RISK MANAGEMENT REPORT BANCO DO BRASIL S.A.

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2 RISK MANAGEMENT REPORT BANCO DO BRASIL S.A. 4rd quarter of 2011

3 Summary List of Tables... 3 List of Figures Introduction President s Message Governance... 8 Risk Exposure... 8 Types of Risks... 8 Corporate Risk Governance... 9 Risk Management Process Reports Regulation Basel Accord Background Basel I Market Risk Amendment Basel II Basel III Basel II at Banco do Brasil Regulations Financial Conglomerate Risk Management Financial Conglomerate Credit Risk Market and Liquidity Risks Operational Risk Non-financial Companies Capital Regulatory Capital Referential Equity (PR) Required Referential Equity (PRE) Basel Index (IB) Economic Capital Banco do Brasil S.A. 2

4 List of Tables Table 1. Timetable for Basel III Implementation in Brazil Table 2. Credit-risk exposure by Risk Weights Table 3. Average credit-risk exposure in each quarter Table 4. Credit-risk exposure by geographic region and country Table 5. Credit-risk exposure of the financial conglomerate by economic sector Table 6. Credit-risk exposure of the economic-financial consolidated group by sector Table 7. Amount of transactions in arrears Table 8. Concentration levels of the ten biggest clients in relation to the total from lending transactions Table 9. Flow of transactions written-off Table 10. Stock of allowances for doubtful accounts Table 11. Loss operations assigned, with substantial transfer of risks and benefits Table 12. Value of the exposures derived from acquiring FIDC and CRI Table 13. Notional value of contracts to be liquidated in clearing house liquidation systems, in which the house acts as central counterparty Table 14. Notional value of contracts subject to counterparty credit risks in which clearing houses do not act as central counterparty Table 15. Notional value of contracts where clearing houses did not act as central counterparty, and which do not have guarantees active position Table 16. Notional value of contracts where clearing houses did not act as central counterparty, and which do have guarantees long and short positions Table 17. Positive gross value of contracts subject to counterparty credit risks, not taking into account the positive values from compensation agreements, as set forth in CMN Resolution 3.263/ Table 18. The value of guarantees which cumulatively meet the requirements of paragraph VI, Article 8, of Bacen Circular 3.477/ Table 19. Notional value of credit derivatives Table 20. Mitigated value of exposure, weighted by respective risk factors Table 21. Derivative financial instruments in the country and abroad 3Q Table 22. Derivative financial instruments in the country and abroad 4Q Table 23. Derivative financial instruments in the country and abroad 1Q Table 24. Derivative financial instruments in the country and abroad 2Q Table 25. Derivative financial instruments in the country and abroad 3Q Table 26. Total value of the Negotiable Portfolio by relevant market risk factor 3Q Table 27. Total value of the Negotiable Portfolio by relevant market risk factor 4Q Table 28. Total value of the Negotiable Portfolio by relevant market risk factor 1Q Table 29. Total value of the Negotiable Portfolio by relevant market risk factor 2Q Table 30. Total value of the Negotiable Portfolio by relevant market risk factor 3Q Table 31. Phases of the operational risk management process Table 32. Monitoring of operating losses Table 33. Referential Equity Table 34. Capital and Retained Earnings Table 35. Equity valuation adjustments Table 36. Non Controlling Participation Table 37. Perpetual Bonds Table 38. Subordinated Debt Table 39. Subordinated Debt Eligible as Capital Banco do Brasil S.A. 3

5 Table 40. Perpetual Bonds Table 41. Financial Instruments excluded from the PR Table 42. PR historical series Financial Conglomerate Table 43. PR historical series Consolidated Economic and Financial Table 44. Required Referential Equity for the Financial Conglomerate Table 45. Required Referential Equity for the Consolidated Economic Financial Table 46. The Basel ratio and capital margin - Financial Conglomerate Table 47. The Basel ratio and capital margin - Consolidated Economic and Financial Table 48. Economic Capital Table 49. Distribution of economic capital in the credit portfolio Table 50. Economic capital for market risk, by risk factors Table 51. Economic capital for operational risk, by loss event category Banco do Brasil S.A. 4

6 List of Figures Figure 1. Governance Structure Figure 2. Management Structure and Process Figure 3. Basel II Pillars... Erro! Indicador não definido. Figure 4. Capital allocation Figure 5. Pillar III Structure Figure 6. Credit-risk management Figure 7. Credit-risk management structure Figure 8. Operational risk management structure Banco do Brasil S.A. 5

7 1. Introduction BB considers risk and capital management as its fundamental vectors for decisionmaking, providing greater stability, better capital allocation, and optimization of the risk-return ratio. The objective of this section is to inform shareholders and interested parties of the management practices and policies that comprise risk management at BB. Banco do Brasil S.A. 6

8 2. President s Message Participation by the country s representative in the Basel Committee on Banking Supervision in Switzerland is a source of pride for Brazilians, reaffirming the new level of stability achieved by Brazil s financial system. As is well-known, banking system sustainability is indissolubly linked with riskmanagement policies and mechanisms. The methods of identifying, measuring, assessing, monitoring, and controlling risk safeguard financial institutions in adverse situations and provide support for positive, recurring earnings over time. The expectation of smaller bank spreads reinforces that conviction. Just as important as increasing the volume of business is the consistency of a company s risk governance and the efficiency of its management processes. Institutions that are able to transcend mere compliance with regulatory requirements and take risk into account in a quick and accurate way when making decisions are the ones that will rise to the challenge. Brazil s participation in the Basel Committee on Banking Supervision will encourage broader, timelier adoption of international prudential standards. These new frontiers of the regulatory environment will require Brazilian financial institutions to become more agile and adaptable. In these aspects the bank is mature and conscious of its commitment to its clients, shareholders, investors, and society. Banco do Brasil continually seeks to keep pace with best management practices, including its risk-management architecture, which has a multidimensional scope to address credit, liquidity, market, and operational risks. The specifics are described in this space. Aldemir Bendine Banco do Brasil S.A. 7

9 3. Governance Risk Exposure Changes to the global financial environment, such as market integration through globalization, the emergence of new transactions and products, increasing technological sophistication, and new regulations, have made financial activities and processes - and their risks - ever more complex. Additionally, the lessons learned from financial disasters, such as those of the Metallgesellschatt Group and Barings, have helped show the essential need for risk management in the banking industry. These factors have influenced regulatory agencies and financial institutions to invest in risk management, seeking to strengthen the financial health of banks and to prevent detrimental effects on the financial system. In concert with this outlook, BB has invested in the continual improvement of its riskmanagement process and practices, in accordance with international market benchmarks and the New Basel Accord, known as Basel II, and by the fine-tuning provided by Basel III. Types of Risks The main risks to which BB is exposed in its business are: a) Situational Risk: arises from the possibility of losses caused by changes to political, cultural, social, economic, or financial conditions in Brazil and other countries. It includes the following risks: i. Strategic Risk risk of losses from adopting unsuccessful strategies, taking into account the dynamics of business and competition, political changes in the country and abroad, and changes in the domestic and global economy; ii. Country Risk understood as the possibility of losses associated with nonfulfillment of financial obligations according to negotiated terms by a borrower or counterparty located outside of the country, resulting from actions taken by the government of the country where the borrower or counterparty is located; and transfer risk, understood as the possibility of difficulties occurring during currency conversion of funds received; and iii. Systemic Risk Possibility of losses due to the financial difficulties of one or more institutions that cause substantial damage to others, or a disruption of normal operations of the national financial system. b) Credit Risk: defined as the possibility of losses associated with non-fulfillment by a buyer or a counterparty of their respective financial obligations according to negotiated terms, the devaluation of a loan agreement due to a drop in the borrower s risk rating, a decline in gains or earnings, advantages offered during renegotiation, and recovery costs. Among other things, credit risk is defined as including: i. counterparty credit risk, understood as the possibility of a given counterparty not fulfilling its obligations related to settlement of transactions that involve Banco do Brasil S.A. 8

10 trading financial assets, including those related to the settlement of financial derivatives; ii. country risk understood as the possibility of losses associated with nonfulfillment of financial obligations according to negotiated terms by a borrower or counterparty located outside of the country, resulting from actions taken by the government of the country where the borrower or counterparty is located; and transfer risk, understood as the possibility of difficulties occurring during currency conversion of funds received; iii. the possibility of having to make disbursements to honor guarantees, bonds, co-obligations, credit commitments, or other transactions of a similar nature; and iv. the possibility of losses associated with a loan broker or intervening party not fulfilling their financial obligations according to negotiated terms. c) Image Risk: possibility of losses from the institution having its name sullied on the market or with authorities, as a result of negative publicity, whether true or not. d) Market Risk: the possibility of losses from fluctuations of the market value of positions held by a financial institution. It includes the risks of transactions subject to fluctuations of exchange rates, interest rates, share prices, and commodity prices. e) Legal Risk: this can be defined as the possibility of losses due to fines, penalties or indemnities arising from actions by regulators, and losses due to unfavorable rulings in lawsuits and administrative actions. f) Liquidity Risk: is the occurrence of imbalances between tradable assets and liabilities payable - "mismatches" between payments and receipts - which can affect the institution s payment ability, taking into account the various currencies and settlement terms of its rights and obligations; and g) Operational Risk: possibility of losses due to failures, deficiencies, or improper internal processes, people and systems or external events. This definition includes the legal risk associated with improper or deficient contracts signed by the institution, as well as sanctions resulting from noncompliance with legal provisions and compensation for damages to third parties resulting from activities engaged in by the institution. Corporate Risk Governance The risk-governance model adopted by BB involves a committee and subcommittee structure, with the participation of many units at the bank, addressing the following issues: a) separation of duties: business versus risk; b) specific structure for risk assessment/management; c) defined management process; d) decisions at several hierarchical levels; e) clear rules and authority structure; and f) referring to best management practices. Banco do Brasil S.A. 9

11 CRG Subcomimtees Portfolio Management and simulations integrated Rating and Measuring Management and Control Models Information Database Market Risk Credit Risk Operation al Risk Other Risks Figure 1. Governance Structure All decisions related to risk management are made jointly and in accordance with BB s guidelines and rules. Banco do Brasil s risk governance, covering the multiple bank and its wholly owned subsidiaries, is centralized in the Global Risk Committee (GRC), consisting of a steering committee, whose main purpose is to establish strategies for risk management, overall risk-exposure limits and levels of conformity and capital allocation in light of risks. Seeking to streamline the management process, several subcommittees were set up to address Credit Risk (CRS), Market and Liquidity Risk (MLRS), and Operational Risk (ORS); they make decisions and/or instruct the GRC, and have delegated decision-making power. The Risk Management Board (DIRIS), which reports to the Office of the Vice President for Credit, Financial Control, and Global Risk, is responsible for managing credit, market, liquidity, and operational risks. This integration provides synergy among processes and specialization, contributing to better allocation of capital while adhering to the New Basel Accord. Banco do Brasil S.A. 10

12 President & Vice- Presidents Global Risk Committee CRG Decision Officers SRML SRC SRO Risk Management Board Boards Business Aréas de Negócio Units Monitoring Aréas de Negócio Units Figure 2. Management Structure and Process Decisions are reported to intervening units through decisions that objectively express the position taken by executive management, guaranteeing application throughout the bank. Risk Management Process The risk-management process involves a continuous flow of information, abiding by the following phases: a) preparation: data gathering and analysis phase. During this stage, risk measures are analyzed and proposed for discussion and deliberation in the subcommittees, and if necessary, for later discussion and deliberation in the GRC; b) decision: decisions are made jointly at the appropriate levels and reported to the intervening units; c) execution: the intervening units implement the decisions made; and d) monitoring/management: the Risk Management Board oversees the process, evaluating compliance with deliberations and their impacts on BB, reporting the status of these actions to the appropriate forum (subcommittee or GRC). Oversight of these decisions and reporting to subcommittees/grc allows for improvement of the management process. Banco do Brasil S.A. 11

13 Reports Risk-management reports provide support for risk-related decisions in the subcommittees, the Global Risk Committee, the Board of Officers, and the Board of Directors. They are prepared every month and have qualitative and quantitative managerial information about the bank s exposure to risk. They support the information disclosed to the market in the Management Report and the Performance Analysis Report. Banco do Brasil S.A. 12

14 4. Regulation Basel Accord The rules established by the Basel Committee, from the outset, have always sought to create an international standard that regulators could use to defend the market against risks specific to the financial industry. Background In 1973, the global financial market was undergoing a period of intense volatility with the end of the International Monetary System based on fixed exchange rates. Liberalization of rates required measures to minimize the system s risk. The fragility reached a critical level in 1974 with the occurrence of disruptions on international markets, such as the failure to settle currency contracts due to the insolvency of Germany s Bankhaus Herstatt. At the end of that year, those in charge of banking oversight in the G-10 countries decided to create the Committee on Banking Regulation and Supervision of Practices, headquartered at the Bank of International Settlements (BIS) in Basel, Switzerland. Thus the name, the Basel Committee. The Committee consists of representatives from central banks and authorities with formal responsibility for banking oversight in the G-10 member countries. This Committee discusses issues related to the banking industry, seeking to improve the quality of banking supervision and to strengthen the security of the international banking system. The Committee does not have formal authority for supranational supervision, but it has the goal of inducing behavior in countries that are not members of the G-10. By following committee guidelines, those countries will contribute to improving practices on the international financial market. Basel I In July 1988, after an intense debate, the Basel Accord was executed, defining the mechanisms for measuring credit risk and establishing the minimum-capital requirements to endure risks. This accord is now known as Basel I. The accord s objectives were to strengthen the health and the stability of the international banking system and to minimize the competitive inequalities among internationally active banks. These inequalities were the result of different minimumcapital requirement rules by national regulators. The 1988 Basel Accord defined three concepts: a) Regulatory Capital - the amount of own capital allocated to cover risks, considering the parameters defined by the regulator; b) Asset Risk Weighting Factors - the exposure of assets (on and off balance sheet) to credit risk is adjusted by varying weights based primarily on the borrower s profile; and Banco do Brasil S.A. 13

15 c) Minimum Capital Index to Cover Credit Risk (Basel Index or BIS Ratio) - quotient between risk-bearing capital and risk-weighted assets (on and off balance sheet). If the amount calculated is equal to or greater than 8%, the bank s capital level is sufficient to cover credit risk Market Risk Amendment The advance made with Basel I, in terms of regulations and capital requirements to cover credit risk, was undeniable. However, a few criticisms emerged, making it necessary to improve upon that document within the Basel Committee. Among the adjustments was the need to set aside capital to cover market risks. Thus, in January 1996, an addendum to Basel I was published, called the Market Risk Amendment, whose main features are: a) expansion of controls over risks incurred by banks; b) extension of requirements to define minimum (or regulatory) capital, incorporating market risk; and c) possibility of using internal risk-measurement models, provided that they are approved by local regulators. Basel II Since the Basel Committee s creation in 1975, banking regulation has made significant strides. Thus, in June 2004, the Committee published the New Capital Accord, commonly known as Basel II, with the following objectives: a) to promote financial stability; b) to strengthen the capital structure of institutions; c) to favor the adoption of best risk-management practices; and d) to encourage greater transparency and market discipline. Basel II proposes a focus that is more flexible for capital requirements and more robust in terms of strengthening banking supervision and stimulating greater transparency in disclosing information to the market, based on three major premises: a) Pillar I - strengthening the capital structure of institutions; b) Pillar II - encouraging the adoption of best risk-management practices; and c) Pillar III - reducing the asymmetry of information while favoring market discipline. PILAR I Minimum Capital Requirements PILAR II Banking Supervision and Governance PILAR III Market Discipline Risks - Credit - Market - Operational Assessment in how banks are adjusting needs to risks incurred Disclosure of relevant information to the market Solidity Management of the national financial system and financial information Lessen asymmetry of information Figure 3. Basel II Pillars System Stability Banco do Brasil S.A. 14

16 Pillar I defines the treatment to be given to determine capital requirements in light of risks incurred in the activities engaged in by financial institutions. In relation to the 1988 Accord, Basel II introduces a capital requirement for operational risk and refines the discussion of credit risk. Credit Risk Market Risk Operational Risk IRB Models Standard Advanced Standard Aproach Standard Standard Simplified IRB Model Standard Aproach IRB Model Advanced Standard Aproach Standard Standard Alternative ********** ********** Basic Figure 4. Capital allocation Modified Maintened Added Basel II encourages the adoption of proprietary models to measure risks (credit, market, and operational), with differing degrees of complexity, subject to regulatory approval, and the possibility of benefits from lower capital requirements by adopting internal approaches. Pillar II reaffirms and strengthens the participation and role of the regulator in the banking supervision process and evaluation of risk governance at institutions, and how they manage capital to deal with the risks that they incur. Pillar III recommends the creation of instruments and conditions to lower systemic risk caused by asymmetric information, encouraging and favoring market discipline and transparency of information about risk-management practices. The combination of these three major elements on which the entire Basel II philosophy is based can be defined, in short, as the pursuit of refining riskmanagement and control practices. Pillar I Minimum Capital Requirements Under Pillar I, various alternatives are proposed to determine capital requirements in keeping with the financial institution s size, complexity, and technical capacity, in order to measure risk. It sought to include a variety of measurement approaches, considering the use of (advanced) internal models as well. The main changes with respect to the first accord are: a) the sophistication of credit-risk measurement methods; and b) the inclusion of metrics for operational risk. Banco do Brasil S.A. 15

17 Even though the internal models to calculate capital allocation require a greater degree of complexity, sophistication and investment, they allow for reducing the capital to be set aside in better reflecting the bank s internal structure. Pillar II Governance and Supervision Process The supervision process establishes rules for risk management. The Committee established four essential principles of supervisory review that demonstrate the need for banks to evaluate capital adequacy in relation to risks assumed and for supervisors to review their strategies and to adopt relevant attitudes in light of these assessments. They are: a) First Principle: banks must have a process to estimate their capital adequacy in relation to their risk profile and have a strategy to maintain sufficient levels of capital; b) Second Principle: supervisors should assess the banks strategies, adequacy estimates, and ability to monitor and to guarantee their compliance with minimum capital requirements; c) Third Principle: supervisors expect, and may require, banks to operate over the minimum capital requirements; and d) Fourth Principle: supervisors may intervene in advance and require banks to take prompt actions if their capital level falls below the minimum level. According to Pillar II, executive management is responsible for both the risk-exposure strategy and compatible levels of capital. The main features of having a rigorous process to assess capital adequacy should involve: a) supervision of the bank s executive management and board of directors; b) solid assessment of capital needs to tolerate business risks; c) comprehensive assessment of risks; d) monitoring and reporting; and e) review of internal controls. Pillar II emphasizes banks need to have an adequate volume of capital to tolerate all risks involved in their business. Capital should not be viewed solely as the only option that regulators may use to address risk issues, but also internal controls and riskmanagement processes that turn out to be insufficient or inadequate. Other means may be used to deal with risk management, such as applying internal exposure limits; strengthening allowance and reserve levels; and refining internal controls in general. Pillar III Market Discipline This represents the set of information-disclosure requirements that will allow market players to evaluate the essential information in the institution s structure, capital measurements, risk exposure, risk-management processes, and capital adequacy. Pillar III is based on four categories/divisions: Banco do Brasil S.A. 16

18 a) scope of application - represents the relationship between recommendations and the bank s structure; b) capital - demonstrates the bank s capacity to absorb eventual losses; c) risk exposure - demonstrates the support for assessing the intensity of risks and the ways of evaluating them; and d) capital adequacy - enables judgment of capital sufficiency in light of risks being incurred. Scope of Application -Qualitative aspects -Quantitative aspects Capital Structure - Qualitative aspects - Quantitative aspects Capital Adequacy - Qualitative aspects - Quantitative aspects Credit Risk Market Risk Operating Risk Equities Qualitative and Quantitative aspects Qualitative and quantitative aspects Qualitative and quantitative aspects Qualitative and quantitative aspects Figure 5. Pillar III Structure Quality of informatios to the market The rationale for creating this third pillar is to complement minimum capital requirements (Pillar I) and the supervisory review process (Pillar II). This means that with the development of rules that encourage and require more open information about banks risk profiles and capitalization levels, market players will feel encouraged to exercise discipline on this market. The use of certain transparency levels will be the benchmark for recognition and qualification of a financial institution in a specific capital-measurement approach. Examples include disclosing qualitative information about the structure of internal rating systems and the process to manage and to recognize the mitigation of credit risk. To guarantee compliance with transparency, Basel II calls for supervisors to have a greater number of persuasive instruments, ranging from dialogue with the bank s management to financial fines, depending on the disclosure deficiency in question. With this format, the role of regulators grows in the sense of accessing and evaluating banks positions, given their risk exposures, with an emphasis on their supervisory role. By encouraging open information, the New Accord seeks to potentialize market players power of evaluation and action. Banco do Brasil S.A. 17

19 Basel III Given the guidelines from the Basel Banking Supervision Committee, the Central Bank of Brazil (BACEN) published Notice 20,615 on 2/17/2011, which set out preliminary guidelines and a timetable for implementation in Brazil of the capital structure, leverage, and liquidity requirements known as Basel III. The main definitions and guidelines of this notice are presented below: a) New definition of capital: Tier I Capital of Referential Equity (PR) will consist of two parts: Principal and Additional Capital; b) Principal: will essentially consist of capital stock and retained earnings, after deducting the following equity items: i. tax credits resulting from temporary differences; ii. tax credits resulting from tax losses and a negative basis for the social contribution on net income; iii. premiums paid in acquiring investments based on the expectation of future profitability and payroll rights, constituted starting on 01/01/2012; iv. deferred permanent assets and other intangible assets; v. assets related to defined-benefit pension funds to which the financial institution does not have unrestricted access; vi. holdings in insurance firms that it does not control; vii. treasury shares; viii. minority holdings that exceed the minimum required principal and buffer capital, defined in paragraph 16 of the notice, recorded at financial institutions that are part of a financial conglomerate or in the consolidated economic/financial group; and ix. funding instruments issued by other financial institutions. Tax credits from temporary differences and major investments in insurance firms that are not controlled may be recognized in the capital structure up to an individual limit of 10% of Principal, and in the aggregate, along with other capital adjustments cited in paragraph 4 of the notice, up to 15% of Principal. These deductions shall occur progressively between 07/01/2012 and 01/01/2018. c) Additional Capital: the trend is for it to consist of authorized hybrid capital and debt instruments that meet the requirements of loss-absorption during a financial institution s operation; of subordination; of perpetuity; and of noncumulative dividends; d) Tier II Capital: it will likely consist of hybrid capital and debt instruments that do not qualify to be part of Additional Capital, along with subordinated debt instruments. For instruments that do not meet the eligibility requirements set out in Basel III, including the conversion clauses disclosed in the Basel Committee press release on 01/13/2011 (BIS, Press Release 03/2011), a gradual timetable for deductions will be defined, initially forecast as follows: 10% deduction of the nominal value of ineligible instruments, on 01/01/2013, adding 10% a year, so as to be completely excluded by 01/01/2022. The rule states that the BACEN shall publish a new referential equity definition by December 2011; Banco do Brasil S.A. 18

20 e) New minimum capital indices: two new indices were created: i) the Minimum Principal Capital Index (PCI), consisting of the ratio of Principal to the sum of risk-weighted exposure (RWE); and ii) Minimum Tier I Capital Index (Tier I CI), consisting of the ratio between Tier 1 Capital and RWE; f) Counterparty credit risk: modifications are anticipated to the capital requirements for counterparty credit risk, both for the standard approach and for internal risk rating (IRR) based approaches, to guarantee the inclusion of relevant risks in the capital structure; g) Buffer Capital: this amount will complement the minimum regulatory requirements and will consist of elements accepted to comprise the Principal; h) Countercyclical Capital: this should also consist of elements accepted in the Principal and will be required in the event of excessive growth of credit associated with the potential accumulation of systemic risk. The established timetable notwithstanding, any increases to the percent of Countercyclical Capital will be published by the BACEN at least 12 months in advance; i) Leverage Index: Basel III recommends implementation of a Leverage Index as a complementary capital measure, determined by dividing Tier I Capital by the amount of total exposure. As of 01/01/2018, the minimum required amount for the Leverage Index is scheduled to begin, initially forecast at 3%; and j) Liquidity measures: two liquidity indices are proposed, one short-term and the other long-term, as described below: i. Short-Term Liquidity Index (LCR): the purpose is to demonstrate that institutions have highly liquid funds to make it through a scenario of acute financial stress lasting one month, and it will be calculated based on the ratio of highly liquid assets to net outflows over a period of up to 30 days; and ii. Long-Term Liquidity Index (NSFR): this seeks to encourage institutions to finance their activities with more stable funding sources and will be calculated by the ratio of total available stable funding to total required stable funding. The timetable for implementing the Basel III recommendations in Brazil is shown in Table 1. Table 1. Timetable for Basel III Implementation in Brazil Source: BACEN Notice 20,615/11. Banco do Brasil S.A. 19

21 5. Basel II at Banco do Brasil Implementation of Basel II at BB is being overseen by the Risk Management Office (DIRIS), which is in charge of coordination and preparation to meet the Basel II requirements. Upon analyzing the New Capital Accord and BACEN regulations, it became clear that further actions needed to be taken among the product and service management units to enable BB to comply with the regulator s requirements, abiding by the phases set out in BACEN Notices /04; /07; and /09. In order to provide continuity to the evolving process of risk and business management practices, the bank made a strategic decision to adopt internal models for market, credit, and operational risk in order to be able to use advanced approaches by the deadlines initially set in BACEN Notice /09.. Market Risk Within the market-risk environment, there were revisions of both overall and specific limits, and of the Market Risk Capital Requirement Stress Test Program, both in line with the stipulations of BACEN Circular 3.478/09, which addresses internal market-risk models. Regarding liquidity risk, the bank s exposure is minimal, given its leading active position in highly liquid federal government bonds. Credit Risk In terms of credit risk, BB uses proprietary methodologies to rate clients risks. Developed according to best market practices and concepts introduced by the Basel Accord, these statistical models take into account background (credit score), credit history (behavior score) with the bank and the market, and the use of banking products. Operational Risk To manage operational risk, Banco do Brasil - adhering to best market practices - monitors operational losses by making use of systematized internal databases, exposure limits, and key risk indicators, in addition to risk matrices to evaluate relevant outsourced services. Seeking continual improvement of the operational-risk management process and more flexibility when proposing mitigation acts, in 2011, BB revised its specific limits for operational losses related to Labor Issues, Business Failures, Process Failures, External Fraud and Theft, "BB's branchesworldwide" and established a new limit for "Internal Fraud". Particularly important also was the work done throughout 2011, concerning about the use of four essential elements in the internal model for measuring operational risk: Internal Database, External Database, Scenario Analysis, Business Environment Internal Control Factors. Banco do Brasil S.A. 20

22 To prevent, correct, or inhibit weaknesses that might cause risks to BB, and to reduce losses and to strengthen the risk culture, has been used the Technical Risk Recommendation, issued to units that manage processes or products when a need is identified to take a loss-mitigation action, and to guarantee compliance with the responsibilities defined in the risk-management phases. Banco do Brasil S.A. 21

23 6. Regulations The BACEN, in concert with the procedures of regulators in developed countries, has issued a series of prudential regulations. Current regulations can be consulted on its website. Banco do Brasil S.A. 22

24 7. Financial Conglomerate Risk management in the Banco do Brasil financial conglomerate is comprehensive and covers credit, market, liquidity, and operational risks. Management activities are performed by specific, specialized structures, pursuant to objectives, policies, strategies, processes, and systems described in each of these risks. Even though activities focus on credit, market, liquidity, and operational risk, the bank uses mechanisms to guarantee capital sufficiency to cover other risks incurred. Banco do Brasil S.A. 23

25 8. Risk Management 8.1 Financial Conglomerate Credit Risk Management Objectives Exposures subject to credit risk are a big part of Banco dobrasil s assets. That is why risk management of these exposures is fundamental for the bank to achieve its objectives. Banco do Brasil s credit risk is managed according to best market practices and following banking supervision and regulatory rules. It seeks to identify, measure, control, and mitigate the risk of exposure, contribute to maintaining the bank s health and solvency, and guarantee that shareholders interests are being met. Credit-risk management at the financial conglomerate involves credit policy, management strategies, management processes, operational procedures, and management systems, as shown in the figure below: CREDIT POLICY CA MANAGEMENT STRATEGY CRG SRC MANAGEMENT PROCESSES DICRE OPERATIONAL PROCEDURES DIRAO MANAGEMENT SYSTEMS DIRIS STRATEGIC LEVEL OPERATIONAL LEVEL TATICAL LEVEL RISK MANAGEMENT STRUCTURE Figure 6. Credit-risk management Note: CA = Board of Directors; CRG = Global Risk Committee; SRC = Credit Risk Subcommittee; DICRE = Credit Board; DIRAO = Asset Restructuring Board; DIRIS = Risk Management Board. Banco do Brasil S.A. 24

26 In accordance with CMN Decision 3.721/09, the Board of Directors (CA) approved the credit-risk management structure of Banco do Brasil, consisting of the Global Risk Committee (CRG), Credit Risk Subcommittee (SRC), Credit Board (DICRE), Operational Asset Restructuring Board (DIRAO), and Risk Management Board (DIRIS). Given that the DIRIS is the unit at the bank in charge of overall risk management and does not have any ties to the management of third-party funds or to performing transactions subject to credit risk, the CA appointed the Director of Risk Management as the person in charge of BB s credit-risk management with respect to the BACEN. This credit-risk management structure is compatible with the nature of transactions, the complexity of products and services, and in proportion to the size of the credit-risk exposure incurred by Banco do Brasil. Credit Policy Banco do Brasil s credit policy contains strategic guidelines to direct credit-risk management actions at the financial conglomerate. It is approved by the Board of Directors and reviewed every year. It is available to all employees, and applies to all business that involves credit risk. The policy is divided up into four blocks: General Aspects, Assuming Credit Risk, Collections and Credit Recovery, and Credit Risk Management. Each block has a broad set of statements that encompass all stages of credit-risk management at Banco do Brasil. Listed below are a few of the topics addressed in Banco do Brasil s credit policy: a) concept of credit risk; g) conditions for assuming risk; b) separation of duties; h) guidelines for collections and credit recovery; c) joint decisions; i) expected loss, economic and regulatory capital; d) risk appetite; j) allowance and capital levels; e) risk limits; k) stress tests and sensitivity analysis; and f) client rating; l) capital planning. Management Strategies Management strategies are established by the CA and the CRG, and implemented tactically by the SRC, all in accordance with the credit-risk management objectives and credit policy of Banco do Brasil. The CRG consists of the President and Vice Presidents of the units involved with credit-risk management. The Committee sets strategies for credit-risk management, defines overall exposure limits, and approves capital allocation. The SRC was created to make faster decisions about credit-risk management. It is a tactical structure, subordinated to the CRG, which has delegated decision-making authority to deliberate on certain issues, instructing the CRG on other issues. Banco do Brasil S.A. 25

27 The SRC consists of officers from the units involved in credit-risk management, coordinated by the Director of the Risk Management Board. Credit-risk management strategies guide actions at the operational level. Strategic decisions include: a) materializing the risk appetite of Banco do Brasil; b) approving credit-risk management models; c) setting goals for fulfillment, recovery, maximum loss, and quality of the credit portfolio; d) setting risk and concentration limits; e) keeping adequate levels of allowances and capital; and f) management of the risk-return ratio. Management Processes According to Banco do Brasil s credit-risk management structure, the Credit (DICRE), Operational Asset Restructuring (DIRAO) and Risk Management (DIRIS) units are responsible for implementing strategic decisions approved by the CA, CRG and SRC, keeping exposure at the risk levels set by the executive management. The DICRE focuses on clients and operations. Its main products are: registration, marketing studies and information on economic sectors, methodologies (risk, risk components, and credit limits), risk analysis (clients, operations, projects, economic sectors, countries, and projects), pre-validation and monitoring of risk methodology and credit-risk components, study of investment and leasing transactions, economic/financial evaluation and diagnosis of businesses/business groups, monitoring the credit portfolio, and producing inputs to price credit risk. The DIRAO deals with, collects, and recovers problem credits. Its main products are: models to rate clients under collections and recovery, collection and recovery strategies, recovery quality indicators, management of collections and recovery channels, rescheduling debt, restructuring transactions, setting negotiating floors and methodologies for dealing with problem credits and/or defaults. The DIRIS focuses on managing the credit risk of aggregate positions. Its main products are: policies, risk limits, credit risk models, information on credit risk, indicators of credit portfolio quality, capital allocation as a function of risk, management of the credit portfolio s risk, and monitoring of risk versus return. Banco do Brasil S.A. 26

28 DICRE DIRAO DIRIS Prepare sector studies and a panorama Manage default portfolio Control risk limits for aggregate exposure Analyze clients and set limits Develop models and strategies to deal with, collect, and recover problem credits Determine regulatory capital for credit risk Analyze credit risk of transactions Manage collection and recovery channels Determine economic capital for credit risk Create and monitor creditrisk methodologies Propose strategies to pursue debts in higher courts Manage credit portfolio Figure 7. Credit-risk management structure The processes and procedures of the credit-risk management structure are validated and evaluated by two internal units at different points in time, a fact that ensures adequate separation of duties and the independence of work. The Internal Control Board (DICOI) is responsible for validating the financial conglomerate s risk determination and measurement models and the bank s internal control system. Internal Audit (AUDIT) periodically evaluates credit-risk management processes to verify whether they are consistent with the strategic guidelines, credit policy, and internal rules. In addition to the units above, independent auditors analyze some of the processes and procedures of credit-risk management, helping to verify whether they are in accordance with regulatory requirements and internal definitions. Communication and Information Processes Disclosure of credit-risk information is a continual and ongoing process. The premises considered when selecting and disclosing information include: best practices, banking laws, user needs, the bank s interests, confidentiality, and the relevance of the information. The communication and information on credit-risk management is provided to internal and external clients, pursuant to the following processes: Banco do Brasil S.A. 27

29 Communication process for internal clients The operational units of the credit-risk management structure always communicate with upper management about risk exposure in order to monitor management actions and for executive management to make decisions. The communication process involves several reports on credit-risk management. These documents are produced periodically and are the result of analyses done by professionals from the units. They demonstrate the credit risk of all exposure or in certain portfolios, such as: a) Credit Risk Exposure Portfolio Report; b) BB vs. SFN Comparison Report (BACEN data); c) Bank Comparison Report (accounting data from banks); d) Capital Management Report; e) Risk-Return Analysis of the Credit Portfolio; f) Stress Monitoring Report; and g) Risk Panel. Communication process for external clients The operational units of the credit-risk management structure produce information for external users and send it to the Investor Relations Unit (IRU). The IRU discloses this information to the market, as a transparent governance practice, allowing investors and interested parties to monitor risk-management actions and the evolution of credit risk, and to prove the bank s capital adequacy to cover all of the risks that it has assumed. Information for external users is provided on a publicly accessible location, easily found on the bank s website. The following documents are published: a) Performance Analysis Report; b) Notes to the Financial Statements; and c) Annual Report. Measurement Systems Credit risk is measured in many ways: by default, arrears, portfolio quality, allowance for doubtful accounts, concentration, expected losses, and regulatory and economic capital requirements, among others. The quantity and nature of our operations, the diversity and complexity of our products and services, and the volume exposed to credit risk require systematic measurement of credit risk at Banco do Brasil. The bank has enough databases and corporate-system infrastructure to ensure comprehensive measurement of credit risk. Some of these risk measures are highlighted below. Banco do Brasil S.A. 28

30 Concentration The bank developed and implemented a system to measure and monitor credit-risk concentration in the corporate portfolio. The model is based on the Herfindahl Index. It evaluates concentration based on borrowers credit risk, and it considers the interrelationship of the various economic sectors that comprise the corporate credit portfolio. Expected Loss The bank also developed specific methodologies and proprietary systems to determine risk components 1 that are used to determine expected loss and economic capital. Expected loss is used in numerous processes and procedures, such as: pricing products and services, verifying allowance levels, and calculating riskadjusted return on capital (RAROC). In addition, an analysis of historic expected loss provides important information about the behavior of credit risk. Regulatory and Economic Capital Requirements The bank measures the regulatory capital requirements for credit risk through a standard simplified approach, whose procedures for calculating Risk-Weighted Exposure were published by the BACEN in Circular 3.360/07, and updates. These procedures were implemented in a proprietary system that determines the capital requirements quickly and securely, allowing for timely verification of the bank s solvency under the regulator s rules. The bank uses regulatory-capital information to assess the efficiency of capital allocation and planning. The bank developed an internal model to measure economic capital whose theoretical foundation is based on an actuarial approach that is now very widely used in the banking industry. Because it was modeled internally, this measure better reflects the risk profile of exposure, which is why it is used managerially in calculating RAROC and in measuring the Herfindahl concentration index. Additionally, the analysis of the historic evolution of economic capital provides important information on capital consumption resulting from exposure of certain clients and/or segments of clients. 1 It is in the refining stage, to comply with regulatory requirements. Banco do Brasil S.A. 29

31 Mitigation Policy Banco do Brasil has a conservative attitude toward credit risk. When doing any business subject to credit risk, the bank s general rule is to tie it to a mechanism that will provide partial or complete hedging of the risk incurred. In managing credit risk on the aggregate level, to keep exposure within the risk levels determined by executive management, the bank seeks to transfer or to share credit risk. The use of credit-risk mitigating instruments is stated in the credit policy, present in strategic decisions, and formalized in credit rules, affecting all levels of the organization and covering all stages of credit-risk management. Credit rules provide clear, comprehensive guidelines for the operational units. Among other aspects, the rules address ratings, requirements, choices, assessments, formalization, control, and reinforcement of guarantees, assuring the adequacy and sufficiency of the mitigator throughout the transaction s cycle. Strategies to Monitor the Effectiveness of Mitigators Strategies that monitor the effectiveness of credit-risk mitigation consist of: a) continually monitoring credit-risk exposure and comparing the default index with the level of allowances for exposure, with and without related guarantees; b) constantly managing capital and comparing regulatory capital requirements with economic capital consumption of exposure, with and without related guarantees; and c) periodically evaluating information from collection and recovery of credits and determining which mitigators contribute effectively to exercising the bank s rights. Processes for Monitoring the Effectiveness of Mitigators Monitoring the effectiveness of mitigators is part of the bank s credit-risk management processes. For example, there are the processes to monitor credit-risk exposure, the risk ratings of credit transactions, capital management, and collections and recovery of credits. The processes of monitoring credit-risk exposure and rating credit-transaction risks produce important information for verifying the effectiveness of mitigating instruments. A low default index in certain segments of the credit portfolio and a low level of allowances in certain transactions may mean that the existence of guarantees tied to exposure is lowering credit risk. The capital management process allows for verifying whether a lower regulatory capital requirement and/or less consumption of economic capital in a given product or service is related to the existence of guarantees tied to exposure to credit risk, lowering the bank s exposure to credit risk. The process of collecting and recovering credits generates information that enables the bank to verify which mitigating factors were the most important for receiving credits in default and for recovering problem credits, allowing for a revision of the criteria for choosing guarantees, allowances, and capital allocation. Banco do Brasil S.A. 30

32 Credit Risk Exposure Exposure by Risk-Weighted and Average Exposure for the Quarter Below is the evolution of credit-risk exposure, abiding by the definitions in BACEN Circular 3.360/07, segmented by risk-weighted factor, along with the average exposure for the quarter. Table 2. Credit-risk exposure by Risk Weights Table 3. Average credit-risk exposure in each quarter Banco do Brasil S.A. 31

33 Exposure by country and geographic region The table below shows the credit-risk exposure, separated by geographic regions and countries. Table 4. Credit-risk exposure by geographic region and country Banco do Brasil S.A. 32

34 Exposure by economic sector Below is the evolution of total credit-risk exposure, separated by economic sector. Table 5. Credit-risk exposure of the financial conglomerate by economic sector Banco do Brasil S.A. 33

35 Table 6. Credit-risk exposure of the economic-financial consolidated group by sector Credit-risk exposure by arrears period The table below shows the portfolio, by arrears period. Table 7. Amount of transactions in arrears Banco do Brasil S.A. 34

36 Exposure by borrower Below are the concentration levels of the ten biggest clients in relation to the total from lending transactions. Table 8. Concentration levels of the ten biggest clients in relation to the total from lending transactions Transactions written-off The table below shows the flow of transactions written off, by quarter Table 9. Flow of transactions written-off Allowance for Doubtful Accounts Below is the stock of allowances for doubtful accounts. Table 10. Stock of allowances for doubtful accounts Banco do Brasil S.A. 35

37 Sale or Transfer of Financial Assets It is BB s policy to assign credits from non-performing retail loans, recorded in losses and for which the bank has full risk, after all collection procedures defined in the collections and credit-recovery process have been exhausted, and the selected transactions have reached the savings point, that is, the cost-benefit ratio does not justify keeping the transactions under collections at a commercial bank. Credit assignment is also used punctually to dispose of specific credits, when such an operation is considered a viable alternative for its recovery, even if partial. Below we show the flow of operations ceded with substantial transfer of risks and benefits. Table 11. Loss operations assigned, with substantial transfer of risks and benefits BB has no exposure in the following categories: a) exposures assigned with no substantial transfer or retention of risks and benefits; b) exposures assigned with substantial retention of risks and benefits; and c) exposures assigned in the quarter with substantial retention of risks and benefits, which were written down as losses. Securities (TVM) operations derived from securitization processes The securities acquired by BB are classified in the following categories: a) category I - securities for trading - securities acquired with the intent of actively and frequently trading them must be registered here; b) category II - securities available for sale - securities that do not fall under categories I or III must be registered here; and c) category III - securities held until maturity securities, except non-redeemable shares, which the institution has the intent and financial capacity to keep in its portfolio until maturity must be registered here. Following are the exposures due to TVM operations derived from securitization processes. a) types of securities: i. Receivables Investment Funds (FIDC) = resource pool that allots most of its net assets to be applied in receivables. These are the rights and securities representing rights arising from operations carried out in the financial, commercial, industrial and real-estate, mortgage, financial leasing, and service-provision sectors, as well as other financial assets and investment modes admitted under the terms of CVM Instructions Nos. 356/2001 and 444/2006; and ii. Real Estate Receivables Certificates (CRI) = these are fixed-income securities collateralized by real estate credits - flows of payments for Banco do Brasil S.A. 36

38 consideration for purchase of real estate properties or rent - issued by securitization companies. Table 12. Value of the exposures derived from acquiring FIDC and CRI b) type of credit collateralizing the issue: i. FIDC = financing of vehicles, company cash flow receivables, debentures, promissory notes, bank credit certificates, bank credit bill certificates, real estate credit certificates, real estate letters of credit, export and other credit rights credit bills; and ii. CRI = real estate credit operations. c) type of security: i. FIDC and CRI = senior quota. Exposure to counterparty credit risks Banco do Brasil admits assuming counterparty credit risks with clients which have been previously analyzed by the risk calculation methodology, with a credit limit applicable to their profile established, subject to the existence of a sufficient operational margin to cover such operations. In this way, the counterparty credit risk exposures fall in line with other exposures in client credit risk operations, within the limits attributed to each client. In the event of a default, these types of operations affect the client s credit risk according to the estimated value of the counterparty credit risk exposure--applicable credit risk mitigators being taken into consideration, such as the adjacent asset issuer risk, the volatility of the asset, the guarantees given, the haircut, and the rules for additional guarantee margin calls, according to the characteristics of the operation being affected. In Clearings operations, there is a risk transfer, in that the value of the operations is reflected in the credit limit of said clearinghouse. The approval of operations is dependent, at least, on the guarantees required by the credit limit order, or on those defined as mandatory by the credit line, being that the level of demand for guarantees varies according to the client s credit risk. When giving guarantees, preference is given: a) to goods acquired with, produced by, or benefiting from the credit; b) to guarantees that give the operation self-liquidity; c) to goods that are easily commercialized and non-perishable; d) to goods of the same type, kind and category as the goods to be acquired or realized with the credit; and Banco do Brasil S.A. 37

39 e) to goods that will produce income to pay for the operation. In order to earmark goods as a guaranty, they are valued by a technical appraisal or by an opinion of value, the validity of which is up to twelve months. In the case of a personal guaranty, the economic-financial situation of guarantors or sureties is analyzed, as are the Bank s direct and indirect liabilities, with debts to third parties being taken into account, especially tax, social welfare, and labor debts. When accepting a good or right as guaranty, the maximum value considered is reached by applying a percentage on the value of said good or right, according to the type and kind of good. In the case of a trade bill or check in custody, the maximum value is obtained by applying the percentage of advance corresponding to the Annual Liquidity Ratio (ILA) of the client s portfolio on the amount given as a guaranty. Goods received as guaranty in credit operations must be backed until the operation is concluded, or, in the case of funds given as guaranty, remain frozen until the operation is concluded. Guarantees linked to credit operations are registered on a corporate basis, which allows automatic control of the linked goods and rights, and the generation of administrative information, such as the guaranty sufficiency analysis, and an adequacy analysis. For operations subject to counterparty credit risks, Banco do Brasil follows the provisions of BACEN Circular 3,068/01, using such risks as a parameter when adjusting the market value of such exposures, which affects the profit/loss for the period, or a Net Worth highlighted account, subject to the exposure s classification. Below is the notional value of contracts subject to counterparty credit risks to be liquidated in clearing house liquidation systems, in which the house acts as central counterparty. Table 13. Notional value of contracts to be liquidated in clearing house liquidation systems, in which the house acts as central counterparty Below is the notional value of contracts subject to counterparty credit risks in which clearing houses do not act as central counterparty. Banco do Brasil S.A. 38

40 Table 14. Notional value of contracts subject to counterparty credit risks in which clearing houses do not act as central counterparty The following tables show the notional value of contracts where clearing houses did not act as central counterpart, divided between those that do and do not have guarantees. Table 15. Notional value of contracts where clearing houses did not act as central counterparty, and which do not have guarantees active position Banco do Brasil S.A. 39

41 Table 16. Notional value of contracts where clearing houses did not act as central counterparty, and which do have guarantees long and short positions The following table shows the positive gross value of contracts subject to counterparty credit risks, including derivatives, outstanding operations, asset loans and repo transactions, not taking into account the positive values from compensation agreements, as set forth in CMN Resolution 3.263/05. Banco do Brasil S.A. 40

42 Table 17. Positive gross value of contracts subject to counterparty credit risks, not taking into account the positive values from compensation agreements, as set forth in CMN Resolution 3.263/05 Following is the value of guarantees which cumulatively meet the following requirements, as per paragraph VI, Article 8, of BACEN Circular 3.477/09: a) are kept or held in custody by the institution itself; b) whose exclusive purpose is to guarantee operations to which they are linked; c) are only subject to movement by order from the depositary institution; and d) are immediately available to the depositary institution in the event that the debtor defaults or they need to be realized. Table 18. The value of guarantees which cumulatively meet the requirements of paragraph VI, Article 8, of Bacen Circular 3.477/09 Banco do Brasil S.A. 41

43 According to the classification of types of guarantees adopted by the BACEN, we have identified those which cumulatively meet the conditions established in BACEN Circular 3.477/09, being that for this calculation we have considered the value committed as guaranty to the linked operation. BB has no compensation and liquidation of obligations agreements, as defined in CMN Resolution 3.263/05. The table below shows the notional value of credit derivatives, divided by type of operation. Table 19. Notional value of credit derivatives Mitigating instruments When accepting guarantees in credit operations, preference is given to guarantees which help the operation self-liquidate. In order to accept a guaranty, the maximum value considered is reached by applying a certain percentage on the value of said good or right. The following goods or rights are considered with a 100.0% advance: a) receivables represented by RDB, CDB, savings, fixed income investment funds, and Pledge Agreements - cash collateral, gold deposits or ingots, and Standby Letters of Credit; b) Guaranty funds: Guaranty Fund for Creation of Jobs and Income (Funproger), Guaranty Fund for Small Companies (Fampe), and Operations Guaranty Fund (FGO), Investment Guarantee Fund (FGI), among others; and c) guaranty given by a banking institution that has a credit limit with the Bank with sufficient margin to back the joint liability, and credit insurance. The credit rights guarantees represented by financial investments must be internalized at the Bank and are blocked by the institution. This block must remain until the operation is concluded. When the financial investment matures, the Bank may, at its discretion, use it to liquidate the balance of remaining installments, with no notice or notification to the assignor/borrower. Besides credit assignment or credit rights assignment clauses, the credit instrument-- for linked mitigators--the credit instrument has a guarantee reinforcement clause to ensure, for the duration of the operation, the coverage percentage agreed on when it was contracted. Banco do Brasil S.A. 42

44 The manager of guarantee funds such as Funproger, FGO, and FGI, among others, is Banco do Brasil. Fampe is managed by Sebrae, as a financial agent. These funds are used as guarantees by the Bank, mitigating the risk of operations, and have the following characteristics: a) maximum coverage percentage limits when using the fund to back operations, according to the type of operation: Investment or Working Capital; b) target market, according to the billing or the client s risk; c) whether or not a counter guarantee was given; d) maximum limits on the amount of resources that constitute the Fund s Net Worth (Leverage Ratio); and e) limits for accrued losses, or, the Stop Loss Limits. Guarantee fund managers keep up with whether an operation falls under the funds rules before granting them in guarantees, as well as manage guarantee operations and fund assets, freezing the use of these funds in guarantee operations, if necessary, before the amount of linked resources surpasses the leverage established for each fund. Considering the credit risk mitigating instruments defined in articles 20 to 22 of BACEN Circular 3.360/07, the following table shows the total mitigated value in terms of exposure, weighted according to risk factors, and segmented by the mitigator type and FPR. Table 20. Mitigated value of exposure, weighted by respective risk factors Banco do Brasil S.A. 43

45 8.1.2 Market and Liquidity Risks Management Objectives The objective of Banco do Brasil s market and liquidity risk management process is to identify, assess, monitor, and control risks related to each individual institution, and to the financial conglomerate, as well as identify and monitor the risks associated with the rest of the companies who are part of the consolidated economic and financial. In line with best practices in the market, the Bank regularly uses procedures that enable managing the market and liquidity risks of its positions, taking internal and external economic scenarios into account and aiming to minimize possible effects on the net financials. Management Policies and Strategies The Bank has established policies and strategies for managing market and liquidity risks, and to manage derivative financial instruments. These policies and strategies determine the Company s operating directives in the risk management process. In the scope of Banco do Brasil s market and liquidity risks management policies and strategies, the general principle adopted is that the liquidity and market risks management model s purpose is to identify, assess, monitor, and control the market and liquidity risk exposures of its own positions. Additionally, the market and liquidity risks management process uses mechanisms set forth in regulatory systems which detail the operational procedures necessary to implement the organizational decisions related to the Company s business and activities and to meet legal, as well as regulatory and oversight bodies requirements. Finally, note that in market and liquidity risks management, systems are used that guarantee that positions registered in negotiable and non-negotiable portfolios are measured, monitored, and controlled, as are operations aimed at meeting the hedge objectives established. Regarding the use of derivative financial instruments, the Bank stipulates in its strategies and policies that operations to meet clients needs and to manage its own positions are to be carried out, taking into consideration the many risk categories and adopting a consolidated vision of the different risk factors. It s also worth noting that negotiating with derivative financial instruments is subject to prior evaluation of the nature and scale of risks involved. The tables below represent the entire exposure to derivative financial instruments by category of market risk factor, segmented into positions bought and sold in the following way: a) derivative financial instrument transactions carried out with a central counterparty, subdivided into those in Brazil and those abroad; and b) derivative financial instrument transactions carried out without a central counterparty, subdivided into those in Brazil and those abroad. Banco do Brasil S.A. 44

46 Table 21. Derivative financial instruments in the country and abroad 4Q10 Table 22. Derivative financial instruments in the country and abroad 1Q11 Banco do Brasil S.A. 45

47 Table 23. Derivative financial instruments in the country and abroad 2Q11 Table 24. Derivative financial instruments in the country and abroad 3Q11 Banco do Brasil S.A. 46

48 Table 25. Derivative financial instruments in the country and abroad 4Q11 Hedge Policies Regarding hedge policies adopted for market and liquidity risk management, the consolidated hedge operations objectives for the entire Financial Conglomerate are set, with individual operational efficiency guaranteed and local regulations observed, in the case of foreign offices. Operations with derivative financial instruments with the objective of hedging are separated from those not intended for hedging, both of which have their own limits and objectives. Communication and Notification Process Proposals for market and liquidity risk limits are submitted by the Risk Management Director to group and book managers, taking into account the set global limits and risk appetite. These limit proposals are formalized in technical notes. When regular strategic market risk committee (Global Risk Committee - CRG and Subcommittee for Market and Liquidity Risk - SRML) meetings are held, the technical notes are submitted for approval, and then new limits go into effect, if approved. After approval by the competent bodies, the limits are managed by the Risk Management Director (DIRIS). Group and book managers linked to Negotiable and Non-negotiable Portfolios receive the limit usage report daily, supported by Banco do Brasil s intranet. Note that, in the event that limits are exceeded, DIRIS, which is responsible for controlling and monitoring a portfolio which exceeds its limit, issues a document named Record of Limit Exceeded. Next, the group and book manager must present his/her justifications for exceeding the limits, and specify a deadline to regularize the situation. In turn, the hierarchical Banco do Brasil S.A. 47

49 level responsible for conducting the case must issue a finding on the manager s declaration. Finally, the team responsible for monitoring the limit monitors the regularization actions. The process of communicating the risks incurred by the Bank to the Top Management occurs in regular meetings of the Strategic Risks Committees and Subcommittees, which are ordinarily held every month. Measurement Systems The market and liquidity risk measurement process uses corporate systems and the Riskwatch market risk analytics application, developed by Algorithmics, a Canadian company. The IT infrastructure for the market risk measurement process is installed at facilities located in Brasília (DF), and Rio de Janeiro (RJ). Market Risk Management Process Banco do Brasil uses statistical and simulation methods to analyze the market risk of its exposures. Of the metrics used in the application of these methods, we highlight the following: a) sensitivities; b) Value at Risk (VaR); and, c) stress. Sensitivity metrics simulate the effects on the value of exposures resulting from variations in the level of market risk factors. VaR is a metric used to assess the potential loss under routine market conditions, dimensioned daily in monetary values, under a set confidence interval and time frame. The risk factors used in VaR metrics to analyze the market risk of exposures are classified into the following categories: a) interest rates; b) exchange rates; c) share prices; and, d) commodity prices. The VaR metrics performance is assessed monthly by a backtesting process. This assessment is segregated from the processes for development and use of VaR metrics. Finally, BB uses stress metrics resulting from simulations on the behavior of its exposures subject to market risks under extreme conditions, such as financial crises and economic shocks. The objective of stress tests is to calculate the impact of events which are plausible, but very unlikely to occur, on regulatory and economic capital requirements. Stress tests include exposure simulations, both retrospective-- based on historical series of shocks to market risk factors--and prospective--based on projected economic and financial scenarios. For more information on the sensitivities, VaR, and stress metrics, visit our website at bb.com.br/relações com investidores, at the Análise do Desempenho (Performance Banco do Brasil S.A. 48

50 Analysis) link, chapter 8: Gestão dos Riscos Risco de Mercado (Risk Management - Market Risk). The models used to measure market risks are subjected to independent validation, the structure of which is kept separate from the divisions responsible for the development and use of the models. In turn, the independent validation process for models is subjected to independent assessment, conducted by Internal Auditing. Therefore, it is seen that Banco do Brasil uses three layers of control over its market risk measurement models, which are the following: a) 1st Layer: development and use of models; b) 2nd Layer: validation of models; and, c) 3rd Layer: assessment of model validation. The Bank has a liquidity and market risk management structure, represented by the Risk Management Director, which is compatible with the characteristics of the Bank s operations and segregated from business units and from the Internal Auditing Unit. Among Diris responsibilities in managing market and liquidity risks, some stand out, namely: the proposal of policies, directives, methodologies, and market risk limits, the identification, assessment, monitoring, and control of the Financial Conglomerate s market and liquidity risks. In the financial risk management process, the decisionmaking, execution, and control functions are segregated in the organizational structure. Negotiable Portfolios The Bank s market risk management processes own positions are divided into Negotiable Portfolios and Non-negotiable Portfolios. In a resolution issued by the Global Risk Committee (CRG), a policy for classification of operations in the negotiable portfolio was stipulated. This document defines that, for the Financial Conglomerate, Negotiable Portfolios include all operations in own positions carried out with the intent to negotiate, or intended to hedge the negotiable portfolio and intended for negotiation before their contractual deadline, given normal market conditions, and which are not non-negotiable. To analyze the VaR of the Negotiable Portfolio, Banco do Brasil adopts the Historical Simulation technique, and the following parameters: a) 99% one-sided confidence interval; b) 252 retrospective scenarios of daily shock factors; and, c) a time frame of 10 business days. The following tables show the total value of the Negotiable Portfolio by relevant market risk factor, for the base dates of 12/31/2009 to 12/31/2010, divided into positions bought and positions sold. Banco do Brasil S.A. 49

51 Table 26. Total value of the Negotiable Portfolio by relevant market risk factor 4Q10 Table 27. Total value of the Negotiable Portfolio by relevant market risk factor 1Q11 Table 28. Total value of the Negotiable Portfolio by relevant market risk factor 2Q11 Table 29. Total value of the Negotiable Portfolio by relevant market risk factor 3Q11 Banco do Brasil S.A. 50

52 Table 30. Total value of the Negotiable Portfolio by relevant market risk factor 4Q11 Non-negotiable Portfolios The Financial Conglomerate s own operations positions not classified under the Negotiable Portfolio are considered components of the Non-negotiable Portfolio. Note too that the own positions held by the companies that are not a part of the Financial Conglomerate cannot be classified under the Negotiable Portfolio. To analyze the VaR of the Non-negotiable Portfolio, Banco do Brasil adopts the Historical Simulation technique, and the following parameters: a) 99% one-sided confidence interval; b) 1,260 retrospective scenarios of daily shock factors; and, c) a time frame of 10 business days. Among other aspects, it s worth noting that the Historical Simulation VaR technique: a) includes all operations which are sensitive to variations in interest rates, and uses widely accepted risk-measurement techniques and financial concepts; b) considers data on fees, deadlines, prices, optionalities, and other suitably specified information; c) requires that suitable premises be defined to transform positions into cash flow; d) measures sensitivity to changes in the temporal structure of interest rates, between the different rate frameworks and in the premises; e) is integrated into daily risk management practices; f) allows the simulation of extreme market conditions (stress tests); and, g) allows an estimation of the Referential Equity (PR) that is compatible with the risks, as determined in Article 3 of CMN Resolution 3.490/07. Banco do Brasil uses statistical and econometric methods, as referenced in literature, to analyze temporal series, more specifically, methods known as ARIMA (Autoregressive, Integrated, and Moving Average) to handle products with no set maturity. In line with the Historical Simulation methodology adopted by Banco do Brasil to calculate the Value-at-Risk (VaR) metrics, the models for products with no set maturity assume the hypothesis that the retrospective behavior of the variations observed in the balances is relevant to forecasting the future behavior of cash flow from redemptions (random variable of interest) of the balances of the deposit products referenced. Therefore, such methods assume the possibility of future balance (financial amount of partial redemptions) fluctuations with a scope similar to that observed in the historical series. Banco do Brasil S.A. 51

53 The criteria for identifying operations that fall under the classification of the Nonnegotiable Portfolio follow the definitions and objectives defined in the resolution issued by the Global Risk Committee. It s also worth noting that the definitions, criteria, and procedures established must be reviewed annually. The Negotiable and Non-negotiable Portfolios are divided into Groups and Books, always observing the internal norms (technical notes and resolutions) approved by the Liquidity and Market Risks Subcommittee (SRML) and by the Global Risk Committee (CRG), which establish the objectives, makeup, financial limits, and market and liquidity risk limits for each Group or Book. The main types of limits used for market risk management are: a) Value-at-Risk VaR; and, b) Stress. In order to provide suitable conditions for assessing the capacity for loss absorption and identifying future risk reduction measures, global limits are defined as a percentage of Referential Equity (PR). The VaR and Stressed VaR metrics are used to demonstrate the level of market risk generated by exposures, and the respective effect in terms of capital required to cover said risk, for the VaR limits of the Negotiable Portfolio. Liquidity Risk Management Process Banco do Brasil maintains liquidity levels suitable to the Institution s commitments in Brazil and abroad, which are the result of its broad and diversified base of depositors, the quality of its assets, the capillarity of its network of external offices and of its access to international capital markets. The strict liquidity risk control is in line with the Liquidity and Market Risks Policy established for the Conglomerate, meeting the requirements of national banking oversight, as well as of the other countries in which the Bank operates. Banco dobrasil s liquidity risk management segregates the liquidity in Reais from the liquidity in Foreign Currencies. For this, the following instruments are used: a) Maps of Deadline Gaps; b) Short, Medium, and Long-term Liquidity Projections; c) Stress test; d) Liquidity Risk Limits; e) Liquidity Contingency Plan; and, f) Liquidity Contingency Measures Potential Test. The liquidity risk management instruments are regularly monitored and reported to the institutions Strategic Committees. Deadline Gap Maps show expected contractual payments and receivables, distributed in previously defined time intervals, and presented both jointly and in detail by operation indexer. Deadline Gap Maps are analyzed in order to determine the contractual cash flow of the institution at a set date. Short, Medium, and Long-term Liquidity Projections allow a prospective assessment of the effect of the gap between deposits and investments, with the objective of Banco do Brasil S.A. 52

54 identifying situations that may compromise the liquidity of the Institution, taking into account both budgetary planning and market conditions. Periodically, Short-term Liquidity Projections are assessed under alternative and stress scenarios. If the result of any of these liquidity projection scenarios is below the adopted liquidity level limit, then the previously established Contingency Measures Potential is put into effect, in order to recover the Institutions liquidity. Furthermore, Banco do Brasil uses the following metrics: a) Liquidity Reserves (RL); and, b) Free Resources Statement (DRL). Liquidity Reserves is the metric used in short-term liquidity risk management. It is the minimum level of high liquidity assets the Bank must maintain, compatible with the risk exposure due to the nature of its operations and market conditions. The Liquidity Reserves methodology is used as a parameter to identify a liquidity contingency and to activate the Liquidity Contingency Plan, and is monitored daily. The Availability of Free Resources (DRL) indicator, used in planning and in the execution of its annual budget, is intended to ensure a balance between resources deposited and resources invested, with a focus on Commercial Divisions and on guaranteeing liquidity financing. The DRL limit used to guide the execution and planning of the budget, according to the deposit and investment goals, is defined annually by the Global Risk Committee (CRG), and is monitored monthly. The Liquidity Contingency Plan, in turn, establishes a set of procedures and responsibilities to be adopted in liquidity contingency situations. In the event of a liquidity contingency, one or more contingency measures can be adopted in order to safeguard the institution s ability to pay. The liquidity contingency measures are assessed monthly Operational Risk Management Objectives In compliance with Article 4 of CMN Resolution 3.380/06, Banco do Brasil s operational risk management structure is composed of the Risk Management Unit (DIRIS), Internal Controls Unit (DICOI) and Security Management Unit (DIGES), all of them linked to the Vice Presidency of Internal Controls and Risk Management - VICRI. The Board of Directors (CA) is responsible for this information published. The Risk Management Director, by recommendation of the Administration Council, is responsible to the Banco Central do Brasil (BACEN), for managing Banco do Brasil s operational risks. Banco do Brasil S.A. 53

55 The chart below shows the main responsibilities of the divisions that comprise the operational risk management structure. DIRIS DICOI DIGES Operational Risk standards and policies Compliance, process and business failures Corporate security governance Establishment and control of RO limits KRI establishment and control RO capital allocation models and methodologies Operational Risk Measurement Support for divisions managing products and services Backtesting Compliance policies Policies, methodologies, standards, and plans regarding safety, fraud, money laundering, and business continuity Figure 8. Operational risk management structure Internal Audit responsible for verifying operational risk management and that its structure is functioning. It should be noted that the operational risk analysis process is assessed by external auditors, and the results are submitted to the Executive Board, Fiscal Council and Board of Directors. In order to guarantee efficiency in the management of BB s operational risk, as well as to ensure that each division performs the functions it s responsible for, five management phases were defined. The main activities linked to each phase are summarized in the table below: Table 31. Phases of the operational risk management process Management Phase Identification Evaluation and assessment Mitigation Control Monitoring Summary of activities Determine the vulnerabilities in the Bank s processes and in relevant services performed by third parties, as well as identify loss events related to these. Propose Exposure Limits and Key Risk Indicators (ICR), capture loss events and calculate capital to be allocated to operational risk. Develop mechanisms and action plans to mitigate operational risks identified, and create business continuity plans. Monitor mitigation actions; propose, implement, and monitor control actions; determine the level of compliance of processes; backtesting. Monitor operational loss events, the behavior of Key Risk Indicators (ICR), exposure limits, as well as of the existence of internal controls and business continuity plans. The activities linked to each phase have predefined responsibilities, either individually or in combination, involving product and service managers and the Risk Management, Internal Controls, and Security Management Units. Banco do Brasil S.A. 54

56 Operational Risk Policy The Operational Risk Policy that is reviewed and approved annually by the Board of Directors (CA) contains instructions for the Bank s divisions, the purpose of which is to guarantee the effectiveness of the operational risk management model. This Policy, which adheres to the recommendations in Basel II and the requirements of CMN Resolution 3.380/06, pervades all activities related to operational risk management, with the objective of identifying, evaluating/assessing, mitigating, controlling, and monitoring the operational risks inherent to products, services, processes and systems within the scope of Banco do Brasil, its Wholly-owned Subsidiaries, and Financial Conglomerate Subsidiaries. The Operational Risk Policy includes guidelines that involve the main management instruments, the composition of the Internal Database, the calculation of expected and unexpected losses, and documentation and reporting to various levels of the Bank and the general public of the main aspects involved in operational risk management. Management Processes and Strategies Banco do Brasil s objective is to manage its operational risks conservatively, segregating the risk management and business functions. For this, the Bank adopts best practices in risk management, observing the norms and directives of banking oversight and regulation. The Bank s current Strategic Planning, composed of the Long-term Plan and the Directive Plan Master , approved by the Board of Directors (CA), includes operational risk among internal processes, aiming to reduce losses, as measured by the Global Operational Loss Limit. Currently, in order to be qualified to use the advanced operational risk measurement model, Banco do Brasil has concentrated its efforts on managing its operational risks, based on using the four essential elements to achieve a desired standard strength, which are: an internal database, external database, scenario analysis, and the factors that reflect the Bank s business environment and internal controls (BEICF Business Environment and Internal Control Factors). Strategic management is done by the Global Risk Committee (CRG), composed of the Chairman and Vice Chairmen of different divisions, whose purpose is to decide on risk policies and directives. In particular, this Committee sets and monitors the global risk limits. In an effort to speed up the management process, the Bank uses the Operational Risk Subcommittee to monitor operational risk in a consolidated way, at least every month, and to propose measures to keep it within the risk tolerance predefined by the Bank s Top Management. Communication and Notification Processes The operational risk communication and notification process aims to maintain effective reporting channels that ensure that all employees at all hierarchical levels Banco do Brasil S.A. 55

57 have access to the operational risk management policies, norms, and procedures, as does the general public, by means of quarterly and semiannual reports made available on the Bank s website. Every month, members of the Global Risk Committee (CRG) and of the Operational Risk Subcommittee (SRO) receive details of losses and Key Risk Indicators related to static and dynamic positions, qualitative and quantitative assessments, and global and specific limits. CRG and SRO s functional dynamics give the strategic levels represented by executive directors of the divisions represented in these forums access to operational risk information that enables the Bank s decision-making process to function. Measurement Systems CMN Resolution 3.490/07 established the inclusion of the Operational Risk Factor (P_OPR) in the calculation of the Required Reference Equity (PRE). BACEN defined the procedures for calculating the P_OPR portion and the composition of the Operational Risk Exposure Indicator (IE) in Circular 3.383/08 and Letter-Circulars 3.315/08 and 3.316/08. Regarding measurement approaches, in Circular 3.383/08, BACEN provides financial institutions the calculation of the P_OPR portion based on one of the following approaches: Basic Indicator, Standardized Alternative and Simplified Standardized Alternative. BB decided to allocate capital for operational risks under the Standardized Alternative Approach, based on segregating the exposure indicator (IE) by lines of business. The implementation of internal models Advanced Approach (AMA) is currently under development, based on using the four essential elements to achieve a desired standard strength, which are: an internal database, external database, scenario analysis, and the factors that reflect the Bank s business environment and internal controls (BEICF Business Environment and Internal Control Factors). Mitigation Policy The divisions that manage processes, products, and services must create action plans and instruments to mitigate operational risk, based on the causes noted in the operational risk identification phase and on the decisions made by the Operational Risk Subcommittee (SRO) and/or the Global Risk Committee (CRG). If so requested, the Internal Controls (DICOI) and Security Management (DIGES) Units assist the manager in creating action plans to mitigate operational risks. Processes and Strategies to Monitor the Effectiveness of Mitigators The monitoring of operating losses in order to generate the due reports and activate the divisions that manage the processes, systems, products, or services when there is a need to propose mitigation actions is done by determining the value of losses monthly, in accordance with the Global Operational Loss Limit. Banco do Brasil S.A. 56

58 In order to make this monitoring even more effective, specific limits for the following operational risk event categories were adopted: a) Labor Problems b) Business-related Failures i. Economic Plans; ii. Collection and Loss Compensation; iii. Exclusion from Restrictive Registration; iv. Claims for Amounts Paid but not Owed (Contractual interest instrument); c) Fraud and External Theft i. External Theft; ii. External Electronic Fraud; iii. Losses with Cards; d) Failures in Processes i. Failures in Services; e) Internal Fraud. Every month, monitoring is performed by the Bank s risks unit, which reports to the Operational Risk Subcommittee (SRO) and to the Global Risk Committee (CRG). If any of the above Specific Limits are exceeded, an RTR is issued a Technical Risk Recommendation in which the limit manager must explain the reasons, as well as mitigating actions performed to bring the exceeded Limit back in line. The following table shows the monitoring of BB s operational losses performed in each risk event category, expressed in percentages. It s worth noting that, from the second quarter of 2010, BB started placing the creation/reversal of provisions in the total defined operational losses in the categories of Labor Issues and Business Failures. Table 32. Monitoring of operating losses Banco do Brasil S.A. 57

59 8.2 Non-financial Companies Banco do Brasil s Board of Directors has determined that non-financial companies that are part of the Consolidated Economic and Financial, in Brazil or abroad, must identify and monitor credit, market, and operational risks by means of their representatives in these companies Boards of Directors, or, in the lack of these, by members of the Executive Committee, using the instructions in the Corporate Risk Management Guide from the Brazilian Corporate Governance Institute (IBGC). Besides this, the Bank measures the required regulatory capital for the credit, market and operational risks of non-financial companies, ensuring that there is enough capital to cover these risks in the scope of the Consolidated Economic and Financial. Banco do Brasil S.A. 58

60 9. Capital 9.1 Regulatory Capital The implementation of the Basel II rules in Brazil, especially in regards to capital requirements, brought many changes to the method of measuring capital to back the risks inherent to banking activities. The implementation timetable for Basel II in Brazil was made official by BACEN in Communiqué 12,746/04, and was later adjusted in Communiqué 16,137/07. This schedule was set up in phases, establishing first, regarding capital requirements, the use of a standardized approach (defined by BACEN) and, finally, the use of advanced models. On 10/29/2009, in Communiqué 19,028, BACEN adjusted the previously published timetables in an attempt to complement the measures and procedures necessary for proper implementation of Basel II in Brazil. In order to govern the transition from Basel I to Basel II (standardized approach), BACEN published different rules on capital requirements (Pillar I), the oversight process and transparency of information (Pillars II and III). BB uses the Prudential Basel Index (IB) and the Regulatory Capital Forum, among other tools, to manage its regulatory capital. The Prudential IB represents the Bank s directive to maintain this index two points above the regulatory minimum, in order to cover the interest rate risk of operations not included in the negotiable portfolio ( portion) and to serve as a prudential margin to tackle other risks not considered in current capital requirements (Pillar II). This indicator is under review due to the new capital requirements under Basel III, which were defined in a preliminary manner in BACEN Communiqué 20,615/11. Representatives from different divisions of BB meet in the Regulatory Capital Forum monthly, with the intent of analyzing the behavior of and projections for the IB, the effects of modifications in the regulatory environment, and any measures to reconstitute the Prudential IB Referential Equity (PR) On 02/28/2007, the National Monetary Council approved changes to the rules for defining and determining the Referential Equity of financial institutions, in CMN Resolution No. 3,444/07. On 03/01/2007, Circular 3,343/07 was published by BACEN. It elaborates on the procedures to be adopted to request that deposit instruments be placed under Tier I and Tier II PR. For the purpose of verifying compliance with the operational limits of financial institutions, the PR is composed of the sum of Tier I and Tier II, minus the balance of the assets represented by the following deposit instruments issued by the financial institution: shares, hybrid capital and debt instruments, subordinate debt instruments, and other financial instruments described in CMN Resolution 3,444/07, article 12, and article 13, paragraph 3. Banco do Brasil S.A. 59

61 Only the accounting information and balances of Votorantim Bank are not included in the operational limit statements and risk management documents, as well as in the basis for determining the Bank s Basel Ratio. Table 33. Referential Equity Tier I Capital The capital of R$ 33,122,569 thousand (R$ 33,077,996 thousand on 12/31/2010) of Banco do Brasil is divided into 2,865,417,020 book-entry common shares without par value. The Federal Government is the largest shareholder, holding the control. The capital increased R$ 44,573 thousand in 2011 due to the exercise of subscription of 1,496,831 bonuses "C". The Bank may, even without amend bylaws, if approved by a General Meeting, and in the conditions established therein, increase its capital up to the limit of R$ 50 billion, by issuing common shares, granting shareholders preference for subscribing the capital increase proportionally to the number of held shares. Revaluation Reserves The revaluation reserves, totaling R$ 4,730 thousand (R$ 6,241 thousand on 12/31/2010), refer to revaluations of assets made by the associated/subsidiary companies. In the period, reserves were held totaling R$ 1,511 thousand. From this amount, R$ 328 thousand due to depreciations transferred to the "Retained Earning (accumulated losses)" and R$ 1,183 thousand due to the write-off of shareholding disposal of the BB Banco de Investimento in the Pronor Petroquímica. The remaining balance will be held until the date of the effective realization, in accordance to the CMN Resolution n. 3,565/2008. Revaluation Reserves are excluded from Tier I and added to Tier II for calculating the Referencial Equity. Banco do Brasil S.A. 60

62 Capital and Retained Earnings Table 34. Capital and Retained Earnings (1) In the consolidated balance, the Retained Earnings and the Statutory Reserve are respectively R$ 20,289,707 thousand and R$ 17,092,393 thousand, due to a elimination of a subsidiary unrealized result, valued at R$ 54,908 thousand. The objective of the Operating Margin Statutory Reserve is to guarantee an operating margin compatible with the operations the company is carrying out, and consists of up to 100% out of net profit, after legal allocations, including dividends, limited to 80% of the company s capital. The Dividend Equalization Statutory Reserve guarantees resources for the payment of dividends, and consists of up to 50% out of net profit, after legalallocations, including dividends, up to the limit of 20% of the company s capital. Equity valuation adjustments Table 35. Equity valuation adjustments Non Controlling Participation Table 36. Non Controlling Participation Banco do Brasil S.A. 61

63 Deferred Permanent Assets These refer to the values recorded under Deferred Permanent Assets, after deducting the premiums paid when acquiring investments, constituted from March 2, It mainly comprises the Company s restructuring costs, and the expenses incurred until 09/30/2008 in third-party real estate, arising from the installation of facilities, and the acquisition and development of systems. Adjustment to Market Value For Referential Equity calculation, the balance of non-realized gains and losses derived from the adjustment to market value of the securities classified under the category securities available for sale and of the derivative financial instruments used to hedge cash flow, constituted since March 2, 2007, is excluded from the Tier I calculation and included in Tier II. Tax Credits excluded from Tier I Refers to the tax credits recorded in the accounting books until 12/20/2002, including those derived from social contributions on the net profit for periods closed on 12/31/1998, with an expected realization timeframe exceeding five years. Hybrid Capital and Debt Instruments Tier I Hybrid Capital and Debt Instruments that meet CMN Resolution 3,444/2007 requirements can make up Tier I, so long as they are authorized by the Banco Central do Brasil, limited to 15% (fifteen percent) of the total of Tier I PR. Table 37. Perpetual Bonds The amount of R$2,718,895 thousand (R$2,414,830 thousand on 12/31/2010) of perpetual bonds comprises the Tier I Referential Equity, in compliance with CMN Resolution 3,444/2007. Tier II Subordinated debt Eligible as Capital Subordinated Debt Instruments that meet CMN Resolution 3,444/2007 requirements can make up Tier II, so long as they are authorized by the Banco Central do Brasil, limited to 50% (fifteen percent) of Tier I PR. A reducer will be applied to the value of subordinated debt instruments authorized to be a part of Tier II PR, according to the remaining time until maturity. Banco do Brasil S.A. 62

64 Table 38. Subordinated Debt Table 39. Subordinated Debt Eligible as Capital Hybrid Capital and Debt Instruments Tier II Hybrid Capital and Debt Instruments which meet CMN Resolution 3,444/2007 requirements can make up Tier II, so long as they are authorized by the Banco Central do Brasil. Table 40. Perpetual Bonds Banco do Brasil S.A. 63

65 The Bank settled, in January 2011, the US$ 500,000 thousand bonus, issued in January 2006, through the exercise of the redemption option provided in the operation. The amount of R$ 816,046 thousand of perpetual bonds comprises the Tier II Referential Equity, in 12/31/2010 according to the percepts of CMN Resolution 3,444/07. Referential Equity Deductions Financial Instruments excluded from the PR Since July 2, 2007, the balance of assets represented by the following deposit instruments issued by financial institutions and other institutions authorized to operate by the Banco Central do Brasil are deducted from the PR. Table 41. Financial Instruments excluded from the PR Table 42. PR historical series Financial Conglomerate Banco do Brasil S.A. 64

66 Table 43. PR historical series Consolidated Economic and Financial Required Referential Equity (PRE) The Required Referential Equity (PRE) is the equity required of institutions, financial conglomerates, and other institutions authorized by BACEN to function, to back the risks to which they are exposed due to the activities they are involved in. According to CMN Resolution 3,490/07, the PRE is made of the following parts: = , Credit Risk Market Risk Operational Risk where: = portion of exposures weighted by the risk weighting factor attributed to them; = portion of risk from exposures to gold, foreign currency, and in operations subject to exchange fluctuations; = portion of risk from operations subject to fluctuating interest rates and classified under the negotiable portfolio; = portion of risk from operations subject to commodity price fluctuations; = portion of risk from operations subject to share price fluctuations; and, = portion of operational risk. The tables below show the PRE of the Financial Conglomerate and the Consolidated Economic and Financial, by type of risk. Banco do Brasil S.A. 65

67 Table 44. Required Referential Equity for the Financial Conglomerate Table 45. Required Referential Equity for the Consolidated Economic Financial Banco do Brasil S.A. 66

68 9.1.3 Basel Index (IB) In compliance with the recommendations of the Basel Committee on Banking Supervision, BACEN established operational limits to be observed by financial institutions, among which the Basel Ratio (IB) stands out. The IB, defined by BACEN Circular 3,477/09, is calculated using the following formula: = where: = sum of the product of the exposures times the respective FPR, calculated according to BACEN Circular 3.360/07; = factor that applies to EPR, pursuant to BACEN Circular 3,360/07. The Basel Committee recommends a minimum IB of 8.0. In Brazil, the minimum ratio required is given by the factor, which currently equals BACEN has determined that financial institutions must permanently maintain a PR value above the PRE value, as per CMN Resolution 3,490/07. Besides this, it also established that institutions must maintain sufficient PR to back the interest rate risk of operations not included in the negotiable portfolio ( portion), called PR to PRE compatibility margin, which is calculated using the formula below: = ( + ) where: = Referential Equity, calculated according to CMN Resolution 3,444/07; = Required Referential Equity, calculated according to CMN Resolution 3,490/07; = capital to back the risk from operations subject to fluctuating interest rates not classified under the negotiable portfolio, as per CMN Resolution 3,464/07; The following tables show the progression of the Basel Ratio, of the portion, and of the PR compatibility margin. Banco do Brasil S.A. 67

69 Table 46. The Basel ratio and capital margin - Financial Conglomerate. Table 47. The Basel ratio and capital margin - Consolidated Economic and Financial Banco do Brasil S.A. 68

70 9.2 Economic Capital In its internal risk management processes, Banco do Brasil uses the economic capital concept. The following table shows the total economic capital requirement, segregated by type of risk. Table 48. Economic Capital Next is the economic capital required for credit risks, detailed by macro-sectors and by company or individual, not considering Banco Votorantim S.A. s operations. Table 49. Distribution of economic capital in the credit portfolio. Banco do Brasil S.A. 69