1. Canadian Chartered Banks – Example of RBC
Cora Wong
Boerge Hernes
Lutz Firnkorn
Thursday, 17 March 2005

2. Overview Structure of Industry Royal Bank of Canada
Risk and Risk Management
Use of Derivatives
Stock Compensation Plans
Capital Requirements
Summary

3. Chartered Banks A type of financial institution
Take deposits, issue personal and corporate loans, and invest in marketable securities
Schedule I Banks
Schedule II Banks
Schedule III Banks
Schedule I bank- widely held, domestic Canadian bank chartered by act of Parliament or letters patent of the Ministry of Finance to conduct banking as defined in the Bank Act
Schedule II bank- closely held, authorized to conduct banking, most are subsidiaries of non-Canadian FIs
Schedule III bank- Branch of foreign bank, can only take wholesale deposits

4. Chartered Banks (Cont.)
Mature industry
Consolidating but highly competitive
Traditional division into 4 Pillars
Banks
Trust Companies
Insurance Companies
Investment Dealers
Now own each other and cross-sell each others’ services
moving towards a universal banking system

5. Chartered Banks (Cont.)
19 domestic banks, 29 foreign bank subsidiaries, 22 foreign branches
Industry dominated by “Big 6”
Royal Bank of Canada
Bank of Montreal
Canada Imperial Bank of Commerce
National Bank of Canada
Scotia Bank
Toronto-Dominion Bank

6. Chartered Banks (Cont.)
Big 6 hold over 92% of total assets in industry
Canada’s Schedule I Banks=
Big 6
Laurentian Bank of Canada
Canadian Western Bank
11 other domestic banks

7. Regulatory Environment
The Bank Act
Central Bank
The Bank of Canada
Office of the Superintendent of Financial Institutions (OSFI)
Canada Deposit Insurance Corporation (CDIC)
Bank Act- All banks incorporated under bank Act , sets out structure, powers standards, method of incorporation and dissolution of banks, each have limited life (sunset clause).
Traditionally limits each Bank Act’s life to 10 yrs so gov’t have to pay periodic attention to changes in banking industry, reset to 5 yrs, now moving towards ongoing assessment and change
Bank of Canada takes deposits from and make loans to the clearing Fis,
Sell T-bills and places gov’t deposits with Fis on daily basis.
lies at center of payments system, fiscal agent for federal gov’t by shifting gov’t balances, have control over interest rates and money supply
Requires detailed periodic reports from Fis
Lender of last resort for Fis facing liquidity crisis
OSFI- Regulating and supervising all Fis, acts for CDIC in conducting bank audits and coordinates with provincial securities commissions and FI regulators
Set capital adequacy, accounting, auditing, and board-of-director responsibility standards
CDIC- insure retail deposits (up to $60,000 per account) of member Fis, all deposit-taking institutions legally must be CDIC members, receives insurance premiums from members, delegates regular supervisory function to OSFI, only becomes actively involved when FI in danger of being unable to repay depositors

8. Regulation in Global Context
Bank for International Settlements (BIS)
Basel Committee on banking Supervision
International group of banking supervisors
Basel II
Revision of 1988 Basel Capital Accord (Basel I)
BIS- Owned by various central banks, effecting payments between central banks, arrange periodic meetings among central bankers
Formulated Basel II 3-pillar approach, offers a new set of standards for establishing minimum capital requirements for banking organizations worldwide (Pillar 1).  Sets standards for the supervisory review process (Pillar 2) and for disclosure practices (Pillar 3).

9. Royal Bank of Canada Schedule I Bank
Canada’s largest bank as measured by assets and market capitalization
1300 domestic locations
40 offices in Caribbean
Branches in more than 30 other countries around the world

10. Royal Bank of Canada

11. Net Income 2004 - Geographic Segment

12. Net Income 2004 - Business Segment

13. RBC- Products Offered Divided into 5 business segments RBC Banking
RBC Investments
RBC Insurance
RBC Capital Markets
RBC Global Services

14. RBC- Banking
Serves individuals, small and medium-sized business, and mid-market commercial clients
Financial planning and advising on deposit accounts, investments, mutual funds, credit and debit cards, business and personal loans, residential and commercial mortgages
RBC Royal Bank, RBC Centura, RBC Mortgage, RBC Builder Finance, RBC Royal Bank of Canada

15. RBC- Insurance
Creditor, life, health, travel, home, auto and reinsurance products and services
Offered through telephone, brokers, travel agents, the sales force and the internet

16. RBC- Investments Wealth management services
Brokerage, financial planning, investment counseling, personal trust, private banking, investment management products and services
RBC Investments, RBC Dain Rauscher, RBC Global Private Banking

17. RBC- Capital Markets
Wholesale financial services to large corporations, government and institutions

18. RBC- Global Services
Specialized transaction processing services to corporations and institutions
Global custody, investment administration, correspondent banking, cash management, payments, trade finance

19. Royal Bank of Canada
A bank is exposed to a lot of different types of risks, and it needs a good organizational structure to control these risks.
The RBC’s main purpose of having risk management is to build and secure the shareholders value.
The risk management groups work in partnership with each business segment
This is to try and measure, monitor and manage all the risk that the bank is exposed to
Reports goes all the way up to the board of directors who can make appropriate strategic decisions based on their risk exposure

20. Stock Price 2004-Today

21. Stock Price 2004-Today

22. Economic Capital Average Economic Capital by Risk Type [2004]
Economic capital is the RBC management’s estimate of the amount of common equity required to underpin all their risks.
Based on desired solvency and to maintain their current rating.
The total EC takes into account the diversification benefits between differnt business segments and types of risks
These benefits are also used in the calculation of the return to equity for each business segment
This chart shows the proportions of EC for each risk type in 2004 (unchanged from 2003)
Credit risk is the biggest
Goodwill and intengibles large due to US aquisitions over the last several years

23. The Risk Pyramid Risk Pyramid
Used as a tool to identify and assess risk across the organization
Risks are shown within the pyramid according to the level of control and influence that they can exert to mitigate or manage each specific risk type
We have focused on the 5 risks at the bottom  the most controlable types of frisk

24. Credit Risk Definition: Risk of default on given loans
Credit risk management:
Credit scoring models
For consumer and small business credit
Applicant scoring model
Behavioral scoring model
For commercial and corporate clients
Risk limits
Credit derivative contracts
Loan sales
Its the type of risk that demands the most of their regulatory capital through Basel requirements
Credit risk:
Risk of loosing money due to a counterparty‘s inability to fulfill its payment obligations
Credit risk management:
Started todays risk measurement method in 2002  has decreased loss on loans
They are using credit scoring models
For cunsumer and small business loans
Applicant scoring is used to anylize the credit history and present economic situation of new borrowers to determined the risk of loan default
Behavioural scoring is used to analize allready made loans
For commercial and corporate clients
Industry sector trends
Market competiveness
Company strategy
Financial strenght
Access to funds
Financial management
And other risks facing the organization
So when the RBC tries to manage its credit risk it has to monitor the risk of all its customers
Risk limits is diversifying. Ex.: make sure their not overexposed to one sector or geographic area
Diversifying is still their main activity on minimizing credit risk
Regularly reporting for individiual loans  concern, monitor or good. 4% of consumer and small business portfolio was concern at year end 2004
Reports on whole portfolios  To monitor shifts in portfolio  indicated as declining, stable or improving
These reports are ment to give the risk managers an early warning so that actions can be made to prevent losses
They also use credit derivative contracts to reduce risk on portions of their portfolio (in 2004 a position to cover $1 billion in credit risk exposure was in place)
Loan sales  they sell of any loans that no longer satisfy their requirements. Risk reward profiles and borrower ratings ($6B was sold off in 2004)

25. Market Risk Definition: Loss due to environmental changes
Types of market risk:
Equity risk
Foreign exchange rate and commodity price risk
Interest rate risk
Debt specific risk
Credit spread risk
Market risk management:
VaR
Sensitivity analyses
Stress tests
Market risk  risk of loss that results from changes in interest rates, foreign exchange rates, equity prices and commodity prices
Different components of market risk;
Equity risk
Risk of impact on earnings caused by movements in individual equity prices and in the level of the stockmarket
Exposed through investment banking activities (buying and selling equities)
Through other trading activities such as offering tailored derivative products to clients, arbitrage trading and propriatary trading
Foreign exchange rate and commodity price risk
Potential adverse impact on earnings and economic value due to currency rate and commodity price movements and volatilities
Through their proprietary positions they are exposed to the spot and forward exchange market, derivatives markets and commodities markets
Interest rate risk
Most of their holdings in financial instruments gives exposure to interest rate risk
Debt specific risk
Used to be included in interest rate risk prior to 2004
Risk exposure due to creditworthiness and credit rating of issuers of bonds and money market instruments, or the names underlying credit derivatives
Credit spread risk
Risk from changes in credit spread associated with issuers of bonds and money market instruments or the names underlying credit derivatives
They are exposed to debt specific and credit spread risk through their positions in bonds, money market instruments and credit derivatives
Credit derivatives are used to manage credit risk, but results in a increased market risk!
Monitoring and managing Market Risk
Have their own Market Risk Group which operates independently from trading operations
It is responible for daily monitoring of their market risk exposure. To do so they use:
Value at Risk
Give a worst case loss expectation over a period of time
They use a 99% confidence interval model
The VaR for 2004 showed an average of $8M for Equity, $2M for Forex and commodity, $9M for interest rate and $1M for debt
Added up is $20M, but total was only $13M. This has to do with their diversification strategy
Sensitivity analyzis
Measures the impact of small changes in interest rates, forex, and other risk factors
Stress tests
Measures the impact of extreme market changes, such as political and economical events.
The market risk group report to senior management about adverse trends or positions

26. Liquidity Risk
Definition: Not to be able to meet financial commitments as they fall due
Liquidity risk management
Structural liquidity risk management
Tactical liquidity management
Contingent liquidity risk management
Funding strategy
Credit ratings
Liquidity risk  the risk of not going to generate or obtain sufficient cash to meet their commitments as they fall due
Liquidity management
Protecting their capital, maintaining market confidence and ensuring they have the cash to expand into profitable business opportunities.
The liquidity risk management is divided into 3 different groups
Structural liquidity risk management
Monitoring the balance sheet and looking for mismatch in maturities in assets and liabilities
Use a cash capital model to compare their illiquid assets to their funding
This is ment to make sure they can still pay their commitments even if they for instance suffer an unexpected withdrawal by the depositors
Tactical liquidity risk management
Adresses their day-to-day funding requirements and is managed by imposing limits on net fund outflows
They do a scenario analysis to determine their need of cash. Then the mentioned limits are adjusted acordingly.
Contingent liquidity risk management
In this part they have action plans that would be implemented in case of general market disruptions or adverse economic developments that would jeopardize their ability to meet their commitments
They use 4 different market scenarios of varying duration and severity to see what these action plans should be
A liquidity crisis team meets regularly to review, test and update the action plans and consider the need to implement them in view of recent developments in Canada and globally
They have a pool of segregated and unencumbered marketable securities, which in the implementation of their action plans would be sold off in order to restore their liquidity
Funding strategy
As for the credit risk, diversification is their most important tool in managing liquidity risk
Diversification expands funding flexibility, minimizing funding consentration and dependency and also generally lowers financing costs
Credit ratings
Thier ability to access unsecured funding markets and to engage in certain collateralized business activities on a cost-effective basis is primarily dependent on their credit rating. They say that a minor downgrade in their rating would not effect their funding access. However a major downgrade in their rating would influence their funding access. They therefor have an action plan that would be implemented to restore their financial strenght and rating. THEY DON‘T SAY WHAT THE PLAN ARE!

27. Insurance Risk
Definition: Risk associated with design and underwriting of insurance policies
Sources of insurance risk
Product design risk
Product pricing risk
Insurance underwriting risk
Insurance risk management
Experience studies
Scenario testing
Diversification
Reinsurance
Insurance risk
RBC has insurance risk cause they have a an insurance company
3 main sources of insurance risk
Product design risk
Product pricing risk
Comes from differences in assumptions made in pricing the insurance contract and the actual expence
Greater for long term insurance because they can not adjust the premiums the same way as in the short term contracts
Managed through experience studies and scenario testing, actuarial science
They keep a portion of the premiums on the balance sheet so they can adjust for misestimations
Insurance underwriting risk
Is the mis-selection of risks to be insured or incorrect expected amount of claims to be made in the future
This is managed by diversification and reinsurance
They monitor every insurance business and rate them in 3 categories; concern, monitor or good. In 2004 none were rated concern.
They also monitor market trends and give the different insurance portfolios 3 different categories; declining, stable or improving.

28. Operational Risk
Definition: Relates directly or indirectly to inadequate or failed processes, technology, and human performance or from external events
Operational risk management framework:
Risk and Control Self-Assessment (RCSA)
Loss Event Database (LED)
Key Risk Indicators (KRIs)
Operational risk:
Its the risk of direct or indirect loss resulting from inadequate or failed processes, technology, and human performance or from external events.
The RBC experienced two notable operational losses in 2004 from a failure in their computer systems.
To monitor and control this risk they have developed an;
Operational Risk Management Framework
Risk and Control Self-Assessment
Every small division throughout the organization is responible for determining their operational risk. If the exposure is to big they have to identify the root causes and agree on an action plan and timeline
Loss Event Database
They collect information of every loss exceding $ due to operational risk in a sentralized database. They then use this to better understand the root causes of operational failures, hoping this will make them more capable of managing operational risk.
Key Risk Indicators
Are used to assist in recognizing and addressing their operational risk exposure and potential losses.

29. Off Balance Sheet Risk
Definition: Items that don't occur or not with the full amount on the balance sheet
Derivatives
Special Purpose Entities
Often not consolidated, they are also used as vehicles to take over risk
Undertaken normally for Risk, Capital and/or funding management purposes
Guarantees
Cause Market, Credit and Liquidity Risk Exposure
Off balance sheet risk arrangements pp
Page 68/69 and 104
SPE not employeesl, one purpose
Guarantees
Maximum potential amount of future payments (important or not  may be a good exampl, compare it to cash position/Short term assets or all assets Maximum amount of future payments p. 104

30. The Risk Pyramid Risk Pyramid
Used as a tool to identify and assess risk across the organization
Risks are shown within the pyramid according to the level of control and influence that they can exert to mitigate or manage each specific risk type
We have focused on the 5 risks at the bottom  the most controlable types of frisk

31. Derivative types Interest Rate derivatives
Foreign exchange Derivatives
Credit Derivatives
Equity Derivatives
Other
Page 106/107 Whole range of derivatives
Interest Rate derivatives – interest rate futures and forwards and swaps and options – obligation to buy or sell interest rate
Foreign exchange Derivatives - futures and forwards and swaps and options – exchange one currency for another
Credit Derivatives – over the counter contracts or swaps – transfer credit risk from one party to another
Equity Derivatives - futures and forwards and swaps and options – equity index, basket of stock or single stock
Other – metal, commodity – both OTC and exchange market – certain warrents and loan commitments that meet the derivative definition are in there as well

32. Derivative types (cont.)
For sale and trading
Sales to clients, those can then hedge against risks
Trading involves market making, positioning and arbitrage activities
Also used for hedging
Fair Value Hedge
Cash Flow Hedge
Hedge of Net Investment in foreign operations
Economical Hedge
Off balance sheet risk arrangements pp
Pqage 80
Maximum amount of future payments p. 104
Page 107
They use basically interest rate swaps to hedge
Derivative related credit risk (see Note 23)
Sales is structuring and marketing of derivatives

33. Derivative types (cont.)

34. Limits for stock holdings
Bank officers are given three years to achieve these minimum
stock holdings and newly employed officers are given five years.

35. Remunerations Stock Options /SAR (Stock appreciation rights)
Executives
Employees
Employee share ownership plan
Deferred shares units DSUs
Performance based deferred shares

36. Stock Option overview May be compare to current stock price
Exercisable
41-29 (kurs) * 15 * 1000 = =165 million transfer von alten an neue
Bei shares outstanding =25 cent pro share weniger = 0,25/29 = 1%

37. Influence on EPS Pretty subjective (we will buy x back)
Ignore Time value (not“in the money“)
Outstanding are  Then EPS 4.13$

38. Equity & Regulatory Requirements
Share capital
Economic capital : Target Equity Level for Rating
Regulatory capital
Tier 1 4% / Tier 2 8%
Basel II from 2007 on requires a more detailed rating and risk access system
Page 96/97
Page 58
Page 63/64
Kind of „external risk management“, to avoid that the bank takes willingly or unwillingly too much risk
Balance sheet
Depends on the risk taken by the bank
What are the requirements?
Analysis of the structure (tier one/two)

39. Regulatory Requirements-Risk Adjusted Assets

40. Regulatory Requirements-Equity
I have to look up the requirements (like tier 2 <= 1,5*tier1 etc)

41. Summary Bank are risk takers Many sources of Risk
Highly complex Risk Management
Align risk appetite and corporate strategy

42. Thank you for your attention