1. CONFIDENTIAL Date: 22 nd October 2010 Author: Martin Gibbon Version: Final Group Risk Change RBS Risk Management The financial crisis and its impact on banking Nottingham University Business School MSc Risk Management

2. Private and Confidential Draft document v1.0 Agenda 1. Run-up to the Financial Crisis: Pre-2007 2. The Financial Crisis: What went wrong? 3. Phasing of the Crisis 4. Characteristics of Banks that Fared Badly 5. Common Themes of Banks that Fared Badly 6. Banks that Fared Relatively Well 7. Example Response to the Crisis 8. Example Risk Change Agenda 9. Q&A

3. Private and Confidential Draft document v1.0 1. Run-up to the Financial Crisis: Pre-2007 Global Economic Imbalance  Trade surpluses and deficits  Interest rates and credit standards  Innovative financial products Financial Market Innovation  Securitisations - ‘originate and distribute’ model  Resecuritisation - ‘CDO-squared’  Complexity and transparency - ‘acquire and trade’ model  Timing mismatch and liquidity risk  Funding from deposits and wholesale money markets

4. Private and Confidential Draft document v1.0 2. The Financial Crisis: What went wrong? Mid 2007  Cycle of increasing asset prices sharply in reverse  Credit losses in US housing market (particularly sub-prime)  Lower prices for securitisation instruments  Investor uncertainty as to where risks lay  Unwillingness to lend - sharply reduced wholesale market liquidity  Inability to refinance short-term funding needs or sell instruments  Further asset price falls and reductions in liquidity Regulatory Fault Lines  Identification and prevention of the credit crisis  Local versus international context  Financial innovation and globalisation  Growth of ‘shadow banking’ activities  Individual institution versus wider financial system supervision

5. Private and Confidential Draft document v1.0 3. Phasing of the Crisis Phase 1: 2006 - July 2007  Localised Credit Concerns  US sub-prime mortgages see rising default rates Phase 2: Aug - Sept 2007  Collapse in Liquidity  Failure of hedge funds  Liquidity dries up in wholesale markets  Central banks inject liquidity Phase 3: Autumn 2007 - Summer 2008  New Capital Raising  Northern Rock Nationalised  Worries about bank liquidity  Severe marked-to-market losses Phase 4: Sept - Oct 2008  Counterparty Crisis  Seizure of capital markets,  Lehman Brothers bankruptcy  AIG rescue  Lloyds take over HBOS Phase 5: Oct 2008 - Feb 2009  Government intervention  Government recapitalises banks  Monetary policy significantly loosened Phase 6: Mar 2009 - Nov 2009  Gradual confidence recovery  Quantitative Easing and public sector debt growth  Further losses from economic downturn Phase 7: Dec 2009 - Present  Sovereign Risk concerns  Greek bond yields sharply increase  Dubai sovereign fund seeks debt restructure

6. Private and Confidential Draft document v1.0 4. Characteristics of Banks that Fared Badly Severe Consequences  All sizes and business models Large Universal Banks  RBS  Citigroup  UBS Smaller Specialist Banks  Northern Rock  Washington Mutual High-profile Investment Banking Casualties  Lehman Brothers  Bear Sterns Casualties with no Major Investment Banking Operations  Dexia  Fortis  HBOS Unprecedented Levels of Government Intervention  Global financial system  Banking sector

7. Private and Confidential Draft document v1.0 5. Common Themes of Banks that Fared Badly Dependence on Wholesale Funding  Over-reliance on funding from wholesale capital markets Growth versus Risk Culture  Pursuit of income growth over balance of risk-adjusted returns were severely penalised  Impacted by credit losses  Struggled to raise new capital and funding Low Capitalisation  Low levels of capital available, relative to risks inherent in asset portfolios  Pursuit of capital efficiency turned into vulnerability Investment Banking Activities  More exposed to asset values marked- to-market due to trading activity  Exacerbate volatility in the cycle  Expected losses realised upfront  React more quickly to improvements in trading markets Strategic Errors  Pursued at the wrong point in the cycle  Growth through acquisition  Increased lending to overheated economic sectors Management and Governance  Leadership  Gaps in corporate governance procedures  Board oversight of strategy pursued by executive Remuneration  Aligned shareholder and employee interests  Incentives often misaligned and encouraged excessive risk taking  Often the case across wider financial system rather than just at failed banks

8. Private and Confidential Draft document v1.0 6. Banks that Fared Relatively Well Stable funding base  liquidity ratios  access to funds Diversified and well-matured risk profiles  product  geographic  size Greater focus on organic growth

9. Private and Confidential Draft document v1.0 7. Example Response to the Crisis Sustainable Growth  Sustainable 15% plus return on equity  AA credit rating category risk profile  Well capitalised balance sheet Strategy and Performance Targets  Macro Re-shaping  Core Business Restructuring  Management and Cultural Change Strategic Risk Objectives  Maintain capital adequacy  Maintain market confidence  Deliver stable earnings growth  Stable/efficient access to funding and liquidity Key Risk Appetite Measures  Credit Risk – single name, sector, asset class and product concentration  Country Risk  Market Risk – value at risk and sensitivities  Treasury – capital, balance sheet risks, funding and liquidity  Operational Risk – policy standards  Regulatory Risk – policy standards Six Key Components  Risk Appetite  Identification  Measurement  Control  Infrastructure  People

10. Private and Confidential Draft document v1.0 8. Example Risk Change Agenda Business as usual  ‘Run the bank’ Restructure  Integration, acquisition, separation  Legacy decommissioning  Cost reduction Regulatory  International  Basel II  Basel III Optimisation  Risk and Finance transformation and integration  Data quality  Workflow Future State  Vision, mandate and budget  IT architecture - applications, data and infrastructure  Business architecture – organisation, process and governance (target operating model) Analytics  Risk  Customer  Financial Data  Extracting, transforming and loading  Integrating and storing  Reporting

11. Private and Confidential Draft document v1.0 9. Q&A Thank you. Martin Gibbon Head of Group Risk Change The Royal Bank of Scotland Level 5, 280 Bishopsgate, London, EC2M 4RB martin.gibbon@rbs.com Mobile +44(0)7824 543655 Telephone +44(0)207 085 7870