Basel II What does it mean for Canadian banks and investors?

Basel II What does it mean for Canadian banks and investors? Presented by: Vivek Wadhwa, McKinsey & Company January 25, 2008 1

Agenda Basel II Overview Background and Timing New Concepts Impact on Capital Building Blocks to Capital Calculations Supervisory Review and Sanity Checks Regulatory Capital - Basel I vs. Basel II Factors Contributing to Differences between FIs Reporting and disclosures Pillar 3 New Concepts and Disclosures Implications for Investors and FIs 2

Basel II Overview Scope New Basel Capital Framework (Basel II) applies to internationally active banks in the G10 Other countries can opt in a large number have indicated they will do so Objectives Establish capital requirements that are more sensitive to a bank's risk profile Confirm primary responsibility in determining the adequacy of a bank s capital and its capital assessment process rests with banks Require banks to provide greater disclosure to the public on their risk exposures (Pillar 3) Timing in Canada Parallel run completed October 31 07 Formal implementation as of November 1 07 Capital floors apply for a two-year transition period to 2009 fiscal year Market disclosure: Phased in over 2008 Full disclosure by end of fiscal 2008 3

Basel II Overview The Basel II Framework has three mutually reinforcing pillars New Basel Capital Accord Pillar 1 Pillar 2 Pillar 3 Minimum Capital Requirements Credit Risk Operational Risk Market Risk 98 Supervisory Review Internal Standards for Capital Assessment Market Disclosure Risk Assessment Capital Adequacy 4

Basel II Overview Basel II calculates minimum capital requirements based on exposure to different risks Credit Risk Operational Risk Market Risk Potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events Risk of losses in onand off-balance sheet positions arising from movements in market prices Major changes New element Minimal change 5

Basel II Overview Basel II offers a range of capital calculation approaches Minimum Capital Credit Risk Operational Risk Market Risk Internal Ratings Based (IRB) Approaches Advanced Measurement Approach (AMA) Internal Model Approach (IMA) Advanced IRB (AIRB) Standardized Approach Standardized Approach Foundation IRB (FIRB) Basic Indicator Approach Standardized Approach 6

Basel II Overview Basel II also offers a range of risk reducing treatments Prescribed eligible types of collateral Methods of reflecting credit risk mitigation (CRM) impact Understanding implications of these different approaches to risk and risk mitigation is critical to any basis of comparability of FIs 7

Agenda Basel II Overview Impact on Capital Building Blocks to Capital Calculations Credit Risk including Securitization and Equity Holdings Operational Risk Market Risk Supervisory Review and Sanity Checks Regulatory Capital - Basel I vs. Basel II Factors Contributing to Differences Between FIs Reporting and Disclosures 8

Building Blocks to Capital Calculations Credit Risk 9 OSFI Expectation that: Banks meeting the following criteria must use AIRB approach for Credit and at a minimum Standardized approach for Operational Risk: Regulatory capital in excess of $5 billion, or > 10% of assets or liabilities that are international Each FI must meet all minimum requirements and obtain approval for AIRB To adopt an alternate approach for specific credit portfolios or subsidiaries requires OSFI approval All other FIs can opt for approach of their choice, subject to OSFI approval

Building Blocks to Capital Calculations Credit Risk OSFI Guidance OSFI permits: A phased in adoption of the AIRB approach for material credit portfolios, if an FI requests a Waiver of same Permanent exemption for non material portfolios if requested, subject to approval A 3 year conversion to AIRB for material portfolios outside Canada, subject to granting an extension to the FI with clear roll out plan 10

Building Blocks to Capital Calculations Credit Risk New Concepts and Definitions Basel II Credit Risk language Risk Parameter Probability of Default Loss Given Default Maturity Exposure at Default Abbr. PD LGD M EAD Description Driven by borrower characteristics, including Borrower s Risk Rating (BRR) May reflect guarantees Driven by the Facility Risk Rating (FRR) May reflect guarantees and/or collateral Can use contractual maturity or effective maturity Takes into account outstanding exposures and potential exposure risks in the event of default Risk parameters are assigned based on the obligor s and facility s risk profile 11

Building Blocks to Capital Calculations Credit Risk Example RWA calculation for a $100 Exposure in a selection of Basel Asset Classes, no collateral impact Risk Parameters Probability of Default (PD) Loss Given Default (LGD) Exposure at Default (EAD) Maturity in year (M) Borrower 1 0.0024 0.38 $100 2.1 Borrower 2 0.0048 0.44 $100 2.3 Basel Asset Class Corporate SME Residential Secured Qualifying Revolving Retail 31.99 17.45 4.70 RWA Impact 54.35 32.95 9.40 12 RWA generally higher on Corporate exposures than Retail

Building Blocks to Capital Calculations Securitization Basel II addresses two key areas of securitization Holdings of securities issued by securitization vehicles Basel II treatment is similar to revised Basel I Risk weights are associated with ratings levels The Basel II risk weights are generally favourable compared with the Basel I risk weights Unrated positions and those with low agency ratings are deducted from capital in both frameworks Provision of credit enhancements (mainly liquidity facilities) to securitization vehicles Basel II treatment very different from Basel I Risk weights are mapped from internal ratings (under Internal Assessment Approach) Range from 7% to 650% with a 100% Credit Conversion Factor on everything Can result in dollar-for-dollar capital deduction for facilities with an equivalent rating level below BB- 13

Building Blocks to Capital Calculations Equities in the Banking Book Standardized Approach Market Based Approach Internal Ratings Based PD/LGD Method Prescribed risk weights: 100% in most cases Simple Risk Weight Non material - similar to Standardized Material - risk weighted at 300% (publicly traded), 400% (other equities) Internal Models Capital same as Internal VaR model Subject to floors equivalent to: 200% (publicly traded), 300% (all other) Only allowed for: non-tier 1 perpetual pref. shares without redeemable feature perpetual pref. shares with redeemable feature at the issuer s option PD s must satisfy same requirements as bank s PD estimate Minimum 90% LGD 5 year maturity adjustment IRB also allows for Grandfathering up to 10 years under Basel I for equity positions as at July 2004 14

Building Blocks to Capital Calculations Operational Risk Standardized Approach Based on Gross income which: Acts as a proxy for the size of the business Serves as an indicator of the operational risk Grouped into eight regulatory business lines Each line charged a rate prescribed by the Framework Average over 3 years for each business line X business line s rate Required capital driven by the type and size of business lines Advanced Management Approach Based on risk measure generated by internal operational risk measurement system Must reasonably estimate expected and unexpected losses based on: internal and external loss data scenario analysis bank-specific business environment internal control factors Requires credible, documented and verifiable approach Required capital driven by analysis of expected and unexpected losses 15

Building Blocks to Capital Calculations Market Risk Market Risk capital calculations remain largely unchanged from Basel I Standardized Internal Model Use requires OSFI approval 16

Agenda Basel II Overview Impact on Capital Building Blocks to Capital Calculations Credit Risk including Securitization and Equity Holdings Operational Risk Market Risk Supervisory Review and Sanity Checks Regulatory Capital - Basel I vs. Basel II Factors Contributing to Differences Between FIs Reporting and Disclosures 17

Supervisory Review and Sanity Checks 18 Framework for banks to assess their own capital adequacy and processes, including: Assessment of regulatory capital in conjunction with economic capital Stress testing regulatory capital calculated under Pillar 1 Internal capital adequacy assessment process Capital plan Framework for supervisors to review banks capital adequacy and processes, including: Evaluation of bank s internal capital adequacy, assessment and strategies, as well as bank s ability to monitor and ensure compliance with regulatory capital ratio and relevant standards Early intervention if a bank s risks are deemed to be out of proportion with its capital Resolution strategies Framework to address all other risks not captured in Pillar 1

Regulatory Capital Key Changes from Basel I Basel I General Allowances Included in eligible capital, to a maximum amount Basel II Only net residual of Total GA + Specific Allowances less Expected Losses can be included 19 50/50 Deductions from Capital Deductions either didn t exist or were deducted from Total Capital Securitizations rated below BB-A3/P3 Any shortfall in GA (above) Non Delivery vs. Payment (Non-DvP) failed transactions (where second contractual payment late by 5 days Expected Loss for equity exposures under PD/LGD approach Minority Interest to be deducted These factors can represent significant deductions from capital

Regulatory Capital Transition Period Individual FI s regulatory capital requirement is subject to: Capital Floors during Transition (if approved by OSFI) FYE 2008: Capital floor is 90% of Basel I calculation FYE 2009: Capital floor is 80% of Basel I calculation Full benefits of Basel II may not accrue to FI s during the Transition Period as a result of floors or choices made by the banks OSFI has the right to increase and/or maintain the floor at their discretion including post Transition Period OSFI approval required on the methodologies, models, and related estimates for banks implementing AIRB 20

Factors Contributing to Differences Among FIs Various factors will contribute to differences in capital requirements including: 1. The risk profile of exposures combined with the calculation approach can produce significantly different capital requirements 2. The composition of a bank s portfolio Corporate and Retail formulas differ 3. Coverage of credit portfolios under AIRB and Standardized 4. Collateral can favourably impact risk parameters producing lower RWA 5. Foreign jurisdiction discretionary rules treatment for foreign portfolios Basel II is a multi-faceted approach to capital calculations 21

Factors Contributing to Differences Between FIs 1. The risk profile of exposures combined with the calculation approach can produce significantly different capital requirements: Under AIRB approach A bank s own risk parameters are assigned to each individual exposure based on risk profile (PD, LGD) Maturity date EAD factors on undrawn commitments Under Standardized approach Range of risk weights (0% up to 150%) prescribed by the Framework - linked to external credit ratings, LTVs (mortgages), and/or other risk characteristics Higher risk profile = higher RWA Longer maturities = higher RWA Higher factors = higher RWA Higher risk = higher RWA 22

Factors Contributing to Differences Between FIs 2. Composition of portfolio Corporate AIRB capital calculation formula different than Retail IRB Retail has no Maturity factor SMEs can be treated as Corporate or Retail, SME adjustment to formula reduces capital All things being equal, Corporate formula will produce higher RWA than Retail 3. Coverage of credit portfolios under AIRB and Standardized Standardized approach typically produces higher RWA If Bank A has 20% of its portfolios under the Standardized approach and Bank B has 50%, it is reasonable to expect higher RWA for Bank B, all things being equal 23

Factors Contributing to Differences Between FIs 4. Credit Risk Mitigation approaches can favourably impact risk parameters producing lower RWA Guarantees Example (IRB approach PD substitution): Assume a mortgagor is assigned a PD of 20% prior to taking collateral into account If the exposure is an NHA insured mortgage, the exposure is treated as Sovereign with associated risk parameters (as low as 0% PD) RWA will be reduced significantly Collateral Example (IRB approach LGD substitution): Assume a Corporate loan is secured by US T-Bills The collateralized loan s RWA is calculated using secured LGD, which will be much lower than the unsecured LGD RWA will be reduced significantly 24

Factors Contributing to Differences Between FIs 5. Foreign jurisdiction discretionary rules for foreign portfolios OSFI typically allows use of foreign national supervisor s treatment for discretionary items if treatment is not too dissimilar to Canadian treatment Example: If exposure to a foreign Public Sector Entity (PSE) is allowed to be treated as Sovereign by the foreign national supervisor, OSFI will allow this exposure to be treated as Sovereign OSFI allows preferential treatment to local currency exposures to foreign governments or central banks, provided the respective national supervisors give similar treatment Example: If foreign supervisor allows local banks to assign 0% risk weight for their local dollar sovereign debt, OSFI will allow similar treatment 25

Agenda Basel II Overview Impact on Capital Reporting and Disclosures Pillar 3 New Concepts and Disclosures Implications for Investors and FIs 26

Reporting and Disclosures Pillar 3 - Market Discipline What is Pillar 3? A set of disclosure requirements to increase transparency and enable market participants to assess important information about a bank s: Risk profile Risk management processes Level of capitalization Particularly important due to reliance on internal methodologies in Advanced Approaches Use and acceptance of internal methodologies by the Regulator is contingent on a number of criteria including appropriate disclosure The Framework imposes minimum disclosure requirements on banks, which include 14 tables covering qualitative and quantitative disclosures 27

Reporting and Disclosures Pillar 3 Deliverables / Timing Deliverable Description Disclosure Frequency Implementation Timing Qualitative Disclosures Information on risk management objectives and processes Annually Required by year-end 2008 Quantitative Disclosures Tables detailing risk exposures and capital requirements Quarterly Canadian banks phasing in over 2008 All disclosures required by year-end 2008 28 Location of disclosures is at the discretion of the institution, but FIs are encouraged to provide related information in one location, to the extent possible

Reporting and Disclosures Overview of Pillar 3 Disclosures Tables 1, 2, 3: Capital 1: Scope of Application 2: Capital Structure 3: Capital Adequacy Tables 4, 5, 6, 7, 8: Credit Risk 4: General Disclosures (all Banks) 5: Portfolios s/t Standardized Supervisory Riskweight in the IRB approaches 6: Portfolios s/t IRB approaches Table 9: Securitization 9: For Banks using Standardized and IRB approaches Tables 10, 11: Market Risk 10: For Banks using Standardized Approach Table 12: Operational Risk 12: (Qualitative only) Table 13: Equities 13: Disclosures for banking book positions 7: Credit Risk Mitigation 8: Exposures related to Counterparty Risk 11: For Banks using Internal Models Approach (IMA) Table 14: Interest Rate Risk 14: Interest rate risk in the banking book 29 Table format is at the discretion of the institution

Reporting and Disclosures New Concepts and Definitions Basel Counterparty Types under the IRB Approach Multiple new classifications which provide added granularity of reporting: Corporate Sovereign Bank Retail Residential Secured Qualifying Revolving Retail (e.g. credit cards and unsecured lines of credit) All Other Retail Basel classifications will likely not align directly with existing reporting practices 30

Reporting and Disclosures New Concepts and Definitions Credit Risk Exposure Types Additional granularity of reporting with exposures categorized as: Drawn, Undrawn, Repo style transactions, OTC Derivatives, Other Off-Balance Sheet exposures Sample Table (Credit Risk Exposures): Total Gross Credit Risk Exposures By Counterparty Type Period 1 (millions of Canadian dollars) Drawn Undrawn Repo style transactions OTC derivatives Other Total Residential secured Qualifying revolving retail Other Retail Corporate Sovereign Bank Total Gross Credit Risk Exposures 31

Reporting and Disclosures Implications for Investors and FI s Enhanced granularity of data will allow for more in-depth analysis and improved understanding of underlying risks However, disclosures will be based on new and/or modified concepts and definitions, making historical comparisons more challenging Banks may select different levels of granularity for their disclosures (e.g. number of Probability of Default (PD) bands) It will be difficult to compare banks relative to their Basel II disclosures, especially in the initial stages of implementation Calculation approach(es) taken by one bank will likely differ from others Links to Basel I and financial statement disclosures are likely to differ at the outset and may become more comparable over time FI s have the choice of location of disclosures - MD&A, financial statements, web site - expect refinements over time 32

Reporting and Disclosures Implications for Investors and FI s The implementation of Basel II will be an evolution Aggregate amount of capital in the banking system is not expected to change significantly. However, shifts will occur over time as AIRB coverage of portfolios including international and US subsidiaries increases and other risk parameters evolve Risk management processes become richer and data, testing and models are enhanced The alignment of risk, capital requirements and business strategy will continue FIs will continue to more closely align pricing, portfolio composition and riskadjusted performance with risk and capital 33

Investor Relations 34 BMO Financial Group: Steven Bonin Steven.bonin@bmo.com : (416) 867-5452 Scotiabank: Mahendra Shah Mahendra.shah@scotiabank.com : (416) 866-7579 TD Bank Financial Group: Kelly Milroy Kelly.Milroy@td.com : (416) 944-5422 National Bank of Canada: Helene Baril Helene.Baril@bnc.ca : (514) 394-5000 ext 0296 CIBC: John Ferren john.ferren@cibc.ca : (416) 980-2088 RBC: William (Bill) Anderson william.anderson@rbc.com : (416) 955-7804

Media Relations 35 BMO Financial Group: Ralph Marranca ralph.marranca@bmo.com : (416) 867-3996 Scotiabank: Ann DeRabbie Ann_DeRabbie@scotiacapital.com : (416) 933-1344 TD Bank Financial Group: Simon Townsend simon.townsend@td.com : (416) 944-7161 National Bank of Canada: Denis Dubé Denis.Dube@bnc.ca : (514) 394-8644 CIBC: Rob McLeod rob.mcleod@cibc.com : (416) 980-3714 RBC: Beja Rodeck beja.rodeck@rbc.com : (416) 974-5506