ZAG BANK BASEL PILLAR 3 AND OTHER REGULATORY DISCLOSURES December 31, 2017
1. OVERVIEW OF ZAG BANK Zag Bank (the Bank ) is a Schedule I federally chartered Canadian bank and a wholly-owned subsidiary of Desjardins Group ( Desjardins ), through Desjardins Financial Holding Inc., a whollyowned subsidiary of the Fédération des caisses Desjardins du Québec, which is collectively controlled by its members the Desjardins Caisses. The Bank s head office is located in Calgary, Alberta. Prior to December 1, 2013, the Bank was a wholly-owned subsidiary of Western Financial Group Inc., a wholly-owned subsidiary of Desjardins Group. In 2014, the Bank changed its name from Bank West to Zag Bank. The name change was approved by the Office of the Superintendent of Financial Institutions Canada (OSFI) on July 22, 2014. The incorporating instrument of the Bank was amended in accordance with the Bank Act and the letters patent were effective on October 1, 2014. The Bank is a direct bank that provides banking services to individuals and businesses across Canada. Loan products provided by the Bank include consumer loans, mortgages and commercial loans. The Bank offers High Interest Savings Accounts (HISAs) and Guaranteed Investment Certificates (GICs) through third-party brokers and direct-to-consumer, and it is a member of the Canada Deposit Insurance Corporation (CDIC). 2. BASEL PILLAR 3 OVERVIEW The Bank makes this regulatory disclosure in accordance with OSFI s Advisory on Pillar 3 Disclosure Requirements issued in November 2007, pursuant to the Basel Committee on Banking Supervision s Pillar 3 disclosure standards. The Basel framework is structured around 3 pillars: Pillar 1: Minimum Capital Requirements Pillar 2: The Supervisory Review Process Pillar 3: Market Discipline Pillar 3 complements both Pillars 1 and 2, by setting disclosure requirements which allow market participants to assess the risk and capital profiles of Zag Bank. The amounts disclosed in the tables throughout are the balance sheet carrying amounts included in the financial statements of the Bank prepared in accordance with International Financial Reporting Standards ( IFRS ) as issued by the International Accounting Standards Board (the IASB ) and using the accounting policies described therein. This Pillar 3 report is unaudited and is reported in thousands of Canadian dollars, unless otherwise disclosed. 3. CAPITAL The Bank is subject to regulatory capital requirements in accordance with OSFI s Capital Adequacy Requirements Guideline issued in December 2012 to implement Basel III capital rules in Canada. These rules are based on standards issued by the Bank for International Settlements, Basel Committee on Banking Supervision (BCBS). Under Basel III, there are two tiers of capital. Tier 1 capital consists of two components: Common Equity Tier 1 (CET1) and Additional Tier1. Tier 2 capital consists of supplementary capital instruments. Total capital is defined as the sum of Tier 1 and Tier 2 capital. Page 2 of 10
Common Equity Tier 1 (CET1) capital includes common shares, retained earnings and accumulated other comprehensive income. CET1 capital also includes regulatory adjustments and deductions for certain items including intangible assets. The Bank currently does not hold any additional Tier 1 or Tier 2 capital instruments. Therefore, the Bank s CET1 is equal to its Tier 1 and Total capital. The Bank is authorized to issue an unlimited number of common shares, without par value. As at December 31, 2017, the number of issued and outstanding common shares was 206,676. The capital composition of the Bank is shown in the following table: December 31, 2017 All-in Transitional (in thousands) basis basis Common shares issued $ 206,676 $ 206,676 Retained earnings (deficit) (60,803) (60,803) Accumulated other comprehensive income 1,147 918 Common Equity Tier 1 capital before regulatory adjustments 147,020 146,791 Cash flow hedge reserves requiring derecognition (1,865) (1,492) Computer software and other intangible assets (5,014) (4,011) Deferred tax asset excluding those for temporary differences (16,980) (13,584) Common Equity Tier 1 (CET1) capital $ 123,161 $ 127,704 Tier 1 capital 123,161 127,704 Total capital $ 123,161 $ 127,704 The Bank calculates and reports capital on an all-in basis, which reflects the complete phase-in of the Basel regulatory adjustments and phase-out of non-qualifying capital instruments that are required by 2019. Capital on a transitional basis shown above refers to the phase-in of the Basel supervisory adjustments and phase-out of non-qualifying capital instruments up to 2017 and is presented for information purposes only. 4. CAPITAL ADEQUACY The Bank s objective is to maintain an adequate level of capital, in line with its risk profile, to support its activities, meet regulatory capital requirements and provide a reasonable return to its shareholder. In order to achieve this objective, the Bank has a capital management framework that includes a Capital Management Policy and an Internal Capital Adequacy Assessment Process ( ICAAP ). The ICAAP is an integrated process that evaluates capital adequacy relative to the Bank s risk appetite and strategy and helps set the internal capital levels acceptable for the Bank. The Bank s capital level underscores its solvency and capacity to cover unexpected losses arising from material risks related to its operations and it allows the Bank to carry on its strategic initiatives while providing depositors and creditors with safeguards. The Board of Directors reviews and approves several capital-related documents on an annual basis, including the Capital Management Policy, the Risk Appetite Policy and Framework, the ICAAP and the strategic plan. The Board s Audit and Risk Committee reviews capital adequacy on a quarterly basis. Management monitors regulatory capital ratios on a continuous basis and these ratios are reported monthly to the Asset and Liability Management Committee (ALCO). The Bank s capital requirements are driven by its risk profile measured by its risk-weighted assets (RWA). The Bank calculates RWA for its exposures to credit risk and operational risk (it does not calculate RWA for market risk as it does not engage in trading activities) and adds them together to Page 3 of 10
determine total RWA. The Bank has adopted the Standardized Approach to calculate capital for credit risk and the Basic Indicator Approach to calculate capital for operational risk. Under Basel III, there are three primary regulatory capital ratios used to assess capital adequacy, Common Equity Tier 1 (CET1), Tier 1 and Total Capital ratios, which are determined by dividing those capital components by risk-weighted assets (RWA). In addition to regulatory capital ratios, Basel III introduced the leverage ratio which has replaced the assets-to-capital multiple. The leverage ratio is calculated by dividing a capital measure by an exposure measure as per OSFI s Leverage Requirements Guideline. The Bank keeps its capital ratios and leverage ratio above the levels required by OSFI and has established target capital ratios significantly higher than the all-in (complete phase-in of the Basel regulatory adjustments and phase-out of non-qualifying capital instruments that are required by 2019) minimum capital ratios, inclusive of the conservation buffer, required by OSFI under Basel III, which has been effective since 2014 (minimum CET1 ratio of 7%, Tier 1 ratio of 8.5% and Total capital ratio of 10.5% of risk-weighted assets). OSFI, however, may require higher capital levels on an institution-specific basis. The components of the Bank s risk-weighted assets and capital ratios are shown in the following table: December 31, 2017 All-in Transitional (in thousands) basis basis Risk-weighted assets (RWA) Credit risk $ 296,378 $ 296,378 Operational risk 12,509 12,509 Adjustment to RWA for transitional basis - 4,772 Total risk-weighted assets $ 308,887 $ 313,659 Credit Valuation Adjustment (CVA) on derivatives $ 11,083 $ - RWA adjusted for CVA on derivatives Common Equity Tier 1 RWA adjusted for CVA on derivatives $ 305,784 $ 313,659 Tier 1 RWA adjusted for CVA on derivatives 306,338 313,659 Total RWA adjusted for CVA on derivatives 306,782 313,659 Regulatory capital ratios Common Equity Tier 1 capital ratio 40.3% 40.7% Tier 1 capital ratio 40.2% 40.7% Total capital ratio 40.1% 40.7% Leverage ratio 1 6.9% 6.9% 1 The leverage ratio implemented in 2015 replaces the assets-to-capital multiple. As with the capital section, the Bank calculates and reports risk-weighted assets and regulatory capital ratios on an all-in basis. The risk-weighted assets and regulatory capital ratios on a transitional basis are presented for information purposes only. The Bank has maintained its capital levels above its regulatory capital requirements throughout the year ended December 31, 2017. Page 4 of 10
5. CREDIT RISK Credit risk is defined as the risk of financial loss due to a borrower or counterparty failing to meet its obligations in accordance with contractual terms and is the most significant risk to the Bank. The Bank s loan portfolio accounts for the majority of its credit risk exposure. The Bank also engages in non-lending activities that may give rise to credit risk, namely the purchase of securities for the liquidity portfolio, maintaining cash and deposits with other institutions and entering into derivative transactions to manage interest rate risk exposure. The Bank s exposure to credit risk is monitored by Management, the Credit Risk Management Committee (CRMC) and ultimately, the Board of Directors. The CRMC is primarily responsible for establishing the Bank s lending risk parameters and monitoring the performance and quality of the Bank s credit portfolio, reviewing and approving allowances for credit loss estimates and assessing the overall adequacy of the allowance for credit losses. The CRMC also establishes, implements and monitors credit risk related policies, strategy and guidelines, taking into account business objectives and the Bank s risk appetite. The credit approval process and loan portfolio acquisitions are guided by policies approved by the Board or the CRMC and it requires, for material credit transactions, approval by the Board, CRMC or credit risk management. Approval of non-material credits may be delegated to the group responsible for originating credit transactions, but subject to lending risk parameters approved by the CRMC. Approval authorities are delegated by the Board to the CRMC, which in turns delegates to officers in risk management and in loan origination. In certain cases, credit requests must be referred to the CRMC or to the Board for approval. Credit concentration limits are established to diversify exposures and manage concentration risk within the loan portfolio. These include limits for individual borrowers, groups of related borrowers, industry sectors, geographic regions, and products. Credit scoring is the primary basis for assessing retail exposures and assigning borrower risk ratings. Risk ratings are reviewed on a regular and ongoing basis and are adjusted as necessary to reflect new information on the creditworthiness of retail borrowers. Each commercial borrower is also assigned a borrower risk rating, reflecting the Bank s assessment of the credit quality of the borrower. The borrower risk rating assigned when a facility is first authorized is re-evaluated periodically and adjusted as necessary to reflect changes in the customer s financial condition or business prospects. Re-evaluation is an ongoing process, and is performed also in the context of general economic changes and specific industry prospects. Techniques used by the Bank to reduce or mitigate credit risk include sound credit policies, practices and procedures for granting credit or acquiring loan portfolios, valuing and managing financial and non-financial security (collateral), and actively monitoring the loan portfolio and collections activities. Security for loans is primarily non-financial and includes commercial and residential real estate, vehicles and other equipment. The Bank also maintains a liquidity portfolio consisting primarily of instruments issued or guaranteed by the Canadian federal government and other high quality securities. The Bank s Liquidity Risk Management and Pledging Policy establishes that such investments be of investment grade. Credit risk associated with deposits at other financial institutions is minimized by ensuring that funds are placed with financial institutions with strong investment grade credit ratings. Page 5 of 10
The Bank s credit risk exposures are located primarily in Quebec, Ontario and Alberta. The geographic distribution of the Bank s gross loan portfolio is shown in the following table: As at December 31, 2017 Residential Consumer and Business and (in thousands) mortgages Personal government Total Quebec $ 805,541 $ 91 $ - $ 805,632 Ontario 226,552 72,149 2,553 301,254 Alberta 41,646 34,377 1,813 77,836 British Columbia 18,459 2,365-20,824 Saskatchewan 5,271 474-5,745 Manitoba 3,798 104-3,902 Other 2,434 5,279 42 7,755 $ 1,103,701 $ 114,839 $ 4,408 $ 1,222,948 The maximum credit risk exposure of the Bank in the event of other parties failing to meet their obligations is detailed below. No account is taken of any collateral held and the maximum exposure to loss is considered to be the balance sheet and off-balance sheet carrying amounts. (in thousands) 2017 Financial assets, as stated in the balance sheet $ 1,789,068 Credit commitments 33,462 Maximum credit exposure $ 1,822,530 Past due loans A loan is classified as past due when the borrower has failed to make a payment by the contractual due date. Impaired loans A loan is classified as impaired when repayment of principal or payment of interest is contractually 90 days in arrears or earlier if the Bank obtains confirmation of the deterioration of the borrower s ability to repay the loan. Loans guaranteed or insured by the Canadian government (federal or provincial) or a Canadian government agency are classified as impaired only when payments are contractually 365 days in arrears. Specific allowances The Bank conducts ongoing monitoring of its loan portfolio and a specific allowance for credit losses is established where objective evidence of impairment exists and the Bank has determined the loan to be impaired. Loans on which repayment of principal or payment of interest is contractually 90 days in arrears are automatically considered impaired. Loans guaranteed or insured by the Canadian government (federal or provincial) or a Canadian government agency are classified as impaired only when payments are contractually 365 days in arrears. The Bank establishes specific allowances for 100% of the unsecured portion of any impaired loan, including the accrued interest up to the time of impairment and costs incurred and estimated to be incurred to obtain repayment. Page 6 of 10
Collective allowance A collective allowance is provided for losses which the Bank estimates are inherent in the portfolio and have occurred, but the individual loans have not yet been specifically identified for individual assessments and classification as impaired. Non-impaired loans are grouped on the basis of similarities in credit risk characteristics and collectively assessed for impairment. A collective allowance is maintained for credit losses which are inherent in the portfolio as at the reporting date. The collective allowance methodology incorporates both quantitative and qualitative factors to determine an appropriate level of the collective allowance. The quantitative factors include probability of default, exposure at default, loss given default and estimates of the time period over which losses that are present would be identified and provided for. The initial quantitative estimate of loss experience is then adjusted to reflect qualitative factors such as Management s judgment on the level of credit losses based on historical experience and taking into consideration current portfolio credit quality trends, portfolio concentrations, risk mitigations, business, macroeconomic conditions, policy and process changes, and other related factors. The allowance for credit losses (specific and collective) represents Management s best estimate of credit losses inherent in the loan portfolio as at the reporting date. Gross outstanding loans and impaired loans, net of allowances for credit losses, by loan type, are as follows: As at December 31, 2017 Gross loans Gross loans Gross neither impaired past due but impaired Specific Collective (in thousands) nor past due not impaired loans allowances allowance 1 Net loans Residential mortgages $ 1,089,730 $ 13,825 $ 146 $ (15) $ (141) $ 1,103,545 Consumer and Personal 111,910 2,249 680 (463) (920) 113,456 Business and government 4,351 57 - - (8) 4,400 $ 1,205,991 $ 16,131 $ 826 $ (478) $ (1,069) $ 1,221,401 1 The total collective allow ance on the Bank s loan portfolio at December 31, 2017 amounted to $1,839, out of w hich $770 is embedded in the fair market value adjustment of the consumer portfolios acquired in 2015, 2016 and 2017 and the remaining $1,069 is reflected above. The change in the Bank s allowance for credit losses for the year ended December 31, 2017 is shown in the following table: As at December 31, 2017 Specific Collective (in thousands) allowances allowance 1 Total 1 Balance at beginning of year $ 537 $ 1,291 $ 1,828 Provision for credit losses 149 (222) (73) Write-offs (431) - (431) Recoveries 223-223 Balance at end of year $ 478 $ 1,069 $ 1,547 1 The total allow ance for credit losses and the collective allow ance on the Bank s loan portfolio at December 31, 2017 amounted to $2,317 and $1,839, respectively. $770 of collective allow ance is embedded in the fair market value adjustment of the credit portfolios acquired in 2015, 2016 and 2017 and the remaining $1,069 is reflected above. Page 7 of 10
Residential Mortgages The Bank s insured and uninsured residential mortgages outstanding principal by province as at December 31, 2017 is shown below: (in thousands) Province Insured Mortgages Uninsured Mortgages Total Mortgages Outstanding Principal % Outstanding Principal % Outstanding Principal % Quebec $ 539,991 79% $ 255,283 63% $ 795,274 73% Ontario 78,882 11% 145,034 35% 223,916 21% Alberta 37,867 6% 3,322 1% 41,189 4% British Columbia 15,804 2% 2,440 1% 18,244 2% Saskatchewan 5,206 1% 5 0% 5,211 0% Manitoba 3,764 1% - 0% 3,764 0% Nova Scotia 1,184 0% 229 0% 1,413 0% New Brunswick 986 0% - 0% 986 0% Total $ 683,684 100% $ 406,313 100% $ 1,089,997 100% The remaining amortization period of the residential mortgages held by the Bank as at December 31, 2017 was: (in thousands) Remaining Amortization Period Outstanding Principal 0 to 15 Years $ 29,485 3% 15 to 20 Years 70,330 6% 20 to 25 Years 873,326 80% 25 to 30 Years 116,441 11% 30 to 35 Years 415 0% Total $ 1,089,997 100% % The weighted average loan-to-value (LTV) of uninsured residential mortgages acquired in 2017 by province was: (in thousands) Province Outstanding Principal at Acquisition Weighted Average LTV Ontario $ 145,144 68% British Columbia 2,410 69% Alberta 1,948 76% Nova Scotia 230 68% Total $ 149,732 68% Page 8 of 10
The Bank conducted a stress test of its residential mortgage portfolio in 2017 and plans to integrate the impact of this stress test on its next ICAAP to determine whether any additional capital over its planned requirement for growth would be necessary in the event of a severe economic and real estate downturn. 6. MARKET RISK Market risk represents the risk of loss as a result of changes in market factors, such as interest rates, foreign exchange rates, commodity prices, credit spreads and equity prices. The Bank does not engage in trading and has no material exposure to foreign exchange risk, commodity risk or equity risk. The Bank s primary source of market risk is structural interest rate risk in the banking book. Structural interest rate risk in the banking book refers to the risk to net interest income and economic value of equity that arises from differences in the maturities or re-pricing dates of assets and liabilities. Interest rate risk is managed in accordance with Board-approved policies and limits, which are aligned with the Bank s risk appetite policy and framework and are designed to control the potential negative impact of interest rate changes on the Bank s earnings and economic value of equity. The earnings limit measures the effect of various interest rate shock scenarios on the Bank s net interest income over a 12-month horizon (Earnings at Risk or EaR ), while the economic value of equity limit measures the impact of various interest rate shock scenarios on the present value of the Bank s net assets (Equity Value at Risk or EVaR ). The Bank sets overall limits on EVaR and EaR based on immediate and sustained ±100 basis points parallel shifts of the yield curve. The Bank also measures and sets an overall limit for duration gap, which is the difference between the duration of assets and the duration of liabilities. Duration gap measures the sensitivity of the market value of assets and liabilities to changes in interest rates. Gap analysis is also used to assess the Bank s interest rate sensitivity. Under gap analysis, interest rate-sensitive assets, liabilities and equity are assigned to defined time periods, on the earlier of contractual re-pricing or maturity dates. Responsibility for day-to-day management of structural interest rate risk resides in the Bank s treasury function and the oversight and strategic direction of the structural interest rate risk management process have been delegated by the Board to the ALCO. The Bank s structural interest rate risk position is reported and reviewed monthly by ALCO. The Board receives reports on a quarterly basis covering interest rate risk exposures and their performance in relation to approved limits. Market risk policies and limits are reviewed and approved annually by the Board. The Bank uses derivatives to hedge its structural interest rate risk. Limits established by the Bank to manage structural interest rate risk are set to limit the Bank s exposure to residual unhedged structural interest rate risk. Based on the Bank s interest rate risk and hedge positions, it is estimated that an immediate and sustained 100 basis point increase in interest rates would increase net interest income over the next 12 months by $55 thousand. It is estimated that an immediate and sustained 100 basis point decrease in interest rates would decrease net interest income over the next 12 months by $10 thousand. 7. OPERATIONAL RISK Page 9 of 10
Operational risk, which is inherent in all business activities, is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Operational risk includes legal risk, but excludes strategic and reputational risk. The impact of operational risk may include financial loss, loss of competitive position or regulatory enforcement actions, among others. The Bank uses the Basic Indicator Approach to calculate capital for operational risk. 8. REMUNERATION Bank employee remuneration is based on both business and individual performance objectives and is structured to incentivize employees to meet strategic business objectives in a manner that is aligned with the Bank s Board-approved risk appetite policy and framework and applicable governing legislation. The Bank s compensation structure is overseen by the Governance, Conduct Review and Compensation Committee of the Bank s Board of Directors. The Committee is comprised of three or more directors, with the majority being independent, as determined by the Board, none of whom shall be an officer or employee of the Bank. The framework of the Bank s compensation program consists of base salary and a general incentive plan. Base salary is reviewed for all employees annually and as required by market conditions. The Bank s general incentive plan is paid to eligible employees annually if threshold goals are achieved. The general incentive targets are expressed as a percentage of base salary determined by position and level within the organization. The Governance, Conduct Review and Compensation Committee has been delegated the responsibility of reviewing and approving the Bank s general incentive plan. The Bank is governed by its Board of Directors, and Senior Management has the authority and responsibility for planning, directing and controlling the activities of the Bank. For the year ended December 31, 2017 the compensation of the Bank's Senior Management and members of its Board of Directors was as follows: (in thousands) 2017 Salaries, short-term benefits and Director fees $ 2,143 Post-employment benefits $ 186 2,329 Page 10 of 10