Basel II and Standard & Poor’s Approach to Financial Institution’s Capital Adequacy Craig Bennett House keeping – due to finish, questions, genuine reason to thank Creative open: Introduction: here to share RACF methodology, timing and use May 20, 2008

Capital ratios “have been the focus of much attention, both internal and external, over recent months,” Chairman Royal Bank of Scotland Group, Tom McKillop. Britain’s second biggest lender announcing the sale of £12 billion shares to boost capital depleted by subprime write-downs and joint acquisition of ABN Amro for €72 billion.

Agenda Why do we need a different capital measure? S&P Risk-Adjusted Capital Framework concepts Interactions with Basel II capital requirements How are we going to use Pillar III Concluding remarks

1. Why do we need a different capital measure?

Two primary goals Enhance our quantitative and qualitative analysis Address inconsistencies in: Local regulations, including definition of regulatory capital; Risk measures; Regulatory options (incl. stress tests); and Economic capital models Incorporate our different risk assessment Trading book, equity portfolios, securitisation, etc. Opinion on credit markets Correlations / diversification Development a globally consistent risk adjusted measure to facilitate the assessment and comparison of capital adequacy as well as profitability. The Project has two main goals     First : Develop a globally consistent risk adjusted measure that will facilitate the assessment and comparison of banks’ capital adequacy as well as profitability. Our ambition is to develop a globally consistent Basel II derived risk adjusted capital measures that will be possible to fine tune in order to reflect more precisely the specificities of banks individual risk profile. Second enhance our quantitative expertise by setting up expert teams responsible to develop methodologies to analyse the information embedded in banks quantitative models (Basel II, Stress tests, Economic capital models), train analysts;

Standard & Poor’s Applauds Basel II More comprehensive and risk sensitive than Basel I Leverage ratio Incentive to develop better risk management systems Increased disclosure to the market should allow better market discipline Global framework But some issues remain … The Project has two main goals     First : Develop a globally consistent risk adjusted measure that will facilitate the assessment and comparison of banks’ capital adequacy as well as profitability. Our ambition is to develop a globally consistent Basel II derived risk adjusted capital measures that will be possible to fine tune in order to reflect more precisely the specificities of banks individual risk profile. Second enhance our quantitative expertise by setting up expert teams responsible to develop methodologies to analyse the information embedded in banks quantitative models (Basel II, Stress tests, Economic capital models), train analysts;

Comparing different approaches will be difficult Differing methodologies employed impact results

Direct comparisons between IRB results could be misleading Database infrastructure and models are still unseasoned.

Transition period could last up to a decade Floors, grandfathering options (up to 2017) Technical challenges to move to advanced methodologies Trend comparisons difficult due to continued changes in methodologies Most bank’s will apply several methodologies at the same time

Trends in Basel II ratios will be complex to compare Transitional regulatory requirements and floors affect peer comparison

2. S&P Risk-Adjusted Capital Framework Concepts

A two stage process to calculate risk weighted assets Starting Point Benchmark Charges Approach (BCA) Based on publicly or already available information Globally consistent “industry capital charges” per risk class and regions through the implementation of “floors” Specific Charges Adjustments (SCA) Leveraging bank-specific data where available and satisfactory Review of the information provided by the institutions and potentially adjust benchmark capital charges to reflect specificities of individual bank’s specificities risk profile compared to the industry average

Specific Case Adjustment Example Illustrative purpose Corporate portfolio average risk weight (after diversification) was reduced to 63.2% from 82.9% to reflect systematic hedging policy Market risk risk-weighted assets (after diversification) was increased from $2.8 bn to $6.9 bn due to large specific risk not captured by the Value-at-Risk Corporate portfolio average risk weight was reduced to 79% from 88% reflecting non public geographic diversification details Large portfolio of investment risk weight was reduced to 322% from 706% to reflect large proportion of low risk funds in the portfolio, such as Money Market type and rated Fixed Income funds

3. Interactions With Basel II Capital Requirements

Introduction of benchmark charges per Basel II Asset Class Floors to the regulatory capital charges to factor in: Standard & Poor’s different risk assessment; or Uncertainty/lack of robustness of the institution’s internal data: or Non risk-sensitive standardized charges. Risk sensitivity maintained across several risk categories under BCA We differentiate with 10 floor levels for each risk class Operational risk, a revenue based floor used Similar to Basel II standardized approach’ Add-ons for above average model risk, legal risk or fraud risk; and In some cases, such as custody, we use other metrics Trading risk Leverage VaR as least worst Scaling the regulatory measure by a factor of three to align 1 year time horizon

S&P capital benchmark charges a function of BICRA score Bank industry country risk (BICRA) affects risk weight

The benchmark concept allows better comparability Future ratios driven by changes in methodologies

Capturing other risks In addition to our adjustments to Basel II “Pillar I”, we will reflect the following factors into the adjusted RWA Concentration & Diversification (name; industry sector; geographic; asset class; risk types); and Interest rate risk in the banking book A number of risks will not impact capital measures at this stage Liquidity and Funding risk; and Reputation risk.

Accounting for diversification / concentration Diversification / concentration is one of the most sensitive factors of loss distributions Results from the International Association of Credit Portfolio Managers (IACPM) ISDA study 2006 It is not differentiated in Basel II Pillar I, which assumes that portfolios are diversified and exposures granular

4. How are we going to use Pillar III

How are we going to use Pillar III Pillar III disclosure will also allow us to enhance our analysis of a bank’s risk profile Expect a far richer disclosure of risk attributes Our intention is to store systematically this information in a S&P internal risk database, and use it for our analysis of bank’s risk profile. Pillar III risk disclosure will allow us to roll out our global Risk Adjusted Capital Framework (RACF) The more granular the information, the more we will be able to factor in diversification benefits.

5. Concluding remarks

Bank responses could potentially impact rating levels Some banks might seek to ‘spend’ the regulatory benefits of Basel II Capital buybacks Higher growth We will assess such changes in capital policy closely Basel II merely changes the measurement of risk but not the economic risk itself We will use our new adjusted RWA to assess banks’ risk adjusted capital adequacy and profitability It is not a change in criteria (no rating changes expected as a consequence of the implementation of this framework) Is the quantitative transcription of our current qualitative opinion on banks risk adjusted capitalization Capital is just one rating factor among others Business profile analysis, strategy, risk management, earnings, liquidity, market risk, credit risk, etc…are equally important factors.

Capital is just one rating factor among others Other factors are equally important

Conclusion: smoothing the transition to Basel II Benchmarking tool Internal (against bank’s own data) External (against other banks and other banking systems) Transparent framework Provide much more insight on the drivers of S&P opinion on capital Opportunity to have more structure dialogue Consistent over time, across banks and geographies Neutralise impact of Basel II methodologies National discretions, grandfathering options, etc. Bank’s internal estimates Less volatile than Basel II

Appendix 1. Pillar III Best Practice Disclosure

Pillar III disclosure – Credit risk What could be best practice? Breakdown by relevant risk classes Mortgage, consumer, revolving, etc. Public sector loans should be separately identified Within corporate loans (break down by other sub-asset class if relevant) For each risk class Exposure at default: before and after credit risk mitigation (we consider that disclosure on CRM is too limited) Breakdown per significant geographic area, with disclosure of weighted average Probability of Default, Loss Given Default and Capital allocated. Industry sector breakdown Disclosure of amount of impaired loans as well as realized losses/expected loss for each significant risk class would also be a useful risk indicator Single name concentration indicator

Pillar III disclosure – Operational Risk What could be best practice? Breakdown of capital charge for each risk factor with explanations of the major drivers behind these charges Breakdown for each business line Magnitude of the largest operational risk losses and event type These disclosures would also contribute to the development of a better operational risk culture and awareness of analysts and investors

Pillar III disclosure – Trading Risk What could be best practice? Definition of trading book / banking book perimeter Disclosure of Specific risk component Capital required, concentration indicator (size of top three contributors to specific risk), breakdown of EAD in the trading book per risk bucket, and incremental default risk measure Disclosure of key characteristics and drivers of regulatory approved Value-at-Risk measures Contribution of risk factors, diversification benefits, maximum/minimum/average VaR during the year, results of VaR back testing Information on Stress tests and or expected shortfall as complementary measures Amount of assets which are fair valued based on mark to model in the absence of reliable observable market prices. Comprehensive analysis of valuation methodologies and assumptions should be disclosed

Pillar III disclosure – Equity Portfolios What could be best practice? Separate disclosure of: Listed and unlisted exposures; Identification of book and current value; Methodology used to determine current value; Geographic breakdown; and Concentration issues, when relevant (sector, geographic, single name).

Pillar III disclosure – Securitisation and Pillar II risks Securitization framework Extensive disclosure would be necessary Volume of securitization performed broken down per type of asset securitized with the details and amounts of retained portions and other supporting factors For Pillar II risks - extensive disclosure should be provided Internal capital assessment process, including identification and quantification of key risk factors not factored in Pillar I Interest rate risk in the banking book 200bp parallel shock impact on NAV and interest income When calculated, sensitivity analysis to multiple interest rate scenarios, including slope curve changes Qualitative and quantitative disclosure on the metric used, including the underlying assumptions and model parameters

Appendix 2. Related Publications

Related Publications on RatingsDirect 2007 Transition To Basel II Creates a Need For A Consistent , Comparable Measure of Bank Capital, February 21, 2008 Implication For Japanese Banks of Basel II Pillar III Disclosure, December 11th, 2007 Latin American Banks In Dissimilar Stages Of Implementation Of Basel II, October 4th, 2007 Greater Basel II Pillar III Disclosure would Enhance Transparency and Comparability In the Global Banking Sector, July 10, 2007 FAQ: Building Standard & Poor's Risk-Adjusted Capital Framework, June 5, 2007 Financial Institutions Group Provides More Transparency Into Adjustments Made To Bank Data, April 26, 2007 Japan’s Banks Rethink Fund Investments As Basel II Dawns, February 20, 2007 Where do the Key Formulas Come From?, February 15, 2007 Basel II In EU Gives Banks Greater Incentive To Invest In High-Quality Fixed-Income Funds, January 3, 2007

Main contacts Asia-Pacific Craig Bennett, Melbourne, craig_bennett@standardandpoors.com Ritesh Maheshwari, Singapore, ritesh_maheshwari@standardandpoors.com Naoko Nemoto, Tokyo, naoko_nemoto@standardandpoors.com Yuri Yoshida, Tokyo, yuri_yoshida@standardandpoors.com Europe Bernard de Longevialle, Paris, bernard_de_longevialle@standardandpoors.com Elie Heriard Dubreuil, Paris, elie_heriard_dubreuil@standardandpoors.com Thierry Grunspan, Paris, thierry_grunspan@standardandpoors.com Nick Hill, London, nick_hill@standardandpoors.com Harm Semder, Frankfurt, harm_semder@standardandpoors.com Renato Panichi, Milan, renato_panichi@standardandpoors.com Unites States Chuck Rauch, New York, chuck_rauch@standardandpoors.com Tanya Azarchs, New York, tanya_azarchs@standardandpoors.com Vicky Wagner, New York, victoria_wagnew@standardandpoors.com Simon Kam, New York, simon_kam@standardandpoors.com Latin America Carina Lopez, Buenos Aires, carina_lopez@standardandpoors.com Angelica Bala, Mexico, angelica_bala@standardandpoors.com

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