026550-001 n o v e m b e r 2 0 0 5

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026550-001 NOVEMBER 2005 BASEL II AND STRATEGIC BALANCE SHEET MANAGEMENT

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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

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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

3

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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

4

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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

5

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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

1

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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)

10

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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

16I B A

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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

28

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

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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

30

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

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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)

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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

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026550-001

JPMorgan credentials

34I B A

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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

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… 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