Central Bank of the Republic of Turkey Implementation, Compliance and Rating Agencies May 2005, Istanbul  Frederik C. Musch Chairman, Global Financial Services Regulatory Practice

PricewaterhouseCoopers 8 October, 2015 Page 2 Basel II about risk management Standardised approach Most banks for long time still: Many if not all in emerging markets Many smaller institutions in G-10 Many IRB in beginning still standardized Some institutions for selected businesses cannot apply IRB uniformity Regulators: IRB for all sizes of banks Little attention so far for standardized approach

PricewaterhouseCoopers 8 October, 2015 Page 3  Reasons for change Basel I to Basel II - Arbitrage: misunderstood - OECD (including Turkey) - US banks focusing on risk After LDC debt crisis in 1987 Real estate debacle early 90’s Unexpected loss of economic capital Introduction of ratings – internal For risk, pricing, control, earnings, capital / risk - At same time financial world much more complex Structured finance: prominent role rating agencies

PricewaterhouseCoopers 8 October, 2015 Page 4 Hence IRB A-IRB approaches But how standardized approach ? Solution: external ratings / rating agencies Risk element in standardized - Claims on corporates: Unrated 100% First incentive: one of many Unrated clients: too high – banks distressed from lending Too low – suffering from easy money Unrated lower risk-weight than loans to companies rated B and below

PricewaterhouseCoopers 8 October, 2015 Page 5 Source: PricewaterhouseCoopers’ analysis Table 1 The standardised approach risk weightings Claim Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Sovereigns (if export credit agencies 0% (1) 20% (2) 50% (3) 100% (4-6) 150% (7) 100% BanksOption %50%100% 150%100% Option % (20%) 3 50% (20%) 3 50% (20%) 3 100% (50%) 3 150% (150%) 3 50% (20%) 3 Corporates (20%)(50%)(100%)BB+ to BB- 100% Below BB- 150% 100% 1 Risk weighting based on risk weighting of sovereign in which the bank is incorporated (but one category is less favourable) 2 Risk weighting based on the assessment of the individual bank 3 Claims on banks of a short original maturity, lass than three months, would generally receive a weighting that is one category more favourable than the usual risk weight on the bank’s claim The Standardised approach risk weightings

PricewaterhouseCoopers 8 October, 2015 Page 6 Faced with this choice, banks will choose lending to unrated Impact to be settled  Recognised Rating agencies ECAI status will be conferred by domestic regulators Issues of applicability For banks which operate internationally AIG will have to play big role here  CESR recognition  Lack of rating agencies and ratings Issue from beginning

PricewaterhouseCoopers 8 October, 2015 Page 7 So far: Moody’s, Standard & Poors, Fitch Not well spread over countries Many countries 2% corporates rated – lack of default data - Reputation rating agencies - Performance rating agencies  Example Germany: few corporates have ratings  Implementation Issues Standardized Approach Approach based on set of defined categories and external ratings Need to map this framework across own business

PricewaterhouseCoopers 8 October, 2015 Page 8 Principle challenges  Data  The wider process  Opportunity to review and formalise the wider credit risk management function  Go further to ensure calculations element of coherent risk management function Good foundation for next IRB approach - Systems to support new process

PricewaterhouseCoopers 8 October, 2015 Page 9 Conclusion: - Vast numbers of smaller banks using a risk- sensitive system - Cruder than IRB approach Still revolution for many institutions - Opportunity to align risk with business objectives Rating agencies Encouragement for new rating agencies ?

PricewaterhouseCoopers 8 October, 2015 Page 10 Thresholds:  Reliability  Record of several years  Rating agencies do affiliations  or banks start own rating agency Danger: better ratings than banks want to lend on Tension + conflict of interest Issue: higher requirements emerging markets Many emerging market regulators:

PricewaterhouseCoopers 8 October, 2015 Page 11 Standardized approach e.g 10% (8%) Basel I Supported by rating agencies views on emerging market debt Banks believe 10% not sensible on Pillar I PwC Impact Study for EU Commission Aim New Accord create a risk management continuum

PricewaterhouseCoopers 8 October, 2015 Page 12 Average change in minimum capital requirements (incl. credit and operational risk) Source: QIS3, EU Commission analysis

PricewaterhouseCoopers 8 October, 2015 Page 13 Expected capital changes by country Source: QIS3 country reports, EU Commission analysis, PricewaterhouseCoopers analysis

PricewaterhouseCoopers 8 October, 2015 Page 14 Expected Change in Risk Weighted Assets for SMEs Source: QIS3 country reports, PricewaterhouseCoopers’ analysis

PricewaterhouseCoopers 8 October, 2015 Page 15 Likely beneficiaries Beneficiary CountryRetailSMECorporateOverall Austria   Either  Belgium  Either Denmark  Either Finland  France  Either  Germany  Greece  IrelandEither  Italy  Either  LuxembourgEither  Netherlands  Either Portugal  Spain  Either Sweden  Either United Kingdom  Either  Source: PricewaterhouseCoopers’ analysis  Customer  Bank

PricewaterhouseCoopers 8 October, 2015 Page 16 Encourage to move along Risk continuum  Better grip on Credit portfolios  Better pricing  In tune with complex products (derivatives etc)

PricewaterhouseCoopers 8 October, 2015 Page 17  Key Question for Turkey Gradual evolvement Or directly to latest technology  Baumol on competition and innovation “Innovation is the central feature that drives the market process, more than competition” And “Innovation comes mostly from existing companies”

PricewaterhouseCoopers 8 October, 2015 Page 18 Basel II is not necessarily the driving force behind risk management and corporate governance improvements  Credit risk 5C’s  Character – reputation of firm  Capital - (leverage)  Capacity – (volatility of earnings)  Collateral  Cycle – (especially for cycle dependent industries)

PricewaterhouseCoopers 8 October, 2015 Page 19 Towards internal ratings All in transition at various levels Much is not there:  Economic capital Only 10% of the interviewed by PwC regarded their approach to economic capital as fully developed and operational  Corporate governance: From our questionnaire together with EIU: Banks uncertain how to improve own standards of disclosure and governance Sarbox to be only ticking the boxes Does not reflect quality of controls

PricewaterhouseCoopers 8 October, 2015 Page 20 - Increasing complexity of systems worldwide Further standards the only way out The Challenge of Compliance Financial institutions face a major challenge Sheer complexity of regulatory environment At same time corporate reporting structures continue to be very much fragmented

PricewaterhouseCoopers 8 October, 2015 Page 21 Where do financial institutions stand ? PwC Compliance Study + 8 th Annual CEO survey 1. Regulators increasingly focusing on role and responsibility of compliance function 2. Compliance office has developed significantly over last 3 years Moving from enforcement towards trusted adviser Increasing independence of compliance function 3. Interesting : Organisations have made minimal efforts in the compliance area until forced by regulatory requirements

PricewaterhouseCoopers 8 October, 2015 Page Expectations industry and regulators have of each other:  Both need to firm up on their understanding of ‘compliance risk’  Internally and across borders Many regulatory / market changes IAS, Corporate Governance, Value Reporting / Corporate Reporting, Cost of capital / Economic Capital – Pillar II Basel II, and the many in the securities and Insurance industry: examples

PricewaterhouseCoopers 8 October, 2015 Page 23 Advisable to look for adding value from it as a wider agenda: Key = Recognition of strong impact on fundamentals Recognition of interactions / linkages Among implementation projects Requires financial institutions to re-orientate PwC started many joint projects with clients Not just a technical challenge It is a management challenge In fact, two to one CEO’s prefer to see compliance as an investment rather than a cost

PricewaterhouseCoopers 8 October, 2015 Page 24 CONCLUSION  Aim to make business and strategy more risk-sensitive Banks and regulators start to “behave” in more risk aware fashion  Take wide perspective Innovation step by step