026550-001 n o v e m b e r 2 0 0 5
TRANSCRIPT
026550-001
N O V E M B E R 2 0 0 5
B A S E L I I A N D S T R A T E G I C B A L A N C E S H E E T M A N A G E M E N T
I B A 026550-001
Executive summary
With BIS 2 changing the way in which banks view risk, there is a greater focus on “economic” performance rather than previously used “accounting” measures of performance
Maximizing shareholder value requires not just a focus on returns, but a focus on the risk taken in generating those returns, to assess whether it exceeds the cost of required capital
Viewing risks on an “economic”, rather than “regulatory” or “accounting” basis, provides banks with a common measure with which to compare contribution to shareholder value (SVA) from competing asset classes
Importantly, SVA links risks and returns in a direct and quantifiable manner which will allow managers at all levels of the firm to make more informed choices on the allocation of scarce capital resources
JPMorgan is pleased to share some of our key experiences in how a bank can apply such a holistic balance sheet management framework to achieve strategic objectives
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Implications of Basel II
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Basel II has led to reevaluation of capital framework across the world
"Basel II will provide one of the biggest structural shocks to the banking industry for decades. Is the industry ready?"
Mercer Oliver Wyman, Dec 2003
"Basel II will provide one of the biggest structural shocks to the banking industry for decades. Is the industry ready?"
Mercer Oliver Wyman, Dec 2003
Capital framework AdvancedRudimentary
Basel I Basel II Economic capital More closely aligns regulatory
capital with economic risks
Standardized
Distinguishes capital charge by asset quality based on rating agency scoring
External ratings correspond to PD
Internal Ratings Based
Foundation: Allows banks to estimate PD while LGD and EAD are provided
Advanced: Allows banks to estimate PD, LGD and EAD
BIS II doesn't address concentration risk explicitly Single name, industry,
country
Economic capital framework based on internal models PD, LGD, EAD Maturity, correlation Spread migration
Does not rely on calibration established by regulator, i.e., not average risk
Static risk weights based on asset type, i.e., sovereign, banks, corp, etc.
No distinction within risk weighting bands for asset quality "One size fits all"
Amendment ('97) allows for use of VaR to estimate market risk
However, measurement of credit risk remains rudimentary
Does not distinguish between market, credit or operational risk per se
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The Three Pillars of Basel II
Pillar 1 Pillar 2 Pillar 3
Requirements for calculation of
regulatory capitalSupervisor’s Role
Disclosure requirements
Use of rating, loss exposure and risk mitigation
Explicit requirement for operational risk capital
Banks to assess solvency relative to risk
Supervisory review of risk management and capital practices
Greater disclosure of risk profile, capital structure and risk management practices
Quantitative aspects critical for capital calculations
Fresh look at control practices
Solvency assessment covers ALL risks
Application of supervisor judgement critical
Improved transparency
Expectations
Consistency with accounting and local regulatory requirements
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Risk Management sophistication tends to improve shareholder value generating ability of banks
Standardized
Standardized
IRB foundation
IRB foundation
IRB advanced
IRB advanced
Maximize Shareholder Value
Ensure Earnings stability
Economic capital
Economic capital
Control Losses Small/local banks
Mid size/regional banks
Large global banks
Risk management sophistication
Cap
ab
ilit
ies o
f th
e
Ban
k
Lend & Hold
Lend & Hold with
Hedging
Active portfolio management/distribution of
risk
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BIS I BIS II
Asset class Standard IRB Foundation Capital change
Mortgages 75% 35% 1%–78%
Retail 125% 75% 4%–88%
SME 100% 75% 5%–180%
Corporate 100% 20%–150% 8%–210%
Securitization 52.5%–102.5% 20%–1,250% 12%–1,250%
NPL 100% 150% ?
Equity 125% 100% 200%–400%+
Market risk VaR VaR
Operating risk NA 15% of Gross income 12–18% of Gross income
Total
Net sector impact is expected to be neutral, however balance sheet composition will determine outcome
Risk weights by asset class
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Asian banks face the following balance sheet challenges
Credit concentration risk Majority of credit exposures tend to be concentrated within the domestic environment Significant exposures concentrated in the middle to lower rated credit grades Industry diversification is limited to the industries available domestically
Increased competition in domestic lending opportunities resulting in diminishing returns: The more attractive segments from a risk adjusted point of view will be main targets for banks potentially resulting in margin compression, i.e. retail and SME lending
Relative low risk adjusted returns of domestic lending opportunities: Significant part of existing domestic lending opportunities may have low risk adjusted returns, e.g. Corporate lending
Challenges
Needs Ability to diversify and improve overall portfolio composition
Flexibility to select asset classes with risk adjusted returns commensurate with the bank’s strategy without having to compete
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BIS II may render a number of valuation and strategic implications, giving rise to balance sheet repositioning needs
Valuation Strategic
Markets will begin to factor in capital structure modification requirements
Focus on return on capital will increase as returns and risks can be more closely followed by the investing community
Justifying low return on capital business segments may be required
Need to continue focus on fee income
Managing historic relationships in light of need to reprice low profitability credits
Greater competition already being felt in higher risk adjusted return businesses—consumer
Higher stock valuations arising from better risk adjusted performance will better position some for expansion through acquisition
Larger groups will be able to pool resources to better fund IRB transition
Need to focus on risk adjusted returns will more clearly highlight benefits of some asset classes over others
Greater need to deploy excess liquidity in most risk adjusted profitably way, while also generating meaningful profit growth
Balance sheet repositioning implications
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Strategic importance
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Therefore to improve SVA, the bank must: Improve yield on assets at current risk level Reduce cost of funding assets without increasing ALM risks Reduce the current risk level (capital) without reducing return, or lower cost of regulatory capital
The income generated on an asset depends on
the interest rate and fees charged
The cost of funding the assets depends
on the mix of instruments used
The amount of capital depends on the
riskiness of the assets and the cost of
capital depends on the mix
Assets Liabilities & Capital
Interest and fee income
Interest, Provisions& operating expense
A
BCostof capital C
There will likely be a greater alignment of risk and reward as banks increasingly focus on economic as opposed to accounting profits
If A - B is positive, the bank makes a profit, but may not improve shareholder value
If A - B is bigger than C, the bank improves shareholder value (SVA positive)
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Shareholder value added provides the framework to align incentives across the entire bank …
¹ Includes charge for expected loss
Valu
e
dri
vers
minus
Mark
et
cap
italiza
tion Franchise value
(discounted future SVA)
Equity at risk
Cost of equity
Shareprice
Capital chargeRisk adjusted operating profits
+
Single performance measure aligning various interests of employees, management and shareholders
Man
ag
em
en
t p
rocess
Asset allocation
ALMRisk
management
Capital managemen
t
=
=Risk
adjusted asset yield1
Liquidity funding
Financial value (book value)
ShareholderValue Added
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… and allows banks to evaluate risks and returns at every level of the company
Bank
Credit portfolio
Business division
Individual transaction
Return on economic capital of whole firm
Incorporates diversification benefits of combined business portfolio
Return on economic capital of whole firm
Incorporates diversification benefits of combined business portfolio
Compare returns on economic capital of individual business units
Determine optimal areas to invest additional capital
Compare returns on economic capital of individual business units
Determine optimal areas to invest additional capital
Identify single name and industry concentration issues within a portfolio
Optimal reinvestment strategies
Identify single name and industry concentration issues within a portfolio
Optimal reinvestment strategies
Price individual deals / customer relationship
Determine return of individual products
Prioritize products for use of client capital limits
Price individual deals / customer relationship
Determine return of individual products
Prioritize products for use of client capital limits
Individual customer
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Ensure economic capital is accurately measured and efficiently allocated Assess current calculation
methodology Suggest refinements to current
model
Ensure economic capital is accurately measured and efficiently allocated Assess current calculation
methodology Suggest refinements to current
model
Structure liabilities to match and support asset base with the lowest funding cost available Measure current ALM position Develop strategies to improve
efficiency
Structure liabilities to match and support asset base with the lowest funding cost available Measure current ALM position Develop strategies to improve
efficiency
Minimize(liquidity cost)
Constraints (assets)
Maximize(asset yield)
Constraints (risk level)
Minimize(risk level)
Constraints (asset yield)
Minimize(capital cost)
Constraints (risk level)
Increase yield on the asset portfolio without increasing risk or decrease risk on the asset portfolio without reducing return Identify positive and negative SVA loans Develop alternative asset strategies
Increase yield on the asset portfolio without increasing risk or decrease risk on the asset portfolio without reducing return Identify positive and negative SVA loans Develop alternative asset strategies
Assets
SVAMaximization
ALM Economic capital
Determine most efficient mix of capital to ensure the lowest cost Establish target credit rating Develop strategies to improve capital
mix Hold capital commensurate with risks
Determine most efficient mix of capital to ensure the lowest cost Establish target credit rating Develop strategies to improve capital
mix Hold capital commensurate with risks
Capital management
Interrelated nature of each process requires issues to be addressed in totality at the most senior level
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The balance sheet management framework enables identification of value creation opportunities
Cash securitization In addition to
providing term funding, securitization can release capital by reducing RWA
Synthetic securitization Releases capital via a
synthetic transfer of risk using credit derivatives (reduces RWA)
REIT Sale and lease back
of land & buildings can result in a gain in Tier 1, and a reduction in RWA
Equity Increase Tier 1 equity
capital via a single strategic partnership or group of financial investors
Hybrid capital Perpetual instruments
can replicate many features of equity, while offering lower cost and tax-efficiency
Subordinated debt Subordinated debt
offers a very efficient means of achieving target CAR objectives while limiting cost
Asset alternatives Capital alternatives
Gross Loans Large Corp. SME Consumer
NPL Securities Land and buildings Fixed Assets
Assets
Deposits Short-term
borrowing Term borrowing Other
Liabilities
Equity Hybrid Tier 1 Tier 2
Capital
Due to the leveraged nature of a bank’s balance sheet, liability-side solutions support significantly greater capacity than asset-side alternatives
Example For every $1 of capital raised, a bank can lend $12.5 of RWA For every $1 of RWA reduce, a bank releases $0.08 capital
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For most banks, asset allocation and capital management are the most relevant opportunities to enhance shareholder value
Cash Short term Fixed income Gross Loans
Large Corp SME Consumer
Assets
Deposits Short-term
borrowing Borrowings Foreign currency
deposits Foreign currency
borrowings Long Term
Borrowing
Liabilities
Capital
Equity Hybrid Tier I Tier II Tier 3
H0 3 /46 8 5
W O O R I B A N K
2 00 3 10 0 8 -m ark fo llett CF O su m ma ry re p ort
Capital management
An incremental KRW500bn Hybrid Tier 1 issue over the next 6 months, and anincremental KRW1,300bn Lower Tier 2 over the next 18 months
#5 Implementation: Execution steps
Target capital posit ion — December 2004
3,900
1,000 4,900
3,700
100
600
500
Economic capital Economic capitalbuffer
Regulatory(hybrid) Tier 1
Lower Tier 2 Upper Tier 2 Tier 3 Optimal capitalstructure
Economic Capital Regulatory capital
7% Tier 1
11% CAR
1,200
1,300
Economic capital Regulatory capital New regulatory capi tal
11B A
L A
N C
E
S H
E E
T
O P
T I
M I
Z A
T I
O N
P
R O
J E
C T
Capital Mgt.2
H0 3 /46 8 5
W O O R I B A N K
2 00 3 10 0 8 -m ark fo llett CFO su m ma ry re p ort
Asset Liability Management
Given the need to retain low cost deposits and generate fee income, Woori shouldbroaden its product alternatives to offer Equity-linked deposits
Woori should launch the product in the first half of 2004, and target to raise at leastKRW50bn in its first tap of the market
Additional offerings for 2004 should then be planned with the terms adjusted basedon the outcome of the first product issue
To lower its cost of funding, Woori should swap existing KRW (floating) funds to USDLIBOR (paid in KRW)
At today’s rates, such a swap would save Woori approximately 1.00% per annumon the cost of its funding (assuming stable differential in interest rates betweenKRW and USD)
Given the steepness of the USD forward swap curve, Woori should enter into arrearsswaps in order to lower its credit spread
The upcoming Lower Tier 2 issue of approximately US$300mm should be used toexecute an arrears swap in Q4 2003
An arrears swap in the current market is likely to lower Woori’s spread byapproximately 0.30% per annum over a 5-year period
Additional existing exposures should be considered to assess which swaps areappropriate for an arrears overlay
#5 Implementation: Execution steps
1.
2.
3.
15B A
L A
N C
E
S H
E E
T
O P
T I
M I
Z A
T I
O N
P
R O
J E
C T
ALM3
1
H0 3 /46 8 5
W O O R I B A N K
2 00 3 10 0 8 -m ark fo llett CFO su m ma ry re p ort
New Exposure
Positive SVA High return on capi tal
Stronger credi t rating Diversified
Exposure s that
genera te positiveSVA and strong
re turn on c apital ne ed
to replace e xposures
that currentlygenera te ne gative
SVA due to high
ca pital requirements
and low return
1
New Exposures
Appreciable positive SVA
Assets Capital cost
Net return
Negative SVA
Assets Capital cost
Net return
Existing exposures
2
Asset allocation
Existing Exposure
Negative SVA
Low return on capital Concentrated Industries
Customers at the limit
#5 Implementation: Execution steps
6B A
L A
N C
E
S H
E E
T
O P
T I
M I
Z A
T I
O N
P
R O
J E
C T
Asset Allocation
Asset strategies Aim to improve risk adjusted returns by
diversifying domestic exposure through investing in international investment grade exposures
Capital strategies Supplement Core Tier I with cost effective Tier
II capital to support growth
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Balance sheet management
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Principles of economic capital management Solvency—the most important principal is to ensure there is a sufficient equity buffer at all
times to cover unexpected losses experienced in the course of business
While maintaining solvency, it is necessary to strike a balance between meeting expectations from stakeholders and the external environment Regulators Bond Holders Depositors Shareholders Rating agencies Analysts
After determining economic capital needs, optimize capital structure by selection of available capital instruments to minimize cost of regulatory capital (subject to meeting various regulatory and external expectations)
Manage shareholder value Improve economic performance of the bank as benchmarked by return On equity, risk
adjusted return on capital and shareholder value added
External stakeholders perspective on equity Emphasis on bank’s debt
servicing capacity Need banks to maintain large
equity base to absorb potential economic losses
Shareholders perspective on equity Emphasis on the bank’s ability
to generate returns on the shareholder’s funds
Need banks to maintain minimal level of equity base
Investors Regulators
Rating agencies Shareholder
returnsCapital
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Other balance sheet management techniques have also been used by international banks, which will be explained in more detail in the following
sections
DBS Group capital ratios
HSBC Plc capital ratios
Standard Chartered Plc capital ratios
HSBC seeks to maintain a prudent balance between the different types of capital
With the advantage of higher returns using leverage, it uses a 8.25% Tier I benchmark for its long-term capital planning
It has also made use of innovative Hybrid Tier I capital
Chinatrust Commercial Bank capital
ratios Post the SE Asian
crisis Chinatrust has raised Tier I capital to shore up capital adequacy
With reduced levels of subordinated capital after 1998, it recently issued US$500mm of UT II capital in the form of perpetual preference shares
¹ Current rating, post-upgrade on 10 Jul, ’05 Source: Company reports, Central Bank website
Banks have actively used non-dilutive capital to bridge the difference between economic requirements and target CAR
0%
5%
10%
15%
1997 1999 2001 2003
Tier I Tier II S&P
A+AA-¹
BBB+BBB
A-A
0%
5%
10%
15%
1997 1999 2001 2003
Tier I Tier II S&P
A+AA-¹
BBB+BBB
A-A
0%
6%
11%
17%
22%
1997 1999 2001 2003
Tier I Tier II S&P DBS has actively managed its capital structure
MAS guidelines have changed from a minimum Tier 1 ratio of above 10% to now a minimum of 7%
DBS has made use of Hybrid Tier 1 capital as well as Upper Tier 2 to boost its capital adequacy
The capital policy is to maintain a Tier I ratio of 7—9% and CAR of 12—14%
Its aggressive use of Tier II capital, going to limits of 50%, has resulted in high return on equity for its shareholders
It has further improved returns and capital adequacy through the issue of innovative Hybrid Tier I capital
¹ Current rating, post-upgrade on 10 Jul, ’05
A+AA-¹
BBB+BBB
A-A
0%
5%
10%
15%
20%
1997 1999 2001 2003
Tier I Tier II S&P
A+AA-¹
BBB+BBB
A-A
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Economic capital estimates are driven based on the asset quality composition of the bank’s credit portfolioBreakdown of Wholesale
portfolio by industry (% of notional)
Assumed credit rating distribution of loan portfolio
JPMorgan estimated the credit economic capital of the loan portfolio needs at a range of target ratings for a 1 year horizon (% of notional exposure)
9.2%
15.3%12.1%
10.2%
19.0%
BBB- BBB A AA AAA
Target credit rating for hypothetical bank
Based on JPMorgan internal capital model
57.6%
16.2%22.0%
1.6%2.7%
(20)%
0%
20%
40%
60%
Agri.&mining
Manuf. &comm.
Real estate& constr.
Util. &services
Others
Hypothetical distribution for illustrative bank Based on hypothetical portfolio and JPM assumptions on remainder of loan portfolio
0.8% 1.2%
31.5%
25.3%
5.0%
34.7%
0.7%0.8%0%
20%
40%
BBB+ BBB BBB- BB+ BB BB- B+ B-
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Economic capital requirements vary depending on the overall asset quality of the industry segments
Economic Capital requirements for a hypothetical bank with a large corporate loan portfolio (% of Notional)
21.7%
7.4%6.1%4.3%
7.6%6.2%7.7% 6.7% 7.4%9.5%
Agribusiness BuildingMaterials
Commerce Construction Energy &Basic
Infrastructure
Food &Beverage
Petro-chemicals
PropertyDevelopment
Telecom Transport &Logistics
Hypothetical corporate bank portfolio, based on JPMorgan internal capital model; LGD assumed to be 70%
Although capital requirement of BIS is 8% for each risk asset, economic capital requirements can differ significantly
Hypothetically, a diversified corporate loan portfolio may contain different capital requirements for different sectors For example, the transport and logistics segment has significant economic capital
requirements resulting in significant capital charges (as you would have to hold 21.7% in equity for each dollar you lend to this segment)
For example, risk pricing for the abovementioned segment would be significantly higher than the risk pricing for petrochemicals, which only require 4.3% economic capital
BIS 8% requirement
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The traditional business model for banks results in balance sheets that are relatively static
Extend credits
Hold to maturity
Extend credits to existing customers—overtime, top accounts receive most credits
Overtime, concentration builds up (industry, geography, single names)
Gather deposits A typical bank’s deposit franchise provides low cost funds
Others36%
Top 3 64%
Potential portfolio concentrationGeographyIndustry Single name
Note: Industry and geographic concentration based on hypothetical Asian bank portfolio
Others85%
Top 10015%
Int'l2%
Domestic98%~
~
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13%
18%
24%
19%19%
23%
34%
15%
6%3%
0%
10%
20%
30%
40%
50%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
0%
2%
4%
6%
8%
10%
Source: Hypothetical bank data
During unpredictable and adverse business cycles, banks could suffer from concentration risks
NPL ratio Provisions/loans
Manifestation ofconcentration risk
Average in Asia
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In recognition of such risks, banks have begun to shift towards a more dynamic business model
Deploy capital in the most efficient manner possible
Maximize risk adjusted returns
Distribute risk
Structured investments portfolio, M&A, distribute to shareholders, etc.
Package risk and sell through capital markets, free up capital
Originate/ acquire customer
Manage/ warehouse risk
Decision to lend based on total value of client, bundle products
Lending and risk taking decisions delinked, warehouse if necessary
Redeploy capital
“Today, credit distress in banks can be traced predominantly to one factor: under-diversification in corporation credit portfolios. Notably, a bank’s riskadjusted profitability is materially influenced by its corporate-credit portfolio’s
stateof diversification, because diversification has the power to reduce risk
without diminishing expected returns.” Standard & Poor's
Capital turnoverDiversify risk
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Diversification reduces concentration and volatility, allowing a bank to take risk efficiently
Illustration: Scenario II
Depending on risk of (i) existing portfolio and (ii) investment, final portfolio may be different Scenario I: total risk is
140 Scenario II: total risk is
115
Impact of risk concentration increases risk profile
Scenario II adds diversified risk minimizing total risk
100 10015
1530
Existing portfolio Investment Diversification Final portfolio
Illustration: Scenario I
100 100
3010
10
30
Existing portfolio Investment Concentration Final portfolio
115
140
Ris
k
level
Concentration premium
Standalone investment
risk
Concentration
Capital at risk
Capital at risk
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Balance sheet management case study
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JPMorgan assisted a leading Korean Bank in its balance sheet optimization initiative
¹ Cost of equity
The objective of the assignment was to develop strategies for improving shareholder value
JPMorgan used the current composition of the balance sheet as a starting point and SVA (“Shareholder Value Added”) methodology as our framework
Increase yield on the asset portfolio without increasing risk or decrease risk on the asset portfolio without reducing return Identify positive and
negative SVA loans Develop alternative
asset strategies
Asset allocation
Determine most efficient mix of capital to ensure the lowest cost
Measure current cost of regulatory capital at the bank
Develop strategies to improve the mix
Capital management
Accurately measure the risk in the balance sheet
Involves determination of the quantum of economic capital
Insights into model for allocating risk-weightings as per BIS II
Risk assessment
SVA = Operating profit - (required capital x capital cost¹)
Man
ag
em
en
t p
rocess
SV
A
dete
rmin
an
ts
Asset allocation
Liquidity management
(ALM)
Capital management
Risk management
Asset yieldLiquidity funding
Risk levelCapital funding
Structure liabilities to match and support asset base y with the lowest funding cost available
Measure current ALM position
Develop strategies to improve efficiency
ALM
The project was divided into 4 sections driven by the SVA formula
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Auto mobi les
5%
Gener al Retai l
4%
Industr ial / manuf actur ing
4%
Metals and mining
2%
P aper & f or est pr od
4%
T r ans por tation and
distr ibution
4%
Chemicals
5%
Br oadcas ting & media
4%
Food and dr ug r etai l
3%
Aer ospace & def ense
3%
Banking & fi nance local
3%
Bui lding & mater ials
2%
Other s
12%
T elecommunications
8%Food, bever age and tobacco
6%
Uti l i ties (P ower )
7%
Ener gy (oi l & gas)
6%
Computer and electr onics
7%
Banking and fi nance global
10%
Identify asset that would help the bank: Reducing negative SVA Earn higher return on capital Diversify its loan portfolio
Asset allocation
Objective JPMorgan solutionCategory
Asset allocation
Improve the risk/return profile of asset portfolio by Sell exposure to low SVA and highly concentrated
exposures, while invest excess economic capital in SVA positive assets
Increase global credit exposure to improve margins and diversification by investing in global portfolio
Consider hedging some negative SVA assets via synthetic securitization
Synthetic securitization is the most cost-effective method to execute the strategic transformation of the bank’s asset portfolio
Execute transformation of the bank’s asset portfolio
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New assetsReturn on Capital + 58.9%SVA contribution + 45.5%Return on Capital + 58.9%SVA contribution + 45.5%
Existing assetsReturn on Capital + 2.5%SVA contribution - 10.9%
2. Return on CapitalSVA contribution
1.
Fitch Industry breakdown
Eur ope
36%
Asia
P acifi c
18%
Amer icas
46%
Building and materials 2.1%
Business services 2.0%
Cable 1.2%
Consumer products 1.5%
Farming and agricultural services 1.2%
Gaming, leisure and entertainment 1.1%
Healthcare 1.0%
Lodging and restaurants 0.6%
Packaging and containers 0.6%
Pharmaceuticals 0.4%
Textiles and furniture 0.4%
Regional breakdown
Fitch industry breakdown for “Others”
Portfolio overview Industry stratification
Portfolio Notional: KRW2,550bn
No of Obligors
Number of Unique Borrowers
Number of Unique Chaebols
Chaebol stratification
18.06
41.89 40.05
AA A BBB BB B
Domestic rating stratification (%)
Textile-tree-paper & others
Fishery & food manufacturing
FinanceFirst metal industry
Construction
Compound & nonmetal
Metal & Machinery
Wholesale & transportation
storage
Daelim
Samsung
SK
DaewooDoosanHanjin
LotteLG
CuritelCJ
HyundaiHyundai Motor
Tong Yang
Unaffiliated
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SVA analysis of existing portfolio
29
ROC by industry sector
186
203
162
185
161
149
140120
100
74
63
48
45
2523
21
21
20
(20.0)%
(10.0)%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
0 5 10 15 20 25
Customer categories by exposure size (US$mm)
RO
C % Cost of capital
Wholesale & Transport(small co)
Wholesale & Transport(large corp)
Wholesale & Transport
(SME)
Assembly(large corp)
Construction(SME)
Compound &Nonmetal(large corp)
Assembly(SME)
Construction(small co)
Wholesale & Transport(public)
Textile(SME)
Construction(large corp)
Compound &Nonmetal
(SME)
Fishery(large corp)
Textile(large corp)
Assembly(small co)
1st Metal(large corp)
Fishery(SME)
Textile(small co)
Po
sitiv
e SV
A
Neg
ativ
e S
VA
I B A 026550-001
Efficient frontier
Return
Risk
High SVA
Low SVA
Current positionBank X’s asset portfolio
Step 2: Investing in alternative assets
Improvement in SVA of asset portfolio by reducing capital at risk and increasing return of capital
Efficient frontier
Step 2 stand-alone: Investing in alternative assets only
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Step 1: Hedging negative SVA and high concentration exposures
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Capital management
Objective JPMorgan solutionCategory
Capital management
In achieving target ratios beyond core economic capital requirements, the bank should seek to maintain the cheapest forms of regulatory capital available
Replace expensive capital by issuing Lower Tier II
Achieve target Tier I ratio by using non-dilutive HT I capital
Time the issue ahead of major capital redemption in 2005 by the bank and other issuers in the same peer group
Issuing more efficient capital instruments to optimise the capital mix
Introduced to capital alternatives which meet both the economic capital requirements and regulatory/competitive standards
Moving towards a more
31
3,900
1,000 4,900
3,700
100600
500
Economic capital Economic capitalbuffer
Regulatory(hybrid) Tier 1
Lower Tier 2 Upper Tier 2 Tier 3 Optimal capitalstructure
Economic Capital Regulatory capital
7% Tier 1
11% CAR
1,200
1,300
3,9001,000 4,900
3,700
100600
500
Economic capital Economic capitalbuffer
Regulatory(hybrid) Tier 1
Lower Tier 2 Upper Tier 2 Tier 3 Optimal capitalstructure
7% Tier 1
11% CAR
1,200
1,300
Economic capital Regulatory capital New regulatory capital
Target capital position—December 2004
I B A 026550-001
Objective JPMorgan solution
Asset liability management
Implement liability management strategy to reduce funding costs
Introduce cost saving strategies such as equity-linked deposits, Quanto swap and Swap in arrears
Lower funding cost and increase fee income On-balance sheet methods, such as holding
longer duration assets (i.e., Introduction of new mortgage loans in Korea) or shortening assumed duration for deposits without maturity can prove be more effective for managing this risk
Category
On-balance sheet methods, such as holding longer duration assets (i.e., Introduction of new mortgage loans in the bank’s home country) or shortening assumed duration for deposits without maturity can prove be more effective for managing this risk
Mitigate asset-liability mismatch (Liabilities longer than the assets
Asset liability management
32
(30,000)(25,000)(20,000)(15,000)(10,000)(5,000)
05,000
10,00015,000
20,00025,000
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12
Assets and Liabilities
(15,000)
(10,000)
(5,000)
0
5,000
10,000
15,000
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12
Monthly assets and liabilities refixing risk (in billion)
Net funding need (in billion)
I B A 026550-001
The bank could enhance shareholder value by around 9% of current market cap. from optimizing the balance sheet
Quantifying the benefit for shareholders—market capitalization (billion)
5,562
3,337
2,6182,305
1,184
459 5,1035,174
0
1,000
2,000
3,000
4,000
5,000
15,000
Peer 1 Bank afteroptimization
Peer 2 Bank beforeoptimization
Peer 3 Peer 4 Peer 5 Peer 6
33
026550-001
JPMorgan credentials
34I B A
I B A 026550-001
JPMorgan is the only investment bank to offer comprehensive balance sheet advisory to FIG clients…
Excerpt of article
Also on the institutional side, the bank has been putting more resources in asset and liability management (ALM), another strategic push for the bank this year. JP Morgan set up an ALM team in Asia at the beginning of this year to target banks and life insurance companies around the region, and the bank now has projects in several countries, says Bulchandani, who heads up the team in conjunction with his credit derivatives role. “We started this effort at the end of February, and my target is to have between eight and 10 companies signed up with some completed, in a 12-month period,” he says.
Similar to the problems encountered by life insurance firms in Europe, Asia’s insurance companies face a mismatch in the yields they are able to achieve on their investments and the returns guaranteed on their policies. At the same time, with domestic fixed-income markets rarely stretching beyond 15years, there is a mismatch in duration in the asset and liability portfolios.
“The liability side is similar to what happened with insurance companies in Europe,” says Bulchandani. “They have guarantees and they have embedded option-ality in their policies. The difference is that, by and large, Asian life insurance companies have realised the problem. They realize the benefits of diversification, they realize that they have to be more in fixed-income and use equity as a way of generating alpha. They really want to take fixed-income, they really want to take international assets and diversity. However, they have to ensure that they operate within the scope of existing regulations. The key regulations to consider are related to the amount of overseas assets the company can hold, the types of assets it can invest in, and the types of derivatives hedges it can execute.”
As part of its ALM approach, the banks first examines market and regulatory constraints and defines the objectives of the analysis, then sets the performance metrics, analyses, the overall asset and liability portfolios, and sets a tactical optimization benchmark for the insurance company to follow. “We are not telling the insurance companies to stop taking risk, but rather to take a mix of risks and to diversify,” continues Bulchandani. “If you look to 2005 and 2006, there are various significant factors that can affect the derivatives market- International Accounting Standard 39, Basel II, the tightening of credit spreads, and so on. And in the world, the bright spot is going to be ALM, which can give some positive momentum to the capital market growth.”
Recognized leader in balance sheet advisory
35
I B A 026550-001
… and has enjoyed significant success across the region in delivering on our total balance sheet approach
Key themes
Advising insurance company on optimal asset
allocation
Advising leading bank on BIS II, economic capital
framework and diversification benefits
Advised bank on economic capital framework and concentration risk
Advised a leading insurance company on embedded optionality of liabilities and concentration risk
Advised leading bank on redeployment of liquidity to
achieve increase diversification and risk adjusted returns
Advised leading bank on capital management, capital
allocation and concentration risk
Advised leading bank on credit portfolio management
and hedging of balance sheet risk
Overall financial efficiency
IAS 39
Basel II
Enhance risk adjusted returns
Merger integration
Concentration risk
Total balance sheet approach to advisory business
36