Global Banks and Brokers

Global regulatory handbook, version 4.0

Primer Equity | 18 May 2018

A primer on global regulation: A shifting landscape United States

US Banks
Regulation remains a crucial consideration for investing in global systemically important
banks (GSIBs), and the backdrop is shifting. In the US, the appointments of new
regulatory agency leadership signal an inflection towards reform. Meanwhile, there does
not appear to be a material change of direction outside of the US. In this deep-dive
primer, we explore: 1) how recent new proposals and legislative bills impacting financial
regulation could impact the banks and therefore balance sheet availability; 2) how post-
crisis regulation affected bank profitability, market dynamics, and the economy; 3) an
overview of the US regulatory leadership structure; 4) Basel-based prudential rules; and
5) key provisions of the Dodd-Frank Act (US).
US regulatory reform: Relief for regionals, less for GSIBs
Since the last publication of this report, there have been meaningful proposals from the
Federal Reserve. The most notable of these address capital standards under the US
stress test process (i.e., the DFAST or Dodd Frank Act Stress Test and CCAR or Erika Najarian
Comprehensive Capital Analysis & Review), “spot” common equity tier 1 ratios (CET1), Research Analyst
MLPF&S
and “spot” SLR (supplementary leverage ratio) minimums. Further, news reports indicate +1 646 855 1584
that the Volcker reform proposal is imminent and Congress appears to be on the brink of erika.najarian@baml.co m
passing a regulatory reform bill focused on bringing relief to US banks under $250bn in Michael Carrier, CFA
assets. In summary, regulatory reform in the US will likely bring meaningful relief to Research Analyst
MLPF&S
regional banks. However, the proposed standards may bring only modest relief to US +1 646 855 5004
michael.carrier@baml.com
GSIBs; and in some cases, could be more burdensome than the current capital regime.
Please see our primer picks note for our stock ideas on this theme. Andrew Stimpson >>
Research Analyst
The impact of regulation: Benefits and costs MLI (UK)
+44 20 7995 1066
Global regulation has, in our opinion, created a safer and sounder banking system. But it andy.stimpson@baml.com

is not without cost. Of course, the direct impact is to bank profitability, and we estimate Alastair Ryan >>
Research Analyst
that post-crisis global regulation erased 500bp from bank ROTCEs (returns on tangible MLI (UK)
common equity), pre-tax cuts. And while market dynamics were already shifting, we alastair.ryan@baml. com
believe regulation has opened the door for less-regulated players to take share, diffusing Michael Helsby >>
Research Analyst
rather than reducing risk in key areas, like mortgage lending and trading. Further, greater MLI (UK)
capital and liquidity burden, along with higher regulatory-related operating costs, michael.helsby@baml.com
benefited scale players, concentrating market share at US GSIBs – who appear largely Winnie Wu >>
balanced across different regulatory constraints and have taken advantage of business Research Analyst
Merrill Lynch (Hong Kong)
synergies to deepen wallet share locally and globally. Lastly, while bank clients have winnie.wu@baml.com
largely avoided being re-priced to reflect these burdens, in our view, less liquid and more Futoshi Sasaki >>
turbulent markets could have a marked impact on institutional client returns. Research Analyst
Merrill Lynch (Japan)
What’s inside: A reference book for global rules, key laws futoshi.sasaki@baml.com
Ebrahim H. Poonawala
As in previous versions, we dive deeply into the following global rules: 1) common equity Research Analyst
tier 1 (CET1); 2) supplementary leverage ratio (SLR); 3) supervisory stress tests; 4) MLPF&S
ebrahim.poonawala@baml.com
liquidity coverage ratio (LCR); 5) net stable funding ratio (NSFR); and 6) total loss
Brandon Berman
absorbing capacity (TLAC). We also look into key provisions of the Dodd-Frank Act, such Research Analyst
as the Volcker Rule, resolution planning (“living wills”), and mortgage reform. Further, we MLPF&S
brandon.berman@baml.com
take a look at the US regulatory agency structure, where nine of the ten previously open,
key leadership positions have been filled by President Donald Trump. Christopher Nardone
Research Analyst
MLPF&S
christopher.nardone@baml.com
US Fixed Income Research
>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under Hima B. Inguva
the FINRA rules. Research Analyst
Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take MLPF&S
+1 646 855 6810
responsibility for this report in particular jurisdictions. hima.inguva@baml.com
BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports.
As a result, investors should be aware that the firm may have a conflict of interest that could See Team Page for List of Analysts
affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision.
Refer to important disclosures on page 184 to 185. 11873601

Timestamp: 18 May 2018 12:00AM EDT

Contents
What’s new in this version 3
Financial regulation cheat sheets 4
Regulation in real time: The most recent global developments 20
Recent developments: United States 21
Recent developments: Basel/EU 40
Regulation in the real world: Quantifying impact 46
Impact of regulation: Benefits & costs 47
Regulatory Structure: United States 85
Regulatory Agency Leadership 86
Global prudential regulatory rules 91
Common Equity Tier 1 ratio (CET1) 92
Supplementary Leverage Ratio (SLR) 109
Total loss absorbing capacity (TLAC) 118
Annual stress testing 128
Liquidity coverage ratio (LCR) 137
Net stable funding ratio (NSFR) 145
United States: Key Dodd-Frank Act provisions 151
The Dodd-Frank Act 152
Department of Labor Fiduciary Rule 181
Research Analysts 186

2 Global Banks and Brokers | 18 May 2018

What’s new in this version
Global regulation for financial companies continues to shift, and remains a primary
consideration for investing in financial stocks – particularly for global systemically
important banks, or GSIBs. Largely spurred by the election of President Donald J. Trump
in the United States, the regulatory backdrop remains dynamic. Now in its fourth
version, this global regulatory handbook is a reference handbook for global prudential
rules and major U.S. laws governing capital, liquidity, and resolution planning, simplifying
thousands of pages in an easy-to-follow format.

For four years in a row, we have published our global bank regulatory primer as a
handbook for investors to better understand the complex landscape that emerged from
the Global Financial Crisis. While readers can continue to find sections on global
prudential rules and Dodd-Frank (US) legislation, we dive more deeply into the “real
world” impact of regulations to bank strategy and clients, or the real benefits and costs
of regulation as well as the real-time developments of regulatory reform in the US.

New this year, given the fluctuations of the regulatory construct, we have a section
called “Regulation in real time” that outlines the most recent relevant formal
proposals and bills from regulatory agencies and legislators, respectively. Given that the
financial industry has now operated under the post-Global Financial Crisis regulatory
framework for some time, we have also expanded our market and business impact
section, titled “Regulation in the real world”.

As in earlier versions of the primer, we have sought to provide a detailed (but simplified)
explanation of each rule, addressed global and local standards, discussed outstanding
issues for each law/rule/regulation, and outlined specific business impacts.

We analyze the following:

1. U.S. regulatory structure;

2. common equity tier 1 (CET1);

3. supplementary leverage ratio (SLR);

4. resolution (total loss absorbing capacity, or TLAC);

5. supervisory stress tests;

6. liquidity coverage ratio (LCR);

7. net stable funding ratio (NSFR);

8. certain provisions of the Dodd-Frank Act (U.S. legislation); and

9. the Department of Labor (DOL) fiduciary rule & SEC Proposals (U.S. only)

The authors of this report are not acting in the capacity of a legal adviser, and the
information contained herein is not intended to constitute legal advice. You should consult
with your legal adviser as to any issues of law relating to the subject matter of this report.

Global Banks and Brokers | 18 May 2018 3

Financial regulation cheat sheets
1B

4 Global Banks and Brokers | 18 May 2018

U.S. Dept. of Treasury reg reform blueprint cheat sheets

Exhibit 1: UST reform proposals: Banks and Credit Unions Exhibit 2: UST reform proposals: Capital Markets
▪ Raise threshold for participation. Remove SEC requirements that duplicate
▪
Eliminate mid-year DFAST cycle and reduce Public companies financial statement disclosures

Acces to Capital
▪
number of stress scenarios to two. and IPOS Allow companies to "test the waters" with
▪
▪ Reassess underlying CCAR assumptions. potential/qualified investor
CCAR / DFAST ▪ Change CCAR to a two-year cycle. Modify rules that would broaden eligibility for
Challeneges for ▪
Adjust the qualitative assessment to the status as a smaller reporting company
small public
▪ horizontal capital review for banks with less Extend length of time a company may be
companies ▪
Capital Requirements

than $250bn in assets. considered an EGC to up to 10 yrs

▪ Improve CCAR transparency.
Allow issuers of less liquid stocks to select
Rely on standardized approaches for ▪

Markets Structure and Liquidity

▪ the exchange which their securities will trade
calculating risk-weighted assets.
Increase transparency of operational risk Allow issuers to determine the tick size for
CET1 ▪ ▪
capital requirement. trading of their stock across all exchanges
Revisit/recalibrate the GSIB surcharge for US Equities Consider amending the Order Protection Rule
▪ ▪ to give protected quote status only to reg
firms.
Leverage exposure denominator should securities exchanges
▪ exclude cash, US Treasuries, and customer Review whether exchanges and ATSs should
SLR ▪
initial margin. harmonize their order types
▪ Recalibrate eSLR for GSIBs. ▪ Adopt amendments to Regulation ATS
Revisit the mandatory minimum debt ratio in ▪ Close the PTF data granularity gap
TLAC ▪ Treasuries
the TLAC and minimum debt rule. Amend regulation to improve the availability
▪
Only subject internationally active banks to of secured repo financing
Requirements

▪ LCR requirement and a less stringent Rationalize the capital required for
Liquidity

▪
standard for non-GSIBs. securitized products
LCR
Allow for high-grade municipal bonds to be Consider the impact that trading book capital
▪ ▪
HQLA eligible. Securitization standards, such as FRTB, on market activity
▪ Raise threshold for living will requirements. Capital
Recalibrate capital requirements to prevent
Adjust living will submission to a two-year ▪ from exceeding the maximum economic
Resolution ▪
cycle. exposure of the underlying bond
Planning
Subject framework and guidance to public Adjust the global market shock scenario for
▪ ▪
comment. stress testing purposes
Align QM requirements with GSE eligibility High-quality securitized obligations should be
▪ Liquidity ▪
requirements. considered level 2B HQLA
Increase the $103k loan threshold for
▪
application of the 3% points and fees cap. Margin Harmonize margin requirements for uncleared
▪
Derivatives

Improve flexibility and accountability of the requirements swaps domestically

▪
Loan Originator Compensation Rule.
Balance the move of derivatives into central
Other Requirements

Delay the 2018 implementation of the new

▪ Capital treatment ▪ clearing with appropriately tailored and
QM requirements HMDA requirements.
targeted capital requirements
Place a moratorium on additional rulemaking
▪
in mortgage servicing. Source: BofA Merrill Lynch Global Research, US Department of the Treasury
Repeal/revise the residential mortgage risk
▪
retention requirement.
Review the regulatory framework for risk-
▪ weighting and stress-testing applicable to
securitization.
Exempt banks with less than $10bn in assets
▪
from the requirement.
Simplify the definition of proprietary trading
▪ (eliminate 60-day rebuttable presumption and
Volcker Rule the purpose test).
Provide increased flexibility for market-
▪
making.
▪ Reduce the compliance burden of hedging.
▪ Improve regulatory coordination on the rule.
Source: BofA Merrill Lynch Global Research, US Department of the Treasury

Global Banks and Brokers | 18 May 2018 5

 Dodd-Frank Act cheat sheet: Summary of major provisions
6
Global Banks and Brokers | 18 May 2018

Exhibit 3: Dodd-Frank Cheat Sheet (Titles I-VI)

Requirements, interpretation &
Title Primary Agencies Select Provision Description enforcement Applicability Alternative Proposals Impact
The FSOC is designed to protect The Economic Growth, Regulatory
Creation of Financial
the financial stability of the US FSOC monitors domestic and Relief, and Consumer Protection Act
Stability Oversight The asset threshold for a bank holding
Financial Stability financial system international financial regulatory proposes to rollback regulation which
Committee company that could pose systemic
Oversight Committee proposals and makes subjects banks over $50bn in assets to
risk to the United States is established
(FSOC) SIFI designation identifies recommendations in such areas to more stringent regulation. There have
Establishment of "SIFI" at $50bn
institutions that could pose Congress. also been discussions around raising
definition
systemic risk to the system the "SIFI" threshold above $50bn.

The Fed administers DFAST & CCAR

Dodd-Frank requires the Fed to Dodd-Frank requires that these tests
(not law) to BHCs with $50bn+ in Changes to the CCAR process were Given that CCAR, not DFAST, is the
conduct an annual stress test to should include at least three (3)
assets annually. BHCs with $50bn+ in already underway. In Jan 2017, the “gating factor” for capital planning for
evaluate whether a bank holding different sets of conditions. More
Federal Reserve Stress Tests assets are required to perform Fed removed the qualitative BHCs over $50bn in assets, we believe
company (BHC) has the capital importantly, DFA appears to give the
company-run tests 2x a year, while assessment for BHCs with $50-250bn that cost directly related to DFAST is
necessary to absorb losses as a Fed broad scope in the design of and
Title I

banks with $10-50bn only need to in assets. the cost it takes to “run” the test.
result of adverse conditions. consequences of such a test.
perform it 1x/year.
Impacted banks over $50bn in assets
The intermediate holding
are required to establish a separately The operating expense of having a
company requirement was Applicable to foreign headquartered
capitalized IHC that would hold all US There are no current alternate completely separate architecture for
Intermediate Holding designed to provide greater institutions that would have aggregate
Federal Reserve bank and non-bank subsidiaries.The proposals that solely affect foreign the IHC within the bank; lower
Companies (IHC) oversight by US regulators of the asset exposure of $50bn or above,
provisions have granted broad powers banks. revenues; burden on leverage ratios
US operations of foreign- domiciled in the US
to the Fed to determine additional from additional liquidity positions
domiciled banks
requirements for IHCs.
For the large SIFI banks (defined as
Requires BHCs to address how >$250bn in assets), resolution plans Operating costs associated with
There are no current alternate
Resolution planning they would properly wind down in must be submitted by July 1st of each Resolution planning: BHCs with over preparing resolution plans; higher
Federal Reserve, FDIC proposals to eliminate banks resolution
("Living Wills") the event of failure without year. Other applicable institutions are $50bn in assets liquidity balances which could be
planning
causing systemic risk required to file their plans by December deployed into higher yielding assets
31st

The Orderly Liquidation Authority

The FDIC, Fed, and Treasury work Lawmakers are targeting the Orderly
(OLA) empowers the FDIC to All "covered companies" that have Operating costs related to resolution
Title II

FDIC, Federal Insurance Orderly Liquidation together to determine whether a Liquidation Fund which helps fund
become a receiver in the received a systemic risk determination planning, burden from additional
Office, Treasury Authority financial company requires the need to liquidation. The CHOICE Act directly
liquidation process of a failing liquidity positions
invoke OLA targets the repeal of Title II
financial firm

The CHOICE Act proposes an "off

The Fed is allowed discretion as to the The applicability for more prudent
Dodd-Frank established the ramp" alternative to Dodd-Frank if a
stringency of greater global Basel standards with regards to stricter Greater capital and liquidity
Heightened Capital power for the Fed to impose bank can hold a leverage ratio of at
Federal Reserve requirements. The Fed has interpreted capital requirements is for nonbank requirements have negatively impacted
Requirements minimum leverage and risk based least 10% and has a composite
rules more stringently, which has been financial companies and banks with bank returns
capital requirements CAMELS rating of 1 or 2 when it
referred to as “gold plating.” assets over $50bn.
makes an election
Title VI

Exceptions to the rule includes: 1) Applicable to money centers and The Fed and other regulators are
Imposed restrictions to prohibit or There are three major “costs”
Buying/selling securities if it relates to broker-dealers; however, as written, the planning to eliminate an assumption
restrict the ability of banking stemming from the Volcker rule: (1)
Volcker Rule underwriting a securities offering for a rule is applicable to “banking entities” written into the original Volcker Rule
Federal Reserve, CFTC, entities from engaging in short- higher compliance costs and
customer; 2) Purchasing/selling and “nonbank financial companies” law that positions held by banks for
SEC, FDIC, OCC term proprietary trading and operational requirements; (2) lower
securities pursuant to market-making designated by FSOC. In other words, less than 60 days are speculative and
sponsoring of or investing in liquidity in the bond markets; and (3)
activity; 3) A bank can trade securities Volcker even applies to BHCs with thus banned; overhaul expected by end
private equity and hedge funds. lower revenues in fixed income trading.
to hedge or mitigate their own risk <$10bn in assets. of May.

Source: BofA Merrill Lynch Global Research, Dodd-Frank, Financial Services Committee, CFTC, SEC, Federal Reserve, FDIC, FSOC, OCC
Key acronyms: SIFI = systemically important financial institution; DFA = Dodd-Frank Act; BHC = bank holding company; IHC = intermediate holding company; OLA = orderly liquidation authority; DCO = derivative clearing organizations; DCM = designated contract market; SEF
= swap execution facility; CDS = credit default swap; and ERISA = Employee Retirement Income Security Act
 Exhibit 4: Dodd-Frank Cheat Sheet (Titles VII-X)

Requirements, interpretation &

Title Primary Agencies Select Provision Description enforcement Applicability Alternative Proposals Impact
Margin requirements for
uncleared swaps requires Uncleared margin requirements will be US swap entities were required to set
Applicability is based on numerous
Federal Reserve, CFTC, regulators to adopt initial margin phased-in over a 5-year period starting aside a significant amount of additional
considerations including its regulatory
SEC, OCC, FDIC, FCA, Uncleared swaps (IM) and variation margin (VM) 9/1/16 for initial margin, while currently None margin to comply, which led to lost
status and qualification of counterparty
FHFA requirements for certain swap all in-scope market participants are revenue assuming firms could earn a
and financial end users
dealers (SDs) and major swap expected to post variation margin return on the IM.
Title VII

participants (MSPs)

Requirements for swaps: Cleared

Established a new regulatory The CFTC initially required that swaps
through a DCO if necessary; reported
Federal Reserve, CFTC, framework for derivatives, and the in four interest rate swap classes and The proportion of investors trading
to a swap data repository or the
SEC, OCC, FDIC, FCA, Derivatives requirement that swaps be two CDS classes be cleared; recent None electronically increased in 2016 for
CFTC/SEC; executed on a designated
FHFA cleared by derivative clearing additions include other interest rate almost every fixed income product
contract market (DCM) or swap
organizations (DCO) swap classes
execution facility (SEF)

The CFPB covers banks and credit

The Consumer Financial
For banks, crossing the $10bn asset unions with more than $10bn in assets According to the CFPB, the agency
Protection Bureau (CFPB) was Under Rep. Hensarling‘s CHOICE Act
threshold leads to CFPB supervision in addition to mortgage lenders, loan has transferred $11.8bn to US
CFPB, FSOC Creation of CFPB created to be the American 2.0, the CFPB’s power would be
with the agency having the authority to modification and foreclosure relief consumers from financial institutions
consumer's watchdog for financial greatly curtailed
conduct examinations services, private education lenders, since its inception
services
and payday lenders.
Title X

There has been more than $2bn

Limits the amount of debit card The Federal Reserve has the power to decline in interchange fees across the
All financial institutions with over $10bn The Financial CHOICE Act has looked
Federal Reserve Durbin interchange fees that larger sized regulate and enforce the Durbin industry between 2011 - 2012 following
of assets to fully repeal the Durbin Amendment
banks can collect Amendment the enactment of the Durbin
Amendment

Defines standard for qualifying

mortgages; imposes minimum Republicans had previously introduced
Title XIV

Directly addresses one of the Applies to creditors including

CFPB, FRB, OCC, FDIC, standards for mortgage origination; the Portfolio Lending and Mortgage Large banks have reduced their
Mortgage Reform main roots of the global financial depository institutions and mortgage
NCUA, FHFA establishes Office of Housing Access Act in 2015 but it did not pass exposure to the mortgage market
crisis: lax mortgage underwriting. banks
Counseling; amends mortgage through Congress
servicing and appraisal standards
DOL Fiduciary Rule

The DOL is looking to apply a With the 1974 Employee Retirement Industry reports indicate potential
fiduciary standard to a broader Income Security Act (ERISA), the DOL The 5th Circuit Court of Appeals ruled costs for the rule range from $200M
Institutions that advise retirement
Department of Labor Fiduciary Rule group of market participants established standards for private that the DOL exceeded its authority in (DOL) to $5B+ (industry), while the
assets
giving advice related to retirement industry pension plans (both DB and promulgating its Fiduciary Rule revenue impact could be positive or
assets 401k). negative depending on the firm

Source: BofA Merrill Lynch Global Research, Dodd-Frank, Financial Services Committee, CFTC, SEC, Federal Reserve, FDIC, FSOC, OCC.
Global Banks and Brokers | 18 May 2018

Note: Title VII also applies to security-based swaps regulated by the SEC; however these rules are not yet final and therefore not addressed further. In addition, while Title VII encompasses a much longer list of requirements (e.g. reporting, business conduct, etc.), we are
only focusing on requirements imposed on OTC derivatives.
Key acronyms: SIFI = systemically important financial institution; DFA = Dodd-Frank Act; BHC = bank holding company; IHC = intermediate holding company; OLA = orderly liquidation authority; DCO = derivative clearing organizations; DCM = designated contract market; SEF
= swap execution facility; CDS = credit default swap; and ERISA = Employee Retirement Income Security Act
7
 Basel regulation cheat sheets: Summary of rules, requirements, and applicability
8

Table 1: Bank regulation cheat sheet

Equation Minimum Status Fully Phased-in
Global Banks and Brokers | 18 May 2018

Regulation Purpose Numerator Denominator Requirement Basel U.S. Europe Timeline

7.0% + surcharge (US)
UK: Final
Common Equity Tier 1 Is the core measure of a Risk w eighted 10% (CH) Final but
CET1 capital Finalized CH: Final 2019
(CET1) bank's ability to absorb losses assets 9-13% (EU) evolving
EU: Final
15.5-19.4% (SE)
Non-risk based measure of 3% (Basel)
Finalized UK: Final
Supplementary Leverage capital adequacy that takes Total leverage 5% (US holdco) 2018
Tier 1 capital (BCBS to Finalized CH: Final
Ratio (SLR) into account on and off- exposure 5% (CH) (CH: 2020)
re-evaluate) EU: Proposed
balance sheet exposures 3%+GSIB (UK)

An annual exercise to assess

Capital whether the largest bank
Supervisory Stress holding co's have sufficient Final but UK: Annual
NA* NA* 4.5% CET1* (U.S.) Finalized Implemented
Testing capital to continue operations evolving EU: Evolving
through times of economic
and financial stress

Requires an institution to put CET1 + add'l Risk w eighted

Total Loss Absorbing in place sufficient amount of Tier 1 + Tier 2 assets or 21.5-23.0% (U.S.) 2019
Finalized Finalized Proposed
Capacity (TLAC) capital and debt to absorb + unsecured leverage 10% leverage (CH) By 2022 (BCBS)
potential losses debt exposure

Designed to ensure that

banks hold sufficient high- Net cash 2016/2017
Liquidity Coverage Ratio High quality
quality, liquid assets to outflow s over 100% Finalized Finalized Finalized (Basel: 2019)
(LCR) liquid assets
withstand an acute stress 30-days (CH: 2015)
scenario that lasts 30 days
Liquidity
Aim is to reduce bank reliance
on short-term funding by
Net Stable Funding Ratio Available Required stable
requiring institutions to hold 100% Finalized Proposed Proposed 2019
(NSFR) stable funding funding
longer-term stable funding
against less liquid assets

Source: BofA Merrill Lynch Global Research, FSB, Federal Reserve, Basel Committee on Banking Supervision (BCBS), FSA
*There are five different capital constraints in the U.S. stress test
Chinese and Japanese GSIBs align themselves according to Basel standards
UK = United Kingdom, CH = Switzerland, EU = Eurozone (i.e., Basel), SE = Sweden
 Table 2: Impacted institutions, businesses and products
Impacted Institutions
Regulation Basel US Europe More Valuable Products Less Valuable Products
Electronic/agency trading
Wealth management
Equity derivatives
Asset management
Securitized products
Advisory
HY credit products
Payments
Common Equity Tier 1 (CET1) All banks All banks All banks Commodities
Clearing
Mortgage servicing
Rates
Non agency MBS
Repo
Higher-risk loans
Agency MBS
Unfunded lending commitments
Electronic/agency trading Equity derivatives
Wealth management Prime brokerage
Asset management Rate
Advanced
Supplementary Leverage Ratio (SLR) All banks All banks Advisory Repo
Capital approaches
Payments IG credit products
Clearing Commodities financing
High yield/ distressed credit Unfunded lending commitments
Largest banks International lending exposure
BHCs with assets Historically low loss content loan
Supervisory Stress Testing All banks covering 70% of Subprime lending
≥ $50bn products (e.g. prime mortgage)
banking assets Non-operational deposits
L/T unsecured funding
Electronic trading
Deposit funding
Wealth management
All G-SIBs (ex- S/T funding
GSIBs (D-SIBs Asset management
Total Loss Absorbing Capacity (TLAC) banks in emerging GSIBs Structured funding
likely) Advisory
mkts) Securitized funding
Payments
HY credit products
Clearing
Agency MBS
Liquidity and credit facilities
G-SIBs (≥$250bn in Lending products to fin'l institutions
Retail deposits
Liquidity Coverage Ratio (LCR) All banks assets) & BHCs All banks Non-operational corporate deposits
Operational corporate deposits
(≥$50bn, < $250bn) Financial institution deposits
Prime brokerage
The current regulatory ST funding
regime places different value
Global Banks and Brokers | 18 May 2018

Financial institution deposits

on similar products
Liquidity Non-operational corporate deposits
Equity derivatives
G-SIBs (≥$250bn in
Rates Prime brokerage
Net Stable Funding Ratio (NSFR) All banks assets) & BHCs All banks
Retail deposits Repo
(≥$50bn, < $250bn)
Non-agency MBS
Municipal market securities
Credit products
Structured products
Source: BofA Merrill Lynch Global Research, FSB, Federal Reserve, BCBS, FSA. Chinese and Japanese GSIBs align themselves according to Basel standards
Note: Value determination based on relative “favor” imposed on businesses and/or products by the regulatory framework in isolation
9
Basel regulatory compliance heat map

Exhibit 5: Regulatory compliance heat map (as of 1Q18 where published)

Capital Liquidity
CET1 SLR TLAC LCR NSFR
BK 10.7% 5.9% 27.4% 116% >100%
C 12.1% 6.7% 24.4% 120% 103%
GS 11.1% 5.7% 40.9% 129% >100%
JPM 11.8% 6.5% 23.5% 115% >100%
Americas
MS 15.5% 6.3% 55.0% 121% >100%
RBC 11.0% 4.2% 122%
STT 10.8% 6.0% 22.7% 109% >100%
WFC 12.0% 7.9% 24.0% 123% >100%
BARC 12.7% 4.8% 24.7% 147% >100%
BNP 11.6% 4.1% 19.9% 120% >100%
CA 11.7% 4.4% 20.6% 137%
CS 12.9% 4.6% 8.9% 208% >100%
DBK 13.4% 3.7% 36.0% 144% >105%
HSBC 14.5% 5.6% 23.3% 142% >120%
ING 14.3% 4.4% 21.4% >115% >100%
Europe
Nordea 17.5% 5.1% 25.3% 174% 104%
RBS 15.1% 5.8% 27.1% 151% 137%
Santander 10.8% 5.1% 16.2% 138% >100%
SocGen 11.2% 4.1% 22.1% 129% >100%
StanChart 13.6% 6.0% 25.5% 146% >100%
UBS 13.1% 4.7% 9.0% 136% 107%
Unicredit 13.1% 5.4% 170% >100%
ABC 10.5% 6.2% 125%
BOC 10.9% 6.8% 118% Exceeds regulatory requirement minimum (2 std dev)
CCB 13.1% 7.5% 136% Exceeds regulatory requirement minimum (1 std dev)
Asia ICBC 12.6% 7.6% 121% Exceeds regulatory requirement minimum (<1 std dev)
Mizuho 11.9% 4.3% 20.3% 126% >100% Meets regulatory requirement minimum
MUFG 12.5% 5.0% 18.8% 146% >100% Below regulatory minimum
SMFG 13.1% 5.0% 21.8% 127% >100% Not disclosed/ not applicable
Source: BofA Merrill Lynch Global Research, company data. Data as of 1Q18 except for China-based BHCs.
Note: Assume BHC meets minimum regulatory requirement where specific ratio isn’t disclosed (i.e., NSFR, TLAC, and LCR). CS and UBS TLAC as percent of leverage exposure
Note: For European-based GSIBs, CET1 requirements include BofAMLe about the pillar 2 guidance buffer or +100bp where data isn’t disclosed

10 Global Banks and Brokers | 18 May 2018

Key proposals – regulation cheat sheet

Exhibit 6: Recent regulatory reform proposals

Regulation Party Proposal Date Summary
Amend capital rules for bank holding companies (BHCs) with $50bn+ in assets, merging
▪
the two current capital requirements for standardized common equity tier 1 (CET1)
Stressed capital/leverage
Federal Reserve 4/10/2018 Fed proposes to replace the capital conservation buffer of 2.5% with the stressed capital
buffer
▪ buffer as well as introducing the stressed leverage buffer (difference between a BHC’s
starting capital ratio and the minimum projected over the duration of the 13-quarter test)
Amend the enhanced supplementary leverage ratio (eSLR) standards applicable to US
▪
GSIBs and their insured depository institution (covered IDI) subsidiaries
Supplementary leverage
Federal Reserve, OCC 4/11/2018 The proposal would replace the current 2% leverage buffer with another buffer equal to 50%
ratio
▪ of the bank’s GSIB surcharge, in line with the Basel proposals from December 2017,
resulting in a lower capital requirement for all US GSIBs

The 5th Circuit Court of Appeals ruled that the DOL exceeded its authority in promulgating
Department of Labor
Senate 3/15/2018 ▪ its Fiduciary Rule, which was slated to go into full effect July 1, 2019. The DOL has until
Fiduciary Rule
June 13th to challenge this decision in front of the Supreme Court

Fed released a package of three proposals centered on increasing the transparency of its
Enhanced transparency stress testing program, to be applicable to the 2019 DFAST/CCAR process: (1) enhanced
Federal Reserve 12/7/2017 ▪
for 2019 CCAR model disclosure (2) changes to scenario design framework (3) supervisory stress testing
model policy update.
The OCC announced it would begin soliciting public feedback on potential changes to the
▪
Volcker Rule
Federal Reserve,
Volcker Rule reform 8/2/2017 The OCC put forth a set of questions for the banking industry to address, focused on the
Congress
▪ following topics: (1) scope of entities subject to rule (2) proprietary trading prohibition (3)
covered funds prohibition (4) compliance program and metrics reporting requirements

Source: BofA Merrill Lynch Global Research, Federal Reserve

Global Banks and Brokers | 18 May 2018 11

Congressional regulatory reform proposals cheat sheet

Exhibit 7: Key legislative regulatory reform proposals

Source Official Short Title Summary Status Next Step CBO cost est.*

Banks with less than $250bn in assets wouldn’t automatically be

Heads to the
designated as systemically important financial institutions (SIFIs).
Passed in House where Increases deficit
Economic Growth, Regulatory Relief, and The exempted banks would no longer have to undergo an annual
S. 2155 Senate Republicans by $671mn over
Consumer Protection Act stress test and would be excused from submitting living will plans.
(3/14/18) may add more 10 yrs
That said, the Fed would still have the authority to apply tougher
provisions
standards for banks with between $100bn and $250bn in assets.

The bill includes policy provisions that would: eliminate regulator's

Reported by
authority to designate companies as systemically important;
Financial Services and General Government Committee on No estimate
H.R. 3280 repeal the Volcker Rule; and subject the CFPB to the Sent to House
Appropriations Act, 2018 Appropriations available
discretionary appropriations process and reduce their regulatory
(7/8/17)
authority.
Referred to the Banks' total
The bill would modify the definition of what qualifies as a High
Passed in Senate capital reserves
Volatility Commercial Real Estate (HVCRE) loan for the purposes
H.R. 2148 Clarifying Commercial Real Estate Loans House Banking, would be
of determining the amount of capital a lender must hold. (Related:
(11/7/17) Housing, and diminished by
S. 2405 "Clarifying Commercial Real Estate Loans")
Urban Affairs. 0.001%

The bill would allow a money market fun, under specified Ordered to be
Consumer Financial Choice and Capital conditions, to elect to operate using a different method of reported to To be voted on No estimate
H.R. 2319
Markets Protection Act of 2017 valuation. If elected, a money market fund shall not be subject to House by House available
specified requirements related to the imposition of liquidity fees. (1/18/18)

Bars regulatory agencies from establishing a capital requirement

for "operational risk" based solely on past events. The bill would
Passed in Increases deficit
require an operational risk capital requirement to be based
H.R. 4296 Operational Risk Capital Requirement** House Sent to Senate by $22mn over 10
primarily on current activities, to be determined using a forward-
(2/27/18) yrs
looking assessment of potential losses, and to allow for
adjustments based on mitigating factors.
Passed in Increases deficit
To require regulatory agencies to take risk profiles and business
H.R. 1116 TAILOR Act of 2017 House Sent to Senate by $80mn over 10
models of institutions into account when taking regulatory actions.
(3/14/18) yrs
Measure would eliminate one of three stress test scenarios, bar Passed in Increases deficit
H.R. 4293 Stress Test Improvement Act of 2017 the Fed from objecting to capital plans based on qualitative House Sent to Senate by $14mn over 10
deficiencies, and reduce the frequency of Co-conducted tests. (4/11/18) yrs
To give the Federal Reserve sole rulemaking authority, to exclude
Passed in
community banks (with $10bn in assets or less) from the
H.R. 4790 Volcker Rule Regulatory Harmonization Act House Sent to Senate Not meaningful
requirements of the Volcker rule. (Related: H.R. 5659 "Volcker
(4/13/18)
Rule Relief Act of 2018")
Source: BofA Merrill Lynch Global Research, Bloomberg
Note: One asterisk (*): Congressional Budget Office (CBO) cost estimate based on the enactment of legislation over a 10 year period between 2018-27. Two asterisks (**):Not formal title of the legislation

12 Global Banks and Brokers | 18 May 2018

 Compliance against local interpretation of regulatory constraints
U.S. Universal Banks

Chart 1: JPMorgan Chart 2: Citigroup Chart 3: Wells Fargo

CET1 CET1 CET1
150% 150% 150%

100% 100% 100%

TLAC NSFR TLAC NSFR TLAC NSFR

50% 50% 50%

LCR SLR LCR SLR LCR SLR

1Q17 1Q18 1Q17 1Q18 1Q17 1Q18

Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data
Note: TLAC estimated based on publicly available data. NSFR not disclosed, Note: TLAC estimated based on publicly available data. NSFR not disclosed, Note: TLAC estimated based on publicly available data. NSFR not disclosed,
assumed 100% assumed 100% assumed 100%

U.S. Broker Dealers

Chart 4: Goldman Sachs Chart 5: Morgan Stanley
CET1 CET1
150% 150%

100% 100%
TLAC NSFR TLAC NSFR

50% 50%
Global Banks and Brokers | 18 May 2018

LCR SLR LCR SLR

1Q17 1Q18 1Q17 1Q18

Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data
Note: TLAC estimated based on publicly available data. NSFR not disclosed, Note: TLAC estimated based on publicly available data. NSFR not disclosed,
assumed 100% assumed 100%
13
 U.S. Trust Banks
14

Chart 6: State Street Chart 7: Bank of New York

Global Banks and Brokers | 18 May 2018

CET1 CET1
150% 150%

100% 100%
TLAC NSFR TLAC NSFR

50% 50%

LCR SLR LCR SLR

1Q17 1Q18 1Q17 1Q18

Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data
Note: TLAC estimated based on publicly available data. NSFR not disclosed, Note: TLAC estimated based on publicly available data. NSFR not disclosed,
assumed 100% assumed 100%

European Banks and Brokers

Chart 8: Barclays Chart 9: Deutsche Bank
CET1 CET1
150% 150%

100% 100%
TLAC NSFR TLAC NSFR

50% 50%

LCR SLR LCR SLR

1Q17 1Q18 1Q17 1Q18

Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data
Note: Use MREL disclosure for TLAC Note: Assumes 4.0% minimum (company target)
 Chart 10: Credit Suisse Chart 11: UBS
CET1 CET1
150% 150%

100% 100%
TLAC NSFR TLAC NSFR

50% 50%

LCR SLR LCR SLR

1Q17 1Q18 1Q17 1Q18

Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data
Note: TLAC as % of leverage exposure. Assumes 5% SLR minimum per FINMA Note: TLAC as % of leverage exposure. Assumes 5% SLR minimum per FINMA

Capital markets revenue market share vs. SLR compliance

Chart 12: Fixed income, currencies, and commodities Chart 13: Equities
160% WFC 160% WFC
Leverage ratio relative to requirement

Leverage ratio relative to requirement

150% 150% Market share opportunity
C HSBC Market share opportunity C
140% JPM BARC 140% JPM BARC
MS HSBC
130% 130%
120% GS SocGen 120% GS SocGen
MS
110% BNP 110% BNP
(2017)

(2017)
100% CS UBS 100% UBS CS
90% DBK 90% DBK
80% Stay the 80%
Stay the
Global Banks and Brokers | 18 May 2018

70% course 70% course

Potential retrenchment Potential retrenchment
60% 60%
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
FICC global investment bank league table rank (2017) Equities global investment bank league table rank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank
15
 Fixed income products
16

Chart 14: Rates Chart 15: FX Chart 16: Emerging Markets

Global Banks and Brokers | 18 May 2018

160% WFC 160% WFC 160% WFC

Lever age r atio r elative to r equir ement (2017)

Lever age r atio r elative to r equir ement (2017)

Lever age r atio r elative to r equir ement (2017)

150% 150% 150%
Mar ket shar e Mar ket shar e C HSBC Mar ket shar e
140% C oppor tunity 140% HSBC C oppor tunity 140% BARCoppor tunity
JPM BARC JPM BARC MS
MS HSBC MS 130% JPM SocGen
130% 130%
120% GS
120% GS SocGen 120% GS SocGen
BNP
110% BNP
110% BNP 110%
100% CS UBS
100% CS UBS 100% UBS CS
90% DBK
90% DBK 90% DBK
80% Stay
80% Stay 80% the Potential
the 70%
Potential Stay the Potential cour se r etr enchment
70% 70%
cour se r etr enchment cour se r etr enchment 60%
60% 60% 0 2 4 6 8 10 12 14
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 EMERGING MARKETS: Global investment bank league
RATES: Global investment bank league table r ank (2017) FX: Global investment bank league table r ank (2017) table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank

Chart 17: Credit Chart 18: Securitizations Chart 19: Commodities

160% WFC 160% WFC 160% WFC
Lever age r atio r elative to r equir ement (2017)

Lever age r atio r elative to r equir ement (2017)

Lever age r atio r elative to r equir ement (2017)

150% 150% 150%
Mar ket shar e C Mar ket shar e C Mar ket shar e
C 140% 140% HSBC
140% JPM BARC oppor tunity JPM BARC oppor tunity JPM oppor tunity
BARC
MS MS HSBC
HSBC 130% 130% SocGen
130%
120% GS SocGen 120% GS
120% GS SocGen MS
110% BNP 110% BNP
110% BNP
100% CS UBS 100% UBS CS
100% CS UBS
90% DBK 90% DBK
90% DBK
80% Stay 80%
80% the Potential Stay the Potential
70% 70%
Stay the Potential cour se r etr enchment cour se r etr enchment
70%
cour se r etr enchment 60% 60%
60% 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
0 2 4 6 8 10 12 14 SECURITIZATIONS: Global investment bank league table COMMODITIES: Global investment bank league table r ank
CREDIT: Global investment bank league table r ank (2017) r ank (2017) (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank
 Equities products
Chart 20: Cash Equities Chart 21: Prime Services Chart 22: Equity Derivatives
160% WFC 160% WFC 160% WFC
Lever age r atio r elative to r equir ement (2017)

Lever age r atio r elative to r equir ement (2017)

Lever age r atio r elative to r equir ement (2017)

150% 150% 150%
Mar ket shar e Mar ket shar e
C C C
140% JPM BARC oppor tunity 140% JPM BARC oppor tunity 140% JPM BARC
MS HSBC MS HSBC MS HSBC
130% 130% 130%
120% GS SocGen 120% SocGen 120% GS SocGen
GS Mar ket shar e
110% BNP 110% BNP 110% BNP
oppor tunity
100% CS UBS 100% UBS CS 100% UBS CS
90% DBK 90% DBK 90% DBK
80% Stay 80% Stay 80% Stay
the Potential the Potential the Potential
70% 70% r etr enchment 70% cour se
cour se r etr enchment cour se r etr enchment
60% 60% 60%
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
CASH EQUITIES: Global investment bank league table r ank PRIME SERVICES: Global investment bank league table EQUITY DERIVATIVES: Global investment bank league
(2017) r ank (2017) table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank

Capital markets revenue market share vs. CET1 compliance

Chart 23: Fixed income, currencies, and commodities Chart 24: Equities
MS
160% 160%
CET1 ratio relative to requirement (2017)

CET1 ratio relative to requirement (2017)

150% 150% Market share opportunity
Market share opportunity MS
140% CS UBS 140% UBS CS
130% WFC 130% WFC
C HSBC C
GS GS
120% JPM 120% JPM HSBC
110% DBK 110% DBK
BARC SocGen SocGen BARC
100% BNP 100% BNP
90% 90%
80% 80%
70% 70%
Stay the course Potential retrenchment Stay the course Potential retrenchment
60% 60%
Global Banks and Brokers | 18 May 2018

0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
FICC global investment bank league table rank (2017) Equities global investment bank league table rank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank
17
 Fixed income products
18

Chart 25: Rates Chart 26: FX Chart 27: Emerging markets

MS MS MS
Global Banks and Brokers | 18 May 2018

160% 160% 160%

CET1 r atio r elative to r equir ement (2017)

CET1 r atio r elative to r equir ement (2017)

CET1 r atio r elative to r equir ement (2017)

150% 150% 150%
Mar ket shar e Mar ket shar e Mar ket shar e
140% oppor tunity 140% oppor tunity 140% CS UBS
oppor tunity
CS UBS UBS CS WFC
WFC WFC 130% C HSBC
130% C 130% HSBC C GS
GS GS 120%
120% JPM HSBC 120% JPM SocGen
110% JPM DBK
110% DBK 110% DBK BNP BARC
BARC SocGen BARC SocGen BNP
BNP 100%
100% 100%
90%
90% 90%
80%
80% 80%
Stay the Potential Stay the Potential 70% Stay the Potential
70% cour se r etr enchment 70% cour se r etr enchment 60% cour se r etr enchment
60% 60% 0 2 4 6 8 10 12 14
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 EMERGING MARKETS: Global investment bank league
RATES: Global investment bank league table r ank (2017) FX: Global investment bank league table r ank (2017) table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank

Chart 28: Credit trading Chart 29: Securitizations Chart 30: Commodities
MS MS
160% 160% 160%
CET1 r atio r elative to r equir ement (2017)

CET1 r atio r elative to r equir ement (2017)

CET1 r atio r elative to r equir ement (2017)

150% 150% 150%

Mar ket shar e Mar ket shar e MS Mar ket shar e
140% UBSoppor tunity 140% CS UBSoppor tunity 140% UBS opporCStunity
CS WFC WFC
WFC 130% C 130% C HSBC
130% C GS GS
GS 120% JPM HSBC 120% JPM
120% JPM HSBC SocGen
110% DBK 110% DBK
110% DBK BARC SocGen BARC
BARC SocGen BNP BNP
BNP 100% 100%
100%
90% 90%
90%
80% 80%
80%
Stay the Potential 70% Stay the Potential 70% Stay the Potential
70% cour se r etr enchment 60% cour se r etr enchment 60% cour se r etr enchment
60% 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
0 2 4 6 8 10 12 14 SECURITIZATIONS: Global investment bank league table COMMODITIES: Global investment bank league table r ank
CREDIT: Global investment bank league table r ank (2017) r ank (2017) (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank
 Equities products
Chart 31: Cash equities Chart 32: Prime Services Chart 33: Equity derivatives
MS MS MS
160% 160% 160%
CET1 r atio r elative to r equir ement (2017)

CET1 r atio r elative to r equir ement (2017)

CET1 r atio r elative to r equir ement (2017)

150% 150% 150% Mar ket shar e
Mar ket shar e Mar ket shar e oppor tunity
140% CS UBS oppor tunity 140% UBS CS oppor tunity 140% UBS CS
WFC WFC WFC
130% C 130% C 130% C
GS GS
120% JPM HSBC 120% JPM HSBC 120% JPM HSBC
GS SocGen
110% DBK 110% DBK 110% DBK
BARC SocGen BARC SocGen BARC
BNP BNP BNP
100% 100% 100%
90% 90% 90%
80% 80% 80%
70% Stay the Potential 70% Stay the Potential 70% Stay the Potential
60% cour se r etr enchment 60% cour se r etr enchment 60% cour se r etr enchment
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
CASH EQUITIES: Global investment bank league table r ank PRIME SERVICES: Global investment bank league table EQUITY DERIVATIVES: Global investment bank league
(2017) r ank (2017) table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition
Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank Note: WFC not included in analysis; assumed #13 rank
Global Banks and Brokers | 18 May 2018
19
Regulation in real time: The most recent
2B

global developments

20 Global Banks and Brokers | 18 May 2018

Recent developments: United States
On February 3, 2017, U.S. President Trump signed an executive order calling for the
administration to review U.S. financial laws and regulations to determine their
compatibility with a set of “Core Principles”. Also in 2017, President Trump appointed
new leadership at eight of the related nine regulatory agencies that are members of
FSOC (Financial Stability Oversight Committee), with five now confirmed. Further,
Congress appears to be on the brink of passing a bill into law that would raise the asset
threshold that defines a systemically important financial institution (SIFI) in the United
States.

In summary, the recent regulatory proposals and related pending legislation in the
United States appear to favor “tailored” regulation, where rules remain mostly
stringent for the eight U.S. GSIBs but less onerous for regional banks.

Summary of executive order, Treasury proposals

While it largely falls upon the regulatory agencies, and, to a lesser extent, Congress, to
facilitate actual change, both the Executive office and the United States Department of
the Treasury attempted to set the tone for reform early into President Trump’s term.
We summarize them below. The actual proposals that followed, which we explain in the
subsequent sections, appear to be less sweeping than expected.

Executive order
What follows is the summary of the original February 2, 2017 Executive Order
pertaining to financial regulation, and include our own observations next to each Core
Principle (see Exhibit 8).

Global Banks and Brokers | 18 May 2018 21

Exhibit 8: Executive Order principles and observations
Principle BofAML research view
This principle targeting “independent financial decisions”
Empower Americans to make independent financial
appears to be a direct response to the Department of Labor
decisions and informed choices in the marketplace,
(DOL) fiduciary rule, which we discuss at length later in this
save for retirement, and build individual wealth
document
Higher capital and liquidity requirements established post-crisis
Prevent taxpayer-funded bailouts
may not be rolled back
Foster economic growth and vibrant financial markets
This appears to make the case for more specific regulation to
through more rigorous regulatory impact analysis that
address systemic risk, rather than the Obama-era “blunt force"
addresses systemic risk and market failures, such as
approach
moral hazard and information asymmetry

Appears to address the “gold-plating” of prudential Basel

Enable American companies to be competitive with standards in the US, which has turned into more stringent
foreign firms requirements for capital, funding, and resolution vs. Basel
minimums
Appears to also directly address the advocacy of certain outgoing
Advance American interests in international financial Federal Reserve governors for international regulatory
regulatory negotiations and meetings cooperation (rather than favor US financial services) and for even
tougher standards (such as "Basel IV")
“Appropriately” tailored appears to allude to differing capital and
liquidity standards depending on systemic risk. Example on
Make regulation efficient, effective, and appropriately
progress includes current negotiations to alter the current “SIFI”
tailored
designations under Dodd-Frank Act (currently at >$50bn in
assets and >$10bn in assets)
Appears to address the number (and powers) of regulatory
Restore public accountability within Federal financial
agencies that currently exist. CFPB and FSOC (Financial Stability
regulatory agencies and rationalize the Federal
Oversight Council) were both new agencies established by Dodd
financial regulatory network
Frank, for example
Source: BofA Merrill Lynch Global Research, White House

Treasury proposed blueprint: Banks and credit unions

On June 12, 2017, the Treasury released a report titled “A Financial System That
Creates Economic Opportunities: Banks and Credit Unions.” This report was focused on
reform impacting deposit-gathering institutions. We summarize Treasury’s specific
recommendations in the previous section, beginning on page 5. Written in consultation
with all nine FSOC member regulatory agencies (we discuss the U.S. regulatory structure
in detail beginning on page 87), Treasury’s summary of recommendations is listed
below, accompanied by our observations (see Exhibit 9).

22 Global Banks and Brokers | 18 May 2018

Exhibit 9: Summary of Treasury recommendations for reform for banks and credit unions
Summary of Treasury Recommendation BofAML Research View
Improve regulatory efficiency and effectiveness by
critically evaluating mandates and regulatory
No notable progress here
fragmentation, overlap, and duplication across regulatory
agencies

Aligning the financial system to support the U.S. economy Progress here focused on regional and community banks

Reducing regulatory burden by decreasing unnecessary

Very modest progress here
complexity
Tailoring the regulatory approach based on size and
complexity of regulated firms and requiring greater Agency proposals and legislation appear to be focused on
regulatory cooperation and coordination among financial tailored regulation
regulators
Aligning regulations to support market liquidity, Agency proposals and legislation appear to be focused on
investment, and lending in the U.S. economy tailored regulation
Source: BofA Merrill Lynch Global Research, US Treasury

For depository institutions, the three arguably most impactful agencies are the Federal
Reserve, the FDIC (Federal Deposit Insurance Corporation), and the OCC (Office of the
Comptroller of the Currency). All new relevant leadership at these agencies were
confirmed after the Treasury report was published.

Treasury proposed blueprint: Capital markets

On October 6, 2017, the Treasury released a second report titled “A Financial System
That Creates Economic Opportunities: Capital Markets.” Treasury’s summary of
recommendations is listed below, accompanied by our observations (see Exhibit 10).

Global Banks and Brokers | 18 May 2018 23

Exhibit 10: Summary of Treasury recommendations for reform for capital markets
Summary of Treasury Recommendation BofAML Research View
Promoting access to capital for all types of companies,
Though there has not been notable progress on related
including small and growing businesses, through
regulatory burden; access to capital across bank and nonbank
reduction of regulatory burden and improved market
financing appears fairly open
access to investment opportunities
Modest progress, with the OCC leading the charge with a
proposal to reform the Volcker Rule in August 2017. (News
reports indicate that the Volcker reform proposal is imminent).
Fostering robust secondary markets in equity and debt
As we discuss in detail later in this report, liquidity has declined
following the Global Financial Crisis, but market volatility has
been until recently subdued
Appropriately tailoring regulations on securitized products
No notable progress
to encourage lending and risk transfer
Recalibrating derivatives regulation to promote market
No notable progress
efficiency and effective risk mitigation
Christopher Giancarlo, Chairman of the CFTC, highlighted that
further deliberations were needed regarding: 1) safety and
Ensuring proper risk management for CCPs (central soundness under extreme but plausible conditions, 2) the
counterparties) and other financial market utilities (FMUs) transparency and predictability of recovery plans and the role of
unfunded resources, and 3) considerations related to
resolution by government authorities
Rationalizing and modernizing the U.S. capital markets
No notable progress
regulatory structure and processes
According to a recent proposal from the Federal Reserve, U.S.
regulators recommends more closely aligning local standards
for the supplementary leverage ratio (SLR) to Basel, or
Advancing U.S. interests by promoting a level playing field
international, standards. However, in this proposal and within
internationally
the recent proposal addressing common equity tier 1 (CET1)
standards, U.S. “gold plating” of Basel CET1 rules for GSIBs
will appear to survive this administration
Source: BofA Merrill Lynch Global Research, US Treasury

For the U.S. capital markets, the primary regulators are: the SEC (Securities and
Exchange Commission), the CFTC (the Commodity Futures Trading Commission), and
state securities regulators. Self-regulatory organizations, or SROs, also are key players in
regulating certain parts of the financial services sector. These SROs include: FINRA
(Financial Industry Regulatory Authority), MSRB (Municipal Securities Rulemaking
Board), and NFA (National Futures Association).

Key regulatory agency appointments

As mentioned previously, we detail the U.S. regulatory structure beginning on page 87.
Below is a graphic with the key leadership appointments at FSOC member regulatory
agencies (see Exhibit 11).

24 Global Banks and Brokers | 18 May 2018

Exhibit 11: FSOC member agencies

Source: BofA Merrill Lynch Global Research, FSOC

Key regulatory agency proposals

Many regulatory appointments, and subsequent confirmations, had come later in 2017
than bank investors had hoped. After all, having the new administration appoint new
leadership at these agencies is crucial to prudential rule reform. That said, we detail the
major proposals below.

Stressed capital/leverage buffer (April 10th, 2018)

Proposed by: The Federal Reserve

In April 2018, the Federal Reserve published a draft proposal that would amend capital
rules for bank holding companies (BHCs) with $50bn+ in assets. While U.S. SIFIs all have
an overarching binding capital constraint (in other words, the most restrictive of all the
different capital requirements), BHCs with $50bn+ in assets were required to balance
business-as-usual, or “spot” capital requirements, and stressed capital requirements
under the annual DFAST (Dodd-Frank Act Stress Testing) and CCAR (Comprehensive
Capital Analysis and Review) process. In this proposal, the Fed would “merge” the two
requirements for standardized common equity tier 1 (CET1). (A discussion of the
difference between standardized and advanced approaches in CET1 can be found
beginning on page 94).

Under the current regime, the graphic below represents the base, non-stressed capital
requirement for CET1 (see Chart 34).
Chart 34: Non-stressed requirements, CET1

0.0 to 2.5%
Counter cyclical buffer

1.0 to 5.5% G-SIB surcharge (if applicable)

Capital conservation buffer (fully

2.5% phased-in Jan '19)
Minimum requirement
4.5%

CET1 to risk-weighted assets

Source: BofA Merrill Lynch Global Research, Federal Reserve

Note: For every 100bp increase in GSIB score, 0.5% is added to the bank’s surcharge

Global Banks and Brokers | 18 May 2018 25

Meanwhile, the graphic below represents the current components of CET1 requirements
under the current DFAST/CCAR regime (see Chart 35). Note that the value indicated
under “planned distributions and balance sheet growth” as well as under “stress test
losses” represent the average result of the 2017 process. There are no minimum floors or
maximum ceilings on the test.
Chart 35: Stress test requirements, CET1
Components of the capital stack represent the average of 2017 DFAST results

~1.5%

~1.4%
Planned distributions and b/s growth
Stress test losses
Minimum requirement
4.5%

CET1 to risk-weighted assets

Source: BofA Merrill Lynch Global Research, Federal Reserve

Note: The values indicated under “planned distributions and balance sheet growth” as well as under “stress test losses” represent the
average result of the 2017 process

Under the current proposal, banks would no longer fail the test in a “quantitative”
fashion, which would occur if the minimum requirements set by the Fed under stress are
breached. (A detailed explanation of the DFAST and CCAR process in the US can be
found beginning on page 130.) Rather, the Fed is proposing to replace the capital
conservation buffer of 2.5% with the net amount of capital “burned” in the test – this is
called the stressed capital buffer. In other words, rather than enforcing a quantitative
failure, poor test results can lead to higher “spot” capital requirements.

Key definition

When we refer to “capital burn”, we refer to the Fed’s measurement that takes the
difference between a BHC’s starting capital ratio and the minimum projected over the
duration of the 13-quarter test

We break the new proposed requirements below (see Chart 36). As with the previous
chart, dividend add-on and stress test losses represent the average of the 2017 results. We
have stripped out balance sheet growth and capital return beyond four quarters worth of
dividend payments to calculate average stress test losses.

26 Global Banks and Brokers | 18 May 2018

Chart 36: Proposed capital requirements
Dividend add-on and SCB based on the average of 2017 DFAST results

1.0 to 5.5%
G-SIB surcharge (if applicable)
~ 0.5% Dividend add-on
2.5% to ∞ Stressed capital buffer
Minimum requirement

4.5%

CET1 to risk-weighted assets

Source: BofA Merrill Lynch Global Research, Federal Reserve

Note: The dividend add-on represents the average of the 2017 results. For every 100bp increase in GSIB score, 0.5% is added to the bank’s
surcharge

Key definition

The stressed capital buffer (SCB) would represent the net amount of capital
“burned” by a bank during the stress test, and would include four quarters worth of
dividends. Unlike in previous tests, the Fed would allow banks to assume no balance
sheet growth and no other capital return other than four quarters of dividend
payments. This SCB would replace the capital conservation buffer in the current
CET1 framework. It cannot be lower than 2.5%, and has no maximum value.

We summarize other noteworthy parts of the proposal below:

• Although banks can no longer fail quantitatively, BHCs can still receive an objection
to their capital plans on a qualitative basis. Note that as of February 3, 2017, the
qualitative assessment is no longer applicable to banks less than $250bn in assets.

• The Fed proposes to remove the “soft cap” on dividends that is currently equivalent
of 30% of earnings

• In a concession to the BHCs, the Fed will no longer assume balance sheet growth.
On average, using the 2017 CCAR results, this would “save” 70bp of capital burn.
Note that there has been a notable difference between Fed projected RWAs and
bank projected RWAs in previous tests (see Chart 37)

Global Banks and Brokers | 18 May 2018 27

Chart 37: Fed had typically assumed banks would increase their b/s during times of stress
14.0
Proj. change in RWA during severely

12.0
10.0
8.0
stressed scenario (%)

6.0
4.0
2.0
0.0
(2.0)
(4.0)
(6.0)
2014 2015 2016 2017
CCAR year

Federal Reserve Co-run (bank models)

Source: BofA Merrill Lynch Global Research, company data, Federal Reserve

• In another concession to the BHCs, the Fed will no longer assume that banks will
continue to return capital via dividends and buybacks in a stressed scenario, other
than four quarters worth of dividend payments. On average, using the 2017 CCAR
results, this would “save” another 40bp of capital burn.

• The CCAR results are regularly released in June. Under this proposal, the stressed
capital buffer set in June by the current-year CCAR would be applicable beginning in
October of the same year, and would be valid for 12 months. In other words, if
finalized into rule by end of this year, the 2019 CCAR result would determine the
SCB, and therefore, the day-to-day standardized CET1 requirements, for October
2019 through October 2020.

• According to the proposal, the Fed would like to finalize this rule in time for the
2019 DFAST/CCAR cycle.

Leverage component
Under the same proposal, the Fed also introduced the stressed leverage buffer,
applicable to the tier 1 leverage ratio (see Exhibit 12). Like the SCB, the stressed
leverage buffer measures capital burn, or the difference between the BHC’s starting and
minimum projected tier 1 leverage ratio (also including four quarters worth of
dividends). This would replace the requirement under the current capital regime that a
firm demonstrate the ability to maintain capital levels above minimum leverage
requirements on a post-stress basis.
Exhibit 12: Tier 1 leverage ratio formula

Tier 1 Capital

Tier 1 Leverage Ratio

Average total
consolidated assets and
certain off balanc e sheet
exposures

Source: BofA Merrill Lynch Global Research, Federal Reserve

28 Global Banks and Brokers | 18 May 2018

Potential impact: Greater volatility for G-SIBs, real relief for regionals
Below, we calculate the potential SCB for each US domestic SIFI, based on the results
of the 2017 DFAST, netted out for the new proposed requirements (see Exhibit 13). On
the surface, this does not appear to have material negative impact. With the exception
of GS and MS, most BHCs would be bound by the 2.5% SCB floor – no different from
the current capital conservation buffer. That said, this assumes no change to business
strategy based on the new proposals, which isn’t very likely for those negatively
impacted.

However, there are certain BHCs whose “pro forma” requirement would be above
their public targets for CET1. This is meaningful as investor expectations for
business growth, dividends, and buybacks are set based on public CET1 targets.

Exhibit 13: Pro forma capital requirements under the Fed’s proposal
I=
J=
Key A B C D E= C - D F G H max [E-G- K L M=K-J N=L-J O P=O-J
A+B+F+I
H or 2.5%]
Proj min Stess test
Add: Less: Less: Stressed Current Spot CET1
Minimum GSIB CET1 ratio CET1 ratio losses Pro forma CET1 ratio Current Target vs. CET1 ratio
Planned RWA DFAST div capital min vs pro ratio vs pro
req surcharge (4Q16) (DFAST (DFAST req "target" min req pro forma (4Q17)
dividends growth payout buffer forma forma
'17) '17)
GSIBs
JPM 4.5% 3.5% 12.2% 9.1% 3.1% 0.6% 0.8% 1.1% 2.5% 11.1% 11.0% 10.5% -0.1% -0.6% 11.8% 0.8%
C 4.5% 3.0% 13.0% 9.7% 3.3% 0.3% 0.8% 0.4% 2.5% 10.3% 11.3% 10.0% 0.9% -0.3% 12.1% 1.7%
MS 4.5% 3.0% 16.7% 9.4% 7.3% 0.5% 0.5% 1.0% 5.8% 13.8% 10.5% 10.0% -3.3% -3.8% 16.1% 2.3%
GS 4.5% 2.5% 14.0% 8.4% 5.6% 0.2% 0.5% 0.5% 4.6% 11.9% 10.5% 9.5% -1.4% -2.4% 11.9% 0.0%
WFC 4.5% 2.0% 10.8% 8.6% 2.2% 0.6% 0.8% 1.3% 2.5% 9.6% 10.0% 9.0% 0.4% -0.6% 12.0% 2.4%
BK 4.5% 1.5% 11.3% 11.2% 0.1% 0.7% 0.8% 1.2% 2.5% 9.2% 9.0% 8.5% -0.2% -0.7% 11.7% 2.6%
STT 4.5% 1.5% 10.9% 7.4% 3.5% 0.6% 0.5% 1.4% 2.5% 9.1% 10.0% 8.5% 0.9% -0.6% 10.8% 1.7%
Regionals
BBT 4.5% 0.0% 10.0% 7.9% 2.1% 0.6% 0.7% 1.3% 2.5% 7.6% 10.0% 7.0% 2.4% -0.6% 10.2% 2.6%
CFG 4.5% 0.0% 11.1% 7.7% 3.4% 0.3% 0.6% 0.5% 2.5% 7.3% 10.0% 7.0% 2.7% -0.3% 11.1% 3.8%
CMA 4.5% 0.0% 11.1% 9.4% 1.7% 0.3% 0.7% 0.5% 2.5% 7.3% 10.0% 7.0% 2.7% -0.3% 12.0% 4.6%
FITB 4.5% 0.0% 10.3% 8.0% 2.3% 0.4% 0.7% 0.7% 2.5% 7.4% 10.0% 7.0% 2.6% -0.4% 10.5% 3.1%
HBAN 4.5% 0.0% 9.6% 7.0% 2.6% 0.6% 0.6% 0.7% 2.5% 7.6% 9.5% 7.0% 1.9% -0.6% 10.5% 2.9%
KEY 4.5% 0.0% 9.4% 6.8% 2.6% 0.4% 0.6% 0.5% 2.5% 7.4% 9.5% 7.0% 2.1% -0.4% 10.0% 2.6%
MTB 4.5% 0.0% 10.7% 7.9% 2.8% 0.5% 0.7% 1.0% 2.5% 7.5% 9.5% 7.0% 2.0% -0.5% 11.0% 3.5%
NTRS 4.5% 0.0% 11.5% 10.9% 0.6% 0.5% 0.8% 1.1% 2.5% 7.5% 8.5% 7.0% 1.0% -0.5% 12.6% 5.0%
PNC 4.5% 0.0% 10.0% 8.0% 2.0% 0.5% 0.8% 0.8% 2.5% 7.5% 8.5% 7.0% 1.0% -0.5% 9.6% 2.1%
RF 4.5% 0.0% 11.1% 8.2% 2.9% 0.4% 0.6% 0.7% 2.5% 7.4% 9.5% 7.0% 2.1% -0.4% 11.1% 3.7%
STI 4.5% 0.0% 9.4% 7.1% 2.3% 0.4% 0.7% 0.7% 2.5% 7.4% 8.5% 7.0% 1.1% -0.4% 9.7% 2.3%
USB 4.5% 0.0% 9.1% 7.6% 1.5% 0.6% 0.7% 1.2% 2.5% 7.6% 8.5% 7.0% 0.9% -0.6% 9.0% 1.4%
ZION 4.5% 0.0% 12.1% 8.5% 3.6% 0.3% 0.8% 0.3% 2.5% 7.3% 10.5% 7.0% 3.2% -0.3% 12.2% 4.9%
Source: BofA Merrill Lynch Global Research, company data, Federal Reserve
Note: Stress test losses based on 2017 DFAST results which compares the CET1 ratio at 4Q16 to the Fed’s projected minimum CET1 ratio under the severely adverse scenario. Planned dividends based on actual 2017
capital ask. “Target” CET1 ratio denotes management’s publicly disclosed optimal CET1 ratio (except CMA which we est.)

Below, we look at the estimated tier 1 leverage requirement under the Fed’s proposal
(see Exhibit 14 and Exhibit 15).

Global Banks and Brokers | 18 May 2018 29

Exhibit 14: Pro forma GSIB capital requirements under the Fed’s Exhibit 15: Pro forma capital requirements under the Fed’s proposal
proposal Add: Stressed
Current T1L ratio Proj min Pro forma
Add: Stressed Planned leverage
Current T1L ratio Proj min Pro forma min req (4Q16) T1L ratio req
Planned leverage dividend buffer
min req (4Q16) T1L ratio req
dividend buffer Regionals
GSIBs BBT 4.0% 10.0% 7.9% 0.6% 2.7% 6.7%
BK 4.0% 6.6% 6.0% 0.3% 0.9% 4.9% CFG 4.0% 9.9% 6.8% 0.5% 3.7% 7.7%
C 4.0% 10.1% 7.3% 0.1% 2.9% 6.9% CMA 4.0% 10.2% 8.5% 1.6% 3.3% 7.3%
GS 4.0% 9.4% 5.9% 0.3% 3.8% 7.8% FITB 4.0% 9.9% 7.7% 0.5% 2.7% 6.7%
JPM 4.0% 8.4% 6.4% 0.1% 2.1% 6.1% HBAN 4.0% 8.7% 6.6% 0.4% 2.5% 6.5%
MS 4.0% 8.4% 4.9% 0.1% 3.6% 7.6% KEY 4.0% 9.9% 6.8% 0.3% 3.4% 7.4%
STT 4.0% 6.5% 4.6% 0.7% 2.6% 6.6% MTB 4.0% 10.0% 7.5% 2.5% 5.0% 9.0%
WFC 4.0% 8.9% 7.2% 0.1% 1.8% 5.8% NTRS 4.0% 8.0% 7.4% 1.4% 2.0% 6.0%
PNC 4.0% 10.2% 8.0% 0.8% 3.0% 7.0%
Source: BofA Merrill Lynch Global Research, company data, Federal Reserve
RF 4.0% 10.2% 7.5% 0.3% 3.0% 7.0%
STI 4.0% 9.2% 7.0% 0.8% 3.0% 7.0%
USB 4.0% 9.0% 7.4% 0.3% 1.9% 5.9%
ZION 4.0% 11.1% 8.1% 1.2% 4.2% 8.2%
Source: BofA Merrill Lynch Global Research, company data, Federal Reserve

As we will discuss later in the report, the proposed tier 1 leverage requirement using
the stressed leverage buffer may be more binding than the proposed CET1
requirement using the stressed capital buffer for MS and STT. Among non-GSIBs,
MTB’s excess capital also may be more restricted by new tier 1 leverage
requirements.

We believe, however, this proposal would drive more volatility in spot capital
requirements. After all the stress test itself is inherently volatile; while the stressed
capital burn has generally narrowed since the CCAR’s inception in 2011, the 2018 test
appears to be more challenging than 2017. (Please see out previously published notes
here and here). An example of how volatile the test is can be seen in the Exhibit below,
which looks at what JPM’s SCB would have been in previous tests – with a range of
2.5%-4.0% (see Chart 38). Such volatility could lead to wider capital “buffers” imposed
by management teams to account for the dynamism of the stress test – which would be
negatively viewed by investors.
Chart 38: JPM CET1 requirement including the stress capital buffer shows volatility of methodology

~12.0%
~11.0%
~10.5%
4.0%
3.0% 2.5%

3.5% 3.5% 3.5%

4.5% 4.5% 4.5%

2015 2016 2017

Regulatory minimum GSIB surcharge Stress capital buffer

Source: BofA Merrill Lynch Global Research, company data (JPMorgan)

30 Global Banks and Brokers | 18 May 2018

For US regional banks, however, the SCB proposal provides real relief. Unlike for
GSIBs, the CET1 guidance for regional banks that qualified as domestic SIFIs was not as
explicit. Clearly, regional banks faced a minimum of 4.5% and the capital conservation
buffer of 2.5%. However, the “management buffers” that were set atop the 7%
minimum requirement varied widely. PNC, NTRS, USB, and STI set 150bp management
buffers, for example, but others were as high as 350bp (ZION, at less than $70bn in
assets). In our view, the SCB proposal appears to set a “hard capital floor” for regionals,
which did not appear to exist previously. Of course, this presumes that regional banks
will continue to deliver DFAST stress test results that are in line with previous years.

Based on 2017 DFAST results, regional banks could harvest, on average, ~200bp
more in excess capital when comparing potential pro forma requirements under SCB
to their own public CET1 targets

Supplementary leverage ratio (April 11th, 2018)

Proposed by: The Federal Reserve and OCC
Also in April 2018, the Federal Reserve, in conjunction with the OCC, published a draft
proposal that would amend the enhanced supplementary leverage ratio (eSLR) standards
applicable to US GSIBs and certain of their insured depository institution (covered IDI)
subsidiaries. (IDIs are simply the bank subsidiaries.) Current requirements for US SLR
are 200bp (2% leverage buffer) greater than the Basel minimum of 3%. Further, the US
imposed an IDI- or bank sub-level minimum of 6%. Our detailed section on the SLR begins
on page 111.

The proposal would replace the current 2% leverage buffer with another buffer equal
to 50% of the bank’s GSIB surcharge, in line with the Basel proposals from
December 2017. This results in a lower capital requirement for all US GSIBs. All US
GSIBs are comfortably above the current SLR minimum, and this proposal can
potentially offer increased balance sheet flexibility. However, since the SLR would
not be the ultimate binding constraint for any US GSIB in a new capital
regime, the amount of excess capital for shareholder distribution unlocked
by this proposal is limited.

Chart 39: Current vs. proposed SLR minimum requirement for US GSIBs
8.0% Current SLR min.
requirement (US),
Pro forma SLR min. requirement (US)

7.0% 5.0%
6.0%
5.0%
4.0% 1.75% 1.50% 1.50% 1.25% 1.25% 1.00% 0.75% 0.75%
3.0%
2.0%
1.0%
0.0%
JPM C MS GS BAC WFC BK STT

SLR min. requirement (3%) Proposed buffer (50% of GSIB surcharge) SLR ratio (1Q18)

Source: BofA Merrill Lynch Global Research, company data, Federal Reserve

Global Banks and Brokers | 18 May 2018 31

 Key definition

An IDI is an insured depository institution. This term is often used

interchangeably with “bank subsidiary”.

The proposal also addresses the 6% requirement at the bank sub, or covered IDI.
Similarly, covered IDIs would be required to maintain a leverage buffer equal to 50% of
the GSIB surcharge (applicable to the BHC) over the 3% SLR minimum. This compares
to the current 6% threshold to be considered “well capitalized.” If applied, this would
free an average of 260bp of capital at the bank sub or IDI level (see Exhibit 16). This is
not insignificant for client activity, as many BHCs warehouse a significant amount of
client activity in their IDIs.
Exhibit 16: Pro forma supplementary leverage requirements for covered IDIs
KEY C=AxB A B D E F=Ex50% G=3%+F H=B-D I=B-G
($bn) T1C Leverage Bank Current GSIB 50% of New Current Pro forma
capital exposure SLR req surcharge surcharge minimum excess excess
JPM 184 2,759 6.7% 6.0% 3.5% 1.8% 4.75% 0.7% 1.9%
C 127 1,901 6.7% 6.0% 3.0% 1.5% 4.50% 0.7% 2.2%
BAC 151 2,065 7.3% 6.0% 2.5% 1.3% 4.25% 1.3% 3.0%
WFC 143 2,010 7.1% 6.0% 2.0% 1.0% 4.00% 1.1% 3.1%
GS 25 346 7.3% 6.0% 2.5% 1.3% 4.25% 1.3% 3.1%
MS 15 168 9.1% 6.0% 3.0% 1.5% 4.50% 3.1% 4.6%
STT 16 234 7.0% 6.0% 1.5% 0.8% 3.75% 1.0% 3.3%
BK 20 296 6.7% 6.0% 1.5% 0.8% 3.75% 0.7% 3.0%
Est. excess tier 1 capital ($bn) 95 255
Est. change in excess tier 1 capital (pro forma standard vs. current) ($bn) 160
Source: BofA Merrill Lynch Global Research, company data, FFIEC call reports (bank subsidiary).

That said, regulators are considering applying the eSLR standard as a capital buffer
requirement. In other words, a 3% SLR would still be considered “adequately
capitalized,” but there would no longer be a threshold for the IDI to be considered “well
capitalized.” Instead, the eSLR standard would be applied to a covered IDI alongside the
existing capital conservation buffer in the same manner that the eSLR standard applies
to GSIBs. Thus under this alternative approach, GSIBs and their IDIs would be required
to maintain a leverage buffer equal to 50% of the GSIB surcharge or the GSIB HoldCo of
the covered IDI over the 3% SLR minimum.

Total loss absorbing capacity (April 11th, 2018)

Proposed by: The Federal Reserve and OCC
On April 11, the Fed and OCC proposed replacing the 4.5% TLE-based LTD requirement
with 2.5% plus 50% GSIB surcharge requirement and the 2% TLE-based TLAC buffer
with 50% G-SIB surcharge. We estimate that the proposed changes effectively lower
the total leverage exposure (TLE) based LTD and TLAC requirements by 25-125bp for
banks that are TLE TLAC constrained - C, JPM, STT and BK.

Department of Labor Fiduciary Rule (March 15, 2018)

Proposed by: The Department of Labor

The Department of Labor’s (DOL) Fiduciary Rule which was finalized in April of 2016
could potentially be struck down. The 2016 rule was slated to go into full effect July 1,
2019 (some parts took effect in 2017); however, in March of 2018 the 5th Circuit Court
of Appeals ruled that the DOL exceeded its authority in promulgating its Fiduciary Rule.
The DOL has until June 13th to challenge this decision in front of the Supreme Court,
though most see this as unlikely, including us, given the DOL and Department of
Justice’s (DOJ) lack of action in appealing the 5th Circuit's opinion since it was given in
early March. However, more recently, the SEC has put out its best interest proposals,
which we expect more likely to get finalized over time.

32 Global Banks and Brokers | 18 May 2018

Enhanced transparency for 2019 CCAR (December 7, 2017)
Proposed by: The Federal Reserve

In December 2017, the Federal Reserve released a package of three proposals centered
on increasing the transparency of its stress testing program, to be applicable to the
2019 DFAST/CCAR process. We summarize them below:

• Enhanced model disclosure. The Fed would provide participating BHCs more
detail about the structure of the supervisory models (e.g., actual equations
calculating credit losses), provide estimated loss rates by loan or asset
category, and publish hypothetical portfolios of loans and assets with
accompanying hypothetical losses, essentially giving BHCs greater insight to
the Fed’s loss forecast.

In the 2017 DFAST, the average difference between the credit provision modeled by
the Fed and the credit provision modeled by the BHC (in the “co-run” model) was
2.5%, with a range of 0.1% to 7.8%. As such, we believe enhanced disclosure on
PPNR, or pre-provision net revenue (net operating income before credit, essentially)
could be more meaningful. The average difference in PPNR between what was
modeled by the Fed and what was modeled by BHCs in the 2017 DFAST was 28%,
with a range of -35% to 98%.

• Changes to scenario design framework. The Fed also proposed to enhance

its framework for designing the hypothetical economic scenario used for stress
testing purposes. Key changes include: providing further clarity on the
unemployment rate, establishing a more explicit guide for home price
assumptions, and incorporate higher short-term wholesale funding (STWF) costs.

• Supervisory stress testing model policy statement. This proposal

addressed three primary subjects:

o Laying out the principles of stress testing. This includes a

statement that the Fed models will be developed in-house and
separately from BHCs (unlike in the UK), and that the Fed will always
take the most conservative approach that result in higher credit losses
or lower revenues
o Policies related to the development and implementation of
supervisory stress test models. The most interesting statement
here is that the Fed will continue its policy of publicly disclosing any
information about stress testing. In other words, the Fed would not
separately and privately provide BHC-specific results or other related
information to the banks themselves.

 Interestingly, this proposal maintained that banks should

continue to provide credit supply in times of stress, which is
translated into RWA (risk weighted asset) or balance sheet
growth in modeling. This was largely negated by the SCB
proposal that we previously discussed.

In today’s stress test regime and under the current proposal, participating banks do
not and will not privately receive any more stress test-related information than what
is publicly disclosed in the results.

Global Banks and Brokers | 18 May 2018 33

Volcker Rule reform (August 2, 2017)
Proposed by: The OCC (note that this was released prior to the appointment and
confirmation of current Comptroller Joseph Otting)

In August 2017, the OCC announced that it would begin soliciting public feedback on
potential changes to the Volcker rule. In a notice published in The Federal Register, the
OCC noted that “there is broad recognition that the final rule should be improved both
in design and in application.” Specifically, the OCC put forth a set of questions for the
banking industry to address, focused on the following topics:
• Scope of entities subject to rule. As we detail later in this report, banks <$10bn
in assets are subject to compliance. The set of questions set forth under this
subject matter appear to be seeking input on limiting the scope of application.

• Proprietary trading prohibition. The questions here appear to be addressing the

“purpose test” (also detailed later in the report) and the automatic 60-day
rebuttable presumption.

The 60-day rebuttable presumption is a rule that states that if banking entity sells a
position or transfers the risk within 60 days, dealer must demonstrate that it did not
purchase or sell the security for short-term trading purposes.

• Covered funds prohibition. Appears to look for guidance on whether the

definition of a “covered fund” is too broad, and looks for suggestions to narrow the
definition.

• Compliance program and metrics reporting requirements. Questions to the

industry here seek opinions on whether the Volcker compliance program
requirements create a “disproportionate or undue” burden on banking entities,
especially smaller banks. Also looking for suggestions for using technology, rather
than (more expensive) actual humans, to help banks fulfill compliance requirements.

34 Global Banks and Brokers | 18 May 2018

Key legislative bills
The Dodd-Frank Act bestowed significant power to the US supervisory agencies to
interpret and enforce the law. That said, there are still some key provisions that would
require a Congressional vote to change. Of the bills on the docket, the most meaningful
for financial investors would be the bill that would look to raise the asset threshold to
qualify as a SIFI (and therefore be subject to DFAST/CCAR and more stringent
requirements on capital and liquidity).
Exhibit 17: Congressional bills related to regulatory reform
Source Official Short Title Summary Status Next Step CBO cost est.*

Banks with less than $250bn in assets wouldn’t automatically be

Heads to the
designated as systemically important financial institutions (SIFIs).
Passed in House where Increases deficit
Economic Growth, Regulatory Relief, and The exempted banks would no longer have to undergo an annual
S. 2155 Senate Republicans by $671mn over
Consumer Protection Act stress test and would be excused from submitting living will plans.
(3/14/18) may add more 10 yrs
That said, the Fed would still have the authority to apply tougher
provisions
standards for banks with between $100bn and $250bn in assets.

The bill includes policy provisions that would: eliminate regulator's

Reported by
authority to designate companies as systemically important;
Financial Services and General Government Committee on No estimate
H.R. 3280 repeal the Volcker Rule; and subject the CFPB to the Sent to House
Appropriations Act, 2018 Appropriations available
discretionary appropriations process and reduce their regulatory
(7/8/17)
authority.
Referred to the Banks' total
The bill would modify the definition of what qualifies as a High
Passed in Senate capital reserves
Volatility Commercial Real Estate (HVCRE) loan for the purposes
H.R. 2148 Clarifying Commercial Real Estate Loans House Banking, would be
of determining the amount of capital a lender must hold. (Related:
(11/7/17) Housing, and diminished by
S. 2405 "Clarifying Commercial Real Estate Loans")
Urban Affairs. 0.001%

The bill would allow a money market fun, under specified Ordered to be
Consumer Financial Choice and Capital conditions, to elect to operate using a different method of reported to To be voted on No estimate
H.R. 2319
Markets Protection Act of 2017 valuation. If elected, a money market fund shall not be subject to House by House available
specified requirements related to the imposition of liquidity fees. (1/18/18)

Bars regulatory agencies from establishing a capital requirement

for "operational risk" based solely on past events. The bill would
Passed in Increases deficit
require an operational risk capital requirement to be based
H.R. 4296 Operational Risk Capital Requirement** House Sent to Senate by $22mn over
primarily on current activities, to be determined using a forward-
(2/27/18) 10 yrs
looking assessment of potential losses, and to allow for
adjustments based on mitigating factors.
Passed in Increases deficit
To require regulatory agencies to take risk profiles and business
H.R. 1116 TAILOR Act of 2017 House Sent to Senate by $80mn over
models of institutions into account when taking regulatory actions.
(3/14/18) 10 yrs
Measure would eliminate one of three stress test scenarios, bar Passed in Increases deficit
H.R. 4293 Stress Test Improvement Act of 2017 the Fed from objecting to capital plans based on qualitative House Sent to Senate by $14mn over
deficiencies, and reduce the frequency of Co-conducted tests. (4/11/18) 10 yrs
To give the Federal Reserve sole rulemaking authority, to exclude
Passed in
community banks (with $10bn in assets or less) from the
H.R. 4790 Volcker Rule Regulatory Harmonization Act House Sent to Senate Not meaningful
requirements of the Volcker rule. (Related: H.R. 5659 "Volcker
(4/13/18)
Rule Relief Act of 2018")

Source: BofA Merrill Lynch Global Research, Bloomberg

Economic Growth, Regulatory Relief, & Consumer Protection Act (S. 2155)
Status: Passed by Senate on March 2, 2018. Pending in the House. News reports
indicate passage before the U.S. Memorial Day holiday (Monday, May 28, 2018).

This bill would lift the asset threshold that defines a US SIFI to $250bn from $50bn (see
Exhibit 18). Banks below $250bn in assets would no longer have to go through the
DFAST/CCAR process, or submit living wills. (We explain what living wills are beginning
on page 160). However, the Fed would have the ability to apply tougher standards for
banks between $100bn and $250bn in assets.

Global Banks and Brokers | 18 May 2018 35

Exhibit 18: BHC between $50-250bn in assets
BHCs ($100-250bn) BHCs ($50-100bn)
Ally Financial Inc. BBVA Compass Bancshares, Inc.
American Express Company Comerica Incorporated
BB&T Corporation Zions Bancorporation
BMO Financial Corp.
BNP Paribas USA, Inc.
CIT Group Inc.
Citizens Financial Group, Inc.
Discover Financial Services
Fifth Third Bancorp
Huntington Bancshares Incorporated
KeyCorp
M&T Bank Corporation
MUFG Americas Holdings Corporation
Northern Trust Corporation
RBC USA Holdco Corporation
Regions Financial Corporation
Santander Holdings USA, Inc.
SunTrust Banks, Inc.
UBS Americas Holding
Source: BofA Merrill Lynch Global Research, Federal Reserve

Volcker Rule Regulatory Harmonization Act (H.R. 4790)

Status: Passed by House of Representatives on April 13, 2018

This would provide the Federal Reserve with sole rulemaking authority to exclude
community banks (defined as those with $10bn in assets or less) from Volcker Rule
requirements.

36 Global Banks and Brokers | 18 May 2018

 Timeline of Volcker Rule-related updates (reverse chronological order)
7B

• 5/15/18: The Fed and other regulators are planning to eliminate an assumption
written into the original Volcker Rule law that positions held by banks for less
than 60 days are speculative and thus banned; overhaul expected by end of May

• 4/25/18: US Comptroller of the Currency Joseph Otting says financial regulators

are preparing “feedback” on Dodd-Frank’s Volcker Rule (could come as early as
May)

• 4/19/18: Fed Governor Lael Brainard said she supports the banking agencies’
ongoing efforts to streamline the Volcker Rule; agencies are focusing on ways
to “tailor the Volcker compliance regime to focus on firms with large trading
operations and reduce the burden for small banking entities”

• 4/17/18: Fed’s Quarles agrees the Volcker Rule hurts capital markets

• 4/13/18: House passes bill to give the Fed exclusive authority to implement the
Volcker rule (H.R. 4790)

• 3/21/18: The House Financial Services Committee holds a markup on eight bills,
including a measure to exclude community banks from the requirements of the
Volcker Rule

Stress Test Improvement Act of 2017 (H.R. 4293)

Status: Passed by House of Representatives on April 11, 2018

This bill has three primary proposals. First, it looks to eliminate one of the three legally
required stress test scenarios (base case, adverse, severely adverse). Second, it would
bar the Fed from objecting to capital plans on qualitative reasons. This is in direct
contrast to the Fed’s SCB proposal, which reaffirms its authority to object on qualitative
reasons. And third, it would look to reduce the frequency of the co-conducted tests.
Again, this appears to be in direct contrast with the Fed’s SCB proposal, where the
proposal was written with the implication that the stress test would remain an annual
exercise.

Key provisions in this bill directly contradict the Fed’s SCB proposal

TAILOR Act of 2017 (H.R. 1116)

Status: Passed by House of Representatives on March 14, 2018

This bill would require regulatory agencies to take into account risk profiles and
business models of institutions when taking regulatory action.

Operational Risk Capital Requirement (H.R. 4296)

Status: Passed by House of Representatives on February 27, 2018

This bill would bar regulatory agencies from establishing a capital requirement for
operational risk based solely on past events. It would require the operational risk capital
requirement to be based primarily on current activities and forward-looking
assessments of potential losses. On the surface, this bill would drive meaningful change,
as US GSIBs hold $1.9tn in operational risk RWAs, representing an average of 30% of

Global Banks and Brokers | 18 May 2018 37

RWAs. However, under the Collins Amendment of the Dodd-Frank Act, the binding CET1
constraint would be the lower of the standardized approach (which does not include op
risk) and the advanced approaches. As a result, even if this bill passes into law, thereby
lowering advanced CET1 requirements, and standardized approach becomes the binding
constraint, translating into limited incremental excess capital for most. GS, BK have
~100bp lower advanced CET1 ratios than standardized; therefore this bill could make a
difference.
Chart 40: Op risk component vs. binding CET1 approach
150 GS BK 
Adv anced CET1 is
Difference between stnd / adv CET1

100 low er, binding

50
C
0 MS
ratios (bp)

(50)
WFC STT
(100)
JPM
(150)
(200) USB Standardized CET1
(250) is low er, binding

(300)
15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0%
Operational risk as % of total RWAs

Source: BofA Merrill Lynch Global Research, company data, SNL Financial

Consumer Financial Choice & Capital Markets Protection Act of 2017 (H.R.
2319)
Status: Ordered to be reported to the House on January 18, 2018

This bill would allow money market funds, under specified conditions, to elect to operate
using a different method of valuation. If the election is taken, a money market fund shall
not be then subject to specified requirements related to the imposition of liquidity fees.

Clarifying Commercial Real Estate Loans (H.R. 2148)

Status: Passed by House of Representatives on November 7, 2017

This bill would modify the definition of a High Volatility Commercial Real Estate loan
(“HVCRE”). The HVCRE classification requires higher levels of capital held against the
related loans, relative to “standard” CRE loans. Below are the banks in our coverage
universe, ranked by total CRE (not HVCRE) exposure to total loans (see Chart 41).
Chart 41: CRE loans as a % of total loans
35%
31%
30%
26%
CRE as % of total loans

25%

20%
16%
15%
15% 14% 13%
11% 10% Median, 10%
10% 9% 9% 8%
10% 8% 7%

5% 3%

0%
MTB ZION BBT KEY CMA PNC WFC JPM USB HBAN CFG FITB RF STI C

Source: BofA Merrill Lynch Global Research, SNL Financial

38 Global Banks and Brokers | 18 May 2018

Financial Services and General Government Appropriations Act (H.R. 3280)
Status: Reported by the Committee on Appropriations on July 8, 2017

The bill includes provisions that would eliminate regulatory authority to designate firms
as SIFIs. It also would look to repeal the Volcker Rule. Further, it would subject the CFPB
(Consumer Financial Protection Bureau) to the discretionary appropriations process and
reduce its regulatory authority.

Global Banks and Brokers | 18 May 2018 39

Recent developments: Basel/EU
After the years-long build-up, the final arrival of Basel IV in December 2017 was a
relatively soft landing – at least, if a range of supervisory options are taken up. The
documents made many changes to capital rules, including:
• Standardized credit risk

• Which assets are eligible for inclusion in an Advanced Internal (IRB) model

• How operational risk is calculated

• GSIB buffer for the leverage ratio

• And finally, the minimum ratio of a Standardized model which a bank’s IRB models
can deliver was set at 72.5%

The European Banking Authority (EBA) estimates a 14% increase in capital

requirements for large European banks. This is worse than the original Basel
commitment (“not material”) but better than the 2016 Basel proposals. The majority
of this impact was driven by the output floors

As a reminder, in the U.S., the Collins Amendment requires that the binding CET1
constraint for each institution would be the lower value under the standardized or
advanced approach. As a result, U.S. banks have already been unable to take advantage
of using a model-based calculation of RWAs to incur a lower requirement.

Standardized credit RWA changes: both up and down

The standardized model changed in different directions, but importantly not all upwards.

Corporate RWA: small benefit

On the corporate side, banks are major lenders to “BBB” and “BB” rated and equivalent
companies and these are the same, or better-off as shown in Table 3.
Table 3: corporate Risk Weights: current and future-state (%)
BBB+ to
External rating AAA to AA– A+ to A– BBB– BB+ to BB– Below BB– Unrated
Risk w eight - Basel II 20% 50% 100% 100% 150% 100%
Base Risk weight - 2015 proposal 20% 50% 100% 100% 150% 100%
Base Risk weight - Final proposal 20% 50% 75% 100% 150% 100% or 85% if SME
Change vs. Basel II 0% 0% -25% 0% 0%
Change vs. 2015 proposal 0% 0% -25% 0% 0%
Source: BofA Merrill Lynch Global Research estimates, Basel Committee

Buy-to-let mortgages
For UK banks, the rise in Buy to let capital requirements shown in Table 4could limit the
benefit of potential adoption of advanced models over the next two to three years.
Table 4: Income producing Real Estate: Risk Weight
Risk weight - Basel II 35% 35% 35% 35% 75% 75% 75%
LTV Bands - 2015 proposal ≤60% >60-80% >80%
Risk w eight - 2015 proposal 70% 70% 70% 90% 120% 120% 120%
LTV Bands - Final proposal ≤50% >50-60% >60-80% >80-90% >90-100% >100%
Risk w eight - Final proposal 30% 30% 35% 45% 60% 75% 105%
Change vs. Basel II -5% -5% 0% 10% -15% 0% 30%
Change vs. 2015 proposal -40% -40% -35% -45% -60% -45% -15%
Source: Basel Committee, BofA Merrill Lynch Global Research estimates

40 Global Banks and Brokers | 18 May 2018

Regular mortgages: better off
Table 5 shows that the classic 60-80% loan-to-value mortgage will see a reduction in its
standardized Risk Weight from 35% to 30%.
Table 5: residential real estate: Risk Weight
Risk weight - Basel II 35% 35% 35% 35% 75% 75% 75%
LTV Bands - 2015 proposal ≤40% >40-60% >60-80% >80-90% >90-100% >100%
Risk w eight - 2015 proposal 25% 30% 30% 35% 45% 55% 75%
LTV Bands - Final proposal <50% 50-60% 60-80% 80-90% 90-100% >100%
Risk w eight - Final proposal 20% 20% 25% 30% 40% 50% 70%
Change vs. Basel II -15% -15% -10% -5% -35% -25% -5%
Change vs. 2015 proposal -5% -10% -5% -5% -5% -5% -5%
Source: Basel Committee, BofA Merrill Lynch Global Research estimates

Fewer assets eligible for advanced models

The removal of various low-risk exposures from being classifiable as low-risk is a
structural disadvantage for the system.

Chart 42 shows that banks will see the proportion of their assets eligible for advanced
internal models fall from 80% to below 60%. This comes from the slightly obscure
reasoning that on assets where defaults are so low as to be difficult to model
accurately, a much higher minimum default probability must be assigned.

This will of course reduce the opportunity for banks to “optimize” models and reduce
Risk Weights accordingly. However, for genuinely low risk assets, banks are likely to lose
share for years to non-bank competitors.
Chart 42: Under final Basel proposals, foundation IRB model doubles in importance (%)
90
80
70
60
50
Current
40
Final
30
20
10
0
Advanced IRB Foundation IRB Standardised, other

Source: Basel Committee, BofA Merrill Lynch Global Research estimates

Overall capital neutral if operational RWA can fall

Basel was able to state that the move was not set to raise overall capital requirements,
as per its originally stated intention, shown in Chart 43.

However, this is clearly dependent on operational risk requirements falling significantly.

Global Banks and Brokers | 18 May 2018 41

Chart 43: Contributors to change in capital requirements (% RWA) from Basel III finalization

Credit risk Output floor Operational risk

3

-1

-2

-3

-4
Source: Basel Committee QIS

The operational risk improvement in turn will only occur if all national supervisors use
their discretion to set the internal loss multiplier to one. That is, the new rules state
clearly that a bank’s operational risk requirement will be influenced by a “Loss
Component”, of 15x average annual operational risk losses incurred over the previous 10
years. A bank with high losses “is required to hold higher capital due to the
incorporation of internal losses into the calculation methodology”.

Output floors on aggregate portfolio

The RWA output floor will be applied to the aggregate, not the individual portfolios.
Importantly, we believe this will allow banks with very high operational RWA to be able
to offset in other areas like Markets/CVA/credit risks. This could be the most important
for the Swiss which already have large operational RWA add-ons from Swiss Financial
Market Supervisory Authority (FINMA).

See the below example from the Basel committee’s paper. Note the final column shows
that while credit RWA sees an increase, there is an offset from portfolios that do not
have a standardized approach, in particular operational RWA. Operational RWA may well
increase for banks, but we see the magnitude as much lower for banks where there have
already been large “add-ons” for the banks already.
Table 6: Basel Committee example of how the output floor will operate in aggregate
72.5% of standardized Delta vs. pre-
Pre-floor RWA Standardized RWAs floor RWA
Credit risk 62 124 89.9 27.9
o/w asset class A 45 80 58 13
o/w asset class B 5 32 23.2 18.2
o/w asset class C (not
modelled) 12 12 8.7 -3.3
Market risk 2 4 2.9 0.9
Operational risk (not modelled) 12 12 8.7 -3.3
Total RWA 76 140 101.5 25.5
Source: BIS, BofA Merrill Lynch Global Research estimates

Timelines are generous

The BCBS set long-dated implementation deadlines. The output floor, possibly the
biggest change for any non-US banks, will be phased in from 1st January 2022 to 2027
giving banks almost 10 years.

Market RWA (fundamental review of the trading book), CVA (move to standardized
measure of counterparty credit risk or SA-CCR) and the operational RWA changes also
had the implementation deadline moved to coincide with the other Basel 4 reforms on
1st January 2022.

42 Global Banks and Brokers | 18 May 2018

Market RWA: “Final”…
Regulators moved to change the Market RWA rules post-crisis and by 2011, a new set of
measures known as “Basel 2.5” had increased the level of capital held against market
risk substantially. At the same time, regulators felt that a complete review of the
measurement of market risk was needed.

The conclusion of the Fundamental Review of the Trading Book (FRTB) shifts the
calculation of market risk from a Value-at-Risk approach to Expected Shortfall. It also
requires that internal models are approved at desk level. The basic, standardized
calculation of market risk has also been overhauled.

Expected impact is +22%-40% increase in Market RWAs

Basel estimates that this will result in a +40% increase in market RWA on a weighted
average basis, or +22% on a median basis. Basel also estimates that a new standardized
approach will require (on average) 40% more capital than internal models. This implies
that some banks will be above this level. We believe that operating on standardized
models would severely hamper banks’ ability to write profitable new business.

A summary of the changes

• More granular approach to model approvals. This will allow supervisors to switch off
any internal models that do not appear to “work” at a desk level, forcing that desk
to use standardized models instead.

• A new standardized approach. This will capture the risk more comprehensively,
making it a more credible fallback option to the internal models.

• Shift from value-at-risk (VaR) to expected shortfall (ES). In simple terms, whereas
VaR may show that “19 days out of 20 I will not lose more than $X,” an expected
shortfall approach says “on the one day in 20 that I do lose more than $X, how
much is that likely to be?”

• A new liquidity horizon factor. Basel acknowledges that a standard 10-day horizon
in the old framework was too standardized to be valid for different instruments.

• Redefinition of the trading book / banking book boundary. The intention here is to
remove subjectivity to where banks book business.

…but tweaks to “final” rules proposed

Basel has finalized the new market RWA framework. In the December Basel reforms it
delayed the implementation from 2019 to 2022. However, in March 2018, the
committee also published a round of proposed amendments to the final rule. The
consultation is open until 20 June 2018.

The consultation proposes changes to both the standardized and internally modeled
approaches.

Standardized: lightening up
The new standardized approach to Market risk was set according to sensitivities. This is
an estimate of how much a bank’s trading portfolio would change for a certain assumed
move, for example a 1bp move in interest rates. The methodology uses a set of defined
correlation assumptions to provide a diversification benefit across different risks.

In March 2018, the BCBS published a consultation paper that sought to fix some of the
potential problems with the new standardized approach. These were generally designed
to fix some potential flaws in the original proposal and to make the standardized
approach a more credible fall-back option.

1. Liquid FX pairs. More liquid FX pairs were given a benefit in risk weights.
However, the committee realized that while for instance USD/EUR and

Global Banks and Brokers | 18 May 2018 43

 USD/BRL (Brazilian Real) were both considered liquid, the cross of EUR/BRL
was not. The consultation paper seeks to give additional benefit to banks for
combining different FX pairs.

2. Correlations. The original changes had prescribed three different correlation

scenarios between different risk classes (median, +25% and -25%) with the
capital requirement being the highest of the three. However, it noted that
some of these scenarios resulted in correlations well outside of the observed
historical moves. The BCBS looks to revise these boundaries.

3. Non-linear instruments (e.g. options). Non-linear products also have

scenarios applied and the highest loss is used for the capital charge calculation.
However this resulted in often different scenarios being used as the capital
calculation for similar instruments. BCBS suggest using a floor approach.

4. Risk weights reduced. The committee discovered that the original proposal
was generating higher RWA inflation than intended. The committee has
therefore proposed to reduce several risk weights: general interest rate risk by
20-40% and equity and FX risks by 25-50%.

a. The committee also suggest they would consider changes to the

standardized approaches to credit valuation adjustment (CVA) as these
were originally calibrated from the market risk weights.

Internal models: less prescriptive

The paper also considers some changes to the internal model approach.

The original changes allow a regulator to force a bank back onto the standardized
approach if the internal models do not work. This led to some fear that such an
automatic move could introduce a cliff-effect to bank capital requirements.

The new proposal would use a traffic light system with green for a pass, red for a failure
and fall-back onto the standardized approach, but with an amber group for those models
that have not met all the requirements but not at such a level to necessitate an
automatic fall-back. The desks in the amber group will have an additional capital charge
between the internal model and standardized model.

Proposed changes to operational RWA calculation

Changes to operational RWA were also simplified with the December 2017 reforms.

As with credit risk, there is currently the option to run with either a standardized model
(which is based upon gross income, also known as SMA), or internal models called the
advanced measurement approach, or AMA. Many of the large global banks use internal
models for the majority of operational RWA. In the US, the Federal Reserve Board had
initially set “floors” for its eight GSIBs, or minimum operational risk RWA.

Internal models had underestimated operational risk, with litigation risk costs being
materially larger than such models had predicted.

Basel now suggests a single, standardized methodology, removing the ability of banks to
model operational risk internally. The model has two elements:
• A business indicator component (BIC), which is a standardized factor that sums
three components ((i) interest, leases and dividends, (ii) services and (iii) the
financial component. Each is given a coefficient which increases the larger the
bank’s revenues are.

• A multiplier based on bank-specific operational loss data, which is 15 times a bank’s

average historical losses over the preceding 10 years.

44 Global Banks and Brokers | 18 May 2018

Crucially, the BCBS paper allows national supervisors the discretion to set a multiplier of
1 to all banks in their jurisdiction. This would allow the supervisor to significantly
mitigate this part of the rule change, if it wished.

Operational RWA had been increasing already

The internal models had gone some way to anticipate the Basel 4 changes already.
Further AMA updates during 2017 and 2018 that take into account the significant
litigation charges of 2016 and any further settlements during 2017 will likely mean that
internal models continue to be a source of RWA inflation. The delta to Basel 4 reforms
by (say) 2022 for instance, may therefore be small versus the internal models at that
date.

Below, we show that European IB operational RWA have already been increasing
significantly in the past seven years.
Chart 44: Operational RWA inflation at European IBs (USDbn, FX neutral)
350
DBK CS UBS BARC
300

250

200

150

100

50

0
2011 2012 2013 2014 2015 2016 2017
Source: BofA Merrill Lynch Global Research, company data

Global Banks and Brokers | 18 May 2018 45

Regulation in the real world: Quantifying
3B

impact

46 Global Banks and Brokers | 18 May 2018

Impact of regulation: Benefits & costs
As prudential rules and laws governing capital and liquidity requirements shift, so does
the business strategy of the impacted firms. As balance sheet availability and client
prioritization adjusts to rule and law changes, there is a meaningful effect on market
participants, market structure, and, of course, the economy. Last but not least, there is a
material impact to bank profitability. In this section, we look at some the key
consequences from the changes in the global regulatory construct.

Impact to profitability: ~500bp on tangible common ROE

Pre-tax reform, we estimated that post-crisis regulation erased 500bp from US FDIC-
insured bank ROTCEs (returns on tangible common equity). To arrive at this estimate,
we tried to isolate clear impact from macro factors, such as lower rates vs. 2006 and
declining provisions as credit quality recovered.
Chart 45: We ascribe nearly all of decline in ROTCE to higher regulation
17%
Return on tang. common equity

15%
13%
11% 15.93%
9%
11.26%
7% Regulatory related
5%
2006 Lower rates Higher Remixed loan Higher capital Balance sheet Lower Higher fee Higher Regulatory 2016
cash/sec portfolio levels growth provisions income expenses (ex- costs
balances reg)

Source: BofA Merrill Lynch Global Research, FDIC, Federal Reserve

Note: Red steps denote negative impacts to ROTCE. Green steps denote positive benefits

Note that we estimate that US corporate tax reform is ~200bp additive to bank
ROTCEs

We have been asked many times why the revenue impact from regulation is not more
negative. We note that a likely unintended consequence of regulation is concentration.
The largest three US banks now hold 36% of deposits vs. 19% pre-crisis (see Chart 46
and Chart 47). And of course, a bigger balance sheet means bigger spread revenues,
even in a challenging rate backdrop. Further, as we discuss in detail later in this section,
US banks have also gained significant market share globally in investment banking and
trading over the last five years.

Global Banks and Brokers | 18 May 2018 47

Chart 46: Deposit market share of top 3 US banks in 2004 Chart 47: Deposit market share of top 3 US banks in 2017

Top 3, 19.3%
Top 3, 35.7%

Rest, 64.3%
Rest, 80.7%

Source: SNL Financial Source: SNL Financial

Why binding constraint is crucial to understand

The majority of this report is dedicated to helping investors understand the key rules
and laws governing capital, liquidity, and different types of products and businesses
(e.g., trading, mortgage lending). However, we think it is crucial for investors to
understand the concept of binding constraint.

Key definition

Binding constraint refers to the most restrictive of the applicable minimums on

capital and liquidity. It typically refers to the rule or ratio where the firm has the
narrowest gap to the minimum, or, in some cases, may have a shortfall.

Here’s an example of why binding constraint is a crucial concept. Let’s take JPM, for
example (see Chart 48). Under the BHC-level supplementary leverage ratio, or SLR, JPM
would have excess capital equivalent of $48.5bn under the current regime. Meanwhile,
under its tailored spot CET1 requirement, JPM would only have $20bn in excess capital.
As such, JPM’s binding constraint is the CET1 requirement, and, specifically, the GSIB
surcharge requirement within CET1. (We go into the components of the CET1
requirement in detail beginning on page 94).
Chart 48: How to compare bank compliance with regulatory requirements (example: JPM)
CET1
At 100% , a bank 150%
is fully compliant A ratio under
with its regulatory 100% represents
minimum, and a shortfall and
implies efficient could negatively
100% impact future
use of capital or
funding TLAC NSFR strategy. Banks
that fall short on
regulatory ratios,
50% regardless of
time to
A ratio too far compliance,
beyond 100% typically feel
represents pressure from
ex cess, under- shareholders to
utilized capital or more
immediately
funding, weighing LCR SLR close the gap.
on returns
1Q17 1Q18

Source: BofA Merrill Lynch Global Research, company data

48 Global Banks and Brokers | 18 May 2018

Each banks’ binding constraint would then help dictate incremental balance
sheet activity. Extending the JPM example, the firm’s current capital positioning may
allow the bank to have modestly more room to grow assets with low risk weight, which
are the assets constrained by SLR – a risk-insensitive measure. Meanwhile, it is most
constrained on growing gross assets with heavier risk weights.

US binding capital constraint: Potentially shifting

Under the current capital regime in the US, the GSIBs and domestic SIFIs (banks over
$50bn in assets that aren’t classified as GSIBS) have to mind two capital constraints:
spot, or day-to-day, requirements and post-stress capital minimums under the
DFAST/CCAR process. The graphics below look at the current binding constraint by
GSIBs today. When taking into account each institution’s binding constraint, we
estimate the US GSIBs we cover have approximately $115bn of excess capital or 6% of
market cap.

Key definition

Current regime binding constraint:

Spot CET1: WFC, C, JPM

Spot total risk-based capital: BK

Stressed tier 1 leverage: MS, STT

Stressed SLR: GS

Chart 49: We est. US GSIBs have ~$115bn of excess capital today (6% of market cap) as of 1Q18
Under current regulatory framework
Current binding constraint:
Spot CET1 Spot CET1 Spot CET1 Spot Tot Cap Stressed T1L Stressed SLR Stressed T1L
14%
13%

5%
4%
2% 1%
0%

WFC C JPM BK MS GS STT

Excess capital as % of mkt cap

Source: BofA Merrill Lynch Global Research, company data, SNL Financial
Note: Excess capital converted into common equity tier 1 capital for comparability purposes.

Of course, as we laid out in the previous section, the Fed recently proposed new rules
governing both spot and post-stress capital requirements. Note that banks would no
longer quantitatively “fail” CCAR, but the amount of capital burned in the test would be
part of spot requirements. This would have the impact of shifting binding constraints
for certain institutions.

Interestingly, based on the 2017 DFAST results, GSIBs would have $25bn less in
excess capital under the proposed regime than in the current regime

Global Banks and Brokers | 18 May 2018 49

 Key definitions

Potential binding constraint based on recent Fed proposals:

Standardized CET1 (with stressed capital buffer or “SCB”): WFC, C, JPM, GS

Spot total risk-based capital: BK

Tier 1 leverage (with stressed leverage buffer): MS, STT

Chart 50: We est. US GSIBs would have ~$90bn of excess capital today (5% of market cap)
Under Fed-proposed requirement changes
Potential binding constraint under new Fed proposals:
Stnd CET1 Stnd CET1 T1L Total Cap Stnd CET1 T1L Stnd CET1

11% 11%

5%
3% 3% 2% 1%

WFC C MS BK JPM STT GS

Excess capital as % of mkt cap

Source: BofA Merrill Lynch Global Research, company data, SNL Financial
Note: Excess capital converted into common equity tier 1 capital for comparability purposes

EU binding capital constraint: Mostly leverage, in contrast

In contrast to US firms, SLR is the binding constraint for 50% of EU GSIBS (see Chart
51). This may not be true once the Basel IV proposals on RWA output floors are
implemented in Europe, but with such a long timeline through to 2027, it is difficult to
say how management actions will help mitigate the effect... Keep in mind that unlike in
the US, EU banks retain low risk residential mortgages on-balance sheet. Conversely, US
banks sell a material amount of eligible residential mortgage originations to Fannie Mae
and Freddie Mac, and therefore have higher risk-weighted loans (e.g., corporate loans at
100% risk weight on standardized approach vs. residential mortgage loans at 25%).
Chart 51: SLR is the binding constraint for majority of European-based GSIBS

EUR IB (market cap weighted)

CET1
150%

100%
TLAC NSFR

50%
European GSIBs currently
ex hibit the narrow est
buffer on SLR v s.
minimum requirements
LCR SLR
1Q17 1Q18

Source: BofA Merrill Lynch Global Research, company data

50 Global Banks and Brokers | 18 May 2018

As the market has witnessed, SLR – which is a risk-insensitive measure – as a binding
constraint materially impacted EU bank ambitions for global investment banking.
Investment banking and markets businesses typically require a significant amount of
gross balance sheet, meaning this business is typically more constrained by SLR rather
than CET1.

We think SLR as a binding capital constraint for EU institutions is partially responsible

for the significant shift in global investment banking and trading market share to the
U.S. banks’ favor over recent years (see Chart 52).
Chart 52: US vs. Europe IB and Trading Market Share (rolling twelve-month basis)
80%

75%

70%

65%

60%

55%

50%
2010 2011 2012 2013 2014 2015 2016 2017 2018
US Europe

Source: BofA Merrill Lynch Global Research, company reports

Regulation, binding constraints redefine product “value”

Prior to the Global Financial Crisis, the lion’s share of global banks primarily managed
capital through a risk-weighted lens. Post-crisis Basel capital rules and subsequent local
regulator interpretations introduced a tension between balancing a new risk-based
requirement (CET1) with a risk-insensitive one (SLR).

To illustrate the tension between the two requirements, we examined the banking
products that are considered “more valuable” and “less valuable” under CET1 or SLR
(see Exhibit 19). Repo is a perfect example of conflicting product-level value. Under
CET1, repo is considered a “more valuable” product given its low risk weight. However,
under SLR, repo becomes less valuable, as the exposure is not “discounted” by its low
risk profile.

If a firm is constrained by post-stress test capital minimums rather than spot, this does
not change product-level value (e.g., GS, who is currently constrained by post-stress
SLR). However, the CCAR overlay could be an exacerbating factor in terms of capital
management. For example, a management team may hold more capital against
exposures and/or in product hurdle rates than what is required by spot capital minimums
to take into account the volatility of the stress test results.

In the graphic following this paragraph, we group global GSIBs relative to their binding
constraints. Note that certain firms, like MS, are not bound by SLR but by tier 1
leverage. We grouped the GSIBs by type of binding constraint: risk-sensitive (CET1, total
risk based capital) and risk-insensitive (SLR, tier 1 leverage).

Global Banks and Brokers | 18 May 2018 51

Exhibit 19: More- and less-valuable financial products under current capital requirement framework

Spot binding constraint Spot binding constraint

(risk-based capital): (risk-insensitive capital):
C, BARC, JPM, WFC, BK DB, UBS, CS

CET1 SLR

More Valuable Products

More Valuable Products • Electronic/agency
• Electronic/agency trading
trading • Wealth management
• Wealth management • Asset management
• Asset management • Advisory
• Advisory • Payments
• Payments • Futures clearing
• Futures clearing • High yield/ distressed
• Rates credit
• Repo (collateral
dependent)
• Agency MBS
Less Valuable Products
• Equity/FICC derivatives
• Prime brokerage
• Rates
Less Valuable Products
• Repo
• Equity/FICC derivatives
• IG Credit products
• Securitized products
• Commodities financing
• HY credit products
• Unfunded lending
• Commodities
commitments
• Mortgage servicing
• Financial deposits
• Non agency MBS
(grosses up bal sheet)
• Higher risk loans

CCAR
(US Only)
More Valuable Products
• Historically low loss
content loan products
(e.g. prime mortgage)

Less Valuable Products

Binding constraint • International lending
exposure Binding constraint
(stressed risk-based
• Subprime lending (stressed leverage):
capital): • Global trading MS, GS, STT
Most regionals operations

Source: BofA Merrill Lynch Global Research

Rules on liquidity and resolution

Of course, post-crisis prudential rules on liquidity (liquidity coverage ratio or LCR and
net stable funding ratio or NSFR) and resolution (total loss absorbing capacity, or TLAC)
have also rendered certain products more valuable than others (see Exhibit 20).
Interestingly, both Basel-originated liquidity requirements, LCR and NSFR, place high
value on deposit funding – particularly retail deposit funding. By contrast, an institution

52 Global Banks and Brokers | 18 May 2018

with high levels of deposit funding will likely have lower levels of debt – creating
potential shortfalls under TLAC. This is another example of conflict between rules.

Note that in the U.S., NSFR is not finalized and therefore not binding. Meanwhile, also
for U.S. banks, resolution planning – also known as the “living will” process – can be the
binding constraint for liquidity over LCR.

Our section on LCR begins on page 139, NSFR on page 147, and TLAC on page 120. Our
discussion on resolution planning begins on page 160.
Exhibit 20: More- and less-valuable financial products under LCR, NSFR, and TLAC constraints

LCR NSFR TLAC

More Valuable Products More Valuable Products

• Retail deposits • Retail deposit funding More Valuable Products
• Operational corporate • Rates (Treasury, • L/T unsecured funding
deposits agency) • Electronic trading
• Wealth management
• Asset management
Less Valuable Products • Advisory
Less Valuable Products • ST funding • Payments
• Liquidity and credit • Financial institution • Futures clearing
facilities deposits • Agency MBS
• Lending products to • Nonoperational
financial institutions corporate deposits
• Nonoperational • Equity derivatives
corporate deposits • Prime brokerage Less Valuable Products
• Financial institution • Repo • Deposit funding
deposits • Non agency MBS • S/T funding
• Prime brokerage • Municipal markets • Structured funding
• Credit products • Securitized funding
• Structured products • HY credit products

Source: BofA Merrill Lynch Global Research

CET1 impact: Banks open for business despite constraints

While we more fully describe common equity tier 1 (CET1) rules and minimums
beginning on page 94, the simplest way to describe CET1 is that it is the rule that
requires the amount of capital held against risk-weighted assets. CET1 is the binding
constraint for 50% of the US GSIBs (representing 81% of global GSIB RWAs) and has
driven some risk reduction and product de-emphasis (see Exhibit 21). But generally
speaking, global banks constrained by CET1 have been opportunistic about balance
sheet allocation here, rather than just systematically shrinking availability to “less
valuable” products.

Global Banks and Brokers | 18 May 2018 53

Exhibit 21: Risk-weights by product (standardized approaches)
Std.
Notes
Product RWAs
α: RWA based on collateral haircut approach (= exposure (less haircut) x risk weight based on counterparty);
Secured financing α
β: outflow assumption based on collateral
IG RMBS (private label)
δ δ: considered securitization: RWA dependent upon underlying parameters
CMBS
US Treasury securities 0%
US GSEs / Agency RMBS 20%
US PSEs (including municipal securities) 35% 20% /50% for general obligation/revenue
Residential mortgage loans 50%
Loans: HELOC, CRE (term), C&I, auto,
100%
credit card
HVCRE loans 150%
Credit: Investment grade bond
π: RWA = exposure x potential future exposure (PFE) x risk weight based on counterparty (assumes daily
Credit: High yield bond π
margin)
EQ Trdg: Equity derivatives
RWA: 300% only applies when position in excess of 10% of CET1, otherwise 100% . level 2b if meets: 1)
EQ Trdg: Cash equities trading (long) ρ publicly traded common stock, 2) in R1K, 3) in USD (held to cover outflows), 4) cant be issued by financial
entity, 5) price couldn’t have fallen more 40% during any 30-day period since 2007
Asset-backed securities δ δ: considered securitization: RWA dependent upon underlying parameters
Cash & equivalents 0%
Off-b/s item: credit facility to financial entity 0%
Off-b/s item: credit facility to non-fin'l entity 50%
Off-b/s item: liquidity facility to financial entity 50%
Off-b/s item: liquidity facility to non-fin'l entity 50%
Mortgage servicing rights 250%
Source: BofA Merrill Lynch Global Research, Basel Committee, Federal Reserve

Impact on traditional lending: No supply reduction to high RWA loans

Interestingly, the growth in on-balance sheet loans since the crisis has been generally
concentrated in two products with 100% risk weight: commercial and industrial (C&I)
and credit card loans. In our view, “recency bias” (against the product that did poorly in
the most recent credit cycle) and client demand overwhelmed regulation as a factor in
supply availability.
Since 2010, C&I loans on-balance sheet has grown at an 8% CAGR (compound annual
growth rate) since 2010, 4x the rate of GDP growth and 400bp higher than the average
growth for overall loans (see Chart 53). Further, corporate bond issuances have similarly
been robust in a low-rate backdrop, growing at an 8% CAGR since 2010.
Chart 53: C&I loan balances and corporate bond issuances
$2.5 2010-2017 $1.8
Commercial loans: +8%
Both commercial loan growth and $1.6
Bond Issuances: +8%
$2.0 corporate bond issuances have
$1.4
rebounded since 2010 lows
$1.2
$1.5
$1.0
$0.8
$1.0
$0.6
$0.5 $0.4
$0.2
$0.0 $0.0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

Balance Sheet Comm'l Loans (lhs) Corporate Bond Issuances (rhs)

Source: BofA Merrill Lynch Global Research, FDIC, Sifma

54 Global Banks and Brokers | 18 May 2018

Meanwhile, competition among US GSIBs and credit card monolines over credit card
balances is fierce. Since 2010, credit card outstandings on-balance sheet have increased
at a 5% CAGR industry-wide (see Chart 54). Note that credit card ABS (asset backed
securities) credit availability is still down and lower than pre-crisis, and on-balance sheet
exposure dwarfs off-balance sheet outstandings (in contrast to 2007-09).
Chart 54: Availability of US credit: credit card
$1,200 1990-2007 2013-2017
CAGR: 9% CAGR: 5%
Total Credit Card Credit Availability ($bn)

$1,000

$800

$600

$400

$200

$0
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
On Balance Sheet Credit Card Loans Credit Card ABS

Source: BofA Merrill Lynch Global Research, FDIC, SIFMA

Unsecured consumer loans (ex-credit card) have also grown on balance sheet, at a 4%
CAGR since 2010 in the US (see Chart 55). Given shrinking home equity portfolios, a
handful of institutions have partnered or purchased “fintech” companies that originate
loans digitally in order to provide a pipeline of consumer loans. Examples include loans
for debt consolidation, home renovation, life events (weddings), elective surgery, etc. Of
course, others, like GS, have built their own technology and capabilities to originate
unsecured consumer loans.
Chart 55: US Consumer loans ex credit cards have grown at a 4% CAGR since 2010
850,000
Consumer loans (ex credit cards)
Consumer loans ex credit cards ($mn)

CAGR since 2010: 4%

800,000

750,000

700,000

650,000

600,000
4Q10
1Q11
2Q11
3Q11
4Q11
1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16
1Q17
2Q17
3Q17
4Q17

Source: FDIC

Auto loans have been recently de-emphasized. But, this is another example of a 100% risk
weight asset that had contributed strongly to loan growth until recently (see Chart 56).

Global Banks and Brokers | 18 May 2018 55

Chart 56: Availability of credit: auto
$800 Auto credit has grow n 8% annually
since 2011
Total Auto Credit Availability ($bn)

$700 $635 $653

$604
$600 $564
$513
$500 $461
$415
$400
$300
$200
$100
$0
2011 2012 2013 2014 2015 2016 2017
Auto ABS On Balance Sheet Auto Loans

Source: FDIC, SIFMA

Impact on Markets: Not CET1 constrained

Most of the largest GSIBs are compliant with or comfortably above the CET1 minimums
as set by their local regulator. While many management teams have publicly stated
goals on which products they’d like to invest in or shrink within the markets (trading)
business, we thought looking at current market share by product (in markets) negatively
constrained by CET1, relative to each firm’s level of compliance to CET1, would be
helpful. After all, institutions with modest excess capital may shrink resources in
products where market share is subpar. Conversely, a bank with material excess capital
under CET1 but less than top 3 market share in a CET1-constrained product could
potentially utilize their balance sheet to gain share.

First, we look at overall fixed income and equities market share relative to CET1
excess (see Chart 57and Chart 58).
Chart 57: Fixed income trading market share vs. CET1 compliance Chart 58: Equity trading market share vs. CET1 compliance
MS
160% 160%
CET1 ratio relative to requirement (2017)

CET1 ratio relative to requirement (2017)

Mar ket shar e Mar ket shar e

150% 150%
oppor tunity MS oppor tunity
140% CS UBS 140% UBS CS
130% WFC 130% WFC
C HSBC C
GS GS
120% JPM 120% JPM HSBC
110% DBK 110% DBK
BARC SocGen SocGen
100% BNP 100% BNP
90% 90% BARC
80% 80%
Stay the Potential Stay the Potential
70% cour se r etr enchment
70% cour se r etr enchment
60% 60%
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
FICC global investment bank league table rank (2017) Equities global investment bank league table rank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition

Further, we look more deeply at global market share for the top 12 banks (under
BofAML coverage) in the following CET1-constrained products: 1) equity derivatives;
2) securitized products; 3) credit (although high yield is more impactful to CET1 than
investment grade); and 4) commodities.

Given shrinking client wallets in cash equities, equity derivatives have been a
significant contributor to equity revenues of late (see Chart 59). JPM, GS, and C all rank
in the top 3 globally and all have excess capital under CET1 under the current regime.

56 Global Banks and Brokers | 18 May 2018

We expect all three players to defend market share avidly. We expect C to be an
especially enthusiastic competitor, given material excess capital positioning and overall
equities market share positioning outside the top five.
Chart 59: Equity derivative trading revenue market share vs. CET1 compliance
MS
160%
Mar ket shar e oppor tunity
CET1 r atio r elative to r equir ement (2017)

150%
140% UBS CS
WFC
130% C
GS
120% JPM HSBC
SocGen
110% DBK
BNP BARC
100%
90%
80%
70%
Stay the cour se Potential r etr enchment
60%
0 2 4 6 8 10 12 14
EQUITY DERIVATIVES: Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

In securitized products, the story at the top is more interesting (see Chart 60). JPM
and C are in the top three, and we of course similarly expect these institutions to defend
their turf. DBK also ranks in the top 3 globally, but has less excess capital and of course
has publicly stated that it would shrink its footprint outside of Europe – suggesting it
has potentially share to give. Interestingly, MS has significant excess CET1 capital and
falls just outside the top five globally, in our view, implying a potential market share
opportunity here.
Chart 60: Securitization revenue market share vs. CET1 compliance
MS
160%
CET1 r atio r elative to r equir ement (2017)

150%
Mar ket shar e oppor tunity
140% UBS
CS
WFC
130% C
GS
120% JPM HSBC
110% DBK
BARC SocGen
BNP
100%
90%
80%
70%
Stay the cour se Potential r etr enchment
60%
0 2 4 6 8 10 12 14
SECURITIZATIONS: Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

In credit, the story at the top is also similarly interesting (see Chart 61). DBK ranks
second globally (tied with JPM), but again could be market share contributors outside of
Europe. C and GS round out the top 5, and C in particular could be another aggressive
competitor here by using balance sheet excess to drive market share higher, in our view.
While we do not have trading market share isolated to high yield – where CET1 is most
meaningful – we looked at recent share (isolated to BofAML coverage universe) of high
yield issuance as a proxy. Not surprisingly, C ranked in the top 3 (see Exhibit 22).

Global Banks and Brokers | 18 May 2018 57

Chart 61: Credit trading revenue mkt share vs. CET1 compliance Exhibit 22: High-yield bond issuance league table
MS High yield bond issuance Rank Revenue ($mn) Share (%)
160% JP Morgan 1 82,672 9.99%
Citi 3 73,184 8.84%
CET1 r atio r elative to r equir ement (2017)

150%
Mar ket shar e Goldman Sachs 4 72,350 8.74%
140% UBS oppor tunity Barclays 5 61,891 7.48%
CS
WFC Deutsche Bank 6 53,962 6.52%
130% C
GS Credit Suisse 7 53,246 6.43%
120% JPM HSBC
Morgan Stanley 8 52,413 6.33%
110% DBK Wells Fargo 9 44,276 5.35%
BARC SocGen RBC Capital Markets 10 34,887 4.21%
BNP
100% UBS 13 15,574 1.88%
90% Source: BofA Merrill Lynch Global Research, Bloomberg
80% Note: Data represents three year time horizon (2014-2017)
Stay the Potential
70% cour se r etr enchment
60%
0 2 4 6 8 10 12 14
CREDIT: Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

And lastly, in commodities, we don’t expect major shifts to the top five global players,
all of whom are in positions of CET1 strength (see Chart 62. Note that GS’s
restructuring of its commodities business is largely completed, though we can see
ongoing changes based on market conditions.
Chart 62: Commodities trading revenue market share vs. CET1 compliance
160%
CET1 r atio r elative to r equir ement (2017)

150%
MS Mar ket shar e oppor tunity
140% UBS CS
WFC
130% C HSBC
GS
120% JPM
SocGen
110% DBK
BNP BARC
100%
90%
80%
70%
Stay the cour se Potential r etr enchment
60%
0 2 4 6 8 10 12 14
COMMODITIES: Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

SLR impact: Constraining for markets, and let’s talk Fed

As mentioned, the introduction of an SLR requirement globally generally curtailed
investment banking and trading expansion ambitions. As such, we examined how lower
dealer balance sheet availability could impact market dynamics. Further, like we did in
the previous section on CET1, we examine the market share dynamics in the products
most constrained by SLR relative to the SLR excess/shortfall positioning of each
institution in the top 12 international banks covered by BofAML.

Impact on markets dynamics: More volatility?

Market volatility has been low until recently. Interestingly, feedback from trading desks
and dealer clients imply lower available liquidity in 2018 YTD. And while the market is
still generally untested, regulation does not appear to have diminished market volatility
in times of stress. The chart below looks at the standard deviation of performance
across different asset classes (see Exhibit 23). Volatility in the S&P and the U.S. 10-
year, and as measured by the VIX (CBOE Volatility Index), is among or the highest in a
data set that goes back as far as the 1920s (for the S&P). In each asset in the chart,
recent volatility has been in the top five largest standard deviations historically. While it

58 Global Banks and Brokers | 18 May 2018

is difficult to point to one driver for these types of moves, we think regulatory changes,
market structure changes, and market growth are all having an impact.

Exhibit 23: Many assets experienced record jumps in recent years from calm to stress
10 Since '28 Since '87 Since '90 Since '98 Since '73 Since '75 Since '62 Since '89 Since '86
Largest and 2nd
8 largest in history
Largest and 2nd
6 largest since 1973
# of stdevs relative to 100d MA

2
SPX SX5E GBPUSD Copper
0
VIX US USDJPY 10y UST Bund
-2 Financials yields

Largest in history
-4

-6 Largest and 3rd

Largest since '40 Largest since 1976
largest in history
-8
21-Jan-08

27-Jun-16

24-Jun-99

14-Jan-15
06-Jun-96
09-Feb-18

05-Feb-18
27-Feb-07

24-Feb-12

10-Mar-76

19-Mar-91

19-Mar-12

12-Feb-90
02-Mar-94

11-Mar-14
24-Aug-15
08-Aug-11
31-Aug-98

06-Aug-90

10-Aug-11

24-Aug-15
08-Aug-11
17-Sep-01

14-Nov-16
11-Nov-05
07-Aug-00

02-Nov-73
10-Sep-14
15-Aug-95
21-Nov-12

13-Aug-08
28-Sep-76

14-Nov-16

11-Nov-16
26-Oct-87

14-Oct-03
28-Apr-06

13-Apr-87
30-Aug-72

16-Apr-93
23-Sep-11
14-May-40
19-Oct-87

10-Oct-79

20-Jul-92
Source: BofA Merrill Lynch Global Research. Daily data of the SPX from 30-Dec-27 to 2-Dec-15, VIX from 2-Jan-90 to 2-Dec-15, SHCOMP
from 31-Dec-90 to 2-Dec-15, USDJPY from 31-Mar-71 to 2-Dec-15, EURCHF from 31-Mar-99 to 2-Dec-15, USGG10YR from 30-Mar-62 to 2-
Dec-15, GDBR10 from 31-Mar-89 to 2-Dec-15 and XAU from 31-Mar-20 to 2-Dec-15. We measure this one day dislocation as the magnitude
of the level relative to its trailing 100d moving average in standard deviations. If we see records set on subsequent days, we only record the
largest as representing that event. For USGG10YR, we use the intraday move on 15-Oct-14.

One of the drivers of market volatility, in our view, has been the significantly lower
market liquidity today, especially when compared to pre-crisis levels. All the
aforementioned rules have had a meaningful impact on bank/broker balance sheets –
particularly trading portfolios – which have declined meaningfully since the financial
crisis (see Chart 63). Rationalization of certain products has directly impacted the
liquidity for those assets. We expect the impact on market liquidity to continue as
recent proposals from the Fed imply limited regulatory relief for US GSIBs.
Chart 63: Bank trading portfolios have declined since the crisis
16
14 -46%

12
($ in trillions)

10
8
6
4
2
0
2009

2010

2011

2012

2013

2014

2015

2016

United States Europe

Source: SNL Financial

Note: Data set includes US and European GSIBs

SLR is particularly punitive to repo exposure, and leverage exposure as calculated in the
SLF requirement feeds into each GSIB’s related surcharge calculation for CET standards.
Along with funding rules (LCR globally, resolution planning in the US), these could have a
negative impact on large dealers’ ability to intermediate between cash lenders (such as

Global Banks and Brokers | 18 May 2018 59

money market funds and securities lenders) and leveraged investors (such as hedge
funds and mortgage REITs) in the repo market.

Note that the size of the primary dealer repo market has already shrunk by nearly 50%
since its peak in 2008; while primary dealer debt trading volumes have declined 30%
over the same period (see Chart 64). A further reduction in the availability and an
increase in the cost of dealer repo would likely translate into lower trading volumes and
subsequently, revenues.

That said, given material progress on leverage capital by certain global firms,
especially in the EU, repo availability has steadied and we expect it to remain steady
from here.

Chart 64: Repo market and dealer volumes have significantly declined

$5,000 Primary Dealer Balance Sheet and Trading Volumes Declined ($bn) $1,600
$1,500
$4,500
$1,400
$4,000 $1,300
$3,500 $1,200
$1,100
$3,000 $1,000
$2,500 $900
$800
$2,000
Period of stability $700
$1,500 $600
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Primary dealer repurchase activit y (Liability, lhs) Total fixed income volume (rhs)

Source: BofA Merrill Lynch Global Research, New York Federal Reserve
Note: 3m moving average

The fixed income markets, in particular, have undergone a transformation

in the years since the financial crisis, reflecting the cross-currents of
aggressive global monetary easing and regulatory tightening. But, as we
discuss in a later section, the Fed is breaking with the rest of the
developed world, and is on a clear path of gradual monetary tightening.

Issuance has been robust, particularly in Treasuries and corporate debt. However, while
the market has grown, the capacity to intermediate this incremental volume has
declined. After all, regulations have constrained dealers’ ability to trade those securities,
as overall dealer assets have declined (see Chart 66).

60 Global Banks and Brokers | 18 May 2018

Chart 65: Dealer fixed income inventories have declined since ‘07 Chart 66: Traditional bond market liquidity had been reduced
$900 2,500 25%
48.0x
$800 43.0x
2,000 20%
$700 38.0x
$600 33.0x
1,500 15%
28.0x
$500
23.0x
$400 1,000 10%
18.0x
$300 13.0x
500 5%
$200 8.0x
Mar-08

Mar-13
Jan-04

Jan-09

Jan-14
Jul-06

Jul-11

Jul-16
May-07

May-12

May-17
Nov-04
Sep-05

Nov-09
Sep-10

Nov-14
Sep-15
- 0%

2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Dealer Fix ed Income Inventories (LHS, $bn) Coporate Bond Fund Assets (LHS, $bn)
Ratio of Real Money FI Holdings to Dealer FI Holdings (RHS) Dealer Corp Inventory (LHS)
Dealer Inv./Corp Bond Funds (RHS)
Source: Federal Reserve Source: Bloomberg, ICI Global

From a product standpoint, these rules could have continued adverse consequences for
market liquidity in U.S. Treasuries, agency debt and MBS. These products are not only
balance-sheet intensive under SLR (products have low risk weight), but comprise the
bulk of U.S. repo collateral.

We would expect the Treasury market impacts to include cheapening of off-the-run

bonds relative to on-the-runs, along with an increase in repo specialness or delivery fails
for on-the-runs, which have been rising in recent years (see Chart 67). Other less-liquid
segments of the Treasury market, such as coupon STRIPS, could also cheapen further
relative to more liquid whole bonds. In addition, less dealer-intermediated leverage
could contribute to a widening of agency MBS spreads relative to Treasuries and swaps,
all else equal. Credit spreads could widen further in absence of dealer support,
particularly in times of stress.
Chart 67: Treasury ‘fail-to-deliver’ are on the rise ($000s)
500
450
400
350
300
250
200
150
100
50
0
Jan-14

Jan-15

Jan-16

Jan-17

Jan-18
May-13

May-14

May-15

May-16

May-17
Sep-13

Sep-14

Sep-15

Sep-16

Sep-17

Source: BofA Merrill Lynch Global Research, Bloomberg

Note: In finance, a failure to deliver is the inability of a party to deliver a tradable asset, or meet a contractual obligation

Impact on global market share: Game changing

As mentioned previously, switching to an SLR binding constraint likely drove the
material shift in global investment banking and trading market share to US banks from
EU banks, in our view. Bank trading volumes have declined since the crisis, more so in
EU than in US dealers.

Global Banks and Brokers | 18 May 2018 61

 Interestingly, however, SLR standards vary even more on a country-to-country basis
than does CET1 standards. As mentioned, US banks have to hold 67% more capital
against leverage exposure than banks whose current minimums are in-line with the
Basel minimum of 3% (e.g., French banks). This introduces the concept of
“regulatory arbitrage”, where a firm can take advantage of lower local capital
minimums relative to competitors and use this advantage to gain market share.

First, we look at overall fixed income and equities market share of twelve
international banks relative to SLR excess (see Chart 68 and Chart 69).
Chart 68: Fixed income trading revenue mkt share vs. SLR compliance Chart 69: Equity trading revenue mkt share vs. SLR compliance
160% WFC 160% WFC
Leverage ratio relative to requirement

Leverage ratio relative to requirement

Mar ket shar e
150% Mar ket shar e
150% oppor tunity
140% C HSBC 140% C
JPM BARC oppor tunity JPM BARC
MS HSBC
130% 130%
120% GS SocGen 120% GS SocGen
MS
110% BNP 110% BNP
(2017)

(2017)
100% CS UBS 100% UBS CS
90% DBK 90% DBK
80% 80%
Stay the Potential Stay the Potential
70% cour se
70% cour se r etr enchment
r etr enchment
60% 60%
0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14
FICC global investment bank league table rank (2017) Equities global investment bank league table rank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition Source: BofA Merrill Lynch Global Research, company data, Coalition

On a product basis, we looked at the following products most constrained by SLR where
we can obtain market share data: 1) equity derivatives; 2) prime services; 3) credit
(converse to CET1, investment grade is more impacted than high yield); and 4) rates.

The market share dynamics in equity derivatives is even more interesting when
observed through the SLR lens (see Chart 70). French banks BNP and SocGen have more
excess SLR than excess CET1; both fall just under the top five, implying that both firms
could be continue to be notable competitors in this area.
Chart 70: Equity derivative trading revenue market share vs. SLR compliance
160% WFC
Lever age r atio r elative to r equir ement (2017)

150%
140% C
JPM BARC
MS HSBC
130%
120% GS SocGen
110% BNP
Mar ket shar e oppor tunity
100% UBS CS
90% DBK
80%
70%
Stay the cour se Potential r etr enchment
60%
0 2 4 6 8 10 12 14
EQUITY DERIVATIVES: Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

62 Global Banks and Brokers | 18 May 2018

Within prime services, the top three banks (MS, JPM, GS) are entrenched and should
continue to avidly defend positioning (see Chart 71). Interestingly, DBK’s shortfall under
SLR targets may drive retrenchment here, something which now seems likely given
recent strategy updates.
Chart 71: Primer services revenue market share vs. SLR compliance
160% WFC
Lever age r atio r elative to r equir ement (2017)

150% Mar ket shar e oppor tunity

140% C
JPM BARC
MS HSBC
130%
120% SocGen
GS
110% BNP
100% UBS CS
90% DBK
80%
70%
Stay the cour se Potential r etr enchment
60%
0 2 4 6 8 10 12 14
PRIME SERVICES: Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

Within credit, investment grade would be the most impacted. Again, we expect JPM and
C to defend its overall market share (IG + high yield) in credit, with GS and MS
potentially using their excess SLR capital to gain market share in investment grade.
Again using issuance as a proxy for overall investment grade market share, WFC could
be an interesting contender here to move market share (see Chart 72). While WFC is
under an asset cap with the Fed, cash and securities comprise a significant amount
(45%) of earning assets, which implies to us that it could continue to compete with
client business – especially in wholesale banking – without breaching the asset cap.
Chart 72: Credit trading revenue mkt share vs. SLR compliance Exhibit 24: Investment grade bond issuance league table
Revenue
160% WFC Investment grade bond issuance Rank ($mn) Share (%)
Lever age r atio r elative to r equir ement (2017)

150% JP Morgan 1 419,546 20.23%

Mar ket shar e
C Citi 3 282,192 13.61%
140% JPM BARC oppor tunity
MS Wells Fargo 4 181,019 8.73%
HSBC
130% Mitsubishi UFJ Financial Group Inc 5 116,733 5.63%
120% GS SocGen Barclays 6 81,189 3.92%
Mizuho Financial 7 65,500 3.16%
110% BNP
BNP Paribas 8 61,254 2.95%
100% CS UBS US Bancorp 9 46,804 2.26%
DBK Deutsche Bank 10 44,570 2.15%
90%
HSBC 11 42,477 2.05%
80%
Stay the Potential Source: BofA Merrill Lynch Global Research, Bloomberg
70% Note: Data represents three year time horizon (2014-2017)
cour se r etr enchment
60%
0 2 4 6 8 10 12 14
CREDIT: Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

In rates, the top four players are firmly entrenched US banks (JPM, C, MS, GS) with
significant excess leverage capital (see Chart 73). Again, DBK ranks fifth and could
potentially be a market share contributor outside of Europe.

Global Banks and Brokers | 18 May 2018 63

Chart 73: Rates trading revenue market share vs. SLR compliance
160% WFC
Lever age r atio r elative to r equir ement (2017)

150%
Mar ket shar e oppor tunity
140% C
JPM BARC
MS HSBC
130%
120% GS SocGen
110% BNP
100% CS UBS

90% DBK
80%
70%
Stay the cour se Potential r etr enchment
60%
0 2 4 6 8 10 12 14
RATES; Global investment bank league table r ank (2017)

Source: BofA Merrill Lynch Global Research, company data, Coalition

Next up: Fed “quantitative tightening” + increase in net new US Treasury supply
We think there are three distinct factors that have driven material amounts of liquidity
build in US banks. First, there has been slower loan demand and less supply in certain
products (e.g., anything residential mortgage related), leading to loan growth that is slower
than in previous economic recoveries. Second, the accommodative backdrop around the
world has led to bank clients storing more cash at the banks in the form of deposits (see
Chart 74). Third, as we will discuss in depth beginning on page 139, new rules governing
liquidity coverage (LCR) also drove material build up in high quality liquid assets (HQLA)
among GSIBs and impacted US regionals (above $50bn assets) (see Chart 75).
Chart 74: Deposit growth is inversely correlated with rising short rates Chart 75: HQLA has grown 86% since ’09 vs. loan growth of 14%
20% -6% 200% +86%
-5%
15% -4% 180%
-3% 160%
(index = 2Q09)

10% -2%
(Inverted)

-1% 140%
5% 0% +14%
1% 120%
0% 2% 100%
3%
-5% 4% 80%
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017

2009

2010

2011

2012

2013

2014

2015

2016

2017
Core Deposits YoY (lhs) Fed Funds YoY (rhs) HQLA Proxy Total Loans

Source: BofA Merrill Lynch Global Research, Federal Reserve, Bloomberg Source: BofA Merrill Lynch Global Research, company data, SNL Financial
Data: HQLA proxy includes cash at central banks, UST securities, and municipal securities

We think that US banks already have limited incremental appetite for more HQLA. After
all, Treasury securities and cash have been dilutive to net interest margin. Ginnie Mae
yields have been more reasonable, but some banks have been hesitant to extend
duration today in a rising rate backdrop in the US. Further, growing balance sheet
through HQLA is generally margin dilutive and consumes SLR capital. And under the
current regime, 3 out of the 8 GSIBs are bound by risk insensitive capital measures,
which is a disadvantage to low-risk assets like Treasury securities.

64 Global Banks and Brokers | 18 May 2018

 What does this mean as the Fed allows $1.4tn of its balance sheet to mature
through 2021 and the Treasury issues a BofAML-estimated $1.6tn in net supply in
2018 and 2019 (see Exhibit 25) In the recent past, there have been three buyers of
Treasuries and agency MBS: 1) the Fed; 2) the banks; and 3) the public, or the
customers of banks. With the Fed out as a buyer and more stringent risk-insensitive
capital rules like SLR tempering bank appetite for incremental HQLA exposure, there
is risk of market dislocation, in our view.

Chart 76: Annual Fed balance sheet normalization expectations Chart 77: Monthly Fed balance sheet normalization expectations
450 50
400 45

Portfolio Reduction ($bn)

40
Portfolio Reduction ($bn)

350 140
133 35
300 30
250 127 25
115
200 20
15
150
267 10
100 229
197 174 5
50 0

Apr '18

Oct '18

Apr '19

Oct '19

Apr '20

Oct '20

Apr '21

Oct '21
Jan '18

Jan '19

Jan '20

Jan '21
Jul '18

Jul '19

Jul '20

Jul '21
0
2018E 2019E 2020E 2021E

Treasury Agency MBS Treasury Agency MBS

Source: Federal Reserve estimates Source: Federal Reserve estimates

Exhibit 25: 2018 and 2019 forecasted coupon supply

Forecasted coupon supply (bn)
Gross Fed
Maturing Net Supply
Supply Reinvest
2018 $2,382 $1,871 $197 $708
2019 $2,678 $1,887 $113 $904
Source: BofA Merrill Lynch Global Research estimates

In our recent report titled, “Not all deposits are created equal: Potential impact of Fed
portfolio unwind”, we go through in detail the mechanics and potential impact of the
Fed’s balance sheet reduction. In the exhibits below, we lay out the mechanics of what
happens when the public (bank clients) buys new Treasury issue (see Exhibit 26) and
when the banks buy the new Treasury issue (see Exhibit 27). Note that when Treasury
securities mature from the Fed balance sheet and Treasury pays the Fed back, the Fed
destroys the proceeds from the Treasury – leading to balance sheet shrinkage. Of
course, the Treasury then issues new bonds to replace what has matured.

Global Banks and Brokers | 18 May 2018 65

Exhibit 26: Mechanics of maturing Treasury holdings (public buys) Exhibit 27: Mechanics of maturing Treasury holdings (banks buy)
The Federal Reserve Banking Industry
Assets Liabilities & Equity Assets Liabilities & Equity
Fed assets and bank
reserves decline Federal Reserve Treasury Bank Cash at
(destroys proceeds Securities reserves the Fed
Pays back Fedfor (-$10bn) (-$10bn) (-$10bn)
from Treasury)
maturing Securities
Treasuries
(+$10bn)
$10bn
Treasury
Banking sectorbuys newly
pays back
issued Treasuries
Fed, Fed
BankingSector US Treasury
destroys
proceeds

Source: BofA Merrill Lynch Global Research,

Public withdraws
deposits to buy Public buysnewly
Treasuries issued Treasuries
Public

Source: BofA Merrill Lynch Global Research, company data

CCAR impact: capital return, product-level appetite

The DFAST/CCAR process is arguably the most stringent, and most credible, regulator-
administered stress test globally. (Our detailed explanation of this process can be found
beginning on page 130.) As mentioned, if post-stress capital levels (either CET1 or SLR)
are an institution’s binding constraint, it tends to increase the minimum capital that a
firm holds on a day-to-day basis and builds into client hurdle rates. As such, many of the
products that we mentioned that are impacted by spot CET1 and spot SLR would of
course be impacted by CCAR. In this section, we focus on whether or not higher stress
test loss content in certain loan products impact growth, the difference in the Fed’s vs.
the bank’s assumption on pre-credit operating income, and the impact to capital return.

Do higher stress test loss content for certain loans limit bank appetite?
Before we dive into this, we do want to recognize up front that economic growth in the
US during this recovery has been slower than previous 35 years (see Chart 78). Of course,
this impacts loan demand, which impacts on-balance sheet growth. Further, given that
residential mortgage lending drove the previous crisis, exposure reduction due to the run-
off of legacy loans and higher underwriting standards followed (see Chart 79).
Chart 78: GDP growth following periods of recessions
10.0%
8.0%
Avg: 4.0% Avg: 3.6%
6.0% Avg: 2.6%
US real GDP (YoY)

Avg: 2.0%
4.0%
2.0%
0.0%
(2.0%)
(4.0%)
(6.0%)
1980
1981
1982
1983
1985
1986
1987
1988
1990
1991
1992
1993
1995
1996
1997
1998
2000
2001
2002
2003
2005
2006
2007
2008
2010
2011
2012
2013
2015
2016
2017

Economic recovery

Source: BofA Merrill Lynch Global Research, Bloomberg, Bureau of Economic Analysis

66 Global Banks and Brokers | 18 May 2018

Chart 79: Change in loan composition over the last ten years… post-financial regulation
3%
2%
2%
10-yr change in loans as % of assets

1% 1% 1%

0%
-1% 0%

-2%
-3% -2%
-3%
-4%
-5%
-5%
-6% -5%
1-4 Family Total Construction HELOC Other cons C&I CRE Credit card

Source: BofA Merrill Lynch Global Research, FDIC

Let’s now look at the loan level stress test losses and the potential impact to growth for
the participants of the stress test (see Exhibit 28).
Exhibit 28: Results of the Fed’s stress test have led to reduction in certain loan exposures, in our view
Avg. projected loan losses Fed's results Company-run (bank models) results Delta: Co-run vs. Fed Historical industry results Delta: YoY loan growth
(% of average loans) 2014 2015 2016 2017 2014 2015 2016 2017 2014 2015 2016 2017 Peak Avg 14/13 15/14 16/15 17/16
First lien mortgages 4.3 3.2 3.5 2.4 2.4 2.4 1.6 1.7 (1.7) (0.7) (1.8) (0.7) 2.5 0.4 -3.0% -13.5% 0.0% -8.6%
Junior liens and HELOCs 7.7 6.3 6.1 4.2 5.1 4.7 4.4 4.2 (2.7) (1.5) (1.8) 0.1 3.1 0.5 -3.1% -5.8% -5.7% -8.6%
Commercial and industrial 5.0 5.0 5.9 5.9 4.0 4.1 4.6 4.3 (1.3) (1.2) (1.4) (1.6) 2.7 0.9 6.3% 5.8% 4.9% 2.0%
Commercial real estate 8.4 9.0 7.6 7.7 5.4 5.0 4.6 4.9 (3.0) (3.8) (3.0) (2.8) 2.0 0.3 2.5% 8.2% 6.6% -22.0%
Credit cards 14.3 12.8 12.9 12.8 15.9 16.4 13.1 14.2 0.3 2.9 0.2 1.4 13.2 4.4 6.0% 11.5% 4.7% 13.4%
Other consumer 5.9 5.7 5.9 5.9 4.2 3.5 6.0 4.6 (0.9) (1.4) 0.2 (1.3) 8.0 0.9 6.1% 5.4% 3.2% 4.7%
Other loans 3.0 3.0 3.5 3.7 2.6 2.4 2.2 2.2 (0.2) (0.4) (1.3) (1.4) - - 12.8% 18.4% 18.4% 9.5%

Source: BofA Merrill Lynch Global Research, Federal Reserve, company data
Note: Data set includes US banks that participated in the Fed’s annual stress test

As a reminder, the stress test requires the Fed and the banks to run separate
models. A bank’s model will largely determine the capital plan presented to the Fed
for non-objection, and the Fed’s model will determine the non-objection or objection
to a bank’s capital plan.

We dive more deeply into the DFAST/CCAR stress test process beginning on page 130.

Generally speaking, while we think the stress test does have some impact to bank
appetite, it is not likely the dominant factor in growth. When looking at residential
mortgage losses – both first lien and junior lien/home equity – the stress test does
appear to have a negative impact, when taken in isolation (see Chart 80). Further, new
mortgage rules under Dodd-Frank likely further curbed bank enthusiasm for this product.

Global Banks and Brokers | 18 May 2018 67

Chart 80: Banks have reduced exposure to resi loans, but likely coincident with DFAST results
2.0% 12.5%

1.0%  Fed loss assumptions 7.5%

better than the banks'
models 2.5%
0.0%
(2.5%)
(1.0%)
(7.5%)
(2.0%)  Fed loss asasumptions
worse than the banks' (12.5%)
models
(3.0%) (17.5%)
2014 2015 2016 2017

∆ betw een Fed and co-run projected loan losses (lhs) YoY loan growth (rhs)

Source: BofA Merrill Lynch Global Research, Federal Reserve, company data

That said, we would mention a few other factors that are not insignificant to growth.
Following cycles, we observe a “recency bias” – in other words, banks tend to clamp
down underwriting standards for the loan product that had the highest loss experience
in the previous cycle. And of course, loan balances – particularly in home equity, not an
especially popular product among consumers at the moment – are impacted by
continued run-off of legacy portfolios.

In fact, given a largely absent secondary market for loans that do not conform to
agency (e.g., Fannie Mae, Freddie Mac) standards, banks have actually been more
aggressive at originating and retaining jumbo mortgage loans.

Second, the growth in commercial and industrial (C&I) loans are the strongest counter-
argument for CCAR results heavily influencing bank appetite. The Fed has consistently
forecasted higher losses in C&I, at a rate of ~1.5% higher than the average bank
forecast. And yet as we mentioned earlier, banks have consistently grown C&I loans (see
Chart 81). Commercial real estate (CRE) is another counterpoint, where losses projected
by the Fed were consistently higher, but this was also an asset class where loans were
growing until recently (see Chart 82).
Chart 81: Despite high loss assumptions, banks grow C&I loans Chart 82: CRE growth recently impacted by mkt conditions, not DFAST
2.0% 7.0% 2.0%  Fed loss assumptions 10.0%
better than the banks'
5.0% 1.0% models 5.0%
 Fed loss assumptions
1.0% better than the banks' 3.0% 0.0% 0.0%
models
1.0% (1.0%)  Fed loss asasumptions (5.0%)
0.0% worse than the banks'
 Fed loss asasumptions (1.0%) (2.0%) models (10.0%)
worse than the banks'
(1.0%) models (3.0%) (3.0%) (15.0%)
(5.0%) (4.0%) (20.0%)
(2.0%) (7.0%) (5.0%) (25.0%)
2014 2015 2016 2017 2014 2015 2016 2017

∆ betw een Fed and co-run projected loan losses (lhs) ∆ betw een Fed and co-run projected loan losses (lhs)
YoY loan growth (rhs) YoY loan growth (rhs)

Source: BofA Merrill Lynch Global Research, Federal Reserve, company data Source: BofA Merrill Lynch Global Research, Federal Reserve, company data

That said, many bank management teams have complained about high loss rate
assumptions for small business loans. While we cannot verify this independently from
publicly-available stress test results, we do note that the commercial loan outstanding
for loans less than $1mn have declined since 2010, at a 1% CAGR (see Chart 83).

68 Global Banks and Brokers | 18 May 2018

Chart 83: Availability of credit: small business loans
800 2002-06: 2010-17: 45%
4% CAGR, avg share: 37% -1% CAGR, avg share: 24%
700 40%
600 35%
30%
500
25%
400
20%
300
15%
200 10%
100 5%
0 0%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Comm'l loans ≤ $1mn ($bn, lhs) Small loan share (rhs)

Source: BofA Merrill Lynch Global Research, FDIC (share of total loans on bank balance sheets)
Note: Yellow bars denote periods of economic recovery

PPNR: Even more volatile that credit loss expectations

Of course, pre-provision net revenue (or PPNR) provides a cushion to the capital burn
created by higher stressed losses. Interestingly, there has been significant volatility
between the Fed’s expectations for PPNR and those of the banks’. Bank management
teams have pointed this out as a challenge, but we do not have the sense that business
strategy was materially impacted by this. The one notable exception is ZION, who had
previously performed poorly on the CCAR. In order to enhance PPNR under stress, ZION
invested its cash more aggressively into securities, driving net interest income higher.

Capital return impact: US dividend payout lower vs. history, global peers
Of course, capital return is the part of US bank capital management that has been most
directly impacted by CCAR. Previous to this process, banks did not have to undergo such
a formal process for approval (or, in regulator parlance, “non objection”) for shareholder
return. That said, over time, total capital payout to shareholders by CCAR participants
has increased, peaking at 91% in 2017 (See Chart 84).
Chart 84: Total payout has continued to increase throughout each CCAR cycle
100%
91%

80% 75%
CCAR capital payout
(BofAML coverage)

62%
60% 54%

40%

20%
2014 2015 2016 2017

Source: BofA Merrill Lynch Global Research, company reports

However, given the “soft cap” of 30% on dividend payouts (as a percentage of earnings),
dividend yields and payouts are still on the lower end of historical ranges. In terms of yield,
the sector was about in-line with the S&P 500 dividend yield in 2017 – pre-crisis (we look
at 2006), the banks were higher than the broad market (see Chart 85). In terms of payout,
the banks have the lowest LTM (last twelve months) payout across S&P sectors at 29%
(see Chart 86). This is also well below the pre-crisis dividend payout average of 45%.

Global Banks and Brokers | 18 May 2018 69

Chart 85: Dividend yields of bank stocks are below pre-crisis levels Chart 86: …while dividend payouts are also below those of other sectors
6% 250%
219
5%
Dividend yield (LTM)

200%
4%

Dividend Payout (LTM)

3% 150%
2% 101
100% 78
1% Pre-crisis avg, 45
60 59
52 48
0% 50%
43 41
33 29 27 27
Industrials

S&P 500

Health Care
Utilities

Banks

Financials
Cons. Staples

Materials

InfoTech
Telecom

Cons. Discr.
Real Estate

Energy

0%

Cons. Discr.
Health Care

Financials
Inf o Tech
Cons. Staples
Utilities

S&P 500
Telecom

Industrials
Materials
Real Estate
Energy

Banks
2006 2017

Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data
Note: Universe consists of S&P 500 constituents Note: Universe consists of S&P 500 constituents

Further, on a global basis, US banks’ dividend yields lag that of their most of their global
developed market peers (see Chart 87).
Chart 87: Most US bank dividend yields currently lag European and Asian GSIB peers
4.0%
Non U.S. Median,
3.9%
3.0%
Dividend Yield

U.S. Median, 1.8%

2.0%

1.0%

0.0%
ZION
WFC

CMA
CFG

MTB
KEY
BBT

GS
BK
HBAN

C
PNC

FITB
USB

JPM

STT
STI

MS
RF

Source: BofA Merrill Lynch Global Research, Bloomberg

Note: Non U.S. Median represents Europe and Asia GSIBs

Impact from liquidity rules

In our opinion, the various rules governing liquidity (LCR, NSFR, and in the US, resolution
planning) have lowered “natural” net interest margins (see Chart 88). Certainly, the
normalizing-but-still-low interest rate backdrop hasn’t helped margins. That said,
liquidity rules encourage banks to hold lower-yielding, lower risk assets and value certain
types of deposits more highly. In a normalizing rate backdrop, the latter can create
significant competition for “valuable” deposits, further hampering margin trends.

70 Global Banks and Brokers | 18 May 2018

Chart 88: Quarterly net interest margins of FDIC insured institutions
4.50%
4.30%
4.10%
3.90%
Net Interest Margin

4Q17: 3.31%
3.70% Historical: 3.50%
3.50%
3.30%
3.10%
2.90%
2.70%
2.50%
1Q84
2Q85
3Q86
4Q87
1Q89
2Q90
3Q91
4Q92
1Q94
2Q95
3Q96
4Q97
1Q99
2Q00
3Q01
4Q02
1Q04
2Q05
3Q06
4Q07
1Q09
2Q10
3Q11
4Q12
1Q14
2Q15
3Q16
4Q17
Source: BofA Merrill Lynch Global Research, FDIC

As we showed in the previous section discussing the Fed’s balance sheet reduction,
bank HQLA (high quality liquid assets) as a proportion of earning assets has grown
significantly over the last five years. Since HQLA typically yields less than a loan, this
change in composition is dilutive to asset yields.

Another aspect to the liquidity rules is that these rules inadvertently render certain
liabilities more “valuable” than others, in our view. As a direct response to the liquidity
issues that arose during the Global Financial Crisis, the LCR was essentially designed for
banks to have enough liquidity to withstand a 30-day stress on its liabilities. As such,
certain deposits were classified as more prone to leave the bank under a stress scenario
than others (see Exhibit 29). In general, the outflow assumption in LCR equals the
amount of HQLA a bank has to hold again every $ of that deposit category. The more
liquidity a bank has to hold against a deposit, it likely means a narrower margin earned
on this deposit relationship.
Exhibit 29: Most valuable deposits according to LCR regulation
"Run-off"
Deposit Category
assumption

Most 3 - 5%
valuable
"Stable" retail deposits (checking accounts)

Less stable retail deposits (excess cash in wealth management accounts) 10%

Operational deposits 5 - 25%

Sovereign or central bank deposits 20 - 40%

Corporate deposits 50%

Least
valuable
Financial institution deposits (hedge funds, asset managers) 100%

Source: BofA Merrill Lynch Global Research, BCBS

Excess deposits typically drain out of the system when short rates rise (see Chart 89).
Recently, we have seen US deposit growth slow. Given where absolute level of rates are,
we expect competition for excess cash at consumer accounts to pick up – potentially
leading to an inflection point in deposit betas (see Chart 90). Given the higher value
liquidity rules place on consumer deposits, we expect LCR-impacted US banks (above
$50bn in assets) to be particularly competitive – and note that it is these larger banks
that typically set the tone for deposit pricing in any given market.

Global Banks and Brokers | 18 May 2018 71

Chart 89: Deposit growth is inversely correlated with rising short rates Chart 90: Deposit beta trends per absolute rate basis
20% -6% 50% 2015 rate cycle 2004 rate cycle
-5%
15% -4% 40%
-3%

Total Cumulative Deposit Beta

10% -2%

(Inverted)
30%
-1%
5% 0%
20%
1%
0% 2% Largest
3% 10% incremental
-5% 4%
0%
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017

100
125
150
175
200
225
250
275
300
325
350
375
400
425
450
475
500
525
25
50
75
Core Deposits YoY (lhs) Fed Funds YoY (rhs) Fed Funds Rate (bp)

Source: BofA Merrill Lynch Global Research, FDIC, Bloomberg Source: BofA Merrill Lynch Global Research, SNL Financial

Liquidity rules could also impact demand, liquidity for certain securities
Given that LCR and NSFR (note that NSFR is not final in the US) encourages banks to
hold lower-risk liquid securities, the market may observe more tempered bank demand
for agency debt, agency MBS, corporate bonds, and municipal bonds relative to U.S.
Treasuries and Ginnie Mae securities.

For example, as we explain in greater depth beginning on page 139, LCR rules caps
Level 2-designated securities at 40% of total HQLA. Agency debt and MBS would be
considered Level 2. As such, while most banks have excess LCR today, we still believe
that banks may prefer to reallocate maturing cash flow to Level 1 securities, such as
Ginnies and Treasuries. We note that banks tend to be most active in the 2-5 year
portion of the yield curve.

Mortgage reform: Nonbanks fill the origination void

In our opinion, the structure of the US residential mortgage market has been the most
impacted by both new regulation and legislation. (For our discussion on mortgage
reform written into Dodd-Frank, please turn to page 181.) As a result, the players in the
mortgage origination market have shifted dramatically. In 2007, banks originated 74%
of the residential mortgages in the US (see Chart 91). In 2016, origination market share
reflect a dramatic shift, with nonbanks accounting for 55% of the originations (see
Chart 92).
Chart 91: Banks comprised majority of mort. origination market in 2007 Chart 92: By 2017, nonbanks comprised the majority

2007 2016
Credit Union
Credit Union 5%
3% Nonbanks
23%

Banks
40%
Nonbanks
55%
Banks
74%

Source: MBA Source: MBA

72 Global Banks and Brokers | 18 May 2018

Interestingly, nonbanks now comprise 6 of the top 10 mortgage originators in the US –
(see Chart 93). In the chart below, we looked at market share in 2017 vs. the growth in
originations over the past five years.
Chart 93: Market share vs. change in originations
600%
#10. Amerihome
500% Mortgage #8. Caliber
% Change in Resi Originations

400% #9. loanDepot

Over Last 5 Years

300% #5. Freedom

Mortgage
200%
#4. Penny Mac
100%
#3. Quicken
0% #7. USB
#2. JPM #1. WFC
-100% #6 BAC
-200%
-2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%
2017 Resi Origination Market share

Source: BofA Merrill Lynch Global Research, Inside Mortgage Finance

Note: Amerihome mortgage didn’t originate loans in 2013 as it was a subsidiary of a different company

What we also examined in this analysis is the balance sheet size of each originator,
which is represented by the size of the bubble in the chart. Of course, many nonbank
originators have an originate-and-sell (mostly to government agencies) business models,
which does not require a large balance sheet. However, if credit does turn, we point out
that during the most recent financial crisis, the US government agencies did “put back”
loans back to the banks that may have violated securitization agreements. This caused
banks to build what is called repurchase reserves, which of course require capital.

That said, mortgage credit availability is still well below pre-crisis levels (see Chart 94).
This is likely because while underwriting standards have tightened dramatically across
the industry, the private-label mortgage-backed securities market is still in rebuilding
mode (see Chart 95). This contrasts with agency MBS originations, which has grown
steadily since prior to and through the Global Financial Crisis (see Chart 96).
Chart 94: Mortgage credit availability well below pre-crisis levels
1,000
Mortgage credit availability index (NSA,

900
800
700
3/2012 = 100)

600
500
400
300
April '18, 177.9
200
100
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: MBA
Note: The MCAI is calculated using several factors related to borrower eligibility (credit score, loan type, loan-to-value ratio, etc.). These
metrics and underwriting criteria for over 95 lenders/investors are combined by MBA using data made available via the AllRegs® Market
Clarity® product and a proprietary formula derived by MBA to calculate the MCAI, a summary measure which indicates the availability of
Mortgage credit at a point in time.

Global Banks and Brokers | 18 May 2018 73

Chart 95: Non Agency RMBS market still down from pre-crisis levels Chart 96: … however, Agency MBS market continues to increase
$3.0 $8.0
$2.7
$2.6 $6.9
Non Agency RMBS Outstanding (tn)

$2.4
$7.0 $6.5
$2.5 $6.2

Agency MBS Outstanding (tn)

$5.9 $6.0
$6.0 $5.7
$2.0 $5.4 $5.5 $5.5
$1.9 $5.0
$2.0
$1.7 $5.0 $4.5
$1.5 $1.4 $3.8
$1.5 $4.0 $3.4 $3.5
$1.2 $3.2 $3.3
$1.0 $1.1
$1.0 $0.9 $3.0
$0.9 $0.8 $0.8
$1.0
$2.0
$0.5
$1.0

$0.0 $0.0
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: SIFMA Source: SIFMA

We think this is likely partly due to risk retention requirements, which may be delaying
the revitalization of the private label mortgage securitization market. Securitizers are
required to retain at least 5% credit risk, unless all of the mortgages that collateralize
the securitization meet the definition of a QRM, or qualified residential mortgage. (Note
under this rule, the QRM definition is closely aligned with the QM, or qualified
mortgage, definition under Dodd-Frank).

Also, note that retaining whole residential mortgage loans could be less
constraining to balance sheet capacity than the risk retained post-
securitization. Under the standardized approach, a residential mortgage
loan has a risk weight of 50%. Meanwhile, depending on credit rating and
subordination, risk weights for retained securitizations vary from 20-
1,250%.

Impact from Volcker Rule: Difficult to isolate

While the Volcker Rule certainly made an impact to the markets, we think that it is tough
to isolate the market impact from Volcker from the structural changes that have
occurred since the crisis. Generally speaking, we think Volcker reform could be helpful,
and necessary to improve liquidity in the fixed income and equity markets – which have
generally experienced a lack of volatility. However, we think Volcker reform alone is an
unlikely cure-all for global trading pools. Further, we note that issues like
electronification and the move to passive investing have played a not-insignificant part
in pressuring revenue pools.

Note that dealer fixed income inventories (including: commercial paper, U.S. Treasury
securities, agency & GSE backed securities, munis, and corporate & foreign bonds)
significantly declined (by 37%) by 2010 from its 2008 peak (see Chart 97). However,
inventories have dropped another 28% since December 2013, when the Volcker rule
came into effect.

74 Global Banks and Brokers | 18 May 2018

Chart 97: Dealer fixed income inventories have declined: only missing pension funds
900
48
Volcker rule
800 43
comes into effect
700 38
600 33
28
500
23
400
18
300 13
200 8
Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17
Jul-04

Jul-05

Jul-06

Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16

Jul-17
Dealer Fixed I ncome Invent ories (lhs, $bn) Ratio of Real Money FI Holdings to Dealer FI Holdings (rhs)

Source: Bloomberg, Federal Reserve

In our opinion, a combination of more stringent post-crisis capital and liquidity

standards and Volcker played a role in driving global revenue pools lower (see Chart 98).
For 2017, the global trading revenue pool was approximately 30% lower than the 2010
peak.
Chart 98: Global trading revenue pool
200
($billions)

$176
180
$161
160
$139
140 $133 $131
$126 $122
$121
120 $112

100

80
2009 2010 2011 2012 2013 2014 2015 2016 2017

Global FICC/EQ trading revenue

Source: BofA Merrill Lynch Global Research, company data

Note: Data set includes trading revenues from the eight largest international financial firms

The results of these rules on balance sheet exposure are significant, as we showed
previously. Trading portfolios are down 46% from 2011 peaks. Meanwhile, as we
showed previously, the primary dealer repo market has been cut in half since 2008,
while primary dealer debt trading volumes have slid 35% over the same period.

Biggest impact from Volcker? Potentially bond market liquidity

The biggest argument made against the Volcker Rule is its impact on bond market
liquidity. While there are numerous reasons for the decline in liquidity, the ambiguity
around what is considered “proprietary trading” has been one of the drivers causing
market participants to significantly reduce bond inventory. Due to both more
restrictive capital and liquidity measures and Volcker, there has been an increasing
focus by market participants on businesses/activities that require less capital/balance
sheet capacity. Meanwhile, IG corporate bond inventories are down by 98% since
peak, despite the robust levels of issuance and the size of the overall market (see
Chart 99 and Chart 100).

Global Banks and Brokers | 18 May 2018 75

Chart 99: Issuance in the US bond markets have been steady… Chart 100: …but lately IG inventories have been on the decline since ‘07
8,000 IG Dealer Inventory ($mn)
Issuance in U.S. bond markets ($bn)

7,000
50,000
6,000 45,000
40,000
5,000
35,000
4,000 30,000 -98%
25,000
3,000
20,000
2,000 15,000
10,000
1,000
5,000
0 0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: BofA Merrill Lynch Global Research, SIFMA Source: BofA Merrill Lynch Global Research, Federal Reserve

As a result, industry credit trading revenue is down 70% since the 2010 peak (see Chart
101).
Chart 101: Credit trading revenues down 70% since 2010 peak
$25,000
Credit trading rev enues
$20,000 dow n 70% since 2010 peak
Qtrly credit trading revenue

$15,000
(annualized) ($mn)

$10,000

$5,000

$0

($5,000)

($10,000)
4Q10
1Q11
2Q11
3Q11
4Q11
1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16
1Q17
2Q17
3Q17
4Q17

Source: BofA Merrill Lynch Global Research, OCC

A recent study attempted to focus on the impact of Volcker. In December 2016, the Fed
released a staff paper on the implementation of the Volcker Rule, with the aim of
isolating it from other factors (such as Basel III implementation) and its impact on bond
market liquidity. While non-Volcker impacted dealers tended to “step up” and provide
greater liquidity during times of stress, the study concluded that bonds are generally
less liquid when liquidity is most crucial. After all, Volcker-impacted dealers are still the
primary liquidity providers in the market.

The Fed study on corporate bond liquidity focused on times of stress, which they
defined as when a corporate bond rating was downgraded. We thought one of the most
interesting parts of the study compared share of corporate bond volume during times of
stress between Volcker-impacted dealers and non-Volcker-impacted dealers, and
compared this share pre-rule and post rule.

Prior to Volcker, “Volcker-impacted dealers” accounted for 93% of dealer-customer

volume during times of stress (see Chart 102). Interestingly, in a post-Volcker world, this
share during stressed times fell to 75%. Given that Volcker-impacted dealers still
account for the lion’s share of non-agency volume, the conclusion here is that liquidity
tightens during times of stress.

76 Global Banks and Brokers | 18 May 2018

Chart 102: Share of volume decline during times of stress among “Volcker-affected” banks (a/o
2015)
100% 93%
Share of volume during stressed times

90%
80% 75%
70%
60%
50%
40%
30% 25%
20%
7%
10%
0%
Pre-Volcker Post-Volcker

Volcker-affected dealers Non Volcker-affected dealers

Source: BofA Merrill Lynch Global Research, Federal Reserve

Notably, when isolated from other regulatory variables, Volcker has also helped push
impacted dealers into (lower-margin) agency businesses, which does not require
inventory-taking, as a dealer would typically have an identified counterparty to
immediately offset a trade with a customer. Pre-Volcker, agency trading comprised 12%
of Volcker-impacted dealer’s trades, on average (see Exhibit 30). This has almost
doubled, to 23% as of 1Q16, in a post-Volcker era. Meanwhile, agency trading used to
comprise 50% of a non-Volcker-impacted firm’s trading volume (see Exhibit 31). This
has been cut almost in half, to 29%.
Exhibit 30: Volcker-affected dealers (as of 1Q16) Exhibit 31: Non-Volcker-affected dealers (as of 1Q16)
Pre-Volcker Post-Volcker Pre-Volcker Post-Volcker

Agency,
12% Agency,
23% Agency,
29%
Non-
agency, Agency,
50% 50%

Non- Non-
Non- agency, agency,
agency, 77% 71%
88%

Source: Federal Reserve Source: Federal Reserve

Pre-crisis Period (January1, 2006 – June 30, 2007) and Post-Volcker Period (April 1, 2014 – March 31, Pre-crisis Period (January1, 2006 – June 30, 2007) and Post-Volcker Period (April 1, 2014 – March 31,
2016). 2016).

Further research supports the assertion that corporate bond market liquidity has
declined. The Center for Financial Stability estimates that corporate bond market
liquidity has declined 46% since its peak in 2008. Meanwhile, a study by PwC found that
a reduction in market liquidity had been accompanied by a 40% increase in bond market
volatility. Taken together, this could mean larger price swings and higher costs as assets
become harder to buy/sell. That said, we think that shift in the bond market have been
driven by the leverage rule on European banks as well as from Volcker.

Electronification has created other revenue pressures

The electronification phenomenon in trading is not new as the fixed income markets
started this shift in the late 1990s. However, post the global financial crisis (GFC), there
was a focus on transparency/central clearing and capital and leverage requirements
became stricter, which made balance sheets more costly, and pushed banks to increase
their electronic footprint.

Global Banks and Brokers | 18 May 2018 77

 Electronification has also led to new participants entering the market (high
frequency trading firms, etc.). This, combined with more stringent post-crisis rules,
has led to more competition, tighter spreads, and lower returns.

The shift of products to be traded electronic typically comes with more transparency, tighter
spreads, and lower revenue, though volumes can increase to provide some offset. The fixed
income markets were traditionally known as a marketplace where dealers would match
buyers and sellers, typically over the phone. Clients would reach out to several dealers, but
lacked transparent information on the bids and offers in a certain security. Dealers earned
attractive ROEs as the spread (bid-ask) earned on a product would be high, albeit with lower
volume. This eventually led to electronic communication networks (ECNs) creating central
limit order books where clients could see outstanding bids and offers by market participants.
As markets turn transparent, more competition requires dealers to price their products more
competitively to win business, which in turns leads to lower pricing (tighter bid-ask spreads).

The fixed income market is different than the equity market, and is generally less liquid
with many more CUSIPs. That said, equity market trends over the years can be used as
potential blueprints for the future of fixed income markets. On this point, equity market
pricing (bid-ask spreads) has dropped roughly 70% from 2001, but for the fixed income
market, it is still early days as many products are still less than 50% electronic (see
Chart 103).

As we look forward, further electronification of products will likely create some revenue
headwind for the industry, partially offset by market growth and/or a pickup in volatility.
Importantly, while electronification is a headwind for the industry, firms with scale and a
strong technology footprint can still gain share and produce attractive margins and
returns in this increasingly electronic landscape.
Chart 103: State of electronification in various asset classes
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

2012 2015

Source: Bank of International Settlements and BofA Merrill Lynch Global Research

Shift to passive also creates some headwinds

The shift from active to passive investing can also create some revenue headwinds for
trading. The active to passive shift has been more pronounced in equities, but the trend
is also gaining traction in fixed income (see Chart 104). In equities, the drivers fueling
the structural growth in passive include new products/uses (ETFs, risk management,
smart beta / factor, etc.), a focus on lower fees in a lower return backdrop, weak active
performance (in part driven by overcapacity in the industry and technology), and new

78 Global Banks and Brokers | 18 May 2018

regulations impacting the old ways of distributing products (RDR, MiFID II, etc.). Since
2004, passive penetration has increased to ~41% in U.S. Equities and ~24% in U.S.
Bonds, while non-U.S. markets are lower. We expect the shift to passive to continue
over the next few years given structural drivers.
Chart 104: Passive penetration by product

45% 41%
40% 37%
35%
30%
24%
25%
20% 18%
15% 15%
15% 12%
8% 9%
10% 6%
5%
5% 2%
0%
US Equity US Bond Non US Non US Total US Total Non
Equity Bond US

2017 2004

Source: Simfund, and BofA Merrill Lynch Global Research

As assets move from active to passive, the level of turnover tends to fall, weighing on
dealer trading activity. This trend has been more pronounced in equities, while fixed
income managers are still outperforming passive funds, which is driving still healthy
active inflows. However, if we use the equities universe as an example, when managers
start making outsized returns, this drives more entrants into the field, leading to
overcapacity and eventually weaker overall performance. This can then drive more of a
shift to passive, which can weigh on turnover and trading revenues. That said, we do
think there will always be a sizeable active market given market inefficiencies.

Shifting market structure: Less dealers, more HFT

The reduced level of dealer liquidity in the fixed income markets has opened the door for
new entrants to provide capacity. These new participants include liquidity providers or
high frequency trading (HFT) firms as well as over 20 electronic platforms. In as recently
as we could gather the data, HFT firms provided 49% of US active equity volume (see
Chart 105). Further, liquidity provided by HFTs picked up steam during the crisis.
Chart 105: US active equity HFT trading volume picked up during the financial crisis
12

10

8
(Bn shares)

4
61%
2 52% 56% 55%
51% 49% 49% 49% 49%
35%
21% 26%
-
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
HFT ADV Other ADV
Source: BofA Merrill Lynch Global Research, TABB Group

Global Banks and Brokers | 18 May 2018 79

Repo financing availability has rebounded, but is still well below pre-crisis levels. As
such, the ability of other leveraged investors to provide liquidity during periods of
market dislocations could also be more limited. While new players entering to provide
liquidity is generally a positive trend, particularly for those products that can trade
electronically and are more liquid, it can also present new risks – as we have witnessed
so far in the markets.

The fixed income market is much larger than the equity market. Some areas have a
much broader impact to global markets and economies, such as FX and Rates. While the
fixed income market is very different than the equity market in size, fragmentation, and
liquidity, we believe the regulatory transformation process could have some similarities.

Thus far, as mentioned, the OTC market is shifting to a cleared environment. Moreover,
some products are already electronic, and we expect more products to become
electronic over time. These market structure changes can provide benefits to users in
terms of costs and capital efficiencies.

That said, these shifts can also present new risks. Among these “new risks” are:
reduced liquidity in times of stress, less regulated entities, technology issues,
fragmentation, and concentration risks at clearinghouses. This is not an exhaustive
list, of new risks, in our view.

We think one of the major issues in the fixed income market is that regulatory change
has occurred much faster than market structure has been able to adapt. In order to
minimize market disruption, regulatory and market structure changes may need to occur
more in tandem. It may help for new liquidity providers to be regulated to ensure
liquidity in times of stress – although this could mean increased costs.

Additionally, in order for transparency and access to information to be significantly

improved, the cash and derivative markets may need to be on the same page. If this is
not achieved in the fixed income markets, then the risk of market disruptions and flash
crashes could increase, which in turn may impact global markets, economic costs, and
market confidence.

Importantly, we believe regulators are aware of the new risks from regulation. The U.S.
Treasury department has recently become more engaged in these efforts and is seeking
input from a wide variety of market participants on changes in Treasury market
structure, the implications for market functioning, and risk management policies and
practices. Mandatory reporting of transaction in U.S. Treasury securities was recently
agreed to and FINRA firms are required to report trades to the Trade Reporting and
Compliance Engine (TRACE).

Impact on dealer clients

Based on the regulatory changes and market growth, we see the potential for market
users to see higher costs (from bid/ask spreads occasionally but especially from
financing costs).

This can lead to lower investment returns relative to historical levels

The combination of reduced depth of the fixed income markets and the significant
growth in outstanding debt over the past few years can present heightened risks to
investors (see Chart 106). The rate backdrop – recently normalizing but still low – has
spurred a “reach for yield,” which has benefited bond fund AUMs and encouraged record
issuance of corporate debt.

80 Global Banks and Brokers | 18 May 2018

As a result, the market has shifted hands, with mutual funds, ETFs and individuals (retail)
taking on an increasing ownership role of U.S. corporate bond assets (see Chart 107).

The recent dip in ownership was driven by money market regulatory reform, which
shifted assets out of prime funds and into treasury funds. These users and products
generally have daily redemptions versus institutional assets and products invested in
are generally stickier and longer term in nature. Hence, we think this could present
increased risks to both investors and the market

Chart 106: Significant growth in debt outstanding Chart 107: Drop in holdings due to decline in money market ownership
Balance sheets of both financial and non-financial firms Balance sheets of both financial and non-financial firms

45,000 20%
40,000 18%
35,000 16%
30,000 14%
Total Debt ($bn)

12%
25,000
10%
20,000
8%
15,000
6%
10,000
4%
5,000 2%
0 0%

1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
Source: BofA Merrill Lynch Global Research, Federal Reserve (Z.1 report) Source: BofA Merrill Lynch Global Research, Federal Reserve (Z.1 report)

Higher funding and capital costs will mean that dealers will need to see larger market
dislocations before being able to justify stepping in to take advantage of mispricings
during times of stress. Further, even this may not allow some dealers to step in,
depending on firm-level regulatory ratios/constraints at the time of dislocation.

Given lower inventory, dealers will be less exposed, and in fact may be able to make
more money on wider spreads. Unfortunately, in our view, investors may see bigger
losses in times of stress due to dealers’ reduced ability to provide liquidity. That said,
this could shift to some degree depending on the outcome of Volcker reform.

In addition, volatility could be exacerbated by new, less regulated or unregulated

liquidity providers in the market that can reduce activity in times of market stress.
This was a factor that contributed to the market dislocations on October 15, 2014
when 10y Treasury yields declined by 30bp in a span of 70 minutes.

The negative regulatory view on short-term funding could put pressure on primary
dealer clients, particularly those using leverage. We expect client financing costs and
thereby investment returns to come under some pressure (potentially impacting hedge
funds, structured products, levered vehicles, and certain mutual fund and pension fund
strategies). Over time, lower returns can impact investor’s allocation decisions and the
growth outlook for these products, including for hedge funds (see Chart 108). We also
expect some areas that relied on short term financing to potentially shrink under the
new rules.

Global Banks and Brokers | 18 May 2018 81

Chart 108: Hedge Fund AUM has increased significantly since the crisis
$4,000

$3,500
Assets Under Management ($bn)

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Source: Barclay Hedge
Note: US hedge fund data

The clearing challenge: Mandate vs. economics

The evolution of regulations make it more challenging to run a derivatives business,
offer clearing, and for dealer clients to hedge risks. One of the reasons for the challenge
is that the FCM (Futures Commission Merchant) business wasn’t exactly a high margin
business to begin with. In other words, margins were already thin. As a result, additional
regulatory pressures will continue to lower an already challenged profitability and return
profile. However, given that it’s mandated, this can generate some issues. With
continued uncertainty on the macro front, this could also create concerns for clients
looking to hedge risks.

We expect banks to do what they can to continue compress their legacy derivative
exposures (collapsing/netting old trades) – particularly if an institution is still falling
short of SLR requirements at either the hold co or bank sub. Going forward (particularly
for CDS), we expect risk/exposure management and systems to place more emphasis on
the notional values of derivatives contracts, which were previously only tangentially
relevant. Additionally, we could see innovation, with exchange traded products launched
and/or products designed with similar attributes but lower maximum losses (notional
exposures).

Under current SLR rules, it is worth noting that the gross up of collateral (both received
and posted) is somewhat controversial, given that it has the effect of dis-incentivizing
the holding of collateral, despite the obvious benefits to the soundness of the business
of holding collateral. However, as we discussed in a previous section, a recent Basel
proposal could lessen the pressure on this issue. We expect this to gain traction over the
next year, which should create some benefit.

Another area of recent focus has been the potential for centrally cleared Treasury repos.
Centrally cleared repo would bring together a broader range of market participants and
facilitate transactions through a single clearinghouse. This would allow for more
transactions between cash investors, such as money funds, and cash borrowers, like
dealers or hedge funds. It would also reduce single name counterparty risk of cash
borrowers. Other benefits of central clearing include reducing the implications of a
single counterparty default, allowing for increased netting capacity, and enhancing
overall repo market liquidity and availability.

That said, there still lies uncertainty with centrally cleared repo
However, numerous questions are outstanding regarding centrally cleared repos such as:
• How to reduce concentration risk in single counterparty that could be vulnerable
should a single or multiple large members default?

82 Global Banks and Brokers | 18 May 2018

• How to provide contingent funding for a CCP default that would not be punitive
from an LCR perspective?

• How to sufficiently capitalize an entity with industry or official sector funding?

A recent study conducted by the Office of Financial Research found that expanding U.S.
Treasury repo central clearing to non-dealer counterparties would reduce risk exposures
81% for dealers. However, this would also increase risk exposure for a central
counterparty by as much as 75%.

The benefits of central Treasury clearing would then depend on the cost of non-cleared
repo activity vs. the additional funds required to guarantee centrally cleared trades. Any
move to centrally cleared repo would reduce the cost of dealer intermediation in the
repo market and compress the spread between GCF (general collateral financing) and
tri-party repo rates (see Chart 109).
Chart 109: Spread between GCF and tri-party repo rates
2.5 70
60
2
50
1.5 40

1 30
20
0.5
10
0 0
2014 2015 2016 2017 2018

Spread (5D MA, RS, bps) BNY Tri-Party (LS, %) GCF (LS, %)

Source: BofA Merrill Lynch Global Research, Bank of New York

Overall, due primarily to SLR, we expect some business to move to exchange traded
products (though this will depend on the users need), some to move to unregulated
firms (though clients generally want to clear with strong counterparties), wider spreads
across derivative contracts, and significant efforts to net/compress exposures. The
impact to clients would likely include less capacity, higher pricing for hedging, more
volatility, and lower investment returns over time.

Core banking system safer

Despite some mixed impact on industry participants and the economy, these regulations
have strengthened the core banking system, in our view. First, transparency has
increased. Second, not only did capital standards increased, but it is measured on
counterbalancing denominators (both a risk-weighted and gross balance sheet basis).
And third, the system is materially more liquid today than it was prior to the last
financial crisis.

To demonstrate this shift change, we looked at five measures of capital and liquidity as
of year-end 2017, and compared these to 2007. (Keep in mind that today’s regulatory
ratios are not comparable generally, as these rules did not exist pre-crisis.)

We looked at the following for the largest U.S. banks under coverage, including now
non-existent companies in the 2007 statistics: 1) tangible common equity/assets
(TCE/TA); 2) short-term wholesale funding/assets; 3) cash/earning assets; 4) trading
assets/earning assets; and 5) loan/deposit ratios. We found that in each of these ratios,
banks are much better positioned today versus in 2007 (see Chart 110).

Global Banks and Brokers | 18 May 2018 83

Chart 110: Capital and liquidity ratios have improved since pre-crisis levels
Tang Common Equity / TA
Higher ratio
is better

Trading Assets / EA Cash / EA

Low er ratio
is better

STWF / Assets Loan / Deposit

2017 2007

Source: BofA Merrill Lynch Global Research, SNL Financial

For example, banks have increased their TCE/TA by 460bp to 8.0% as of 4Q17 versus
3.1% in 2007. Moreover, they have more liquidity, with cash/earning assets of 30% in
2017 versus 21% in 2007. Funding profiles have also improved with lower short term
wholesale funding/assets of 17% vs. 29% and loan/deposit ratios at 77% as of 4Q17 vs.
106% in 2007. Banks are also carrying less inventory, as trading assets have declined to
19% of earning assets in 2017 vs. 26% in 2007

84 Global Banks and Brokers | 18 May 2018

Regulatory Structure: United States
4B

Global Banks and Brokers | 18 May 2018 85

Regulatory Agency Leadership
After reading through the entirety of the Dodd-Frank Act, one key element stood out:
the post-crisis law not only created new regulatory agencies (e.g., the CFPB), but vested
a material amount of power and authority in new and existing agencies. With certain
exceptions (Durbin, mortgage provisions), the language of Dodd-Frank is broad and open
to significant interpretation by the relevant empowered regulatory agencies. We think
this is especially true for capital standards, including stress testing.

Given the sweeping power granted by Dodd-Frank to regulatory agencies to interpret

and enforce the law, changes in agency leadership (appointed by the President)
and/or agency funding may be just as impactful to regulatory relief as a repeal of
various Dodd-Frank provisions, in our view.

In this section, we explore current agency vacancies, and provide some insight to the
regulatory agencies that are most responsible for carrying out Dodd-Frank.

Leadership vacancies across agencies mostly filled

The turnover in administration created 11 leadership vacancies across five agencies,
many of which have since been filled (see Exhibit 32). These regulatory heads could
have a potential impact on the interpretation of Title VII, which regulates the derivatives
market and requires clearing for certain swaps, among other.
Exhibit 32: Vacancies at key regulatory agencies
Agency/Department Title Nominee Confirmed?
Federal Reserve Board Chairman of the Board Jerome Powell Yes (1/23/2018)
Federal Reserve Board Vice Chair for Supervision Randy Quarles Yes (10/13/17)
FDIC Chairman Jelena McWilliams (11/30/17) Not yet
FDIC Vice Chairman NA NA
OCC Comptroller of the Currency Joseph Otting Yes (11/27/17)
CFTC Chairman J. Christopher Giancarlo Yes (8/3/17)
CFPB Director J. Mark McWatters (expected Jun '18) Not yet
SEC Chairman Jay Clayton Yes (5/4/17)
Treasury Secretary Steve Mnuchin Yes (2/13/17)
Source: Bipartisan Policy Center

Title XI: Establishing a Vice Chairman of Supervision

A position created by Title XI of the Dodd Frank Act, this position has broad powers with
regards to setting prudential regulatory standards, and interpreting and enforcing
regulatory oversight required by Dodd-Frank.

What we think could be most crucial for bank investors, is how the Vice Chair of
Supervision Randy Quarles will interpret the following: the administration of the Dodd-
Frank Act stress test with regards to the CCAR overlay, the Volcker Rule, and the “gold-
plating” of Basel prudential regulatory standards for U.S. banks.

Key regulatory agencies for investors to know

Below is a non-exhaustive list of key regulatory agencies in the U.S., a group that is
crucial for setting the future tone of regulatory policy. These agencies were all
bestowed some responsibility for executing certain provisions of Dodd-Frank.

Bureau of Consumer Financial Protection (CFPB)

Current Acting Director: Mick Mulvaney (appointed by President Trump)
The CFPB was created out of Title X of the Dodd Frank Act with the intent to be the
American consumer’s watchdog for financial services. The CFPB governs banks and
credit unions with more than $10bn in assets in addition to mortgage lenders, loan
modification and foreclosure relief services, private education lenders, and payday

86 Global Banks and Brokers | 18 May 2018

lenders. The CFPB initiated the qualified mortgage (QM) rule, which sets underwriting
criteria lenders must follow in order for a borrower to qualify for a loan. (Refer to Title
X: Consumer Financial Protection Act of 2010, on page 178).

The CFPB operates as an independent agency funded by the Federal Reserve. Mr.
Mulvaney was named acting director of the Bureau in November 2017, following the
resignation of former director Richard Cordray. President Trump is expected to name J.
Mark McWatters, the current chairman of the National Credit Union Administration, as
his CFPB nominee in June. If named the official nominee, McWatters would have to be
confirmed by the Senate Banking Committee, followed by a vote in the Senate.

Commodity Futures Trading Commission (CFTC)

Current Chairman: Christopher Giancarlo (appointed by President Trump)
The CFTC was created in 1974 as part of the Commodity Futures Trading Commission
Act. The CFTC is an independent agency of the U.S. government responsible for
regulating futures and options markets. As part of the Dodd Frank Act, the CFTC gained
additional responsibility to regulate the OTC swaps market.

The Commission consists of five Commissioners appointed by the president. The

current acting chairman is J. Christopher Giancarlo and his term expires in April 2019.

Federal Deposit Insurance Corporation (FDIC)

Current Chairman: Martin J. Gruenberg (appointed by former President Obama);
Vice Chairman: Thomas M. Hoenig (appointed by former President Obama)
The FDIC is an independent agency established in the Banking Act of 1933 in response
to the thousands of bank failures that occurred in the 1920s and early 1930s. The FDIC
insures deposits in banks and thrift institutions for at least $250,000 per insured bank.
In Title II of the Dodd Frank Act, the FDIC is granted authority to liquidate systemically
risky large failing financial firms. Meanwhile, Title III gives the FDIC acquired supervisory
and rulemaking authority over state chartered savings associations.

The FDIC is managed by a five-person Board of Directors who are appointed by the
President and confirmed by the Senate (no more than three can be from the same
political party). The current Chairman is Mr. Martin J Gruenberg and the Vice Chairman is
Mr. Thomas M. Hoenig. Mr. Gruenberg’s term ended in November 2017, but he is
expected to continue serving until a successor is in place. President Trump has
nominated Jelena Williams, most recently an executive vice president and chief legal
officer of Fifth Third Bank, to replace Mr. Gruenberg as Chairman of the FDIC. Mr,
Hoenig announced his retirement from his post as Vice Chairman of the FDIC in April
2018.

Federal Housing Finance Agency (FHFA)

Current Director: Melvin L. Watt (appointed by former President Obama)
The FHFA was created in July 2008 when President Obama signed the Housing and
Economic Recovery Act of 2008. The Agency works to strengthen and secure the U.S.
secondary mortgage markets by providing effective supervision, sound research, reliable
data, and relevant policies. Beginning in 2014, the FHFA has required Fannie Mae,
Freddie Mac and each individual Federal Home Loan Bank to conduct stress tests
pursuant to the Dodd Frank Act.

The FHFA is a member agency of the Financial Stability Oversight Council (FSOC). The
director of the FHFA, Mr. Melvin L. Watt, was confirmed by the Senate in December
2013 and is serving a five-year term, ending in January 2019. The current Trump
administration has placed focus on GSE reform for 2019.

Global Banks and Brokers | 18 May 2018 87

Federal Reserve Board of Governors (FRB)
Current Chair: Jerome H. Powell (appointed by President Trump)
Current Vice Chair of Supervision: Randal K. Quarles (appointed by President
Trump)
The FRB is the central bank of the U.S. and was founded by Congress in 1913 to provide
the nation with a safer monetary and financial system. Dodd Frank gave authority for
the FRB to conduct annual stress tests. The FRB was granted authority to continue
regulating State member banks and retained supervision of savings and loan holding
companies. As discussed later in this report, systemic risk bank holding companies and
non-bank financial institutions are required to prepare and consistently report on
contingent resolution plans (living wills) to the FRB. Separately, Title II of the Dodd
Frank Act includes the creation of the Orderly Liquidation Fund by the U.S. treasury to
cover the administrative costs of liquidation for companies under this title.

The Board of Governors, Reserve Banks, and the Federal Open Market Committee
(FOMC) are the key entities of the FRB. The seven members of the Board of Governors
are nominated by the President and confirmed by the Senate. The seven member board
has two vacancies. The Chairman and the Vice Chairman of the Board are named by the
President from among the members and are confirmed by the Senate. On February 5,
2018, Mr. Jerome Powell was sworn in as the Chairman of Federal Reserve Board,
replacing Ms. Yellen who served as Chairman for four years. Mr. Quarles replaced former
(de facto) Vice Chair of Supervision Daniel Tarullo).

Financial Stability Oversight Council (FSOC)

Current Chair: Treasury Secretary Steven Mnuchin (appointed by President
Trump)
The FSOC was established under the Dodd Frank Act and provides comprehensive
monitoring of the stability of the U.S. financial system. The Dodd Frank Act authorized
the Council to issue rules regarding the FSOC's authority to require supervision and
regulation of certain nonbank financial companies, to designate financial market utilities
as systemically important, and to implement of the Freedom of Information Act. The
Treasury Secretary is required to coordinate two major rules under Dodd Frank: the joint
rulemaking on credit risk retention for asset-backed securities and the issuance of final
regulations implementing the Volcker Rule.

The Council supervises and regulates bank holding companies over $50bn in assets and
systemically risky non-bank financial companies. The Council consists of 10 voting
members and 5 nonvoting members and brings together the expertise of federal
financial regulators, state regulators, and an independent insurance expert appointed by
the president. The Chair of the Council is Steven Mnuchin.

Department of Housing and Urban Development (HUD)

Current Secretary: Dr. Ben Carson (appointed by President Trump)
HUD was created in the U.S. Housing Act of 1937 and founded as a Cabinet department
in 1965. HUD’s mission is to create sustainable communities and qualify affordable
homes for all. Dodd Frank authorized $1bn for the Neighborhood Stabilization Program
(NSP3). This program provides formula grant awards to states and units of general local
government to create eligible activities as provided under the Housing and Economic
Recovery Act of 2008 (HERA). Dodd Frank also reauthorized the Emergency
Homeowners Loan Program provided by the Emergency Housing Act of 1975 and made
$1bn available for this program. Dodd Frank revised the 1975 Act to include temporary
involuntary unemployment or under-employment that may also be due to medical
conditions. Additionally, HUD may fund states with programs substantially similar to the
Emergency Homeowners Loan Program. This program provides up to 24 months of
mortgage payments assistance or $50,000, whichever occurs first. The current
Secretary of the Department of Housing and Urban Development is Mr. Ben Carson.

88 Global Banks and Brokers | 18 May 2018

National Credit Union Administration (NCUA)
Acting Chairman: Mark McWatters (designated by President Trump)
The NCUA was created by the U.S. Congress to regulate and supervise federal credit
unions. The NCUA is backed by the full faith and credit of the U.S. and manages the
National Credit Union Share Insurance Fund, insuring deposits of account holders in all
federal credit unions and most state-chartered credit unions. The Union is governed by a
three-member board, which is appointed by the President and confirmed by the Senate.
Dodd Frank established NCUA’s maximum share insurance amount at $250,000. Trump
appointed J. Mark McWatters as the Acting Chairman of the NCUA Board in January
2017.

As previously mentioned, President Trump is expected to name Mark McWatters as his

nominee for CFPB Director in June 2018.

Office of the Comptroller of the Currency (OCC)

Current Comptroller: Joseph Otting (appointed by President Trump)
The OCC charters, regulates, and supervises all national banks and federal savings
associations as well as federal branches and agencies of foreign banks. The OCC is an
independent Bureau within the U.S. Department of the Treasury. Title III of the Dodd
Frank Act abolished the OTS (Office of Thrift Supervision), which was previously
responsible for regulating state and federal savings associations and their holding
companies. The previous responsibilities of the OTS were transferred to the OCC, FDIC,
and the Federal Reserve. In particular the OCC acquired supervisory and rulemaking
authority over national banks and federal savings associations. The OCC also outlines
stress testing rules for national banks and federal savings associations with more than
$10bn in assets.

In November 2017, Joseph Otting replaced Thomas Curry as Comptroller of the Currency
after Mr. Curry’s more than five year term at the helm of the Office of the Comptroller
of the Currency. Recently, Mr. Otting has voiced his support for industry deregulation as
a means to encourage bank lending

Office of Financial Research (OFR)

Current Acting Director: Ken Phelan (appointed by President Trump)
The OFR is an independent Bureau within the U.S. Department of the Treasury which
analyzes risks, performs research, and collects data to promote stability across the
financial system. The OFR was established by the Dodd Frank Act and is expected to
support the FSOC and its member agencies to promote financial stability in the markets.
The OFR contains two primary operational centers: a Data Center to help regulators
identify vulnerabilities of the financial system and a Research and Analysis Center to
conduct research to improve regulation. Dodd Frank requires the OFR to provide annual
reports to Congress on threats to the financial system and its key research publications.

The OFR is currently run by Director Ken Phelan, who replaced previous OFR Director
Richard Berner in January 2018.

Securities and Exchange Commission (SEC)

Chairman: Jay Clayton (appointed by President Trump)
The SEC is an independent agency created by the Securities Exchange Act of 1934. The
SEC was created to protect investors, maintain fair, orderly, and efficient markets; and
facilitate capital formation. Under Dodd Frank, the SEC was granted authority to
oversee security-based swaps and work with the CFTC to regulate the OTC derivatives
industry. In addition, the SEC requires hedge funds that manage over $100mn to
register as investment advisers subject to federal regulation. Dodd Frank also created
the Office of Credit Rating Agencies within the SEC. The SEC requires registration of
municipal financial advisers, swap advisers and investment brokers in addition to
enforcing rules created by the Municipal Securities Rulemaking Board.

Global Banks and Brokers | 18 May 2018 89

President Trump nominated Mr. Jay Clayton to head the SEC in January 2017, replacing
Ms. Mary Jo White. Mr. Clayton was sworn in on May 4, 2017. Since joining the SEC,
Chairman Clayton has focused on the long-term assets interest of America’s retail
investors.

90 Global Banks and Brokers | 18 May 2018

Global prudential regulatory rules
5B

Global Banks and Brokers | 18 May 2018 91

Common Equity Tier 1 ratio (CET1)
Global bank investors are most familiar with looking at common equity tier 1 (CET1)
under Basel 3 standards as a measure of capital adequacy. This rule, on its face, is the
most risk-sensitive out of the current capital standards, as it requires banks to hold
capital against its risk-weighted assets. That said, the additional surcharge required for
GSIBs (globally systemic important bank) – which takes into account gross exposures as
well as off-balance sheet exposures – also takes into account a bank’s risk profile of its
assets.

CET1 requirements globally have mostly been set. Two potential changes are on the
horizon, however. First in April 2018, the Federal Reserve published a draft proposal that
would amend capital rules for bank holding companies (BHCs) with $50bn+ in assets,
one that would reset capital minimums annually based on each BHC’s current year stress
test (or CCAR) results. Specifically, the proposal would replace the 2.5% conservation
buffer with a stressed capital buffer (“SCB”) equal to the amount of capital “burned
down” in the binding scenario of the test. This would result in the same or higher capital
requirements for impacted U.S. banks.

Second, in December 2017 the Basel Committee published the final regulatory
standards in its post-crisis Basel III reforms. Although final on an international basis,
national regulators may consider applying these updates. Separately, in March 2018 they
proposed changes to the market risk methodology. (See section above for additional
detail).

Based on today’s standards, the lion’s share of GSIBs comply with transitional phase-in
requirements, and given current levels, are all on track to exceed or meet 2019 fully
phased-in minimums (see Chart 111, Chart 112, and Chart 113). As we will explain in
this section, there is no uniform ratio standard for all 30 GSIBs, as each bank’s standard
depends on its surcharge.
Chart 111: North American GSIBs Chart 112: European GSIBs Chart 113: Asian GSIBs

Nordea
MS CCB
RBS
C HSBC
SMFG
ING
WFC StanChart
ICBC
DBK
JPM
UBS
MUFG
Unicredit
GS
CS
Mizuho
RBC BARC
CA
BOC
STT BNP
SocGen
BK ABC
Santander
0.0% 5.0% 10.0% 15.0% 20.0% 0.0% 5.0% 10.0% 15.0% 20.0% 0.0% 5.0% 10.0% 15.0%

1Q18 1Q17 1Q18 1Q17 1Q18 1Q17

Source: company data Source: company data Source: company data

The current CET1 requirement breaks down as follows:

• Minimum requirement of 4.5%;

• Capital conservation buffer of 2.5%, although the Fed has proposed a

replacement for U.S. BHCs (see stressed capital buffer);

92 Global Banks and Brokers | 18 May 2018

• GSIB surcharge, ranging from at least 1% -3.5% under Basel rules and at least
1%-5.5% under U.S. rules (note both increase by 1.0%/0.5%, respectively, for every
100bp increase in score);

• Countercyclical buffer of 0-2.5%

• Pillar 2 buffers are disclosed and applied by some countries, in particular in

Europe where it forms a part of what we would class as the “minimum”

The simplest way to think about the minimum for each GSIB is the minimum
requirement of 4.5% + capital conservation buffer of 2.5% + each bank’s surcharge. In
essence, the GSIB CET1 minimum is 7.0% + the bank’s surcharge. That said, this
minimum could increase for U.S. BHCs if the Fed replaces the capital conservation
buffer (currently 2.5%) with its proposed stressed capital buffer (equivalent to CET1
“burned down” in U.S. CCAR stress test: minimum of 2.5%-no maximum) and/or includes
a countercyclical buffer (0-2.5%). In a later section, we will discuss how exactly each
individual institution’s surcharge is calculated (see Chart 114).
Chart 114: Common equity tier 1 buffer composition
20.0%
Fed has proposed a stressed
18.0%
CET1 to risk-weighted assets

0.0% - 2.5% capital buffer to replace

16.0% conservation buffer
14.0% 0.0% - 2.5% At least 2.5%
12.0% 1.0% 0.0% - 2.5% ~1.6%
At least 0.75%-2.75%
10.0%
1.0% At least At least 1.0%
8.0% At least 1.0%
2.5%
6.0% 2.5% (no max ) 2.5% 2.5%
4.0%
2.0% 4.5% 4.5% 4.5% 4.5%
0.0%
US - Current US - Proposed Basel Europe average

Minimum requirement Conservation buffer GSIB surcharge buffer

Pillar 2 Req. Pillar 2 Guid. Counter cyclical buffer

Source: BofA Merrill Lynch Global Research, BCBS, FRB

Note: the SCB portion (gray) in the above chart reflects the largest “burn down” experienced during the 2017 CCAR cycle is expected to
replace the current conservation buffer. That said, we note there is no upper limit as the buffer will be determined by the amount of capital
burned down. Pillar 2: We show average values for Europe from the most recent SREP, although P2R had a minimum of 0.75% and a
maximum of 2.75%. We also use the average P2G as disclosed by the EBA, but has a range of 1-2.25% from the banks that have disclosed it.

Investors may have heard the terms “transitional” or “fully phased-in” to describe CET1
standards. While we have seen the market impact banks to comply sooner rather than later
by assigning discounts to shares of banks that have lagged behind, GSIBs technically have
until 2019 to comply with the full 7.0% + surcharge standard (see Chart 115). Starting in
2014, GSIBs have been under a transitional period (see chart). In 2015, banks technically
only had to comply with the 4.5% minimum capital requirement. Beginning in 2016,
standards began to include part of the “fully-phased in” or full 2019 requirement. Each
year adds another 25% of the buffer and surcharge into the compliance requirement, until
the entirety of both are fully phased-in in 2019. In this example, JPM in 2018 will have to
comply with 4.5%, plus 75% of the 2.5% capital conservation buffer (1.88%) and 75% of
its current 3.5% surcharge (2.63%).

Global Banks and Brokers | 18 May 2018 93

Chart 115: Example of minimum CET1 capital ratio progression during transitional periods
12.0%
10.5%
10.0% 9.0%

8.0% 7.5%
6.0%
6.0%
4.5%
4.0%
4.0%

2.0%

0.0%
1/1/14 1/1/15 1/1/16 1/1/17 1/1/18 1/1/19

Minimum requirement Capital conservation buffer GSIB surcharge

Source: BofA Merrill Lynch Global Research, company data, Basel Committee

Global regulators have the option to add yet another buffer during frothy times
Note that global regulators have the optionality of adding a “countercyclical capital
buffer” should they determine frothiness in credit growth. (Note: This would be in
addition to the proposed stressed capital buffer in the U.S. and capital conservation
buffer in both Basel and U.S. approaches). The countercyclical capital buffer is a
potential expansion of the capital conservation buffer that takes into account the macro
financial environment in which large, internationally active banks function.

As of September 8, 2016 the Federal Reserve published the framework that will apply to
setting the countercyclical capital buffer. On December 1, 2017 the Federal Reserve
reaffirmed setting the U.S. countercyclical capital buffer at 0% and stated that it will
review the amount at least annually. The countercyclical capital buffer can be increased
when policy makers see an elevated risk of above-normal future losses. The
countercyclical buffer can be set at up to an additional 2.5% of risk-weighted assets
(RWA) subject to a 12-month implementation period. Although the implementation can
be shorter at the Fed’s discretion, the rule text states, “However, economic conditions
may warrant an earlier or later effective date.”

In other words, if U.S. regulators determine excess growth in the system, the CET1
standard could comprise of the 4.5% minimum + 2.5% capital conservation buffer +
GSIB surcharge + up to 2.5% incremental countercyclical buffer. So, if Bank A’s
surcharge is 3.5%, the resulting minimum CET1 in this case would be 13%, before
the potential replacement of the capital conservation buffer by the proposed
stressed capital buffer (incremental to 2.5% with no maximum)

Meanwhile, Europe already has a countercyclical buffer in effect for certain countries.
According to the European Systemic Risk Board (ESRB), the countercyclical buffer for
the Sweden and Norway is already set at 2.00%, with 0.5% for Slovakia and the Czech
Republic.

The basics: How CET1 is calculated

As with previous primers, we thought walking through the calculation behind these
ratios could be helpful to investors. Breaking down how exactly these regulatory
formulas are calculated could help investors discern what the vulnerable spots are for
individual institutions (e.g., banks with large broker/dealers subject to large market risk
RWAs), and what the upcoming issues may be as cycles shifts (e.g., accumulated
comprehensive other income (AOCI) has been a benefit in a low rate environment and
will be a detriment to capital ratios in today’s rising rate environment.) Also, where we

94 Global Banks and Brokers | 18 May 2018

can, we would pull in a “real world” example to bring context to the discussion. In the
following section, we walk through how CET1 is defined (see Exhibit 33):
Exhibit 33: Breakdown of CET1
Numerator Denominator

Common Shareholders Equity Credit Risk weighted assets

+ +
Qualifying minority interests
Market Risk weighted assets
-
Adj. AOCI +
- Operational Risk weighted assets
DTA from carryforwards (Advanced approaches only)
-
Adj. Intangible Assets
= =
Common Equity Tier 1 Capital ÷ Total Risk weighted assets
=
Common Equity Tier 1 ratio
Source: BofA Merrill Lynch Global Research, Basel Committee.
Note: For the numerator a key adjustment should add an adjustment for DVA for liabilities and derivatives (aka own credit). DTA = Deferred
tax assets

Understanding standardized vs. advanced approach (U.S. only)

Before we get into the definition of CET1, we thought it would be worth it to explain
the difference between the standardized approach and the advanced approaches in
calculating CET1 (see Table 7).
Table 7: Standardized versus advanced approach (U.S. only)
Standardized Approach Advanced Approach
Applicability Entities with over $500mn in assets Entities with consolidated assets > than $250bn
or Balance sheet foreign exposures > than $10bn
Approach Uses prescribed risk weights Model based implementation
RWA Credit Risk RWA and Market Risk RWA Credit Risk RWA, Market Risk RWA, Operational RWA
Timeline January 1, 2015 January 1, 2014
Source: BofA Merrill Lynch Global Research, BCBS, Federal Reserve

The difference between the standardized approach and advanced approaches

impacts RWA calculations.

The difference between the two can be most felt in the calculation of risk-weighted
assets, or the denominator. Very simply, standardized risk weights are set by regulators
and are the same across all banks. Meanwhile, under advanced approaches, regulators
require banks to use internal models (taking into account credit experience and internal
ratings) to calculate risk weights.

For example, under the standardized approach, Bank A and Bank B will both incur a
100% risk weight on corporate exposure (see Exhibit 34). However, under the advanced
approaches, each bank’s models will determine a risk weight that is very specific to each
individual institution’s portfolio – which could be lower or higher than the standardized
risk weight. Additionally, the advanced approaches take into account operational risk,
which we’ll discuss in more detail in the RWA section of this report.

Global Banks and Brokers | 18 May 2018 95

Exhibit 34: Difference between standardized and advanced approaches for sample risk weights

Standard Advanced
RWA based on
Secured financing collateral haircut
approach
US PSEs (including municipal
20 or 50%
securities) Determined by the
Residential mortgage loans* 50% likelihood of default
Home equity loans 100% and recovery given
HVCRE loans 150% default, based on firm
CRE loans (term + construction) 100% experience (could be
Auto loans (consumer) 100% below or above
C&I loans 100% 100%)
RWA based on
potential future
FI Trdg: Currencies & gold
exposure and
counterparty
Source: BofA Merrill Lynch Global Research, Federal Reserve
Asterisk denotes “prudentially written”

The advanced approaches are applicable to institutions with over $250bn in assets or
balance sheet foreign exposure of greater than $10bn. For U.S. based banks, the
approach that results in the lower capital ratio will be used as the binding constraint as
ruled by the Collins Amendment of the Dodd Frank Act. While the binding constraint
varies across the banks, generally the standardized approaches have become the more
restrictive of the two approaches (see Chart 116).

The Collins Amendment in the U.S. requires banks to use the lower of the
standardized or advanced ratios as the binding constraint.

As of 1Q18, there was an average difference of 80bp between a U.S. GSIB’s CET1 ratio
under advanced vs. under standardized. That said, many banks are now bound by the
standardized approach, driven mostly by balance sheet optimization and model
improvements.
Chart 116: CET1 Ratio, Standardized vs. Advanced (as of 1Q18)

16.0% 15.5%

12.7% 12.5% 11.8%

11.9% 12.2% 12.1% 12.1% 12.1% 11.7%
10.8% 11.1% 10.7%

MS WFC JPM C STT GS BK

Advanced CET1 Ratio (%) Standardiz ed CET1 Ratio (%)

Source: BofA Merrill Lynch Global Research, company data, SNL Financial

96 Global Banks and Brokers | 18 May 2018

Numerator definition: What defines CET1?
In the following sections, we walk through the different major components that
comprise common equity tier 1 (CET1).

Common shareholders' equity

This component of the formula is the most self-explanatory and includes common stock
and related surplus, as well as retained earnings. Other capital standards, like the
supplementary leverage ratio (SLR) includes additional tier 1 (e.g., preferred stock) or in
the case of TLAC (total loss absorbing capacity) includes additional tier 1 and qualifying
tier 2 capital in addition to other long term debt that is not regulatory capital. But, as
the name suggests, the CET1 ratio has the most stringent definition in the numerator of
the three prudential capital standards.

AOCI: A positive today, but with negative impacts as rates rise (U.S. banks)
While mostly relevant for U.S. based banks, accumulated other comprehensive income
(AOCI) is also included in the numerator. AOCI includes unrealized gains and losses on the
available-for-sale (AFS) securities portfolio. This inclusion applies to banks that are
considered “advanced approaches” by regulators. Institutions that are not under the
“advanced approaches” (those under $250bn in assets or $10bn in foreign exposure) can
make a one-time, permanent election to “opt out” of including AOCI in the calculation.

AOCI served as a boost to capital ratios as rates remained low, leading to an increase in
the value of banks’ bond portfolios. However, as long interest rates have risen, we have
seen the negative impact on capital as bond portfolios are marked lower through AOCI,
eroding unrealized gains as well as creating unrealized losses. These gains and losses
are added or subtracted from the numerator. We plotted Citi’s AOCI on a quarterly basis
from 2Q13 through 1Q18 against the average 10-year U.S. Treasury yield to show
readers the relationship between the two (see Chart 117).
Chart 117: Example: AOCI has benefited C’s regulatory capital in a declining rate backdrop
$4,000 3.0%

$2,000
2.5%
$0

($2,000) 2.0%

($4,000)
1.5%
($6,000)

($8,000) 1.0%
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16
1Q17
2Q17
3Q17
4Q17
1Q18

YoY change in AOCI ($mn, lhs) Avg. 10yr UST Yield (rhs)

Source: BofA Merrill Lynch Global Research, company data, Bloomberg

Investments in unconsolidated financial institutions

Outside of common equity, there are a few items that are not deducted from the
numerator (but included as part of RWA). However, each individual item listed below is
subject to a 10% limit of CET1, and the sum of these items cannot exceed 15% (see
Exhibit 35).
• Significant investments in unconsolidated financial institutions. Only
common equity tier 1 capital issued by depository institutions or foreign bank
subsidiary can count toward the numerator. CET1 issued by other types of
institutions (to note, CET1 issued by bank holding companies, or BHCs are excluded)
do not qualify as CET1 but could qualify as additional tier 1 capital.

Global Banks and Brokers | 18 May 2018 97

• Mortgage servicing rights. A portion of mortgage servicing assets (MSAs) can
count toward the calculation, net of associated deferred tax liabilities (DTLs).

• Deferred tax assets (DTAs), but only those arising from temporary differences.
DTAs that can be included in CET1 are those created, for example, from the timing
difference between reporting a provision for credit losses in an income statement and
actually charging off the associated loan. Of course, a handful of banks saw their DTAs
increase from this timing difference during the financial crisis. Allowable DTAs are those
that cannot be realized through net operating loss carrybacks. Additionally, these
allowed DTAs are net of any related valuation allowances (also incurred by a handful of
institutions, which wipes the DTA out of one’s equity base) and DTLs.
Exhibit 35: Limitations included in CET1

Deferred Tax Assets 10%

+
Minority Interest 10%

+
Mortgage Servicing Rights 10%

=
Aggregate 15%
Source: BofA Merrill Lynch Global Research, BCBS

Numerator deductions: Goodwill, deferred tax assets

The deductions that each bank must take are just as important to understand for
investors. The more stringent definition of the numerators makes sense – after all, there
are capital components that have no real loss-absorbing capacity in times of stress. The
following are deductions from CET1 (see Exhibit 36):
• Goodwill, net of associated DTLs;

• Defined benefit pension fund assets, again net of associated DTLs;

• Deferred tax assets created from operating losses and tax credit carry
forwards, net of associated DTLs.
Exhibit 36: CET1 Deductions

Deductions

Goodwill

Deferred Tax Assets

Defined Benefit Pension Assets

Other Intangibles (ex MSA)

Source: BofA Merrill Lynch Global Research, BCBS

98 Global Banks and Brokers | 18 May 2018

We walk through a “real world” (Citi) example of which DTAs qualify and which don’t in
the chart below, which talks about the deductions to CET1 (see Chart 118).
Chart 118: Citi’s DTA balance – Inclusions and exclusions in regulatory capital (as of 1Q18)
25.0 $23.0

20.0
(ex . tax credits,
DTA balance ($bn)

$12.0 Ex cluded from CET1

net operating
15.0
losses)

10.0
(ex . provision / Capped to 10% of
5.0 charge off timing) $11.0
CET1

0.0
DTA Balance

Temporary DTA Non-Temporary DTA

Source: BofA Merrill Lynch Global Research, company data

Numerator deductions: other common deductions

In Europe, other deductions are common place. Unrealized gains on certain cash flow
hedges are not allowable for capital purposes. As such, while unrealized gains are
included in book value, these are deducted from the CET1 numerator calculation. We
think this makes the European banks less susceptible to shifts in interest rates from a
capital perspective.

Other common deductions relate to investments in financial companies, of which the

most prevalent would be an investment in an insurance company. In the U.S. non-
significant investments in financial institutions are deducted when such instruments in
aggregate above 10% CET1 threshold. This reduces the amount of double leverage
allowable. For the universal banks, the regulators have also been making prudential
valuation deductions to bridge accounting deficiencies in the measurement of assets.

Denominator definition: Risk weighted assets

Below, we discuss the different components of risk weighted assets, under advanced
approaches: 1) credit risk; 2) market risk; and 3) operational risk. The composition
of RWAs for each bank is going to be dependent upon each institution’s business model
(see Chart 119).
Chart 119: Composition of risk-weighted assets by GSIB (as of 1Q18)
100%

80%

60%

40%

20%

0%
ICBC
WFC

BOC

CCB
ABC
ING

SocGen
GS
BK

Nordea

MUFG
BARC

HSBC
C

StanChart
RBC

BNP

DBK

RBS

UBS
JPM

Unicredit
STT
MS

CA

CS

Mizuho

SMFG
Santander

-20%

North America Europe Asia

Credit Risk Market Risk Operational Risk Floor adjustment

Source: BofA Merrill Lynch Global Research, company data, SNL Financial.

Global Banks and Brokers | 18 May 2018 99

1) Credit RWA: Lending, counterparty risk
Credit risk-weighted assets (RWAs) segments an institution’s credit exposures into risk
weightings. A lower RWA indicates a lower risk of default and/or a lower loss given
default. For example, under the standardized approach, prudently written residential
mortgage loans have a 50% risk weight. By contrast, also under the standardized
approach, a commercial loan (C&I) would have a risk weight of 100%. In other words,
under standardized, the net exposure for residential mortgages is 50c for every $1 of
exposure. For a commercial loan, it would be $1 for every $1.

Credit RWA is also assigned for non-loan assets, though this is calculated differently.
Examples include:
• “Vanilla” securities (U.S. Treasuries, U.S. government sponsored
entities/agency RMBS, publicly-sponsored entities, munis). RWAs assignations
are similar to loans. U.S. Treasuries have a 0% risk weight, U.S. GSEs/agency RMBS
have a 20% RWA, and U.S. PSEs/munis have a 20-50% RWA.

• Secured financing transactions. The RWA for SFTs are typically calculated based
on the underlying collateral, with a haircut. Counterparty type and tenor of the
transaction also factor into the risk weight.

• Asset- and mortgage-backed securities. RWAs are based not just on the quality
of the underlying assets, but on the structure of the security.

• Credit and other trading inventory. RWAs are calculated by multiplying the total
exposure with the PFE (or potential future exposure), which ranges between 0-20%.
PFE is determined by tenor, with the shortest tenor having the lowest multiplier
and the longest tenor having the highest multiplier. Every product has its own PFE,
scaled toward the perceived inherent risk of each. For example, currencies and gold
have a PFE range between 1-8%, while equity swaps have a PFE range of 6-10%.
Important to note that the PFE has a multiplier not a haircut effect. As such, the higher
the PFE, the riskier the asset. After calculating the PFE, the counterparty type is then
also taken into account to finalize the risk weight.

Note that European banks have historically retained residential mortgage exposure on-
balance sheet, whereas U.S. banks have sold qualifying conforming mortgages to U.S.
government-sponsored entities Fannie Mae and Freddie Mac. Holding low RWA loans
like retail mortgages can be advantageous to the CET1 calculation.

2) Market RWA: Capturing trading-related risk

Market RWA is more complicated than credit RWA and in March the BCBS published a
proposal. The calculation of market RWA is model based, and takes into account the
following (see Exhibit 37)
• Value-at-risk, or VaR

• Most recent measure of stressed VaR

• Incremental risk, which measures default and migration for non-securitized credit
products

• Comprehensive risk, which captures all price risk for correlation trading portfolios

• Specific risk add-ons, which takes into account the value and risk weighting of long
or short positions in debt, equity, and securitization products

100 Global Banks and Brokers | 18 May 2018

Exhibit 37: Market risk breakdown
Specific Risk
VAR + Stressed Var + Incremental Risk + Comp Risk + = Market RWA
Add-ons
Source: BofA Merrill Lynch Global Research, BCBS

3) Operational risk RWA

The inclusion of operational risk is added to market and credit risk in the calculation of
RWA related to the advanced approach. The Basel committee defines operational risk as
“the risk of loss resulting from inadequate or failed internal processes, people and
systems or from external events”. For example, larger-than-normal trading losses and
various large-ticket legal settlements in the industry (external events) would
theoretically lead to an increase in an institution’s op-risk RWAs.

Due to the qualitative nature of such activities, there had traditionally been few analyses
done in identifying and measuring such risk. However, following the financial crisis,
regulators have determined that credit and market risk were not entirely sufficient in
capturing the risks faced by financial institutions.

There have been three general sets of approaches in calculating operational risk: 1)
basic indicator approach based on total revenues, 2) standardized approach based on
business segment revenues, and 3) advanced measurement approaches based on a more
detailed internal risk framework of each bank. Banks are allowed to apply their own
definitions of operational risk after following a set of guidelines issued by the Basel
committee.

In the Dec. 2017 proposal, the BCBS also set forth a new standardized measurement
approach (SMA) for operational risk. First, the SMA allows national regulators to decide
whether to require institutions to include historical operational-risk losses in the
operational-risk capital calculations. The new SMA would also recognize three rather
than five business-size categories for measurement.

Putting it all together: An example calculation

We thought it would be helpful to provide an illustration of the various components of
the ratio to see how it all fits together. Below is the CET1 ratio for Citi as of 1Q18 (see
Exhibit 38).

Global Banks and Brokers | 18 May 2018 101

Exhibit 38: Citigroup CET1 breakdown (as of 1Q18, $ in millions)
Common Stockholders' Equity 182,943
+
Qualifying noncontrolling interests 140

(Less Regulatory Capital Adjustments and Deductions)

Accumulated net unrealized losses on cash flow hedges and

(1,418)
changes in fair value of financial liabilities
-
Goodwill and other intangible assets 26,691
-
Defined benefit pension plan net assets 871
-
DTAs from carryforwards 12,811
-
Excess over 10% / 15% DTAs, minority interest and MSRs 0
=
Total Common Equity Tier 1 Capital 144,128
÷
Risk-Weighted Assets (Basel III Standardized Approach) 1,195,981
=
Common Equity Tier 1 Capital ratio 12.1%
Source: BofA Merrill Lynch Global Research, company data

GSIB surcharges
The CET1 ratio is relatively consistent with historical measures of risk-adjusted capital
ratios, with of course refined and tightened standards. Since the global financial crisis,
regulators have been concerned about the impact that failure of one or more systemically
important financial institutions could have on the broader financial system. In an effort to
address the spillover risks of GSIB failure, the BCBS adopted an additional CET1 capital
surcharge for such banks. As mentioned, the 30 largest global banks are required to add a
CET1 surcharge in addition to the 4.5% minimum CET1 requirement and the 2.5% CET1
Capital Conservation Buffer.

Country variation: the U.S. includes short-term funding exposure in calculation

There is a global method for calculating the surcharge for all GSIBs. As with all rules,
local regulatory standards can be the binding constraint. In this case, U.S. regulators
have modified the calculation of the surcharge for its eight GSIBs. The primary
difference between the global, or Basel, method versus the U.S. method is that U.S.
regulators take into account exposure to short-term wholesale funding (STWF).

A U.S. bank holding company that is designated a GSIB under the established
methodology will be required, on an annual basis, to calculate a surcharge using two
methods (“method 1” and “method 2”) and will be subject to the higher of the two
surcharges.

The Method 1 framework, created by the BCBS, compares a bank’s activities grouped
into five categories of systemic importance, with the aggregate global figures of all
banks in a specified sample. Method 2 only applies to the eight U.S. GSIBs. This method
replaces “substitutability” (one of the five Method 1 categories) with “reliance on short-
term wholesale funding” and employs a fixed calculation approach.

Surcharge calculations tend to be backward looking by one year

Effective for 2017 and thereafter, the GSIB surcharges calculated under both method 1
and method 2 are based on measures of systemic importance from the prior year (e.g.,

102 Global Banks and Brokers | 18 May 2018

the method 1 and method 2 GSIB surcharges to be calculated by December 31, 2017
will be based on 2016 systemic indicator data).

Should a GSIB becomes subject to a higher surcharge, the higher surcharge would not
become effective for a full year (e.g., a higher surcharge calculated by December 31,
2017 would not become effective until January 1, 2019). However, if a GSIB’s score
would result in a lower surcharge, it would be subject to the lower surcharge beginning
the next calendar year (e.g., a lower surcharge calculated by December 31, 2017 would
become effective January 1, 2018).

How the Method 1 GSIB surcharge is determined

In order to determine each bank’s GSIB surcharge, the BCBS looks at a bank’s exposure
across five major categories:
• size

• inter-connectedness

• complexity

• cross-jurisdictional activity

• substitutability

The Method 1 calculation considers each bank’s exposure on a relative basis, with the
size of each GSIB compared to the size of the largest 75 banks globally. For example, if
industry growth is flat and a GSIB is growing above this level, its size indicator would
increase year over year. The converse is also true. We break down what comprises each
category below (see Exhibit 39).

Global Banks and Brokers | 18 May 2018 103

Exhibit 39: GSIB systemic indicator score key determinants Exhibit 40: List of GSIBs and Basel implied surcharge
Global Systemically Surcharge
• Total Leverage exposures (according Important Bank 2017 YoY
Size to SLR definitions) JP Morgan Chase 2.5% =
Citigroup ▼
Bank of America =
Proportional to Global Industry Aggregate

2.0%
Deutsche Bank =
• Intra-financial system assets
HSBC =
Interconnectedness • Intra-financial system liabilities
• Securities outstanding Bank of China ▲
Barclays =
BNP Paribas ▼
• Notional amount of OTC derivatives China Construction Bank ▲
• Trading and AFS securities
1.5%
Complexity Goldman Sachs =
(excluding HQLA)
• Level 3 Assets
ICBC =
Mitsubishi UFJ FG =
Wells Fargo =
Agricultural Bank of China =
Cross- • Cross-jurisdictional claims
Bank of New York Mellon =
Jurisdictional Activity • Cross-jurisdictional liabilities
Credit Suisse ▼
Groupe Crédit Agricole =
ING Bank =
• Payments Activity Mizuho FG =
Substitutability • Assets under custody Morgan Stanley =
• Underwriting activity
Nordea =
Royal Bank of Canada 1.0% new
Source: BofA Merrill Lynch Global Research, BCBS
AFS = available for sale. HQLA = high quality liquid assets Royal Bank of Scotland =
Santander =
Société Générale =
Standard Chartered =
State Street =
Sumitomo Mitsui FG =
UBS =
Unicredit Group =
Source: BofA Merrill Lynch Global Research, FSB, BCBS
As of November 2017

Sample Method 1 surcharge calculation: The JPM example

Using JPM in the analysis, we walk through a sample calculation of how the BCBS
calculates the surcharge for the 30 GSIBs (see Exhibit 41).

The score of each category is determined by taking JPM’s exposure in that category
(e.g., complexity), converting this into euro, and dividing it by the sum exposure of the
75 largest global banks. The scores across the five categories are then averaged. Once
averaged, this final score is compared to a schedule, which brackets a range that
corresponds to each institution’s CET1 surcharge. In this example, JPM’s score of 465
corresponds to a 2.5% surcharge.

104 Global Banks and Brokers | 18 May 2018

Exhibit 41: Sample GSIB determination and surcharge calculation by the BCBS (example: JPM) (as of 2017)
A B = A ÷ $1.05/€ C D=B÷C
Category Indicator USD in millions EUR converted Sum of 75 GSIBs (€) Score (bp) Average
Size Total exposures 3,252,348 3,085,426 75,900,828 407 407
Cross-jurisdictional claims 649,543 616,206 18,677,719 330
Cross-jurisdictional activity
Cross-jurisdictional liabilities 708,701 672,328 16,375,314 411 370 Method 1 score (bp) Surcharge
Intra-financial assets 309,068 293,206 7,834,153 374 < 130 0.0%
Interconnectedness Intra-financial liabilities 419,919 398,367 8,847,383 450 130 229 1.0%
Securities outstanding 675,653 640,976 13,337,073 481 435 230 329 1.5%
Assets under custody 23,263,058 22,069,119 139,936,012 1,577 330 429 2.0%
Substitutability Payments activity 287,828,840 273,056,484 2,156,973,532 1,266 430 529 2.5%
Underwriting activity 506,172 480,194 5,999,121 800 500 530 629 3.5%
≥ 630 4.0%
Notional OTC derivs 44,734,022 42,438,120 530,406,137 800
Complexity Level 3 assets 19,207 18,221 501,411 363
Trdg and AFS securities 244,246 231,710 3,441,947 673 612
Final GSIB score (average of category averages) 465
Source: BofA Merrill Lynch Global Research, company data (FR Y-15 filings), BCBS

How the U.S. surcharge is determined under Method 2

During the global financial crisis, many banks experienced difficulties due to inadequate
liquidity when adverse market conditions led to the evaporation of short-term funding
sources. U.S. regulators chose to include short-term wholesale funding component in
the GSIB surcharge because such funding sources are a key detriment of the impact of a
firm’s failure on financial stability. Increasing capital is likely to reduce the risk of
liquidity runs because capital helps maintain confidence in the firm among creditors and
counterparties. Accordingly, Method 2 replaces the “substitutability” category with
“reliance on short-term wholesale funding”.

As a reminder, substitutability looks at payments activity, underwriting activity, and

assets under custody. That said, if the surcharge determined under Method 1 is greater
than the surcharge determined under Method 2, that institution is bound by Method 1.
Among the U.S. GSIBs, the only two institutions where Method 1 had been relevant are
the trust banks BK and STT.

The U.S. GSIB surcharge took effect on January 1, 2016. The current surcharge is based on
the systemic indicator scores as of December 31, 2016 (includes the aggregate global
indicator amount, i.e., denominator) while the STWF score will be based upon the last
twelve month average of a bank’s risk weighted assets. For the surcharge calculated in
2017 and thereafter, GSIBs will compute their STWF score using average daily amounts.

Sample Method 2 surcharge calculation: The JPM example

Again using JPM in the analysis as an example, we walk through a sample calculation of
how the Fed calculates the U.S. GSIB surcharge under Method 2 (see Exhibit 42). The
scoring methodology is, for the most part, consistent with Method 1. In this example,
we calculate JPM’s score to be 711, which corresponds to a 3.5% surcharge. This is
based on exposures as of December 31, 2016, as year-end 2017 regulatory data used to
calculate this surcharge is not yet available.
Exhibit 42: Method 2 calculation by the Fed (example: JPM) (as of 2017)
A B C =Ax B Method 2 score (bp) Surcharge
Category Indicator Coefficient USD in millions Score (bp) Sum (bp) < 130 0.0%
Size Total exposures 4.34% 3,240 141 141 130 229 1.0%
Cross-jurisdictional claims 9.10% 647 59 230 329 1.5%
Cross-jurisdictional activity
Cross-jurisdictional liabilities 10.09% 698 70 129 330 429 2.0%
Intra-financial assets 13.31% 325 43 430 529 2.5%
Interconnectedness Intra-financial liabilities 11.96% 386 46 530 629 3.0%
Securities outstanding 8.60% 599 51 141 630 729 3.5%
Notional OTC derivs 0.18% 44,555 79 730 829 4.0%
Complexity Level 3 assets 170.78% 23 40 830 929 4.5%
Trdg and AFS securities 32.64% 263 86 205 930 1,029 5.0%
Short-term wholesale funding 95 1,030 1,129 5.5%
Final GSIB score (sum of categories) 711 ≥ 1,130 6.0%

Source: BofA Merrill Lynch Global Research, company data (FR Y-15 filings), Federal Reserve

Global Banks and Brokers | 18 May 2018 105

Accounting for short-term wholesale funding under Method 2
Determining short-term funding exposure is not as simple as looking at liabilities due
under a year vs. liabilities due in over a year. As shown in Exhibit 43, U.S. regulators look
at the collateral value securing the funding, the counterparty, and the remaining
maturity. For example, funding secured by a Level 1 asset (the definition of a Level 1
asset can be found in the section on the Liquidity Coverage Ratio) and remaining
maturity of 181-365 days has a 0% weight, and therefore doesn’t contribute to the
surcharge score. Conversely, unsecured wholesale funding where the counterparty is a
financial institution, and the remaining tenor is less than 30 days, the weight is 100% -
contributing dollar for dollar to the surcharge score.

Once each bank’s short-term wholesale funding (STWF) weighting is calculated, this
weighting is then divided by its last twelve month average risk-weighted assets then
multiplied by 350 (the fixed conversion factor).
Exhibit 43: Short-Term Wholesale Funding Weighting (STWF)
Remaining Remaining Remaining Remaining
Maturity of Maturity of Maturity of Maturity of
Component of short-term wholesale funding
30 days of 31 to 90 91 to 180 181 to 365
less days days days
Secured funding transaction secured by a level 1 liquid asset 25% 10% 0% 0%
Secured funding transaction secured by a level 2A liquid asset;
Unsecured wholesale funding where counterparty is not a financial entity;
Brokered deposits and brokered sweep deposits provided by a retail customer or counterparty; 50% 25% 10% 0%
Covered asset exchanges (level 1 liquid asset for a level 2A liquid asset);
Short positions (borrowed security: level 1 or level 2A liquid asset)
Secured funding transaction secured by a level 2B liquid asset;
75% 50% 25% 10%
Covered asset exchanges and short positions (other than those described above)
Unsecured wholesale funding where counterparty is a financial entity
100% 75% 50% 25%
Any other component of short-term wholesale funding
Source: Federal Reserve

Why understanding the exact surcharge score matters

Whether under Method 1 or Method 2, we believe understanding a GSIB’s score – and
where this falls in the range – is just as important as knowing its surcharge. Why is it
important to know? Bank management teams are often juggling reducing regulatory
burden, enhancing regulatory compliance, and growth opportunities.

Where a bank falls within a range can show investors how much, or how little, room
each bank has to grow its balance sheet/increase exposures before broaching the next
surcharge. Conversely, it can also show how far/close each institution is from lowering
their surcharge.

In examining where the biggest U.S. GSIBs fall at YE17, JPM and GS, are all at the
higher end of their ranges (see Exhibit 44). This suggests that these banks need to be
careful about growing exposures, and are likely closely considering the impact of a
higher GSIB surcharge. On the other hand, WFC and STT appear to be at the low end of
its range – implying potential for balance sheet growth.

106 Global Banks and Brokers | 18 May 2018

Exhibit 44: BofAMLe GSIB scores across the spectrum based on the Fed’s methodology (as of YE17)

Source: BofA Merrill Lynch Global Research, company data, Federal Reserve

European CET1 requirements: SREP

The ECB’s supervisory review and evaluation process (SREP) sets the minimum
transitional and fully loaded capital levels that banks must reach each year. In all cases,
this is above the Basel requirements. We would therefore characterize the SREP process
as reflecting the pillar 1 and pillar 2 requirements for ECB-regulated banks.

During 2016, the ECB changed the way it looks at the pillar 2 element of RWA. This was
partly to make the additional tier 1 market more stable.

The pillar 2 element of the requirement is now split into two parts:
• Pillar 2 requirement (P2R)

• Pillar 2 guidance (P2G)

Pillar 2 requirement
This element is a mandatory requirement and is used to address risks not captured in
pillar 1. This is the level that is key for banks’ maximum distributable amounts (MDA)
which informs whether banks may pay dividends to shareholders or AT1 holders. This
element is disclosed by the banks.

Pillar 2 guidance
This element is an additional buffer that banks are expected to meet. Falling below this
level (but above the pillar 2 requirement) has no effect on the banks’ ability to pay AT1
dividends and reduced legal action. This element does not have to be disclosed, but a
small number of EU banks have chosen to disclose.

While the term “guidance” may imply that this is optional in some way, the ECB has
been clear that it expects the banks to comply with the pillar 2 guidance.

“…for an individual bank with a 2016 Pillar 2 requirement (P2R) of 11%, after this
clarification, all other things being equal, it may have a P2R of 10% and a Pillar 2
guidance (P2G) of 1%. But, as only the P2Rs are published (because they are
relevant for calculating the maximum distribution amount for dividends and
coupons), it looked as if “the capital demand” (P2R +P2G) had been reduced, from
11% to 10% in my example. But this is not correct; we still expect banks to
comply with the Pillar 2 guidance as well. So it may look like it is decreasing, but
it’s not.” – SSM Chair Danièle Nouy, interview with La Repubblica 30 January
2017

A bank breaching the pillar 2 guidance level of capital could result in increased non-
public supervisory action to improve its capital levels.

Global Banks and Brokers | 18 May 2018 107

Below, we show three banks that have already disclosed their Pillar 2 Guidance and what
difference this makes to the total CET1/RWA requirement. We show the pillar 2 level
guidance as a blended bar on a fully loaded basis, as it is unknown whether this will
reduce through time to reflect:

1. Higher buffers elsewhere (e.g. as GSIB increases, SREP may reduce)

2. Higher RWA as a result of other Basel initiatives or the ECB’s TRIM project (see
below)

Chart 120: Fully loaded capital requirements

14%
Minimum* GSIB Countercyclical P2R P2G**
12% 1.66% 2.25%
1.00%
10% 1.75%
1.75%
0.15% 3.45%
0.15%
8% 2.00% 1.50%

6%

4%
7% 7% 7%
2%

0%
Erste Bank KBC Permanent TSB
Source: Company data, BofA Merrill Lynch Global Research. Note: * Minimum includes 4.5% minimum + 2.5% Capital conservation buffer. **
Pillar 2 G may or may not reduce by 2019

ECB’s TRIM project

Separate to the Basel review of the risk weights, the ECB is conducting its own
Targeted Review of Internal Models, called TRIM for short. There does appear to be
some overlap of objective.

TRIM aims to assess whether the internal models currently used by banks comply with
regulatory requirements and whether they are reliable and comparable. The ECB has
inherited supervision of the Eurozone’s major banks from a larger number of national
regulators. New internal models require the approval of the regulator. With a new
regulator, it therefore seems logical that the ECB wants to check what it inherited and
that the models currently in use are fit for purpose.

The key differences we can see versus the Basel 4 measures are:
• Basel 4 penalizes low-risk lending by imposing a floor

• TRIM appears to focus on higher risk books first

Timing
TRIM is expected to last through 2019, although given the objectives of the project, it
does seem reasonable to assume that this is a one-off project.

Some studies by the EBA have in the past shown that a large proportion of the
variability in risk weights from individual banks has been explained by historical losses.
I.e., quite often the different risk weights the banks use can be explained by different
risk levels.

Some Irish banks have signaled some first round effects of the TRIM project with higher
RWA in 2016-2018.

108 Global Banks and Brokers | 18 May 2018

Not aiming for overall capital increase…but is a likely side-effect
Similar to the Basel committee’s language around the Basel 4 changes, it does not set
out to put more capital into the system, see quote below. However, if banks with
relatively high risk weights are being asked to increase risk weights, then it could
indicate RWA inflation across the European banking sector.

“It is important to note that while the project aims to reduce unwarranted
variability in RWAs across banks, a general increase in RWAs is not the intention.
Nevertheless, TRIM could result in increases or decreases in capital needs for
individual banks.” – ECB

Strategic impact: What products does CET1 affect most?

Most of the banks we talk about in this piece are large universal banks, and therefore
have diverse business models. However, we thought it would be value-added to show
investors which products would be considered more valuable (defensible standalone
returns) and less valuable (lowered standalone returns) to offer clients if CET1 was the
sole binding constraint (see table 8).

Obviously, banks have to be compliant across six broad pieces of prudential regulation,
and also, there are some products (e.g., wealth management, etc.) that are universally
more valuable across all constraints.
Table 8: More and less valuable products under an RWA constraint
CET1: More Valuable Products CET1: Less Valuable Products
Electronic/agency trading Equity/fixed income derivatives
Wealth management Securitized products
Asset Management HY credit products
Advisory business Commodities
Payments business Mortgage servicing rights
Futures clearing Non agency MBS
Rates Higher risk loans
Repo (collateral dependent)
Agency MBS

Source: BofA Merrill Lynch Global Research

Surcharge impact: Products impacted

Equally as important, we thought it would also be prudent to include this table for the
surcharge, which would include more products to consider.
Table 9: More and less valuable products under an surcharge constraint
Surcharge: More Valuable Products Surcharge: Less Valuable Products
Retail deposits Financial institution deposits
Operational corporate deposits OTC derivatives
Trading inventory
Credit & equity derivatives
Short-term borrowings
Secured financing transactions

Source: BofA Merrill Lynch Global Research

Supplementary Leverage Ratio (SLR)

The supplementary leverage ratio (SLR, also known as the Basel 3 leverage ratio, or LR)
requires banks to hold capital against gross balance sheet exposure and certain off-
balance sheet items. This capital rule is designed to restrict the build-up of leverage in
the banking sector and to set capital requirements without accounting for the riskiness
of the asset. In other words, unlike CET1, SLR is risk insensitive.

Global Banks and Brokers | 18 May 2018 109

The Basel minimum standard is set at 3%. However, country-level standards are
typically the binding constraint for each institution, and currently, there is meaningful
variance between certain countries.

Countries with the highest minimums, of 5%, include: U.S. and Switzerland.
Meanwhile, countries with the lowest minimums include: some countries in the EU,
Japan, and Canada.

China is at a 4% minimum, while the UK requires a 3.25% minimum + 35% of the GSIB
surcharge. Many countries within the EU also require an additional leverage ratio
minimum for banks which are considered domestic-systemically important banks
(DSIBs): e.g., Netherlands at 4%.

This differential across local regulators is important to note as varying SLR

minimums could introduce the idea of “regulatory arbitrage.” In other words,
dissimilar standards could cause institutions with lower requirements to be more
aggressive with balance sheet growth than banks domiciled in higher-requirement
countries. This competitive dynamic could especially play out in the Markets
(trading) business, in our view.

Conversely, unlike with CET1, there are a handful of banks that are still below their
future, Basel 4 fully-loaded minimums, such as DBK and the Swiss banks (although we
note the Swiss are now above the 3.5% CET1 leverage ratio they are also held to). While
each bank has until 2022 to comply, this current shortfall nevertheless informs current
plans, as has been evidenced in recent years and months. As such, we think this
particular rule will continue to have measurable impact on market share dynamics in
trading, with institutions holding excess SLR relative to local rules best positioned to
consolidate market share.
Chart 121: North American GSIBs Chart 122: European GSIBs Chart 123: Asian GSIBs

StanChart
WFC ICBC
RBS
C HSBC
CCB
Unicredit
JPM Santander
BOC
Nordea
MS
BARC
ABC
UBS
STT
CS
MUFG
BK ING
CA
SMFG
GS SocGen
BNP
RBC Mizuho
DBK
0.0% 5.0% 10.0% 0.0% 2.0% 4.0% 6.0% 8.0% 0.0% 2.0% 4.0% 6.0% 8.0%

1Q18 1Q17 1Q18 1Q17 1Q18 1Q17

Source: company data Source: company data Source: company data

110 Global Banks and Brokers | 18 May 2018

The basics: How SLR is calculated
SLR is calculated by taking a bank’s tier 1 capital (numerator) and dividing it by its total
leverage exposure (denominator), which includes all on-balance sheet assets and many
off-balance sheet exposures (see Exhibit 45). Below, we walk through the basics.

Numerator: CET1 capital + additional tier 1

The numerator calculation for SLR is fairly simple. The numerator comprises of common
equity tier 1 capital (please refer to our discussion on the components of CET1 on page
13) and additional tier 1 capital.

Regional differences on allowable additional tier 1

Additional tier 1 capital definitions differ between the U.S. and Europe. In the U.S.,
additional capital includes non-cumulative preferred stock and qualifying minority
interests. Impacted U.S. banks currently hold $111.2bn in preferred stock.

In Europe, non-cumulative prefs are disallowed. Instead, new permanent contingent

convertible debt is used. These instruments “trigger” on a going-concern basis when the
bank breaches a certain level of CET1 capital (usually set at either 5.125% or 7% of
RWA). At that stage, the bonds either convert to equity or are written down. UK and
Switzerland regulations have stipulated that additional tier 1 instruments should have a
“high-trigger” and convert at 7% CET1/RWA.
Exhibit 45: Leverage ratio formula breakdown

Numerator Denominator

On B/S assets
+
Off B/S derivatives
Common Equity Tier 1 exposures
+
Off B/S securities financing
transaction
+ +
Off B/S unfunded lending
commitments
Additional Tier 1 Capital +
Off B/S standby letters of
credit
= =
Basel III Tier 1 Capital ÷ Total Leverage Exposure
=
Leverage Ratio
Source: BofA Merrill Lynch Global Research, Financial Stability Board, Federal Reserve

Denominator: Exposure includes on- and off-B/S assets

The calculation of the leverage exposure is much more complicated. It is broken down
into four major categories: 1) on-balance sheet assets, 2) derivative exposures; 3)
repo-style transaction exposures; and 4) other off-balance sheet exposures.
After observing this breakdown, it is easy to see why this rule is particularly constraining
to a Markets business. We break out the different off balance sheet components below
(see Exhibit 46, Exhibit 47, and Exhibit 48).

Global Banks and Brokers | 18 May 2018 111

This said, the standards below are under the current Basel standards. In later sections,
we discuss a recently unveiled Basel proposal revising the calculation of derivatives
exposure.

Summary of included derivative exposures

Exhibit 46: Key Derivative Exposure Items
BCBS Denominator
Derivative Exposure Derivative Term Definition Role in Leverage Ratio Denominator

Derivative Assets Mark to market value of derivatives less collateral received and Included as reported under US SLR, under
On Balance Sheet Exposures
(GAAP) enforceable counterparty netting agreements BCBS ex netting collateral

Collateral pledged for written derivatives for the event of a

Collateral Gross-Up Posted Collateral Is added back/grossed up under BCBS
default
Sold CDS exposure at notional value under
Derivative Notional Value of a derivative's underlying asset at the current price
BCBS
Net Potential Future The potential future loss for each derivative contract to which Net PFE = (40% * Gross PFE) + (60% * Gross
Exposure (PFE) the banking organization is a counterparty, calculated with CEM PFE * Net to Gross Ratio)
Current Exposure Framework for estimating PFE from multiplying notional values Framework for calculating Gross PFE under US
Net Potential Future Exposure Method (CEM) times a credit conversion factor that reflects the risk profile SLR and BCBS
(add-on) Credit Conversion Factor applied to contractual amount to calculate exposure of Applied to derivative notionals and unfunded
Factor (CCF) an off-balance sheet item lending commitments
Net to Gross Ratio GAAP On BS Derivatives plus collateral posted divided by
Ratio used to net 60% of gross PFE
(NGR) gross derivatives, calculated at a netting set level (undisclosed)
Master Netting An agreement that creates a legal obligation for all transactions Most are allowed under US SLR, BCBS is more
Agreement (MNA) covered upon an event of default particular with SFT netting
Provides protection on IG or HY Bonds, most common Written CDs included at notional under BCBS, at
Written Credit Derivatives Credit Derivatives
example is a Credit Default Swap notional x 5-10% under US
Source: BofA Merrill Lynch Global Research, Financial Stability Board, Federal Reserve
Note: written CDS also at notional

Summary of security financing transactions (SFT) exposures

Exhibit 47: Key Security Financing Transactions (SFT) Items
BCBS Denominator
Security Financing
Transaction Exposure SFT Term Definition Role in Leverage Ratio Denominator

Net value of SFT, allows netting of certain collateral and master Included as reported under US SLR, included ex
On Balance Sheet Exposures SFT (GAAP)
netting agreement netting under BCBS

Collateral Financial collateral given/received to/from lender/borrower in Remove the value of securities received &
Posted/Received exchange for security recognized as an asset by transferor
Netted SFT under GAAP
Master Netting Netting agreements enforceable in the event of a default or a
Netting disallowed under BCBS
Agreement (MNA) legal judgment

Maximum of 0 total fair value of the securities and cash lent to Included under BCBS using current exposure
Counterparty Exposure Counterparty Exposure
the counterparty minus cash and securities received with no add on

Agent in SFT Included under BCBS as difference btwn value

Agency Exposure An agent holds the collateral for the lender in an SFT
Transaction of the security & collateral provided

Source: BofA Merrill Lynch Global Research, Financial Stability Board, Federal Reserve
Note: Only cash netting under certain conditions can occur

112 Global Banks and Brokers | 18 May 2018

Summary of unfunded commitment exposures
Exhibit 48: Key Unfunded lending commitment items
BCBS Denominator
Unfunded Commitment
Exposure Term Definition Role in Leverage Ratio Denominator

Legally Binding The unused portions of commitments to extend credit that,

Legally Binding Unfunded
Unfunded Lending when funded, would be reportable as loans, includes most Included at a 100% Credit Conversion Factor
Lending Commitments (ULCs)
Commitments lending purposes/loan buckets except cards

Unconditionally Cancellable The unused portions of commitments to extend credit that,

Cancellable Unfunded
Unfunded Lending when funded, would be reportable as loans, includes credit Included at a 10% Credit Conversion Factor
Lending Commitments
Commitments (ULCs) card loans, most other loans are uncancellable

Obligation to pay a 3rd-party beneficiary when a customer fails

Standby Letters of Credit Included at a 100% Credit Conversion Factor,
Standby LOCs to repay an outstanding loan or debt instrument, can also be for
(LOC) sometimes at 10% if conditional (but rare)
a contractual non-financial obligation

Source: BofA Merrill Lynch Global Research, Financial Stability Board, Federal Reserve

Differences between U.S. and Basel leverage exposure

The U.S. leverage exposure definition varies from Basel for certain components. The
chart below summarizes these differences (see Exhibit 49).
Exhibit 49: Leverage ratio differences between U.S. vs. Basel with respect to exposure calculation
Leverage Ratio (US vs Basel)
US Final Rule Basel Rule
On-balance sheet Include balance sheet carrying value of all on- Include all balance sheet assets and collateral
assets balance sheet assets relating to derivatives and repo-style transactions
Cash variation margin generally not included Cash variation margin generally not included unless
unless certain conditions are met certain conditions are met
Generally does not permit collateral to reduce Total Cannot reduce Exposure Measure by collateral
Derivative
Leverage Exposure received from the counterparty
Exposure
Derivatives subject to an eligible bilateral netting
Derivatives subject to an eligible bilateral netting
contract is adjusted to reflect sum of PFE amounts
contract is calculated similarly to Basel rules
subject to netting
Include PFE amount for each derivative transaction
Current Exposure Includes replacement cost plus potential future
calculated using the CEM without regard to the
Method exposure with adjustments for certain collateral
recognition of eligible collateral
Settlement system must not require all securities
Permits regulatory netting of repo transactions if
transactions to settle before settling any net cash
certain conditions are met
obligations
Repo-style
Exclude collateral where the securities lender does Exclude collateral where the securities lender does
Transactions
not use the security to further leverage itself not use the security to further leverage itself
Include counterparty credit risk to capture a bank's Include counterparty credit risk to capture a bank's
exposure exposure

Other Off-B/S Uses a "standardized approach" for converting into Can apply the lower of two applicable CCFs to
Exposures RWAs rather than the uniform 100% CCF method provide a sommitment on an off balance sheet item

Source: BofA Merrill Lynch Research, Federal Reserve, BCBS

Global Banks and Brokers | 18 May 2018 113

Putting it all together: An example
Below, we walk through a sample calculation of holding-company level SLR for Citigroup
(see Exhibit 50):
Exhibit 50: Supplementary leverage ratio calculation (sample: Citigroup; $ in mn) (as of 1Q18)

Tier 1 Capital $163,490

÷ ÷
On-balance sheet assets $1,904,223
+ +
Potential future exposure on
$190,824
derivative contracts
+ +
Effective notional of sold credit
$51,006
derivatives, net
+ +
Counterparty credit risk for repo-
$26,673
style transactions
+ +
Unconditionally cancellable
$68,240
commitments
+ +
Other off-balance sheet exposures $237,272
- -
Tier 1 Capital deductions $41,421
= =
Supplementary Leverage ratio 6.7%
Source: company data

Standards for institutions: Country specific, big differences

The Basel minimum for SLR used to be a flat 3%, but the December 2017 reforms
added a GSIB buffer to the leverage ratio. One of the most stringent appears to be the
U.S. standard, which requires the holding company to maintain a 3% minimum, with an
additional 2% buffer. In other words, a 5% minimum requirement.

Switzerland mirrors the U.S. hold co minimum of 5%. The majority of the EU currently
has a 3% minimum but is likely to follow the Basel 4 reform of adding a GSIB surcharge.
The UK requires an additional buffer equivalent to 35% of the GSIB surcharge.

Since January 2015, banks have been required to disclose their leverage ratios, but are
not required to comply with the rule until January 1, 2018. In the case of the Swiss
banks, the compliance date is January 1, 2020. That said, the implications of the
framework are being felt today, as banks adjust their business models.

Leverage add-on for G-SIBs

As part of the Basel 4 reform, the committee also mandated a leverage ratio add-on for
the G-SIBs. The add-on is on top of the 3% minimum tier 1 leverage ratio that Basel set
originally. We note that the US, UK and Switzerland have already created their own add-
ons. Switzerland and US tier 1 leverage minimums (SLR in the US) are 5% at group
level. While in the UK, the Bank of England requires that banks add on 35% of the RWA
G-SIB buffer. This must be held in CET1.

114 Global Banks and Brokers | 18 May 2018

The new Basel 4 rule states that the leverage add-on for G-SIBs should be 50% of the
RWA add-on. In our view, this only has a material impact on Deutsche Bank. In theory, the
tier 1 leverage minimum at Barclays also increases from the 3.7% level, but given 1) this is
a 5bp increase and 2) Barclays is comfortably above this level at 4.4% (see Table 10).
Table 10: Basel 4 leverage add-on is only an issue for Deutsche Bank: selected G-SIBs (as of 1Q18)
B4 G-SIB Current Current tier
GSIB RWA B3 3% lev leverage B4 lev local 1 leverage
add-on minimum add-on minimum minimum ratio
JPM 2.5% 3% 1.3% 4.3% 5.0% 6.6%

Bank of America 2.0% 3% 1.0% 4.0% 5.0% 7.1%

Citigroup 2.0% 3% 1.0% 4.0% 5.0% 7.1%
Deutsche Bank 2.0% 3% 1.0% 4.0% 3.0% 3.8%

Barclay s 1.5% 3% 0.8% 3.75% 3.7% 4.4%

Goldman Sachs 1.5% 3% 0.8% 3.75% 5.0% 6.1%
Wells Fargo 1.5% 3% 0.8% 3.75% 5.0% 7.9%

Credit Suisse 1.0% 3% 0.5% 3.5% 5.0% 5.2%

Morgan Stanley 1.0% 3% 0.5% 3.5% 5.0% 6.5%
UBS 1.0% 3% 0.5% 3.5% 5.0% 4.7%
Source: FSB, BofA Merrill Lynch Global Research

UK leverage ratio excludes central bank cash

The UK leverage ratio was amended to exclude qualifying exposures to central banks.

It is measured in both average (of end of each month for each quarter) and end of each
quarter. The minimum in the UK is set as 3.25% minimum pillar 1 plus 35% of the GSIB
RWA buffer, plus the countercyclical buffer. For BARC this is equal to 3.975% on a fully-
loaded basis (1st January 2019 in the UK). The GSIB and countercyclical buffer must be
held in CET1, plus 75% of the minimum. Again, for BARC this means a minimum
CET1/leverage ratio of 3.16%.

U.S. standards: Bank subsidiary minimum unique to country

Final leverage rules in the U.S. were published in September 2014 (see Exhibit 51). As
mentioned, for U.S. banks with $700bn or more in consolidated assets or $10tn or more
in assets under custody (AUC), the holding company minimum is 3% of leverage
exposure, plus a 2% buffer.
Exhibit 51: Leverage ratio differences between U.S. vs. Basel with respect to applicability
Leverage Ratio (US vs Basel)
US Final Rule Basel Rule
eSLR: Banks with $700bn or more in total
consolidated assets or $10tn or more in AUC
Applicability SLR: Banks with $250bn or more in total Applies to internationally active banks
consolidated assets or $10bn or more in foreign
exposures
3% for "advanced approaches banking
Minimum
organizations" 3% Minimum
Requirement
5% for Holdco and 6% for bank sub
Off-balance sheet exposure is reported as the
Frequency of Calculation is the average of the three month-end
average of the month-end balances for the
Calculation leverage ratios over a quarter
reporting quarter.
Implementation/ Minimum requirement: Jan 1, 2018 Minimum requirement: Jan 1, 2018
Disclosure Public disclosure: Jan 1, 2015 Public disclosure: Jan 1, 2015
Ratio Tier 1 Capital / Total Leverage Exposure Tier 1 Capital / Exposure Measure
Source: BofA Merrill Lynch Research, Federal Reserve, BCBS
Note: Frequency of calculation for U.S. Final Rule excludes applicable Tier 1 Capital Deductions

Global Banks and Brokers | 18 May 2018 115

EU standards: “Blunt” leverage standard a major shift
Previous to the leverage rule, the banks had been able to inflate balance sheets with low
risk assets with a very small amount of additional capital needed. As long as wholesale
markets were open to fund these assets then there was no problem.

The introduction of a “blunt” leverage ratio in Basel 3 signaled a major change for the
large European wholesale banks. It has significantly changed the economics of many
“normal” banking products as well as the more naturally leverage-intensive products
within an investment bank.

While no longer a new concept in Europe, implementation has been slow and some
banks remain below fully-loaded minimums. With return on assets generally lower in
Europe (largely reflecting the lower risk on EU balance sheets) it has been significantly
more difficult for banks to adjust to this new reality.

The European Union has so far proposed a 3% leverage ratio minimum although many
banks and some national regulators have imposed higher minimums. Given the
requirements around pillar 2, the majority of banks within the EU are in any case
constrained on RWA rather than leverage.

The methodology differs to that of the Basel requirements slightly, but importantly
allows banks to calculate it using the period-end exposures rather than the three-month
average. In line with Basel requirements, the ratio has been disclosed since 2015.

We would also note that Europe and Basel look set to form additional leverage ratio
requirement for GSIBs once there is international agreement.

UK: Rules finalized for some time

UK rules are much more progressed with a clear ruling made in December 2014. Banks
are required to have a minimum of 3.25% plus 35% of the GSIB RWA buffer. AT1
issuance can make up a maximum of 25% of the 3.25% minimum (i.e., 0.81%) but 100%
of the buffers must be CET1. This means for the systemically important banks, the
minimum Tier 1 requirement is 3.6-4.125%, of which 2.79-3.32% must be CET1.

Switzerland: Final rule also active for some time

In October 2015, Switzerland made significant changes to the too-big-to-fail regime
with increased leverage ratios and RWA ratios. These changes aligned Switzerland with
other global rules and definitions, introducing a difference between tier 1 and tier 2
instruments rather than the former high-trigger and low-trigger definitions.

Large Swiss banks (UBS and CS) will be required to reach a 3.5% CET1/leverage ratio
and a 5% tier 1/leverage ratio

On a RWA basis, banks will still need 10% CET1, but an extra 4.3% of additional tier 1.

TLAC requirements come on top, with both banks needing 2x their tier 1 requirements,
i.e., 10% of leverage, or 28.6% on RWA.

Swiss regulators indicated that there would be penalties (i.e., increased requirements)
for banks that expanded aggressively or became more complex. Similarly, there may be
a benefit in the form of lower TLAC requirements if they become simpler or smaller.

We understand that the 5% minimum tier 1 leverage ratio is effectively a true minimum
of 3%, plus a 2% buffer. Additionally, the 3% must be CET1. On RWA, an 8% minimum
has a 6% buffer added to it to get to the 14% Tier 1 requirement. If banks dip into the
buffer, then they must inform the regulator on what steps they are taking to re-
establish it.

116 Global Banks and Brokers | 18 May 2018

Chart 124: Swiss too-big-to-fail rules: old versus new regime
30%

25%

20%

15%

10%

5%

0%
Old New Old New
Leverage RWA

CET1 High-trigger AT1 Bail-in instruments High-trigger (T1/T2) Low-trigger (T1/T2)

Source: FINMA

Asia: Chinese minimums in place, Japanese rules in flux

For China based banks, the minimum leverage ratio requirement is 4%. Moreover,
compliance for GSIBs started in April 1, 2015, while other China banks need to comply
by the end of 2016. In Japan, domestic regulators are anticipated to decide more exact
definitions and standards in 2018, but expected to apply it in-line with the Basel
timeline.

Impacted products and businesses: Binding for markets

As mentioned, the leverage rules are especially constraining to a universal bank’s trading
business on a standalone basis. Banks are bound by a notional and risk insensitive
approach under this method. Hence, products that have traditionally consumed material
balance sheet like secured financing/prime brokerage (repo), fixed income, and equity
derivatives are particularly negatively impacted (see Table 11).

As a result, even banks with excess SLR have a reduced ability to retain inventory to
facilitate client activity. As we discuss in the “The benefits and costs of regulation”
section, this has and will continue to have a lasting negative impact on secondary
market liquidity. While competitive factors have precluded GSIBs from fully passing this
on to their clients, we think investors nonetheless have and will likely continue to see
higher costs to transact.
Table 11: More and less valuable products under leverage ratio
Leverage Ratio: More Valuable Products Leverage Ratio: Less Valuable Products
Electronic/agency trading Equity / FICC derivatives
Wealth Management Prime Brokerage
Asset Management Rates
Advisory Repo
Payments IG Credit products
Futures clearing Commodities financing
High yield / distressed credit Unfunded lending commitments
Financial deposits

Source: BofA Merrill Lynch Global Research

Global Banks and Brokers | 18 May 2018 117

Total loss absorbing capacity (TLAC)
The final capital requirement we discuss, is aimed at tackling resolution in the event of
failure. TLAC is designed to ensure that financial institutions have an adequate mix of
liabilities and equity to cover potential losses in the event of failure in a way that avoids
the use of taxpayer funds – preventing systemic disruption to the financial system.
TLAC requires additional “bail-in-able” capacity in the form of qualifying unsecured debt
that can be written down or converted into equity during the resolution of a GSIB
without disrupting the critical functions of the firm. In other words, qualifying debt
would serve as an extra buffer in the event of resolution, incremental to CET1 and Tier 1
capital.

In November 2015, the Financial Stability Board (FSB) issued its final rules for Total
Loss Absorbing Capacity (TLAC). In December 2016, the Federal Reserve Board finalized
the TLAC framework in the U.S.

Unlike with funding regulation, institutions with significant deposit funding fare the
worst under TLAC.
Chart 125: United States GSIBs Chart 126: European GSIBs Chart 127: Switzerland GSIBs
60% 40% 9.2%
35%
50% 9.0%
30%

TLAC % of Leverage
TLAC % of RWA

40% 25% 8.8%

TLAC % of RWA

20%
30%
15%
8.6%

10%
20% 8.4%
5%
10% 0% 8.2%
ING
SocGen
Nordea
BARC
HSBC
StanChart
DBK
RBS

BNP
CA

Santander

0% 8.0%
MS GS BK C JPM WFC STT UBS CS

Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research, company data Source: BofA Merrill Lynch Global Research, company data
Note: BofAMLe using publicly available data (as of 1Q18) Note: Data as of 1Q18 Note: Data as of 1Q18

Standards for large institutions: Multi-layered

As with other prudential regulatory rules, standards vary by jurisdiction. We walk through
the global standards below, as well as on a regional/country level where differences
exist between the local requirements and Basel.

Global rules: External TLAC/RWAs final as of November 2016

The final global rule requires TLAC to comprise 18% of RWA (plus buffers) and at least
6.75% of total leverage exposure (as defined by SLR) by January 1, 2022. Qualifying
TLAC includes eligible unsecured debt (includes Tier 2 subordinated debt), preferred
stock/additional tier 1 (AT1), and CET1 in the numerator (see Exhibit 52).
Exhibit 52: Total loss absorbing capacity formula

+ Unsecured + Preferred + CET1 = TLAC

Debt Stock/AT1 Capital
Source: BofA Merrill Lynch Global Research, Federal Reserve

118 Global Banks and Brokers | 18 May 2018

• Qualifying unsecured debt includes unsecured senior and subordinated debt
issued by the parent holding company with at least one year remaining until
maturity (see Exhibit 53).

• Subordinated debt is defined as qualifying debt that absorbs losses prior to

“excluded liabilities” in insolvency, and must be subordinate to excluded liabilities.

• Preferred stock/AT1, similarly, qualifies as TLAC capital in whole (any

deductions/adjustments are reflected). To help ensure that there are sufficient
resources available in the event of a resolution, TLAC capital that is not CET1 or
preferred stock/AT1 must constitute at least 33% of the TLAC requirement. This
means that no more than 67% of the TLAC requirement can be met with CET1 and
preferred stock/AT1 alone.

• CET1 included in TLAC is calculated as previously illustrated in this report,

excluding GSIB and conservation buffers.

• Liabilities excluded from TLAC include insured deposits, derivatives or

instruments with derivative linked features, tax liabilities, or liabilities that cannot
be effectively written-down or converted into equity.

Exhibit 53: Components of TLAC

Components of TLAC
Unsecured senior and subordinated debt not
Qualifying unsecured debt subject to netting rights, with >1yr remaining until
maturity
Qualifying debt that is subordinate to excluded
Subordinated debt
liabilities
Must not constitute more than 2/3 of TLAC
Preferred stock/AT1
requirement with preferred stock/AT1 and CET1
CET1 included in TLAC Excludes GSIB and consservation buffers
Includes insured deposits, derivatives, tax
Liabilities excluded from TLAC liabilities, other liabilities that can be converted to
equity
Source: BofA Merrill Lynch Global Research, Federal Reserve

TLAC rules at the individual country level will also need to distinguish which legal entity
must hold TLAC-eligible capacity, an important discussion for banks without a U.S.-style
holding company structure.

As with the other rules, there is a phase-in period to compliance. Global banks must
meet a minimum ratio of at least 16% of RWA and a Leverage requirement of at least
6% by 2019 (see Exhibit 54). Emerging market GSIBs will have additional time to
comply, with a required TLAC/RWA ratio of 16% (and 6% TLAC/Leverage exposure) by
January 1, 2025 and a full compliance by 2028.

Global Banks and Brokers | 18 May 2018 119

Exhibit 54: Phase-in to compliance under FSB's TLAC global standard
RWA Leverage

2019 16% of RWA 6% of Leverage Exposure

2022 18% of RWA 6.75% of Leverage Exposure

Source: BofA Merrill Lynch Global Research, FSB

Global external vs. internal proposed requirements

The holding company TLAC would be considered the “external” TLAC requirement by
regulators. In addition, the proposal also includes “internal” TLAC requirements. The
internal requirements would require for each foreign “material subsidiary” of a GSIB
that is not a resolution entity to maintain a minimum of 75-90% of the external TLAC
requirement that would apply if the subsidiary were a stand-alone entity. The internal
requirements are meant to diminish any incentives to ring-fence assets domestically,
and to ensure that foreign companies will have enough loss absorbing capacity outside
in foreign jurisdictions where they have a material presence.

For example, if Bank X based in the U.S. were to have a subsidiary of material size in
Brazil, the Brazilian government would not have to worry that Bank X has kept all loss
absorbing assets in their home country, allowing their Brazilian subsidiary to dissolve
without absorbing any losses.

U.S.: A more complex final TLAC rule, explained

U.S. regulators finalized three requirements related to TLAC regulation: 1) a long-term
debt (LTD) requirement (filled only with LTD); 2) an external TLAC requirement (filled
with LTD, CET1 and AT1 capital), similar with Basel, coupled with; 3) an external TLAC
buffer (filled only with CET1 or Tier 1 capital) which goes on top of the external total
TLAC requirement. In the U.S final rule, the Fed estimates the aggregate TLAC shortfall for
the U.S. GSIBs at $70bn as of 3Q16.

The U.S final requirement sets out two minimum ratios outlined below. Per the final
rule, all of the requirements phase in on January 1, 2019.
• Based on RWAs

• Based on Total Leverage Exposure (TLE, the SLR denominator).

U.S GSIBs are required to measure outstanding LTD/TLAC against both the RWA- and
TLE-based required ratios and comply with the most binding one. Important to note, a
GSIB in excess of the total TLAC (plus buffer) requirement could have a shortfall under
the LTD requirement, or vice versa, depending on the composition of its outstanding
TLAC.

How was the U.S. final rule different from the U.S. NPR?
The Fed published the TLAC NPR (Notice for Public Rule Making), the “proposal” in
October 2015. The biggest difference between the proposal and the U.S final rule
published in December 2016 included:

1. Removal of the phase-in period for the RWA-based TLAC requirements

2. Grandfathering of non-U.S. law debt issued prior to December 31, 2016

3. Grandfathering of LTD with ineligible acceleration clauses. This provided the

biggest relief for U.S. GSIBs, in our view. Overall, the shorter phase-in period is

120 Global Banks and Brokers | 18 May 2018

 punitive for U.S. GSIBs but is more than offset by the grandfathering of
existing debt (non U.S law as well as debt with acceleration clauses), in our
view.

Detail on the three U.S. TLAC requirements

Long-term debt (LTD) requirement
The first requirement banks must clear is the debt requirement itself, which measures
eligible debt against both RWAs and TLE. For each U.S. GSIB:
• The requirement for eligible debt/RWAs is 6% + each bank’s GSIB surcharge
(the greater of the charge under Method 1 or Method 2); and

• The requirement for eligible debt/TLE is fixed at 4.5% (see Exhibit 55).

U.S. final rule requires the eligible debt to be:

• Issued by the hold-co.

• Unsecured.

• Issued with a maturity of greater than or equal to one year.

• U.S. law governed (if issued after December 30, 2016).

• “Plain vanilla”:

1. Not a structured note.

2. Not have a credit-sensitive feature.

3. Not be convertible to or exchangeable for hold-co equity.

4. Not include payment acceleration clauses other than “certain date” put,
insolvency or payment default related clauses (if issued after December 30,
2016).

Note the final rule grandfathers eligible debt issued under foreign law and/or containing
ineligible acceleration clauses if it was issued before December 31, 2016. This is
positive for U.S. GSIBs since nearly all of the outstanding debt issued by GSIBs includes
ineligible acceleration clauses, and a significant portion is under foreign law, non-
grandfathering such debt would have been market disruptive and result in very high
costs to banks given tenders and replacements, exchanges or obtaining bondholder
consent to amend ineligible indentures tend to be very expensive actions.

Eligible debt with remaining maturities of less than one year does not qualify. Debt with
remaining maturities between one to two years still qualify, but at a 50% haircut.
Although eligible external LTD maturing between one and two years would be subject to
a 50% haircut for purposes of the external LTD requirement, such eligible debt would
count at full value for purposes of the external TLAC requirement.

Ineligible debt includes subsidiary level debt, debt maturing in less than one year,
structured notes (including “principal protected notes”), trust preferred securities
(TruPS), “survivor put” debt, and both foreign law debt and debt containing ineligible
acceleration clauses if issued after December 2016.

Global Banks and Brokers | 18 May 2018 121

Exhibit 55: Long-term debt components
Fed TLAC final rule - LTD requirement
RWA-based: 6% + GSIB surcharge
Calculation
TLE-based: 4.5%

Senior unsecured "plain-vanilla" debt at parent maturing ≥ 1 year

Eligible debt
Subordinated "plain-vanilla" debt at parent maturing ≥ 1 year

Eligible debt with 1-2yr remaining maturity must take a 50% haircut
Haircut
(will count at full value for external TLAC).

Subsidiary level debt

Debt maturing <1yr

TruPS

Structured notes (including "principal-protected" notes)

Ineligible debt
"Survivor put" debt

Foreign-law debt (if issued after December 30, 2016)

Debt with ineligible acceleration clauses (if issued after December

30, 2016)

Source: BofA Merrill Lynch Global Research, company data, Federal Reserve
Note: GSIB surcharge for LTD requirement is the greater of Method 1 or Method 2

Unsurprisingly, given the structure of their business model, MS and GS are well above
the LTD requirement (see Chart 128 and Chart 129). C, JPM and WFC are moderately
above at the time of writing.
Chart 128: RWA-based LTD vs. requirement (as of 1Q18) Chart 129: TLE-based LTD vs. requirement (as of 1Q18)
40% 14% Minimum
Minimum 12.3% 12.2%
Outstanding eligible external LTD as % of

Outstanding eligible external LTD as % of

34.3% requirement,
35% requirement
12% 4.5%

30% 26.7%
total leverage exposure

10%
25%
8%
RWAs

20% 6.3%
6% 5.5%
13.5% 4.9% 4.6%
15% 3.9%
10.0% 9.7% 9.6% 9.1% 4%
10%

5% 9.0% 8.5% 9.0% 9.5% 2%

7.5% 8.0% 7.5%
0% 0%
MS GS BK C JPM WFC STT GS MS BK WFC C JPM STT

Source: BofA Merrill Lynch Global Research, company data, Bloomberg, Federal Reserve Source: BofA Merrill Lynch Global Research, company data, Bloomberg, Federal Reserve
Note: Above data represents BofAML estimates based on publicly available data for ease of Note: Above data represents BofAML estimates based on publicly available data for ease of
comparability comparability

External TLAC requirement

The external TLAC can be met with LTD, AT1 (additional tier 1), and CET1. This
requirement is similar to the FSB requirement, which applies to eligible debt +
qualifying capital against both RWAs and TLE (see Exhibit 56):

122 Global Banks and Brokers | 18 May 2018

• The requirement for eligible debt + qualifying capital as a % of RWAs is 18% (plus
capital conservation buffer, countercyclical capital buffer (if any) and the Method 1
GSIB surcharge) and as a % of TLE is 7.5% plus 2% leverage buffer.

The U.S. final rule removes the additional 2019-2022 phase-in period for the RWA-
based requirement and incorporates a 2% external TLAC TLE-based buffer.
Exhibit 56: External TLAC RWA-based ratio formula
Category Components

Eligible Senior unsecured "plain-vanilla" debt at parent maturing ≥ 1 year

debt
Qualifying LTD Subordinated "plain-vanilla" debt at parent maturing ≥ 1 year
Less: 50% of eligible debt maturing between 1-2 years

Add back: 50% of eligible debt maturing between 1-2 years

Additional TLAC Fully phased in CET1 Capital
Fully phased in AT1 Capital

Total Loss Absorbing Capacity

RWAs (higher of standardized/advanced)

Reported TLAC RWA-based ratio

Source: BofA Merrill Lynch Global Research, Federal Reserve

External TLAC buffer requirement

The external TLAC buffer requirement can only be met with CET1 (RWA-based) or Tier 1
capital (TLE-based). A U.S GSIB is required to meet two external TLAC buffers: 1) RWA-
based buffer and 2) TLE-based buffer.
• The external TLAC RWA-based buffer requirement is simply the sum of the capital
conservation buffer (2.5%) + each bank’s Method 1 GSIB surcharge (see Table 16).

• The external TLAC TLE-based buffer has been set at 2%.

The U.S. final rule requires both an external TLAC RWA-based buffer (2.5% + method 1
surcharge) and an external TLE-based buffer (fixed at 2%) to be held in addition to the
18% RWA/ 7.5% TLE requirement. On the other hand, FSB deducts the 2.5% capital
conservation buffer and Basel III GSIB surcharge (known as Method 1 in the U.S.) from
qualifying capital without including additional buffers above its 18% RWA/ 6.75% TLE
requirement.
Exhibit 57: External TLAC Buffer
MS GS C JPM WFC BK STT
2.5% buffer 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5%
Method 1 GSIB surcharge 1.0% 1.5% 2.0% 2.5% 1.5% 1.0% 1.0%
External TLAC RWA-based buffer 3.5% 4.0% 4.5% 5.0% 4.0% 3.5% 3.5%
External TLAC TLE-based buffer 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%
Source: BofA Merrill Lynch Global Research, company data. As of 4Q17

The calculation of a bank’s actual external buffer itself is complicated (see Exhibit 68).
The central idea is that the CET1 (RWA-based) or Tier 1 capital (TLE-based) used toward
meeting the external TLAC requirement cannot be used to fill the external TLAC buffer,
both under RWA and TLE requirements.

Bear with us: to calculate a bank’s external buffer, investors need to start with the
minimum TLAC requirement, which as a reminder is 18% of RWAs and 7.5% of TLE.
Then, subtract from this percentage the ratio of qualifying AT1 capital and eligible LTD
as a % of RWAs or just the ratio of eligible LTD as a % of TLE depending on which of

Global Banks and Brokers | 18 May 2018 123

the two buffers is being calculated. The result would equal the CET1/Tier 1 capital used
to meet the RWA/TLE-based external TLAC requirement. The remaining CET1/Tier 1
capital would count toward the RWA/TLE-based external TLAC buffer.
Exhibit 58: External TLAC Buffer Level formula (RWA-based)

Common Equity Tier 1 External TLAC External TLAC Buffer

Additional Tier 1 Ratio (%) Eligible external LTD (%)
Ratio (%) Requirement (%) Level (%)

Source: BofA Merrill Lynch Global Research, Federal Reserve

MS, GS, JPM, C and WFC all met the external total TLAC (plus buffer) requirement at the
time of writing (see Chart 130).
Chart 130: TLAC by bank (as of 1Q18)
60% 55.0% Additional TLAC/RWAs
Qualifying LTD/RWAs
50%
40.9%
Jan '19 min + buffers
40%

30% 27.4%
24.3% 23.5% 23.4%
22.0% 22.5% 23.0% 22.0%
21.5% 21.5% 21.5%
20%

10%

0%
MS GS BK C JPM WFC STT

Source: BofA Merrill Lynch Global Research, company data, Bloomberg, Federal Reserve
Note: Above data represents BofAML estimates based on publicly available data for ease of comparability

Non-compliance in the U.S. could lead to capital payout restrictions

Unique to the U.S. is the restriction of capital payout to shareholders, based upon the
level of compliance to the rule. The Fed has decided to measure compliance based on
the external buffer requirement.

The shortfall between actual and the requirement determines payout limitations, as
detailed by the schedule below (see Exhibit 59). For example, if it were 2019 today, a
bank with an external buffer at 80% of the requirement would be restricted to paying
out just 60% of earnings in the form of dividends and buybacks.
Exhibit 59: Payout ceiling (TLAC buffer level vs. requirement)
External TLAC buffer
Payout ceiling RWA-based buffer TLE-based buffer
level vs. requirement
C: 139% C: 216%
GS: 276% GS: 281%
No payout ratio limitation > 100% JPM: 110% JPM: 185%
MS: 385% MS: 312%
WFC: 133% WFC: 294%
60% ≤ 100% , > 75%
40% ≤ 75% , > 50%
20% ≤ 50% , > 25%
0% ≤ 25%
Source: BofA Merrill Lynch Global Research, company data, Bloomberg, Federal Reserve. Data as of 5/2018

124 Global Banks and Brokers | 18 May 2018

That said, given the time to compliance and that all banks are over 100%, we do not
think this rule will practically restrict future capital payouts for impacted banks.

Management buffers increase TLAC shortfalls

Banks currently hold a management buffer over U.S. Basel III minimum capital ratios to
avoid falling below requirements due to ratio volatility (AOCI volatility, Tier 2 sub debt
amortization, etc.). We expect banks to take a similar approach with LTD and TLAC
requirements. Therefore, we expect U.S. GSIBs to hold two management buffers: 1) over
LTD minimum requirement, and 2) over total TLAC plus buffer minimum requirement. In
our models, and per management commentary, we assume a 1% management buffer
over both requirements.

Putting it all together: Sample calculations

Below, we walk through a sample calculation of all U.S. TLAC requirements:

Global Banks and Brokers | 18 May 2018 125

Exhibit 60: U.S. TLAC requirements – Wells Fargo example ($mn) (as of 1Q18)
WFC % of RWAs % of TLE Detailed steps
1) External LTD Requirement
(A) Senior hold-co "plain-vanilla" debt 105,634
(B) Subordinated hold-co "plain-vanilla" debt 25,872
Less: Non-U.S. governed debt non-grandfathered in (A) & (B) 0
Sub-total 131,506
Less: 50% 1-2 yr. remaining maturity 2,060
LTD requirement

Less: 100% <1 yr. remaining maturity 6,862

(C) Outstanding eligible external LTD 122,583 9.5% 5.5%
(D) RWA approach external LTD requirement 103,014 8.0% RWAs x (6% + Method 2 surcharge)
(E) TLE approach external LTD requirement 101,058 4.5% TLE x 4.5%
(Y) External LTD shortfall (surplus) (19,569) -1.5% MAX ( (D) , (E) ) - (C)
LTD 100 bps buffer 12,877 1.0% RWAs x 1%
Binding approach RWA MAX ( (D) , (E) )

2) External TLAC requirement

Outstanding eligible external LTD 122,583
Add back: 50% 1-2 yr. remaining maturity 2,060
Fully phased-in CET1 capital less any CET1 minority interest 152,304
Fully phased-in AT1 capital less any AT1 minority interest 23,506
(F) Outstanding external TLAC amount 300,453 23.3% 13.4%
(G) RWA approach external TLAC requirement 231,781 18.0% RWAs x 18%
(H) TLE approach external TLAC requirement 168,431 7.5% TLE x 7.5%
External TLAC shortfall (surplus) (68,672) -5.3% MAX ( (G) , (H) ) - (F)
Binding approach RWA MAX ( (G) , (H) )

3) External TLAC buffer

Total TLAC requirement

RWA-based
(I) External TLAC buffer level 68,672 5.3% CET1 not used to meet (G)
(J) External TLAC buffer requirement 51,507 4.0% RWAs x 4.0% (2.5% + Method 1 surcharge)
Maximum external TLAC payout ratio No limit Check payout ratio calculation
External TLAC buffer shortfall (surplus) (17,165) -1.3% (J) - (I)

TLE-based
(K) External TLAC buffer level 132,023 5.9% Tier 1 not used to meet (H)
(L) External TLAC buffer requirement 44,915 2.0% TLE x 2.0%
Maximum external TLAC payout ratio No limit Check payout ratio calculation
External TLAC buffer shortfall (surplus) (87,108) -3.9% (L) - (K)

Total TLAC plus buffer requirement

(M) Total TLAC RWA-based requirement 283,288 22.0% (G) + (J)
(N) Total TLAC TLE-based requirement 213,346 9.5% (H) + (L)
(Z) Total TLAC shortfall (surplus) (17,165) -1.3% -0.8% MAX ( (M) , (N) ) - (F)
TLAC 100 bps buffer (includes LTD 100 bps buffer) 12,877 1.0% RWAs x 1%

Total shortfall (surplus)

Shortfall (surplus) excluding mgmt. buffer (17,165) MAX ( (Y) , (Z) )
Shortfall (surplus) including 100 bps buffer (4,288) MAX ( (Y) + LTD buffer , (Z) + TLAC buffer )

Denominators
RWAs 1,287,675
TLE 2,245,743

Source: BofA Merrill Lynch Global Research, company data, Federal Reserve, Bloomberg
Notes: Total shortfall numbers assume minimum CET1 capital ratios exceed TLAC RWA-based buffer requirements.

126 Global Banks and Brokers | 18 May 2018

Switzerland: Again more stringent requirements
In Switzerland, regulators require UBS and CS to meet TLAC requirements of 28.6% of
RWAs or 10% of total leverage exposure by 2019. UBS and CS both currently exceed the
RWA restriction, but currently fall short of the leverage minimum.

EU: MREL comparable to TLAC, but risk insensitive

Our credit team have written a more detailed take on the European MREL rules: The
MREL survival kit

The Minimum Requirement for Eligible Liabilities, or MREL, is a European approach to

ensuring that in the event of failure, banks will hold sufficient instruments that can bear
losses before taxpayers are involved.

Originally, MREL was going to require all banks in the EU to hold 8% of assets, un-
weighted, in capital and bail in-able debt.

However, the current MREL rules have now set the requirement according to a RWA
denominator.

The Single Resolution Board (SRB) is responsible for setting the MREL requirements for
most of continental Europe, but has so far not published these at a single entity level.
The calculation is known, but the perimeter of the RWA could be different, as the ESRB
can take into account perimeter changes according to the bank’s living will.

At its simplest definition, MREL will work as the sum of:

1. Loss Absorption Amount = Pillar 1 + Pillar 2 Requirement + combined buffer

(combined buffer = countercyclical buffer, systemic buffer, capital conservation
buffer)

2. Recapitalisation Amount = Pillar 1 + Pillar 2 Requirement

3. Market Confidence charge = Combined Buffer Requirement less 125bp

The SRB also states minimum levels of the numerator be in the form of subordinated
instruments:
• G-SIBs minimum of 13.5% of RWA + Combined Buffer Requirements

• Other systemically important institutions held to 12% of RWA plus Combined

Buffer Requirements.

MREL is applicable to many banks in the EU, not only the systemically important ones.
The bonds that qualify as MREL eligible are an issue of national discretion. For example:
• In Germany, a law makes existing unsecured debt eligible for MREL. This is why
DBK has an unusually high TLAC ratio. With new legislation expected in the
autumn, DBK is likely to be allowed to issue more “senior preferred” bonds
over time.
• In France and some other European countries, banks have begun issuing
“senior non-preferred” (aka SNP or Tier 3) bonds which are subordinate to
existing senior unsecured debt.
• Banks with existing (or new) holding company structures are gradually issuing
holding company debt to meet MREL/TLAC requirements.

Impacted products and businesses

Contrary to the aforementioned funding requirements, a bank with a traditional, large
deposit franchise or secured funding base would be at a relative disadvantage, while a
bank with wholesale funding would be at a relative advantage (see Table 12). This is
principally because deposits are not included in TLAC.

Global Banks and Brokers | 18 May 2018 127

As a result, a bank that relies on deposit funding more heavily than their universal bank
peers has a much lower theoretical score than another bank that relies much more on
unsecured debt and preferred stock. This is counterintuitive as banks that rely less on
deposit funding tend to have business strategies with more inherent risk, and are more
likely to come under financial duress. However, given the importance of core deposit
funding, not just to funding requirements, but on overall bank profitability, we do not think
banks will materially shift deposit strategies.

Indirectly, given that CET1, surcharge, and SLR limitations are the base of the ratios,
businesses directly affected by these rules are indirectly impacted by TLAC.
Table 12: More and less valuable products under TLAC
TLAC: More Valuable Products TLAC: Less Valuable Products
LT unsecured funding Deposit funding
Electronic/agency trading Short-term Funding
Wealth management Structured funding
Asset Management Securitized products
Advisory High yield credit products
Payments
Futures clearing
Agency MBS

Source: BofA Merrill Lynch Global Research

On April 11, the Fed and OCC proposed replacing the 4.5% TLE-based LTD requirement
with 2.5% plus 50% GSIB surcharge requirement and the 2% TLE-based TLAC buffer
with 50% G-SIB surcharge. We estimate that the proposed changes effectively lower
the total leverage exposure (TLE) based LTD and TLAC requirements by 25-125bp for
banks that are TLE TLAC constrained - C, JPM, STT and BK.

Annual stress testing

The largest global banks have to undergo regular stress tests conducted by local
regulators (see Exhibit 61). This process ensures that these institutions have enough
capital to absorb losses – including plans to increase dividends and/or buyback activity –
during a time of severe economic stress, without broaching capital minimums outlined
in each individual test. More importantly in the U.S., the stress test is also seen as a way
for regulators to weigh in on an institution’s capital and risk management processes and
internal controls annually, and is mandated by law through the Dodd-Frank Act, as
previously mentioned.
Stress tests parameters are designed for constant evolution, and unlike with other rules,
can reflect regulators’ real-time concerns. For example, higher assumed credit losses on
energy portfolios and testing bank pre-credit operating income for negative interest
rates.
That said, the Federal Reserve has had significant leeway in designing the
annual stress tests, given the broad powers established by Dodd-Frank. This is
important as Randy Quarles, the new Vice Chair of Supervision, could potentially lead to
another evolution of the annual tests: a potential easing of the annual regulatory burden.

We cannot emphasize how important the recent change in agency leadership is to

the U.S. stress test process (“CCAR”), as many U.S. institutions refer to the U.S.
stress tests as the “binding constraint” of the six prudential regulatory requirements
we discuss in this report.

128 Global Banks and Brokers | 18 May 2018

Exhibit 61: Stress Test by region
Region Regulator Status
United States Federal Reserve Annual
UK Bank of England Annual
Switzerland FINMA Ad-hoc
China China Banking Regulatory Commission Ad-hoc
European Union European Banking Authority Ad-hoc
Canada Bank of Canada Evolving
Japan Financial Services Agency Evolving
Source: BofA Merrill Lynch Global Research. Note Fed also requires mid-year stress test for BHCs with $50bn+ in assets

U.S.: CCAR test arguably the most developed globally

The U.S. stress test is the longest-running (since 2011) and arguably the most
comprehensive among global tests. As such, this section will primarily focus on the
U.S.’s Dodd-Frank Act Stress Testing (DFAST) and the Comprehensive Capital Analysis
and Review (CCAR) process. Prior to 2016, results were released in March, with BHC
submissions due by that previous January. However starting during the 2016 CCAR
cycle, the deadline for submissions was pushed back to April from January. This year,
results are expected to be released by the Fed in June 2018 (see Exhibit 62).
Exhibit 62: 2018 capital planning and stress testing timeline

February 2018 February 2018 April 2018 June 2018

Fed publishes stress test
Fed publishes CCAR BHCs submit 2017 capital Fed releases stress test
scenarios for annual
Summary Instructions plan to the Fed results
DFAST/CCAR exam
Source: BofA Merrill Lynch Global Research, Federal Reserve

In a nutshell, the annual DFAST and CCAR process requires banks with over $50bn in
assets to demonstrate sufficient capital to withstand a hypothetical, highly stressful
operating environment, while executing on its submitted capital plan. DFAST is a
forward-looking quantitative evaluation of the impact, while CCAR is the overlay created
by the Fed that inputs capital planning and non-objections/objections to these plans by
regulators.

As a reminder, DFAST and CCAR are not the same process. DFAST is the process
mandated by law. The Dodd-Frank act requires stress testing annually and for there
to be three scenarios under which to stress the banks. The rest of the CCAR process,
including qualitative objections and non-objections described below, was designed by
the Fed however is not law.

The DFAST results, which come out a week prior to the CCAR results, include the
previous year’s capital plan (without stock buybacks and other repurchases), not the
current year’s “capital ask”, like CCAR. Note however, both CCAR and DFAST include an
estimate of projected revenues, losses, reserves, pro forma regulatory capital ratios, and
any other additional capital measures. In addition to plans to distribute dividends and/or
buyback stock, a capital plan can also include potential acquisitions, divestitures, and/or
more general balance sheet actions (e.g., calling debt). The test is divided into two
portions:
• Quantitative assessment of a bank’s post-stress capital adequacy; and a

• Qualitative assessment of the bank’s capital plan, and importantly, the practices
and processes used by the banks to assess its capital needs. This part of the test
has been an issue for banks that have received objections or conditional non-
objections, more so than the quantitative, or “mathematical”, part of the test.

Global Banks and Brokers | 18 May 2018 129

The best result is receiving a non-objection from the Fed on both counts. However, U.S.
banks greater than $250bn in assets can clear the capital minimum hurdles on the
quantitative assessment, and still receive an objection on their capital plans if the Fed
finds an institution lacking in the qualitative assessment (as C shareholders have
suffered through twice). Additionally, the Fed also grants conditional non-objections,
which allows institutions to carry out capital plans as long as qualitative “deficiencies”
are addressed by a bank by a certain date specified by the regulators.

That said, participating banks are allowed to revise their capital plans between the
release of the DFAST results and the CCAR results (i.e., “mulligan” clause), as the DFAST
results can be informative of how the CCAR quantitative results will turn out. For
example, during the 2016 test, MTB adjusted its original capital plan.

Removal of qualitative portion for certain banks

In February 2017, the Fed issued a final rule adopting certain revisions to its capital
planning and stress testing rules (which became effective with the 2017 CCAR cycle).
The previously enacted revision removed BHCs with $50-250bn in total assets from the
qualitative component of the annual CCAR process. While the announcement was largely
expected (first proposed in Sept. 2016) and these banks still have to go through the
quantitative part of the stress test, the message it sends is nonetheless positive, in our
view.

Federal Reserve could increase transparency of stress testing program

In December 2017, the Fed released a package of proposals that would increase the
transparency of its stress testing program. One of the proposals would release greater
information about the models the Fed uses to estimate the hypothetical losses in the
stress tests. Some items that would be made public for the first time include: a range of
loss rates estimated by using the Board’s models, for loans held by CCAR firms,
portfolios of hypothetical loans with loss rates estimated by the Boards’ models and
more detailed descriptions of the Board’s models, including equations and key variables
that influence results of those models.

“This enhanced transparency will bolster the credibility of our stress tests and help the
public better evaluate the results,” Vice Chairman for Supervision Randal K. Quarles said.
“The proposed changes will also generate valuable insight from stakeholders and we
look forward to it.”

Moreover, the Fed is proposing to modify its framework for the design of the annual
hypothetical economic scenarios. The modifications are set to improve transparency and
to further promote the resilience of the banking system throughout the economic cycle.
In particular, the revisions include more information on the hypothetical path of house
prices as well as notice that the Board is exploring the addition of variables to test for
funding risks in the hypothetical scenarios.

The so-called de minimis exception threshold was previously be lowered from

the current 1.0% to 0.25% of Tier 1 Capital, and will be available to these banking
organizations, subject to compliance with certain conditions, including 15 days prior
notification as to planned execution of the exception and no objection by the Federal
Reserve Board within that timeframe. The latest amendment for the capital plan and
stress test rules also instituted a blackout period. During the second quarter of each
year while the Federal Reserve is undertaking the CCAR exercise, BHCs cannot request
additional capital distributions or make distributions under the de minimis exception.
Beginning this year, the minimum supplementary ratio (SLR) requirement of 3% applies
to firms that meet the thresholds for applying the advanced approaches framework.

Below is a list of 2018 CCAR participants (see Exhibit 63):

130 Global Banks and Brokers | 18 May 2018

Exhibit 63: 2018 CCAR Participants
Ally Financial Inc.* Huntington Bancshares Incorporated*
American Express Company* JPMorgan Chase & Co.***
Bank of America Corporation*** KeyCorp*
The Bank of New York Mellon Corporation** M&T Bank Corporation*
BB&T Corporation* Morgan Stanley***
BBVA Compass Bancshares, Inc.* MUFG Americas Holdings Corporation*
BMO Financial Corp.* Northern Trust Corporation*
Capital One Financial Corporation The PNC Financial Services Group, Inc.
CIT Group Inc.* Regions Financial Corporation*
Citigroup Inc.*** Santander Holdings USA, Inc.*
Citizens Financial Group, Inc.* State Street Corporation**
Comerica Incorporated* SunTrust Banks, Inc.*
Discover Financial Services* TD Group US Holdings LLC
Fifth Third Bancorp* U.S. Bancorp
The Goldman Sachs Group, Inc.*** Wells Fargo & Company***
HSBC North America Holdings Inc.** Zions Bancorporation*
New to CCAR 2018
Barclays US LLC*** DB USA Corporation***
BNP Paribas USA, Inc.* RBC USA Holdco Corporation***
Credit Suisse Holdings (USA)*** UBS Americas Holdings LLC***

Source: Federal Reserve. One asterisk denotes BHC is excluded from qualitative portion of CCAR. Two asterisks denote BHC is subject to
counterparty default. Three asterisks denote BHC is subject to global market shock and counterparty default

Quantitative assessment: Parameters and results change annually

Each year, U.S. bank holding companies submit a capital plan with expected uses and
sources of capital over a nine-quarter horizon. Each participating company must submit
its stress results under three supervisory scenarios provided by the Fed: 1) a supervisory
baseline scenario; 2) a supervisory adverse scenario; 3) a supervisory severely adverse
scenario – this being the scenario the banks must withstand in order to get approval for
capital plans (see Table 13).The Fed also requires submission under two bank-defined
scenarios (a baseline and a stress), designed to help regulators understand each
individual bank’s unique vulnerabilities.

Global Banks and Brokers | 18 May 2018 131

Table 13: Summary of quantitative assessment
Category Scenario
Planning Horizon 9-quarters
Baseline
Fed Scenarios Adverse
Severely Adverse
Fed Capital Plan Submission Baseline & Stressed
Capital Plan Approval Assessment Scenario Severely Adverse
Source: BofA Merrill Lynch Global Research, Federal Reserve

As noted above, passing the severely adverse scenario is the binding constraint for
capital plans. Although the Fed provides quarterly, progressive parameters for all 16
domestic factors and 12 international factors within its supervisory macroeconomic
scenarios, the table below provides the peaks or troughs for each factor (see Exhibit 64).
Exhibit 64: Severely adverse scenario shocks
Starting Stressed Ending Relative stress More/less
Point Level Point 2017 2018 Δ Severe
Domestic
Dow Jones Index 27,673 9,689 20,168 -50% -65% (15bp) More
Real GDP growth 2.70% (8.90%) 4.50% (1,060bp) (1,160bp) (100bp) More
Unemployment rate 4.10% 10.00% 8.60% (530bp) (590bp) (60bp) More
10-year Treasury yield 2.40% 2.40% 2.40% (140bp) 0bp 140bp Less
Mortgage rate 3.90% 6.00% 4.70% 70bp 210bp 140bp More
Market Volatility Index (VIX) 13 62 14 205% 376% 171bp More
CRE Price Index 279 167 181 -35% -40% (5bp) Similar
House Price Index 194 136 143 -25% -30% (5bp) Similar
BBB corporate yield 4.00% 8.10% 5.00% 240bp 410bp 170bp More

International
Euro area real GDP growth 2.30% (5.20%) 2.30% (840bp) (750bp) 90bp Less
USD/euro exchange rate 1.20 1.07 1.14 -12% -11% 1bp Similar
Developing Asia real GDP growth 5.90% (1.50%) 6.60% (610bp) (740bp) (130bp) More
Japan real GDP growth 1.80% (11.40%) 1.30% (1,030bp) (1,320bp) (290bp) More
Yen/USD exchange rate 112.70 99.30 100.10 -8% -12% (4bp) More
U.K. real GDP growth 1.40% (5.10%) 2.60% (800bp) (650bp) 150bp Less
USD/pound exchange rate 1.35 1.27 1.29 -9% -6% 3bp Similar
Source: BofA Merrill Lynch Global Research, Federal Reserve

Notable differences in stress parameters for 2018 vs. 2017 include:

• Sharp increase in mortgage rate (peaking at 6% from 3.9% at 4Q17 vs. 4.6% peak
last year)

• 10yr Treasury rate drops to 2.4% and remains constant (vs. dropping to 0.8% last
year and steadily rising to 1.8%)

• Equity markets to sustain a 51% decline immediately (65% decline start-to-trough),

whereas last year’s CCAR scenario bottomed out after only a 50% decline four
quarters in

• The decline in real estate (residential and commercial) prices begins with a steep
drop off, reaching double digit declines starting in the second quarter of the
forecast period

• Deeper GDP trough (-1160bp) vs. last year (-1060bp)

• A higher decline in CRE prices (-40% vs. -35% last year)

132 Global Banks and Brokers | 18 May 2018

Global market shock expanding to six new firms in CCAR 2019
The six BHCs with large trading operations (JPM, C, BAC, GS, MS, and WFC) are
additionally required to include a global market shock as part of their post-stress capital
evaluation. This part of the test is designed to assess potential losses stemming from
trading books, private equity positions, and counterparty exposures. Because this shock
is a “point in time” stress it results in an instantaneous loss and capital reduction.
Moreover, BHCs subject to the global market shock test typically cannot assume a
decline in portfolio positions or related RWAs. The as-of date for the global market
shock is December 4, 2017.

In December 2017, the Fed approved a modification of the scope of the global market
shock component of the supervisory stress test to apply to a firm that has aggregate
trading assets and liabilities of $50bn or more, or equal to or greater than 10% of total
consolidated assets. The following IHCs will become subject to the global market shock
beginning in CCAR 2019: Barclays US LLC, Credit Suisse Holdings (USA), Inc., DB USA
Corporation, HSBC North America Holdings Inc., UBS Americas Holding LLC, and RBC
USA HoldCo Corporation. In CCAR 2018, in lieu of the global market shock component,
these IHCs will be subject to interim market risk components in the supervisory adverse
and severely adverse scenarios.

The global market shock for the severely adverse scenario incorporates a
sudden sharp increase in credit risk, a steepening of the U.S. yield curve, and a
general selloff of U.S. assets relative to other developed countries. Notable
differences in the 2018 severely adverse global market shock scenario relative
to last year include;
• Rise and steepening of the U.S. yield curve

• Greater depreciation of the U.S. dollar relative to other advanced currencies

• More muted shocks to some credit-sensitive assets, such as non-agency RMBS

Counterparty default scenario

Additionally, all of the aforementioned banks with large trading operations, along with
STT and BK (given their substantial custodian operations), also undergo a counterparty
default scenario. In this test, these eight banks are required to estimate potential losses
stemming from an unexpected and instantaneous default of each bank’s counterparty
that would generate the largest losses across their derivatives and securities financing
activities, including securities lending and repo/reverse repo agreement activities. This
is estimated by applying the aforementioned global market shock to revalue non-cash
securities financing activity assets (securities or collateral) posted or received.
Derivative value is calculated by the value of the trade position and the non-cash
collateral exchanged. The as-of date for the counterparty default scenario component is
December 4, 2017, the same date as the global market shock.

Current quantitative U.S. CCAR standards

Under all five baseline and stressed scenarios, all participating BHCs must clear four of
the following capital ratios, under Basel 3 standardized: 1) common equity tier 1 of
4.5%; 2) tier 1 risk based capital of 6.0%; 3) total risk-based capital of 8.0%; and 4) tier
1 leverage and SLR of 3% beginning January 1, 2018 (see Exhibit 65).

Global Banks and Brokers | 18 May 2018 133

Exhibit 65: Required minimum capital ratios for CCAR 2018
Regulatory ratio Minimum ratio
Common equity tier 1 capital ratio 4.5%
Tier 1 risk-based capital ratio 6.0%
Total risk-based capital ratio 8.0%
Tier 1 leverage ratio 4.0%
Supplementary leverage ratio 3.0%
Source: BofA Merrill Lynch Global Research, Federal Reserve
Note: BHCs subject to the advanced approaches are required to maintain a SLR above 3% for 1Q18-1Q19.

Putting it all together: What the results look like

As mentioned above, each BHC is required to conduct their own stress test, applying
these scenarios through their models, stressing income statement and balance sheet
items. The Fed then separately applies its scenarios to each individual bank’s data. We
note the differences between a bank’s outputs and the Fed’s can vary widely. We
thought the best example to show investors is the variance between Fed model results
and WFC’s outputs for the 2017 CCAR cycle (see exhibit). After all, WFC is often thought
of by investors as more “transparent” than other more diverse, and more global,
universal bank counterparts. Even in WFC’s case, there were significant differences in
the bank’s results and the Fed’s – most notably in stressed pre-provision net revenue,
PPNR, ($35bn differential) and in stressed provisions ($12bn differential).
Exhibit 66: Company-run stress test results vs. Fed’s results under the severely adverse scenario (example: WFC, as of 2017)
Company-run
Projected losses, revenue, net income ($bn) Fed's Results Variance
Results
Pre-provision net revenue $36.0 $71.2 $35.2
less
Provisions 43.8 55.9 12.1
Realized losses/gains on securities (AFS/HTM) 1.6 1.6 0.0
Trading and counterparty losses 7.7 7.7 0.0
Other losses/gains 0.0 1.1 1.1
equals 0.0
Net income before taxes (17.1) 4.8 21.9
Memo items 0.0
Other comprehensive income (2.1) (3.5) (1.4)
Other effects on capital 0.0
AOCI included in capital (billions of dollars) (2.0) (2.0) 0.0
Stressed capital ratios (March 31, 2019)
Common equity tier 1 capital ratio (%) 9.4% 8.6% -0.8%
Tier 1 risk-based capital ratio (%) 11.2% 10.2% -1.0%
Total risk-based capital ratio (%) 14.8% 13.4% -1.4%
Tier 1 leverage ratio (%) 8.3% 7.2% -1.1%
Supplementary Ratio(%) 7.0% 6.1% -0.9%
Projected loan losses as % of avg. loans
Total 3.4% 5.0% 1.6%
First-lien mortgages, domestic 1.2% 1.8% 0.6%
Junior liens and HELOCs, domestic 3.8% 4.3% 0.5%
Commercial and industrial 3.0% 6.4% 3.4%
Commercial real estate, domestic 4.7% 7.7% 3.0%
Credit cards 17.2% 15.3% -1.9%
Other consumer 5.7% 6.9% 1.2%
Other loans 1.4% 3.4% 2.0%
Source: BofA Merrill Lynch Global Research, Federal Reserve, company data. Note Fed’s results reflect estimates based on DFAST

134 Global Banks and Brokers | 18 May 2018

Qualitative assessment: Arguably more important than quantitative
U.S. banks have significantly built up their capital levels which suggest that the test
should be easier even if standards don’t change. However, the qualitative assessment is
equally important (if not arguably more so). A handful of banks have received objections
on this portion of the test in the past (e.g., C, BBT, and FITB). In the qualitative
assessment, regulators assess the internal practices and processes each bank uses to
manage its capital planning and policies. The Fed looks to assess each BHC’s risk
identification, measurement, and management practices, and stress “effective”
oversight by the board of directors and senior management.

That said, in February 2017 the Fed removed the qualitative component for BHCs with
$50-250bn in total assets. This is a positive in two ways. First, it streamlines the
“procedure” for CCAR participation. Second, the element of risk of getting an
objection on a qualitative basis is clearly removed

For BHCs over $250bn, the entire qualitative process remains opaque, though the
assessment is crucial. BHC’s with total assets of $250bn or greater have the equivalent
of a “to-do” list from regulators each year – not disclosed publicly – that address
identified deficiencies in the capital planning and risk management process. For
example, feedback from management teams suggests that regulators are particularly
interested in the “systems readiness” of these BHCs. Think of this like the Y2K
phenomenon, where systems could not process beyond the year 1999. The Fed appears
to want to make sure those BHCs can handle various severe economic stressed in real-
time.

BHCs with $50-250bn in assets are the immediate beneficiaries. The Fed’s proposal
may not only result in increased capital return to shareholders, but could also befit banks
to reallocate “dead weight” capital sitting in Treasury securities to revenue-generating
businesses.

That said, we believe this poses an interesting decision tree about organic and inorganic
growth at firms above $200bn in assets. In other words, do these institutions stay
below the threshold for some time, or leap over it to scale the cost of additional CCAR
burden?

Off-process incremental capital actions allowed up to 25bp of tier 1 capital

U.S. BHCs formally present their request for dividend increases and/or share buyback
plans during the formal annual process, along with other capital planning actions like
mergers or debt buybacks. However, BHCs may make incremental capital distributions
that exceed the amount in their original capital plan by giving prior notice to the Fed.
This is separate from a BHC’s ability to revise its request during the formal process.

As we note previously, the amount of additional capital distributions a BHC can make
during a capital plan cycle was reduced from 100bp to 25bp of a firm’s tier 1 capital (as
of the most recent first quarter FRY-9C regulatory filing). For example, a BHC requesting
an additional buyback from the Fed in February 2018 would be restricted to <25bp of its
tier 1 capital as of 1Q17. Banks do not have to be re-stressed to receive a non-objection
from the Fed.

To qualify for these additional distributions, the Fed states that the BHC would need to
hit the following standards:
• Remain well capitalized pro forma for this additional request. Well-capitalized
is defined as at least 6% tier 1 capital ratio and at least 10% total risk-based
capital ratio

Global Banks and Brokers | 18 May 2018 135

• Maintain performance and capital levels consistent with projections under
expected conditions in the BHC’s capital plan;

• Fed has 15 days to object or not object, upon receiving the notification

EU stress testing: Tracking the evolution

Europe has evolved in multiple directions over stress testing. In key markets:
• Switzerland will use ad hoc, non-disclosed stress tests to gain perspective on
banks’ concentrations and areas of concern.

• In the Euro area, concentrations and levels of problem assets – key attributes of
stress tests - are a part of the annual supervisory process. Periodically, the
authorities run system-wide stresses but these have not tended to be binding for
most banks. More recent stress tests are used to help set the SREP capital
requirement for the year ahead.

• The UK has developed its stress testing to the most complete degree and
embeds it in annual bank capital requirements.

EBA stress test 2018

The European Banking Authority will conduct another round of stress testing in 2018.
The test will not have a pass or fail threshold but will instead inform the EBA when it
sets the SREP (capital requirements) for 2019.

The test will cover 44 banks, equal to more than 70% of banking assets.

As well as an adverse set of macroeconomic factors set by the ECB (e.g. real GDP
growth of -1.2% in ’18, -2.2% in ’19 and +0.7% in ’20, 19% fall in residential house
prices, 20% fall in CRE), the test will focus on four areas:
• Abrupt and sizeable repricing of risk premia and resulting tightening of financial
conditions in Europe

• Adverse feedback loop of low bank profitability and low economic growth

• Public and private debt sustainability concerns

• Liquidity risks in the non-financial sector

The test also has a conduct risk element whereby banks must estimate conduct and
litigation risk costs on a stricter basis than current accounting rules allow.

UK stress testing
We believe the UK system is most interesting. It is in some ways more evolved than
CCAR in that it seeks to be predictable and symmetrical. For example, in a period where
asset prices move further away from historical averages relative to incomes, the stress
test is designed to show a greater potential drawdown in asset prices. But in a
recession where asset prices fall against historical averages, the opposite is also
intended to take place and the stress test be less onerous. In this way, the Bank of
England characterizes itself as having a consistent risk appetite and seeks to provide
clarity that it will be balanced in its capital requirements.

The 2018 stress test for the UK will be the same as the 2017 test in that it is more
severe than the global financial crisis and in the opinion of the FPC, it also encompasses
a range of outcomes that could be related to Brexit.

The UK is likely to include the ring-fenced entities separately in the 2020 stress text
onwards.

136 Global Banks and Brokers | 18 May 2018

Different to the EBA stress test, the Bank of England sets hurdle levels for both
CET1/RWA and leverage ratios.

The macroeconomic forecasts are similar to the EBA test (UK GDP start to trough of -
4.7%, residential house prices -33%, CRE -40%. Similar to the EBA test, it also allows
for an element of conduct risk costs.

Asia: Nascent stages

In China, regulators engage in routine stress testing, but there is no official process in
place similar to the U.S. and the E.U. Note that China also does not publish the results of
its routine stress tests.

In Japan, there is no current requirement for regular stress tests by the authorities.
Although the financial authorities have also started to argue the need for this to be
introduced, no specific protocol has been established and schedules are yet to be
decided.

Impacted products and businesses

The CCAR process theoretically discourages U.S. banks from adding risky products to its
balance sheet as such products would endure significant credit stress under the test
(see Table 14). U.S. bank credit underwriting standards have been fairly pristine since
the global financial crisis (especially for CCAR participants), and we do not expect a
significant change in philosophy. Note that prime mortgages not only carry a lower risk
weight, but have historically had low loss content (~25bp through-cycle credit loss rate).
We think it’s notable to point out that large banks have been materially growing their
share of jumbo prime mortgages retained on balance sheet.

CCAR serves as a check for banks to benefit from accrual accounting when it comes to
lending decisions. What do we mean by this? In today’s economic backdrop, it is likely
that losses across all credit categories will remain de minimis, or at least in our view
below cycle averages. As such, losses and higher provisions may not impact a bank’s
EPS power and valuation for a few years. That said, CCAR has the impact of “marking to
market” a bank’s credit risk profile every year. After all, the Fed can certainly apply very
high stressed losses to a portfolio they consider risky, or object to an institution’s
capital plan for qualitative reasons should it feel that its risk profile is changing for the
worse.
Table 14: More and less valuable products under supervisory stress
Stress Tests: More Valuable Products Stress Tests: Less Valuable Products
Historically low loss content loan products International lending exposure
Subprime lending
Global trading operations

Source: BofA Merrill Lynch Global Research

Liquidity coverage ratio (LCR)

The other set of requirements for GSIBs governs funding standards, and one such rule is
the liquidity coverage ratio, or LCR. The rule, final under Basel and most local
jurisdictions, is designed to require banks to hold enough high quality, easily liquidated
assets (HQLA, or high quality liquid assets) to withstand an acute liquidity stress
scenario involving 30 days of funding outflows. In other words, institutions have to hold
a certain amount of liquidity, depending on the perceived volatility of their liability mix.

This is applicable to all GSIBs and all banks in Europe. In the U.S., large regional banks
above $50bn in assets are also subject to this rule, but with modified (less stringent)
requirements. Like with NSFR (the net stable funding ratio, which we will discuss in the
following section), this rule distinguishes between “good” liabilities and “less good”
liabilities. Moreover, given that banks are required to hold HQLA against certain

Global Banks and Brokers | 18 May 2018 137

liabilities, it forces banks to significantly dial down the risk composition (and therefore
yield) of their securities portfolios.

Impacted banks are mostly in compliance with this ratio today (see Chart 131 and Chart
132). That said, this ratio is highly volatile, and we think this could have two specific
negative impacts on bank net interest margins and ROEs: 1) the aforementioned build-
up of liquid assets today; and 2) potentially aggressive competition for retail deposits,
which, like the NSFR requirement, are more highly valued by this regulatory rule.
Chart 131: Liquidity coverage ratio by GSIB (as of 1Q18)
250% Americas Europe Asia

200% Regulatory requirement, 100%

150%

100%

50%

0%

ICBC
WFC

CCB

ABC

BOC
ING
SocGen
GS

BK

Nordea

MUFG
BARC

HSBC
C

StanChart
RBC

RBS

DBK

UBS

BNP
JPM

Unicredit
STT
MS

CS

CA

Mizuho
SMFG
Santander
Source: BofA Merrill Lynch Global Research, company data

Chart 132: Liquidity coverage ratio U.S. regional banks (as of 1Q18)
160%
144% Regulatory
140% 126% requirement, 100%
120% 113%
>100% >100% >100% >100% >100% >100% >100% >100% >100%
100%
80%
60%
40%
20%
0%
ZION
CMA
CFG

MTB
KEY
BBT

HBAN

FITB

PNC

USB

STI
RF

Source: BofA Merrill Lynch Global Research, company data

The basics: how LCR is calculated

LCR requires a bank’s unencumbered high-quality liquid assets to equal or exceed 100%
of its total net cash outflows over a 30-day period (see exhibit). Each liability is assigned
an outflow assumption, which is equivalent to the amount of HQLA needed to “cover” the
potential outflow of that liability. For example, a retail deposit with a 5% outflow
assumption means that a bank must hold 5c in HQLA for every $1 of retail deposit.
Conversely, short-term borrowings with an outflow assumption of 100% would require $1
for $1 of HQLA against it.

In the following section, we walk through the components of the numerator and
denominator:

138 Global Banks and Brokers | 18 May 2018

Exhibit 67: Liquidity coverage ratio formula
HQLA (Numerator) ÷ Total Net Cash Outflow (Denominator)

Cash, Central bank reserves,

Retail deposits x run-off assumption
USTs, certain gov't entities, Level 1
+
foreign withdrawal reserves

US GSEs, certain sovereign

Wholesale deposits x run-off assumptions
entity securities (<20% risk Level 2A
+
weight)

Unsecured wholesale funding x run-off assumptions

Certain publicly traded corp -
debt and publicly traded Level 2B
common stock, munis
Certain offsetting inflows (capped at 75% of outflows)

≥ 100%

Source: Federal Reserve

Numerator: High quality liquid assets (HQLA)

To qualify as a high quality liquid asset, or HQLA, regulators require such assets to be
unencumbered (i.e., free of any restrictions). Pushing banks to hold higher quality assets
is intended to reduce the risk that they are only able to generate cash by liquidating
assets at “fire sale” prices, therefore also exacerbating capital positioning in a stress
scenario. There are modest differences between the final Basel rules and the final U.S.
rules (see Table 15).
Table 15: HQLA definition: Basel vs. Federal Reserve
Basel Committee’s LCR Framework (January 2013) U.S. LCR Final Rule (Sept. 2014)
• Includes securities issued or guaranteed by certain public sector entities • HQLAs do not include:
(PSEs) in Level 1 and Level 2A assets - Certain municipal securities (e.g., obligations of a financial sector entity or
consolidated subsidiary of a financial sector entity)
• Includes certain AA- or higher corporate debt securities and covered bonds in - Covered bonds and other securities issued by financial institutions
Level 2A assets subject to a 15% haircut - RMBS

• Includes certain residential mortgage-backed securities (RMBS) in Level 2B • Corporate debt securities are not included in Level 2A assets
assets subject to a 25% haircut
• Certain corporate debt securities may qualify as Level 2B assets subject to a
• Includes certain A+ to BBB- corporate debt securities in Level 2B assets 50% haircut
subject to a 50% haircut
Source: BCBS, Federal Reserve Board, FDIC, OCC

Qualifying assets for HQLA: Level 1 assets, Level 2A assets, and Level 2B assets (see
Table 16 for U.S. and Table 17 for EU). Clearly, excess cash at central banks, and U.S.
Treasuries would be considered the most liquid type of asset. The combination of Level
2A and 2B assets cannot exceed 40% of HQLA, after accounting for haircuts. Lastly,
Level 2B assets are capped at 15% of HQLA.
Table 16: U.S. HQLA rules summary
Category Level Includes Haircut
Central bank reserves, USTs, foreign withdrawal reserves, and certain U.S.
Level 1 None
gov’t/ sovereign entity securities

U.S. GSE securities and certain sovereign entity securities (those that have
Level 2A 15%
no higher than a 20% risk weight)

Certain publicly traded corporate debt, publicly traded common stock (not 50% (cannot exceed 15% of
Level 2B
ETFs) and certain municipal securities total stock of HQLA)
Source: Federal Reserve Board, FDIC, OCC. Note Munis are HQLA eligible only in the Fed rule. The OCC and FDIC rules do not include munis in HQLA

Global Banks and Brokers | 18 May 2018 139

Table 17: European Union HQLA rules summary
Category Includes Limit Haircut
Cash, deposits at central banks, government or government guaranteed bonds. n/a n/a
Level 1
ECAI 1 covered bonds (AAA to AA-) allowed up to 70% after a 7% haircut. 70% 7%
3rd country government bonds, bonds issued by public entities with a 20% risk weight.
ECAI 2 EU covered bonds (A+ to A-)
Level 2A 40% 15%
Non-EU covered bonds rated ECAI 1
Corporate bonds rated ECAI 1
Unrated high quality covered bonds 30%
Corporate bonds rated ECAI 3 50%
Level 2B Shares from major stock exchange 15% 50%
ABS: RMBS + Auto 25%
ABS: SME + Consumer 35%
Source: European Commission

Below, we provide a graphic for what typically constitutes HQLA for an institution, using
C as an example (see Chart 133).

Chart 133: Composition of Citi’s HQLA (as of 1Q18)

$450 bn $427 bn 100%

$400 bn 90%
Available Cash
$350 bn 80%
US Treasuries 70%
$300 bn
60% 84%
$250 bn Foreign Govt Level 1 Assets
50%
$200 bn Level 2 Assets
40%
US Agency/Govt
$150 bn
Gtd 30%
$100 bn IG Corp/Equities 20%
$50 bn 10% 16%
$0 bn 0%

Source: company data

Denominator: Liabilities, multiplied by an “outflow” assumptions

The denominator is comprised of net cash outflows, which is essentially the projected
“stickiness” of a bank’s liabilities during a 30-day period of stress. To determine this,
each bank estimates expected cash outflows over this period, minus the lesser of total
expected cash inflows or 75% of total expected cash outflows (see Exhibit 68).

Expected cash outflows are calculated by multiplying the outstanding balance of various
liabilities and off-balance sheet items by “expected run-off” or outflow rates. (A similar
approach is applied for inflows; however, inflows are subject to a cap of 75% of
expected outflows). The higher the “run-off” rate, the higher the amount included in the
outflow calculation. For example, a 5% outflow rate is applied to deposits classified as
“stable” (see Exhibit 69). Conversely, a 100% rate applies to short-term borrowings.

140 Global Banks and Brokers | 18 May 2018

Exhibit 68: Select total expected cash outflow schedule
Type of Cash Outflow Run-Off Rate
Stable retail deposits 3 - 5%
Less stable retail deposits 10%
Operational deposits 5 - 25%
Deposits/ other unsecured funding from sovereigns, central banks, PSEs, MDBs 20 - 40%
Deposits/ unsecured funding sources from a financial entity 100%
Transactions with central bank secured by any assets 0%
Transactions with any counterparty secured by Level 1 Assets 0%
Transactions with any counterparty secured by Level 2A Assets 15%
Transactions secured by RMBS eligible for inclusion in Level 2B Assets 25%
Other transactions secured by other Level 2B Assets 25%
Derivatives and other collateralized transactions 100%
Asset-backed securities and structured financing facilities 100%
Undrawn portion of committed credit and liquidity facilities 5 - 100%
Customer short positions covered by other customers’ collateral (not HQLA) 50%
Source: Federal Reserve, Basel Committee, Davis Polk

Exhibit 69: Total Net Cash Outflow Amount (denominator)

Total Net
= +
Cumulative Cash Maturity Mismatch
Cash Outflow
Outflows ― Capped Cumulative Cash Inflows
Add-on
Amount

lesser of
Instruments with no
maturity date are
Cumulative Cash Inflows
generally excluded
from cash inflows Net Cumulative
and Peak Day Maturity
minus
75% of cumulative cash outflows Outflow Net Day 30
Cumulative Maturity
Outflow

Source: Federal Reserve Board, FDIC, OCC

Putting it all together: Two examples

Funding requirements were previously notoriously difficult to calculate from public
disclosure. However, due to recently improved disclosure, we were able to put together
an example from a U.S. GSIB, C, to show investors the line items used to calculate the
ratio (see Exhibit 70).

Global Banks and Brokers | 18 May 2018 141

Exhibit 70: Sample calculation: Liquidity coverage ratio (example: C as of 1Q18)
Asset line item ($bn) Liability line item ($bn)

Available Cash 120 Deposit outflow from retail customers 34

+ +
U.S. Treasuries 143 Unsecured wholesale funding outflow 245
+ +
Foreign Govt. 82 Secured wholesale funding 99
+ +
U.S. Agency/Govt. Gtd. 80 Other cash outflow 96
+ +
IG Corporate/Equities 2 Total cash inflow (131)
+ +
Maturity mismatch add-on 11

High Quality Liquid Assets 427 Total estimated outflow 355

LCR = 120%
Source: company filings
Note: Foreign Govt. includes securities issued or guaranteed by foreign sovereigns, agencies, and multilateral development banks

This next chart provides the publicly disclosed LCR breakdown for UBS (see Exhibit 71).

Exhibit 71: UBS 1Q18 publicly disclosed LCR ratio

Asset line item (CHF billion) Liability line item (CHF billion)
1
Cash balances 101 Retail deposits and deposits from small business customers 25
+ +
Securities 82 Unsecured wholesale funding 106
+
Secured wholesale funding 78
+
Other cash outflows 43
+
Secured lending (80)
+
Inflows from fully performing exposures (30)
+
Other cash inflows 3

High Quality Liquid Assets2 183 Total estimated outflow 135

LCR = 136%
1
. Includes cash and balances with central banks and other eligible balances as prescribed by FINMA
2.
Calculated after the application of haircuts and accordance with FINMA requirements
Source: company filings
Note (1): Includes cash and balances with central banks and other eligible balances as prescribed by FINMA. (2) Calculated after the application of haircuts and accordance with FINMA requirements

Don’t underestimate the volatility of this ratio

To note, the LCR ratio is a volatile one – leading us to believe that impacted institutions
may continue to build greater buffers to their respective minimums. This, of course,
would lead to pressure on net interest margins (NIMs). Banks have been deposit rich as
rates have been low. That said, there is typically an inverse correlation between core

142 Global Banks and Brokers | 18 May 2018

deposit volumes and Fed funds, which is forecasted to rise (by the Fed’s own dot plots)
another five times between now and the end of 2019. As deposits flow out, banks may
need to be competitive on pricing to keep such funding – especially deposits with low
outflow assumptions, like retail.

To demonstrate the sensitivity of LCR, we use BBT as an example. Deposit volumes

have historically been inversely correlated with short rates. Let’s say $1bn of BBT’s
money market and savings deposits – carrying a very low 3% outflow assumption –
leave the bank. And let’s say this is replaced by short-term borrowings in the meantime,
which carries a 100% outflow assumption. Just this switch of $1bn of funding (in BBT’s
case, representing 0.6% of liabilities and 0.5% of assets) would move its LCR ratio by
3% – representing the need for institutions to build buffers and fight aggressively for
low outflow deposits (see Chart 134).
Chart 134: LCR sensitivity (example: BBT as of 1Q18)
150% Every $1bn in short-term funding
equals a 3% reduction in the ratio

145%
Liquidity coverage ratio

-3%
140%

135% 144%
141%
130%

125%
Current Pro forma

Source: BofA Merrill Lynch Global Research, company data

Standards for large institutions

All GSIBs are subject to the full version of LCR. The same applies to all European banks.
On a local level, specifically in the U.S., banks with assets between $50-250bn will be
subject to less stringent requirements and must comply with a “modified LCR”. In the
U.S., both the phase in requirements and the absolute level of LCR differ between U.S.
GSIBs and U.S. regional banks above $50bn in assets. The difference in requirements
can be found in the charts below (see Exhibit 72).

On December 19, 2016, the Federal Reserve published their final U.S. LCR public
disclosure requirements. Starting April 1, 2017, required firms started to disclose their
consolidated LCR every quarter according to the U.S. rules. Required disclosures include
the Firm’s average LCR for the quarter, amount of HQLA by category, and net outflow
amounts including from retail deposits and derivatives, and a qualitative discussion of
material drivers of the ratio, changes over time, and causes of such changes.

Global Banks and Brokers | 18 May 2018 143

Exhibit 72: Liquidity coverage rule: Basel vs. U.S. framework
Basel Framework U.S. Full Version U.S. Modified Version
Advanced approaches banking organizations (≥ U.S. bank holding companies and savings
Designed for all internationally
Scope of Application $250bn in assets or ≥ $10bn in on-b/s foreignand loan holding companies with ≥ $50bn
active banking organizations
exposure in assets
Banks subject to full LCR must maintain a 90% by January 2016; 100% by
Compliance Timeline 100% by January 1, 2019
100% ratio beginning on January 1, 2017 January. 1, 2017

Frequency of Calculation Monthly basis 1H15: monthly basis; 2H15 on: daily basis 2016: monthly basis

• A banking organization's LCR

• A banking organization must notify the • A banking organization must notify the
may falls below 100% during
appropriate regulator on any business day when appropriate regulator on any business day
periods of idiosyncratic or systemic
its LCR is < 100% . when its LCR is < 100% .
stress.
LCR Falling Below 100%
• A banking organization should • If its LCR is < 100% for three
• If its LCR is < 100% for three consecutive
notify its regulator immediately if its consecutive business days, the banking
business days, the banking organization must
LCR has fallen, or is expected to organization must submit a liquidity
submit a liquidity compliance plan
fall, below 100% compliance plan
Total net cash outflow amount is
Prescribed cash flow rates are broadly similar
Prescribed Cash Inflow based on the total cumulative Same calculation as Full LCR but without
to the Basel framework but apply a maturity
and Outflow Rates amount at the end of the 30-day the peak-day maturity mismatch add-on
mismatch add-on component*
liquidity stress period
Source: Davis Polk. Note: Net cash outflows are multiplied by 70% in the U.S. modified LCR

Impacted products and businesses: More than meets the eye

Efforts to comply with the LCR are now acting as a headwind to some banks'
profitability. After all, adding HQLA – particularly in this low rate environment – will
always be dilutive to bank NIMs versus adding loans. In particular, we think the
reinvestment run rate in Ginnie Maes and Treasuries will remain pressured relative to
historical levels as banks/brokers build balances in order to maintain compliance.

We think the most impacted product under LCR will be deposit funding (see Table 18).
Under LCR rules, deposits are assigned liquidity values based on expected behavior under
stress, the type of deposit and the type of client. In other words, the final U.S. rule
prioritizes operating accounts of consumers (i.e., retail and commercial banking deposits)
and corporations, while assigning a 100% outflow assumption to balances of financial
institutions. In particular, retail deposits likely have very low outflow assumptions. This
leads us to believe that retail deposit competition – and deposit betas – could be greater
even before interest rates normalize in earnest. As mentioned in the NSFR, some non-
traditional deposit gatherers (GS) are already offering significantly higher rates on
deposits than traditional deposit gathering GSIBs.

That said, any products that have been traditionally funded short – such as secured
financing, or prime brokerage/repo – could also be impacted. This is where the
discussion on LCR sensitivity fully kicks in. LCR could be more of a binding constraint
than is appreciated by the market, given the sensitivity of the ratio to small shifts in
funding.
Table 18: More and less valuable products under LCR
LCR: More Valuable Products LCR: Less Valuable Products
Retail deposits Liquidity and credit facilities
Operational corporate deposit Lending products to financial institutions
Nonoperational corporate deposits
Financial institution deposits
Prime brokerage
Source: BofA Merrill Lynch Global Research

144 Global Banks and Brokers | 18 May 2018

Net stable funding ratio (NSFR)
The net stable funding ratio (NSFR) requires banks to hold more stable and longer-term
funding sources against their least liquid assets, thereby reducing maturity
transformation risk – and reducing the need for emergency liquidity support from
central banks in a crisis. This rule is final under Basel but has faced more challenges in
being enacted by individual countries.

On the U.S. side, the FDIC, the Federal Reserve and the OCC jointly released NPRs
(notice of proposed rulemaking) to outline the proposed local interpretation of the rule.
The NSFR, as proposed, is applicable to both the holding company and the bank
subsidiary. Interestingly, these rules were not pushed down to the broker/dealer level
given lack of jurisdiction by both the FDIC and Fed. This is important to note, given that
most short-term (and “least stable”) funding sources for universal banks are often
housed at the broker/dealer subsidiary. Similar to LCR (liquidity coverage ratio), a
modified, or less strict, version is applicable to banks with $50-250bn in assets.

The NSFR could be most impactful on the traditional investment banking monoline
model, which typically holds a significant amount of short-term funding in matched
trading books and has historically been light on deposit funding. But, given that the U.S.
proposal is similar to Basel, we don’t expect a significant shortfall. In addition, U.S.
proposals appear to be limiting how much “excess” stable funding that are typically
housed at bank subs can be counted for the holding company’s requirement, which we
talk about in more detail in the following sections.

We estimate that most impacted banks are at 100% today or higher (see Chart 135).
Moreover, while the U.S. proposal is modestly tougher than the Basel rule, we think the
current U.S. NPR should ease concerns that the NSFR will be a material, incremental
catalyst for further liquidity reduction in the repo market and areas of fixed income.
Chart 135: Net stable funding ratio as of 1Q18
Many banks do not disclose the NSFR but merely indicate that they are “in compliance” with the ratio

160%
Americas Europe
140% Regulatory
requirement, 100%
120%

100%

80%

60%

40%

20%

0%
WFC

ING
SocGen
GS
BK

Nordea
HSBC

BARC
C

StanChart
RBS

UBS
DBK
JPM

BNP
STT

Unicredit
MS

CS

Santander

Source: Company data, BCBS, Federal Reserve. Although applicable, NSFR has not been disclosed by Chinese or Japanese GSIBs
Note: many banks do not disclose the NSFR but merely indicate that they are “in compliance” with the ratio. As such, we assumed 100%

The basics: how NSFR is calculated

NSFR equals available stable funding (ASF) divided by required stable funding (RSF). The
requirement is that this ratio equals 100%. Simply, the denominator (RSF) more heavily
weights assets that are considered less liquid, and therefore requires more stable
funding. Meanwhile, the numerator (ASF) more heavily weights liabilities that either has
long tenors or is considered more stable (i.e., retail deposits). Below, we break down the
RSF and ASF weights, which are nearly identical under both the final Basel rule and the
U.S. proposal (see Exhibit 73).

Global Banks and Brokers | 18 May 2018 145

Exhibit 73: Components and weighting of the NSFR (proposed U.S. rules)

Source: Federal Reserve, FDIC, OCC

The regulatory minimum of this ratio is 100% by January 2018. Basel also
requires banks to meet the requirement on an ongoing basis although they will only be
reported quarterly. Below, we break down the major components of the numerator and
denominator.

Numerator: What constitutes available stable funding (ASF)

We walk through the various categories of the numerator below, in order of most stable
to least stable according to the rule. The ASF equals the weighted sum of an
institution’s capital and liabilities after the application of an ASF factor. Given that this
is the numerator, the higher the ASF factor, the better.
• 100% ASF factor: Regulatory capital, debt with maturity >1 year that is not
a retail or brokered deposits. Included regulatory capital includes common equity
tier 1 and additional tier 1 (preferred stock), before the application of capital
deductions. For sub debt or certain preferred stock to be Tier 2 capital, the maturity
must be > 1 year.

• 90-95% ASF factor: Retail deposits, deposits under <$250k. Retail deposits
count between 90-95%, regardless of maturity and collateralization. Brokered
deposits and sweep accounts (regardless of counterpart) would fall in this category,
so long as the deposit is covered by deposit insurance. In the U.S., this is currently
$250,000. CDs over a year in maturity also fall in this category.

• 50% ASF factor: Corporate deposits, SFTs within remaining maturities

between 6-12 months. Unlike with the CET1 surcharge and the LCR rules, the NSFR
does not make a material distinction between operational and non-operational
corporate deposits. Secured funding transactions (SFTs) with financial sector or
central bank parties can count here, so long as the remaining maturity is between 6-
12 months. Also, any other short-term funding that has a maturity date between 6-12
months also falls here. Funding from sovereigns, public sector entities (PSEs) and
multilateral and national development banks also receive a 50% ASF factor.

146 Global Banks and Brokers | 18 May 2018

• 0% ASF factor: Financial institution deposits, trading/pension liabilities,
SFTs with <6 months in remaining maturity. Financial institution deposits are
treated similarly harshly under NSFR as it does in the CET1 surcharge calculation
and in LCR. Any other short-term funding with maturities <6 months fall under this
category. This is clearly part of the rule that is most negatively impactful for
institutions with higher short-term exposure, and punitive toward “matched books”
in trading.

Denominator: What constitutes required stable funding (RSF)

RSF is measured based on the liquidity risk profile of the bank (i.e., asset
categorization). Upon bucketing, each asset is assigned an RSF requirement. Converse
to the ASF factor, the lower the RSF factor, the better. Below is a discussion of select
components of the denominator.
• O% RSF factor: cash, central bank reserves, net derivatives where payable
< receivable. No surprise, cash requires no stable funding. “Trade date”
receivables from sales of financial instruments, foreign currencies, and
commodities that are expected to settle within the standard settlement cycle also
receive a 0% RSF factor.

• 5% RSF factor: Level 1 securities, off-balance sheet commitments. Level 1

securities include U.S. Treasuries and certain readily marketable and liquid U.S.
government or other sovereign entity securities. Off balance sheet commitments
include undrawn credit and liquidity facilities. In Europe, ECAI 1 covered bonds (AAA
to AA-) are allowed in the definition of Level 1 assets, up to 70% after a 7% haircut.

• 10% RSF factor: Loans (secured) maturing in less than 6 months, loans
secured by Level 1 assets, and loans to banks and other financial sector
entity.

• 15% RSF factor: Level 2A liquid assets, unsecured loans <6 months in
maturity. Level 2A assets include U.S. GSE (government sponsored entities)
securities and certain sovereign issued securities, so long as the risk weight is 20%
or less. In Europe, ECAI 2 covered bonds (A+ to A-), non-EU covered bonds rated
ECAI 1, and corporate bonds rated ECAI 1 are included.

• 50% RSF factor: Level 2B liquid assets, loans maturing between 6-12
months (retail and wholesale), PSEs (i.e., munis). Level 2B liquid assets include
certain publicly traded corporate debt and publicly traded common stock (not ETFs,
or exchange-traded funds), as well as municipal securities.

• 65% RSF factor: Retail mortgages >1 year in remaining maturity, loans
maturing >1 year. Retail mortgages that belong in this category cannot have a risk
weight of more than 50%, while other loans over one year in maturity cannot have a
risk weight of greater than 20%.

• 85% RSF factor: Retail mortgages and wholesale loans with higher risk
weightings, non-HQLA securities. Retail mortgages with over 50% risk weight
and wholesale loans with over 20% risk weight fall in this category. Meanwhile,
wholesale and other consumer loans with a risk weight of greater than 20% fall
under here. All other securities that do not qualify as HQLA (high quality liquid
asset, as defined by the LCR) also fall in this category. These include: cash,
securities, or other assets posted as initial margin for derivative contracts; cash or
other assets that would contribute to the default fund of a central counterparty
(CCP); unencumbered securities with remaining maturity of >1 year and exchange-
traded equities that do not qualify as HQLA; and physically traded commodities,
including gold.

Global Banks and Brokers | 18 May 2018 147

• 100% RSF factor: Net derivatives where receivable > payable,
nonperforming loans, credit to financial institutions with maturities <1
year. NSFR derivative assets (defined as derivative assets net of cash collateral
received as variation margin) net of NSFR derivative liabilities (defined as derivative
liabilities net of total collateral posted as variation margin), should NSFR derivative
assets > than NSFR derivative liabilities.

Unencumbered vs. encumbered assets

Under the proposed rule, an RSF factor is assigned to an asset based on whether or not
it is encumbered. (Rule uses same definition currently used as part of the LCR rule).
Because encumbered assets cannot be monetized during the period in which they are
encumbered, U.S. regulators require these assets to be supported by stable funding for
purposes of this rule. For example, an asset that is encumbered for less than six months
would be assigned the same RSF factor as if the asset were unencumbered. However,
an asset encumbered for a period of greater than six months but less than one year
would be assigned an RSF factor of the greater of 50% and the factor the asset would
be assigned if it were unencumbered (see Exhibit 74).
Exhibit 74: RSF factors for encumbered assets
Asset encumbered Asset encumbered Asset encumbered
< 6mos ≥ 6mos < 1yr ≥ 1yr
If RSF factor for RSF factor for the
unencumbered asset as if it were 50% 100%
asset is ≤ 50% : unencumbered
If RSF factor for RSF factor for the RSF factor for the
unencumbered asset as if it were asset as if it were 100%
asset is > 50% : unencumbered unencumbered
Source: Federal Reserve, FDIC, OCC

Putting it all together: An example

Although we note, it is difficult to calculate NSFR using publicly available data, below we
provide an estimate for Citigroup (see Exhibit 75).

148 Global Banks and Brokers | 18 May 2018

Exhibit 75: Sample net stable funding ratio calculation (example: C as of 1Q18)

Liabilities and capital line items Factor ($mn) Asset line item Factor ($mn)
Retail/ small business deposits 90.0% 278,010 Cash 0.0% 0
+ +
Corporate deposits 50.0% 333,000 Loans and advances to banks 50.0% 121,285
+ +
Deposits from banks 0.0% 0 Loans 80.0% 528,467
+ +
Short-term borrowings: Securities:
< 6mos 0.0% 0 Level 1 5.0% 7,955
6mos to ≤ 12mos 50.0% 18,047 Level 2 40.0% 58,403
+ +
Long-term borrowings 100.0% 237,938 Net derivatives 100.0% 67,957
+ +
Trading liabilities 0.0% 0 Other assets 100.0% 184,474
+ +
Regulatory capital 100.0% 178,091 Off-b/s exposure 5.0% 26,143

Available Stable Funding (BofAMLe) 1,045,086 Required Stable Funding (BofAMLe) 994,684

NSFR = 105%
Source: BofA Merrill Lynch Global Research, company data
BofAMLe calculation based on publicly disclosed data

Standards for large institutions

As noted above, the Basel standard is final and required 100% NSFR by January 2018. In
the U.S., institutions between $50-250bn have to adhere to a “modified” version of
NSFR – the standard is still 100%. While methodology for the ASF calculation is the
same, a bank subject to modified NSFR would multiply its aggregate RSF by 70% –
resulting in a naturally higher NSFR. In the U.S., regulators are proposing to enforce
NSFR at both the holding company level and bank subsidiaries, provided that the
subsidiary has over $10bn in assets.

What’s outstanding: Clarity on subsidiary excess ASF in U.S.

While the U.S. did not relax the treatment of derivatives in the ASF calculation, as
lobbied, there were nonetheless two sources of relief when the U.S. NPR was released:
1) that the methodology itself is nearly identical to the Basel standard; and 2) that there
was no enforcement at the broker/dealer level.

That said, there was language in the proposal that implied that holding companies will
be precluded from utilizing the full funding synergy of having both a stable deposit-rich
bank subsidiary and a broker/dealer subsidiary with short-term funding for full
compliance to the rule. While the limitations were not yet explicitly set and language in
the proposal is vague, it appears as though U.S. regulators are setting the stage to limit
the amount of “excess” stable funding a bank sub can count toward the holding
company ratio.

To provide clarity to this, let’s say bank holding company A had two subsidiaries: a bank
sub with an NSFR of 130% and a broker/dealer with an NSFR of 75%. If the amount
over 100% at the bank sub that can count toward holding company compliance is
limited, then NSFR has to be managed at the parent to address the broker/dealer
contribution shortfall.

While the rule is naturally challenging for monoline investment banks, this proposed
limitation would be more incremental for money-center banks – whose rich deposit
bases have been supporting its RSF calculations. Solutions could include issuing more

Global Banks and Brokers | 18 May 2018 149

debt out of the holding company (which can also count toward the eligible debt
requirement under the TLAC rules) and holding more cash at the parent.

Impacted products and businesses: Tough for markets

As we’ll discuss in the section reserved for potential market impact, the NSFR’s
treatment of short-term funding could have a notable negative impact on secondary
market liquidity, and by extension, trading revenues. While the full list of negatively
impacted products is below, the pressure could be especially material on the repo
market, prime brokerage, and derivatives (see Table 19). We note the U.S. NPR coming
in-line with Basel doesn’t mean there won’t be an impact to the market – it’s just that
the impact may be better than feared.

Additionally, the new funding regulations also have the impact of valuing deposits
differently. Given the high ASF factor, the NSFR places a high premium on retail
deposits – which might require banks to pay up for this type of funding in a rising rate
environment, or even today, as we’ll discuss below. Conversely, rates on financial
institution deposits will likely exhibit a low beta in a rising rate environment, given their
punitive treatment under the NSFR (as well as the LCR and GSIB surcharge).
Table 19: More and less valuable products under NSFR
NSFR: More Valuable Products NSFR: Less Valuable Products
Retail deposit funding ST funding
Rates (Treasury, agency) Financial institution deposits
Nonoperational corporate deposits
Equity derivatives
Prime brokerage
Repo
Non agency MBS
Municipal markets
Credit products
Structured products
Source: BofA Merrill Lynch Global Research

150 Global Banks and Brokers | 18 May 2018

United States: Key Dodd-Frank Act
6B

provisions

Global Banks and Brokers | 18 May 2018 151

The Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into
United States federal law by former President Barack Obama on July 21, 2010. Designed
to be a sweeping response to the financial crisis, the Dodd-Frank Act, as it is more
commonly known, introduced the most material changes to financial regulation since
the reforms borne out of the Great Depression.

The mission statement of the Dodd-Frank Act is as follows: (1) address risks to the
stability of the U.S. financial system; (2) end too-big-to-fail bailouts of large,
complex financial institutions; (3) increase transparency and regulation for certain
complex financial instruments; and (4) strengthen protections for consumers and
investors.

There are sixteen provisions (Titles I-XVI) within the 849 pages of Dodd-Frank
that address the primary goal of the legislation. For the purpose of this report, we
focus on those that we view have been the more impactful to industry returns, bank
stock performance, and the economy:

1. Title I – Financial Stability: Includes the designation of a domestic U.S.

“SIFI” (systemically important financial institution), establishment of stress-
testing, the requirement for foreign domiciled company to form an
intermediate holding company (IHC), resolution planning

2. Title II - Orderly liquidation authority: establishes liquidation process for a

failing financial firm

3. Title VI – Improvements to Regulation of Bank and Savings Association

Holding Companies and Depository Institutions: Raised minimum capital
requirements, prohibited proprietary trading (later known as the Volcker Rule)

4. Title VII – Wall Street Transparency and Accountability: Includes the

regulation of over-the-counter (OTC) derivative markets, derivative clearing,
and requirements that certain derivatives must be traded electronically. Title
VII also applies to security-based swaps regulated by the SEC. (Note: while Title
VII encompasses a much longer list of requirements (e.g. reporting, business
conduct, etc.), we are only focusing on requirements imposed on OTC
derivatives.)

5. Title X – Bureau of Consumer Financial Protection: Established what is

now known as the CFPB, the establishment of rules and “reasonable” fees for
payment card transactions (later known as the Durbin Amendment)

6. Title XIV – Mortgage reform and Anti-Predatory Lending Act: Includes

new rules governing mortgage origination standards

We explain these provisions and its impact on the industry and the economy in this
section. Further, we also explore current proposed alternatives to Dodd-Frank.

Title I: The Financial Stability Act of 2010

Broadly, Title I under Dodd-Frank is designed to govern systemic risk. Included in Title I
is the establishment of the Financial Stability Oversight Council (FSOC), the definition
of SIFI, the requirement of annual stress tests for bank holding companies (BHCs)
greater than $50bn in assets, and the mandate for foreign-domiciled companies to form
intermediate holding companies (IHCs) in order to provide greater oversight powers to
the Federal Reserve.

152 Global Banks and Brokers | 18 May 2018

Primary regulatory agencies for Title I
The following agencies appear to have primary responsibility for the interpretation and
enforcement of Title I:
• The Federal Reserve (FRB)

• The Financial Stability Oversight Council (FSOC), which is chaired by the Treasury
Secretary

The creation of FSOC

In the exhibit below, we summarize the purpose, key duties, and membership composition
for FSOC, which appear to have been assigned broad powers (see Exhibit 76).
Exhibit 76: What is FSOC?
• Identify risk to financial stability
• Promote market discipline by “eliminating expectations on the part of shareholders,
creditors, and counterparties” that the government will shield them from losses in the
event of failure
Purpose
• Respond to emerging threats to the stability of the US financial system

• Monitor domestic and international financial regulatory proposals and developments

and to advise Congress and make recommendations in such areas
• Recommend to the member agencies general supervisory priorities and principles
• Identify gaps in regulation that could pose risks to the financial stability of the United
States
Key Duties • Make recommendations to the Federal Reserve Board of Governors and other
primary regulators on new or heightened prudential standards, including but not
exclusive to capital, leverage, liquidity, resolution

• 10 voting members (9 of which are federal regulators) and 5 non-voting supporting

members
Membership • Chair of the Council: the Treasury Secretary

Source: BofA Merrill Lynch Global Research, FSOC, Dodd-Frank

Establishment of the SIFI definitions

Under Sections 115 and 165 of Title I, the asset threshold for a bank holding company
that could pose systemic risk to the United States is established at $50bn. Also under
Section 165, financial companies that are $10bn in assets or above must conduct an
annual stress test. (This is different from participation in the Comprehensive Capital
Analysis and Review, or CCAR, exam, which is cut off at bank holding companies over
$50bn in assets. A more robust discussion of CCAR is below.)

Alternate proposals
There appears to already be momentum in Washington to raise the threshold in the
definition of SIFI, as defined by Dodd-Frank. The Economic Growth, Regulatory Relief,
and Consumer Protection Act – or more commonly referred to as the Crapo Bill – would
change the regulatory framework for banks with less than $10bn in assets and for banks
with over $50bn in assets. At the time of us writing this report, the bill has already been
passed in the Senate and has been sent to the US House of Representatives for voting.

The creation of DFAST, or regular stress tests

Section 165 of Dodd-Frank gives the Federal Reserve the power to establish prudential
standards for BHCs with $50bn+ in assets. More specifically, and embedded within,
Dodd-Frank requires the Fed to conduct an annual stress test to evaluate whether a
bank holding company (BHC) has the capital necessary to absorb losses as a result of
adverse conditions.

Global Banks and Brokers | 18 May 2018 153

 This test is commonly referred to as DFAST, the acronym for the Dodd-Frank Act
Stress Test.

Important distinction: DFAST is not CCAR

DFAST is the legally required backbone of the Comprehensive Capital Analysis and
Review (CCAR) process. The CCAR itself which requires BHCs with $50bn or more in
total assets to submit a capital plan to the Fed annually, and was established as part of
the capital planning rule of Regulation Y. We provide additional detail on this topic later
in the document.

It is important to distinguish between DFAST (Dodd-Frank Act Stress Test)

and CCAR (Comprehensive Capital Analysis and Review). DFAST is the actual
process of stress testing, and under Dodd-Frank, is required by law. Meanwhile,
CCAR was established under Regulation Y by the Federal Reserve, and requires the
submission and non-objection of a capital plan. Importantly, it is much easier to
amend agency-established regulation than it is to repeal law.

Requirements, interpretation, & enforcement

The stress test requirements under Dodd-Frank are shorter than what we think investors
believe. Under “Test Parameters and Consequences,” Dodd-Frank requires that these
tests should include at least three (3) different sets of conditions: 1) a baseline case; 2)
an adverse case; and 3) a severely adverse case. This is the most specific stress-test
requirement under Dodd-Frank.

That said, Dodd-Frank appears to give the Federal Reserve broad scope in the design of
and consequences of such a test, noting that the Fed “may develop and apply such other
analytic techniques as are necessary to identify, measure, and monitor risks to the
financial stability of the United States”. As such, the robust framework (e.g., CCAR 2018
has 28 variables to stress) has been created by the Fed, and not by Dodd-Frank.

Mostly through Regulation Y, the Federal Reserve then established the CCAR as a
“complementary” exercise to DFAST. The Fed itself notes that DFAST and CCAR are
“distinct testing exercises”. Of course, the Fed has taken Title I several steps further by
evaluating individual capital plans by each participating BHC for objection or non-
objection.

Applicability
The Fed is required to administer DFAST to banks above $50bn in assets. Each bank
holding company is also required to conduct its own stress testing. The frequency
requirement is twice a year for BHCs above $50bn, and once a year for BHCs above
$10bn. This said, CCAR does not exist for BHCs below $50bn. Therefore, DFAST is not
typically seen as a constraint for capital planning and distribution for institutions below
$50bn in assets.

The “cost” of DFAST regulation

Given that the “gating factor” for capital planning for BHCs over $50bn in assets is
CCAR and DFAST is not a binding constraint, we believe that the “cost” directly related
to DFAST is the cost it takes to run the test. The introduction of the DFAST process
requires increasing staffing and often times outside consultants. However, it is difficult
to quantify the additional operating cost related to just DFAST.

Intermediate Holding Companies (IHCs) requirements

The intermediate holding company, or IHC, requirement was designed to provide greater
oversight by U.S. regulators over the U.S. operations of foreign-domiciled banks. Dodd-
Frank required the formation of intermediate holding companies, as the U.S. sought to

154 Global Banks and Brokers | 18 May 2018

gain more control regulating foreign-domiciled banks that operated in its market. Note
that the Federal Reserve only has jurisdiction over holding companies, not bank or
broker/dealer subsidiaries.

Key provisions of IHC requirements

• Dodd-Frank Act (section 113) requires that banks with assets >$50bn in non-branch
assets are required to establish a separately capitalized intermediate holding
company (IHC). Such an IHC would hold all U.S. bank and non-bank subsidiaries. This
would then provide the Federal Reserve jurisdiction to regulate all U.S. operations
of a foreign-domiciled institution.
• The enhanced supervision is specified in section 165 (b) 1. Impacted IHCs would
need to maintain separate risk-based capital and leverage requirements, liquidity
requirements, overall risk management requirements, resolution planning, and
concentration limits. The Fed also has discretion for requirements around
contingent capital, public disclosures and short term debt limits.
• Section 165 (a)(2)(A) also requires that the standards applied to systemically
important banks are more stringent than for other banks (165 (a) 1 (A)).
• The majority of these requirements do not have minimum levels specified within
the Dodd-Frank act itself. For example: (1) there is no metric given for how much
more stringent the rules for larger banks should be; and (2) the rules around the
exact requirement of what a risk committee looks like are fairly vague (“include
such number of independent directors as the Board of Governors may determine
appropriate” with “at least 1 risk management expert”). Again, it appears that
the provisions have granted broad powers to the Fed to determine
additional requirements for IHCs.
• Section 165(i) requires DFAST participation annual stress tests by the Federal
Reserve for IHCs with assets >$50bn.

Requirements, interpretation, & enforcement

The Federal Reserve has been in charge of supervising bank holding companies in the
U.S. since the Bank Holding Company Act (BHC Act), enacted in 1956. However, the
translation of Dodd-Frank into rules affecting Foreign Banking Organizations (FBOs)
was most recently finalized in February 2014.

The FBO rule is a combination of a legal requirement set out in Dodd-Frank and rules
set out by the Federal Reserve, the regulator for bank holding companies and IHCs in the
U.S. Branch assets are not included within the IHC, although some different U.S. rules do
also apply to branches. The Fed has interpreted the Dodd-Frank Act and translated it
into actual metrics and rules for the banks.

The FBOs are required to comply with U.S. capital rules, consistent with U.S. BHCs. The
leverage ratio requirements were effective January 1, 2018 (see Exhibit 77).
Exhibit 77: IHC Requirements
IHC Requirements
US leverage ratio of > 4% (tier 1 capital / US GAAP
All IHCs
assets)
IHCs > 250bn in assets Supplementary leverage ratio of > 3% (not 5%)
Required to establish a US risk committee and a US chief
risk officer
For major foreign banking
Enhanced risk management
organizations with non branch
Enhanced liquidity risk management
US assets > $50bn
Locally binding liquidity coverage ratio and liquidity stress
tests
Source: Federal Reserve, Dodd-Frank

Global Banks and Brokers | 18 May 2018 155

Stress testing requirements for IHCs
Stress testing requirements are also applicable to FBOs with consolidated assets
>$10bn.

The foreign IHCs are currently going through their first public CCAR process (i.e.
required to file capital plans). The banks took part in the CCAR process in 2017, but this
was not publically disclosed, at the time.

Applicability
The formation and adherence to this rule would apply to foreign institutions that would
have, in aggregate, asset exposure of $50bn or greater, domiciled in the U.S. (Dodd-
Frank Act (section 165(a) 1).

European institutions that would be subject to IHC requirements: Credit Suisse, UBS,
Deutsche Bank, Barclays, HSBC, BNP Paribas, Santander, and BBVA.

That said, the applicability of which rule (IHC vs. FBO) to which kind of foreign banking
organization is rather complex. Please see Exhibit 78 below.
Exhibit 78: U.S. rules for FBOs change significantly depending upon the global size, U.S. presence and legal structure
Size of FBO Large Large Reasonable
US presence Large Limited Limited
FBO US assets >$50bn <$50bn >$10bn
FBO Global assets >$50bn >$50bn <$50bn
Yes (unless non-branch assets Yes (unless non-branch assets
IHC needed? No
<$10bn) <$10bn)
Same as US BHCs, plus annual
Capital requirements Same as US BHCs No
capital plan
Yes...but can be home regulator
Stress test Same as US BHC Same as US BHC
version
US liquidity requirements for IHC
Yes, report results of internal test
Liquidity and branches + liquidity stress No
to Fed
tests.
Yes. Committee must have one
Risk management independent expert + US chief Yes Yes, if publically listed
risk officer required
Source: Federal Reserve, BofA Merrill Lynch Global Research
IHC = intermediate holding company. FBO = federal banking organization

Foreign banks have shrunk subsidiaries, grown branches

There are some other things the European firms can do, and are seeking to do, to
address the impact.
• Deutsche Bank has already moved many exposures from the IHC into its New York
branch:

o This has meant the IHC assets have fallen 27% since 3Q16 (the first
public reporting date), while assets in the branch have increased 37%.

o DBK’s branch is now 20% larger than its US IHC.

o The CET1/leverage ratio of the IHC has improved from 3.3% in 3Q16
to 4.6% by FY17.

"Cost" of regulation
The cost of the IHC requirement comes in several forms:

156 Global Banks and Brokers | 18 May 2018

 1. The operating expense of having a completely separate architecture for the IHC
within the bank;

2. Lower revenues from either higher funding costs or negative carry on liquidity
portfolios;

3. Burden on leverage ratios from additional liquidity positions; and

4. New for 2018 is the potential for these structures to incur additional US tax
burdens through the BEAT tax.

Operating expenses
There was a significant cost in setting up the IHCs. Ongoing costs should not be
underestimated, either: additional IT infrastructure, reporting requirements, data quality
improvements as well as the cost of an additional board and risk committee can all add-
up to be a significant drag on earnings. Further, bank management teams have
suggested new legal structures seem to cost banks more than expected.

While not IHC specific, some banks have given some numbers on the costs of moving to
new legal structures:
• Credit Suisse had reported annualized costs of almost CHF0.5bn in 2015 from its
legal entity program, which consists of the IHC, the Swiss legal entity and the
formation of a service company. It expects such costs to become minimal by 2018.

• A Bloomberg article from June 2016 suggested a cost of between $0.1-$0.5bn per
bank in legal, technology and other compliance costs. Therefore, in our view, it may
be reasonable to assume that setting up a separate legal structure could translate
into incremental cost that falls in the aforementioned range.

Lower revenues from funding and liquidity costs

Funding externally in Europe and using those dollars to fund the U.S. business in an IHC
structure is increasingly difficult. Intra-group balances used to have very little meaning.
But, with an IHC, it is extremely important as it creates a larger balance sheet at the
IHC. Due to leverage requirements, the IHC then needs to hold capital against these
assets. If the funding is short term, it may also need to hold that funding in cash to
comply with the liquidity coverage rules, further depressing ROAs. Below is some
additional insight from Deutsche Bank and Credit Suisse:

“…in particular as it relates to our markets business we have in the IHC, there is
also quite some internal transactions from a group's point of view, but from an
IHC, it's between IHC and rest of group, which creates leverage in the IHC which
we don't necessarily have to leave in place.” – Deutsche Bank Deputy former
Chief Executive Officer and CFO Schenck, capital raising presentation, 6th
March 2017

“What you have in there, for example, assume that the capital is actually
intercompany funding because it reflects how the IHC is actually funding which
actually attracts capital itself. And the second component is the SRU [Strategic
Resolution Unit], a large SRU actually sits in the IHC. Therefore, that, A, it's partly
generating, mostly generating the losses which you actually have seen in that
filing; and, B, as the SRU wind down, that's true, which we talked about already,
that will itself radically improve the financial performance of the IHC, additionally
to what Brian's talked about in terms of the projections for the Global Markets
business.” – Credit Suisse CFO Mathers, Strategy update, Dec ‘16

Alternatively, the European banks may fund directly in the U.S., but we expect this would
be more expensive.

Global Banks and Brokers | 18 May 2018 157

Below, we show some summary data of the European bank’s IHCs (see Exhibit 79).
Some observations:
• The European IHCs saw some additional litigation charges and US DTA hits from
the US tax reform.

• Most IHCs are materially better capitalized than the overall European consolidated
groups.

• CET1 leverage differs materially, from a low of 4.6% at DBK, up to 13% at

Santander

Exhibit 79: U.S. IHC accounts for 2017 ($ in millions)

2017 CSGN UBS DB HSBC BNPP BARC BBVA SAN
Revenues 5,198 12,016 6,637 6,003 5,115 8,879 3,374 9,253
Costs (5,940) (10,556) (6,365) (4,827) (3,976) (6,434) (2,309) (5,771)
LLC (1) (13) 11 165 (160) (1,259) (288) (2,661)
PBT (744) 1,447 283 1,341 979 1,186 777 820
Tax & mins (1,603) (2,992) (1,371) (2,116) (692) (873) (318) (259)
Net profit (2,347) (1,544) (1,088) (775) 288 313 459 561

Total assets 141,413 140,699 148,248 273,486 139,136 157,927 87,321 128,294
Tangible assets 132,075 128,250 147,267 268,594 133,031 155,386 82,074 122,089
Tangible equity 14,776 8,276 6,961 17,683 12,432 11,557 7,538 17,305

CET1 16,120 10,995 7,257 20,418 12,532 12,954 7,965 16,342

RWA 65,333 49,566 44,091 131,945 100,775 99,232 67,489 99,756
Leverage 219,896 135,712 158,803 270,181 139,232 190,594 82,148 125,632

CET1/RWA 24.67% 22.18% 16.46% 15.47% 12.44% 13.05% 11.80% 16.38%

CET1/leverage 7.33% 8.10% 4.57% 7.56% 9.00% 6.80% 9.70% 13.01%
RWA/leverage 29.71% 36.52% 27.76% 48.84% 72.38% 52.06% 82.16% 79.40%
Source: BofA Merrill Lynch Global Research, company data

Resolution Planning, or “Living Will”

In order to prevent systemic risk across the global financial system associated with the
failure of any particular firm, the Fed requires BHCs over $50bn in assets to prepare
resolution plans, or a “living will”, to address how they would properly wind down in the
event of failure without causing significant disruption to the financial system.

Primary regulatory agencies

• Resolution planning oversight: Federal Reserve and FDIC; FSOC (to help
determine restrictions if living will deficiencies are not addressed within two years).
Following their review, the two agencies may jointly determine that a plan is not
credible or would not facilitate an orderly resolution.

Applicability
Resolution planning, or “living wills”, are applicable to bank holding companies with
$50bn in assets or greater and nonbank financial companies designated by the FSOC for
supervision by the Federal Reserve and the FDIC. More restrictive planning and
oversight are placed on the large SIFI institutions.

Requirements, interpretation, & enforcement

Dodd-Frank requires financial institutions to periodically submit resolution plans to the
Fed and the FDIC. These plans detail the institution’s strategy for rapid and orderly
resolution in the event of material financial distress or failure of the company.

158 Global Banks and Brokers | 18 May 2018

 For the large SIFI banks (currently defined as ≥$250bn in assets), resolution plans
must be submitted by July 1 of each year. Other applicable institutions are required
to file their plans by December 31.

In assessing resolution plans, the Fed and FDIC evaluate seven key areas:

1. Capital

a. Resolution Capital Adequacy and Positioning (RCAP)

b. Resolution Capital Execution Need (RCEN)

2. Liquidity

c. Resolution Adequacy and Positioning (RLAP) – banks should be

able to measure stand-alone liquidity position of each US non-branch
entity (i.e. HQLA) and ensure the liquidity is readily available to cover a
period of at least 30 days.

d. Resolution Liquidity Execution Need (RLEN) – a methodology for

estimating the liquidity needed after the bankruptcy filing to stabilize
any surviving subsidiaries. The minimum operating liquidity estimates
should capture all subsidiaries; intraday liquidity requirements, opex,
capital needs, and inter-affiliate funding frictions.

3. Governance mechanisms

4. Operational capabilities

5. Legal entity rationalization

6. Derivatives and trading activities

7. Responsiveness

We discuss the major objectives for each of those core areas and how the agencies are
evaluating the financial institutions with regards to each of those areas (see Exhibit 80).
Exhibit 80: Evaluation of resolution plans
Description Objective for each key area Evaluation by the Agencies
Firms must provide sufficient capital to material entities to Determined whether the firm had enough resources to
1) Capital ensure that they can continue to provide critical services as recapitalize or support all entities needed to execute its plan
the firm is resolved under its scenario
Appropriately forecast size and location of liquidity needs;
Firms must be able to reliably estimate and meet their
2) Liquidity incorporation into everyday process; size, positioning of
liquidity needs prior to, and in, resolution
resources
Firms must have an adequate governance structure capable
3) Governance mechanisms of identifying the onset and escalation of financial stress Firms' impact of plan on broader financial system
events in sufficient time
Firms must maintain significant operational capabilities and Possess fully developed capabilities related to managing
4) Operational capabilities
engage in regular contingency planning collateral, have management information systems
Simplification of legal entity structure to facilitate orderly Development of criteria to achieve structure and actionable
5) Legal entity rationalization
resolution options to wind down or sell discrete operations
6) Derivatives and trading Understanding the impact of trading activities at major dealer Completeness of supporting analyses in the context of
activities firms and its impact on the broader financial system broader resolution plans
Firms should take agency guidance into account for
7) Responsiveness Compliance with prior feedback in developing their new plans
developing future plans
Source: BofA Merrill Lynch Global Research, Federal Reserve, Dodd-Frank

Once each institution has submitted its “living will” plans, the Federal Reserve Board
(FRB) and FDIC review the documents and inform the institution whether there are any
deficiencies or shortcomings to their resolution plans. In April 2017, the Fed/FDIC

Global Banks and Brokers | 18 May 2018 159

announced that WFC had adequately remediated the deficiencies in its 2015 resolution
plan. (Recall in Dec. 2016 the agencies determined the bank had not remediated two of
the three deficiencies identified previously). In August/September 2017, the agencies
extended the resolution plan filing deadline. Nineteen foreign banking organizations
(FBOs) and two large US BHCs have until 12/31/18 to file, giving them an additional
year to address any supervisory guidance in their net plan submissions. The eight US
GSIBs have until 7/1/19 to submit their next resolution plan. In December 2017, the
Fed/FDIC announced the resolution plans of the eight US GSIBs didn’t have
“deficiencies.”

Consequences of living will deficiencies

Failure to properly address the living will deficiencies could result in significant
consequences. The agencies can impose “more stringent capital, leverage, or liquidity
requirements, as well as restrictions on growth, activities, or operations of the firm, or
any subsidiary thereof.”

Institutions have two years to remedy such requirements. If, following a two-year period
beginning on the date of the imposition of such requirements, a firm still has failed to
adequately remediate that deficiency, the agencies, along with the FSOC, may jointly
require the firm to divest certain assets or operations.”

Cost of regulation
The cost associated with resolution planning stems from personnel and systems costs,
reduction of legal entities, and additional liquidity requirements.

For example, JPM noted that it has added $50bn in incremental liquidity as a result of
complying with resolution planning. While other SIFI banks have not disclosed the
amount of liquidity, they have added liquidity since receiving feedback on their living will
submission and each bank’s liquidity requirement will vary depending on their legal
entities structure, we believe that they have all needed to increase their liquidity levels
even if they were compliant with LCR rules.

It is hard to separate liquidity build stemming from compliance with the liquidity
coverage ratio (LCR, a Basel prudential requirement) vs. what is required from resolution
planning requirements. However, since 2010, cash and securities have grown as a
percentage of earning assets, particularly at large SIFIs (see Chart 136). This has come
at significant cost to net interest margins, which would be naturally lower with greater
liquidity requirements.
Chart 136: SIFI banks have built up greater cash and securities balances
30.0% 29%
Cash and securities as % of earning

29.0%

+3% in sev en
28.0% y ears
assets (%)

27.0%
26%
26.0%

25.0%

24.0%
2010 2017

Source: BofA Merrill Lynch Global Research, company data, SNL Financial
Note: population includes U.S. financial institutions with over $50bn assets

160 Global Banks and Brokers | 18 May 2018

Alternate proposals
In its June 2017th proposal, the US Treasury recommends that the living will process be
made a two-year cycle rather than the current annual process. They also recommended
that the threshold for participation be revised to match the revised threshold for
application of enhanced prudential standards.

Title II: Orderly Liquidation Authority

The Orderly Liquidation Authority (OLA) empowers the FDIC to become a receiver in the
liquidation process of a failing financial firm. The OLA was created to address the “too
big to fail” perception in 2008, when there were limited mechanisms for the federal
government to handle the systemic risk arising from the failure of financial institutions.
The OLA establishes a process to wind down banks in the event of a failure, limiting or
eliminating systemic risk or the need for taxpayer support.

Primary regulatory agencies for Title II

The following agencies appear to have primary responsibility for the interpretation and
enforcement of Title II:
• Receiver: Federal Deposit Insurance Corporation (FDIC)

• Manager of the Orderly Liquidation Fund: U.S. Department of the Treasury

• Nonbanks: Securities Exchange Commission (SEC), Federal Insurance Office (part

of the Treasury Department and established by Title V of Dodd-Frank)

Key provisions of OLA

Normal bankruptcy rules would apply first if an institution is in trouble. However, in the
event that the bankruptcy process does not work, the FDIC can effectively take control of
the distressed bank through various processes including the establishment of a temporary
bridge company (see Exhibit 81).

Exhibit 81: How an OLA resolution could work

Holding Company Bridge Financial Company
Assets Private market
Equity transferred Equity sources
Assets Assets
Liabilities Liabilities Orderly
Liquidation Fund

Some liabilities
Funding Sources
transferred to bridge
(Equity wiped out)

Source: BofA Merrill Lynch Global Research

In this scenario, the bridge company would first receive the assets from the distressed
bank, along with certain senior liabilities. Existing shareholders would be wiped out. By
establishing a new entity with a stronger balance sheet, critical bank operations
including ATM withdrawals and payments processing would be allowed to continue until
the bridge company can be orderly terminated. The bridge company would also be able
to support funding/liquidity needs through private market sources and the government.

How a bridge financial company would be funded: the Orderly Liquidation Fund
One of the most controversial parts of OLA involves the Orderly Liquidation Fund (OLF),
a fund created by the U.S. Treasury from which the FDIC can borrow from to support the
liquidation of a failing firm. Proponents of this rule note that the fund would not require
the use of taxpayer dollars, as it requires the Treasury to be reimbursed in full for any
losses that are incurred. Moreover, without the OLA, proponents note there is a greater

Global Banks and Brokers | 18 May 2018 161

risk of another situation similar to what happened during the financial crisis (i.e.
Lehman) as there will be limited ways for the government to reduce the systemic
impact from a failing firm.

That said, OLA does not solve the issue of moral hazard as the Fed may face significant
pressure to authorize taxpayer bailouts in a distressed environment. Opponents of the
rule counter that the rule reinforces the notion of too big to fail as banks would have
support from the government in those situations. Additionally, the establishment of the
liquidation fund requires costs that can be deployed into other uses.

Applicability
The OLA process is applicable to all financial companies (referred to as “covered
companies” in Dodd-Frank) for which a “systemic risk determination” has been made.
This includes bank holding companies, banks, broker/dealers, insurance companies, and
other nonbank institutions. OLA was designed to supersede federal laws that were
designed more narrowly to conduct the liquidation and receivership of supervised banks,
insured depositories, and broker/dealers (previously handled by the FDIC and the
Securities Investor Protections Corporation (SIPC)).

Alternate proposals
The current administration may view Title II as unnecessary. Treasury Secretary Steven
Mnuchin has said, “...if we have proper regulation, a lot of the need for Title II also goes
away.”

That said, many of the larger institutions are concerned that a replacement would result
in more draconian regulation. Some Republicans have voiced their desire to replace the
OLA with a new chapter in the Bankruptcy code. In particular, Rep. Jeb Hensarling (R-
Tex.) and Secretary Mnuchin have discussed their support for changes to the bankruptcy
code that would be sufficient to prevent widespread damage in a distressed scenario.

Opponents of OLA are targeting the Orderly Liquidation Fund, which would effectively
limit the ability for OLA to function. Given that the OLA has an impact on congressional
budgets, the removal of the fund could be passed with a simple majority vote (i.e.,
“reconciliation” process). Rep. Hensarling’s Financial CHOICE Act calls for the repeal of
Title II.

"Cost" of regulation
According to the Congressional Budget Office (CBO), ending the Orderly Liquidation
Fund would reduce the deficit by $15.5bn over a 10-year period starting from 2018-
2027 driven by a reduction in both direct spending and revenues of $19.8bn and $4.3bn,
respectively (see Chart 137). We note that the Orderly Liquidation Fund is sourced from
assessments charged by the FDIC on the large financial companies. Additionally, while
there could be some cost relief to individual banks associated with a change in OLA, we
note that banks may need to establish and source their own fund if the OLF were to be
repealed.

162 Global Banks and Brokers | 18 May 2018

Chart 137: Estimated budget deficit reduction from the en d of OLF
$25
orderly liquidation fund (2018-2017. $bn)

$19.8 $4.3
Estimated deficit reduction from the

$20
$15.5
$15

$10

$5

$0
Revenue Expenses Net deficit reduction

Source: BofA Merrill Lynch Global Research, CBO

Title VI: Bank and Savings Association Holding Company

and Depository Institution Regulatory Act of 2010
In general, Title VI requires more stringent regulation of bank holding companies (BHCs),
savings and loans, and depository institutions. Title VI also establishes what will later be
known as the Volcker rule, which was intended to prohibit institutions from engaging in
proprietary trading.

Primary regulatory agencies for Title VI

The following agencies appear to have primary responsibility for the interpretation and
enforcement of Title VI:
• The Federal Reserve

• Volcker: U.S. Commodity Futures Trading Commission (CFTC), Securities Exchange

Commission (SEC), Federal Deposit Insurance Corporation (FDIC), the Office of the
Comptroller of the Currency (OCC) (broad powers laid out in Title I), and the Federal
Reserve Board (FRB)

Heightened capital requirements

In both Title I and Title VI, Dodd-Frank established a broad power for the Fed to impose
minimum leverage and risk based capital requirements for financial institutions. In Section
165, the Fed is allowed discretion as to the stringency of greater capital requirements and
the ability to differentiate among the institutions with regards to their recommendations,
based on an individualized or group level, including by size, capital structure, or riskiness.
The purpose of the rule is to mitigate the risks associated with a failing or distressed firm
by ensuring there is sufficient capital and liquidity to manage a stressed scenario.

Written broadly, we emphasize that Dodd-Frank itself does not establish capital and
leverage limits, but empowers the Federal Reserve to do so.

Collins Amendment eliminates trust preferreds as regulatory capital

Additionally, Section 171 of Dodd-Frank, otherwise known as the Collins Amendment,
mandated that capital requirements for BHCs are not less stringent than the requirements
imposed to depositories. Collins sets the Standardized as a floor to Advanced for those
firms that qualify for Advanced. Standardized is referred to as “generally applicable risk-
based capital requirements.” The Collins Amendment also noted that trust preferred
securities could not be included as capital in regulatory calculations.

Global Banks and Brokers | 18 May 2018 163

Applicability
The applicability for more prudent standards with regards to stricter capital
requirements is for nonbank financial companies and banks with assets over $50bn.

Requirements, interpretation, & enforcement

The Fed is given the authority to ensure that financial institutions meet minimum
capital requirements and continues to provide new standards for the level of capital
institutions are required to support. The Fed has taken minimum capital, liquidity, and
resolution requirements are set by the global Basel committee as a base. Generally, the
Fed has interpreted these rules more stringently, which has been referred to as “gold
plating.”

We have dedicated an entire section to these post-crisis Basel rules, and how local
regulators have interpreted them across the U.S., Europe, and Asia, beginning on page
93.

Alternate proposals
There are no numerical standards set in Dodd-Frank. Thus, the power granted to the
Federal Reserve to set regulatory standards is significant.

Rep. Hensarling’s Financial CHOICE Act appears to propose an alternative to the broad
power vested by Dodd-Frank to the agencies and also an alternative to compliance to
Basel-based rules governing capital and liquidity. The CHOICE Act proposes an “off-
ramp” option from the Dodd-Frank and Basel III regimes – provided that an institution
maintains a leverage requirement of at least 10%. Given where supplementary leverage
ratios (SLR) are today (and note the SLR calculates a smaller denominator than in the
CHOICE Act’s definition of leverage), this would not appear to be the desired option for
most U.S. GSIBs (see Chart 138).

Chart 138: 1Q18 SLRs vs. 10% potential leverage minimum under the CHOICE Act
12.0 Min. req. under
CHOICE Act, 10%
Supplementary leverage ratio (%)

10.0
7.9%
8.0
6.7% 6.5% 6.3% 6.0% 5.9% 5.7%
6.0

4.0

2.0

0.0
WFC C JPM MS STT BK GS

Source: BofA Merrill Lynch Global Research, company data

"Cost" of regulation
We believe that the Collins Amendment has positioned U.S. banks in better shape versus
EU banks for “Basel 4”, due to their existing standardized floor when determining RWA
calculations for regulatory purposes. Under the Collins Amendment, U.S. banks must use
the lower of either the standardized or advanced approaches as their binding constraint.

On the other hand, EU banks do not have that restriction. This has led to arguments
between global regulators over the newly proposed Basel rules around operational risk
calculations which would negatively impact EU BHCs more than US BHCs.

164 Global Banks and Brokers | 18 May 2018

While the restrictions on the U.S. banks have resulted in more required capital, they
appear better positioned to weather the proposed Basel RWA changes versus EU banks.
The reason EU banks are more opposed to the SMA (standardized measurement
approach) op risk proposal and to the Standardized floor (which will include op risk) is
because they have held much lower op risk than U.S. banks under AMA (advanced
measurement approach). Some U.S. banks have supervisory floors on top of AMA for op
risk. This is unrelated to Collins, which is a Standardized floor but unlike Basel
Standardized floor, Collins excludes op risk.

As for the direct cost of higher post-crisis capital and liquidity standards to the
economy and industry return, we provide in more detail beginning on page 134.

The Volcker Rule

Title VI of the Dodd-Frank Act introduced restrictions to prohibit banking entities from
engaging in short-term proprietary trading and from sponsoring, or investing in, private
equity and hedge funds. In other words, the intent of the rule was meant to push out
“risky and non-core” activities from the banking sector. This is primarily known as The
Volcker Rule. The final rule was adopted by regulators (the Fed, SEC, CFTC, OCC and
FDIC) on December 10, 2013.

The rule encompasses various exceptions:

• Buying/selling securities if it relates to underwriting a securities offering for a
customer;

• Purchasing/selling securities pursuant to market-making activity, although this

activity must not exceed reasonably expected near-term demand; and

• A bank can trade securities to hedge or mitigate their own risk.

Note that proprietary trading itself, on average, represented less than 15% of
aggregated U.S. SIFI revenues during the five years ended 2010 (see Chart 139).
Chart 139: Total “proprietary trading” revenue est. of 5 largest U.S. BHCs as % of total revenues
20%
"Proprietary trading" revenues at the 5

18%
largest U.S. BHCs as % of total revs

16%
14% Median, 13%
12%
10%
8%
6%
4% (negativ e rev enues)
2%
0%

Source: BofA Merrill Lynch Global Research, company data

Note: “proprietary trading” activities disclosed as: principal transactions, principal investments or trading account profits/(losses)

Applicability
The applicability of the Volcker Rule is more sweeping than meets the eye, as alluded to
by the number of agencies involved in enforcing Volcker. In theory, the restriction on
proprietary trading is most applicable to money center banks and broker/dealers. That
said, as written, the rule is applicable to “banking entities” and “nonbank financial
companies” designated by FSOC. In addition, the rule applies to the U.S. operations of
foreign banks. In other words, Volcker is felt more broadly down the size spectrum,
impacting even community banks with <$10bn in assets.

Global Banks and Brokers | 18 May 2018 165

With respect to compliance implementation, the Volcker Rule adopts a three-tiered
approach:

1. Less than $10bn in assets: Implementation of a simplified compliance

program

2. Greater than $10bn in assets: Required to implement a detailed compliance

program that includes written policies and procedures and internal controls,
etc.

3. Greater than $50bn in assets: Enhanced compliance obligations, as laid out

in the following section

List of impacted and non-impacted dealers

Interestingly, not all major broker/dealers are subject to the Volcker Rule (Exhibit 82).
Exhibit 82: List of major dealers affected and not affected by Volcker
Dealers Affected by Volcker Rule
Bank of Nova Scotia J.P. Morgan Securities
Barclays Capital Merrill Lynch, Pierce, Fenner & Smith
BMO Capital Markets Mizuho Securities USA
BNP Paribas Securities Morgan Stanley & Co.
Citigroup Global Capital Markets RBC Capital Markets
Credit Suisse Securities (USA) RBS Securities
Deutsche Bank Securities SG Americas Securities
Goldman, Sachs & Co. UBS Securities
HSBC Securities (USA)

Dealers Not Affected by Volcker Rule

Cantor Fitzgerald & Co. Jefferies & Company
Daiwa Capital Markets Americas Nomura Securities International
Source: BofA Merrill Lynch Global Research, Federal Reserve

Requirements, interpretation, & enforcement

Despite the rule’s attempt to exempt “market-making” activities from the general
prohibition on proprietary trading, there is a great deal of ambiguity between what is
and what isn’t permitted when facilitating customer activity. As such, how the final rule
has been implemented may make it more difficult for banks to buy and sell securities
for their own inventory in anticipation of client demand as it could look like “proprietary
trading,” subjecting the bank to regulatory sanctions and monetary penalties.

In addition, because of the rule’s broad scope, even small banks that aren’t in the
business of underwriting or market making have had to incur large costs just to prove
that they aren’t engaging in proprietary trading. For instance, community banks must
review their investment portfolios to determine whether they are purchasing or selling
any securities for a “trading account.” Of course, most banks, regardless of size, may
purchase securities to hedge balance sheet positioning (mostly interest rate risk).

The agencies appear to also recognize the broad scope of this rule. On December 18,
2014, the Fed announced that it would give financial institutions an additional one year
(deadline: July 21, 2016) to conform investments in and relationships with covered funds
that were in place prior to 2013. On July 7, 2016, the Fed granted financial institutions
an additional one-year extension of the conformance period (July 21, 2017).

On January 14, 2014, regulators approved an interim final rule to permit financial
institutions to retain interests in certain collateralized debt obligations (CDO) backed
primarily by trust preferred securities (TRuPs) from the investment prohibitions of the
Volcker Rule. Under the interim final rule, the agencies permit the retention of an
interest in or sponsorship of covered funds by banking entities if certain qualifications
are met.

166 Global Banks and Brokers | 18 May 2018

Given the broad scope on Volcker, enforcement and exams are and can be done by all
Volcker regulators.

Reporting and compliance requirements

Impacted banking entities must report the following to its primary supervisory agency:

1. Value-at-risk (VaR)

2. Position limits

Entities with $50bn in consolidated trading assets must report the metrics on a monthly
basis. Smaller entities are required to report these metrics on a quarterly basis.

Global Banks and Brokers | 18 May 2018 167

For banks with greater than $10bn in assets, each Volcker compliance program
must include the following six elements:

1. Written policies and procedures

2. System of internal controls

3. Management framework

4. Independent testing

5. Training for trading personnel

6. Sufficient records

Entities with greater than $50bn in assets, as well as foreign banking entities with total
U.S. assets of $50bn or more, are required to adopt an enhanced version of the basic
six-element compliance program. Regulators require more detailed policies, limits,
governance processes, and independent testing and reporting. Further, the CEOs of
entities with greater than $50bn in assets must attest that the banking entity has a
program in place to achieve Volcker compliance.

Investment restrictions broader than we expected

Volcker directly restricted bank investments in covered funds, such as hedge funds and
private equity funds. That said, the scope of what’s excluded ended up being broader
than what appeared to be the initial intent of this provision. First, the definition of an
“issuer” of funds restricted by Volcker includes any entity that relies upon two specific
exemptions laid out in the Investment Company Act of 1940: 1) funds that have 100 or
fewer investors; and 2) funds that are only sold to “qualified purchasers”.

Moreover, the test of “ownership interests” was similarly broader than what the
industry expected. Volcker defines ownership interest in a fund as any equity,
partnership, or other similar interests. Potentially ensnared in “other similar interests”
were characteristics of a standard cash flow waterfall of a securitization. As such,
certain debt investments/structured products were included, such as debt tranches of
collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and
collateralized loan obligations (CLOs) may be considered to be ownership interests.

Among the investments restricted are CDOs backed by trust preferred securities,
typically issued by banks and insurance companies. These types of investments were
particularly popular with regional banks prior to the crisis. (Some have been
grandfathered, as discussed on previous page).

“Cost” of regulation
We think there are three major “costs” stemming from the Volcker rule:

1. Higher compliance costs and operational requirements, particularly burdensome

for smaller banks;

2. Lower liquidity in the bond markets, particularly in corporate bonds; and

3. Lower revenues in fixed income trading for money-center banks.

The cost (and revenue) burden for community banks

One of the most interesting aspects of the Volcker Rule, as it is currently written in
Dodd-Frank, is the scope of applicability. Given the reporting, procedural, and other
operating requirements, we believe Volcker has even further accelerated an increase in
compliance costs. While the enhanced compliance requirements are aimed at larger
banks, we think the relative cost burden is actually greater at community banks.

It is very difficult to isolate compliance and control costs in general for banks, much less
costs related to Volcker compliance. However, a study by the Federal Reserve Bank of

168 Global Banks and Brokers | 18 May 2018

St. Louis concluded that economies of scale certainly exist for banks with regards to
compliance costs. As illustrated in the chart below, compliance expenses for community
banks (<$100mn in assets) ranged from 7-9% of total expenses, vs. 3% for a bank
between $1-10bn in assets (see Chart 140).
Chart 140: Compliance expenses as % of total opex at surveyed community banks
10.0%
Compliance expenses as % of

9.0%
noninterest expenses

8.0%
7.0%
6.0% Highest-rated banks
5.0% Other banks
4.0%
3.0%
2.0%
<$100mn $100 to $250mn $250 to $500mn $500mn to $1bn $1 to $10bn
Bank Asset Size

Source: BofA Merrill Lynch Global Research, St. Louis Fed

Note: analysis includes ~470 community banks surveyed by the St. Louis Fed

While again very difficult to quantify in aggregate, we believe Volcker has also likely had
a negative impact on community bank spread income and capital as well. Without the
existence of Volcker, TRUPs CDO investments proved problematic during the financial
crisis, as underlying issuers would miss interest payments to preserve capital. That said,
regional and community banks typically had to sell restricted instruments at a loss,
triggering after-tax charges that impacted capital. Further, the yields on these
instruments were typically attractive, especially in light of a low rate environment, and
therefore impacted spread income negatively when sold.

Please refer to our discussion on page 76 on Volcker’s potential impact on bond market
liquidity.

Title VII: Wall St. Transparency & Accountability Act of 2010

Generally speaking, Title VII of Dodd-Frank creates a framework for the regulation of
derivatives markets, which has been blamed for exacerbating the financial crisis. Title
VII vested authority in the CFTC to regulate over swaps, except for security-based
swaps. Security-based swaps are regulated by the SEC.

Prior to the financial crisis, derivatives trading was executed in the over-the-counter
(OTC) market. One of the contributors to the financial crisis was the lack of
transparency and liquidity for certain complex FICC products. To address this issue,
Dodd Frank implemented requirements that certain derivatives must be traded
electronically. In particular, Title VII of Dodd Frank requires certain derivatives to be
cleared by a clearinghouse and executed on an electronic execution facility.

Note: Title VII also applies to security-based swaps regulated by the SEC. However,
these rules are not yet final and therefore not addressed further in this report. In
addition, while Title VII encompasses a much longer list of requirements (e.g. reporting,
business conduct, etc.), we are only focusing on requirements imposed on OTC
derivatives.

Primary regulatory agencies for Title VII

The following agencies appear to have primary responsibility to the interpretation and
enforcement of Title VII:
• The Commodity Futures Trading Commission (CFTC)

Global Banks and Brokers | 18 May 2018 169

• Securities Exchange Commission (SEC)

• Swap entities that are prudentially regulated by a U.S banking regulation

(also known as a bank “CSE” or covered swap entity): The Federal Reserve
Board (FRB), the Office of the Comptroller of the Currency (OCC), the Federal
Deposit Insurance Corporation (FDIC), the Farm Credit Administration (FCA), and the
Federal Housing Finance Agency (FHFA).

Regulation of swaps
Post the financial crisis, regulations were passed around OTC/swaps products, including
margin, clearing, and trading of the instruments. However, as rules have gone into effect
and there has been time to review the pros and cons of the regulations, there is the
potential for some modifications ahead, which we discuss in this section.

Margin requirements for uncleared swaps are part of the Commodity Exchange Act
(CEA) in the Dodd-Frank Act which required regulators to adopt initial margin (IM) and
variation margin (VM) requirements for certain swap dealers (SDs) and major swap
participants (MSPs). The final rules would establish initial and variation margin
requirements for SDs and MSPs but would not require SDs and MSPs to collect margin
from nonfinancial end users.

Requirements, interpretation, & enforcement

In October 2015, the FRB, OCC, FDIC, FCA, and the FHFA adopted their version of the
uncleared swaps rule which covers Swap Entities (bank CSEs) that are supervised by
these five prudential regulators

In December 2015, the CFTC adopted its own version of the uncleared swaps rule which
covers swap entities not supervised by the aforementioned prudential regulators (non-
bank CSEs) if they are registered with the CFTC. The SEC is expected to adopt its own
rule for all non-bank CSEs that trade in security-based swaps which are required to
register with the SEC.

As part of the final rule published on August 2016 (effective date October 1, 2016),
regulators adopted interim final margin rules providing an exemption for uncleared
swaps entered for hedging purposes by qualifying commercial end users, small banks,
treasury affiliates acting as agents, and certain cooperative entities.

Uncleared margin requirements will be phased-in over a 5-year period for initial margin,
while currently all in-scope market participants are expected to post variation margin.
However, U.S. regulators have, either through formal no-action relief or examiner
guidance, allowed non-compliant counterparties to continue trading subject to certain
conditions. These conditions include, but are not limited to, good faith efforts to ensure
full compliance with variation margin requirements, as soon as possible after the
original March 1, 2017 effective date of the variation margin requirements as well as
requiring any in-scope transactions executed after March 1, 2017 to become fully
compliant with margin requirements by Sept. 1, 2017.

Below, we lay out the initial margin (IM) and variation margin (VM) requirements, along
with date of required compliance (see Exhibit 83).

170 Global Banks and Brokers | 18 May 2018

Exhibit 83: Margin requirements
Compliance Date Initial Margin Requirements
September 1, 2016 Initial margin where both the CSE combined with all its affiliates
and its counterparty combined with all its affiliates have an average
daily aggregate notional amount of "covered swaps"* for March,
April and May of 2016 that exceeds $3 trillion.
September 1, 2017 Initial margin where both the CSE combined with all its affiliates
and its counterparty combined with all its affiliates have an average
daily aggregate notional amount of covered swaps for March, April
and May of 2017 that exceeds $2.25 trillion.
September 1, 2018 Initial margin where both the CSE combined with all its affiliates
and its counterparty combined with all its affiliates have an average
daily aggregate notional amount of covered swaps for March, April
and May of 2018 that exceeds $1.5 trillion.
September 1, 2019 Initial margin where both the CSE combined with all its affiliates
and its counterparty combined with all its affiliates have an average
daily aggregate notional amount of covered swaps for March, April
and May of 2019 that exceeds $0.75 trillion.
September 1, 2020 Initial margin for any other CSE with respect to covered swaps with
any other covered counterparty.

Compliance Date Variation Margin Requirements

September 1, 2016 Variation margin where both the CSE combined with all its affiliates
and its counterparty combined with all its affiliates have an average
daily aggregate notional amount of covered swaps for March, April
and May of 2016 that exceeds $3 trillion.
March 1, 2017 Variation margin for any other CSE with respect to covered swaps
with any other counterparty that is a swap entity or financial end
user.
Source: Dodd-Frank Federal agencies. *The term “covered swaps” in the exhibit above refers to uncleared security-based swaps, foreign
exchange forwards, and foreign exchange swaps.

Applicability
Given the complexity of applicability, we thought it would be clearer to explain
applicability in a graphic, from a November 2015 publication from Davis Polk, on the
follow page (see Exhibit 84).

Global Banks and Brokers | 18 May 2018 171

 Exhibit 84: Flow chart showing U.S. margin rules (sourced from Davis Polk)
172

Is Counterparty B:
No SEC or CFTC • a commercial end user; Yes
CSE: covered swap Does Counterparty B have material sw aps
Global Banks and Brokers | 18 May 2018

Is Counterparty A margin rules No • a qualifying small bank or captive No

entity exposure (“MSE”)?
prudentially regulated for uncleared finance company;
FEU: financial end
user (i.e., a CSE)? sw aps apply to • a cooperative; or
IM: initial margin Counterparty A • a treasury affiliate acting as
(not yet Yes
MSE: material sw aps agent?
exposure Yes finalized)
VM: variation margin
No
Yes Is Counterparty B an affiliate of Counterparty
A?
Is Counterparty B a sw ap
entity?
Would the uncleared sw ap with Counterparty B
satisfy a clearing exemption to hedge or Counterparty A may adopt Counterparty A may
an IM threshold amount, Yes
mitigate commercial risk? adopt an IM threshold
up to a maximum of $50M, amount, up to a
Yes for all uncleared sw aps maximum of $20M, for
Yes betw een Counterparty A all uncleared swaps
No Is Counterparty B a financial and its affiliates and Affliate FEU w ithout
FEU betw een Counterparty A MSE
end user (“FEU”)? Counterparty B and its and that affiliate.
affiliates. w ithout
Prudentially Is Counterparty B MSE
Regulated prudentially regulated or CFTC or SEC
regulated by the SEC or Exempt sw ap: U.S. Non-affliate
CFTC? banking regulators’ FEU w ithout
Non-exempt sw ap
rules do not apply to w ith non-FEU that MSE
this uncleared swap is not a sw ap entity
w ith Counterparty B
No

Counterparty A may adopt an IM

threshold amount, up to a
Cpty A must:
Cpty A must : maximum of: • Collect IM under U.S. banking Cpty A must: Cpty A must: Cpty A must:
• Collect IM under U.S. banking $50M for all uncleared swaps Cpty A must:
regulators’ rules, • Collect IM as determined • Collect and post IM under U.S. • Collect, but is not required to post,
regulators’ rules, betw een Counterparty A and its • Collect IM as determined
• Post IM that Cpty B must collect appropriate by Cpty A banking regulators’ rules IM under U.S. banking regulators’
• Post IM that Cpty B must collect affiliates and Counterparty B appropriate by Cpty A
per CFTC or SEC rules • Collect VM as determined • Collect and post VM under U.S. rules
under U.S. banking regulators’ rules, and its affiliates; or • Collect and post VM under U.S.
• Collect and post VM under U.S. appropriate by Cpty A banking regulators’ rules • Collect and post VM under U.S.
• Collect and post VM under U.S. for uncleared swaps with an banking regulators’ rules
banking regulators’ rules banking regulators’ rules
banking regulators’ rules affiliate, $20M for all uncleared
sw aps between Counterparty A
and that affiliate.

Source: BofA Merrill Lynch Global Research, Davis Polk

Counterparty definition
The CFTC defines CSE counterparties into the following categories:

1. Swap entities;

2. Financial end users with material swaps exposure

3. Financial end users without material swaps exposure

4. Other entities, including sovereign entities, multi-lateral development banks,

and the Bank of International Settlements (BIS)

Financial end users include, but are not limited to:

1. Banks (including credit unions, trust companies, fiduciary companies, IHCs,
savings and loan companies, and industrial loan companies) plus BHCs and
depository institutions

2. Non-bank SIFIs

3. Market intermediaries (including future commissions merchants (FCMs),

broker/dealers, investment advisors)

4. Government agencies Fannie Mae, Freddie Mac, or the Federal Home Loan
Bank

5. An investment fund

6. State-licensed lenders, foreign companies

7. Insurance companies

8. A firm that trades as an agent or for its own account

9. A non-U.S. entity that would be considered a financial end user if organized

under U.S. federal or state laws

"Cost" of regulation
Some derivatives participants currently already set aside some initial and variation
margin. However, assuming the requirements were fully implemented (no phase-in
period), the CFTC stated that U.S. swap entities would be required to set aside a
significant amount of additional margin to comply, which would lead to lost revenue
assuming firms could earn a return on the IM.
Exhibit 85: U.S. participants would need to set aside additional margin to comply
($ in bil) FRB CFTC
Estimated IM Margin Requirements $315bn $800bn
FRB annual opportunity cost $760-410mn NA
CFTC annual opportunity cost between 25-160bp NA $320mn -2.05bn
Source: BofA Merrill Lynch Global Research, Federal Reserve, CFTC

Swaps clearing
Requirements, interpretation, & enforcement
Title VII of the Dodd-Frank Act also established a new regulatory framework for swaps,
and the requirement that swaps be cleared by derivative clearing organizations (DCO).
The Commodity Exchange Act (CEA), as amended by Title VII, now requires a swap:

1. To be cleared through a DCO if the CFTC has determined that the swap, or
group, category, type, or class of swap, is required to be cleared, unless an
exception to the clearing requirement applies;

2. To be reported to a swap data repository (SDR) or the CFTC/SEC directly; and;

Global Banks and Brokers | 18 May 2018 173

 3. If the swap is subject to a clearing requirement, to be executed on a
designated contract market (DCM) or swap execution facility (SEF), unless no
DCM or SEF has made the swap available to trade.

Note that Dodd Frank introduced swap execution facilities (SEFs) to increase
transparency in the OTC derivatives markets. SEFs are regulated platforms that execute
swap transactions with thorough bid/offer information (i.e. trade details). Such
platforms must register as a SEF or DCM with the CFTC. SEFs can list products for
trading, following product approval rules governed by the CFTC. SEFs must file a “made
available to trade” determination with the CFTC if a product is listed that is subject to
clearing mandate. Pre-trade transparency that should generate more competition and
pricing improvements is the goal of self-trading, since the market becomes more
transparent.

As mentioned, the creation and enforcement of swaps rules is divided between the SEC
and CFTC. The SEC has authority over “security-based swaps,” and the CFTC has
primary regulatory authority over all other swaps. The two commissions share authority
over “mixed swaps,” which are security-based swaps that also have a swaps component.

In November 2012, the CFTC set the timeline for mandatory clearing for certain interest
rate and credit default swaps, which made up approximately 90% of the swaps market.
Clearing for Category 1 entities began March 11, 2013, Category 2 on June 10, 2013,
and Category 3 on September 9, 2013.

Applicability
The CFTC initially required that swaps in four interest rate swap classes and two CDS
classes be cleared (see Exhibit 86 and Exhibit 87).
Exhibit 86: Initial CFTC interest rate swap classes
Specification Fixed-to-Floating Swap Class
1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP) Yen (JPY)
2. Floating Rate Indexes LIBOR EURIBOR LIBOR LIBOR
3. Stated Termination Date Range 28 days to 50 years 28 days to 50 years 28 days to 50 years 28 days to 30 years
4. Optionality No No No No
5. Dual Currencies No No No No
6. Conditional Notional Amounts No No No No

Specification Basis Swap Class

1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP) Yen (JPY)
2. Floating Rate Indexes LIBOR EURIBOR LIBOR LIBOR
3. Stated Termination Date Range 28 days to 50 years 28 days to 50 years 28 days to 50 years 28 days to 30 years
4. Optionality No No No No
5. Dual Currencies No No No No
6. Conditional Notional Amounts No No No No

Specification Forward Rate Agreement Class

1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP) Yen (JPY)
2. Floating Rate Indexes LIBOR EURIBOR LIBOR LIBOR
3. Stated Termination Date Range 3 days to 3 years 3 days to 3 years 3 days to 3 years 3 days to 3 years
4. Optionality No No No No
5. Dual Currencies No No No No
6. Conditional Notional Amounts No No No No

Specification Overnight Index Swap Class

1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP)
2. Floating Rate Indexes FedFunds EONIA SONIA
3. Stated Termination Date Range 7 days to 2 years 7 days to 2 years 7 days to 2 years
4. Optionality No No No
5. Dual Currencies No No No
6. Conditional Notional Amounts No No No

Source: BofA Merrill Lynch Global Research, CFTC

174 Global Banks and Brokers | 18 May 2018

Exhibit 87: Initial CFTC CDS classes
Specification North American Untranched CDS Indices Class
1. Reference Entities Corporate
2. Region North America
CDX.NA.IG
3. Indices
CDX.NA.HY
CDX.NA.IG: 3Y, 5Y, 7Y, 10Y
4. Tenor
CDX.NA.HY: 5Y
CDX.NA.IG 3Y: Series 15 and all subsequent Series, up to and including the current Series
CDX.NA.IG 5Y: Series 11 and all subsequent Series, up to and including the current Series
5. Applicable Series CDX.NA.IG 7Y: Series 8 and all subsequent Series, up to and including the current Series
CDX.NA.IG 10Y: Series 8 and all subsequent Series, up to and including the current Series
CDX.NA.HY 5Y: Series 11 and all subsequent Series, up to and including the current Series
6. Tranched No

Specification European Untranched CDS Indices Class

1. Reference Entities Corporate
2. Region Europe
iTraxx Europe
3. Indices iTraxx Europe Crossover
iTraxx Europe HiVol
iTraxx Europe: 5Y, 10Y
4. Tenor
iTraxx Europe Crossover: 5Y
iTraxx Europe HiVol: 5Y
iTraxx Europe 5Y: Series 10 and all subsequent Series, up to and including the current
Series
iTraxx Europe 10Y: Series 7 and all subsequent Series, up to and including the current
Series
5. Applicable Series
iTraxx Europe Crossover 5Y: Series 10 and all subsequent Series, up to and including the
current Series
iTraxx Europe HiVol 5Y: Series 10 and all subsequent Series, up to and including the current
Series
6. Tranched No

Source: BofA Merrill Lynch Global Research, CFTC

Recent additions to clearing requirements

In September 2016, the CFTC expanded clearing requirements to the following interest
rate swap classes:

Certain fixed-to-floating interest rate swaps denominated in:

• Australian dollar (AUD)

• Canadian dollar (CAD)

• Hong Kong dollar (HKD)

• Mexican peso (MXN)

• Norwegian krone (NOK)

• Polish zloty (PLN)

• Singapore dollar (SGD)

• Swedish krona (SEK)

• Swiss franc (CHF)

• Certain basis swaps denominated in AUD

• Certain forward rate agreements denominated in NOK, PLN, and SEK

• Certain overnight index swaps (OIS) denominated in AUD and CAD, as well as U.S.
dollar-, euro-, and sterling-denominated OIS with termination dates up to 3 years

Impact on FICC execution

The proportion of investors trading electronically increased in 2016 (compared to the
prior year) for almost every fixed income product.

Global Banks and Brokers | 18 May 2018 175

Alternate proposals
A full repeal of Title VII would likely require significant Congressional support, which we
view as challenging given that many of the rules are in effect and Congressional leaders
on both sides of the aisle attribute the uncleared swaps market as a primary cause of
the financial crisis. However, given that the new administration is in favor or reviewing
and simplifying regulations when possible, we believe there are some near-term options
for change in the form of no-action relief, cost/benefit analysis, and/or modifying some
areas. We believe the main areas where swaps regulation may be altered are around
Swap Execution Facilities, Swap Dealer Capital and an End User Exemption.

Congress enacted the G-20 swaps execution reforms in the Dodd-Frank Act by requiring
that swaps transactions be traded on regulated platforms called swap execution
facilities. As CFTC Chairman Giancarlo states, it “grafted into its SEF rules a number of
market practices from highly liquid futures markets that are antithetical to episodically
liquid swaps trading. The CFTC limited methods of swaps execution in a misinformed
attempt to re-engineer the market structure of swaps execution.”

In regards to swap dealer capital, the Chairman is looking to introduce a more principles
risk-based capital requirements, taking into account risk mitigating features of
offsetting swap positions between pairs of counterparties and posted margin. Finally
with the end user exemption, the Chairman is looking to extend the same end user
exemption to small financial end users (that don’t carry systemic risk) as it was provided
to commercial end users.

Title X: Consumer Financial Protection Act of 2010

Title X establishes the creation of the Consumer Financial Protection Bureau, or CFPB,
for the purpose of regulating consumer products. The Durbin Amendment, targeting
interchange fees, was also introduced into law by Title X.

Primary regulatory agencies for Title X

The following agencies appear to have primary responsibility for the interpretation and
enforcement of Title X:
• CFPB

• FSOC has the authority to issue a stay to the CPFB for any rules it deems a threat
to financial stability with a 2/3s vote

The creation of the CFPB

The Consumer Financial Protection Bureau (CFPB) was borne out of Title X of the Dodd-
Frank Act with the intent to be the American consumer’s watchdog for financial
services. The CFPB operates as an independent agency at the federal level and its main
functions include enforcing financial laws (i.e., Truth in Lending Act), supervising
depository institutions with $10bn+ in assets, as well as supervising non-banks,
investigating financial fraud/complaints, and advocating for consumers.

The CFPB is headed by a director appointed by the President, for a term of 5 years.

Requirements, interpretation, & enforcement

For banks, crossing the $10bn asset threshold leads to CFPB supervision with the
agency having the authority to conduct examinations. The CFPB also has the authority
to issue rules but must engage in a cost-benefit analysis for each rule, weighing the
“potential reduction of access by consumers”. As a check on power, any agency of the
FSOC (i.e. FDIC, Treasury Department) can veto CFPB regulations. That said, the CFPB
has strong executive authority as it headed by a single director appointed by the

176 Global Banks and Brokers | 18 May 2018

President with a five year term who can only be removed “for cause,” Currently, the
constitutionality of the “for cause” clause is under review by the courts.

Applicability
The CFPB covers banks and credit unions with more than $10bn in assets in addition to
mortgage lenders, loan modification and foreclosure relief services, private education
lenders, and payday lenders.

"Cost" of regulation
While the creation of the CFPB added to banks’ compliance and risk-related costs, it is
difficult to clearly isolate the incremental cost of the CFPB. However, we note that
according to the CFPB, the agency has transferred $11.8bn to U.S. consumers from
financial institutions since its inception, primarily through principal reductions/debt
cancellation ($7.7bn), followed by monetary compensation ($3.7bn) as well as relief as a
result of supervisory activity ($400mn).

Moreover, the CFPB’s laws and new rules have also led to increased costs. We flesh out
costs of mortgage regulation as outlined by Dodd Frank, in the section discussing Title
XIV beginning on the next page.

The Durbin Amendment

Requirements, interpretation, & enforcement
The Durbin Amendment is part of Section 1075 in the Dodd-Frank and Consumer
Protection Act that limits the amount of debit card interchange fees that larger sized
banks (≥$10bn of assets) can charge retail merchants. The rule went into effect in
October 2011 and set a base interchange fee of $0.21, plus a per transaction cost of
5bp. An additional $0.01 charge is included for card issuers that comply with certain
fraud protection components. The intent of the law was to help drive relief to
merchants, who could theoretically pass on those savings to the consumer.

The Durbin Amendment is enforced by the Federal Reserve, which has the power to
regulate the amount of interchange fees banks can collect. As the law is specific around
the amount that institutions are allowed to charge, a change in leadership at the Fed
would unlikely be enough for relief. Instead, a full repeal of the Amendment would likely
be needed before banks would be able to realize any relief from interchange restrictions.

Applicability
The Durbin Amendment applies to all financial institutions with over $10bn of assets.

Alternate proposals
A full repeal of the Durbin Amendment would require significant Congressional support,
which we view is unlikely given that the law itself had bipartisan support. For example,
the retail industry has benefitted the most from Durbin and may likely challenge any
attempt to repeal the Amendment.

Unlike the other Dodd-Frank laws, the Durbin amendment specifically lays out the
maximum interchange fee and transaction cost a bank can provide. As such, change
in regulatory agency leadership may be insufficient to provide any change to
interchange restrictions.

"Cost" of regulation
We found that there was a $2bn decline in interchange fees across the industry in 2011-
2012 following the enactment of the Durbin Amendment (see Chart 141), with some
banks noting greater than 40% decline in interchange fees. This translates to 15bp in
returns that could be generated if that revenue were to be returned. The industry has
been able to recover some of the loss fee revenue by increasing rates on other products.

Global Banks and Brokers | 18 May 2018 177

For example, with banks limited on their debit card interchange fees, they have focused
on driving incremental revenue through their credit card offerings. As a result, there has
been increased competition around credit card rewards among issuers – focused mostly
on the premium card category. We note that American Express and JPM have seen
significant competition around their Amex Platinum and Sapphire Reserve cards. As
such, other banks have further eroded profitability in their card business as a response,
by offering generous rewards to entice market share gains and high spending, in order
make up for the lost swipe fees.
Chart 141: There was an initial $2bn decline in interchange fees following Durbin
$43
$42.1 $42.3
$42
Bank Intercharge Fees ($bn)

Nearly $2bn of fees

$41 lost following the $40.5 $40.5
$40.1 Durbin Amendment
$40
$39.1
$39
$38.2
$38

$37

$36
2011 2012 2013 2014 2015 2016 2017

Source: BofA Merrill Lynch Global Research, company data, SNL Financial
Note: population includes U.S. financial institutions with $10bn or more in total assets

Title XIV: Mortgage Reform and Anti-Predatory Lending Act

Title XIV directly addresses one of the main causes of the global financial crisis: lax
mortgage underwriting. As a result, the CFPB issued numerous rules governing
mortgage origination standards, amending many existing federal laws, including: Real
Estate Procedures Act (RESPA) and the Truth in Lending Act (TILA).

Primary regulatory agencies for Title XIV

The following agencies appear to have primary responsibility to the interpretation and
enforcement of Title XIV:
• Consumer Financial Protection Bureau (CFPB)

• Appraisal activity regulation and oversight: The Federal Reserve Board (FRB),
the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance
Corporation (FDIC), the National Credit Union Administration Board (NCUA), the
Federal Housing Finance Agency (FHFA), CFPB

Requirements, interpretation, & enforcement

Title XIV is divided into the following Subtitles. (Note that Subtitles A, B, C, and E
together constitute the Enumerated Consumer Law).
• Subtitle A – Residential Mortgage Loan Standards. Defines the standard for
what qualifies as a “residential mortgage originator,” which was not previously
defined under TILA. TILA establishes the “ability to repay” standard, and a violation
of this standard may be raised as foreclosure defense. Subtitle A also governs
unfair lending practices. Originator compensation is also required to be
disconnected from loan terms, other than principal amount.

• Subtitle B – Minimum Standards for Mortgages. Imposes minimum standards

for mortgage, focused on ability to repay and income/documentation verification.
This act also prohibits certain prepayment penalties and limits negative

178 Global Banks and Brokers | 18 May 2018

 amortization. Subtitle B also introduces the concept of a qualified mortgage (QM)
or qualified residential mortgage (QRM), which statutorily defines a mortgage with
less risky features. QM and QRM loans provide limited Safe Harbor characteristics
(i.e., certain legal benefits), and is intended to promote the origination of relatively
“safer”, or more conservatively underwritten, loans. We dive more into QM in the
following section.

• Subtitle C – High Cost Mortgages. This law defines a “high cost mortgage”,
including but not exclusive to a first mortgage that is 6.5% higher than the average
Prime offer rate, or a second mortgage with an interest rate that is 8.5% higher
than the average Prime offer rate. This subtitle also requires such borrowers to
receive pre-loan counseling, and prohibits balloon payments. Late fees and other
points/fees on such loans are also limited by this subtitle.

• Subtitle D – Office of Housing Counseling. This act establishes the Office of

Housing Counseling, which is organized under the Department of Housing and
Urban Development (HUD). This office is tasked with conducting research and
public outreach, and to establish, coordinate, and administer all regulations related
to housing and mortgage counseling. This act also gives HUD the responsibility of
maintaining a national database of single-family defaults and foreclosures.

• Subtitle E – Mortgage Servicing. Establishes amendments to RESPA, notably

changing how mortgage servicers may interact with their customers. This subtitle
also requires banks to establish a five-year escrow to pay real estate taxes and any
necessary insurance (e.g., hazard, flood, mortgage insurance), with certain
exemptions (operating in underserved or rural communities, on-balance sheet
retention).

• Subtitle F – Appraisal Activities. Amends TILA by requiring a written appraisal

before extending a higher-risk mortgage to a borrower.

• Subtitle G – Mortgage Resolution and Modification. Under HUD, created

program that creates protection for current and future multifamily (apartment)
properties, particularly at-risk properties.

• Subtitle H – Miscellaneous Provisions. In this act, Congress acknowledged that

there should be meaningful structural reforms to Fannie Mae and Freddie Mac. Also
establishes a program to provide legal foreclosure assistance to low- and
moderate-income borrowers.

Deeper dive into Qualified Mortgage (QM) rule

Requirements, interpretation, & enforcement
The qualified mortgage (QM) rule sets the necessary underwriting criteria lenders must
abide by in order for the borrower to be qualified for a loan, thus providing the bank
certain legal protections (safe harbor).

Requirements for QM loans include:

1. Evaluate a borrower’s ability to repay the mortgage

2. Points and fees less than 3% of the loan amount

3. Exclude features such as interest only, balloon payments, negative amortization

4. Maximum term of the loan is less than or equal to 30yrs

QM mortgages typically have the advantage of being eligible to be guaranteed,

purchased, or insured by a government sponsored enterprise (GSE) such as Fannie Mae
or Freddie Mac.

Global Banks and Brokers | 18 May 2018 179

The CFPB issued the QM rule in January 2013 with an effective date of January 2014.
The agency has the authority to enforce the QM rule as it supervises banks $10bn+ in
assets as well as mortgage lenders. While a change at the CFPB would not change the
QM rule, a change in tone at the top of the CFPB could alter how aggressive the agency
levies fines or directives against lenders.

Applicability
The QM rules apply to creditors including depository institutions and mortgage banks.
However, certain mortgages do not qualify as QM. The rule is subject to borrowing
limits with loans over a certain level ($424k or $636k in high-cost areas) excluded from
QM status and thus the legal protections. Other types of lending such as interest only
are also excluded from QM status.

"Cost" of regulation
While banks likely beefed up mortgage standards prior to the QM rule going into effect
in 2014, we note large banks have reduced their exposure to the mortgage market in
recent years as QM was discussed and set as law (see Chart 142). The most dramatic
shift has been at WFC, where its share has fallen to 7.6% in 2015 vs. 12.9% in 2012. We
note that had the largest banks kept their market share in 2015 at 2012 levels, the
banks would have accreted between 2bp-22bp in additional ROTCE in 2015, assuming
they sold the loans for a 2% gain on sale (see Chart 143).
Chart 142: Mortgage market share Chart 143: Impact to ROTCE, if applied ’12 mortgage mkt share to ’15
14.0 12.9 0.25%
HMDA Mortgage market share (%)

12.0
0.20%
10.0
7.6
Impact to ROTCE

8.0
0.15%
5.6
6.0
4.5
4.0 0.10%
2.2
1.6 1.8 1.5
2.0 1.0 0.9
0.05%
0.0
WFC JPM C USB PNC
0.00%
2012 2013 2014 2015 WFC USB JPM PNC C

Source: BofA Merrill Lynch Global Research, company data, SNL Financial Source: SNL Financial, Note: Mortgage data from Home Disclosure Act
Note: Mortgage data from Home Disclosure Act; Data for banks based on largest operating subsidiary Note: Impact based on 2% gain on sale of additional loan originations, expense adjusted (75%
efficiency ratio) as well as tax-effected (35%).

While larger banks have reduced their exposure to the market, mortgage banks have
helped to fill the gap. For example, Quicken loans increased its share to 4.1% in 2015
versus 3.2% in 2012. That said, the mortgage market in 2015 was still below 2012
levels at $1.8 trillion vs. $2.1 trillion in 2012.

180 Global Banks and Brokers | 18 May 2018

Chart 144: Funded mortgage loans and impact from Qualified Mortgage (QM)
3.0

2.5
Funded mortgage loans ($tr)

QM rule
2.0 issued
QM rule
1.5 effectiv e

1.0

0.5

0.0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: BofA Merrill Lynch Global Research, SNL Financial

Note: Mortgage data from Home Disclosure Act

Department of Labor Fiduciary Rule

The Department of Labor’s (DOL) Fiduciary Rule which was finalized in April of 2016
could potentially be struck down. The 2016 rule was slated to go into full effect July 1,
2019 (some parts took effect in 2017); however, in March of 2018 the 5th circuit court
of appeals ruled that the DOL exceeded its authority in promulgating its Fiduciary Rule.
The DOL has until June 13th to challenge this decision in front of the Supreme Court,
though most see this as unlikely, including us, given the DOL and Dept. of Justice’s (DOJ)
lack of action in appealing the 5th circuit's opinion since it was given in early March.
However, more recently, the SEC has put out its best interest proposals, which we
expect more likely to get finalized over time.

Background on the DOL and Fiduciary Rule

As retirement assets have migrated from defined benefit (DB) plans to defined
contribution/401k plans (DC) and IRAs, regulatory oversight of those assets has become
disparate. Historically, the Securities and Exchange Commission (SEC), the Financial
Industry Regulatory Authority (FINRA), the Department of Labor (DOL) and the IRS had
created or enforced the regulatory standards that can apply to retirement assets. With
the 1974 Employee Retirement Income Security Act (ERISA), the DOL established
standards for private industry pension plans (both DB and 401k). A primary requirement
under ERISA is that a fiduciary standard applies to those who manage retirement plan
assets, so that person must act in the asset owner’s (individual employee’s) best
interest.

The growth of DC assets has placed an increasing proportion of retirement assets

outside a fiduciary standard, which generally does not currently govern brokerage IRA
accounts. Additionally, while the asset management firms that create the funds and
platforms for DC plans generally follow a fiduciary standard for their investment
professionals, sales people and call center employees generally do not fall under a
fiduciary standard. The DOL has been focused on revamping its rules around retirement
accounts for some time, given the shift taking place in the retirement industry. The DOL
has stated that its primary objective in proposing the new regulation is to apply a
fiduciary standard to a broader group of market participants giving advice or making
investments decisions related to retirement assets.

The DOL has also noted that it believes existing rules have insufficient scope, given
changes in where retirement assets are held (rapid growth in 401ks and IRAs) as well as
how retail investors receive advice. Since about 30% of the retirement industry is DB,
this segment is already governed under the fiduciary standard, as well as many 401(k)

Global Banks and Brokers | 18 May 2018 181

platforms (see Chart 145). However, many financial professionals (brokers vs. advisors)
that advise clients on 401(k) plans or IRAs are generally not under this standard, which
we estimate to be roughly 25-50% of the market. Note: DB/DC and IRA assets are
subject to DOL’s existing fiduciary rule (i.e., 5 part test). The new rule revised the 5-part
fiduciary rule making it easier for advisers/brokers to be deemed fiduciaries.
Chart 145: One-third of retirement plans are governed under the fiduciary standard

IRAs
33%
Other retirement
assets
40%

Defined contribution
plans
27%

Source: BofA Merrill Lynch Global Research, Cerulli (2017)

For those advisors who do not currently fall under the DOL fiduciary standard, they are
still subject to regulation and oversight, but the standard they are required to meet is
generally a “suitability” standard. Although the definitions of each are subject to some
interpretation, the primary difference between the two is that the fiduciary standard
requires an advisor to manage plan assets prudently and with undivided loyalty to the
plans and their participants (ERISA section 404a), while an advisor falling under the
suitability standard must give advice that is suitable for the client (though interests do
not necessarily have to be fully aligned).

SEC moves forward with proposals, as DOL likely out

In early April, the SEC voted to propose a package of rules and interpretations related to
investment advice, which provides for safety, quality, transparency, & consistency, while
preserving access to various types of advice and products. The SEC proposed two rules
and one interpretation, which amounts to >900 pages, with a 90 day comment period.
Our first glance is that the proposals are generally in-line with expectations, & while
details will matter & practices will likely be retooled, the general tone vs. DOL should be
more manageable for the industry and easier to understand for investors. Since this was
expected and is still a proposal, the DOL Fiduciary Rule is currently in doubt following 5th
Circuit's ruling, and the move toward fee based/advice vs. commissions has already been
a trend, we don't expect any significant reaction to the stocks in our coverage.

Regulation Best Interest for broker dealers

The first proposal establishes a best interest obligation that would apply to broker
dealers (BD) making investment recommendations to retail customers. A BD will satisfy
this obligation if prior to or at the time of the recommendation it: a) reasonably
discloses in writing the nature of its relationship and all material conflicts of interests
(COIs); b) exercises diligence, care, skill, and prudence to understand the risk/reward of
the rec/transactions, and believes it is in the client's best interest; and c) establishes,
maintains, and enforces written policies to identify, disclose, mitigate, and/or eliminate
all material COIs associated with the recommendation and financial incentives. By doing
the above, the BD would effectively satisfy its disclosure, care, and COI obligations.
These requirements go beyond existing BD suitability rules by requiring a BD to act in
the clients' best interest without placing the BD interest ahead of the client.

182 Global Banks and Brokers | 18 May 2018

Investment Adviser Interpretation
The commission also proposed an interpretation to reaffirm and clarify their view of the
fiduciary duty that investment advisers owe their clients. While the SEC acknowledged
that interpretations are “generally consistent with investment advisers' current
understanding of the practices,” the SEC is looking to propose some enhancements. In
addition, if current conduct falls short of the SECs view of the fiduciary standard, this
would put the market on notice of the Commission's views.

Form CRS, amend ADV, and use of the term advisor

In the 2nd proposal, the SEC is looking to provide a simple relationship disclosure
document (Form CRS, 4 pages max) that would provide investors with information about
the type of relationships and services the firm offers, the legal standards of conduct,
the fees and costs associated with those services, specified conflicts of interest, and
whether the firm and its financial professionals currently have reportable legal or
disciplinary events. In addition, the SEC is proposing amendments to Form ADV and to
restrict the use of "advisor" or "adviser" by broker dealers to minimize confusion.

What’s next?
The Commission will seek public comment on the proposed rules & interpretations for
90 days. Following the 90 days, along with a period to interpret the comments, we
would expect final rules.

Global Banks and Brokers | 18 May 2018 183

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Global Banks and Brokers | 18 May 2018 185

Research Analysts
U.S. Banks Marta Sanchez Romero >>
Research Analyst
Erika Najarian
MLI (UK)
Research Analyst +44 20 7995 7652
MLPF&S marta.sanchez_romero@baml.com
+1 646 855 1584
erika.najarian@baml.co m Tarik El Mejjad >>
Research Analyst
Ebrahim H. Poonawala
MLI (UK)
Research Analyst +44 20 7996 0014
MLPF&S tarik.el_mejjad@baml.com
+1 646 743 0490
ebrahim.poonawala@baml.com Sofia Carlstrom >>
Research Analyst
Brandon Berman
MLI (UK)
Research Analyst
+44 20 7996 7469
MLPF&S
sofia.carlstrom@baml. com
+1 646 855 3933
brandon.berman@baml.com Greater China Financial Insititutions
Christopher Nardone Winnie Wu >>
Research Analyst Research Analyst
MLPF&S Merrill Lynch (Hong Kong)
+1 646 743 2016 +852 3508 3058
christopher.nardone@baml.com winnie.wu@baml.com
Ryan Morrison Michael Li >>
Research Analyst Research Analyst
MLPF&S Merrill Lynch (Hong Kong)
+1 646 855 2455 +852 3508 7381
ryan.p.morrison@baml.com m.li@baml.com

US Brokers, Asset Managers & Japanese Banks

Exchanges Futoshi Sasaki >>
Research Analyst
Michael Carrier, CFA
Merrill Lynch (Japan)
Research Analyst +81 3 6225 8590
MLPF&S futoshi.sasaki@baml.com
+1 646 855 5004
michael.carrier@baml.com Daiki Kato >>
Research Analyst
Michael Needham, CFA
Merrill Lynch (Japan)
Research Analyst +81 3 6225 6043
MLPF&S daiki.kato@baml.com
+1 646 743 0179
michael.needham@baml.com U.S. Fixed Income Research
Sameer Murukutla, CFA Hima B. Inguva
Research Analyst Research Analyst
MLPF&S MLPF&S
+1 646 855 2960 +1 646 855 6810
sameer.murukutla@baml.com hima.inguva@baml.com
Jeffrey Ambrosi Mark Cabana, CFA
Research Analyst Rates Strategist
MLPF&S MLPF&S
+1 646 855 5034 +1 646 855 9591
jeffrey.ambrosi@baml.com mark.cabana@baml.co m
Shaun Calnan, CFA Ralph Axel
Research Analyst Rates Strategist
MLPF&S MLPF&S
+1 646 855 1362 +1 646 855 6226
shaun.calnan@baml.com ralph.axel@baml.com

European Banks & Brokers Olivia Lima

Rates Strategist
Alastair Ryan >>
MLPF&S
Research Analyst +1 646 855 8742
MLI (UK) olivia.lima@baml.co m
+44 20 7996 4806
alastair.ryan@baml. com
Michael Helsby >>
Research Analyst
>> Employed by a non-US affiliate of MLPF&S and is
MLI (UK) not registered/qualified as a research analyst under the
+44 20 7995 7659 FINRA rules.
michael.helsby@baml.com Refer to "Other Important Disclosures" for information
Andrew Stimpson >> on certain BofA Merrill Lynch entities that take
Research Analyst responsibility for this report in particular jurisdictions.
MLI (UK)
+44 20 7995 1066
andy.stimpson@baml.com
Alberto Cordara >>
Research Analyst
MLI (UK)
+44 20 7995 7893
alberto.cordara@baml.com

186 Global Banks and Brokers | 18 May 2018