U.S. Department of the Treasury

Office of Debt ManagementNovember 2, 2010Presentation to theTreasury Borrowing Advisory Co
Agenda

2 

•Fiscal Developments•Auction Demand•Portfolio Metrics•Long-Term Challenges
FISCAL DEVELOPMENTS

3
Tax Receipts Continue to Improve

4

-40%-30%-20%-10%

0%

10%20%30%40%50%60%

Mar-00

Jun-00

Sep-00

Dec-00

Mar-01

Jun-01

Sep-01

Dec-01

Mar-02

Jun-02

Sep-02

Dec-02

Mar-03

Jun-03

Sep-03

Dec-03

Mar-04

Jun-04

Sep-04

Dec-04

Mar-05

Jun-05

Sep-05

Dec-05

Mar-06

Jun-06

Sep-06

Dec-06

Mar-07

Jun-07

Sep-07

Corporate Taxes Withheld Taxes Non

Note: Adjusted for 9/11/01 Corporate Tax Receipts disruptionSource: Monthly Treasury Statement

Quarterly Tax ReceiptsYear over Year Percentage Change

A closer look at Corporate: +43Withheld: +5%Nonwithheld: 0%

Note: Data plotted are ye
Receipts as a Percentage of GDP are Projected to Re

Receipts as a Percentage of GDP are Projected to Re

5

$0

$500

$1,000$1,500$2,000$2,500$3,000

FY1960

FY1962

FY1964

FY1966

FY1968

FY1970

FY1972

FY1974

FY1976

FY1978

FY1980

FY1982

FY1984

FY1986

FY1988

FY1990

FY1992

FY1994

FY1996

FY1998

FY2000

Receipts Deflated by GDP Deflator (LHS) Receipts as a % 

Total Inflation Adjusted ReceiptsIn 2005 $ Billions, Percentage of GDP 

Receipts as Percentage of GDP50-Year Average: 18%50-Year High: 21% (FY2000)50-Year Low: 15% (FY2009)FY 2010 based on OMB projected GDP: 15%

Source: OMB projected GDP and GDP deflator, Monthly Treasury Statement receipts
TARP Repayments Continue

6

-$125-$100

-$75-$50-$25

$0

$25$50$75

$100$125

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Aug-09

Sep-09

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Repayments, Dividends, Interest (LHS) Cash Outflows (LHS) Cum

TARP Cash FlowsIn Billions $

The Automotive Industry Financing Program providedapproximately $80bn in loans and equity investment.

In June, over $68bn was repaid to the CapitalPurchase Program by JPMorgan, Morgan Stanley,Goldman, US Bancorp, AMEX, BONY, BB&T,Capital One, State Street, and Northern Trust.

In March, the Term Asset -BackedLending Facility , a joint venture with the Federal Reserve, was launched.

On October 14, 2008, the Capital Purchase Program is launched. By January 1, 2009, over $247bn in funds had been disbursed to U.S. banks.

In December, Bank Wells Fargo, and C$90bn.
Non-Marketable Redemptions Have Increased Marke

Non-Marketable Redemptions Have Increased Marke

7

-$30-$20-$10

$0

$10$20$30

Q1 

2005

Q2 Q3 Q4 Q1 

2006

Q2 Q3 Q4 Q1 

2007

Q2 Q3 Q4 Q1 

2008

Q2 Q3 Q4 Q1 

2009

Savings Bond Foreign Series SLGS

Net Non-marketable IssuanceIn Billions $
The Budget Deficit for Fiscal Year 2010 Narrowed Mo

8

Source: OMB for end of Fiscal Yea

0

200400600800

1,0001,2001,4001,600

October November December January February March April May Ju

FY2008 FY2009 FY2010

Cumulative Budget Deficits by Fiscal YearIn Billions $
Net Financing Amounts Have Recently Exceeded Bu

Net Financing Amounts Have Recently Exceeded Bu

9

Budget Deficit

$162

Budget Deficit

$459

Budget Deficit

$1,413 

-$200

$0

$200$400$600$800

$1,000$1,200$1,400$1,600$1,800$2,000

FY2007 FY2008 FY2009 

Other Guaranteed Loan AOther Direct Loans Education (Direct STARP & HERA (Direct Loans) Change in OperatinBudget Deficit

Net Financing: $206 Billion

Net Financing: $769 Billion

Net Financing: $1,742 Billion 

Annual Budget Deficit and Net FinancingFiscal Year in Billions $

Total Direct Loans: $399 Billion

Tot$15

Total Direct Loans: TARP, HERA, Education 'sDirect Student Loans and Loan Purchases and Other Direct Loans
Primary Dealer and Government Deficit Estimates

10

FY 2010-2012 Deficit and Borrowing Estimates 

Primary

Dealers* 

FY 2011 Deficit Estimate 1,214 

FY 2012 Deficit Estimate 1,023 

FY 2013 Deficit Estimate 906 

FY 2011 Deficit Range 1,075-1,350FY 2012 Deficit Range 800-1,350FY 2013 Deficit Range 600-1,300FY 2011 Marketable Borrowing Range 1,026-1,400FY 2012 Marketable Borrowing Range 800-1,400Estimates as of: Oct 2010 Au

*Based on Primary Dealer feedback on October 25, 2010. Deficit estima
AUCTION DEMAND

11
12

Auctions Continue to Exhibit Strong Coverage

$0

$500

$1,000$1,500$2,000$2,500

FY2000 FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 

Weighted Average Coverage Ratio on Notes and Bonds In Billions $, Coverage Ratio

Gross Private Issuance (LHS) Weighted Average Coverage 

Note: Excludes TIPS and Bills issuance. 
13

Bid-to-Cover Ratios for Other Sovereign Issuers

1

1.5

2

2.5

3

3.5

2005 2006 2007 2008 

Canada France Germany U

Nominal Coupon Auction Bid-to-Cover Ratios for Other SovWeighted Average by Allotment Amount, Calendar Year

Source: Bank of Canada, Agence France Tresor, Deutsch
14

Investment Funds Have Increased Coupon Auction PInvestment Funds Have Increased Coupon Auction P

Note: Includes TIPS but excludes Bills; *FY2005 through FY2009 Source: Treasu

SOMA, 3% Depository Institutions, 1%

Individuals, 1%

Primary Dealers, 43%

Other Dealers &

Brokers , 8%

Investment Funds ,

21%

Foreign &

International , 23%

FY2010: Average Investor Class Allotments

Other Dealers

& Brokers , 2%

Investment Fund

14%

Foreign 

Internationa

Five-Year Average 
15

Bill Auctions Exhibiting an Increase in the Diversity oBill Auctions Exhibiting an Increase in the Diversity o

Source: Treasu

SOMA, 4% Depository, 1%

Individuals, 2%

Primary Dealers,

52%

Other Dealers &

Brokers , 11%

Investment Funds,

14%

Foreign, 14%

Other, 2%

FY2010: Average Investor Class Allotments

*FY2005 through FY2009

Other

Dealers &

Brokers ,

5%

Investment

Funds, 11%

Foreign

O

Five-Year Average 
16

TIPS Auctions Continue to Perform Well

1.01.52.02.53.03.54.0

7/1/04

10/1/04

1/1/05

4/1/05

7/1/05

10/1/05

1/1/06

4/1/06

7/1/06

10/1/06

1/1/07

4/1/07

7/1/07

10/1/07

1/1/08

4/1/08

7/1/08

10/1/08

1/1/09

Bid-to-Cover RatiosBids Tendered Divided by Bids Accepted

5-Year 10-Year Bond
17

Concentration in TIPS Secondary Market Trading has 

0%

10%20%30%40%50%60%70%80%90%

100%

Q1CY2000

Q3CY2000

Q1CY2001

Q3CY2001

Q1CY2002

Q3CY2002

Q1CY2003

Q3CY2003

Q1CY2004

Q3CY2004

Q1CY2005

Q3CY2005

Q1CY2006

Q3CY2006

Q1CY2007

Q3CY2007

Primary Dealer Market Share in TIPS by QuintilePercentage of Secondary Market Flows, Number of Primary Dealers

1st Quintile (L) 2nd Quintile (L) 3rd Quintile (L) 4th Quintile (L) 5th 
PORTFOLIO METRICS

18
19

Nominal Coupons and Bills as a Percentage of the P

24%

20%25%30%35%40%

2000-01

2000-04

2000-07

2000-10

2001-01

2001-04

2001-07

2001-10

2002-01

2002-04

2002-07

2002-10

2003-01

2003-04

2003-07

2003-10

2004-01

2004-04

2004-07

2004-10

2005-01

2005-04

2005-07

2005-10

2006-01

2006-04

2006-07

2006-10

2007-01

2007-04

2007-07

BillsPercentage of Total Portfolio

Average 2000 - 2007

69%

50%55%60%65%70%75%80%

2000-01

2000-04

2000-07

2000-10

2001-01

2001-04

2001-07

2001-10

2002-01

2002-04

2002-07

2002-10

2003-01

2003-04

2003-07

2003-10

2004-01

2004-04

2004-07

2004-10

2005-01

2005-04

2005-07

2005-10

2006-01

2006-04

2006-07

2006-10

2007-01

2007-04

2007-07

200710

Nominal CouponsPercentage of Total Portfolio

Average 2000 - 2007
TIPS Issuance Will Continue to Increase

20

$0

$25$50$75

$100

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2

TIPSCalendar Year Issuance in Billions $, Percentage of Portfolio

5‐Year (L) 10‐Year (L) 20‐Year (L) 30‐Year (L) Projected (L) 
Average Maturity of the Debt Continues to Lengthen

21

4045505560657075

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Average Maturity of Marketable DebtIn Months

Average Maturity Without Supplementary Financing Bills Average Le

Current 58.6 as of 9/2010

Average 58.1

Min 42.4 in 4/1980

Max 70.9 in 5/2001

Statistics on Average Maturity since CY1980
Percentage of Debt Maturing in the Near-Term is at H

e Near-Term is at H

22

20%30%40%50%60%70%

Jan-90

Jul-90

Jan-91

Jul-91

Jan-92

Jul-92

Jan-93

Jul-93

Jan-94

Jul-94

Jan-95

Jul-95

Jan-96

Jul-96

Jan-97

Jul-97

Jan-98

Jul-98

Jan-99

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

J05

Percentage of Debt Maturing in Next 12 to 36 Months

Maturing in 12 Months Maturing in 24 Months Maturing in 
LONG-TERM CHALLENGES

23
OMB FY2011 Mid-Session Review Projections

24

-$1,600-$1,400-$1,200-$1,000

-$800-$600-$400-$200

$0

$200$400

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Budget Surplus/DeficitIn Billions $, Percentage of GDP

Surplus/Deficit $ (LHS) Surplus/Deficit Percentage 
OMB Long-Term Debt Metrics

25

$0$5

$10$15$20$25$30

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Fiscal Year Outstanding DebtIn Trillions $, Percentage of GDP

Held by Public (LHS) Held by Government Accounts (LHS) Government Accounts As a % of GDP (RHS) Public 

$0

$100$200$300$400$500$600$700$800

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

Fiscal Year Interest ExpenseIn Billions $, Percentage of GDP

Interest Expense (LHS) Interest Expense as a % of GDP (RHS) Average Interes

Note: Interest costs based on net interest on Treasury debt minus interest on trust funds and other income.

Average 1960-2010

2%
26 

What adjustments to debt issuance, if any, should Treasconsideration of its financing needs in the short, medium

Comparing October and April levels of issuance, Treasubillion in annualized borrowing capacity.

2Y Note 3Y Note 5Y Note 7Y Note 10Y N

April Coupon Issuance $44 $40 $42 $32 $25/$21

October Coupon Issuance $35 $32 $35 $29 $24/$21

% Change April-October -20% -20% -17% -9% -2% 

Annualized Cuts From October $108 $96 $84 $36 $4 
Treasury Borrowing Advisory Commi

Presentation to Treasury

Charge #2

November 2, 2010
Outlook for Non-Bank Financial Institutions P

Financial Crisis

Prior to the 2008 financial crisis, a number of non-bank finstitutions played a critical role in providing credit and across the global financial system. Many of these entitiplay a more diminished role in the allocation of credit. Pdiscuss the current state of non-bank financial institutiothe outlook going forward. What are the implications for markets and the Treasury market specifically?
2

Shadow bank liabilities vs traditional bank liabilities Shadow bank liabilities vs traditional bank liabilities

Shadow banking liabilities shrank during the crisis,but still exceed those of traditional banking 

05

10152025

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2

$tn

Shadow 

liabili

Source:Federal Reserve

2
3

Source:Federal Reserve

Shadow banking liabilities shrank during the crisis,but still exceed those of traditional banking (cont)

Shadow bank liabilities Shadow bank liabilities

05

10152025

1980 1985 1990 1995 2000 2005 2010

 MM  ABS  GSE pools  GSE debt  Security RP  Repo  CP 

$tn

MM: 

$2.9tn

ABS: 

$2.8tn

GSE pools:

$1.0tn

GSE debt:

$6.7tn

Security RP:

$0.8tn

Repo: $1.5tn

CP: $1.1tn

Traditional bank liabilities Traditional bank liabilities

-1

13579

111315

1980 1985 1990 1995 2000 

 Misc Taxes payable Credit instruments Fed funds & Security RP  Large time deposits  Small time deposits  Chk deposits  Interbank

Source:Federal Reserve

$tn

3
4

Taxable money fund and securities lenders assets under management der management

Key liquidity investors were transformed by the crisis

1.01.52.02.53.03.5

2Q07 4Q07 4Q08 4Q09 

$tn

Sec Lenders

Biggest buyers of floating rate financial debt 

maturing 1yr <3yr

Taxable MM

Biggest buyers of f

debt maturing < 

Note: Securities lenders assets are J.P. Morgan estimatesSource: J.P. Morgan, iMoneyNet

4
5

Prime money market fund AuM

Source: iMoneyNet as of October 20, 2010

Balances in money funds have declined significantly sincSeptember 2008 but are higher than pre-crisis levels

500750

1,0001,2501,500

Jan-07 Jul-07 Jan-08 Aug-08 Feb-09 Aug-09 Mar-10 Sep-10

Prime Inst

Pre-crisis: 

Jun 30, 2007

Prime Retail

Pre-Lehman 

bankruptcy: 

Sep 12, 2008

Government money market fund Au

0

250500750

1,0001,250

Jan-07 Jul-07 Jan-08 Aug-08 Feb

Pre-crisis: 

Jun 30, 2007

Pre-Lehman 

bankruptcy: 

Sep 12, 2008

$bn $bn

$1,071bn

$551bn

$1,323bn

$741bn

$964bn$661bn

$686bn$236bn

$283bn

$171bn

Balances in Prime funds have 

returned to pre-crisis levels 

while Government MMF AuM

have grown 

5
6

Credit sensitive money market assets fell during the cri

56789

10

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Sep-10

Source: J.P. Morgan; Data through September 30, 2010

-26%

26%

5% 2%

Total ex USTAgency DN Neg. CDs Agency Cpn Bonds <13m

Percentage change in asset classes sincPercentage change in asset classes sinc

Supply of money market instruments excluding Treasuries Supply of money market instruments excluding Treasuries

 The size of the shadow banking system has shrunk significantly already 

 Sophisticated ABCP issuers such as SIVs and securities arbitrage vehicles have become extinct as liquidity inv

market-valued based structures and mortgage exposures. Traditional cash-flow, client funding ABCP models a

 Repo utilization has also declined as dealers have delevered and reduced their reliance on repo as a funding s

6.5

$tn

9.6

6
7

Cumulative changes in Repo and ABCP outstanding

Source: Federal Reserve, J.P. Morgan

Certain products providing leverage to banks and financiadeclined, even as cash in banks and money funds have g

(2,250)(2,000)(1,750)(1,500)(1,250)(1,000)

(750)(500)(250)

0

250500750

Jun-07 Jan-08 Jul-08 Jan-09 Aug-09 Feb-10 Aug-10

ABCP

Repo

Cumulative changes in taxable MM

0

250500750

1,0001,2501,5001,750

Jun-07 Jan-08 Jul-08 Jan-09 

$bn $bn

Source: iMoneyNet, FDIC

7
8

90

177 188

275

328

266

17

304

332 331

377

459

515

46

394

509 519

652

787 781

63

Q4 2002 Q4 2003 Q4 2004 Q4 2005 Q4 2006 Q4 2007 Q4 2

Sec Arb Total ABCP

Sec Arb outstandings compared to the total ABCP market ($bn) t ($bn)

Source: Moodys; includes U.S. and European ABCP programs (multi-seller, hybrid and securities arbitrage)

Securities financed by ABCP climbed steadily until 2007 wmarket reversed course

8
9

Taxable money fund AUM vs. total money market supply Taxable money fund AUM vs. total money market supply

Delevering cut supply while demand has grown

(3.5)(3.0)(2.5)(2.0)(1.5)(1.0)(0.5)

0.00.51.01.5

Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 

$tn

Supply ex UST 

< 1y

Taxable MMF

Source: J.P. MorganNote: Supply data includes UST bills and coupons, agency discount notes and coupons, repo sold, unsecured commercial paper, ABCP, negotiabmoney market eligible extendible notes

9
10

Money fund balances are only partly related to demand forisky assets like bonds and stocks

(300)(200)(100)

0

100200300400500600700800900

1,0001,100

Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 

Institutional 

MMF

Cumulative monthly flow of cash since June 2007

$bn

Source: iMoneyNet, ICI

Retail MMF

10
11

Structured products and floating rate securities were tools maturity transformation; Use of both have declined

2.02.53.03.54.04.55.05.56.0

2Q07 4Q07 4Q08 4Q09 2Q10

MBS and ABS outstanding

$tn

Source: SIFMA

0

50

100150200250300

2Q07 4Q07 4Q08 

FRN with 1 to 3 year maturity outsta

Non-agency 

MBS

Agency MBS

ABS

$bn

Source: J.P. Morgan

Bank

financ

the co

pre-c

base h

11
12

Source: Federal ReserveNote: “Other” includes loans to AIG, TALF, Maiden Lane holdings, Gold, Special drawing rights certificates, and Treasury currency outstanding

Fed emergency programs to provide temporary liquidity wwell and have largely expired as the need for them subsid

Assets at the Fed; $bn

0

500

1,0001,5002,0002,500

Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 

AMLF CPFF Currency Swaps TAF Other Securities Held

AMLF & CPFF expiration: 

Feb 1, 2010

MMIFF expiration: 

Oct 30, 2009

TALF expirat

collateraliz

CMBS eligib

Mar 31

12
13

 Investor demand for cash-like investments remains high and h

grown during the crisis in spite of near zero interest rates

 Delevering and changes in investor assets under managemen

appetite has decreased the supply of credit sensitive products markets

 The combination of more demand and lower supply of alternat

reinforce the demand for Treasury bills and other short duratio

 Regulatory changes like 2a-7 liquidity requirements and Basel 

coverage ratio also serve to reinforce greater holdings of Trea“shadow banks” and traditional banks

Summary and Outlook

13
Treasury Borrowing Advisory Commi

Presentation to Treasury

Charge #3

November 2, 2010
TBAC Charge #3Potential Impacts of Basel 3 Regulatory Reform• The Basel 3 banking regulatory framework, which is expected to be implem

the next decade, includes tighter definitions of Tier 1 capital, prescribed leliquidity ratios, counter cyclical capital buffers, additional capital requireminterconnected firms and new limits on counterparty credit risk. Please copotential impact of Basel 3 on the financial markets and the Treasury debt 
Executive SummaryBasel 3 spans stricter capital, liquidity and leverage requirements• Timing for implementation is over next decade, however markets adjusting • Capital most clearly defined, liquidity and leverage in the process of being 

may be most onerous constraint 

• Financial sector trading at 20 year low reflects significance of Basel 3 in p

other regulatory requirements in a slow economic environment

Impact assessment of Basel 3 complex given interplay with other • Challenge of assessing the macroeconomic, financial, and Treasury debt m

the Basel 3 capital and liquidity changes is complicated by other regulatory factors, such as other Basel initiatives, US regulatory reforms and Fed poli

Impact on Treasury markets multi-faceted• Treasury requirements affected generally by economic growth and credit c

implications of Basel 3 and more specifically by rules governing ownershiand loans. 

– Economic Growth. Economy benefits through lower volatility over the 

result of reduced systemic risk. However, reduced availability and/or a credit could impinge on growth. Achieving appropriate balance of objecparamount. 

– Treasury Holdings. Liquidity requirements likely to cause banks to incr

holdings but some flexibility to hold Agency and Agency MBS may mu
“Steps banking industry will take as a result of the LCR and 

NSFR: 

• “First, banks will have to increase liquid assets

(primarily by holding more central bank reserves and more Treasuries), which will crowd out holdings of higher yielding loans and securities.” 

• “Second, the supply of bank credit will likely decline, 

and what remains will be more expensive.” 

• “Third, the amount banks borrow in the short term and 

interbank markets will decrease sharply, while the amounts they borrow from the term markets may very well run laps around current levels”. – JP Morgan

• “In the medium term, as banks increase their capital 

ratios by reducing lending, access to credit is likely to become more difficult and borrowing costs are liable to increase.”

• “The proposed new regulation is likely to result in 

significantly higher trade financing costs and tighter access to traditional trade financing instruments, such as letters of credit.”. -- Dun & Bradstreet October 2010 Special Report

• “For the “G3” (United States, Eur

project that full implementation oour assumed time frame would saverage of about 0.6 percentagof real GDP growth over the five and an average of about 0.3 perc

growth path over the full ten year – Impact of Basel 3, June 2010

• “Less active money markets, hig

term interest rates; could make tmonetary policy signals more steepness of money market yield policy transmission mechanism” Smaghi, Member of the ExecuSeptember 29, 2010 on Basel 3 

• “The core message... is that net 

for a broad range of capital ratiosbetween benefits and costs for a assumptions still suggests that in output there is considerable roo

and liquidity requirements whpositive net benefits.” – BCBS long term economic impact of liquidity requirements, August 

Small and Medium Enterprises: Banking Indus

Investors Policy Maker

Different Perspectives on the Impacts of Basel 
Basel 3 Overview
Basel 1 Introduced minimum capital standards for banking book Basel 1.5 Introduced VaR model based capital for trading bookBasel 2 Recalibrated capital for banking book capital by allowing internal modelsBasel 2.5 Substantially revised Basel 2 for certain credit products—Securitization, C

Basel 3

Introduced liquidity and funding ratiosRecalibrated quality of capital and materially raised minimum capital ratioIntroduced higher capital requirements for certain credit productsIntroduced operational risk capitalIntroduced leverage ratio

Basel 3 more complex than previous Basel Acc• Unlike prior Basel Accords which focused on one or two objectives — suc

a new capital standard or recalibrating an existing standard — Basel 3 has multiple actions on multiple standards in what is expected to be a relatively of time than prior Basel regulations due primarily to market expectations 
+~60%

Current

RWA

Capital Requirements Increase with Higher RisWeights of Certain Asset Classes• Based on bank disclosure to date, risk-weighted assets are expected to incr

approximately 60%, pre-mitigation

– Some banks have also disclosed mitigation opportunities not quantified 

• Ongoing appropriate calibration critical to support credit activities, such as 

and hedging activities

– Banks need to ration credit further, likely increasing end-user rates– Ability to hedge credit risk declines, potentially reducing extension of cr

Basel 2.5• Incremental Risk Charge• Securitization Framework• Correlation Trading• Stressed VaR

Basel 3• Counterparty Credit Risk 

(CVA)
Tier 1 Capital 

z Perpetual Preferred Stockz Trust Preferredz Intangibles (e.g. MSR) z Non-controlling Interestz Deferred Tax Assets

Quality of Capital: Increased Deductions in NuPlace Further Constraints on Bank Capital
2%

4.5%

2.5%

7%

Current Tier 1

CommonMinimum

New 

Minimum pre buffer

Conservation

Buffer

New Minimum SIFI

Buffer

?

Higher Capital Requirements, Some Still to be 

Note: 2% Tier 1 Common minimum based on 4% minimum Tier 1 capital requirement and predominance test which implies at least 50% must be in the form of 
Research highlights interplay between capital requirements, ROE, lendinpotential of lending moving to shadow banking

Note: AXP excluded from grey ranges because high 28% ROE skews the scale, making changes difficult to observe.

Source: Company data, Morgan Stanley Research

Capital Calibration Will be a Key Determinant oEconomy Will Be Impacted by Basel 3Estimated ROEs vs. Cost of Equity for US Large Cap Banks

4%6%8%

10%12%14%16%18%20%

7% 8% 9% 

B3 Tier 1 Common M

2012 ROE

Median ROE Cost of Equity
4.5% 4.5% 4.5% 4.5% 

4.0% 3.5%

6.375% 5.75% 5.125% 

7.875%

7.25%

6.625%

6.0%

5.5%

4.5%

9.875%

9.25%

8.625%

8.0% 8.0%

8.0%

2013 2014 2015 2016 2017 2018 

Required Regulatory Capital RatiosBasel Implementation Schedule Provides a MuGlide Path for Meeting Capital Ratios

Banks and investors already focused on pro-forma impact, compressing 
Liquidity Ratios Defined, Calibration Ongoing

• LCR: Likely problematic as currently proposed, particularly in its treatment of deposits and unfunded com

– Without further calibration, requires banks to carry higher percentage of liquid assets which reduces len

• NSFR: Problematic for most banks and Basel has stated they are considering changes

– “Basel NSFR suggests significant deposit shrinkage including 75-100% of non-operational deposits. Ou

cycle was inflows.... We do think it will reduce credit.” (source: JP Morgan)

Liquidity Coverage Ratio (LCR) & Net Stable Funding Ratio (NSFR)
Liquidity Ratio’s Secondary Impact on Econom• Liquidity Ratio Impacts (assuming no change in rule):

– Higher Cost of Lending: For each dollar lent, more liquid assets are requ

lowers lender efficiency and raises borrowing costs 

• May impact interbank liquidity, lower hedge availability and raise fun

– Expected to impact money market industry by reducing back-stop facili

TOBs necessary to meet 7-day money fund liquidity requirements

– Incremental crowding out of bonds not eligible for the Liquidity Ratio– May incent rise of unregulated non-banks
Leverage Ratio Represents a Higher Bar for MBanks Due to Stricter Criteria; Calibration Ong• Disclosure to begin 2015• Minimum ratio proposal is 3% versus today’s 5% in the US. 

– Viewed as constraining given the inclusion of off balance sheet assets, s

meaningful deleveraging required without further calibration 

Basel 3 E

Tier 1 CapitalAverage Total Assets

Stricter Definition of TieInclusion of off balance derivatives and contingcommitments to the co

Leverage Ratio =
Leverage Ratio’s Impact on MarketsLines of Credit: Likely to lead to lower availability, higher cost

• Money market funds: business model impact if credit lines pulled in this lo

environment

• Corporates: less CP would affect balance sheet efficiency and profitability• Municipals: cost of financing would rise 

Lending: Lower availability of financial derivative hedges, likely to lead to s

• Banks: may reduce lending and raise cost of loans. Competition grows fro

banking.
Large Cap Banks Trading MultipleLarge Cap Bank Index (1)

Note 1. Median of current BKX constituents excluding trust banks (STT, BK and NTRS)

0.00.51.01.52.02.53.03.54.04.55.0

Jan-92

Dec-92

Nov-93

Sep-94

Aug-95

Jul-96

Jun-97

Apr-98

Mar-99

Feb-00

Dec-00

Nov-01

Oct-02

Sep-03

Jul-04

Jun-05

Ma

Price / Tangible Book Price / Book

Large Cap Bank Trading MultiplesPrice / Book and Price / Tangible Book Value(x)Source SNL Financial

Trading Multiples

Large Cap Bank Index

Price /

Book Tangible Book

Current 0.9x 1.3x

5-Year Avg 1.3x 2.1x

10-Year Avg 1.8x 2.6x

15-Year Avg 2.0x 2.8x
Implications for the Treasury Debt Markets
The goal of Basel 3 is to improve the resilience of the financial system. Howevlong run macroeconomic benefits are difficult to quantify with any degree of prthere may be costs associated with the tightening in financial conditions that acimplementation of higher capital standards and increased liquidity requirementconsidered.

“The main benefits of a stronger financial system reflect a lower probability of banking crises and their associated output losses”

– BIS“The commonly expressed view is that whatever economic implications may result from implementing these reforms, they are a ‘cost worth paying– IIF

Questions for Discussion

1) What are the potential macro-economic costs associated with Basel 3 and 

financial crises be appropriately reduced without constraining necessary e

2) What are the ramifications of a compressed timeline for implementation o

requirements ?

3) How will financial markets be impacted, in particular the Treasury marke

Costs versus Benefits
Source(1) Bank for International Settlements, “Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements - Interim Report(2) Douglas J. Elliott, “Basel III, the Banks, and the Economy”, The Brookings Institution, July 26, 2010.(3) Anil Kashyap, Jeremy Stein, Samuel Hanson, “An Analysis of the Impact of Substantially Heightened Capital Requirements on Large Financial Institutio(4) Institute of International Finance, “International Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulato

What are the Potential Costs? A Number of Studies with a Wide Range of Estimates1. BIS: Modest economic impact. Lending rates rise by about 30 bp, but the

slowly dissipate and the long run impact is negligible. GDP reduction in 

years is about 0.4% -- or 1/8 the size of the IIF estimate.

2. Elliot: Modest economic impact. A large increase in capital requirements 

to increase average loan pricing by only about 20 bp, with little effect on (note: did not analyze impact of higher liquidity requirements).

3. KSH: Modest economic impact. A 10 percentage point increase in capita

would raise loan rates by only 25 bp to 45 bp (note: did not analyze impa

liquidity requirements).

4. IIF: Very large economic impact. Significant rise in lending rates (+100 b

in US and Europe). GDP growth over the next five years is reduced by 0points per year in the US and 0.9 percentage points per year in Europe. Cimpact on the level of real GDP in the G-3 after 5 years is -3.1%, with an 

sizeable effect on unemployment rates.
Why is the IIF’s Assessment of the Economic Iso Different?• The IIF simulation includes all regulatory changes (higher capital requirem

countercyclical buffers, liquidity requirements, Dodd-Frank and FCRF). 

• IIF does not decompose the estimated impact on lending rates and the over

but it seems that the new liquidity requirements are responsible for much odrag on economic growth. 

– Specifically, the LCR requirement leads to higher holdings of cash and 

bond assets together with less lending, while the NSFR implies a need to longer maturity deposits. Both of these factors are assumed to result in growth.

• The link between credit growth and GDP appears to be much stronger in th

simulation than in the BIS models. 

• Finally, BIS simulations include a monetary policy response 

– that is, easi

assumed to offset some or all of the tightening in credit. 
BIS Estimates Reflect a Modest Impact to the BIS modeled the capital and liquidity impacts independently:• Capital: A GDP reduction of 0.38%, on a global basis after four and a half • Liquidity: estimated to be a median decline in GDP on the order of 0.08% 

analysis indicated that there was greater uncertainty regarding the estimaterise in liquidity requirements than for the higher capital standards). 

BIS used a variety of models which looked at the impact on:– Lending spreads – Credit supply – Monetary policy– Liquidity 
IIF Projects a Substantial Negative Economic I

Change in Real Lending Rate to Private Sector Borrowers (1)basis points

Notes: (1) Difference between bank lending rate paths in “regulatory reform” scenario versus “base” scenario.

(2) Difference between Real GDP paths in “regulatory reform” scenario versus “base” scenario.

Source: IFF Estimates

2010 2012 2014 2016 2018 

Japan

US

240200160120

8040

0

Change in Real GDP (2)%

2010 2012 2014 2016 2018 

J

Euro Area

0

(1)(2)(3)(4)(5)
Ramifications of changing adoption timeline

Analysis of Basel 3 impacts (e.g. BIS, IIF, other economists) largely astimeline. Given the markets’ accelerated adoption of Basel 3, how mighbe adjusted, if at all? Policy makers believe the markets will respect the timelines set out for adoption...

“We are not enforcing the 2019 standards today and do not expect banks to meet thWe expect the banks to have come up with capital plans that show how they will meet thtime and I would think the markets will be very accepting of that strategy.

”

– William Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New 2010 Institute of International Finance Annual Membership Meeting, Washington, D.C.)

However, other organizations are pushing for quicker adoption and 

“As the global financial system stabilizes and the world economic recovery is firmly entr

intangibles completely and scaling back the transition period should be considered.”

– IMF Staff Position Note October 2010 Shaping the New Financial System

Investors want banks to get there quickly....

Based on 3Q10 earnings calls, investors are increasingly asking when they can expect bu
Notes: (1) The IIF model simulation implies a sharp rise in the securities share of bank credit over the next decade. The BIS model simulation assumes a 25% increliquid assets and a lengthening of the maturity of banks' wholesale liabilities.Source: Federal Reserve H8 report for historical data, IIF for 2010-2020 estimatesShaded areas indicate recessionBank Credit equals bank loans plus securities holdings (note: it excludes asset items such as excess bank reserves).

• At present, bank credit consists of about 26% securities (mostly MBS) and 74% loans. 

securities share tends to rise during and shortly after recessions, then lending usually precovery becomes more firmly entrenched.

Basel 3 Liquidity Requirements Imply More SeFewer Loans 

US Bank Securities Holdings as a Share of Total Bank Credit

0.200.220.240.260.280.300.32

1970 1975 1980 1985 1990 1995 2000 2005 2010 

IIF / BIS Regulatory Change Scenario (1)
Source: based on Federal Reserve Flow of Funds Accounts. Haver Analytics 

Private Domestic Nonfinancial Debt (% change YoY) Share of Private Nonfinancial Debt Outstanding

New Capital & Liquidity Standards will Place EGreater Reliance on Troubled Securities Marke

• The liquidity coverage ratio (LCR) component of Basel 3 could lead to withdrawal of bac

ultimately eliminate that market as a viable form of short term financing. 

• Thus, any pullback in bank lending is likely to lead to a tightening in financial conditions

such as small business might face significantly tighter credit availability.

Securities MarketsDepositoryInstitutions

253035404550556065

1980 1983 1986 1989 1992 1995 1998 2001 2004 

(2)

26

1014
Basel 3 Liquidity Coverage Ratio: Impact Likely to Vary Significantly Across Regi

Source National data and IIF estimates

The IIF estimates that Euro Banks fall well short of LCR standardsStatistics for various banking areas; %

Economy’s dependence on banks Distance f

Banks assets 

as % GDP

Banks’ share of 

credit Intermediation

Liquidity

Coverage Ratio

United States 83.1 26.6 81.8 

Euro Area 346.6 73.8 27.8 

Japan 168.8 52.6 92.4 
2010 2015

Bank Holdings of Treasuries 181 Bn 675 BnTotal Treasuries Outstanding 8.4 Tr 12.5 TrBank Ownership Share (%) 2.2% 5.4%

Based on our analysis, we believe Basel 3 is likely to lead to increased bank dema

1. The estimate for bank holdings of Treasuries in 2015 is based on analysis by Barclay

concluded that Basel 3 liquidity requirements would lead to $400 billion of new TreUS commercial banks. We also factor in the expected rise in overall securities holdi

2. Within the securities portfolio, banks are likely to boost their holdings of Treasuries 

securities because of more favorable treatment in the calculation of the LCR. Specifagency securities receive a 15% haircut in the calculation of the LCR and so-called Lare limited to 40% of total liquid assets.

The Change in Liquidity Requirements is Likely to a Shift in Bank Balance Sheets

Note: The expected size of the Treasury market in 2015 is based on the latest official estimates from the CBO. 
Source Haver Analytics 

• Bank holdings of Treasuries in 2015 are based on Barclay’s Capital estimates of the impact on Treasu

expected rise in overall securities holdings. 

• Holdings of agencies are based on the expected rise in overall securities holdings alone. Also, the 201

account for the potential impact of the 40% limitation on Level 2 liquid assets and thus are subject to c

• We calculate the expected ownership share under certain assumptions for growth in the overall marke

the latest official CBO estimates and for agencies we assume a 4% annual growth rate. 

Assessing the Impact of Basel 3 on Bank HoldTreasuries and AgenciesAssets Will Consist of More Securities and Fewer Loans

0.0000.0500.1000.1500.2000.250

1980 1985 1990 1995 2000 2005 20

Bank Ownership Share of Agencies and Agency MBS Markets 

Bank Ownership Share of US Treasury Market
Under Basel 3, excess bank reserves are among the items included in the calcliquidity ratio. The US banking sector currently has an approximate $1 trillion o

reflecting the unprecedented expansion of the Federal Reserve’s balance sheePresumably, this is a temporary phenomenon and the volume of excess reservrevert to historic norms. Such a development could magnify the strains associabanking system’s adjustment to higher liquidity requirements. This issue also rethat the markets are currently being buffeted by a whole host of unusual factors to gauge the impact of major policy initiatives, such as Basel 3, on the econom

A Final Complicating Factor to Consider ... 

Source: Federal Reserve Board / Haver Analytics

07 08 09 10

1,200,0001,000,000

800,000600,000400,000200,000

0

1,200,0001,000,000800,000600,000400,000200,0000

Adjusted Excess Reserves of Depository InstitutionsNSA, $MM

Source: Federal Reserve Board / Haver Ana

07 08 

Cash Assets: All Commercial BanksSA, $Bn

1,4001,2001,000

800600400200
Treasury Borrowing Advisory Commi

Presentation to Treasury

Charge #4

November 2, 2010
U.S. Treasury Borrow

Advisory Committe

Presentation to Treas

Charge #4

Implications of Additional Policy Actions

Monetary authorities in a number of countries are considerin

measures in an effort to improve growth. What range of measu

expected? What are the potential near-term and long-term impa

markets and the Treasury market specifically? 

November 2, 2010
2

November TBAC MeetingI. Market expectations for QE2II. Medium term (1-2 year) market impacts from QE2III. Long term (3+ years) market impacts from QE2IV. Impact on Treasury debt issuanceV. Global impact from U.S QE policies
3

I - Market expectations for QE2• $100bln a month (including ~$30bln of mortgage • Open-ended, no “shock and awe”• Tied to “economic conditions” or “progress toward• Expectations for the Fed program is for 1 year (~$• If conditions do not improve, it is expected the pro

beyond one year (and possibly include other asse
4

II – Medium term impacts• Treasury yield curve: Lower and flatter led by the 

maturities

• 30Yr Yields: Remain high versus historical curve • TIPS Breakeven Inflation Rate: Bias higher• Intermediate Swap Spreads: Wider• Rate Volatility: Lower• Credit Spreads: Tighter• Term Risk Premiums: Lower• Mortgages: Initially wider versus Treasuries, keep 

swaps. Tighten versus Treasury and swap curve 

• Equities: Higher• Dollar: Weaker
5

Policy reshapes the yield curve• Rates first fall and curve flattens• Since September FOMC, 30yr point resteepens to near July l

sector remains lower in yield

UST Par Curves

0.000.501.001.502.002.503.003.504.004.50

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 2

Years to Maturity

Yield

10Yr Point 7/14/2010 Sept 21 FOMC 10/22/2010 
6

Impact of Fed purchases on the curve

• Implied Fed purchases are based up $1.2trln in new purchase

$360bln of MBS reinvestments ($30bln a month)

• Maturity distribution based upon 2010 purchase pattern. QE2 

a longer duration profile

* Available Gross Issuance for the Fed to purchase under 35% SOM

Projected 35% of Still Need Fl

($bln) Implied Fed Purchases Gross Issuance Gross Issuance to Buy availa

1.5-2.5yr 79.6 364.0 127.4 - 

2.5-4yr 238.7 328.0 114.8 123.9 

4-6yr 464.9 364.0 127.4 337.5 

6-10yr 619.3 573.0 200.6 418.8 

10+yr 124.8 160.0 56.0 68.8 

TIPS 31.2 119.0 41.7 - 
7

Rising inflation expectations impact 30yr yi

Percent

10s30s

• The fear of reflation or weaker USD has pushed 30yr yields 2

yields since the September 21st FOMC meeting

• 10yr Inflation Breakevens have also risen 36bps since Septem
8

Expectations of QE widen swap spreads

• The lack of net Treasury supply after Fed purchases will drive 

the intermediate sector

• Implications for tighter repo markets also push swap spreads 
9

Implied volatility will naturally fall as 0% bound app

8090

100110120130140150160170

Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 J

1y5y implied 1y30y implied 10/27/2010 (at 

R^2 = 69.53% (y~0.96x + 10.87)

Implied Rate Vol (bpvol)

• However, realized volatility in the long end remains higher as 

concerns build
10

Credit spreads compress despite record grgrade + high yield September issuance

• QE is good for risk assets
11

III – Long term impacts• Potential liquidity issues • Does lack of supply in 5yr to 10yr sector push buyers i• Do large Fed purchases crowd out private investors? I

to push investors out the risk curve?

• Do foreign and central bank investors diminish purchas

dollar?

• Repo markets will tend to tighten as collateral supply s

limitations to the Fed’s System Open Market Account (capabilities 

• How does Fed exit QE? 

3⁄4 Sequencing previously discussed: drain reserves throug

deposits, hike IOER/fed funds rate, then sell assets. Hoincreasingly large balance sheet, assets may now need previously envisioned.

3⁄4 Market reactions could be extreme when Fed signals po
12

Path of the FF rate extracted from yield curealistic tightening scenario. Note the existimplying a very slow moving Fed that level
13

Exit strategy: When the Fed signals tightening, the quick and strong reaction is high. Below are the difvarious maturities between the Oct 22 yield curve aconsistent with the previous slide’s tightening scen

Changes in swap rates under scenario

-20-10

0

1020304050607080

2 3 4 5 6 7 8 9 10 

swap maturity, years

bp change in swap rate
14

Exit strategy and asset sales

• While shedding assets could potentially exacerbate the 

yields as exit strategy unfolds, the Interest On Excess enables the Fed to manage the timing/pace of sales. Tand the IOER, the Fed can drain reserves while runninbalance sheet.

• If asset sales are predictable and gradual, the impact o

market rates can be minimized.

• Policy normalization would presumably occur after the 

at a healthy pace. At that time, the budget situation shthat Treasury could be cutting issuance as the Fed is s

• The total amount of assets the Fed must ultimately sel

long QE II remains in place and how quickly policy is r

• On the positive side, asset sales can prevent another “

words, the Fed now has a tool to control long term ratecycle. This is in contrast to 2004 when 10yr yields drofirst year following the commencement of the tightenin
15

Lack of net supply of high quality $ assets• The net projected supply of alternative high-grade fixed incom

historically low

• YTD mutual fund flows show $38bln out of stocks, $185bln in• The projected total purchase amount of QE2 of $1.56trn exce

net issuance of these asset classes

(bln) 2009 2Treasury 1284 1

Agency -17 -

Agency MBS 445 IG Corporate 150 

Total 1862 1
16

IV. Impact on Treasury debt issuance - shoTreasury alter its issuance strategy due to • The U.S. Treasury and the Federal Reserve are two 

independent entities. 

• It is not in the long-term interest of the U.S. Treasur

the Treasury to appear to coordinate with one spec

• The Federal Reserve may or may not be a long-term 

Treasury portfolio. Therefore, to alter issuance bas

patterns rather than desired debt maturity profiles mproblematic in the future. 

• Due to the benchmark liquidity status of Treasuries 

Treasury must keep issuance "regular and predicta

• The Treasury must issue in all market conditions. If 

general liquidity deteriorates due to Fed purchases, consider steps such as more frequent reopenings innew issues in the 3yr, 5yr, and 7yr maturities.
17

V. Global impact from U.S. QE policies Expectations of QE have weakened the US

Real Trade-Weighted USD (March 1973 = 100)

Other Important Tra

Major Countries: 

(EZ + Swi + Swe + Jpn + 

Can + Aus + UK)

• The USD has weakened considerably vs. the majors but not v

the Asian currency pegs
18

... while the US Trade imbalance has shiftetoward EM countries ...

US Trade Balance ($ Millions)

Major Countries: 

(EZ + Swi + Swe + Jpn + Can + Aus + UK

All Other Countries
19

... leaving surplus nations with a few choic1. Appreciate, allowing related adjustments

3⁄4 Singapore

2. Not Appreciate

3⁄4 Unsterilized (accommodate via intervention), impo

reflationary policy (Asian nations)

3⁄4 Sterilized (Switzerland, Brazil)

3. Institute Capital Controls

3⁄4 Brazil (taxes on certain foreign investments), Thai

tax), under consideration in Korea (withholding tax

4. Enact Additional Monetary Easing

3⁄4 Japan, potentially the UK
20

Cumulative reserve growth of top 5 Treasury holde

thousand billions
21

Asian FX reserve growth in particular has a

Asia Foreign Exchange Reserves ($ billions)

China + Hong Kong + Taiwan + Malaysia 

+ South Korea + Singapore + Indonesia + 

Philippines
22

Dollars recycled
23

Importing Fed policy, China tightens• When China intervenes in the FX market to 

reduce upward pressure on the renminbi, the PBOC buys US dollars from the banking system and sells renminbi, which become domestic bank reserves. 

• To remove these reserves from the banking 

system (sterilize) , the PBOC sells bills to the banks. 

• To the extent that sterilization is incomplete 

and reserves remain in the banking system, these reserves are a potential source of money supply growth which, if excessive, can lead to inflation (cause for benchmark rate hike in October?)

• This chart shows the relationship between FX 

reserve and M1 growth. The association between FX reserves and M1 suggests that at least a portion of China's FX reserves are unsterilized. Whether this is by design or not is less clear. 

-100

0

100200300400500600

Jan-08 Jul-08 Jan-0

FX Reserves versu

Change in FX reM1 %y/y (rhs)