Capital & risk management - PDF Free Download

S E B E N S K I L D A S E M I N A R Capital & risk management In the world of CRD Tonny Thierry Andersen CFO & Member of the Executive Board October 9, 2006

Basel I Return on Equity CRD Risk adjusted performance measures 2

Capital management is a key value driver - At the hands of management +2%-point Lending BA* CAGR 05-08 Base 17% 34% +1%-point 2,58% NII margin BA* Margin 08 2,26% 27% 2,42% 2008 ROE 16,1% -2% 11% Cost growth CAGR 05-08 -0,4% -5% 16% Fees growth CAGR 05-08 Base: 1% Base: 6% Source: Selected broker reports *Note: BA equals Banking activities (DB, BG, Fokus, ÖEB, NIB and NB). Margin based on NII from BA over avg. BA lending -0,8% Core tier I ex hybrid 3

Capital adequacy - Overview of the development so far When? What? jul-88 Basel I introduced risk weightings and off-balance-sheet activities jan-96 Measures to capture market risk were introduced in several areas, including - Foreign exchange risk - Interest rate risk (specific and general) jun-99 Publication of the first consultative package of Basel II. Based on three pillars: - Pillar I: Minimum capital requirement - Pillar II: Supervisory review - Pillar III: Market discipline (disclosure) 2005 Final approval of CRD jan-07 Implementation of the new CRD: Start of the transition period jan-10 End of the transition period 4

FAQ Q: What are the main differences between Basel I and CRD on an overall level? 5

FAQ Q: What are the main differences between Basel I and CRD on an overall level? Basel I One single risk measure One size fits all Broad brush structure Basel II / CRD Focus on banks own internal methodologies, supervisory review and market discipline Calibration between economic and regulatory capital Flexibility, variety of approaches and incentives for better risk management More precise risk estimation 6

Capital adequacy as it is today - Too simplistic and non-granular Capital base Risk weighted assets = Capital base Credit risk + Market risk 8% Non-granular credit risk categories: 0% 20% 50% 100% 7

The three pillars - Danske Bank aims for best in class in all pillars Min. Capital requirement Credit risk Market risk Operational risk Supervisory review Process Market discipline National legislation EU Directive (CRD) Basel Accord (Basel II) 8

Capital adequacy - After: Evolution or revolution? Capital base Risk weighted assets = Capital base Credit risk + Market risk + Operational risk 8% Improved risk sensitivity & granularity: 50% 9

Models Models and input - Different models reflecting capability & desired level of sophistication Degree of sophistication Credit risk Operational risk Implementation High IRB Advanced Advanced 2008 Medium IRB Foundation Standardised 2007 Low Standardised Basic 2007 Input data Degree of sophistication Probability of default Loss given default Exposure at default IRB A High Internal data Internal data Internal data IRB F Low Internal data Regulator Regulator 10

Models Models and input - Our choices reflect a comprehensive data-set and the beauty of a single IT-platform Degree of sophistication Credit risk Operational risk Implementation High IRB Advanced Advanced 2008 Medium IRB Foundation Standardised 2007 Low Standardised Basic 2007 Input data Degree of sophistication Probability of default Loss given default Exposure at default IRB A High Internal data Internal data Internal data IRB F Low Internal data Regulator Regulator 11

Calculation of risk weighted assets - Complicated? N RW = LGD N 1 1 ( PD) + R N ( 0.999) ( 1+ ( M 2.5) b) 1 R PD 1 1.5 b 12.5 1.06 12

Calculation of risk weighted assets - Not necessarily, when the formula is debugged N RW = LGD N 1 1 ( PD) + R N ( 0.999) ( 1+ ( M 2.5) b) 1 R PD 1 1.5 b 12.5 1.06 Input Risk weight Risk weighted assets Minimum capital requirements PD Core cap. 4% RWA LGD CRD-equation for calculating risk weight (RW) Risk weighted assets = RW EAD M Total cap. 8% RWA 14

Case study (I) - Mortgage loan Regulation Model LTV, % Customer rating Risk-weight, % Basel I <80 50 15

Case study (I) - Mortgage loan Regulation Model LTV, % Customer rating Risk-weight, % Basel I <80 50 CRD Standardised Approach <80 35 16

Case study (I) - Mortgage loan Regulation Model LTV, % Customer rating Risk-weight, % Basel I <80 50 CRD Standardised Approach <80 35 Internal Rating Based, Advanced 50<LTV<80 C1-C2 1-3* C3-C4 1-6* C5-C6 5-30* D1-D3 35-110* *Based on Danske Bank's internal estimates. Lower limit: LTV = 50 and minimum maturity, upper limit: LTV = 80 and maximum maturity. % Return on equity Assumptions (pre losses and tax) Margin 50 bp Illustrative Interest rate 3% 10 20 30 40 50 60 70 80 90 100 110 Risk weight (%) 3 different CoC (depending on risk profile and size) 17

Case study (II) - Credit risk: IRB Advanced vs. IRB foundation Advanced Foundation Loan 1,000 1,000 Margin 0.05% 0.05% Interest income loan 0.50 0.50 Income capital 0.15 0.28 Total income 0.65 0.78 Risk-weight (A2 rated bank) 8.5% 15.3% Allocated capital (6%) 5.10 9.18 Return on equity (pre costs & tax) 12.8% 8.4% CRD will/should imply a significant value creation impact 18

Nordic banks - What models are used by peers and domestic players? Degree of sophistication High Credit risk IRB Advanced Medium IRB Foundation Low Standardised Degree of sophistication High Operational risk Advanced Medium Standardised Low Basic Source: Company presentations 19

Impact at a glance - Significant changes at least on the surface Index 100 80 60 100 88 Minimum required capital under Pillar I Pre-CRD versus Post-CRD 84 71 62 40 20? 0 Basel I QIS4 (US) FSA (UK) Swedbank DnbNor Danske Bank Source: Company reports and presentations, FSA US and FSA UK 20

FAQ Q: This shows that there will be quite significant capital relief. Right? 21

FAQ Q: This shows that there will be quite significant capital relief. Right? A: NO! Pillar I is just one part of the story. One must not forget Pillar II, a Banks strategy and internal goals, rating agencies and peers. 22

How the future targets will be set - CRD is only one out of many components Rating Agencies Authorities Solvency, CRD (Pillar I & Pillar II) Capital Rating ambitions, Tier I, ACE Management Pillar III, dont want to be an outlier ICAAP, strategy, growth ambitions, risk profile etc. Peer Group 23

Supervisory review - Capital above the minimum requirement Pillar II Capital requirement Risks not fully covered under Pillar I (e.g. residual risk) Add on for Pillar II?% Risks not covered by Pillar I (e.g. concentration risk & liquidity risk) Pillar I 8% Tier II capital Tier I capital Pillar I External factors (e.g. business risk & strategy) Rules for capturing the risk of an average bank Pillar II Customised rules, based on each banks internal assessment 24

Illustration of concentration risk - Geographies, industries and customers (Inter) National bank Regional bank Local bank Geographies Industries 25

Country correlation - UK and IE adds significant diversification to the Group Denmark Finland Ireland Norway Sweden UK Total OECD Denmark 100 Finland 50 100 Ireland 45 74 100 Norway 68 27 35 100 Sweden 64 81 70 14 100 United Kingdom 54 83 49 32 71 100 Total OECD 79 65 57 49 65 59 100 Source: OECD & own calculations 26

Stand alone vs. diversification - Size and scope matters Index Economic capital (Illustrative) Marginal contribution to a diversified portfolio (Index 100) & Stand alone Danske Markets DB-brand Realkredit Danmark BG Bank Norway Sweden Good questions: What about mono-liners? What about single name concentration? What about geographical diversification? 27

FAQ Q: What about diversification between risk types? One could argue that there is some diversification between credit risk and market risk? 28

FAQ Q: What about diversification between risk types? One could argue that there is some diversification between credit risk and market risk? A: This is still to be decided by the Danish FSA. The UK FSA has stated that risk diversification between risk types not will be allowed during the transition period. Empirical data of poor quality is another issue one needs to take into consideration. 29

Stress testing - What happens if/when the freak wave comes? 30

Eight different scenarios - Severe, but plausible scenarios Scenario Brief description Years covered I Recession (1 in 25) Sharp fall in exports and rising taxes lead to decline in 3 demand II Deflation Structural problems in Europe leads to recession and 5 deflation III Falling property prices Rising interest rates lead to plunging housing prices 5 IV Mild recession Zero growth two quarters in a row 3 V Oil price hike Sharp increase in oil and commodity prices leads to lower 3 purchasing power (consumers and companies) VI Fall in US dollar Deficit in the US trade balance leads to a global recession 3 VII Liquidity crisis, sector Liquidity crisis which leads to credit losses and a negative effect on funding VIII Liquidity crisis, Danske Bank Default of one of Danske Bank's largest customers and a downgrade of Danske Bank's rating 5 5 Important assumption: No management intervention. 31

Macro economic impact - Some tough years (figures from selected scenarios) % Macro economics (worst year) 20 GDP Unemployment Property prices (change in nominal prices) 2.5 O -15 Recession (1 in 25) Deflation Falling property prices Mild recession Oil price hike Fall in US dollar 32

Management intervention - Smoothing out the development % Solvency (illustrative) Management intervention: 1st line of defence 2nd line of defence 3rd line of defence Time 33

Management intervention - Captured in Contingency Plans The contingency plans answer the following questions: What is the effect on the capital structure? How attractive is the action plan (visual indication)? Who makes the decision? Who is responsible for the process? Are there any approved limits? What are the estimated costs? Can the action be reversed? Has the action any effect on our customer relations? Is there any signalling effect? What is the time to market (normal/forced)? What does the workflow look like? Should any external parties be involved? Is there any relevant legislation which should be taken into consideration? What documentation is needed? Are there any specific market conditions which should be noted? Should the Board of Directors approve the action? How is the action implemented? 34

FAQ Q: Will Danske Bank get a capital relief under CRD? 35

FAQ Q: Will Danske Bank get a capital relief under CRD? A: It is too early to say. There are too many uncertainties under Pillar II, which must not be forgotten. There are however, four important factors that may be beneficial for Danske Bank under the new capital adequacy rules. 36

Danske Banks future capital structure - Four important factors Mortgage portfolio Diversification High & stable internal capital generation Risk, capital & performance management 37

Danske Bank is well prepared - Good dialogue with the rating agencies 38

Stating your risk appetite - The risk appetite sets the boundaries for your commercial behaviour Risk appetite Target risk profile Important questions when stating your risk appetite Where to place strategic bets? How much risk to take? What risk profile do we want for our organisation? How to allocate in order to promote profitable growth? How much capital do we have? How much do we need? What discretionary risk taking/shedding decisions does the structure and outlook prompt? Actual risk profile Risk capacity 39

New performance metrics required - Capital allocation and performance evaluation ROE ROAC* Framework Regulatory Internal Time horizon Point-in-time 3-5 years Confidence level NA 99,97% Credit risk Simple Internal Concentration risk No Yes Migration risk No Yes Operational risk No Standard Market risk Advanced Advanced Performance capital All capital All capital Other risk No Yes *Return on Allocated Capital 40

ROE vs. Risk adjusted measure - From performance measurement to performance management Low Risk adjusted measure (ROAC) High High ROAC-/ROE+ ROAC+/ROE+ ROE Low ROAC/ROE- ROAC+/ROE- 41

ROE vs. Risk adjusted measure - Policy and business consideration ROE +, ROAC - Situation: Beating peers but customer relations are destroying value, typically when the customer is perceived as very risky with an associated low rating Key Figures: Increase in ROAC Actions: Reduction in credit exposure, increase of margins and generation of ancillary business ROE +, ROAC + Situation: Peers are beaten and customer relations are creating value Key Figures: Increase ROE/ROAC and more likely increase AVA Actions: Revenue generation both risk taking business as well as ancillary business ROE -, ROAC - Situation: Not matching peers and customer relations are destroying value, typically when the customer is perceived as very risky, margins that do not reflect the associated risk coupled with an insufficient amount of ancillary business Key Figures: Increase in ROE and ROAC Actions: Reduction in credit exposure, increase of margins and generation of ancillary business. If not possible reduce or terminate customer relations ROE -, ROAC + Situation: Not matching peers but customer relations are creating value, typically when the customer internally is perceived as low risk with an associated relative high rating Key Figures: As a minimum increase ROE with potential positive effect on ROAC Actions: Revenue generation. Change in credit exposure must be a balance between return and associated Risk Weighted Assets 42

FAQ Q: Where can I find more information on CRD? 43