CAPITAL. Pillar I of Post-Crisis Bank Regulations. Yielding to a New Regulatory Reality A Six Part Series. ssga.com

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1 Yielding to a New Regulatory Reality A Six Part Series CAPITAL ssga.com For investment professional use only. Not for use with the public. [Body - 07.audience] [BODY - 06.disclosure] The views expressed in this material are the views of Author Name through the period ended Month DD, YYYY and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. [DISCLOSURE - 00.bold] Past performance is not a guarantee of future results. Solo voluptatem se vendeliquas seceaquid modi dolore, ommo tor Tem nihilliquis moluptate poribuscipic tesecestium volore voluptis magnis illiqua musapide poraest et eossequibus as ene porro dolumquiaes nist, simodiorio. Nem quiduntinvel moloreritem aditas el et eostium nulla doloris dolecte mporernatis eum es aut pro dunto verum autem qui dolecum aniam etum quostio nseque secesti busandaepro bere natibus maioren derovide lab ipsa ium endella borepta dundempe evel moloribusam fugit, aut a qui comnimpor aut verumquia volorpor si odit quid eostibus, esequae ritibusam atem sam dolut evendip iducipsum eiur atius sam, quiam, velicid et odi omnis ne rest, sequi si accat dollit quam, siminctatem harum ex erio militin pos ea vellesequi omnim quatios voluptur aborepe pra nonsentem. Estrumquis quos evenisi mporem fugit moluptus molum dolo et a cumquis si restia con ra ped quis dem sequaest quae sequunt omnis is veris accaboriatur sit, sunt quid quiae con eum ab in Pillar I of Post-Crisis Bank Regulations enditia cus ene la adit odisinulles solorenihil il ipsus dis ditas et exerati ssusapelecte et venim laboreperae officto tatiate voluptae elia quate pedit remolupiet aliciet volupta nis evel maios doluptate volore as restem nonsent fuga. Nam doluptis nis reserum iumquissi culla volenis enistiis et is exeribus dus, core, ut quis diti corrunt que latur molorer spicipides nempedi picienda ducimpo repudia volorumet apidem. Itat lautem qui alia volorion pligent utem unt quunt poreprerum volupturia consediti id ma quas por aut volorro voluptate parchitiist, sunt. Solo voluptatem se vendeliquas seceaquid modi dolore, ommo tor Tem nihilliquis moluptate poribuscipic tesecestium volore voluptis magnis illiqua musapide poraest et eossequibus as ene porro dolumquiaes nist, simodiorio. Nem quiduntinvel moloreritem aditas el et eostium nulla doloris dolecte mporernatis eum es aut pro dunto verum autem qui dolecum aniam etum ab in enditia cus ene la adit odisinulles solorenihil il ipsus dis ditas et exerati ssusapelecte et venim laboreperae officto tatiate voluptae elia quate pedit remolupiet aliciet volupta nis evel maios doluptate volore as restem nonsent fuga. Nam doluptis nis reserum iumquissi culla volenis enistiis et is exeribus dus, core, ut quis diti corrunt que latur molorer spicipides nempedi picienda ducimpo repudia volorumet apidem. Itat lautem qui alia volorion pligent utem unt quunt poreprerum volupturia consediti id ma quas por aut volorro voluptate parchitiist, sunt. Nem quiduntinvel moloreritem aditas el et eostium nulla doloris dolecte mporernatis eum es aut pro dunto verum autem qui dolecum aniam etum ab in enditia cus ene la adit odisinulles solorenihil il ipsus dis ditas et exerati ssusapelecte et venim laboreperae officto. Estrumquis quos evenisi mporem fugit moluptus molum dolo et a cumquis si restia con ra ped quis dem sequaest quae sequunt omnis is veris accaboriatur sit, sunt quid quiae con eum ab in. State Street Global Advisors, One Lincoln Street, Boston, MA XX State Street Corporation. All Rights Reserved. IDXXXX-ABCD-XXXX MMYY Exp. Date: MM/DD/20XX

2 THE THREE PILLARS OF POST-CRISIS BANK REGULATION The approach employed by US regulators following the financial crisis has been built on three pillars: capital, liquidity and funding, and resolution. This series explores these regulatory changes and their effects on the banking industry and short-term funding markets. Grappling with the implications of new regulations can be a challenging proposition. In this paper, we explore the practical implications of the first pillar capital on banks and short-term markets. GOAL End Too Big to Fail Strengthen Financial System Prevent De-Stabilizing Asset Fire Sales IMPACT Shifting Bank Business Models ROE Pressures Weaker Market Liquidity Lower Supply of Short-Term Liquid Assets CAPITAL Regulatory Capital (CET1), Captial Buffers and Accumulated Other Comprehensive Income (AOCI) Supplementary Leverage Ratio (SLR) Stress Testing LIQUIDITY & FUNDING Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) Short-Term Wholesale Funding Capital Buffer RESOLUTION PLANNING Living Wills Orderly Liquidation Authority (OLA) Total Loss Absorbing Capacity (TLAC) Source: SSGA 6/30/2015.

3 PROGRESS HAS BEEN MADE Efforts to eliminate the need to bail out too-big-to-fail institutions have primarily consisted of new regulations aimed at improving core fundamentals and reducing complexities. The Dodd-Frank Act and the implementation of Basel III are the driving forces behind regulatory reforms globally. While these regulations are not without consequences both intended and unintended banks have clearly become stronger in the wake of the financial crisis. This is evident in the credit markets. Indeed, despite facing prospects of explicit debt write-downs, reduced government support and negative ratings pressure, the banking sector s credit spreads now trade well inside their industrial peers (Figure 1). The trend, which is driven in large part by the industry s proactive compliance with regulatory implementation, has translated into a greater willingness on the part of investors to take on bank risk. Figure 1: Investors Demand Less Spread for Bank Risk, Despite Bail-In Regimes and Reduced Government Support Basis Points Banks Trade Tight to Industrials Banks Percieved Riskier Than Industrials; High Beta Back to Pre-crisis Relationship Capital is the lifeblood of a bank, acting as a cushion against losses and as layer of protection for depositors and creditors. The Basel Committee on Banking Supervision sets global capital standards and acts as a forum for cooperation on banking supervisory matters. The committee proposes global banking rules, which are then adopted with various modifications by individual countries. Though the Basel Committee has modified capital rules since the 1988 introduction of Basel C, the changes that have occurred in the wake of the financial crisis represent the most material overhaul yet. The culmination of these new rules has been dubbed Basel III. Two new capital ratios were created by the Basel committee in The first ratio, the common equity tier 1 (CET1) ratio, requires that banks hold minimum amounts of common equity capital the strongest and most expensive form of capital relative to their riskweighted assets. The second ratio, the supplementary leverage ratio (SLR), requires that banks hold minimum amounts of tier 1 capital relative to all leveraged exposures, both on- and off-balance sheet, regardless of their risk. 1 0 July 2005 Nov 2007 Mar 2009 July 2011 Nov 2013 June 2015 Industrial IG Option Adjusted Spread (OAS) Banking IG OAS Source: Barclays Capital. As of June 30, State Street Global Advisors 3

4 Common Equity Tier 1 Ratio Supplementary Leverage Ratio CET1 = Tier 1 Common Equity 7%+ Buffers SLR = Risk Weighted Assets Tier 1 Capital Total Leveraged Exposure (i.e. on and off balance sheet) 5% (Bank) and 6% (Holding Company) Under Basel III, global banks must maintain a minimum CET1 ratio of 7 percent, which includes a 2.5 percent capital conservation buffer. In addition to this requirement, there are two additional buffers: a countercyclical buffer of up to 2.5 percent that can be required by regulators during times of frothiness in the banking system 2 and a Global Systemically Important Bank (G-SIB) buffer that is based on a measure of systemic importance. 3 Note that the US G-SIB buffer ranges up to 5.5 percent and is more punitive than the 3.5 percent called for under Basel rules. Accounting for these new rules, US banks are mandated to hold a CET1 ratio of between 7 and 15 percent, as shown in Figure 2. By comparison, this ratio dipped to just over 4 percent during the financial crisis. 4 This significant growth in capital is positive for bank creditors, including money fund investors, to the extent that it provides a new layer of protection against default which is especially important given the elimination of government support for too-big-to-fail banks. (See Part 1 in this series, No More Bank Bailouts. ) Implications of CET1 Requirements Requirements to hold higher levels of common equity will result in greater protection for creditors but weaker Return on Equities (ROEs) for bank shareholders. Over time, a higher CET1 requirement may prompt banks to retreat from business lines and operating segments that do not meet their return thresholds. The industry s appetite for certain asset classes could wane as certain assets become more expensive to hold as a result of their risk weightings. Banks already have shown less appetite to hold a range of higher-risk assets, from municipal bonds to derivatives. Fewer trades in those arenas can have ripple effects on the money markets, because they restrict the amount of short-term debt banks issue to maintain liquidity. The result can be a more expensive securitization business, less liquidity in the marketplace and higher transaction costs for customers. 5,6 The supplementary leverage ratio (SLR) is intended to complement risk-based capital requirements. It treats all assets equally, regardless of risk. This approach helps to reduce the probability that risk-based capital requirements understate true risk, which was a problem during the financial crisis. 7 The SLR also allows for a better comparison of capital ratios globally. 8 In the United States, G-SIBs must meet minimum requirements in order to pay discretionary bonuses or make capital disbursements. While the Federal Reserve prefers risk-based capital metrics as the binding capital constraint for large banks, it believes that the SLR could act as a binding constraint for some institutions, depending on their business model. 9 To comply with the SLR, US banks with more than $250 billion in assets must maintain a 3 percent ratio. For US banks with over $750 billion in assets or $10 trillion in custody assets (i.e., G-SIBs), the SLR is superseded by the enhanced SLR, which requires the bank to maintain a 5 percent ratio at the holding company and a 6 percent ratio at bank subsidiaries. Implications of SLR Requiring capital to be held against low-risk assets creates a drag on a bank s profitability. For example, a bank receiving a large institutional deposit inflow at the end of the quarter may choose to park that cash at the Fed as an excess reserve earning 0.25 percent. Though this is a very low-risk asset, banks must still hold 5 percent capital against the exposure under the SLR, resulting in a very low return on equity. It is no surprise that some banks are now charging institutional clients for maintaining large deposit balances.10 Banks can shed low-yielding liquid assets to reduce the capital drag, but this runs contrary to new liquidity rules (spelled out in the next installment in this series). Banks have responded by reducing low-risk secured financing such as repurchase agreements. Banks run large matched books of repurchase agreements and reverse repurchase agreements. This high volume, low margin, capital intensive business has become less attractive under the SLR. In fact, this business has already shrunk by half since Recent evidence illustrated in Figure 2 suggests that there has been a modest shift to more profitable repo balances collateralized by non-traditional assets such as equities. shift to more profitable repo balances collateralized by non-traditional assets such as equities. State Street Global Advisors 4

5 While repo should continue to be a vital part of how banks finance their inventory of securities and cover short positions, banks may have less capacity to finance lower-risk assets. For example, a bank previously might have loaned money to a mortgage REIT, taken its mortgages as collateral and then used those mortgages as its collateral on repurchase agreements. Today the need to hold capital against the initial loan makes such arrangements prohibitively expensive. As the bank s role in the collateral transformation process shrinks, the result could be higher pricing and less availability of low-risk repo. Overall, the SLR has a very meaningful impact on short-end markets. To meet the SLR, banks must either de-lever their balance sheets, pass along additional costs to customers (in the form of wider spreads in short-term markets) or eliminate less profitable lines of business. Moving forward, as every asset a bank finances becomes more highly scrutinized, the SLR likely reduces the frequency with which banks use the money markets to borrow opportunistically via such traditionally low-risk instruments as repo, fed funds and commercial paper. The end result for money market funds and their investors is likely to be a lower supply of investable money market securities. Figure 2: Tri-Party Repo (Small Business) Gradually Shifting Towards Riskier Collateral Types Repo Collateral Type 2010 ($)* 2014 ($)** % Change Traditional Collateral Agency MBS US Treasury Excluding Strips Agency Debentures & Strips Agency CMOs US Treasury Strips Subtotal: Traditional Collateral 3, , Non-Traditional Collateral Corporate Investment Grade Equities CMO Private Label ABS Corporates Non Investment Grade Money Market Instruments Other Subtotal: Non-Traditional Collateral Total Tri-party Repo 3, , Source: Federal Reserve Bank of New York, SIFMA. *State date: 5/11/2010 **End date: 12/9/2014 Glossary Agency MBS the purchase of mortgage-backed securities issued by government-sponsored enterprises such as Ginnie Mae, Fannie Mae or Freddie Mac. Agency Debentures Debt issued by a federal agency or a governmentsponsored enterprise (GSE) for financing purposes. Agency CMOs A collateralized mortgage obligation (CMO) is a type of mortgage-backed security in which principal repayments are organized according to their maturities and into different classes based on risk. US Treasury STRIPS STRIPS is an acronym for 'separate trading of registered interest and principal securities. These are fixed-income securities sold at a significant discount to face value and offer no interest payments because they mature at par. Corporate Investment Grade A rating that indicates that a municipal or corporate bond has a relatively low risk of default. Equities the difference between the value of the assets/interest and the cost of the liabilities of something owned. CMO Private Label Any deal that is not securitized under an agency or GSE shelf can be considered private label, as the issuing entity has no connection to the US government. Asset backed security (ABS) A security whose income payments and hence value are derived from and collateralized (or backed) by a specified pool of underlying assets. Corporates Non Investment Grade A bond rating that signifies low credit quality with a relatively high risk of defaulting. Money Market Instruments Short-term, low risk financial instruments such as bankers' acceptance, certificates of deposit, commercial paper or treasury bills. State Street Global Advisors 5

6 Stress Testing Since 2009, when the Federal Reserve first publicly released a stress test on the US banking industry, the process has evolved into a critical tool to manage the industry s capital levels. The stress test process is actually a series of two tests: the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test (DFAST). To pass CCAR, banks must not only keep their capital levels above minimum thresholds currently a CET1 level of 4.5 percent but they must also ensure to regulators that their capital planning processes are robust and well governed. 11 Implications Complying with stress test requirements is expensive. 12 Banks will need to absorb this additional cost or pass it on to customers. CCAR can effectively reverse-engineer minimum capital ratios higher. For example, consider Figure 3, which shows the impact of CCAR on a bank with a 10 percent all-in CET1 requirement. If the bank lost 500 basis points of capital in the prior year s stress test and assumed a similar result in the current year, 13 it would need a ratio of 5 percent to pass versus the 4.5 percent minimum. However, this stressed ratio does not include proposed capital returns to shareholders. If shareholder returns were a presumed 200 basis points of capital, as shown in section (B), the bank s ratio would fall to 3.0, resulting in a failing grade. What s more, the Fed recently indicated that it might eventually raise the minimum stressed CET1 ratio by incorporating additional buffers. 14 Any uptick in the minimum ratio would call for an equivalent rise in a bank s implied requirement. This remains a significant unknown but is extremely important for banks capital planning process. CCAR serves to limit leverage and creates an incentive for banks to reduce riskier assets. Moreover, a failing grade constrains the ability of a bank to return capital to shareholders. As CCAR becomes more of a binding constraint for the banking industry especially if minimum requirements are raised banks could become even more conservative with their balance sheets, resulting in a smaller supply of investable securities for money market funds. Figure 3: CCAR Illustrating Impact of Stress Test Scenerios on Required Capital Levels (A). No Capital Returned to Shareholders Minimum CET1 Ratio 7.0 Add: Management Buffer to CET1 0.5 Add: GSIB Buffer 2.5 "All-in" Implied CET1 Requirement 10.0 Less: Capital Return to Shareholders 0.0 Less: Losses from Prior Year CCAR -5.0 Stressed CET1 Ratio 5.0 Minimum Requirment 4.5 Pass/Fail PASS Additional Capital Needed to 'Pass' Implied CET1 Requirment to Pass CCAR 10.0 (B). 200bp Capital Returned to Shareholders Minimum CET1 Ratio 7.0 Add: Management Buffer to CET1 0.5 Add: GSIB Buffer 2.5 "All-in" Implied CET1 Requirement 10.0 Less: Capital Return to Shareholders -2.0 Less: Losses from Prior Year CCAR -5.0 Stressed CET1 Ratio 3.0 Minimum Requirment 4.5 Pass/Fail FAIL Additional Capital Needed to 'Pass' 1.5 Implied CET1 Requirment to Pass CCAR 11.5 Source: SSGA, July The information contained above is for illustrative purposes only. State Street Global Advisors 6

7 The Impact on Investors In our view, the main impact on short-term funding markets comes in the form of a higher cost of liquidity, driven by supply and demand imbalances for liquid assets and the diminished ability of large banks to intermediate. These factors will likely cause spreads to widen between high-grade government and non-government short-term securities, and will ultimately push risk into less regulated areas of the financial system. To take advantage of these opportunities and protect against these risks, cash investors must differentiate between their cash needs and investment objectives, and invest accordingly. In Part 3 of this series, we will examine Pillar II, Liquidity and Funding. 1 The CET1 ratio applies to all US banks, while the SLR is applicable to two sub-segments advanced approach US banks those with over $250 billion in assets and those with over $750 billion in assets or $10 trillion in custody assets. 2 Applies to bank holding companies with more than $250 billion in assets. 3 The US rule utilizes a five-tiered scoring system that includes size, cross-jurisdictional activity, interconnectedness, complexity and short-term wholesale funding. It applies to banks with more than $50 billion in assets. 4 Bank holding companies with more than $500 billion in assets: research/banking_research/quarterlytrends2012q4.pdf 5 Presentation to TBAC, Assessing fixed income market liquidity retrieved from treasury. gov/resource-center/data-chart-center/quarterly-refunding/documents/ Charge_2.pdf 6 Basel Committee on Banking Supervision, Basel III document, Revisions to the securitisation framework, December 11, 2014, retrieved from publ/d303.pdf 7 Opening Statement by Governor Daniel K. Tarullo, Board of Governors of the Federal Reserve System, April 8, 2014 retrieved fro newsevents/press/bcreg/ bcreg a-tarullo-statement.htm 8 International Monetary Fund, How Risky Are Banks Risk Weighted Assets? Evidence from the Financial Crisis retrieved from wp1236.pdf 9 Federal Reserve, Transcript of Open Board Meeting, April 8, 2014 retrieved from federalreserve.gov/mediacenter/files/open-board-meetingtranscript pdf 10 Bloomberg Business, JPMorgan to Charge Some Large Customers Fees on Certain Deposits, February 24, 2015, retrieved from jpmorgan-to-charge-some-large-customers-fees-on-certain-deposits 11 Federal Reserve Bank of New York, CCAR: More Than a Stress Test retrieved from libertystreeteconomics.newyorkfed.org/2012/07/ccar-more-than-a-stress-test. html 12 Board of Governors of the Federal Reserve System, Stress Testing after Five Years, retrieved from fed-broadens-scope-of-stress-tests Annual performance will vary based on the Fed s stress scenarios, which change, and any bank-by-bank balance sheet changes. 14 Board of Governors of the Federal Reserve System, Comprehensive Capital Analysis and Review, 2015 Summary Instructions and Guidance, October, 2014, retrieved from federalreserve.gov/newsevents/press/bcreg/bcreg a1.pdf Glossary Dodd-Frank Act is a United States federal law that places regulation of the financial industry in the hands of the government. It aims to prevent another significant financial crisis by creating new financial regulatory processes that enforce transparency and accountability while implementing rules for consumer protection. Option Adjusted Spread (OAS) is a measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Common Equity Capital is a measurement of a bank's core equity capital compared with it total risk-weighted assets. Risk-Weighted Assets, in terms of the minimum amount of capital that is required within banks and other institutions, are based on a percentage of the assets, weighted by risk. Capital Conservation Buffer is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. Countercyclical Buffer's objective is to encourage banks to build up buffers in good times that can be drawn down in bad times. Leverage Exposure Exposure to the use of leverage in an investment vehicle. Global Systemically Important Bank (G-SIB) is a financial institution whose distress or disorderly failure, because of its size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity. Return on Equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Repurchase Agreement or repo is a form of short-term borrowing for dealers in government securities. Reverse Repurchase Agreement is the purchase of securities with the agreement to sell them at a higher price at a specific future date. Stress Test is a simulation technique used on asset and liability portfolios to determine their reactions to different financial situations. Comprehensive Capital Analysis and Review (CCAR) is a regulatory framework introduced by the Federal Reserve in order to assess, regulate, and supervise large banks and financial institutions. Dodd-Frank Act Stress Test (DFAST) evaluates the potential impact of stressed economic and financial conditions based on hypothetical scenarios (supervisory scenarios) determined by bank regulators. State Street Global Advisors 7

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