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The recent financial crisis has lead to material losses, an almost collapse of the financial system and negative repercussions on the real economy. Various institutions have prepared proposals for an overhaul of the banking regulatory framework. The upcoming changes will cover a whole range of supervisory fields, such as capital, risk management, governance and others.
The recent financial crisis has lead to material losses, an almost collapse of the financial system and negative repercussions on the real economy. Various institutions have prepared proposals for an overhaul of the banking regulatory framework. The upcoming changes will cover a whole range of supervisory fields, such as capital, risk management, governance and others.
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The recent financial crisis has lead to material losses, an almost collapse of the financial system and negative repercussions on the real economy. Various institutions have prepared proposals for an overhaul of the banking regulatory framework. The upcoming changes will cover a whole range of supervisory fields, such as capital, risk management, governance and others.
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Attribution Non-Commercial (BY-NC)
Formate disponibile
Descărcați ca PDF, TXT sau citiți online pe Scribd
Potential Impact November 2010 Dr. Philip Goeth 2010 Deloitte All rights reserved. The recent financial crisis has lead to material losses, an almost collapse of the financial system and negative repercussions on the real economy Regulators are under pressure around the globe to ensure that the systemic soundness of the financial sector is improved materially The financial crisis was kicked off by massive loss of value of US real estate, triggering loss of value of subprime related securities Hundreds of tranches of AAA debt were downgraded and major stock markets lost more than 60% Subprime Losses The collapse of Lehman lead to a freezing of the interbank markets, and previously unseen liquidity squeezes took place The freezing of the credit markets created a knock on effect on the real economy, increasing bankruptcy rates und funding difficulties Financial Turmoil With the financial markets tumbling and the repercussions on the real economy, Governments intervened on a global scale In total, estimates are that banks were so far supported with more than USD 4tr (alone USD 1.8tr in the US) Massive Intervention In 2009, interbank markets returned to normal levels, and various banks have meanwhile successfully completed capital issuances Central bank liquidity supply at almost zero rates acted as a major stabilization factor Stabilization The causes for the turmoil were analyzed by various institutions, such as the IMF, World Bank, BIS, IIF, Group of Governors, as well as national think tanks The almost collapse of the financial system is seen, amongst other reasons, as a major failure of banking regulation and supervision Analysis of Failure With previously unseen amounts of tax payers' money spent to stabilize tumbling financial markets, politicians are under pressure to "fix the system This pressure is passed on directly to the regulators, who have been criticized of lax supervision and weak standard setting Political Pressure As a result, various institutions have prepared proposals for an overhaul of the banking regulatory framework It is broad consensus that the upcoming changes will material, covering a whole range of supervisory fields, such as capital, risk management, liquidity, governance and others Regulatory Tsunami Financial Institutions Investors Governments A Regulatory Reform Tsunami on its Way. Regulators Media Page 2 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Scope of Basel III "Basel " is the response of the Basel Committee on Banking Supervision (BCBS) to the financial crisis, encompassing a comprehensive set of reform measures to strengthen the regulation, supervision and risk management of the banking sector. The reform targets both micro and macro economic improvements: Bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress. Regulation that deals with macroprudential, system wide risks that can build up across the banking sector as well as the pro-cyclical amplification of these risks over time. 3 The Main Documents outlining Basel III International LRM Framework Enhancements to the BII Framework Revisions to BII market risk Framework Guidelines for IRC calculation Principles for sound liquidity RM Strengthening the resilience of the banking sector Capital Calibration Sept 12, 2010 ReguIators' Consensus July 26, 2010 Page 3 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Reform Environment: Status of the Western FS ndustry ("post crisis?) United States Recovery Crisis Back to profit: 7,000-plus commercial banks overseen by FDIC reported $21.6bn in profits Q1 2010 (vs $4.4bn loss in Q1 2009) Bank failures: 294 banks failed in the US since 2008; notwithstanding some signs of recovery, 129 banks failed in 2010 Shrinking write offs: Uncollectable loans fell $214m during Q1 2010 (first decrease since 2006) Foreclosures: US foreclosures hit new highs in summer 2010, with a particular acceleration in July and August 2010, according to LPS Large banks, such as JP Morgan Chase, Goldman and BofA, have emerged stronger than pre-crisis, and are dominating the markets post crisis in many areas Regulatory threats: Threat to traditional business models due to regulatory reform (Dodd Frank Act), particularly in the field of prop-trading and hedge fund investments Europe Recovery Crisis Stress tests: CEBS stress test revealed that with aggregate losses of C566bn, only seven banks' tier 1 capital ratios fell below 6% Bad debts: Banks in Greece, CEE, Spain, Ireland and Portugal remain in doubtful conditions; loan losses 2010: C123bn, 2011e: C105bn (ECB), with austerity packages upcoming. Euro-Stabilization: The C- zone has stabilized in late 2010, with the C being seen as some kind of "emergency valve" with respect to the weakening USD State debt in doubt: With budget deficits soaring (Ireland: 11.6%), banks B/S are loaded with doubtful State debt (Greek debt in French banks: estimated at C 76bn) Hiring spree: In July 2010, London headhunters reported the biggest wave of mandates since 2007, particularly in the area of financial services Stand alone funding not secured: ECB carries a large bulk of bank financing, with C1,300bn to be refinanced in the coming 3 years The Western financial markets are showing signs of both recovery and remainders of the crisis Clearly, the system is still vulnerable and has not yet reached fully a status of resilience to further volatility and sloppy economic growth Page 4 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. The Situation in Asia Asia Recovery Crisis Large Chinese Banks grew in the range of 20 30 % annually from 2007 to 2009, with China naming 4 out of the 10 largest banks in the world Inflation and Asset Bubbles: Inflation in China has increased over 3 % in 2010, and the government has implemented massive measures to take control of the looming real estate bubble Shrinking write offs: Provisions / total loans ratio dropped massively across the region until 2008, and stayed low in major economies during the crisis Currency wars: Withthe Euro and the USD coming under pressure due to increasing state debts and unsustainable funding needs, there is increasing pressure on Asian currencies to appreciate in value Strong profits reported in 2010 in major parts of the region, such as in China, India, Australia, Korea and Singapore Japanese banks: Profitability of Japanese banks lagged behind the benchmark in Asia, with key players reporting massive losses in 2008 and 2009 The Asian financial system has proved to be rather stabile, with losses and lack of growth hitting mainly Western economies so far The stimulus package of the Chinese government has been the key driver to keep the Asian economies floating Page 5 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. The Dilemma of the Regulators Cheap money suppIy and Quantitative Easing. The root of the problem: Continuing lack of growth of Western economies The US economy shows signs of continuous weakness in the second half of 2010, with unemployment rates hitting 15.2% in Michigan (3Q10) Cheap Money to stimulate growth Low central bank's lending rates keep the Western economy floating, with further Quantitative Easing (QE) announced Is leverage a sustainable tool to stimulate private consumption? Long term, cheap money will not be able to substitute the weakness of private consumption, which is created by asset loss, high unemployment, rising taxes and increased insecurity Stimulus packages based on QE create asset and market bubbles It is to be expected that banks will continue to pass on cheap money to consumers, leading to unsustainable asset bubbles and leverage .create obstacles to regulatory reform Stimulate Growth / Promote Deleveraging: Regulators have the task to strengthen the capital base of banks and restrict risky lending, while the Western Central banks are at the same time pushing cheap lending and further leverage in order to stimulate the economy Government as Regulator / Central Bank / Shareholder / Growth Agent: With Governments not only promoting growth through Central Banks, but also being shareholders of major financial institutions, there is a high likelihood of conflicts of interest to their roles as regulators Regional Conflicts: With Asia's influence growing and Asian banks not hit that hard by the financial crisis, it is to be expected that there will be resistance in Asia to be obliged to "use medicine that was developed to a large extent to cure an illness that occurred elsewhere Regulators globally face the dilemma that economic growth levels can only be maintained based on widening debt financing, whi le the financial sector needs deleveraging in order to increase its resilience to crisis Page 6 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Main Building Blocks of Basel III Capital Clean Up and Risk Limitation Clean up of Regulatory Capital The new proposals focus on improvement of quality of Tier 1 "Predominant form of Tier 1 must be common shares and retained earnings Tier 2 capital will be harmonized and simplified; only one class of Tier 2 capital will remain. Tier 3 capital (currently available to cover market risk requirements) will be eliminated. Refining Risk Management July 2009 changes: ntroducing "stressed VaR into capital requirement, as well as capital requirements for an "ncremental risk charge (RC) Creating addition capital requirements for Counterparty Credit Risk (CCR), especially in the areas of Annex 4 of the July 2006 accord (Credit Value Adjustment - CVA, Asset Value Correlation AVC, Wrong Way Risk WWR) Strengthening internal credit risk due diligence, and decrease (sole) reliance on external ratings Countercyclical Measures Promote more forward looking provisions, in line with the recent IASB proposals Introduce additional capital conservation buffer that can be used in stress Protect the banking sector from periods of excess credit growth through introduction of additional capital buffers in such periods Limitation of Overall Leverage The proposal introduces an overall restriction of leverage (exposure / capital) Aim is to reinforce the risk-based requirements with a simple, non-risk-based "backstop measure based on gross exposure Liquidity Risk Management Introduction of qualitative LRM standards, relating to Due Process, Emergency Funding Plan (EFP), stress testing requirements, etc Introduction of Liquidity Coverage Ratio (LCR) and Net Stabile Funding Ratio (NSFR) Systemic Risk Additional capital and liquidity surcharges for systemically important banks are in discussion These rules are not yet clearly fleshed out and will therefore not be discussed further in this pack Page 7 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Phase in of new Capital and Liquidity Requirements The BCBS has recently published its time table under which the new capital and liquidity rules should become applicable. Given that the current banking industries capital cushions would not support a "big bang implementation, grand fathering and transitional provisions are meant to materially support a "soft landing of the new regulatory requirements 2011 2012 2013 2014 2015 2016 2017 2018 As of 1 January 2019 Leverage Ratio Supervisory monitoring Parallel run 1 Jan 2013 - 1 Jan 2017 Disclosure starts 1 Jan 2015 Migration to Pillar 1 Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50% Minimum common equity plus capital conservation buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials) 20% 40% 60% 80% 100% 100% Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum Total Capital plus conservation buffer 8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5% Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital Phased out over 10 year horizon beginning 2013 Liquidity coverage ratio Oberservation period begins Introduce minimum standard Net stable funding ratio Oberservation period begins Introduce minimum standard Page 8 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Strategic relevance of the upcoming rules Basel II - (overall) capital neutral In developing the revised Framework in 2006, the BCBS has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the supervisory and accounting systems in individual member countries. These are to broadly maintain the aggregate level of such requirements, while also providing incentives to adopt the more advanced risk-sensitive approaches of the revised Framework. Basel III - not capital neutral Other than Basel II, Basel III targets to significantly increase capital and liquidity requirements compared to status quo, with both risk weighted assets (RWA) and capital percentages rising Basel III will thus have a material impact on growth strategies and the sustainability of current business models of banks Page 9 Basel III Design and Potential Impact Strengthening the Capital Base 2010 Deloitte All rights reserved. Background and Goals of the New Rules Strengthening Core Capital Flaws of the existing system Many regulatory adjustments are not applied to common equity, allowing to report high Tier 1 ratios No harmonized list of regulatory adjustments Hybrid capital proved to be less valuable in times of stress than anticipated Capital to support trading activities has minor quality (almost like a liability) Weak transparency Goals: Quality and Simplicity The definitions of Tier 1 and Tier 2 capital should correspond to capital which absorbs losses on a going concern basis and capital which absorbs losses on a gone concern basis, respectively. Number of tiers and sub-tiers of capital must be limited Minimum set of regulatory adjustments must be harmonized internationally Capital composition must be disclosed in detail Tier 1 is King Tier 1 capital = highest quality component of capital. Subordinated to all other elements of funding, absorbs losses as and when they occur Has full flexibility of dividend payments and no maturity date There can be no features which add additional leverage or which could cause the condition of the bank to be weakened during periods of market stress Innovative Tier 1 will be phased out Changes for Tier 2 and Tier 3 Tier 2 will be simplified, one set of entry criteria, removing subcategories of Tier 2 Subordinated to depositors and general creditors, original maturity of at least 5 years Recognition in regulatory capital will be "amortised on a straight line basis during the final 5 years Tier 3 capital will be abolished Page 11 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Capital Components under BII and Proposed New Composition BII (current version) Proposed new standard Tier 1 Common Stock and other forms of Tier 1 (including perpetuals) Tier 1 Common Equity (common stock plus retained earnings and OCI) Disclosed reserves (including from minority interests) Additional going concern capital 15% innovative instruments (Annex 1 to BII) n.a. Deduct goodwill and equity from securitizations Deduct goodwill and many other items 1:1 from common equity Deduct 50% of investments in other financial institutions Transformed into 1:1 adjustment Tier 2 max 100% of Tier 1 Undisclosed reserves and asset revaluation Tier 2 Only one form of Tier 2 capital remains General loan-loss reserves Unrealized gains will be reviewed by BCBS until y/e 2010 Hybrid capital instruments n.a. Subordinated debt (max 50% of Tier 1) n.a. Tier 3 For market risk coverage (limitations apply) Tier 3 n.a. Common shares will need to meet a set of entry criteria before being permitted to be included in the predominant form of Tier 1 capital. Must be predominant form of Tier 1 capital A new system of limits and minima will apply : common equity component of Tier 1 Total Tier 1 Total capital Page 12 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Example for Current Tier 1 Composition Minority interest: major part of many institutions' Tier 1 capital The bank deducts intangibles from core components Innovative capital forms a major part of Tier 1 XYZ Bank 1) 1) These figures were extracted from a publicly available annual report of a major internationally operating banking group Page 13 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Tier 2 Capital Main Features Main Features of Tier 2 Capital under the New Regime Subordinated. No agreements that legally or economically enhance the seniority of the claim vis--vis depositors and general bank creditors allowed Minimum original maturity of at least 5 years, amortization over the remaining 5 years of maturity. No incentives to redeem Callable, but only under (very) restrictive circumstances No acceleration rights for payments (coupon or principal), except in bankruptcy and liquidation No credit sensitive dividend features No direct or indirect funding through the bank (group) SPV structures fall under the same rules as for Tier 1 Example for Tier 2 Capital composition under the current regime Some of the debt in item 3 and 4 will qualify also under the new regime Will be deducted from Tier 1 in the future 1) These figures were extracted from a publicly available annual report of a major internationally operating banking group XYZ Bank 1) Page 14 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Adjustments to Tier 1 Regulatory Capital Capital Adjustments Topic Comments Relevance Stock surplus Stock surplus (i.e. share premium) will only be permitted to be included in the Common Equity component of Tier 1 if the shares giving rise to the stock surplus are also permitted to be included in the Common Equity component of Tier 1. The new rule ensures that there is no loophole for including instruments other than common shares in the Common Equity component of Tier 1 Some banks issued instruments that did not qualify for equity, but created a surplus which was accounted for as a reserve. Rare, but if instruments have been issued, can be high volume Goodwill and other intangibles *) Goodwill and other intangibles should be deducted from the Common Equity component of Tier 1, net of any associated deferred tax liability. Option to use IFRS in determining the level of intangible assets if national GAAP results in a wider range of assets (e.g. building rights) Addresses the high degree of uncertainty that intangible assets would have a positive realisable value in periods of stress or insolvency. Avoids giving acquisitive banks a capital advantage over banks with the same real assets and liabilities which have grown organically. Is quite standard in many jurisdictions Can have huge impact, but is new only with regards to subcategories of Tier 1 Deferred tax assets *) Deferred tax assets which rely on future profitability of the bank to be realized should be deducted from the Common Equity component of Tier 1. Deferred tax assets are capitalized in case of timing differences and potentially in the form of loss carry forwards Assets the worthiness of which depends on future profitability are usually collapsing in times of stress Does not refer e.g. to prepayments to tax authorities Can be very material, but is already standard in various jurisdictions Investments in own shares (treasury stock) All of a bank's investments in its own common shares should be deducted from the Common Equity component of Tier 1 (unless already derecognized under the relevant accounting standards) Counts for trading and investment portfolios, as well as components of index securities, investment funds, and forwards to purchase own stock Not too relevant, given existing IFRS rules Investments in the capital of certain institutions *) For all holdings in banking, financial and insurance entities which are outside the regulatory scope of consolidation Goal: remove the double counting of capital in the banking sector and limit the degree of double counting in the wider financial system, within the appropriate tier of capital rather than at the total capital level. Corresponding deduction approach: the deduction should be applied to the same component of capital for which the capital would qualify if it was issued by the bank itself. Full deduction: All holdings of capital which form part of a reciprocal cross holding agreement or are investments in affiliated institutions (e.g. sister companies) Threshold approach: For all other holdings Today in many jurisdictions 50/50% deduction Has potentially massive implications for complex affiliated groups Shortfall of the stock of provisions to expected losses The deduction from capital in respect of a shortfall of the stock of provisions to expected losses under IRB approach will be 100% from the common equity component of Tier 1 capital. The current regime (50/50% deduction) results in the bank with a low stock of provisions showing more Tier 1 capital, which could be acting as an incentive for banks to provision at low levels Depends on accounting policy and results of IRB approach *) Instead of a full deduction, a bank must deduct the amount by which the aggregate of the three items with *) above exceeds 15% of its common equity component (for intangibles only applicable for "mortgage servicing rights) Page 15 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Capital Adjustments (2) Topic Comments Relevance Minority interest Minority interest will no longer be eligible for inclusion in the Common Equity component of Tier 1. However, the Committee will allow some prudent recognition of the minority interest supporting the risks of a subsidiary that is a bank (7/2010) The proposal addresses the concern that while minority interest can support the risks in the subsidiary to which it relates, it is not available to support risks in the group as a whole and in some cases banks set up risk free subsidiaries, controlled by 2 entities, both banks consolidated and used the capital injected by the third party Potential impact might be massive, depending on group structure Unrealised gains and losses on financial instruments No adjustment should be applied for gains or losses recognized on the balance sheet The proposal addresses concerns that the existing policy adopted in certain jurisdictions of filtering out certain unrealized losses has undermined confidence in Tier 1 capital. It helps ensure that the Common Equity component of Tier 1 is fully available to absorb losses (both realized and unrealized). Relevant in many cases Cash flow hedge reserve Remove the positive and negative cash flow hedge reserve from the Common Equity component of Tier 1 where it relates to the hedging of projected cash flows which are not recognized on the balance sheet. CF reserves give rise to artificial volatility in common equity, as in this case the reserve only reflects one half of the picture (the fair value of the derivative, but not the changes in fair value of the hedged future cash flow) Depends on use of CF hedging; can be material Cumulative gains and losses due to changes in own credit risk on fair valued financial liabilities Filter out from the Common Equity component of Tier 1 all gains and losses resulting from changes in the fair value of liabilities which are due to a changes in the bank's own credit risk. The existing filter established in the 8 June 2004 press release only applies to gains and losses on liabilities which are fair valued as a result of the application of the fair value option MtM of own debt due to deterioration of own credit risk is currently under review by the IASB and will potentially be eliminated Some banks recorded massive gains in valuation of own liabilites in the crisis Defined benefit pension fund assets and liabilities Deduct of any DBO pension fund asset from the Common Equity component of Tier 1. Assets in the fund to which the bank has unrestricted and unfettered access can, with supervisory approval, offset the deduction. Addresses the concern that assets arising from pension funds may not be capable of being withdrawn and used for the protection of depositors and other creditors of a bank Depends heavily on pension scheme used Remaining 50:50 deductions All remaining regulatory adjustments which are currently deducted 50% from Tier 1 and 50% from Tier 2, and which are not addressed elsewhere in the proposal, should be transformed into assets that need capital coverage The 50:50 deductions complicate the definition of capital, particularly in the application of the limits and so the proposal is that they will receive a 1250% risk weight. Examples for current 50/50 deductions: Certain securitization exposures, Certain equity exposures under the PD/LGD approach; Non- payment/delivery on non-DvP and non-PvP transactions; Significant investments in commercial entities Diverse Adjustments to Tier 1 Regulatory Capital Page 16 Basel III Design and Potential Impact Strengthening Risk Management 2010 Deloitte All rights reserved. Overview of Changes of the RM Framework Failure to capture major on- and off-balance sheet risks, as well as derivative related exposures, was a key destabilising factor over the past two and a half years. The proposed changes to the RM framework focus on this area, and on the role of ECAIs Changes through July 2009 papers Raise capital requirements for the trading book and complex securitization exposures, a major source of losses for many internationally active banks. Introduces capital requirements for stressed value-at-risk (VaR) based on a 12-month period of significant financial stress Also introduces higher capital requirements for so-called re-securitizations in both the banking and the trading book Raise the standards of the Pillar 2 supervisory review process and strengthen Pillar 3 disclosures. To be implemented by the end of 2010 Treasury related changes December 2009 Calculate effective EPE with stressed parameters to address general wrong-way risk Use bond-equivalent of the counterparty exposure to capture CVA credit valuation adjustments for counterparty downgrades Raise multiplier asset value correlation for large financial institutions exposures Additional collateral and margining requirements for illiquid derivate exposures Capital charges for bilateral OTC derivative transactions Explicit Pillar 1 capital charge for wrong-way risk Haircut for repo transactions using securitization collateral (and prohibition of re- securitizations as eligible financial collateral for regulatory capital purposes) Strengthen back-testing and stress testing General CR related changes Mitigate the reliance on external ratings of the Basel II framework, Requirements for banks to perform their own internal assessments of externally rated securitization exposures, Elimination of certain "cliff effects associated with credit risk mitigation practices Tightening of the eligibility criteria for the use of external ratings Focus of Change Tail risks in trading portfolios and securitization Risks Stress testing relating to market risk Incremental risk charge (specific MR) Counterparty Credit Risk in treasury transactions Scenario analysis and stress testing relating to CCR Dealing with overreliance on external ratings Page 18 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Topic Noted Issues Correlation of defaults and high EAD Defaults and deteriorations in the creditworthiness of trading counterparties occurred at the time when market volatilities, and therefore counterparty exposures, were higher than usual Generally, wrong way risk was not covered adequately CVA MtM Potential mark-to-market losses due to credit valuation adjustments (CVA) were not subject to capital requirements. Within the crisis, roughly two-thirds of CCR losses were due to CVA losses and only about one-third were due to actual defaults. Correlation of exposures to FI Large financial institutions were more interconnected than currently reflected in the capital framework. As a result, when markets entered the downturn, banks' counterparty exposure to other financial firms also increased. Close out periods The close-out period for replacing trades with a counterparty with large netting sets often took much longer than anticipated on average Initial margining and EPE Initial margining typically was very low at the start of the crisis and increased rapidly during the turmoil. Capital required for EPE was not sufficient Note: Expected Positive Exposure (EPE) is the weighted average over time of expected exposures where the weights are the proportion that an individual expected exposure represents of the entire time interval Overreliance on OTC clearing Central Counterparties (CCPs) were not widely used to clear trades Securitizations Securitizations were treated as if they had the same risk exposure as a similarly rated corporate debt instrument, while recently securitizations have continued to exhibit much higher price volatility Stress Testing and Back Testing The use of models with poor backtesting results contributed to an underestimation of actual losses Stress testing of counterparty credit risk was not comprehensive Many institutions were not properly managing their trading book related CCR exposures Lessons learnt from RM Failures relating to CCR Page 19 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. E A D E s t i m a t i o n E x t e r n a l
C o n t r a c t s Trading and Treasury Risk Management C o n s i d e r
F a t
T a i l s Bank B Current Framework to Capture CCR C u r r e n t N e t E x p o s u r eOptions Futures Swaps E s t i m a t e d
F u t u r e N e t E x p o s u r e Forecast market parameters C o l l a t e r a l Forecast collateral values Bank A Calculate EPE E s t i m a t i o n
o f
M (Standard or model) Page 20 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Summary of Proposed Capital Requirement Changes for CCR Add CVA loss capital coverage to credit risk calculation Calculate correlation adjustment Calculate Maturity adjustment (if applicable) Calculate Capital requirement Calculate RWA Factor specific WWR into EAD estimates Raise AVC for Financial Institutions Trading example from slide 31 Calculate Unexpected Loss (UL) Increase standard add ons if EPE is modeled without margin agreements Page 21 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Credit Valuation Adjustment (CVA) - Introduction Definition CVA is the price of counterparty risk (Expected Loss) CVA = Value of the derivative under default free assumption minus value of the derivative accounting for failure to pay. CVA Development 1999/2000: Banks first start using CVA to assess the cost of counterparty risk Treated in an "insurance style approach (passive management) 2006: Accounting rules (FAS 157, IAS 39) imply that the value of derivatives positions must be corrected for counterparty risk Post Lehman: Since the collapse of Lehman, CVA is a key issue of managing counterparty risk Treated in a "trading desk approach (active management) CVA has material impact on pricing considerations CVA T t V T t V , , ~ Page 22 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Capital Add on based on Bond-equivalent to capture CVA losses Background Original Proposal (12/2009) This proposed change also refers to Annex 4 of the June 06 BII framework. Banks must calculate an additional capital charge to cover potential mark-to-market counterparty risk losses. For this purpose, it is proposed that banks should implement the "bond-equivalent of the counterparty exposure approach In practice, this proposal provides a capital add-on by using a bond equivalent as a proxy for CVA risk Single name CDS can also be used as an alternative Each counterparty is long a hypothetical bond issued by the counterparty where: ! the notional of the bond is the total current EAD of a counterparty (treated as fixed) ! the maturity of the "bond is the effective maturity of the longest dated netting set of a counterparty type of bond: zero-coupon When using the internal model for market risk, a bank has to calculate a 99% VaR. The time horizon is one year Calculation on standalone basis (without accounting for hedging) Exception: Single name CDS or other equivalent instruments directly referencing the counterparty Page 23 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. July 2010 Modifications to CCR Methodology Modifications to the CCR Calculation Modify the bond equivalent approach to address hedging, risk capture, effective maturity and double counting To address the excessive calibration of the CVA, eliminate the 5x multiplier that was proposed in December 2009 Keep the asset value correlation adjustment at 25% to reflect the inherent higher risk of exposures to other financial entities and to help address the interconnectedness issue, but raise the threshold from $25 billion to $100 billion Banks' mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognizant that CCP exposures are not risk free More advanced alternatives to the bond equivalent approach could be considered as part of the fundamental review of the trading book Page 24 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Moody's Investor Services Standard & Poors Fitch Ratings M a i n
I n t e r n a t i o n a l
R a t i n g
A g e n c i e s External credit rating agencies were a major contributor to the financial crisis, with lax rating practices, commercial involvement in structures that were subject to rating, and massive downgradings, also to below investment grades, of previously AAA rated investments As a consequence, the regulatory framework for CRAs was tightned both in the US and in Europe Changes in the BII Framework also reflect the loss in trust in the activities of credit rating agencies Addressing (Over-)Reliance on External Ratings Page 25 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Reform Proposals Relating to CRAs July 2009 Measures Banks must supplement regulatory capital requirements based on externally rated securitizations with their own credit analysis and capital estimates of the exposure Need to collect a range of information on the underlying collateral supporting securitizations exposures Failure to conduct such due diligence will result in the bank having to deduct the exposure from capital IOSCO Code and operational requirements CRAs must comply to the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies Rating must be published in an accessible form and included in the ECA's transition matrix Loss and cash-flow analysis as well as sensibility of ratings to changes in the underlying ratings assumptions should be publicly available Cliff Effects Currently, "eligible guarantors" for the SA and FRB are defined as "externally rated A- or better or "internally rated and associated with a PD equivalent to A- or better f a guarantor falls under this threshold, "cliff effects might take place, triggering a material change in the capital treatment The new proposal departs from a single requirement, while maintaining a requirement in the Standardised Approach that a guarantor other than sovereigns, PSEs, banks, and securities firms - be externally rated. Page 26 Basel III Design and Potential Impact Introduction of an Overall Leverage Ratio 2010 Deloitte All rights reserved. Current Version of Overall Leverage Ratio (7/2010) Draft 12/2009 Definitionof Total Exposure 12/2009 Include all assets (including high quality liquid assets) in the measure of exposure Net of provisions and valuation adjustments (e.g. credit valuation adjustments) Derivatives: Either accounting approach but with no netting or current exposure method to measure potential exposure but with no netting Credit derivatives: exposure is effectively the same as providing a guarantee, and therefore a 100% credit conversion factor will be applied. Commitments: 100% credit conversion factor No reduction by physical or financial collateral, guarantees or credit risk mitigation no netting of derivatives, repo style transactions and of loans / deposits Modifications 7/2010 Definitionof Total Exposure 7/2010 For off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review to ensure that the 10% CCF is appropriately conservative based on historical experience). For all derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method. This ensures that all derivatives are converted in a consistent manner to a "loan equivalent amount. BCBS proposes a minimum Tier 1 leverage ratio of 3% during the parallel run period (33,3x), tracking LR quarterly The supervisory monitoring period commences 1 January 2011 and focus on the developing templates to track the ratio Parallel run period commences 1 January 2013 and runs until 1 January 2017, tracking LR and its components Bank level disclosure of the leverage ratio and its components will start 1 January 2015. The Committee will closely monitor disclosure of the ratio Page 28 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Illustrative Example Balance Sheet and Off Balance Sheet Volumes Tier one Common Equity: 1.500 Capital Adjustments: 400 Total balance sheet volume: 18.000 Derivatives (CCR) 4.600 Guarantees, CDS 6.200 Outstanding Commitments: 3.200 Calculation of Exposure Calculation of Leverage Ratio Balance Sheet Volume 18,000 Balance Sheet Volume 32,000 Off Balance Sheet Volume Total Capital Derivatives (CCR) 4,600 Tier 1 Common Equity 1,500 Guarantees 6,200 Adjustments 400 Commitments 3,200 Total eligible capital 1,100 Total OBS 14,000 Total Exposure 32,000 Leverage Ratio 29x Page 29 Basel III Design and Potential Impact Dealing with Procyclicality 2010 Deloitte All rights reserved. Dealing with Pro-Cyclicality Current measures to address procyclicality: Requirement to use long term data horizons to estimate probabilities of default The introduction of so called downturn loss-given-default (LGD) estimates Appropriate calibration of the risk functions, which convert loss estimates into regulatory capital requirements Stress tests that consider the downward migration of their credit portfolios in a recession. The proposals to further counterbalance pro-cyclicality focus on: Forward looking provisioning (see next slides) Capital conservation Building capital buffers in times of excessive credit growth In its proposal to strengthening the resilience of the banking sector, the BCBS also tries to address procyclical features of current regulation. As it is in the nature of micro economic behavior to reduce lending in times of increased risk, it is of particular difficulty for regulators of privately owned banks to balance the need for proper risk management and macro-economic goals. Establish a buffer range above the regulatory minimum capital requirement Capital distribution constraints are imposed on the bank when capital levels fall within this range (only on distribution, not on business operations) Distribution constraints increase as the banks' capital levels approach the minimum requirement Should not result in the range being viewed as establishing a new minimum capital requirement Capital Conservation Build up a capital buffer in times of excessive credit growth (ave credit growth exceeds GDP growth materially) Adjust the capital buffer range when there are signs that credit has grown to excessive levels This will ensure that banks build up countercyclical capital buffers, increasing their ability to absorb losses Expected to be fully fleshed out approach at the BCBS' July 2010 meeting Capital Buffer for ,excessive credit growth" Page 31 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Measures against Pro-Cyclicality The BCBS and the G20 have, in various documents, made clear that current banking and accounting regulation have certain pro-cyclical effects, meaning that those rules may exacerbate an economic crisis by producing pro-cycIicaI feedback and second round effects, which might end up in a vicious cycIe ("downward spiraI"): "One of the most destabilizing elements of the crisis has been the procyclical amplification of financial shocks throughout the banking system, financial markets and the broader economy. The tendency of market participants to behave in a procyclical manner has been amplified through a variety of channels, including through accounting standards for both mark-to-market assets and held-to-maturity loans, margining practices, and through the build up and release of leverage among financial institutions, firms, and consumers. The Basel Committee is introducing a number of measures to make banks more resilient to such procyclical dynamics. These measures will help ensure that the banking sector serves as a shock absorber, instead of a transmitter of risk to the financial system and broader economy." Regarding forward looking provisioning, the BCBS outlines: "The Committee strongly supports the initiative of the IASB to move to an expected loss approach. The goal is to improve the decision usefulness and relevance of financial reporting for stakeholders, including prudential regulators. It has issued publicly and made available to the IASB a set of principles that should govern the reforms to the impairment standards. In particular, loan loss provisions should be robust and based on sound methodologies that reflect expected credit losses in banks' existing loan portfolios over the life of the portfolio. The accounting model for provisioning should allow for early identification and recognition of losses by incorporating a broader range of available credit information than is permitted under the incurred loss model." The envisaged changes in accounting regulation will have a massive impact on both profitability and regulatory capital, as the key effect will be that banks need to build up loan loss reserves from day 1, based on loss expectations, rather than waiting for an impairment trigger to occur. 32 Page 32 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Building up Forward Looking Reserves IASB Roadmap to IAS 39 Overhaul The IASB has revised its schedule for IAS 39 overhaul several times As most of the issues are joint projects with the FASB, coordination takes time and requires multi-channel communication; further, the process to obtain comment letters is also time consuming Most projects are expected to be completed by Q4 2010 The IASB has issued ED 2009/12 on amortized cost and impairment in Q4 2009. A final IFRS on the matter is expected to be issued in Q2 2011 Focus on Loan Loss Accounting The BCBS promotes vigorously the building up of foward looking reserves It supports the expected loss (EL) approach as recently promulgated by the IASB IASB issued an ED to change from an incurred loss approach to EL approach Part of the larger agenda to overhaul IAS 39 Committee considers EL approach to be less procyclical than the current "incurred loss approach IASB has not yet finally defined their approach. FASB is currently in the process of developing its own approach, with the recent draft on FI diverging from the IASBs concept in various aspects Page 33 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. High Level Overview of ED 2009/12 Asset by asset or groups of similar assets Estimate expected cash flows taking into account expected future credit losses over the life of the asset Probability-weighted possible outcome approach even if most likely outcome is full repayment No initial loss is recognized immediately ED 2009/12 requires PIT estimates TTC estimates not allowed Initial recognition: Estimate future credit losses over life of asset Net interest revenue recognized: Less margin to reflect estimated future credit losses Allowance for credit losses built up over time Ongoing adjustments to estimates of future credit losses Adjustment to the effective interest rate method (EIR) Margin deducted from EIR rate for estimate of future credit losses Applies to fixed rate, floating rate or combination rate financial assets carried at amortized cost Solve for effective interest rate that equates (1) the initial carrying amount with (2) the PV of expected future cash flows incorporating initially expected credit losses Margin for initially expected credit losses that is deducted from gross interest revenue in each period is set aside to gradually build-up an allowance for expected future credit losses Applies even if no actual losses have yet been incurred Does not require objective incurred loss evidence as under current IAS 39 rules Each period, the entity must reassess the asset's expected cash flows , taking into account expected future cash flows Any changes in credit loss expectations both favourable and unfavourable are recognized immediately on a discounted cash flow basis as a gain or loss in earnings. Discount revised expected future cash flows at asset's original EIR Page 34 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Existing Impairment Model (IAS 39) vs. Proposed Model Aspect Incurred Loss Approach Expected Loss Approach Initial determination of the effective interest rate (EIR) Based on initial net carrying amount and expected future cash flows ignoring future credit losses Based on initial net carrying amount and expected future cash flows that are adjusted for future credit losses Trigger for impairment Required indicator based (objective evidence of impairment) No trigger Measurement of revised carrying amount Expected cash flows reflecting incurred losses discounted at original EIR No fair value adjustments No reflection of future credit losses Continually updated expected cash flows Discounted at original EIR (fixed rate instruments) or combination of spot curve for benchmark rate and a spread (floating rate instruments) No fair value adjustments Reflects expected future credit losses Recognizing impairment Profit or loss Profit or loss Subsequent impairments If further losses have been incurred Recognized automatically through continual re- estimation of cash flows Revenue recognition after impairment Based on EIR Compatible with cost-based measurement objective Based on EIR Compatible with cost-based measurement objective Reversals Required if triggered by event after recognition of impairment loss Limit to reversal up to amortized cost Automatically by adjusting the expected future cash flows (no trigger) Upper limit is full contractual flows discounted at EIR Page 35 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Comparison of Basel II and ED 12/2009 Estimates of PD represent probability of default over 12 month horizon. PD is calculated using statistical methods on the basis of long run historical average. Estimates of loss inherent in cash flows are required over the life of a loan. Point in time estimates need to be made; over the cycle estimates are not permitted. LGD is an economic loss concept. It includes direct and indirect collection costs, such as allocations of internal overheads and other non-cash costs. Losses are discounted to the point of default using an entity's cost of capital / Funding Cost. At the default point, Basel 2 requires estimation of the present value of expected future cash flows. ED 12/2009 impairment calculations are cash flow driven. They may include direct cash collection costs, but should exclude non-cash costs. ED 12/2009 requires recoveries to be discounted by the original effective interest rate At each payment date (and therefore potential default point), requires estimation of the expected future CF. For Banks using the advanced approach, with the exception of certain short term exposures, the maturity will be the greater of 1 year / remaining effective maturity. This mainly equates to the remaining contractual period of the exposure. IAS 39 Impairment requires an estimation of the amount and timing of prepayment over the instrument's effective life. In respect of credit facilities, EAD takes into account expectation of future draw-downs through a credit conversion factor. Uses Carrying Value and Actual Cash Flow as the basis for estimations. P D L G D E A D M Synergies and Differences Basel II ED 2009/12 Page 36 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Incurred Loss, Expected Loss and Basel II Incurred Loss Model IASB Expected Loss Model Basel II Expected Loss Model y/e 2010 y/e 2011 PD 1 year Loss event Loss event Default EL = EAD * PD * LGD Impaired, no consideration of emergence period as loss is already identified Extrapolationof loss events through LEP Calculation IL = EAD * PD * LGD * LEP Emergence Period Emergence Period Loss Identification Loss Identification NAV of CF(t) = f(PD(t), LGD(t), EIR) Past default and loss data is used to estimate PD and LGD (usually 5 years) t Page 37 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. "Decoupling In practice, the ECF approach would give rise to operational difficulties because financial institutions and others typically store comprehensive contractual and accounting data (in particular effective interest rate data) and EL data information in separate systems ('accounting' and 'risk' systems). These operational difficulties were a major concern raised by members of the EAP. (The ECF approach proposed by the IASB features an integrated EIR calculation that would require integration of the data in the accounting and risk systems.) The ECF approach (as an approximation) could be simplified by 'decoupling' separately sourcing the information in accounting systems (interest revenue as determined today under IAS 39 Financial Instruments: Recognition and Measurement that excludes EL estimates) and the information in risk systems. Such an approach would adjust the interest revenue calculated in the accounting system using an allocation profile for expected credit losses derived from EL data in the risk system. In order to better understand a possible decoupling approach, the following slides give some details on how banks typically manage credit risks, based on the Basel II methodology, and make a comparison of the ECF and credit risk methodology. Based on existing differences, we also analyze practical issues, such as data requirements (and limitations) and the like. Page 38 Basel III Design and Potential Impact Management of Liquidity Risk 39 2010 Deloitte All rights reserved. Fundamental principle 1. A bank needs to establish a robust liquidity risk management framework Governance of liquidity risk management 2. A bank should clearly articulate a LR tolerance appropriate for its business strategy and role 3. Senior management needs to be actively involved in LRM 4. Liquidity costs need to be factored into internal transfer pricing, so that LR is considered adequately Measurement & management of liquidity risk 5. A bank should have sound a process for identifying, measuring, monitoring and controlling LR 6. A bank should actively monitor and control LR exposures throughout the group and take into account legal, regulatory and operational limitations to the transferability of liquidity 7. A bank should establish a funding strategy for effective diversification of sources / tenor of funding 8. A bank should actively manage its intraday liquidity positions and risks 9. A bank should actively manage its collateral positions 10. A bank should conduct stress tests regularly and use the results to adapt strategy / positions 11. A bank should have a formal contingency funding plan 12. A bank should maintain a cushion of high quality liquid assets as insurance against a range of liquidity stress scenarios (see International framework for LRM) Public Disclosure 13. A bank should issue regular public disclosure on LRM and positions Role of supervisors 14. Comprehensive assessment of liquidity risk management framework 15. Monitoring of internal reports, prudential reports & market information 16. Effective and timely intervention (New) 17. Communication with other supervisors and public authorities The 17 BCBS Principles Fundamental Principles Governance of Liquidity Risk Public Disclosure Measurement and Management of Liquidity Risk Role of Supervisors Framework for Liquidity Risk Management (LRM) BCBS Paper on Fundamental Principles of LRM Page 40 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. The core of the framework consists of two ratios, which have been developed to achieve two separate but complementary objecti ves. BCBS International Liquidity Framework Aim to strengthen short-term liquidity profile Defines level of liquidity buffer to be held to cover short-term funding gaps under severe liquidity stress Cash flow perspective Predefined stress scenario Time horizon: 30 days Aim to strengthen medium- to long-term liquidity profile Defines minimum acceptable amount of stable funding in an extended firm-specific stress scenario Balance sheet perspective Predefined stress scenario Time horizon: 1 year LCR Stock of high quality liquid assets Net cash outflows over 30-day horizon NSFR Available amount of stable funding Required amount of stable funding L i q u i d i t y
C o v e r a g e
R a t i o N e t
S t a b l e
F u n d i n g
R a t i o 2 100% 2 100% Overview of BCBS Liquidity Ratios Page 41 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Banks must maintain an adequate level of unencumbered, high quality assets to meet their liquidity needs for a 30-day time horizon under an acute stress scenario. 'Net cumulative liquidity mismatch position under stress scenario' based on contractual maturities Survival period of 30 days Stress scenario is a combination of idiosyncratic and systematic factors, defined through asset and runoff factors specified by regulators 'One size fits all' philosophy reduces risk sensitivity for the sake of harmonisation internal stress tests at banks based on BIS sound principles are required to complement ratio LCR Stock of high quality liquid assets Net cash outflows over 30-day horizon Market value Cash Outflows Cash Inflows Asset factor Cash Outflows _ Cash Inflows Runoff Factor Runoff Factor _ _ _ _ Three-notch credit rating downgrade Partial run-off of deposits Partial loss of wholesale funding capacity Increased market volatility higher collateral haircuts Unscheduled draws on committed facilities S T R E S S
S C E N A R I O 2 100% Liquidity Coverage Ratio Page 42 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Conservative approach and restrictive wording by BIS as a result of the crisis Additional restrictive criteria for corporate & covered bonds e.g. max. 50% of buffer Note no blanket inclusion of sovereign bonds, additional criteria e.g. 0% risk weight apply Bank deposits are not part of the liquid assets buffer, but can count as "cash inflow when calculating the potential net cash outflow in the stress scenario The nominator of the LCR is composed of a 'stock of unencumbered, high quality liquid assets'. The exact composition of the buffer remains a matter of intense discussion. List of quaIifying 'high quaIity Iiquid assets' Factor 1 Cash 100% Central bank reserves Marketable securities issued or guaranteed by sovereigns, central banks, PSEs and multilateral development banks Domestic sovereign /central bank debt in domestic currency 2 Specific plain vanillacorporate bonds, rating > A+ 80% Specific plain vanillacovered bonds, rating > A+ 3 Specific plain vanillacorporate bonds, rating A+/A/A- 60% Specific plain vanillacovered bonds, rating A+/A/A- i n
d i s c u s s i o n Low market and credit risk Ease and certainty of valuation Listing on a developed exchange Characteristics of 'high quaIity Iiquid assets' Fundamental characteristics Market characteristics Operational requirements Active and sizeable market ,Safe-Haven' Assets Ideally central bank eligible Unencumbered and freely available High Quality Liquid Assets as Nominator Page 43 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Outflows Inflows Deposits Unsecured wholesale funding Committed credit/liquidity facilities ABS/ ABCP Secured wholesale funding Collateral/ derivates Various Retail customers Stable: 7,5% Instable: 15% 10% 100% Repos: Buffer Assets 0% Other Assets 100% 3-notch Downgrade Triggers: 100% Negative market value changes Collateral: 20% Derivatives: tbd** Retail/ Wholesale: 100% Repos: Buffer Assets 0% Other Assets 100% Credit facilities: 0% SME Stable: 7,5% Instable: 15% Credit facilities: 10% Liquidity facilities: 100% Non-Financials (with operational relationships) 25% Non-Financials (without operational relationships) 75% Sovereigns (with operational relationships) 25% Credit and liquidity facilities: 100% Sonstige* & Sovereigns (w/o operational relationships) 100% Current Categorizations for Liquidity Coverage Ratio (LCR) Changed to 5%/10% Introduce new bucket (custody and clearing), 25% outflow Changed to 75% Only recognise roll- over of transactions backed by liquidity buffer eligible assets Lower to 5% For sovereigns etc: 10% run-off for credit lines and 100% run- off for liquidity lines Page 44 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. This metric establishes a minimum acceptable amount of stable funding based on the liquidity characteristics of an institution's assets and activities over a one year horizon. NSFR promotes medium to long-term funding thus reducing incentives for short-term wholesale funding and supplements the LCR (by also counterbalancing "cliff-effects) The stress scenario is defined differently from the one underlying the LCR idiosyncratic stress over 1 yr "Stable funding is defined as those types of equity and liabilities expected to be reliable sources of funds under an extended stress scenario of one year For determination of the required funding amount accounting and regulatory treatment is irrelevant required funding amount depends solely on the respective instrument's liquidity characteristics NSFR Available amount of stable funding (ASF) Required amount of stable funding (RSF) Carrying Value Carrying Value RSF Factor ASF Factor _ _ _ Significant decline in profitability Significant decline in solvency Potential downgrade by any nationally recognised credit rating organisation Material event which calls into question the reputation or credit quality of the institution S T R E S S
S C E N A R I O 2 100% Net Stabile Funding Ratio Page 45 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. RSF Categories (denominator) Factor 1 Cash, money market instruments 0% Securities, loans to financial entities, effective maturity< 1 Y 2 Specific unencumbered government/quasi-sovereign bonds with excellent rating, active repo-markets, < 1 Y 5% 3 Specific credit and liquidity facilities 10% 4 Specific unencumbered corporate bonds or covered bonds with excellent rating, active and liquid markets, < 1 Y 20% 5 Gold, loans to non-financial corporate clients < 1 Y, etc. 50% 6 Loans to retail clients, < 1 J 85% . 7 All other assets 100% 8 Other (non-contractual) contingent funding obligations tbd* ASF Categories (numerator) Factor 1 Total amount of capital, including both Tier 1 and Tier 2 100% Preferred stock not included in Tier 2, effective maturity < 1 Y Total amount of secured and unsecured borrowings and liabilities < 1 Y 2 Stable Retail/SMEdeposits < 1 Y 85% 3 Less stable Retail/SME deposits < 1 Y 70% 4 Unsecured wholesale funding and deposits provided by non- financial corporate customers< 1 Y 50% 5 All other liabilities and equity categories 0% Current Version of ASF / RSF Percentage Weighting for NSFR Raise to 80% Raise to 90% Lower to 65% for residential mortgages and other loans that would qualify for the 35% or better risk weight under StA for CR Lower to 5%, insofar as pre-funded Transition: Carry out an "observation phase" to address any unintended consequences across business models or funding structures before finalising and introducing the revised NSFR as a minimum standard by 1 January 2018. Page 46 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. On top of the LCR and the NSFR the framework introduces four tools which enable the regulator to monitor the liquidity situat ion of the respective bank. Tool Definition Aim Contractual Maturity Mismatch Reporting of contractual maturity mismatch profile Mapping of inflows and outflows of both on- and off- balance sheet positions to defined time bands based on their contractual maturities Insight into the extent to which the bank relies on maturity transformation, based on (very) conservative assumptions Supplemented by internal profiles including behavioural assumptions (Going Concern, Stress) according to the BIS Sound Principles Concentration of Funding Reporting of significant" concentrations within the wholesale funding profile For: counterparts, products, currencies; reported e.g. as simple, pre-defined ratios; "significant defined as > 1% total liabilities Diversification of funding sources, as required within the BIS Sound Principles Liability equivalent to "Large Exposure regulation on the asset side Available Unencumbered Assets Reporting of available unencumbered assets, that could serve as collateral in secondary markets or are eligible for central banks' standing facilities Insight into available additional funding Market-related monitoring tools Regulator's monitoring of market-wide information, information on the financial sector as well as bank- specific information Early warning signals for potential liquidity crisis situation LRM Monitoring Tools Page 47 Basel III Design and Potential Impact Potential Impact Analysis and Forward Looking Actions 2010 Deloitte All rights reserved. Topic Proposed Actions Overall Approach While the details of various approaches to limit leverage and stronger regulatory scrutiny and restrictions on business activities will unfold in the near future, we believe that it is already now necessary to anaIyze an institution's vuInerabiIity to the proposed measures Regulatory Capital The impacts of the upcoming definitions of Tier 1 and Tier 2 capital can be massive The same counts for the new deduction requirements Banks need to run a test calculation what the implementation of the new rules would mean Risk Management RM of treasury and trading departments should be reviewed and the impact of the new regulations on capital requirements analyzed Credit risk management departments need to analyze the impact of the new requirements for the use of external ratings Leverage Ratio Banks should calculate their current leverage ratio under the new proposals and monitor the calibration efforts of the BCBS closely Provisioning Banks should perform quantitative impact analysis of the proposed expected loss methodology and monitor closely the latest developments on this front The level of granularity depends on the available data. Data gaps should be analyzed Capital Buffers Banks should analyze if they are operating in environments of excessive credit growth and prepare for additional capital requirements for such business activities Liquidity Risk Management LRM should be reviewed, as part of pillar 2 process, and strengthened in accordance with the BCBS basic principles Meaningful stress tests and CFPs should be designed and implemented Liquidity Ratios Banks should perform a pro forma calculation of the new liquidity ratios and assess the impact on business activities The proposed changes to the regulatory framework necessitates various actions in well managed banks, to assess the impact of the various new measures and prepare for potential concrete actions with an impact analysis being the predominant aspect at this time How to Prepare for the Upcoming Changes? Page 49 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Example for an Impact Analysis: Introducing XYZ Bank In order to outline the strategic consequences of Basel III in more detail, we modeled the impact of the new regulations on XYZ Bank, a stylized retail and wholesale bank in Asia which is ambitious to expand their loan and derivatives trading business The following slides are based on XYZ Bank's growth plan, first outlining Basel compliance and then analyzing effects of Basel III The table below shows the (simplified) growth projections for assets, liabilities and off balance sheet volumes, as a starting point of the analysis Growth Plan XYZ Bank (Basel II) 2011 2012 2013 2014 2015 Growth ASSETS In bn CUR units In % Deposits (CB, other banks) 740 814 895 985 1,083 10% Net trading assets 50 60 72 86 104 20% Loans to customers 1,950 2,438 3,047 3,809 4,761 25% Investment securities 450 495 545 599 659 10% investments in affiliates 45 45 85 85 85 Acquisition Deferred tax assets 18 23 28 35 44 25% Other assets 150 165 182 200 220 10% Total 3,403 4,039 4,853 5,799 6,955 LIABILITIES Due to other banks 320 384 461 553 664 20% Due to customers 2,700 3,240 3,888 4,666 5,599 20% Debt issued 50 63 78 98 122 25% Tier 2 capital bonds 104 114 126 138 152 10% Other 50 39 75 85 118 Total 3,224 3,840 4,628 5,539 6,654 OFF BALANCE SHEET VOLUME Commitments 230 288 359 449 562 25% Underwriting, Derivatives 1,250 1,500 1,800 2,160 2,592 20% Total 1,480 1,788 2,159 2,609 3,154 Page 50 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. XYZ Bank Basel II Capital and Risk Weighted Assets Forecast Growth Plan XYZ Bank (Basel II) 2011 2012 2013 2014 2015 EQUITY, REGULATORY CAPITAL Share Capital 50 50 50 50 50 Share Capital Surplus 55 55 55 55 55 Innovative Tier 1 15 15 15 15 15 Retained earnings 59 79 105 139 181 Tier 1 capital before deductions 179 199 225 259 301 Deduction: 50% Associated Entity -23 -23 -43 -43 -43 Net Tier one capital 157 177 183 217 259 Tier 2 Capital 104 114 126 138 152 Deduction: 50% Associated Entity -23 -23 -43 -43 -43 Total Tier 2 capital 82 92 83 96 110 Total regulatory capital 238 291 309 355 411 RISK WEIGHTED ASSETS RWA banking book (bank's systems) 1,600 1,899 2,282 2,726 3,270 Trading book capital (VaR based) 25 29 33 38 44 RWA Trading book (x12.5) 313 359 413 475 547 Total RWA 1,913 2,258 2,695 3,202 3,817 XYZ Bank's regulatory capital is a function of core capital, deductions under Basle , and of tier 2 capital. Innovative Tier 1 capital has been issued in order to achieve a more flexible capital composition As can be seen in the table below, XYZ Bank plans to increase its regulatory capital by retaining earnings over the coming years Risk weighted assets reflect mainly loans to customers, as deposits and investment securities achieve low ratings due to the standing of the debtors Page 51 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. XYZ Bank Basel II Capital Compliance and Profitability Forecast Growth Plan XYZ Bank (Basel II) 2011 2012 2013 2014 2015 BASEL II CAPITAL REQUIREMENTS Minimum required Tier one capital (0.5% over reg-floor) 4.5% 4.5% 4.5% 4.5% 4.5% Minimum required tier one capital 86 102 121 144 172 Tier one surplus / deficiency 70 75 61 73 87 Required Total capital percentage (1% over minimum) 9.0% 9.0% 9.0% 9.0% 9.0% Required capital (credit risk, market risk) 172 203 243 288 344 Total capital GAP (-) / surplus (+) 66 88 66 67 67 PROFITABILITY AND PERFORMANCE Annual consolidated profit 25 31 39 49 61 Dividend 5 5 5 7 7 ROE 14.0% 15.7% 17.3% 18.8% 20.3% Number of shares (m) 50 50 50 50 50 Earnings per share (in CUR units) 500 625 781 977 1,221 Expected share price (in CUR units; multiple: 10x) 5,000 6,250 7,813 9,766 12,207 The table below outlines that the capital increases through earnings retention are sufficient to fund the projected business growth under Basel II requirements The bank's plan shows both tier 1 and total capital levels well above the minimum capital requirements, which have been raised by the board of directors by 1 %age point Given the increase of profitability and EPS, the bank expects material improvements of their share price on the stock market, assuming a multiple of 10x EPS for market capitalization Page 52 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Basel mpact on XYZ Bank's Regulatory Capital Basel III Impact 2011 2012 2013 2014 2015 Capital deduction requirements under Basel III Net Tier 1 capital under Basel II 1) 157 199 225 259 301 Investment in Subsidiaries (50%) 23 23 43 43 43 Deferred Tax Asset 18 23 28 35 44 41 45 71 78 86 minus 15% capital threshold 2) 23 30 34 38 44 Effectivededuction requirement 17 15 37 39 41 Phase in 0.0% 0.0% 0.0% 20.0% 40.0% 0 0 0 -8 -17 Innovative Tier1 Phase out 0.0% 0.0% 10.0% 20.0% 30.0% 0 0 -2 -3 -5 Profit impact of IASB impairment project As a percentage of RWA (simplification) 0.0% 0.0% 0.75% 0.75% 0.75% Impact on Tier 1 capital 0 0 -17 -20 -25 Impact on Tier 2 capital Tier 2 capital 104 114 126 138 152 Phase out 50% sub-deduction -23 -23 -43 -43 -43 Phase out percentage 0.0% 0.0% 10.0% 20.0% 30.0% Effective deduction -23 -23 -38 -34 -30 Tier 2 capital under Basel III 82 92 88 104 123 Adjusted capital under Basel III Adjusted Tier 1 Capital under Basel III 157 199 207 228 256 Tier 2 capital under Basel III 82 92 88 104 123 Adjusted Total Capital under Basel III 238 291 294 333 378 The Table below outlines the impact of Basel III on regulatory capital of XYZ-Bank Main effects are derived from deferred tax assets, investments in affilates, and the phase out of innovative capital forms n line with the BCBS's support of the ASB expected loss credit risk provision model, the impact of ASB ED 12/2009 is modelled as well 1) Deduction under BII stays fully in force until BIII transition is completed (subjective interpretation) 2) Innovative Tier 1 stays in the base until it is phased out (subjective interpretation) Page 53 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Basel III Additional Capital Requirements Basel III Impact 2011 2012 2013 2014 2015 Basel III Capital Requirement Basel 3 Minimum Tier 1 Requirement 4.0% 4.0% 4.5% 5.5% 6.0% Discretionary board add on 0.5% 1.0% 1.0% 1.0% 1.0% 4.5% 5.0% 5.5% 6.5% 7.0% Basel 3 Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% Discretionary board add on 1.0% 1.0% 1.0% 1.0% 1.0% Countercyclical Capital Buffer 0.0% 0.0% 1.5% 1.5% 1.5% 9.0% 9.0% 10.5% 10.5% 10.5% Trading book capital requirement (incorporating the 6/2009 changes and Basel III) Current 25 29 33 38 44 Stressed VaR capital add on (150%) 38 43 50 57 66 CCR add on (50%) 13 14 17 19 22 Total add on 50 58 66 76 87 Total TB capital requirement 75 86 99 114 131 The Basel capital requirements increase based on the BCBS published phase in plan of additional Basel III capital needs, as well as based upon the 2009 enhancements to capital requirements of trading activities Stressed VaR as part of the capital formula is deemed to have an impact of 1.5x (total: 2.5x), with QIS conducted by BIS outl ining potentially higher impact levels CCR is modeled as a simiplified 50% add on to BII capital requirements Page 54 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. XYZ Bank's Capital and Liquidity GAP under Basel Basel III Impact 2011 2012 2013 2014 2015 RWA under Basel III RWA banking book 1,600 1,899 2,282 2,726 3,270 RWA trading book (x12.5) 938 1,078 1,240 1,426 1,640 Total RWA 2,538 2,977 3,522 4,152 4,910 Required Tier 1 Capital under Basel III 114 149 194 270 344 Required total capital under Basel III 228 268 370 436 516 Capital Shortfall under Basel III Tier 1 Capital Shortfall 42 50 13 -42 -88 Total Capital Shortfall 10 23 -76 -103 -137 Leverage Ratio Limitations Leverage Ratio under Basel III 31x 29x 34x 37x 40x maximum leverage (3%) 33x 33x 33x 33x 33x Adjustment need 2x 4x -1x -4x -7x Liquidity Ratios Basel III LCR Funding GAP 0 0 0 0 - 200 Basel III LTFR (observation only) 141% 137% 130% 126% 123% As can be seen in the table below, XYZ bank faces material shortfalls of both tier 1 and tier 2 capital under Basel III The planned business growth leads to a potential material breach of the upcoming maximum leverage ratios Under the upcoming mandatory liquidity ratios, the bank would be obliged to hold at least 200m additional liquid funds in order to sustain the LCR Funding test As a consequence, the bank's plans need to be materially adapted in order to reflect the additional capital and liquidity needs of Basel III Page 55 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Potential Plan Adaption: Reduction of Trading Business Impact Mitigation 2011 2012 2013 2014 2015 growth Reduction of trading and underwriting volumes Adapted net trading assets 50 60 72 86 104 Adapted trading OBS volume 1,250 1,375 1,513 1,664 1,830 10% Adapted capital requirement 25 26 28 29 31 Scale down in volume 0.0% -8.3% -16.0% -23.0% -29.4% Impact on profitability Trading part of profitability 6.7 8.5 10.6 13.3 16.6 Profitability of reduced trading activity 6.7 7.8 8.9 10.2 11.7 Impact 0.0 -0.7 -1.7 -3.0 -4.9 Impact on capital Tier 1 capital before trading reduction 157 199 207 228 256 Profitability reduction 0.0 -0.7 -2.4 -5.4 -10.3 Tier 1 capital after profitability reduction 156.5 198.3 204.2 222.7 245.3 Tier 2 capital 81.5 91.9 87.6 104.4 122.5 Total capital 238.0 290.2 291.8 327.1 367.8 Impact on RWA RWA banking book 1,600 1,899 2,282 2,726 3,270 RWA trading book 938 988 1,042 1,098 1,158 Total RWA 2,538 2,887 3,324 3,825 4,428 XYZ Bank decides to model a reduction of their planned trading business, growing derivative and underwriting volumes by 10 % instead of the envisaged 20% This downsizing (30% by 2015) impacts both profitability and RWA / VaR growth (the latter reducing capital requirements and l everage ratio) Page 56 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Additional Plan Adaption: Capital Increase to Mitigate Capital GAP Impact Mitigation 2011 2012 2013 2014 2015 Required Tier 1 capital 114 144 183 249 310 Required total capital 228 260 349 402 465 Tier 1 GAP 42 54 21 -26 -65 Total capital GAP 10 30 -57 -74 -97 Impact on leverage ratio Maximum leverage ratio 33x 33x 33x Leverage ratio 33x 36x 38x Required Tier 1 capital 114 144 183 249 310 Tier 1 Capital Increase Number of shares (m CUR units) 13 Share price (CUR unit) 7,813 Total increase tier 1 100 100 100 Impact on profitability: 2% risk free return (cumulated) 2 4 Total impact on Capital and Leverage Ratio Tier 1 Capital GAP 42 54 121 76 39 Total Capital GAP 10 30 43 28 7 Leverage ratio 31x 29x 22x 24x 27x In addition, the bank deems it necessary to increase its capital by 2013, in order to achieve compliance with the Basel III capital and leverage ratio requirements The capital increase is done based on the share price predictions as contained in the unchanged plan, and may therefore need to be discounted if using a more conservative planning approach As a result of the two plan adaptions (scale down of trading business, capital increase), XYZ Bank is back on track in projecting sufficient capital levels to comply with regulatory requirements, both for RWA and leverage ratio Page 57 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Impact of Plan Adaption on Profitability and Performance Impact Mitigation 2011 2012 2013 2014 2015 Impact on ROE Annual consolidated profit 25 31 20 27 36 Dividend 5 5 5 7 7 ROE after plan adaptations 14.0% 13.8% 8.3% 10.7% 13.4% Planned ROE 14.0% 15.7% 17.3% 18.8% 20.3% Impact on ROE (percentage points) 0.0% -1.9% -9.1% -8.1% -6.9% ROE Delta (in percent) 0.0% -11.9% -52.4% -42.9% -34.1% Share Price Impact Number of shares (m) 50 50 63 63 63 Earnings per share (in CUR units) 500 611 323 435 567 Expected share price in CUR units (multiple: 10x) 5,000 6,109 3,226 4,353 5,675 Planned share price 5,000 6,250 7,813 9,766 12,207 Impact on Share Price vs. expected 0 -141 -4,586 -5,413 -6,532 Share price vs. starting point 22.2% -35.5% -12.9% 13.5% However, as can be seen in the tables below, XYZ Bank's measures to maintain compliant with regulatory capital requirements have a material impact on the bank's profitability and share price Given the reduced trading growth ambitions and that the capital increase can not be used to leverage additional business but only t o maintain the growth expectations of the original plan, ROE reaches initial levels only after 2015 EPS are equally impacted, resulting into material loss of share price in 2013, reaching initial levels only in 2015. Thus, there is a clear trade off between regulatory compliance and gorwth and profitability goals under Basel III. Page 58 Basel III Design and Potential Impact 2010 Deloitte All rights reserved. Strategic Consequences Ensure Capital and Liquidity Funding Enable capital planning based on growth plans Plan, prepare and execute capital raising seamlessly Diversify funding sources and investors Build liquidity management capabilities Introduce a leading cost of capital and funds concept Build sustainable Trust Improve corporate governance Improve risk culture and ICAAP implementation (involving top leadership) Anticipate risks (expecially bubbles and aggregation risks) early, and prepare for market stress Avoid regulatory failure and reputational risks Focus on meaningful disclosure Enhance Profitability and Operative Excellence Optimize target operating model, focusing on scale where possible and on individualization where profitable Create a world class IT platform, focusing on functionality and economies of scale Lead through world class finance management (client / product profitability, risk / reward, etc) Attract and maintain world class talent Focus on "Good Growth" Focus on highly profitable customer segments (affluent , private banking etc) Target customer segments with high future growth potential (green industry etc) Optimize use of capital (e.g. through collateral etc) Enhance the customer experience to outplay the competition To sum it up: With Basel III creating additional requirements for capital and liquidity, the new rules will have a material impact on both growth and profitability. With many major financial institutions reaching out to the stock market to recapitalize, it is to be expected that there will be a ,battIe for capitaI" in the banking industry It is thus impediment that the strategic direction of banks are designed to stay ahead of the curve and to outplay the compet ition, in order to be an outstandingly attractive and reliable counterpart for investors and customers over the coming challenging years. Page 59 Basel III Design and Potential Impact