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Examining How the Capital Buffer Standards are Impacting the Use and Availability of Tier 1 Capital London, 18 February 2011

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Agenda

• How buffers work

• Dividend policies under the capital conservation buffer and the countercyclical capital buffer

• How buffers might simultaneously impact

• Profitability

• Pricing

• Lending

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Overview of regulatory timetable

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2011 2012 2013 2014 2015 2016 2017 2018 2019

Min Common Equity Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

Capital conservation buffer 0.625% 1.25% 1.875% 2.5%

Min common equity + cap conservation buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%

Phase in of deductions from Common Equity 20% 40% 60% 80% 100% 100%

Minimum Tier 1 4.0% 4.0% 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%

Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Min Total Capital + Capital Conservation buffer 8.0% 8.0% 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%

Capital instruments that no longer qualify as Tier 1 or Tier 2

Phased out over 10 year period starting 2013

From 1 January:

Shading indicates transition periods

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Capital conservation buffer

Objective: ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred in order to avoid breaches of minimum capital requirements:

•outside of periods of stress, banks should hold buffers of capital above the regulatory minimum

•when the capital level falls below the minimum requirement + buffer, banks should rebuild them through

• raising private capital in the market

• reducing discretionary distributions of earnings (reducing dividend payments, share-backs and staff bonus payments)

• in the absence of raising capital in the private sector, the share of earnings retained by banks for the purpose of rebuilding their capital buffers should increase the nearer their actual capital levels are to the minimum capital requirement.

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Capital conservation buffer

The framework reduces the discretion of banks which have depleted their capital buffers to further reduce them through generous distributions of earnings, therefore discouraging banks to engage into “unacceptable practices” such as:

•to use future predictions of recovery as justification for maintaining generous distributions to shareholders. Shareholders, not depositors, must bear the risk that recovery will not be forthcoming;

•to try and use the distribution of capital as a way to signal their financial strength.

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Capital conservation buffer: the mechanics

• A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement. Capital distribution constraints will be imposed on a bank when capital levels fall within this range

• Banks will be able to conduct business as normal when their capital levels fall into the conservation range as they experience losses. The constraints imposed only relate to distributions, not the operation of the bank

• The distribution constraints imposed on banks when their capital levels fall into the range increase as the banks’ capital levels approach the minimum requirements.

• The Basel Committee does not wish to impose constraints for entering the range that would be so restrictive as to result in the range being viewed as establishing a new minimum capital requirement.

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Elements subject to restriction

• Items considered to be distributions include dividends and share buybacks, discretionary payments on other Tier 1 capital instruments and discretionary bonus payments to staff

• Earnings are defined as distributable profits calculated prior to the deduction of elements subject to the restriction on distributions. Earnings are calculated after the tax which would have been reported had none of the distributable items been paid

• The framework should be applied at the consolidated level, ie restrictions would be imposed on distributions out of the consolidated group. National supervisors would have the option of applying the regime at the solo level to conserve resources in specific parts of the group

• Supervisors have the additional discretion to impose time limits on banks operating within the buffer range on a case-by-case basis, as banks should not choose in normal times to operate in the buffer range simply to compete with other banks and win market share

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Capital conservation buffer: impacts on capital

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How capital conservation buffer affects Tier 1

• Capital conservation buffer is designed to be on top of minimum requirements, to be a cushion in case of stress

• As being on top of minimum requirement, it “resembles “ Pillar 2 add-on but it is not designed to cover risks not covered under Pillar 2 but possible loses in periodo if stress

• Under Pillar 2, banks are not obliged to set aside capital to cope with stressed scenarios; they have to set up a credible strategy (management actions and capital contingency plan) to cope with the scenario identified and analyzed

• In addition, under Pillar 2 banks have the possibility of identifying those items to be included in their internal capital definition, in addition to those items that are included in the definition of regulatory capital

• Therefore, the introduction of the capital conservation buffer, as a matter of fact, increases the quality and enhance the quality of capital needed to support the business

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Capital conservation buffer: the mechanics

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No dividend distribution allowed

No constrains on dividend distribution

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Is the resiliency of the banking system enhanced ?

• Capital is the cushion against future unexpected losses

• Basel 2 weighting curves provides a scaling factor K which, multiplied by 12,5 and the EAD provides, the Risk Weighted Asset for any given exposure. The RWA multiplied by 8% provides the capital requirement for the exposure at hand

• Although not intended to be a minimum requirement, the introduction of the CCB implies that banks, at least in normal times, should operate with a “minimum” capital of 10,5% of their total RWA. Therefore, minimum requirement is “de facto” increased by 31,5% (10,5%/8% - 1)

• Basel 2 weighting curves are calibrated for a probability level of 99,9%, roughly equivalent to a rating A.

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• Raising the implied minimum requirement from 8% to 10,5% is equivalent to raising the scaling factor K by 31,5%

• All other things equal, it is equivalent to raising the probability level implied in the calibration curves to a different, and higher, level.

• The weighting curve for corporate exposure is:

K =1.06 *LGD *{ N [(1 – R)^–0.5 * G (PD) + (R / (1 – R))^0.5 * G (0.999)] – PD} * [1 + (M – 2.5) * b]/ (1 – 1.5 * b) where

• Ln denotes the natural logarithm.

• N (x) denotes the cumulative distribution function for a standard normal random variable

• G (z) denotes the inverse cumulative distribution functions for a standard normal random variable

• R denotes the correlation and is calculated as follows: R = 0.12 * [1 + EXP (–50 * PD)]

• b denotes the maturity adjustment and is calculated as follows: b = [0.11852 – 0.05478 * Ln (PD)]^ 2

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• Example: exposure to corporates with the following features:

• PD = 1%

• LGD = 45%

• Maturity = 2,5 y

• EAD = 100

• Using the standard Basel 2 weighting curves, the scaling factor K = 0,08429 , the RWA is about 105 and the minimum requirement is 8,4%

• In order to estimate the effect on the implied probability level of an increase of capital requirements by 31,5%, we have estimated the implied probability coming from raising the scaling factor by 31,5%

• The implied probability level that raises the scaling factor, and hence, the RWA by 31,5% is 99,97%, as compared to the 99,9% of the standard formula

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Loss distribution

Capital required @8%Expected losses

Probability

Aggregate annual losses

99,9% 99,97%

Extra capital

to 10,5%

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Countercyclical capital bufferObjective: ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate:

•deployed by national jurisdictions

•the buffer for internationally-active banks will be a weighted average of the buffers deployed across all the jurisdictions to which it has credit exposures

The countercyclical buffer regime consists of the following elements:

•national authorities will monitor credit growth and other indicators that may signal a build up of system-wide risk and make assessments of whether credit growth is excessive and is leading to the build up of system-wide risk

•internationally active banks will look at the geographic location of their private sector credit exposures and calculate their bank specific countercyclical capital buffer

•each Basel Committee member jurisdiction will identify an authority with the responsibility to make decisions on the size of the countercyclical capital buffer

•this will vary between zero and 2.5% of risk weighted assets, depending on their judgement as to the extent of the build up of system-wide risk

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Countercyclical capital buffer• Internationally active banks will look at the geographic location of their private sector credit

exposures (including non-bank financial sector exposures) and calculate their countercyclical capital buffer requirement as a weighted average of the buffers that are being applied in jurisdictions to which they have an exposure.

• Credit exposures include all private sector credit exposures that attract a credit risk capital charge or the risk weighted equivalent trading book capital charges for specific risk, IRC and securitisation the buffer for internationally-active banks will be a weighted average of the buffers deployed across all the jurisdictions to which it has credit exposures

• The countercyclical buffer regime will be phased-in in parallel with the capital conservation buffer between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019.

• Maximum countercyclical buffer requirement will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final maximum of 2.5% of RWAs on 1 January 2019. Countries experiencing excessive credit growth during this transition period will consider accelerating the build up of the capital conservation buffer and the countercyclical buffer

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Countercyclical capital buffer

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4,5% CET1 + 2,5% Capital Conservation Buffer + 2,5% Countercyclical Capital Buffer

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The mechanics of the countercyclical capital buffer

• Three main steps are required to regulators for defining the countercyclical capital buffer:

• Step 1: Calculate the aggregate private sector credit-to-GDP ratio

• Step 2: Calculate the credit-to-GDP gap (the gap between the ratio and its trend)

• Step 3: Transform the credit-to-GDP gap into the guide buffer add-on

• Step 1: The credit-to-GDP ratio in period t for each country is calculated as:

RATIOt=CREDITt / GDPt * 100%

where GDPt is domestic GDP and CREDITt is a broad measure of credit to the private, non-financial sector in period t. Both GDP and CREDIT are in nominal terms and on a quarterly frequency.

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• Step 2: The credit-to-GDP ratio is compared to its long term trend. If the credit-to-GDP ratio is significantly above its trend (ie there is a large positive gap) then this is an indication that credit may have grown to excessive levels relative to GDP. The gap (GAP) in period t for each country is calculated as the actual credit-to-GDP ratio minus its long-term trend (TREND):

GAPt=RATIOt – TRENDt.

TREND is a simple way of approximating something that can be seen as a sustainable average of ratio of credit-to-GDP based on the historical experience of the given economy. It is calculated using a special algorithm, called Hodrick-Prescott filter it has the advantage that it tends to give higher weights to more recent observations rather than simple averages or moving averages.

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• Step 3:

• The size of the buffer add-on (VBt) (in percent of risk-weighted assets) is zero when GAPt is below a certain threshold (L). It then increases with the GAPt until the buffer reaches its maximum level (VBmax) when the GAP exceeds an upper threshold H.

• BCBS analysis has found that an adjustment factor based on L=2 and H=10 provides a reasonable and robust specification based on historical banking crises.

• The actual VB will vary linearly according to the value of the Gap. For example, a Gap of 6 could imply a VB=1,25%, as its half the way between L and H.

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What international banks have to do:

Firm

60% assets in Country A

60% assets in Country A

40% assets in Country B

40% assets in Country B

2% 1%

(60% * 2%) + (40% * 1%) = 1.6%Countercyclical Capital Buffer

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Relationship with Pillar 1 and Pillar 2

• The countercyclical capital buffer incorporates is “hybrid” between Pillar 1 and 2:

• Pillar 1: framework consisting of a set of mandatory rules and disclosure requirements

• Pillar 2: jurisdictional judgement in setting buffer levels and the discretion provided in terms of how authorities explain buffer actions are more akin to a Pillar 2 approach

• Countercyclical capital buffer may overlap with capital add-on included in Pillar 2.

• Authorities to ensure that a bank’s Pillar 2 requirements do not require capital to be held twice for financial system-wide issues, if they are already captured by the countercyclicalbuffer when the latter is above zero.

• As Pillar 2 may capture additional risks that are not related to system-wide issues (eg concentration risk), capital meeting the countercyclical buffer should not be permitted to be simultaneously used to meet these non-system-wide elements of any Pillar 2 requirement.

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Joint impact of buffers on profitability and pricing

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Total assets RWA % RWA Liabilities

Cash 10 0% 0 Current and deposit accounts 47,12

Government bonds 10 0% 0 Bonds 47,12

Loans to banks 10 20% 2 Tier 2 instruments 2,88

Loans to customers 60 100% 60 Other tier 1 instruments 1,44

Other assets 10 100% 10 Equity 1,44

Total assets 100 72 100

Capital structure

Tier 1 - in % RWA 4,0% 2,88

Tier 2 - in % RWA 4,0% 2,88

Minimum requirement 5,76

- o/w

Equity - in % RWA 2,0% 1,44

Equity - Cap Cons Buffer 0,0% 0,00

Equity - Countercyclical 0,0% 0,00

Interest ratesGovernment bonds 3,0%Loans to bank 1,0%Loans to customers 7,0%Current and deposit accounts 1,0%Bonds 4,0%Tier 2 instruments 6,0%Other tier 1 instruments 7,5%Cost of risk 1,0%General expenses (as a % of revenues) 50,0%

ILLUSTRATIVE

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Capital structureTier 1 - in % RWA 4,0% 2,88Tier 2 - in % RWA 4,0% 2,88Minimum requirement 5,76- o/wEquity - in % RWA 2,0% 1,44Equity - Cap Cons Buffer 0,0% 0,00Equity - Countercyclical 0,0% 0,00



ILLUSTRATIVE

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Interest ratesGovernment bonds 3,0%Loans to bank 1,0%Loans to customers 7,0%Current and deposit accounts 1,0%Bonds 4,0%Tier 2 instruments 6,0%Other tier 1 instruments 7,5%Cost of risk 1,0%General expenses (as a % of revenues) 50,0%

PricingAmount financed 100,00Interest rate 5,12%Interests received 5,12Cost of funding -2,64Interest margin 2,48General expenses -1,24Cost of risk -1,00Gross profit 0,24Net profit (@ 40%) 0,14Cost of equity(@10%) -0,14Value 0,00

ILLUSTRATIVE

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ILLUSTRATIVE

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Potential impact on lending

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Maximum lending volumes:

Basel 2 rules: 117

Basel 3 rules (both buffers):

72

Minimum requirement T1+T2 = 5,76

Capital Conservation Buffer = 1,80

Countercyclical Capital Buffer = 1,80

Capital structure

Tier 1 - in % RWA 6,0% 4,32

Tier 2 - in % RWA 2,0% 1,44

Minimum requirement 5,76

- o/w

Equity - in % RWA 4,5% 3,24

Equity - Cap Cons Buffer 2,5% 1,80

Equity - Countercyclical 2,5% 1,80

ILLUSTRATIVE

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Conclusions

• The aim of Committee’s proposals is to have a more stable financial system, increasing the quality and quantity of capital and enhancing some areas of Basel 2 framework.

• The parameters’ calibration and the capital transitory period are two important factors that would determine the impact of the new Basel proposals.. As you know “devil is in the detail…”.

• Buffers will make banks significantly more resilient, but at the same time will pose significantly constrain on the use of common equity and Tier 1

• Most of these proposals would have relevant impact on bank profitability making at the same more difficult for banks to raise fresh capital in the market.

• The next challenge for banks will be to be able to be “adequately” profitable in a much more capitalized world.

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