1. Confidential. This presentation is provided for the recipient only and cannot be reproduced or shared without Fair Isaac Corporation's express consent. © 2010 Fair Isaac Corporation. 1 Countercyclical Capital Management David Molyneaux Principal Consultant FICO November 16 th 2010

2. © 2010 Fair Isaac Corporation. Confidential. 2 2 Agenda »Introduction & Background »Basel III Countercyclical Buffer Proposal »Risk Weighting Cyclicality »FICO Approach to Cyclicality »FICO Methodology Overview

3. © 2010 Fair Isaac Corporation. Confidential. 3 3 Introduction & Background

4. © 2010 Fair Isaac Corporation. Confidential. 4 In a Nutshell »Countercyclical Capital Buffers »To increase capital requirements in the upturn phase & reduce in the downturn phase compared to the present BII IRB Pillar 1 framework – which tends to be procyclical in practice »FICO ideas on this »Mechanism is to vary the requirement via changing the Probability of Default (PD) input to the Risk Weighted Asset (RWA) calculation »Change of PD based upon macroeconomic variables – increasing PD in upturn from current, and reducing PD from current in the downturn »Change of PD at the score/grade level and via grade migration (two transmissions due to nature of rating systems) »Models developed are portfolio and region/country specific

5. © 2010 Fair Isaac Corporation. Confidential. 5 FICO Approach to Capital Stability »Procyclical capital requirements were identified as a problem in the first drafts of the Basel II Accord in 1998. » Procyclicality was the flipside of more risk sensitivity » As conditions worsen in the cycle, internal risk models transmit more risk into the capital requirement (and less risk in better cycle conditions) because models have ‘point-in-time ‘characteristics »Countercyclicality would be a much better flipside to risk sensitivity » Financial Institutions could build reserves in good times and release in bad times - reducing institution risk and macro-economic risk »FICO has developed analytics that can estimate the effect of user defined economic scenarios on Probability of Default » Enabling estimation of how much the capital requirement of today's portfolio would vary over the cycle and over user defined economic scenarios

6. © 2010 Fair Isaac Corporation. Confidential. 6 European & Global Developments on Countercyclicality »European Banking Regulators (CEBS) ‘Position Paper on a Counter Cyclical Capital Buffer – July 2009 » Focus on ways to deal with pro-cyclicality of risk weights of assets »Basel Committee consultative document – ‘Countercyclical buffer proposal’ – July 2010 »Focus on ways to increase capital in times of systemic risk build-up »Group of Governors and Heads off Supervision (oversight body of the Basel Committee) – 12 September 2010 »New capital requirements announcement (% of Risk Weighted Assets) » Common equity: increased from 2% to 4.5% » Conservation buffer introduced – 2.5% » Countercyclical buffer proposed – up to 2.5%

7. © 2010 Fair Isaac Corporation. Confidential. 7 7 »Excess Credit Growth Tracking Mechanism Basel III Countercyclical Buffer Proposal

8. © 2010 Fair Isaac Corporation. Confidential. 8 Summary of 12 September Announcement

9. © 2010 Fair Isaac Corporation. Confidential. 9 Countercyclical buffer implementation »Will be either ‘on’ or ‘off’ »According to national circumstances »Pre-announced at least 12 months before switched on »Can be switched off immediately »Switched on and off by national authority according to judgement within guidelines

10. © 2010 Fair Isaac Corporation. Confidential. 10 Example of credit to GDP tool

11. © 2010 Fair Isaac Corporation. Confidential. 11

12. © 2010 Fair Isaac Corporation. Confidential. 12 © 2010 Fair Isaac Corporation. Confidential. 12 Risk Weighting Cyclicality

13. © 2010 Fair Isaac Corporation. Confidential. 13 Basel III and Risk Weighted Assets »The new countercyclical capital buffer is focussed on the numerator of the capital ratio: »Risk Weighted Assets ÷ Capital »The denominator, RWA, is also as important »The procyclicality of RWA is being handled through existing Basel II rules

14. © 2010 Fair Isaac Corporation. Confidential. 14 Countercyclical Buffer - CEBS »CEBS idea was to initially implement as part of Basel Pillar Two as a validation of capital adequacy and as an add on to the Pillar One Minimum Capital Requirement (MCR) »Build the buffer in good times and run down in bad »MCR is based on grade level long run Probability of Default (PD one year horizon) »Buffer size v MCR will depend on underlying nature of each portfolio’s PD rating/scoring system »Stylized nature is either Through-the-Cycle (TTC) or Point-in- Time (PIT) rating system, truth in practice all are hybrid »The relative size of the buffer will depend on the TTC/PIT mix of the scoring/rating model used, with more pit making the buffer bigger (but the total RC would be the same)

15. © 2010 Fair Isaac Corporation. Confidential. 15 Your rating philosophy will determine how economic factors influence these drivers »Point in Time (PiT): Risk grades defined by characteristics influenced by the economy »Through the Cycle (TTC): Risk grades defined by non-cyclical variables »Most rating philosophies take a hybrid approach Portfolio PD Time Through The Cycle Point in Time Hybrid

16. © 2010 Fair Isaac Corporation. Confidential. 16 Comparison of PiT vs. TTC Driver #1 Driver #2

17. © 2010 Fair Isaac Corporation. Confidential. 17 Example of rating system impact on capital requirement across the cycle

18. © 2010 Fair Isaac Corporation. Confidential. 18 Through-the Cycle Rating System – capital make- up of buffer and permanent minimum

19. © 2010 Fair Isaac Corporation. Confidential. 19 Point-in-Time Rating System – capital make-up of buffer and permanent minimum

20. © 2010 Fair Isaac Corporation. Confidential. 20 © 2010 Fair Isaac Corporation. Confidential. 20 FICO Approach to Cyclicality

21. © 2010 Fair Isaac Corporation. Confidential. 21 FICO Approach to Capital Stability »Using FICOs method the rating/scoring system can provide PD estimates that are conditional upon the economic scenario (the ‘target economic condition’) »The PD estimates, based on the ‘target economic condition’ can be used as parameter values to calculate Risk Weighted Assets and Capital Requirement »The target economic condition could be varied over the cycle so that the target was set to the counterpoint of the cycle. »‘Surplus’ capital would be required in the upswing which would then be unwound in the downswing according to the target condition »The ‘surplus’ and ‘deficit’ capital over the cycle are easily identifiable: »Compare the capital requirement using current economic condition values with target condition values.

22. © 2010 Fair Isaac Corporation. Confidential. 22 Rating Systems & Economic Change »Transmission of impact of economic condition changes »The impact of economic change on a portfolio default rate works through two dimensions of a portfolio rating/scoring system: 1. Through a migration of exposures that changes the exposure distribution of the portfolio and thus changes the overall portfolio default rate » This is a change in an average caused by ‘weight’ changes, and, 2. Through changes in individual rating/scoring ‘buckets’ default rates to change the overall average portfolio default rate (or ‘bad’ rate to generalise) » This is a change in ‘class’ or ‘segment’ values causing the average to change

23. © 2010 Fair Isaac Corporation. Confidential. 23 Why separating the transmission is important »When using the PD to determine capital requirements of a portfolio we apply PD estimates to the portfolio as at a given date » PDs are estimated in credit portfolios at the grade/score level to the exposure value at the given date » We can apply an appropriate grade level PD (e.g. economic scenario counterpoint), but that will not capture grade migration/distribution change we would expect from an economic condition consistent with the grade level PD condition » The migration needs to be modelled separately to determine how much that migration would cause the portfolio level PD to change when an economic change consistent with the grade level PD condition is imposed.

24. © 2010 Fair Isaac Corporation. Confidential. 24 FICO EIS Framework for Capital Stability »We can separately isolate the migration and grade rate changes caused by economic condition change »The FICO approach for capital stability makes use of two model methodologies »An econometric ‘overlay’ to making a scoring model’s predictions dependant on macro-economic variables (additional to and without giving up any discriminative power of classic scoring characteristics), and, »A panel regression econometric model set to predict the change in the distribution of a portfolio for a user defined set of macroeconomic variable values

25. © 2010 Fair Isaac Corporation. Confidential. 25 PD for the ‘Target Economic Condition’ »The isolation of the two transmissions allows the portfolio owner to use PD estimates, for input into ongoing capital requirement calculations, that can be varied to scale to a ‘target economic condition’ »For a given ‘target economic condition’ (say the cyclical counterpoint) a set of economic variable values can be applied to both models »The models’ results provide the grade level PDs and the portfolio’s account grade distribution consistent with the target economic condition »The outputs of these models are: »Coefficient values to apply to PD scores to arrive at PD’s by grade/score that are consistent with the ‘target economic condition’ »Re-distribution of the current grade/score distribution of the portfolio exposures/accounts consistent with the ‘target economic condition’ »Each grade/score PD can then be scaled to incorporate the change in the portfolio level PD caused by the migration simulation. »This process can be used to dynamically adjust the PD input to the capital requirement periodically – the migration scaling will change with the updated distribution baseline and the ‘target economic condition’ and associated economic values can also be changed.

26. © 2010 Fair Isaac Corporation. Confidential. 26 Example The ratio of the portfolio level PD with and without the impact of account migration (0.88/1.04) A two grade rating system covering the portfolio with observed exposure volumes Now we apply the economic models using the target condition variable values Then we apply a scalar to the Target Economic PD’s to reflect the target exposure distribution

27. © 2010 Fair Isaac Corporation. Confidential. 27 © 2010 Fair Isaac Corporation. Confidential. 27 FICO Methodology Overview

28. © 2010 Fair Isaac Corporation. Confidential. 28 Calculation of a Long Run PD Method A: Using historical data »Long-run average calculated off of at least 5 year history of data »Quarterly snapshots taken over the data history »Each account assigned to a risk grade or pool for each snapshot »Historical average and worst PD calculated for each pool 01234567891011121314151617181920212223 Snap 1 Snap 2 Snap 3 Snap 4 … Pool Mar-00Jun-00Sep-00Dec-00Mar-01Jun-01Sep-01Dec-01…AverageWorst 10.0990.0590.0360.0920.0480.0030.0780.007…0.0530.092 20.0840.1290.1230.1190.1390.1440.055 …0.1060.119 30.5300.4560.5810.4340.4600.4870.4960.529…0.4970.434 40.9331.0110.9151.0681.0850.9330.9820.898…0.9781.068 51.4571.3781.6581.6181.3671.3601.3371.639…1.4771.618

29. © 2010 Fair Isaac Corporation. Confidential. 29 »Risk grades can be represented by an average “score” »Using the average score for each risk grade, one can estimate the PD for each grade under the expected economic conditions for each quarter »Offered through FICO Economic Impact Service (EIS) Average Score Q1 2003Q2 2003Q3 2003…Q3 2010Q4 2010 Grade 12710.2%0.1%0.2%…0.3%0.2% Grade 22470.5%0.4%0.6%…0.7%0.5% Grade 32162.2%1.8%2.3%…2.8% Grade 41897.0%6.1%7.2%…7.9%7.8% Grade 517213.9%12.4%14.0%…15.2%14.6% Calculation of a Long Run PD Method B: Using economic modeling to create a forward looking PD

30. © 2010 Fair Isaac Corporation. Confidential. 30 Some Challenges to Consider… »A score’s log-odds is impacted by many factors. The true impact of macro-economic needs to be isolated »Macro-economic conditions »Changes in underlying population (e.g. origination strategies) »Slope and Intercept are correlated »One must distinguish between » a change in slope » a change in intercept unconnected with a change in slope »FICO has created algorithms to handle these 2 challenges

31. © 2010 Fair Isaac Corporation. Confidential. 31 Economic Model Applied Back to the Last Recession »Using the economic model, we estimated default rates back to 1989 in order to get a broader historical perspective.

32. © 2010 Fair Isaac Corporation. Confidential. 32 Economic Model Used to Create Long Run Averages »Using the economic model, we estimated a long run average for each pool using history back to1989.

33. © 2010 Fair Isaac Corporation. Confidential. 33 Economic Model Used to Create Downturn Estimates »One could also calculate downturn estimates over the same historical period. For PD, this is not required but does remain informative. © 2010 Fair Isaac Corporation.

34. © 2010 Fair Isaac Corporation. Confidential. 34 Calculating Driver #2: Account Migration Over Time

35. © 2010 Fair Isaac Corporation. Confidential. 35 How economic variables impact the migration of scores across bands… 0 Low ScoreHigh Score As unemployment rises, accounts migrate from the middle to the tails… Rising home prices are associated with an increase in higher scoring accounts

36. © 2010 Fair Isaac Corporation. Confidential. 36 Example stress testing scenarios »Sensitivity Analysis »Designed to understand the effect of the individual stressors on credit performance »Example: How much will default change if unemployment rate increase by 1%? »Historical Scenario Testing »Designed to simulate the impacts of historical extreme events on the portfolio today »Utilized as reference for hypothetical scenarios that might happen in the future »Example: What if we booked new accounts that were of the same quality as those booked in 2005? »Hypothetical Scenario Testing »Must be forward-looking, turning uncertainties into measurable risks, and preparing for the future stresses »It should combine expert opinion on the portfolio with historical experience as well as economic outlook »Example: 1 in 25 year event

37. © 2010 Fair Isaac Corporation. Confidential. 37 Bringing it all together to determine impact on RWA »Migration Model combined with EIS Model: Current Estimates & Observations Stressed Economic Scenario (Model type used in ()) PD% Asset Volume (EAD) PD% Asset Volume (EAD) Pool A0.5600.6 (EIS)50(Migration) Pool B2.5403.0 (EIS)50 (Migration) Total Portfolio1.31001.8100 Current Estimates & ObservationsStressed Economic Scenario Current RWAObserved EADStressed RWAStressed EAD Pool A32603050 Pool B41405250 Total Portfolio7310082100 »Apply to RWA requirement »Transmission of economic stress via grade level and migration impact »RWA based on the ‘Other Retail’ IRB Formula and an LGD of 75%

38. © 2010 Fair Isaac Corporation. Confidential. 38 Benefits of this Approach »Works with existing models – low implementation costs »Does not compromise discriminatory power of scoring – is used in credit strategy and decisions »Economic impact works at the score level – granular approach and flexible »Can be used for scenario and stress testing – consistent framework across many internal risk management uses »Capital planning tool based on economic condition scenarios

39. Confidential. This presentation is provided for the recipient only and cannot be reproduced or shared without Fair Isaac Corporation's express consent. © 2010 Fair Isaac Corporation. 39 THANK YOU 16 November 2010