BSIC Special Report

Markets Team
November 2015
www.bsic.it

European Investment Banks Not All Gloom

and Doom

The European banking sector has been facing significant changes in the post crisis era. We think
that in order to understand institutions properly, it is crucial to see how the new regulatory
environment alters their way of doing business.
In particular, we highlight the impact on European investment banks, as we deem them as
disproportionally affected by the new rules. Among the individual banks we view UBS as best
placed to profit from the emerging themes.
In Europe, banks represent the biggest sector, accounting for c.15% of market value. In terms of geography,
the UK (including institutions that primarily operate in Asia) and Spain house the biggest share of banks in
Europe (proxied by its contribution to the Stoxx Europe 600 Banks).
Their shares underperformed the broader European market significantly during the global financial crisis
in 2008/2009 and up to today. Factors contributing to their unpopularity among investors were severe
trading and credit losses in the post-crisis economic downturn and unprecedented amounts of litigation
charges. Global regulatory fines since Q1 2012 summed up to a total of $116bn an amount that could
have supported a leverage exposure of c.$2.3tn if a 5% leverage ratio was assumed. Furthermore, also
regulatory changes made in the aftermath of the crisis required many banks to conduct capital raises which
in turn diluted existing shareholders at prices far below their pre-crisis peaks.

European Investment Banks Not All Gloom and Doom

Chart 1: Geographic breakdown of the Stoxx Europe 600 Banks Index
Germany
4%

Austria Ireland Other

1%
1%
1%

Benelux
7%

Spain
16%

Italy
10%
UK Asia
15%
France
10%

UK
13%

Switzerland
11%
Nordic
11%

Source: Bloomberg

As for today, financial institutions are still adjusting to the regulatory changes. However, as the outlook
becomes clearer and growth picks up in the European economy, we believe that the picture for European
banks is set to finally brighten up.
Since regulatory changes have a disproportionate effect on the investment banking business, we strive to
analyse the individual trends and how players in this field are positioned. In particular, we shed light on four
specific topics: Rising capital requirements, a switch from bank loans to bonds, the increasing importance
of wealth and asset management and decreasing market liquidity. Moreover, we briefly highlight how
individual institutions are positioned towards the changing environment and how they might likely be
affected going forward.

We restate the educational purpose of this report. To contact the authors of this analysis, please write
to: as.investmentclub@unibocconi.it

European Investment Banks Not All Gloom and Doom

Rising capital requirements

As regulatory changes have put a strong emphasis on capital requirements, this is the most obvious area in
which European investment banks are impacted. In particular leverage requirements have caused headaches
for institutions. So far, only Barclays is above the final requirements. The minimum threshold for Swiss
banks has recently been increased to 5% reflecting the highest level among European banks.
The requirement to hold adequate levels of capital is rooted in the nature of the traditional banking business
model. They take deposits from savers and lend them on to economic agents in need of funding. Since the
possibility exist that a borrower may not repay his loan, banks must be run with sufficient amounts of
equity, capable of absorbing resulting losses without affecting depositors.
The minimum threshold for equity capital for banks has changed significantly in the course of the recent
years, becoming ever more complex, sophisticated and characterized by a variety of (at times) confusing
acronyms. In order to properly understand the crucial aspect of capital regulation, we briefly sketch out the
development of these rules.

Exhibit 1: Capital regulation for banks has tightened since the introduction of the Basel 1
framework
Basel 1

Weighting different assets by their credit

riskiness

Introduction of Tier 1 and Tier 2 capital

to separate higher quality capital (e.g.
shareholders equity, but also hybrid
instruments) from more senior types of
funding (subordinated bonds)

Introduction of threshold to cover at least

8% of risk-weighted assets with total
regulatory capital (at least 4% with Tier 1
Capital)

Basel 2

Basel 2.5

Pillar 1: Need for banks to hold capital

also against operational risks and market
risk

Introduction of Stressed Value-at-Risk,

measuring VaR deploying conditions of
economic turbulence

Pillar 2: Possibility of increased capital

requirments above the Pillar 1 minimum
if demanded by national supervisors

Application of Incremental Risk Charge

(IRC), designed to eliminate the
advantage some banks gained from
holding credit risk in their trading book

Pillar 3: Requirement for banks to

disclose granular details about risk
modelling assumptions and reconciliation
from shareholders equity to regulatory
capital

Basel 3

Significant changes to the calculation of

regulatory capital (much stricter
definition of equity and hybrid
instruments)

CET1/RWA of at least 4.5%

complemented by a capital conservation
buffer of 2.5% of CET1 (further
countercyclical buffers of 0-3% might be
added by national regulators to keep
credit growth under control

Buffers for globally systematically

important banks can add up to 2.5%
CET1

Introduction of a leverage ratio, Liquidity

Coverage Ratio (LCR) and Net Stable
Funding Ratio (NSFR) to further limit
the absolute size of banks balance sheets
and make funding structure more resilien
to market swings

Use of Comprehensive Risk Measure

(CRM) to capture the risk surrounding
correlation trading portfolios

Note: Basel 3 requirements to be phased-in until 2019.

Source: BSIC

In the past, banks were mainly regulated on a single metric of Tier 1 capital against risk-weighted assets
(RWA). Hence, as long as institutions were engaged in low-risk activities, they could ramp up their balance
sheet significantly without being required to hold high levels of capital against it.
Going forward, banks will face additional constraints about funding structure and also absolute balance
sheet limits. Hence, bank managers are set to find a balanced model in order to both maximize shareholder
returns and also satisfy regulatory requirements. Therefore, we believe that the most efficient way for banks
would be to slightly exceed the minimum levels.
Below we list the minimum thresholds for regulatory requirements according to the Basel 3 framework (see
the appendix for further explanation of the terms):
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European Investment Banks Not All Gloom and Doom

Table 1: Basel 3 minimum requirements also regulate absolute balance sheet size and funding
structure
Category

Basel 3 Regulatory Minimum

Common Equity Tier 1 capital

10%

Supplementary Leverage Ratio

3%

Liquidity Coverage Ratio

100%

Net Stable Funding Ratio

100%

Total Loss Absorbing Capacity

18%

Note: According to Pillar 2 of the Basel 2 framework, national regulators might require banks to operate with capital levels
above the bare Basel minimum.

Source: BSIC

To identify how individual banks are positioned towards these rules, we map current requirements against
actual levels at different institutions:

Chart 2: Barclays regulatory balance vs. minimums

Chart 3: UBS regulatory balance vs. minimums

CET1

CET1

150%

150%

100%

100%

TLAC

SLR

TLAC

SLR

50%

NSFR

50%

LCR

Regulatory minimums are set in accordance with UK modifications:

10% CET1, 3.7% SLR, 100% LCR and NSFR, 25% TLAC
Source: BSIC, company information

NSFR

LCR

Regulatory minimums are set in accordance with Swiss modifications:

12% CET1, 5% SLR, 100% LCR and NSFR, 25% TLAC
Source: BSIC, company information

European Investment Banks Not All Gloom and Doom

Chart 4: DB regulatory balance vs. minimums

Chart 5: CS regulatory balance vs. minimums

CET1
150%

CET1
150%

100%

100%

TLAC

SLR

TLAC

SLR

50%

NSFR

50%

LCR

Regulatory minimums are set in accordance with UK modifications:

10% CET1, 3.7% SLR, 100% LCR and NSFR, 25% TLAC
Source: BSIC, company information

NSFR

LCR

Regulatory minimums are set in accordance with Swiss modifications:

12% CET1, 5% SLR, 100% LCR and NSFR, 25% TLAC
Source: BSIC, company information

We view UBS and Barclays as overall better placed than Deutsche Bank and Credit Suisse who are
currently further behind in terms of restructuring their business models. CS recent announcement of a
capital raise amounting to CHF6bn can be seen as a further attempt to shore up the lenders capital base,
bridging the gap to meet minimum requirements for CET1 and leverage ratio.

European Investment Banks Not All Gloom and Doom

Financing switch form loans to bonds

Corporations in Europe have historically financed themselves through bank loans. This, however, has been
changing since the beginning of the crisis and data also shows that the corporate world has finally moved
on to diversify its sources of financing.
During the crisis, European banks were broadly unwilling to lend, much to the detriment of CFOs. On the
contrary, in the US, firms were more accustomed to accessing the bond markets so that their stream of
funding turned out to be more resilient (as the FED was propping up capital market activity). Moreover, in
Europe, the recapitalization of banks post the crisis is still ongoing and financial institutions continue on a
trajectory of deleveraging a fact that also contributed to a more sluggish economic recovery as compared
to the US.
Furthermore, the European insurance industry is forced to shift assets away from equities into fixed-income
due to regulatory requirements (Solvency II). This trend has further increased demand for corporate bond
issuances, and has also been followed by European pension funds. Beyond the traditional banking space,
private equity investors and other shadow banking entities are more and more either buying or helping to
fund corporates, thereby lowering bank loan demand and further supporting capital market activity (e.g.
leveraged loans).
We believe this pattern to be somewhat of a structural shift in the corporate landscape and think that
investment banks are most likely to profit from this trend, as they are naturally geared towards capital market
operations.
Chart 6: Although total borrowings have stagnated since 2008, the share of funding from bond
issuances has increased (bn)
6000
5000
4000
3000
2000
1000
0
Sep-97

Sep-00

Sep-03

Sep-06

Sep-09

Bank Loans

Corporate Debt Issued

Sep-12

Sep-15

Source: ECB

European Investment Banks Not All Gloom and Doom

Increased attractiveness of Wealth and Asset Management:

Households are not merely saving through the use of bank deposits, but also invest in a variety of other
financial assets such as equities, fixed-income securities, mutual funds, ETFs, pension funds and in some
cases even alternative investments.

Chart 7: Households hold significant amounts of financial assets different from deposits
100%
80%
60%
40%
20%
0%
UK

Germany

France

Currency and Deposits

Debt and Loans

Insurance and Pensions

Other

Spain

Italy

Equity and Mutual Funds

Source: Bank of England, Bundesbank, Banque de France, Banco de Espana, Banca DItalia

Since banks have struggled to completely pass on the diminished investment returns of a zero-interest rate
environment to their customers via equivalent reduction in deposit rates, some institutions have tried to
encourage their customers to switch into asset management products. The respective divisions generate a
recurring management fee instead of traditional net interest income.
Therefore, banks that have a big asset management franchise should be able to escape or at least mitigate
the effect of depressed interest margins. With regard to the overall market, some European investment
banks show up among the top players in the space, but are not dominating the field which is spearheaded
by Blackrock, a pure-play asset manager.

European Investment Banks Not All Gloom and Doom

Table 2: While traditional asset managers largely dominate the space, some banks display a
significant amount of Asset under Management (2014)
Global Ranking
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25

Institution
Blackrock
Vanguard AM
State Street
Fidelity
BNY Mellon
JPMorgan AM
Capital Group
PIMCO
Pramerica IM
Amundi
Goldman Sachs AM
Northern Trust AM
Wellington
Natixis Hlobal AM
Frankin Templeton
Deutsche A&WM
TIAA-CREF
Invesco
Legal & General IM
AXA IM
T. Row Price
Legg Mason
UBS Global AM
BNP Paribas IP
Affiliated Managers

AUM (US$bn)
3844.4
2577.4
2023.1
1595.4
1407.2
1266.8
1167.2
1162.6
968.6
866.0
846.2
772.0
755.1
735.5
727.4
721.7
703.5
654.6
643.1
623.0
617.2
586.0
552.1
514.0
512.6

Source: Investment and Pensions Europe 2014

Being a hybrid between typical asset managers and traditional retail banks, many investment banks offer
specialized services to their most affluent customers in dedicated Wealth Management businesses. Top
market shares in the field are occupied by diversified, global banks. The rest is made up of regional specialists
(mainly from Switzerland).

European Investment Banks Not All Gloom and Doom

Table 3: UBS and CS rank at the top among global wealth managers when compared for Assets
under Management (2013)
Global Ranking
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25

Institution
UBS
Bank of America Merrill Lynch
Morgan Stanley
Credit Suisse
Royal Bank of Canada
BNP Paribas
Deutsche Bank
HSBC
JPMorgan
Pictet
Goldman Sachs
Julius Baer
Barclays
ABM Amro
Northern Trust
Wells Fargo
Lombard Odier
Santander
Bank of NY Mellon
Credit Agricole
BMO Financial Group
CIC
Societe Generale
Bank Safra Sarasin
Citi Private Banking

AUM (US$bn)
1,966.9
1,866.6
1,454.0
888.2
673.2
395.1
384.1
382.0
361.0
338.1
330.0
282.5
233.2
231.7
221.8
218.0
198.0
196.5
185.0
182.0
171.7
141.8
116.3
115.6
112.3

Source: Scorpio Partnership Global Private Banking Benchmark 2014

Both of the areas mentioned above, asset and wealth management, are very attractive for banks in the new
regulatory framework. They generate recurring fees, their asset base displays a relatively high level of
stickiness, and they both require only a comparatively low level of capital to be run. By charging a fee on
assets which are held off-balance sheet, institutions are able to operate with significantly less capital than in
a banking division returns are also considered among the highest among all operating units. As investment
banks are well positioned in that space, we believe that they are the main beneficiaries of this emerging
trend within the broader banking industry. Again, especially UBS has a strong footprint in both areas, which
is further underpinned by its strategical focus on that field, following a radical restructuring of its business
model after the financial crisis.

European Investment Banks Not All Gloom and Doom

Decreasing Market Liquidity:
Banks have reacted to new regulatory requirements by slashing trading inventories and exiting products or
geographies. The most recent example is Deutsche Bank, which decided in the wake of a strategic overhaul
to exit 10 countries and cut its staff by 9,000 employees. Moreover, it will gradually stop doing business in
some parts of its investment banking division, such as securitized trading and market making for uncleared
credit default swaps, areas heavily burdened by new capital rules.
As a result, the industry sports trading portfolios which are 40% smaller than at the outbreak of the financial
crisis in 2008. What sounds good in terms of potentially smaller, better-capitalized and more stable
institutions who are less likely to require state support in the next banking crisis, will be to the detriment of
customers who are facing decreasing levels of liquidity.

Chart 8: Bank trading portfolios have dropped by c.40% since their peak in 2008 (US$tn)
20
16
12
8
4
0
1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14
Euro Area

Other Europe

United States

Source: IMF

A potential remedy to this issue is seen in moves towards more agency-style business models with
standardized products and electronic trading. While this has also proven to work well in equities and FX, it
is still to be seen if standardized swap products will meet investors interest. In contrast, the transition of
the corporate bond market seems to be more troublesome. Since the market is very wide and lacks
significant depth with tens of different sorts of bonds for each equity, trading activity in these instruments
is relatively low. For banks it has so far not been successful to establish proprietary trading platforms and
reach a critical mass, as clients shy away from revealing demand for buyers/sellers in case anyone trades in
front of them (recent LIBOR and FX scandals prove them right). Also corporate issuers are less likely to
expose themselves to refinancing risk which would come along with standardized issuance schedules.
We view UBS focus on equities and its relatively good level of progress in the field of electronic trading as
favourable for the bank in the near-term. The outlook for Deutsche Bank seems more tarnished as the bank
has traditionally a strong footprint in the debt trading space and is likely forced to significantly reprioritize
its activities while still maintain adequate levels of profits and returns.
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European Investment Banks Not All Gloom and Doom

Appendix
AuM:

Assets under Management. Assets managed by the bank on behalf of clients. Off-balance sheet.

Basel 3:

The current global minimum bank capital requirements. Includes CET1, RWA and leverage.

CET1:

Common Equity Tier 1 capital. The highest quality measure of a banks capital.

LCR:

Liquidity Coverage Ratio. A measure designed to ensure banks have enough high quality liquid assets
that it can sell in order to survive a 30-days liquidity crisis.

NSFR:

Net Stable Funding Ratio. Requires banks to make sure the bank does not fund long-term assets
with very short-term liabilities.

RWA:

Risk-Weighted Assets.

SLR:

Supplementary Leverage Ratio. An equivalent to the US leverage ratio. Measures CET1 capital
against total assets.

Tier 2:

In Europe, a non-perpetual debt instrument which is designed to absorb losses on a gone-concern

basis.

TLAC:

Total Loss Absorbing Capacity. Subordinated parts of bank capital required to avoid losses jumping
from equity investors directly to deposit holders.

VaR:

Value-at-Risk. An industry standard measure of risk from change in market valuations.

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European Investment Banks Not All Gloom and Doom

Disclaimer
All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi
University. All the financial recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any
responsibility for eventual losses you may incur implementing all or part of the ideas contained in this website. The Bocconi Students
Investment Club is not authorised to give investment advice. Information, opinions and estimates contained in this report reflect a judgment
at its original date of publication by Bocconi Students Investment Club and are subject to change without notice. The price, value of and
income from any of the securities or financial instruments mentioned in this report can fall as well as rise. Bocconi Students Investment
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Copyright Nov-15 BSIC | Bocconi Students Investment Club

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