows is still in its early stages with only 3.5% for 2010 Private clients remain on the sidelines though improved performance is more supportive. However, we expect flows remain institutionally dominated in 2011e 20%

2,500 Bull 2,395

13%

2,300

144 5%

3%

Hedge Fund Assets ($bn)

1,900

3%

5% 3% 1,917

2%

0%

1,870

1,769

1,700 1,668 1,600

-8%

1,500

144

10%

5% Bear 1,835

1,648

0%

-5%

1,535

1,470

-10%

1,430

1,410 1,300

Base 2,205

1,330

-12%

Annualised Flow Rate

2,100

1,100

15%

11%

-15%

1,105

-20%

900

-25%

700

-30% -31%

500

-35% 2005

2006

2007

2008

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410 2011e 2011e Perf Flows

End 2011e

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

48

23 March 2011 Wholesale & Investment Banking

Industry Revenue Outlook Debate: What is the industry revenue outlook? Market view: Anaemic revenue outlook in both equities and FICC, given macro concerns and margin compression. Our view: We are likely to see a shrinking revenue pool in FICC again this year (base case (5)%). While we see strength in FX, rates, and commodities, credit will be much weaker – although falling legacy losses should offset a reasonable amount of this. We expect growing equities and investment banking (more than 5-10% base case), with European equities up the most year over year. Over the next two to three years, we expect equities, equity underwriting, and advisory to pick up steam. Advantaged: Banks with FICC exposure where our estimates are higher than street estimates (Deustche, Barclays, UBS). Equities exposed banks where we expect continued solid growth (UBS, Soc Gen, Credit Suisse, Nomura). Bank of America in the US as it regains lost market share. Potentially challenged: Players who are underweight equities/advisory (Deutsche, Bank of America, Royal Bank of Scotland, Barclays), although depends on business mix and growth initiatives. Our 2011 base case forecasts for underlying investment banking revenue growth are 1% in Europe and 6% in North America, with the key difference being a lower fall in FICC and higher advisory expectations for the North Americans. Market expectations in FICC are conservative. Although we think that FICC is shrinking, we see strength in some areas (FX, rates, and commodities), suggesting that the market may be overly cautious. We forecast a 5% FICC revenue decline in Europe and a 3% decline for US banks. We have higher-thanstreet estimates in FICC for UBS, Deutsche Bank, and Barclays. We believe equities will demonstrate strong growth at ~10%, which should benefit equities-geared houses like UBS, Soc Gen, and Credit Suisse. In Europe, we expect slightly stronger equities revenues growth of 12% versus the North American banks, up 9%. For investment banking (advisory, equities capital markets, debt capital markets), we forecast robust 7% revenue growth for European banks in

2011 and 28% for North American banks. Of the three US money center banks, we expect Bank of America will have the greatest revenue growth, as it has been regaining share lost during 2008-09. Exhibit 48

Our base case forecasts for European i-banking revenues are broadly flat underlying EUR bn

86

84.7

84 82 80

79.9 78.8

78 76 74 10 Underlying

11e Underlying

12e Underlying

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

Exhibit 49

Our base case forecasts for North American i-banking revenues are for 6% growth EUR bn

76

74.0

74 72

70.2

70 68

66.3

66 64 62 10 Underlying

11e Underlying

12e Underlying

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

49

23 March 2011 Wholesale & Investment Banking

Exhibit 50

Equities: We forecast 11% YoY underlying growth globally in 2011, with the highest increase from those players who suffered in derivatives in 2010 Equities in bn EUR

CSG DBK UBS Investment Banks BARC RBS UK Banks BNPP Soc Gen French European BAC C JPM US BMO BNS CM RY TD Canadian Nomura Global Banks Coverage

10 Reported

Marks

DVA

10 U/L

11e U/L

11e/10e

12e U/L

12e/11e

4.7 3.1 3.6 11.4 2.4 1.1 3.5 2.0 2.5 4.5 19.3 4.9 4.1 3.6 12.6 0.2 0.3 0.1 0.6 0.3 1.6 2.3 35.8

0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.2 -0.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1

4.8 3.1 3.5 11.4 2.4 1.1 3.5 2.0 2.5 4.5 19.4 4.9 4.3 3.4 12.6 0.2 0.3 0.1 0.6 0.3 1.6 2.3 35.9

4.8 3.6 3.8 12.2 2.9 1.2 4.1 2.4 3.1 5.5 21.8 5.8 4.5 3.2 13.5 0.3 0.2 0.1 0.9 0.3 1.9 2.5 39.7

0% 15% 9% 7% 20% 10% 17% 22% 25% 24% 12% 18% 6% -7% 7% 33% -14% 31% 40% 9% 23% 9% 11%

5.1 3.8 4.1 13.0 3.1 1.2 4.4 2.6 3.4 6.0 23.5 6.6 4.8 3.3 14.7 0.3 0.3 0.2 1.0 0.4 2.1 2.7 43.0

7% 6% 8% 7% 10% 4% 8% 8% 10% 9% 8% 14% 7% 3% 9% 8% 12% 9% 10% 9% 10% 7% 8%

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

Exhibit 51

FICC: We forecast underlying revenues down (5)% YoY in Europe and (3)% in the US in bn EUR

CSG DBK UBS Investment Banks BARC RBS UK Banks BNPP Soc Gen French European BAC C JPM US BMO BNS CM RY TD Canadian Nomura Global Banks Coverage

10 Reported

Marks

DVA

FICC 10 U/L

11e U/L

11e/10e

12e U/L

12e/11e

5.2 9.7 4.5 19.4 10.1 6.0 16.1 5.1 2.6 7.7 43.2 12.0 10.3 11.4 33.7 0.7 0.8 0.5 1.8 0.9 4.7 2.9 84.5

0.2 0.5 -0.6 0.1 0.1 0.6 0.7 0.0 -0.1 -0.1 0.7 0.0 0.0 0.0 0.0 0.0 0.0 -0.1 -0.2 0.0 -0.3 0.0 0.4

0.2 0.0 0.0 0.2 0.0 -0.2 -0.2 0.0 0.0 0.0 0.0 0.0 0.1 -0.2 0.0 0.0 0.0 0.0 0.1 0.0 0.1 -0.1 0.0

5.5 10.2 3.9 19.6 10.3 6.4 16.7 5.1 2.5 7.6 43.9 12.0 10.4 11.2 33.6 0.7 0.8 0.4 1.8 0.9 4.5 2.9 84.9

5.2 9.1 4.9 19.1 9.6 6.4 16.0 4.5 2.3 6.8 41.9 12.6 9.4 10.6 32.6 0.6 0.8 0.4 1.7 0.8 4.3 3.4 82.2

-7% -11% 25% -3% -7% 0% -4% -11% -9% -10% -5% 5% -10% -6% -3% -5% 6% -12% -4% -11% -4% 19% -3%

5.3 9.4 5.6 20.3 9.9 6.7 16.5 4.6 2.4 7.0 43.8 12.3 9.9 10.9 33.1 0.7 0.9 0.4 1.9 0.9 4.9 4.6 86.4

3% 3% 15% 6% 3% 4% 3% 3% 3% 3% 5% -2% 5% 3% 2% 13% 13% 16% 12% 15% 13% 35% 5%

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

50

23 March 2011 Wholesale & Investment Banking

Exhibit 52

Investment banking: We forecast revenues up 7% YoY in Europe and higher in the US in bn EUR

CSG DBK UBS Investment Banks BARC RBS UK Banks BNPP Soc Gen French European BAC C JPM US BMO BNS CM RY TD Canadian Nomura Global Banks Coverage

10 Reported

Marks

3.2 2.5 1.9 7.6 2.9 2.2 5.0 0.6 0.3 0.9 13.5 4.3 2.9 4.6 11.8 0.3 0.4 0.3 0.9 0.3 2.2 1.0 28.6

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Advisory/ECM/DCM Total DVA 10 U/L 11e U/L

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

3.2 2.5 1.9 7.6 2.9 2.2 5.0 0.6 0.3 0.9 13.5 4.3 2.9 4.6 11.8 0.3 0.4 0.3 0.9 0.3 2.2 1.0 28.5

3.6 2.8 1.8 8.2 3.4 1.9 5.4 0.6 0.3 0.9 14.4 5.2 4.0 5.8 15.0 0.4 0.5 0.4 1.3 0.3 3.0 1.0 33.4

11e/10e

12e U/L

12e/11e

13% 14% -9% 8% 18% -10% 6% 5% 5% 5% 7% 20% 41% 25% 27% 34% 19% 27% 43% 22% 33% -2% 17%

3.8 2.8 2.1 8.7 3.7 2.0 5.7 0.6 0.3 0.9 15.4 5.6 4.4 5.9 15.9 0.5 0.6 0.4 1.4 0.4 3.2 1.0 35.5

5% 0% 20% 7% 9% 4% 7% 5% 5% 5% 7% 8% 9% 2% 6% 8% 10% 8% 8% 9% 8% 2% 7%

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

Exhibit 53

Overall, we expect total underlying i-banking revenues to be up 4% YoY Ibank Total in bn EUR

CSG DBK UBS Investment Banks BARC RBS UK Banks BNPP Soc Gen French European BAC C JPM US BMO BNS CM RY TD Canadian Nomura Global Banks Coverage

10 Reported

Marks

DVA

10 U/L

11e U/L

11e/10e

12e U/L

12e/11e

13.0 17.5 9.5 40.0 15.9 9.2 25.1 7.6 5.4 13.0 78.1 21.2 17.2 19.5 58.0 1.2 1.5 1.0 3.3 1.5 8.5 6.3 150.8

0.3 0.5 -0.7 0.1 0.1 0.6 0.7 0.0 -0.1 -0.1 0.7 0.0 0.0 0.0 0.0 0.0 0.0 -0.1 -0.2 0.0 -0.3 0.0 0.4

0.2 0.0 0.4 0.6 -0.5 -0.2 -0.6 0.0 0.0 0.0 0.0 0.0 0.3 -0.3 0.0 0.0 0.0 0.0 0.1 0.0 0.1 -0.1 0.1

13.4 17.9 9.3 40.7 15.6 9.6 25.2 7.6 5.3 12.9 78.8 21.2 17.5 19.3 58.0 1.2 1.5 0.8 3.3 1.5 8.3 6.2 151.3

13.5 17.4 10.5 41.3 15.9 9.5 25.4 7.5 5.7 13.2 79.9 23.6 17.9 19.5 61.0 1.4 1.6 0.9 3.9 1.5 9.2 6.9 157.1

0% -3% 13% 2% 2% -1% 1% -1% 8% 2% 1% 11% 2% 1% 5% 13% 6% 8% 18% -1% 11% 11% 4%

14.2 18.0 11.9 44.1 16.7 9.9 26.7 7.9 6.1 14.0 84.7 24.5 19.1 20.1 63.7 1.5 1.8 1.0 4.3 1.7 10.2 8.3 166.9

5% 4% 13% 7% 6% 4% 5% 5% 7% 6% 6% 4% 7% 3% 4% 10% 12% 11% 10% 12% 11% 20% 6%

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

51

23 March 2011 Wholesale & Investment Banking

Impact of Basel lll on Investment Banking Divisions Debate: How large is the impact of Basel lll on investment banking divisions?

Exhibit 54

Basel lll gives the advantage to equities over FICC RoAE (pre-provision) - Avg 2010e

Equities

FICC Advisory

Overall

Market view: The market is pricing investment banking divisions at 0.71.1x, suggesting that all businesses will struggle to make more than CoE.

Basel 2 (%)

18.8

13.6

18.6

Basel 3 (%)

15.7

8.3

18.6

9.4

Our view: Equities and advisory units will sustain RoEs in the 15-20% range, even after Basel lll; hence, they will be strategically reprioritized.

Difference (%)

-3.2

-5.4

0.0

-5.3

FICC Advisory

Overall

Advantaged: UBS (51% of revenues in equity and advisory), Soc Gen (49%), Credit Suisse (48%), Nomura (51%). For the US banks, JPMorgan (30%) has one of the strongest equity and advisory franchises, although a smaller proportion of group earnings.

Basel 2 (%)

23.1

16.2

18.5

17.5

Basel 3 (%)

19.6

9.5

18.5

11.0

Difference (%)

-3.6

-6.7

0.0

-6.5

Potentially challenged: Most US banks' IB businesses are skewed to fixed income (~70% is FICC, ~26% is equities, and 4% is advisory). Canadian banks are also heavily skewed to FICC (~69% is FICC, ~31% in equities/advisory). In Europe Barclays (29% of revenues in equity and advisory), Deustche (25%) and Royal Bank of Scotland (28%) are far less balanced. On the emerging markets, higher costs will be felt broadly. We think this is why costs have been drifting up for Standard Chartered and HSBC and why they need to be more cost focused. It will also affect private banking at Credit Suisse and UBS. We also think this is why Standard Bank has revisited its ambitious emerging market strategy. Equities-geared banks are best positioned for Basel lll. Equities (including equities capital markets) will become an even more attractive business over fixed income (including debt capital markets) due to Basel lll, benefiting equitiesgeared banks (UBS, Credit Suisse, and Soc Gen). Prior to management action, we model that the impact of Basel lll capital ratios alone could make returns on allocated equity in equities ~900bps better than FICC (19% vs. 10%) (exhibit 54). Little wonder so many firms are trying to enter or beef up their equities divisions. However, within FICC we still think the flowmonsters are advantaged (in Europe, Barclays, Deutsche Bank, and BNP Paribas stand out) and our updated analysis suggests only these made an adequate RoE in 2010, prior to what could be a 5-7% fall in returns from Basel lll. Furthermore, FICC revenue shrank in 2010 and we model that at an underlying level it will shrink again in 2011, but we expect equities to show positive growth in 2011 from cyclical recovery. This is why we think 2011 will be such a critical year for firms to make portfolio decisions.

RoAE (pre-provision) - Avg 2012e

Equities

14.7

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research Includes Credit Suisse, Deutsche Bank, UBS, BARC, RBS, BNP Paribas, Natixis, SG, Bank of America, Citi, JPMorgan. Based on weighted average

Although equities is very competitive – the top nine players are tightly bunched and numerous players are trying to enter or expand in the market (e.g., Soc Gen, Barclays, BNP Paribas, Nomura, Mediobanca, etc.) – the highly scaled global players with strong capabilities in technology, derivatives, prime brokerage, and risk management are able to make RoAE well above CoE. We estimate UBS, BNP Paribas, Soc Gen, and Credit Suisse are among the most profitable equity franchises both in Europe and globally, with RoAE of greater than 20% in 2010. We think their global reach and strong market shares will mean they continue to enjoy significant advantage. We also see firms in transition – for example, we estimate Barclays at ~17% RoAE as it builds out aggressively in Asia and Europe. The second tier, though, make far less than this, but given the capital-light business of equities, firms could still at least achieve CoE, making the business attractive. Under Basel lll, we estimate RWAs in equities grow ~20% for all firms, driving RoAE down ~3%. This compares to a ~5-7% drag in FICC due to Basel lll prior to management action. This equals 5-6% overall, consistent with our work with Oliver Wyman. But given the high initial returns and the capital-light model in equities, we still estimate compelling returns of ~19% on average. FICC will feel the most pressure from Basel lll and other regulatory reforms. Compared with equities, FICC is prima facie under most pressure from Basel lll, with RoAE falling ~57%, we estimate, from a greater-than-50% increase in RWA, and it remains the business in the greatest transition from other regulatory changes, too – most notably, derivative reforms. We estimate the leading European firms made RoAE of ~14% on average in FICC (including debt capital markets) in 2010 – a year with significant legacy costs and many businesses rebuilding (e.g., UBS). In 2012, we estimate that

52

23 March 2011 Wholesale & Investment Banking

prior to regulation our coverage universe could make ~16% RoAE, and while Basel lll could take ~7% off RoAE at the group level, we see only a ~3% cut in RoAE for equities (all prior to management action). However, we believe ceteris paribus is very unlikely and underscores the need for 1) repricing, as we think banks will seek to pass on higher capital costs to investors, 2) shifting the business model and practices (e.g., use of clearinghouses, etc.), and 3) significant efficiency measures, particularly through greater use of electronic trading.

business. (This is part of the reason why we assume a higher cost/income in advisory.) Hence, we believe comp/cost pressure is the biggest risk to RoAE, as unlike the other divisions, the business requires little capital (except to maintain the physical operations of the business). However, our analysis outside-in cannot capture effectively the role the best advisory bankers play in generating equity and debt mandates. We also have looked at players such as Greenhill and Lazard (both not covered) for context, although we imagine that they would make higher RoAEs than a captive unit, given allocations of group overhead. We also have not been able to allocate “relationship lending” into advisory, which also may be a material factor.

Advisory will remain profitable, but it is still a small contributor to the bottom line. We expect advisory to remain a healthy, profitable business but still the smallest direct contributor to profits in the investment banks, given its smaller scale, lower margins, and lumpiness of revenues. In contrast with FICC and equities, in advisory scale is less important when compared to talent, relationships, and expertise, which may drive upward pressure on compensation, especially given the attractions of the less-capital-intensive

The firms with the biggest bias to equities and advisory based on revenues (ex-DVA) are shown in exhibit 55 – UBS, Soc Gen, and Credit Suisse stand out among European banks, as do the Japanese banks, whereas US banks, Deutsche Bank, BNP Paribas, Royal Bank of Scotland, and Barclays are more FICC-skewed.

Exhibit 55

Equities- and advisory-biased players in Europe such as UBS, Soc Gen, Credit Suisse benefit from strong RoAE 2010 (% of Total Rev)

Mizuho

Nomura

UBS

CASA

SG

CSG

GS

Natixis

BAC

C

JPM

BNPP

BARC

RBS

DBK

22

Equities (incl ECM) (%)

45

47

44

49

48

41

36

44

28

28

24

27

21

16

Advisory (%)

12

4

7

2

1

7

8

0

4

3

6

2

7

12

3

FICC (incl DCM) (%)

43

49

49

49

51

52

56

56

68

69

70

71

71

72

75

100

100

100

100

100

100

100

100

100

100

100

100

100

100

100

Total (%)

Source: Company data, Morgan Stanley Research

Revenues exclude DVA

53

23 March 2011 Wholesale & Investment Banking

Exhibit 56

Exhibit 57

Equity revenues by quarter 0

1

2

IBD revenues by quarter

3

4

5

6

7

8

0

9

1

2

3

4

5

6

7

Equity sub-total

-14%

IBD subtotal

GS

-32%

JPM

-14%

CSG

-18%

BAC

6%

GS

-1%

CSG

33%

-4%

JPM

-1%

UBS

-5%

BAC

-15%

BARC

19%

DBK

2%

C

-20%

-27%

DBK

7%

Soc gen

-31%

RBS

54%

BARC

-6%

UBS

-24%

Nomura

17%

Nomura

16%

BNP

33%

HSBC

C

HSBC

10%

RBS

-37%

1Q10

2Q10

3Q10

4Q10

BNP

-32%

Soc Gen

%change vs 2009(rhs)

Source: Company data, Morgan Stanley Research

-15% -32%

1Q10

2Q10

3Q10

4Q10

%change vs 2009(rhs)

Source: Company data, Morgan Stanley Research

Exhibit 58

Post-Basel lll returns in equities remain attractive Equities (incl ECM) ROAE (B3, preprovision)

40% 35% 30% 25% 20% 15% 10% 5% 0% C

JPM

BARC

RBS

BNPP 2010

Source: Morgan Stanley Research

DBK

Natixis

BAC

UBS

CS

SG

2012e e = Morgan Stanley Research estimates

54

23 March 2011 Wholesale & Investment Banking

Exhibit 59

Within equities, French banks are most exposed to derivatives Equities % (2010)

UBS

DBK

CSG

BARC

RBS

SG

BNPP

Natixis

Cash (%)

40

40

42

33

40

10

15

12

Derivatives (%)

35

20

22

50

40

90

80

38

Prime services (%)

23

30

36

17

20

0

5

0

Other (%)

2

10

0

0

0

0

0

50

Total (%)

100

100

100

100

100

100

100

100

Source: Company data, Morgan Stanley Research

Note BNP’s cash equities are in JV Exane, and not reported on similar basis

55

23 March 2011 Wholesale & Investment Banking

Impact of Regulation on FICC Debate: How will regulation affect returns in fixed-income trading? Market view: Given higher capital requirements in FICC, it will at best be a break-even business. Our view: We agree that FICC will be heavily challenged, but the market is underestimating how very different the impact of regulation will be by business. Foreign exchange and rates will feel the least impact, while structured credit the most. Probably ~65% of FICC revenues will see a limited impact from regulation. Advantaged: Banks most heavily geared to FX (Deutsche, UBS) and areas within FICC that are less impacted by new regulation (Citigroup, BNP Paribas, Bank of Nova Scotia, Mizuho). Potentially challenged: Banks more exposed to credit/structured credit and lighter on FX and rates (Credit Suisse, Bank of America, Unicredit).

commodities (26%) and FX (22%), or roughly 50% of FICC trading revenues. Bank of Nova Scotia is also more focused on emerging markets. This compares to Credit Suisse, the UK banks, Bank of America, and Unicredit, which are potentially challenged, given they are most focused on credit, where RWAs are likely to double or triple. Exhibit 60

Basel lll total RWA increase, 2012e 0%

50%

100%

DBK

105%

SG

82%

UBS

81%

Natixis

78%

CSG

78%

BNPP

73%

Nomura

RWAs for the investment banks rise dramatically under Basel lll, ranging from 46-105% even post mitigation. Our analysis shows that of the increase in RWA, most of the increase is attributed to FICC, ranging from 52-124%, which should not be a surprise because the business is more balance-sheetintensive, has more counterparty risk, and absorbs more capital under new regulation. In contrast, we believe the increase in RWA in equities from Basel lll is only ~20% on average. This said, a lot depends on how leverage ratios are applied, since for US banks this is a check on capital for the equities divisions (primarily prime brokerage), although this is not yet a factor in Europe.

62%

BARC

55%

C

53%

BAC

53%

RBS

49%

JPM

46%

Source: Morgan Stanley Research estimates

Exhibit 61

Basel lll-derived FICC RWA increase, 2012e 0%

20%

40%

60%

80%

100%

120%

DBK

113% 106%

Natixis 92%

CSG UBS

91%

BNPP

88% 64%

C BARC BAC

140%

124%

SG

However, not all businesses within FICC will be affected to the same degree, with structured credit seeing a much bigger impact than FX and rates. Given their business mix, we think DBK, C, BNP Paribas, Bank of Nova Scotia, and Mizuho are best positioned under new regulation. All US banks are relatively attractive, as their RWA increase is less than that of their European peers. Out of the US money center banks, Citigroup is best positioned, as it has the highest level of FX and rates as a percentage of total trading revenues, whereas Bank of America has the highest credit-trading revenues. Of the Canadian banks, Scotiabank (Bank of Nova Scotia) is best positioned relative to peers, given its higher skew to

150%

59% 58%

JPM

53%

RBS

52%

Source: Morgan Stanley Research estimates

56

23 March 2011 Wholesale & Investment Banking

Exhibit 62

Breakdown of FICC revenues: French banks and Deutsche Bank most exposed to macro trading FICC % (2010)

Macro (%)

UBS

DBK

CSG

BARC

RBS

SG

BNPP

Natixis

JPM

BAC

C

GS

CM

RY

BMO

BNS

TD

40

60

24

33

46

75

60

54

53

28

93

79

79

56

93

74

100 34

FX & MM (%)

30

6

9

9

25

20

14

11

7

19

20

49

13

28

22

Rates (%)

30

18

24

37

50

40

40

42

21

74

59

30

43

65

51

30

59

48

48

15

30

36

21

71

15

40

Credit (%) Investment Grade (%)

41

10

RMBS (%) Leveraged finance (%) Mortgages and ABS (%) EM (%) Other (%)

28 21 17 9

5

13

13

0

0

0

0

10

5

4

6

6

10

10

10

26

1

7

21

6

5

7

26

5

4

6

10

10

10

26

1

7

21

6

5

6

26

0

100

100

100

100

100

100

100

100

100

100

100

100

100

100

100

Commodities (%) Total (%)

100

100

0

Source: Company data, Morgan Stanley Research. We allocate trading revenue across the various asset classes for BAC based on company disclosure, for JPM based on disclosure of average revenue allocation during 2006-2010 and adjust for higher proportion of commodities in recent years (given Bear and Sempra acquisitions). For Citi, we allocate trading revenues in proportion to the VaR allocation that Citi discloses and refine by using actual allocation of disclosed equity revenues and then reallocate among the remaining asset classes. For Citi, credit is included in rates as they do not separately disclose Credit VaR. GS, BMO, BNS, and TD have no breakdown for credit and is included in rates/macro. Also, for BAC, credit includes positive revaluation of credit assets in 2010 but we do not think this is a true representation of “core” earnings.

57

23 March 2011 Wholesale & Investment Banking

Sources of Competitive Advantage Minimum scale point is becoming critical. Flowmonsters in FICC drive most of investment banking profit, as FICC revenues comprise the majority of total investment banking revenues. There is a positive relationship between FICC revenues and investment banking before-tax profit (PBT), as FICC is a key driver of profits (exhibit 64). This is due to the minimum scale point, which, as we argue with Oliver Wyman in the first section of this report, is becoming critical.

Debate: How will the nature of competitive advantage change? Market view: Investment banks do not have many levers to pull to create competitive advantage. Our view: The strategic value of scale, distribution, and technology/infrastructure will grow dramatically at the expense of innovation or “good ideas”. Winning market share will be key. Advantaged: Flowmonsters, especially in FICC, such as JPMorgan, Bank of America, Citigroup, Deutsche, Barclays. In market infrastructure ICAP stands out with leadership and scale. Potentially challenged: Some mid-size players which will attempt to build a global platform (such as UBS, Nomura). We have been consistently arguing in our research that flowmonsters have the obvious advantages of scale: flowmonsters make more profits, have lower volatility of revenues and enjoy higher RoAE. We think scale and diversification are key; however, smaller players who focus on a few specialized areas can still generate decent returns. It is also interesting that many of the firms with scale are the commercial banks that also have corporate management or commercial lending to aid the business. Larger (i.e., Deutsche Bank, JPMorgan) or more-focused players (i.e., BNP Paribas) generate higher RoAE than smaller banks, demonstrating the need to have scale advantage or to specialize. Exhibit 63

Larger or more-focused players tend to have higher returns FICC (incl DCM), 2010, B2 30%

Highly scaled players appear to have less volatile revenues in the “post-crisis” quarters. We think there are probably two drivers of this. First, we think some of it is due to the portfolio, since smaller players are often less diversified or have depth in rates and FX. Second, smaller players benefit more in proportion when volumes are high and are left with less trading revenues in downturns, as flowmonsters consolidate market share. Whilst we are the first to say that the relationship is a hypothesis, since seven quarters do not make a statistically reliable data set, we do think it is illustrative of the post-banking crisis world we are now in. In exhibit 65 we show that UBS, Credit Suisse, and Soc Gen clearly have far higher volatility than some other, more scaled players such as JPMorgan, Citigroup or Deutsche Bank. The benefit of size can drive overall earnings, reduce volatility, and ultimately result in higher returns. However, not all banks can be a flowmonster, so first-mover advantage or consolidation is important. Banks can also decide to be more focused – as BNP Paribas is, with strengths in Eurobond trading and a smaller presence in the US – and still generate decent returns. The least well positioned are those that attempt to be a global player from a relatively low position. These are the banks that we believe need to refocus and potentially retrace some of their investments.

BNP

ROAE (pre-prov)

25% DBK 20%

BARC

RBS

JPM

15%

C CSG

10%

BAC

UBS

5% 0% 0

5,000

10,000

15,000

Revenues (US$m)

Source: Morgan Stanley Research estimates

20,000

25,000

We think the best positioned are GS, JPMorgan, Bank of America, C, Deutsche Bank, and Barclays; and the least well positioned are relatively smaller players like Credit Suisse and UBS. All three US money center banks are flowmonsters and have scale. In particular, we should see improvement in Bank of America in 2011, as it is regaining footprint lost during the downturn. Regionally, Royal Bank of Canada benefits from scale within Canada. Capital markets revenues are at a minimum double that of peers, with particular size in FICC. We see parallel opportunities in the market infrastructure space for those players able to position effectively as platforms of choice (SEFs or exchange platforms under Dodd-

58

23 March 2011 Wholesale & Investment Banking

Frank), as we see regulatory pressure for transparency and standardisation accelerating the shift to electronic in OTC markets. As we argued in our note The Future of Capital Markets Infrastructure, February 16, 2010, we see ICAP as best positioned of our coverage names given early mover advantage in launching iSwap electronic trading for interest rate swaps in Europe, which has established initial traction. 2011 will be a critical year for portfolio decisions. Given higher capital charges under Basel lll (we assume mainly attributed to FICC), we expect only the flowmonsters will achieve RoAE above CoE. Despite a ~6% (post-Basel lll, premanagement action) hit on RoAE, we estimate larger players like JPMorgan, Deutsche Bank, and Barclays can still have profitable returns. We believe smaller FICC players can still achieve returns above CoE if they: 1) focus on specific products where they already have large market share (e.g., UBS in FX), and 2) reduce exposure to certain businesses, especially structured credit and OTC swaps, which are under pressure. For example, we note Nomura recently downsized its

commodities operation. We think players such as UBS will have to make tough portfolio decisions in 2011. For instance, we think it would make strategic sense to redouble efforts to be a category leader in FX, from which it has slipped, but it is less clear if it will try to gain share in the US swaps business. In most industries, firms want to be category leaders but do not feel a need to be the leader in every single category. Investment banking has been an oddity in that most players want to be in the top three in almost everything. This is what is likely to change – choices and focus will be key. Our illustrative analysis underscores how well a player such as BNP Paribas has gained scale in a few select areas. In our view, it is a clear category leader in European fixed rates and credit but does not have the same massive scale in the US business or commodities. We expect investors to focus increasingly on the specialization aspect of returns. We note a number of regionals have already announced plans to reduce their scope of investment (e.g. Standard Bank) although many others are looking to grow (e.g. Unicredit, Credit Agricole, Natixis).

59

23 March 2011 Wholesale & Investment Banking

Exhibit 64

Flowmonsters in FICC benefit from scale of investment banking PBT, 2010

IBank PBT (2010, $m)

14,000

GS BAC

12,000

C

DBK

10,000

JPM

8,000 6,000

BARC

CSG

4,000

BNPP

GLE

2,000

UBS

0 -

2,000

4,000

6,000

8,000

10,000

12,000 14,000

16,000

FICC revenues (2010, $m) Source: Morgan Stanley Research, Company data Exhibit 65

Flowmonsters have lower volatility of FICC revenue: scale and diversity clearly help Coefficient of variance (for quarterly revenues) on y-axis has been lower for banks with high market shares in FICC, as you would expect in markets where scale has become more important

50% CSG

GS

Soc Gen

45%

BAC

UBS

40% DBK 35%

JPM

Nomura

C

BNP 30%

BARC

25% 20% 2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

Average FICC revenue share of top 15 players (recent quarters) Source: Company Data, Morgan Stanley Research For all companies we have used last seven quarters save UBS, where we have taken only four quarters (as 2009 had many one-off adjustments). Whilst there are numerous caveats to the analysis (too short a time frame to be statistically relevant; the last 18 months has clearly been a transition period; that reported revenues have many extraordinary items which can skew such a short-term relationship and so on), we think is nevertheless interesting as an illustrative snapshot.

60

23 March 2011 Wholesale & Investment Banking

Gaining share will be key Outstanding execution and focus on market share will clearly be critical. Last year we showed the first snapshot of changes in market share pre and post crisis. Below we highlight how

this changed in 2010. It is clear how in some categories some of the majors bounced back strongly (Bank of America in IBD, UBS in equities) although some crisis winners continued to retain share. Below we highlight who is up and down in market shares among the globals.

Exhibit 66

Exhibit 67

IBD revenues: Changes in market shares in 2010 versus 2H09 and 1H07

Equities revenues: Changes in market shares in 2010 versus 2H09 and 1H07

0%

2%

4%

6%

8% 10% 12% 14% 16%

0%

JPM PF BSC

GS

BAC PF MER

CSG

GS

JPM PF BSC

CSG

UBS

BARC

BAC PF MER

C

DBK

DBK

C

RBS

Soc gen

UBS

BARC

Nomura

Nomura

HSBC

BNP

BNP Paribas

HSBC

Soc Gen

RBS

2010

2H09

Source: Company data, Morgan Stanley Research

1H07

2010

2% 4%

6% 8% 10% 12% 14% 16% 18%

2H09

1H07

Source: Company data, Morgan Stanley Research

61

23 March 2011 Wholesale & Investment Banking

Exhibit 68

FICC revenues: Changes in market shares in 2010 versus 2H09 and 1H07 0%

2%

4%

6%

8% 10% 12% 14% 16%

JPM PF BSC C GS BARC BAC PF MER DBK RBS HSBC BNP CSG UBS Nomura Soc gen 2010

2H09

1H07

Source: Company data, Morgan Stanley Research

62

23 March 2011 Wholesale & Investment Banking

Improving Returns Through Cost Cutting Debate: How much can cost-cutting improve returns? Market view: With more client-flow-focused business, returns should be more stable and predictable without the volatility of proprietary trading. Our view: A shift to more client-flow businesses could result in higher quarterly revenue and bottom-line volatility. Gaining cost flexibility and operational gearing will be key. Advantaged: Ongoing cost cutting initiatives at some banks appear somewhat underestimated by the market – Deutsche (€0.5bn alone in CIB), Barclays, HSBC, Mizuho and UBS stand out. Bank of America has the most potential among US banks. Potentially challenged: Banks that are subscale globally or do not focus on particular regional or product niches will find it more challenging to cut costs. Also, those firms who want to continue to invest for share gains in a reasonable but not outstanding year (Credit Suisse).

Several European investment banks such as Deutsche Bank, Barclays, UBS have started to cut costs in anticipation of a slowing environment, increased competition, and tougher regulation. Deutsche Bank is further integrating the corporate investment bank and expects to achieve ~€500m of net cost savings in 2011. Deutsche Bank expects a further ~€600m of net savings in 2011 from its complexity reduction programme, which should deliver annual efficiency gains of €1bn from 2012. After much investment in the investment bank, UBS is considering a cost review if the bank does not turn around. With higher fixed costs from compensation, gaining cost flexibility and operational gearing is key as more client flow revenues drive more bottom line volatility. We expect the US banks to bring down expenses moderately. This is largely due to declining credit losses, a benefit for US banks, which have leveraged loans in the markets business. We expect cost-cutting to start next year, with Bank of America benefitting the most. Nomura has also made cost cuts in the investment bank after several years of rapid expansion following the acquisition of Lehman’s European and Asian assets. In London, it has started to cut costs in equities as it takes a critical view of its market positioning. Recently, it has also withdrawn from certain commodities trading activities.

Exhibit 69

Many investment banks increased the cost base in anticipation of a turnaround after Q209, Q309, and Q110 Cost-cutting will be strategically even more important in 2011

$80bn

4

2 3

$70bn $60bn

40 44

$50bn $40bn $30bn

3

48

25

4

3

4

29

29

22

12

13

25 20

$20bn $10bn

42

47

14 16

$0bn

18

13

17

14

8 (2)

12

10

13

11

9

10

14

Q1 09

Q2 09

Q3 09

Q4 09

Q1 10

Q2 10

Q3 10

Q4 10

-$10bn Q107 IBD

Equities

FICC

Other

Source: Company data, Morgan Stanley Research

63

23 March 2011 Wholesale & Investment Banking

Potential Discontinuities of Future Change Debate: What discontinuous change should management and investors prepare themselves for? Market view: Regulatory uncertainty and rebounding markets have meant banks have tried to keep as many options open as possible and build out in flow opportunities to load their platforms. Our view: As regulations and market opportunity becomes clearer 2011-13 could see more fundamental change in business models and drive some M&A. 3 big dependencies of future change: the level of SIFI premia by country, funding rules and costs, and subsidiarisation Advantaged: US, French, German, and Canadian banks are likely to be advantaged in the debate on global SIFIs. We expect US banks to go with a 100-200bps “SIFI premia” and not get any tougher on liquidity and funding. We think France, Germany, Canada, and Japan will move to ratios very similar to the US. Potentially challenged: The Swiss and UK banks will likely be disadvantaged versus the US. The top five US banks are ~60% of US GDP compared to the top two Swiss banks, which are ~420% of GDP and top five UK banks, which are ~315% of GDP (both adjusted to US GAAP). Therefore, we think the SIFI requirement is likely to be ~300bps plus a further co-co buffer in these markets (i.e. 10% plus cocos/novel hybrids). We expect the US to go with a competitive systemically important financial institution (SIFI) (100-200bps is our best guess) and not get any tougher on liquidity and funding rules. This should put the US on a slightly better footing relative to Swiss and UK banks, where capital and funding rules look far more challenging. We do not expect any of the Canadian banks to be considered global SIFIs, and look for Basel 3 Common Tier 1 ratios to shake out at levels similar to the US (~8.5-9%).

We think concerns over a potential 300bps SIFI buffer in the US are misplaced. With the recent contingent-convertible (co-co) issuance in Europe, we have been getting questions on why the US is not going to follow lock-step, including a 300bps SIFI buffer. We offer two reasons: 1) US banking size to GDP is smaller and US RWAs appear less optimized; and 2) we expect a SIFI buffer in the 100-200 bps range for US banks and model a conservative ~9% B3 common tier 1. Top US banks are smaller in size relative to US GDP as compared with European banks: The top five US banks are ~60% of US GDP, compared with the top two Swiss banks, which are ~420% of GDP, and the top five UK banks, which are ~315% of GDP (both adjusted to US GAAP). The Irish bank system is ~8x GDP. Meanwhile in the Nordic region, the largest bank in Sweden is 1.8x GDP and in Denmark 2.3x GDP. That is why we think the SIFI requirement is likely to be ~300bps, plus a further co-co buffer in these markets (i.e., 10% plus co-cos/novel hybrids). In contrast, we expect US regulators to be less severe on the SIFI buffer, given the smaller relative size of US banks. France and Germany are likely to settle nearer the US in our view. European bank ratios appear more optimized: Cross-border analysis suggests that Swiss banks have RWA/asset ratios that are 24% points lower than US banks. We try to adjust for business model, accounting differences, and Basel lll. We believe the differential is due to optimization of RWA calculation, Basel II versus Basel I, as well as other factors, such as business mix and hedging practices. Given significantly higher RWA/asset ratios for US banks, we expect US regulators to consider the more conservative nature of US RWA calculations when determining the SIFI buffer, ultimately leading to a lower SIFI buffer when compared with some European jurisdictions.

64

23 March 2011 Wholesale & Investment Banking

Exhibit 70

RWA/Assets are 33% higher for US banks versus European banks, but … Reported RWA / Reported Assets: 4Q10 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% CSG CSG ibank

UBS

DBK

BARC SOGN

BNP

BAC

JPM

C

WFC

GS

Euro Avg

US Avg

Source: Company data, Morgan Stanley Research

Exhibit 71

RWA/Adj GAAP assets show convergence, US bank ratios remain 15% higher

90%

15%

80%

10%

70%

5%

60%

0%

50%

-5%

40%

-10%

30% 20%

-15%

10%

-20%

0%

Change in RWA / Assets

RWA / Assets

Adj RWA / Adj GAAP Assets: 4Q10

-25% CSG CSG - UBS DBK BARC SOGN BNP ibank

Adj RWA / Adj GAAP Assets

BAC

JPM

C

WFC

GS

Euro Avg

US Avg

Change in RWA/Assets Due to Adjustments (right)

Source: Company data, Morgan Stanley Research

65

23 March 2011 Wholesale & Investment Banking

Exhibit 72

Even under Basel Ill (Post-mitigation), US bank ratios remain 15% higher Adj RWA / Adj GAAP Assets (Basel 3) Post Mitigation: 4Q10 90%

0%

80%

RWA / Assets

60%

-4%

50% -6%

40% 30%

-8%

20%

Change in RWA / Assets

-2%

70%

-10%

10%

-12%

0% CSG CSG - UBS ibank

DBK BARC SOGN BNP

Post Mitigation B3 RWA / Adj GAAP Assets

BAC

JPM

C

WFC

GS

Euro Avg

US Avg

Change in B3 RWA/Asset Due to Mitigation Impact (right)

Source: Company data, Morgan Stanley Research

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23 March 2011 Wholesale & Investment Banking

Exhibit 73

Expect lower SIFI buffer for US banks, given smaller size relative to GDP 350%

Top 2 Swiss Banks: on IFRS ~600% of GDP on US GAAP ~488% of GDP

820% 332%

Top 5 French Banks: on IFRS ~325% of GDP on US GAAP ~253% of GDP

Top 5 UK Banks: on IFRS ~345% of GDP on US GAAP ~276% of GDP

Top 5 Italian Banks: on IFRS/US GAAP ~140 % of GDP

Top 5 Belgium Banks: on IFRS/US GAAP ~199% of GDP

Top 5 Netherlands Banks: on IFRS ~441% of GDP on US GAAP ~427% of GDP

300% 268%

Top 3 Australian Banks: ~ 145% of GDP

250% 232% 212%

200% 178%

Top 3 Canadian Banks: ~ 140% of GDP 150% 111% 106% 93% 92% 91%

100%

89% 89%

Top 5 US Banks: ~ 60% of GDP

84% 72%

64% 63% 61%

50%

54% 53% 53% 52%

48% 46% 44% 44%

40%

32% 22% 22%

18% 16% 16% 15%

14%

9% 9% 9% 6% 4% 3%

G ol BI dm a M n ed io BP M

BP

U

C

Ire

la nd re di U B tS S ui s D se an sk e IN G N R ord a b ea ob an k B Ba NP rc la ys K D B eu C ts ch H e S C A BC G ro up D ex R ia BS ( AB Bel N g.) Am ro U C Ll G oy d BP s C E R BC N So AB c W Gen es t TD pac Ba nk IS P C BA BN F C ort S re is di t M NL SN utu S el Ba S rea nk ta al of nda Am rd er ica JP M M PS or C gan i t W igr el ou ls Fa p rg o

0%

Adj GAAP Assets / GDP

Reported Assets / GDP

Source: Company data, Morgan Stanley Research

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23 March 2011 Wholesale & Investment Banking

Appendices Appendix 1: Tracker of Q1 revenues Exhibit 74

Our tracker of Q1 capital markets activity Global Capital Markets

Latest

1Q11TD vs

Data as of

1Q10

2010 Avg.

4Q10

Europe Average Value Traded (€bn)

11 Mar 11

19%

16%

25%

US ADV ('000s)

10 Mar 11

-8%

-6%

8%

Eurex Equity Derivatives ADV (m)

11 Mar 11

-3%

-8%

13%

Liffe Equity Derivatives ADV (m)

11 Mar 11

-19%

-30%

-10%

CME Equity Derivatives ADV (m)

10 Mar 11

-2%

-5%

9%

US Equity Options ADV (m)

10 Mar 11

21%

19%

14%

ECM ($m)

14 Mar 11

17%

2%

-35%

DCM ($m)

14 Mar 11

3%

17%

13%

M&A ($m)

14 Mar 11

18%

0%

-20%

Total ($m)

14 Mar 11

11%

7%

-16%

Equities

IBD Revenues

FICC Rates US FI Average Value Traded ($m)

02 Mar 11

8%

1%

-8%

ICAP Treasuries Value Traded ($tn)

28 Feb 11

16%

2%

-4%

ICAP Repos Value Traded ($tn)

28 Feb 11

20%

10%

1%

Eurex Interest Rates ADV (m)

11 Mar 11

12%

15%

21%

Liffe Interest Rates ADV (m)

11 Mar 11

2%

20%

50%

CME Interest Rates ADV (m)

10 Mar 11

25%

17%

15%

CME Commodities ADV (m)

28 Feb 11

51%

29%

11%

ICE Commodities ADV (m)

28 Feb 11

9%

16%

18%

CME Energy ADV (m)

28 Feb 11

29%

25%

31%

CME Metals ADV (m)

28 Feb 11

17%

21%

3%

CME FX ADV (m)

10 Mar 11

10%

6%

10%

ICAP FX Value Traded ($tn)

28 Feb 11

-5%

-4%

1%

10 Mar 11

-23%

-20%

-13%

Commodities

FX

Credit ICE CDS ADV ($m) Source: Company data, Morgan Stanley Research

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23 March 2011 Wholesale & Investment Banking

Exhibit 75

Index Performance Index Performance

Latest

Last 3 Months

Last 12 Months

Data as of

YTD

MSCI World Performance

14 Mar 11

0%

1%

6%

S&P 500 Performance

14 Mar 11

3%

5%

13%

MSCI Europe Performance

14 Mar 11

-1%

-1%

1%

Equity Hedge HF Performance (HFRI)

28 Feb 11

2%

5%

13%

14 Mar 11

-11%

-12%

-5%

Hedge Fund Performance (HFRXGL)

14 Mar 11

0%

1%

5%

Macro HF Performance (HFRI)

28 Feb 11

1%

4%

11%

VIX Volatility Index

14 Mar 11

19%

20%

20%

VDAX Volatility Index

14 Mar 11

8%

24%

17%

Equities

FICC - Credit iTraxx Europe Crossover Index Hedge Fund Performance

Volatility Index

Source: Company data, Morgan Stanley Research

Our trading proxies – imperfect as they are – help give some useful pointers to complement our industry discussions. Q1 up to mid-March is off to a reasonable but not outstanding start, with activity well ahead of last year in rates and commodities and European equities. Secondary equity activity in value in Europe is up 19% YoY and 25% QoQ, which has been helped by rising indices. In contrast, US average volumes are down 8% YoY but still up 8% on a seasonally weak Q4. Derivative volumes in Europe are mostly down YoY, but in the US, equity option volumes are up strongly 21% YoY and 14% QoQ. This feels consistent with our +5-10% YoY expectation. Market moves and hedge fund performance also normally have strong correlation with equities revenues. Fixed income volumes are up in rates and commodities, flattish in FX, and down in value and volume terms YoY in credit. FX volume indicators are between 5-10% YoY and rates volumes are flat to up 25% YoY, benefiting from macro

uncertainty and volatility. Although a smaller segment within most investment banks, commodity volumes were also strong, with our proxies up 9-51% YoY. However, credit secondary volumes were weak (as are credit gains), down 23% YoY and 13% QoQ. Q1 data so far supports our expectations of YoY growth of FICC underlying 10%, prior to legacy. IBD revenues based on Q1 run-rate are up a decent 11% YoY but down 16% from a strong Q410, with ECM and M&A softening, given rising risk. With strong pipelines we think both can grow when market sentiment improves and macro uncertainty subsides. Debt capital markets remain the most resilient, up 3% YoY and 13% QoQ as corporates refinance balance sheets while interest rates are low. While banks speak to a strong outlook given pipeline, the key is sovereign/macro risks both in the Middle East and in Europe. Of the European banks, Barclays, BNP, and SG Q1 run-rate IBD revenues are up the most on 2010 average.

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23 March 2011 Wholesale & Investment Banking

Appendix 2: Market Shares in Investment Banking Exhibit 76

Investment banking comparison side-by-side All in $m. Adjusts for FV/CVA but not marks

IBD

Equities

FICC

Total revenues

JPM BAC GS BARC CSG C DBK UBS RBS Nomura HSBC BNP Soc Gen IBD subtotal GS CSG DBK JPM BARC UBS Soc gen Nomura C BAC BNP HSBC RBS Equity sub-total BARC BARC (ex credit marks) JPM C DBK BAC RBS (ex credit marks) GS BNP RBS HSBC Nomura UBS CSG Soc gen FICC sub-total GS BARC DBK C BAC CSG HSBC UBS BNP RBS Nomura Soc Gen (core) Total sub-total

Source: Company data, Morgan Stanley Research

1Q09

2Q09

3Q09

4Q09

1Q10

2Q 10

3Q 10

4Q 10

1,380 1,055 823 476 393 982 454 601 756 125 195 294 111 8,458 2,504 2,012 359 1,557 772 1,182 844 (325) 1,244 1,489 (54) 565 532 14,188 3,564 6,230 5,721 7,807 4,897 4,789 5,097 6,749 3,568 990 2,482 961 (1,698) 3,191 2,085 46,577 8,668 4,812 5,552 10,033 7,333 5,378 3,851 (254) 3,808 2,278 761 3,001 67,156

2,239 1,646 1,440 999 634 1,160 989 885 175 305 282 365 177 12,418 3,793 2,041 1,384 1,034 1,160 1,312 1,408 1,066 1,795 1,198 780 462 564 19,531 3,465 6,021 5,127 5,667 3,503 5,584 3,265 7,095 2,452 1,112 2,482 880 (53) 3,036 1,519 44,223 13,139 5,624 6,505 8,622 8,428 5,658 3,749 1,905 3,597 1,851 2,251 3,055 78,041

1,658 1,254 899 774 734 1,163 911 821 295 167 244 257 143 10,359 3,302 1,756 1,367 1,284 894 1,096 1,512 947 1,324 1,265 768 595 463 17,964 3,232 4,452 5,006 4,582 3,147 4,480 2,950 6,211 2,079 1,680 2,003 1,040 929 2,539 1,338 41,545 11,673 4,900 6,505 7,069 6,999 4,997 3,328 2,684 3,105 2,438 2,155 2,947 72,571

1,892 1,255 1,680 975 1,171 1,458 715 807 614 489 294 246 110 13,185 2,173 1,104 941 971 545 929 1,023 790 732 949 550 439 746 12,888 4,156 4,427 2,066 2,952 1,926 2,507 3,062 3,353 1,203 1,300 1,336 922 289 1,019 380 24,871 8,577 5,677 4,268 5,142 4,711 3,217 2,506 2,148 1,999 2,660 2,200 1,453 53,524

1,446 1,240 1,203 1,024 845 1,057 779 575 731 338 210 228 94 10,659 2,470 1,613 1,306 1,462 769 1,195 1,088 781 1,218 1,530 1,102 669 490 17,064 4,280 4,202 5,411 5,084 5,259 5,515 3,382 5,937 2,432 2,978 2,428 716 2,062 2,535 1,078 48,439 11,580 6,073 8,293 7,714 8,285 5,024 3,890 3,704 3,762 4,199 1,834 2,260 79,967

1,405 1,319 941 694 902 674 688 437 867 224 155 160 61 9,412 1,534 1,579 771 838 840 1,247 453 585 620 852 257 528 355 11,745 3,190 3,361 3,163 3,488 2,710 2,316 1,871 3,047 1,521 1,732 1,918 555 1,555 1,364 720 28,922 7,308 4,724 4,614 5,700 4,487 3,800 3,073 3,202 1,938 2,954 1,365 1,234 53,618

1,502 1,371 1,159 807 881 930 728 418 541 290 217 203 83 10,137 2,012 1,075 888 1,231 557 895 826 641 1,062 974 599 469 307 12,657 2,750 3,021 3,272 3,385 2,890 3,527 1,681 2,857 1,435 1,902 1,608 1,332 860 1,494 848 29,129 7,825 4,113 5,438 5,494 5,872 3,443 2,645 2,172 2,237 2,750 2,263 1,757 55,113

1,833 1,590 1,507 1,327 1,266 1,167 1,098 929 703 412 280 203 128 13,958 2,033 1,420 1,169 1,128 987 964 929 881 808 789 765 600 289 13,947 3,209 3,025 2,875 2,302 2,130 1,800 1,782 1,726 1,321 1,275 1,189 953 939 901 615 22,049 7,254 5,523 5,003 4,571 4,179 3,604 2,847 2,832 2,289 2,267 2,246 1,672 53,635

Note Goldmans 2010 FICC disclosure different to 2009

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23 March 2011 Wholesale & Investment Banking

Appendix 3: Morgan Stanley Global Banks Exposure Basket Constituents (Bloomberg ticker: ) Morgan Stanley has created a trading basket containing 10 stocks we believe are most positively leveraged to the themes outlined in this report. The stocks are modified equal-weighted (adjusted for liquidity) and the basket is denominated in EUR. Company Barclays Societe Generale UBS ICAP Partners Group Bank of America J.P. Morgan Chase Bank of Nova Scotia Toronto Dominion Nomura

Ticker

Ccy

Price

Weight

BARC LN GLE FP UBSN VX IAP LN PGHN SW BAC US JPM US BNS CN TD CN 8604 JP

GBp EUR CHF GBp CHF USD USD CAD CAD JPY

288.50 48.36 16.66 512.50 167.80 13.88 45.47 59.21 84.55 455.00

12.1% 12.2% 12.1% 1.0% 1.0% 12.0% 12.1% 12.3% 12.2% 12.8%

Source: Morgan Stanley Research

An Investable Basket: Morgan Stanley Research has created a basket of the 10 stocks that we believe are most leveraged to the themes outlined in this report. The basket of 10 stocks can be viewed on Bloomberg under the symbol MSSTBNKS.

The information contained herein has been prepared solely for informational purposes and is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Products and trades of this type may not be appropriate for every investor. Please consult with your legal and tax advisors before making any investment decision. Please contact your Morgan Stanley sales representative for more details.

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23 March 2011 Wholesale & Investment Banking

Morgan Stanley Blue Papers Morgan Stanley Blue Papers address long-term, structural business changes that are reshaping the fundamentals of entire economies and industries around the globe. Analysts, economists, and strategists in our global research network collaborate in the Blue Papers to address critical themes that require a coordinated perspective across regions, sectors, or asset classes.

Recently Published Blue Papers Global Gas A Decade of Two Halves March 14, 2011

Brazil Infrastructure Paving the Way May 5, 2010

Tablet Demand and Disruption Mobile Users Come of Age February 14, 2011 The China Files Chinese Economy through 2020 November 8, 2010 The China Files Asian Corporates & China’s Megatransition November 8, 2010 The China Files European Corporates & China’s Megatransition October 29, 2010 Petrochemicals Preparing for a Supercycle October 18, 2010

Solvency 2 – Joint report with Oliver Wyman Quantitative & Strategic Impact, The Tide is Going Out September 22, 2010 The China Files US Corporates & China’s Megatransition September 20, 2010

To find downloadable versions of these publications and information on Other Morgan Stanley reports, visit www.morganstanley.com

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23 March 2011 Wholesale & Investment Banking

Disclosure Section Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA.

Analyst Certification The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Huw van Steenis. Unless otherwise stated, the individuals listed on the cover page of this report are research analysts.

Global Research Conflict Management Policy Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies.

Important US Regulatory Disclosures on Subject Companies The following analyst or strategist (or a household member) owns securities (or related derivatives) in a company that he or she covers or recommends in Morgan Stanley Research: Michael Cyprys - Bank of America (common or preferred stock); Greg Saffy - Standard Bank (convertibles). Morgan Stanley policy prohibits research analysts, strategists and research associates from investing in securities in their sub industry as defined by the Global Industry Classification Standard ("GICS," which was developed by and is the exclusive property of MSCI and S&P). Analysts may nevertheless own such securities to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition. A household member of the following analyst or strategist is an employee, officer, director or has another position at a company named within the research: Cheryl Pate; J.P.Morgan Chase & Co.. Citigroup may be deemed to control Morgan Stanley Smith Barney LLC due to ownership, board membership, or other relationships. Morgan Stanley Smith Barney LLC may participate in, or otherwise have a financial interest in, the primary or secondary distribution of securities issued by Citigroup or an affiliate of Citigroup that is controlled by or under common control with Morgan Stanley Smith Barney LLC. As of February 28, 2011, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in Morgan Stanley Research: Allianz, Barclays Bank, Citigroup Inc., Credit Agricole S.A., Credit Suisse Group, Deutsche Bank, Mizuho Financial Group, Societe Generale, UniCredit S.p.A.. Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of Bank of Montreal, Bank of Nova Scotia, Barclays Bank, BNP Paribas, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Agricole S.A., Deutsche Bank, HSBC, Lloyds Banking Group, Mizuho Financial Group, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Toronto Dominion Bank, UniCredit S.p.A.. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from Allianz, Bank of America, Bank of Montreal, Bank of Nova Scotia, Barclays Bank, BNP Paribas, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Agricole S.A., Credit Suisse Group, Deutsche Bank, HSBC, J.P.Morgan Chase & Co., Lloyds Banking Group, Mizuho Financial Group, Natixis, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Toronto Dominion Bank, UniCredit S.p.A.. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from Allianz, Bank of America, Bank of Montreal, Bank of Nova Scotia, Barclays Bank, BNP Paribas, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Agricole S.A., Credit Suisse Group, Deutsche Bank, HSBC, J.P.Morgan Chase & Co., Lloyds Banking Group, Mizuho Financial Group, Natixis, Nomura Holdings, Partners Group, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Standard Bank, Standard Chartered Bank, Toronto Dominion Bank, UniCredit S.p.A.. Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from Allianz, Bank of America, Bank of Montreal, Bank of Nova Scotia, Barclays Bank, BNP Paribas, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Agricole S.A., Credit Suisse Group, Deutsche Bank, HSBC, ICAP, J.P.Morgan Chase & Co., Lloyds Banking Group, Mizuho Financial Group, Natixis, Nomura Holdings, Partners Group, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Standard Bank, Standard Chartered Bank, Toronto Dominion Bank, Tullett Prebon, UBS, UniCredit S.p.A..

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23 March 2011 Wholesale & Investment Banking

Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following company: Allianz, Bank of America, Bank of Montreal, Bank of Nova Scotia, Barclays Bank, BNP Paribas, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Agricole S.A., Credit Suisse Group, Deutsche Bank, HSBC, J.P.Morgan Chase & Co., Lloyds Banking Group, Mizuho Financial Group, Natixis, Partners Group, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Standard Bank, Standard Chartered Bank, Toronto Dominion Bank, UniCredit S.p.A.. Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the past has entered into an agreement to provide services or has a client relationship with the following company: Allianz, Bank of America, Bank of Montreal, Bank of Nova Scotia, Barclays Bank, BNP Paribas, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Agricole S.A., Credit Suisse Group, Deutsche Bank, HSBC, ICAP, J.P.Morgan Chase & Co., Lloyds Banking Group, Mizuho Financial Group, Natixis, Nomura Holdings, Partners Group, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Standard Bank, Standard Chartered Bank, Toronto Dominion Bank, Tullett Prebon, UBS, UniCredit S.p.A.. Morgan Stanley & Co. Incorporated makes a market in the securities of Bank of America, Bank of Montreal, Bank of Nova Scotia, Barclays Bank, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Suisse Group, Deutsche Bank, HSBC, J.P.Morgan Chase & Co., Lloyds Banking Group, Mizuho Financial Group, Nomura Holdings, Royal Bank of Canada, Royal Bank of Scotland, Toronto Dominion Bank, UBS. The equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues. Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report. Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.

STOCK RATINGS Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations.

Global Stock Ratings Distribution (as of February 28, 2011)

For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.

Stock Rating Category

Overweight/Buy Equal-weight/Hold Not-Rated/Hold Underweight/Sell Total

Coverage Universe Investment Banking Clients (IBC) % of % of % of Rating Total Count Count Total IBC Category

1175 1219 120 380 2,894

41% 42% 4% 13%

463 439 23 109 1034

45% 42% 2% 11%

39% 36% 19% 29%

Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months.

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Analyst Stock Ratings Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.

Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index. .

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Other Important Disclosures Morgan Stanley & Co. International PLC and its affiliates have a significant financial interest in the debt securities of Allianz, Bank of America, Bank of Montreal, Bank of Nova Scotia, Barclays Bank, BNP Paribas, Canadian Imperial Bank of Commerce, Citigroup Inc., Credit Agricole S.A., Credit Suisse Group, Deutsche Bank, HSBC, ICAP, J.P.Morgan Chase & Co., Lloyds Banking Group, Mizuho Financial Group, Natixis, Nomura Holdings, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Standard Chartered Bank, UBS, UniCredit S.p.A.. Morgan Stanley is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Morgan Stanley produces an equity research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Client Link at www.morganstanley.com. Morgan Stanley Research does not provide individually tailored investment advice. Morgan Stanley Research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them. The fixed income research analysts, strategists or economists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality, accuracy and value of research, firm profitability or revenues (which include fixed income trading and capital markets profitability or revenues), client feedback and competitive factors. Fixed Income Research analysts', strategists' or economists' compensation is not linked to investment banking or capital markets transactions performed by Morgan Stanley or the profitability or revenues of particular trading desks.

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Additional information on recommended securities/instruments is available on request.

Other Important Disclosures from Oliver Wyman Copyright © 2011 Oliver Wyman. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of  Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect.  The information and opinions in the first section of this report were prepared by Oliver Wyman.  This report is not a substitopute for tailored professional advice on how a specific financial institution should execute its strategy. This report is not investment  advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisers. Oliver Wyman  has made every effort to use reliable, up‐to‐date and comprehensive information and analysis, but all information is provided without warranty of any kind,  express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report.  Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or  sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. 

This report may not be sold without the written consent of Oliver Wyman.

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Close Price (03/22/2011) €97.01 US$13.88 C$62.33 C$59.21 289p €52.57 C$84.31 US$4.42 €11.8 SFr39.05 €41.13 626p 513p US$45.47 61p ¥149 ¥149 €4.08 ¥455 SFr167.8 C$59.98 42p €48.35 ZAc9,837 1,604p C$84.55 408p SFr16.66 €1.76