2012 and Beyond – The New Era in U.S. BankingAdapting to High Risk and Lower Reward

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 1

Throughout the U.S. banking spectrum, business models and strategies that will have

the most long-term success are based on consistent return on capital, accurate risk

identification, prudent selection, efficient allocation of capital, and sensible customer

base management.

End-of-year 2011 earnings statements, economic statistics and industry news confirm the U.S. banking industry paradigm of the past decades will need to undertake a strategic shift to maintain financial performance levels. Conventional profitability sources are under heavy pressure and look to remain so for some time to come, given a disadvantageous U.S. monetary policy, the European sovereign debt crisis, continued expansion of regulatory requirements and evolving customer interaction channels, among other market and competitive influences. Capital availability, significantly influenced by proposed U.S. regulatory requirements and their potential to constrain shareholder potential for return on equity, is also likely to tighten, while other industries and investment opportunities offer more appealing, long-term risk-return dynamics to would-be investors, requiring deeper assessment of traditional business lines and consideration of risk-return dynamics.1

As a result, bigger will not necessarily mean better in U.S. banking, as it had during the economic growth cycles of the 1990s and 2000s. Early 2012 merger and acquisition news already is hinting at more selective deployment of capital resources: A leading North American life insurance provider announced the closure of its multibillion dollar credit card business after failing to find a buyer at any price, and a private equity-owned regional bank announced that it failed to find a buyer after engaging a Wall Street advisory firm to evaluate alternatives.

Instead, “better” increasingly will be defined by focus and discipline. Throughout the U.S. banking spectrum, business models and strategies that will have the most long-term success are based on consistent return on capital, accurate risk identification, prudent selection, efficient allocation of capital, and sensible customer base management. As a result, continued and balanced enhancement of financial risk management capabilities, combined with the capacity to reach out readily to and maintain a complementary customer base, will drive competitive advantage.

1 “How Much Capital is Enough?” Capital Levels and G-SIB Capital Surcharges – The Clearing House Association LLC, September 26, 2011.

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 2

A CONFLUENCE OF ENVIRONMENTAL CHALLENGES

Early review of end-of-year 2011 earnings releases demonstrates that the Federal Reserve Zero Interest Rate Policy (ZIRP) and current balance sheet, or “Operation Twist,” strategy are having a compression effect on net interest margins, the traditional earnings engine of the U.S. banking industry. Each of the six largest diversified U.S. banking institutions reported year-over-year declines in net interest margin, a trend also reflected among their regional and community banking peers.

Net Interest Margins

Top Diversified U.S. Banking Institutions Q4 2011 Q4 2010 ChangeBank of America 2.45% 2.69% -0.24%

JP Morgan Chase 2.60% 2.80% -0.20%

Citibank 2.90% 2.95% -0.05%

Wells Fargo 3.89% 4.16% -0.27%

U.S. Bank 3.65% 3.88% -0.23%

PNC 3.86% 3.93% -0.07%Source: January 2012 public earnings releases

This margin pressure will continue for some time. The Federal Reserve (Fed) has announced that ZIRP will last at least through 2014, and the inflation-indexed U.S. Treasury bond market suggests low levels of real interest will prevail, with the yield on 10-year indexed bonds fluctuating around negative 15 to 25 basis points.

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%

5-Year 10-Year 20-Year 30-Year

Yield on Inflation Indexed U.S. Treasuries

Source: Bloomberg

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 3

U.S. fiscal dynamics are also likely to promote an extension of the current interest rate environment, as interest expense in such an environment would consume an ever-increasing percentage of GDP, a problem brought on by the massive expansion of Treasury borrowing at a lower-than-average historical rate and without commensurate growth in economic output.

In the retail markets, the consumer mortgage refinance wave, a fee income offset to the net interest margin compression brought on by ZIRP and Operation Twist, is showing signs of running its course, while negative equity continues to loom as an obstacle to further home mortgage refinancing activity and as a risk of future credit losses.

$0

$50

$100

$150

$200

$250

$300

Q1 2011

Q2 2011

Q3 2011

Q4 2011

Q1 2012

Q2 2012

Q3 2012

Q4 2012

Q1 2013

Q2 2013

Q3 2013

Q4 2013

(Bill

ions

of D

olla

rs)

U.S. Historical and Forecasted Refinance Activity for One- to Four- Family Residential Properties

Source: Mortgage Bankers Association Mortgage Finance Forecast, February 16, 2012

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 4

Private wealth management businesses have realized lower revenue from decreased retail investment activity, driven by global market volatility. Some revenue loss has been minimized by the industry’s continuing transition to asset management-oriented pricing structures and away from the more traditional transaction-based revenue generation.

In the wholesale markets, the European sovereign debt and banking crises have presented widespread concerns of a spillover into other markets and dampened global economic growth prospects, facilitating a sharp drop in trading and investment banking revenues. Loan growth across the industry has been tepid, at best, and driven mostly by investment-grade corporate customers refinancing their capital structures, taking advantage of the historically low interest rate environment.

$0.0

$500.0

$1,000.0

$1,500.0

$2,000.0

$2,500.0

$3,000.0

Dec 2010 Jun 2011 Jul 2011 Aug 2011 Sep 2011 Oct 2011 Nov 2011 Dec 2011 Jan 2012

Assets and Liabilities of Commercial Banks in the U.S. (Seasonally Adjusted, Billions of Dollars)

Commercial and Industrial LoansCommercial Real Estate LoansC&I and CRE Credit Combined

Source: Federal Reserve Assets and Liabilities of Commercial Banks in the United States, February 3, 2012

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 5

Among other macro influences, the U.S. banking industry does not appear to be getting any lift, at least any time soon, from credit expansion or U.S. economic growth. U.S. households are continuing the deleveraging that began in 2008, much of which is being driven by new defaults on mortgage and consumer credit.

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

U.S. Household Financial Leverage

U.S. household obligations as a % of disposable incomeU.S. household mortgage debt as a % of disposable incomeU.S. household consumer debt as a % of disposable income

Source: Federal Reserve

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 6

The Fed, following its January 2012 forecast, estimates U.S. GDP to grow by 2.2 percent to 2.7 percent,

a downward revision from its November 2011 projection of 2.5 percent to 2.9 percent,2 while the IMF projects U.S. GDP to grow at a rate of 1.8 percent during 2012, with significant downside risk posed by the fiscal issues of Europe and Japan.3

ADDITIONAL CHALLENGES LIE AHEAD

Looking forward, U.S. banks must respond to regulatory change that is likely to add overhead expense while limiting leverage and eliminating certain profitability opportunities. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2011 continues to be a driving force, with additional aspects of the law requiring implementation in 2012. The Consumer Financial Protection Bureau (CFPB) will have the most widespread effect on the industry through its initiation of new examinations and added regulatory reporting, as well as oversight of potential fees that could be implemented to offset existing overhead and service costs. The Volcker Rule will challenge the business models of selected wholesale institutions, limiting the opportunity for proprietary trading and equity investment profits, and increasing the cost of exchanging over-the-counter derivative instruments, as parties thereto will now be required to clear transactions through a central authority.

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

2005 2006 2007 2008 2009 2010 2011

New Consumer Credit Defaults: 2004 to 2012

First Mortgage DefaultsSecond Mortgage DefaultsComposite Consumer Credit Default Index

Source: Standard & Poor’s/Experian

2 Projections of Federal Reserve Board members and Federal Reserve Bank presidents, FOMC Meetings, November 2, 2011, and January 25, 2012.

3 World Economic Outlook Update, January 24, 2012.

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 7

“Basel III,” the next version of the New Basel Capital Accord, will employ new capital and liquidity requirements with changes to the definition of risk-based capital and the introduction of a new capital buffer, above and beyond the current Prompt Corrective Action requirements. Such regulation will limit financial leverage, while revised minimum liquidity requirements will necessitate new measurement and maintenance standards for short-term and long-term liquidity, constraining future profitability by limiting the balance sheet carry trade.

The largest, internationally active U.S. institutions will be subject to the new capital buffer or surcharge of 1.0 percent to 2.5 percent, beyond the minimum core capital requirement of 7 percent, beginning in 2016. A 2011 study conducted by The Clearing House Association, the oldest U.S. banking and payments system advocacy association, suggests that U.S. banks would have to increase their credit spreads to customers by 60 basis points (a 15 percent increase in net interest margin) or decrease their non-interest expense ratio by 11 percentage points (a 19 percent reduction in non-interest expenses) to make up for the reduction in return on shareholder equity brought on by the additional capital buffer.4

EMBRACING THE SOCIAL MEDIA REVOLUTION

All signs point to social media continuing its rapid growth and driving the evolution of relationship management, transaction execution and new business development capabilities. As part of its early-2012 IPO filing, Facebook announced that its global user base exceeded 845 million.5 Twitter also claimed more than 500 million accounts6 as of February 2012, a user base that executes more than 1.6 billion search queries per day.7

Starting with retail banking, the explosive growth of these communication vehicles will necessitate robust evaluation of customer communication channels, product and service messaging, and ongoing relationship management options across business segments. The degree to which social media can be employed to gain competitive advantage is not entirely clear, but the social media wave does carry significant risks, including those related to data security, customer identity integrity, fraud potential and reputational exposure, among other areas. At some point, social media will allow for additional removal of overhead and operating costs as service models continue to evolve beyond ATM banking and the more traditional brick-and-mortar and branch interaction method. However, a transition to the new state will take both time and capital investment. The opportunity will remain for some service delivery models to continue emphasizing “high touch” as their value proposition and differentiating factor to consumers.

4 “How Much Capital is Enough?” Capital Levels and G-SIB Capital Surcharges – The Clearing House Association LLC, September 26, 2011.

5 http://www.sec.gov/Archives/edgar/data/1326801/000119312512034517/d287954ds1.htm.6 http://www.mediabistro.com/alltwitter/twitter-statistics-2012_b18914.7 http://www.cmswire.com/cms/customer-experience/35-key-twitter-statistics-infographic-012384.php.

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 8

FACING UP TO THE CHALLENGE: ENHANCING THE BUSINESS MODEL In response to these and other marketplace factors, and after having already addressed much of the “low hanging fruit” in terms of cost reduction opportunities, U.S. banks will require further focus and specialization across market strata in the face of limited top-line growth potential, new regulatory compliance expense, additional limitations on financial leverage and a limited capacity to pare overhead costs any further.

Consequently, we see the greatest opportunity for building shareholder value coming from a renewed emphasis on the enhancement of risk management capabilities, with the long-term goal of better facilitating the steady generation of economic or “alpha” (risk-adjusted) returns on capital across all business lines. Among the top-tier U.S. institutions, advanced financial risk measurement tools and management methodologies have largely been put in place and are now being utilized to drive such returns. In the area of operational risk, new performance tracking methods such as the internal Risk Index are advancing management capabilities.8 The next step for top-tier U.S. banks, however, will largely be to hone the precision and accuracy of their existing tools and approaches, such that future risk “misses” ultimately will have an overall decreased effect on consolidated performance.

Among midtier and large community banks, we see opportunity for shareholder value enhancement coming from the continued adoption and honing of leading risk management tools and practices. For these institutions, the paradigm is more likely to be one of adoption of the leading practices already utilized by the largest institutions, as the overall cost of implementing proven tools and methods typically is more economical than that of developing and implementing approaches from scratch.

Tactical responses for midtier and large community banks may include such initiatives as the introduction of a more definitive risk appetite or set of operating parameters linking financial risk and performance, the continued adoption of leading portfolio management methods, or the implementation of leading quantitative risk management tools. In these cases, the learning curve for many organizations may be steep, but the ability to unlock long-term value will be worth the investment, whether or not the undertaking is driven from a regulatory standpoint.

Ultimately, however, the key question at all levels of the industry will continue to be how to enhance what is already in place in the face of significant challenges and uncertainty. Focusing attention toward honing the fundamentals of accurate risk identification, prudent risk selection and efficient allocation of capital while maintaining and serving the complementary customer base is the sensible course of action for further enhancing shareholder value. This approach will continue to separate the leading franchises from the pack and position these organizations for the next wave of growth.

8 For more information, read Volume 3, Issue 7 of Protiviti’s FS Insights, “Creating a Risk Index – the Advantage of a Single-Number Snapshot of Organizational Risk Progress,” available at www.protiviti.com.

PROTIVITI • 2012 AND BEYOND – THE NEW ERA IN U.S. BANKING • 9

ABOUT PROTIVITI

Protiviti (www.protiviti.com) is a global consulting firm that helps companies solve problems in finance, technology, operations, governance, risk and internal audit. Through our network of more than 70 offices in over 20 countries, we have served more than 35 percent of FORTUNE® 1000 and Global 500 companies. We also work with smaller, growing companies, including those looking to go public, as well as with government agencies.

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At Protiviti, we understand the challenges faced by financial services companies. Our solutions are designed to help your company turn these challenges into competitive advantages.

ContactsCarol BeaumierManaging Director+1.212.603.8337carol.beaumier@protiviti.com

Cory GundersonManaging Director+1.212.708.6313cory.gunderson@protiviti.com

Michael SchuchardtManaging Director+1.415.402.3620michael.schuchardt@protiviti.com

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