basel iii goeth112410

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2010 Deloitte All rights reserved.

Basel III Design andPotential Impact

November 2010

Dr. Philip Goeth


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The recent financial crisis has lead to material losses, an almost collapse of the financial system and negative repercussions on the real economy

Regulators are under pressure around the globe to ensure that the systemic soundness of the f inancial sector is improved materially

The financial crisis was kicked offby massive loss of value of USreal estate, triggering loss ofvalue of subprime relatedsecurities

Hundredsof tranches of AAAdebt were downgraded and majorstock markets lost more than60%

Subprime Losses

The collapse of Lehman lead to afreezing of the interbank markets,and previously unseen liquiditysqueezes took place

The freezing of the credit marketscreated a knock on effect on thereal economy, inc reasingbankruptcy rates und fundingdifficulties

Financial Turmoil

With the financial marketstumbling and the repercussionson the real economy,Governments intervened on aglobal scale

In total, estimates are that bankswere so far supported with morethan USD 4tr (alone USD 1.8tr inthe US)

Massive Intervention

In 2009, interbank marketsreturned to normal levels, andvarious banks have meanwhilesuccessfully completed capitalissuances

Central bank liquidity supply atalmost zero rates acted as amajor stabilization factor

Stabilization The causes for the turmoil were

analyzed by various institutions,such as the IMF, World Bank,BIS, IIF, Group of Governors, aswell as national think tanks

The almost collapse of thefinancial system is seen, amongstother reasons, as a major failureof banking regulation andsupervision

Analysis of Failure

With previously unseen amountsof tax payers money spent to

stabilize tumbling financialmarkets, politicians are underpressure to fix the system

This pressure is passed ondirectly to the regulators, whohave been criticized of laxsupervision and weak standardsetting

PoliticalPressure

As a result, various institutionshave prepared proposals for anoverhaul of the bankingregulatory framework

It is broad consensus that theupcoming changes will material,covering a whole range ofsupervisory fields, such ascapital, risk management,liquidity, governance and others

Regulatory Tsunami

Financial InstitutionsInvestors

Governments

A Regulatory Reform Tsunami on its Way

Regulators

Media

Page 2 Basel III Design and Potential Impact


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Scope of Basel III

Basel III" is the response of the Basel Committee on Banking Supervision (BCBS) to the financial crisis, encompassing a comprehensiveset of reform measures to strengthen the regulation, supervision and risk management of the banking sector.

The reform targets both micro and macro economic improvements:

Bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.

Regulation that deals with macroprudential, system wide risks that can build up across the banking sector as well as the pro-cyclicalamplification of these risks over time.

3

The Main Documents outlining Basel III

InternationalLRM Framework

Enhancements to theBII Framework

Revisions to BIImarket riskFramework

Guidelines forIRC

calculation

Principles forsound liquidity RM

Strengtheningthe resilience of

the bankingsector

CapitalCalibration Sept

12, 2010

RegulatorsConsensus July

26, 2010



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Reform Environment: Status of the Western FS Industry (post crisis?)

United States

Recovery Crisis

Back to profit: 7,000-pluscommercial banks overseenby FDIC reported $21.6bn inprofits Q1 2010 (vs $4.4bnloss in Q1 2009)

Bank failures: 294 banksfailed in the US since 2008;notwithstanding some signsof recovery, 129 banks failedin 2010

Shrinking write offs:Uncollectable loans fell$214m during Q1 2010 (firstdecrease since 2006)

Foreclosures:USforeclosures hit new highs insummer 2010, with aparticular acceleration in Julyand August 2010, accordingto LPS

Large banks, such as JP

Morgan Chase, Goldman andBofA, have emergedstronger than pre-crisis, andare dominating the marketspost crisis in many areas

Regulatory threats: Threat

to traditional business modelsdue to regulatory reform(Dodd Frank Act), particularlyin the field of prop-trading andhedge fund investments

Europe

Recovery Crisis

Stress tests: CEBS stresstest revealed that withaggregate losses of566bn,only seven banks tier 1

capital ratios fell below 6%

Bad debts: Banks in Greece,CEE, Spain, Ireland andPortugal remain in doubtfulconditions; loan losses 2010:123bn, 2011e:105bn(ECB), with austerity

packages upcoming.

Euro-Stabilization:The-zone has stabilized in late2010, with the being seenas some kind of "emergencyvalve" with respect to theweakening USD

State debt in doubt: Withbudget deficits soaring(Ireland: 11.6%), banks B/Sare loaded with doubtful Statedebt (Greek debt in Frenchbanks: estimated at 76bn)

Hiring spree: In July 2010,

London headhunters reportedthe biggest wave of mandatessince 2007, particularly in thearea of financial services

Stand alone funding not

secured: ECB carries a largebulk of bank financing, with1,300bn to be refinanced inthe coming 3 years

The Western financial markets are showing signs of both recovery and remainders of the crisis

Clearly, the system is still vulnerable and has not yet reached fully a status of resilience to further volatility and sloppy economic growth



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The Situation in Asia

AsiaRecovery Crisis

Large Chinese Banks grewin the range of 20 30 %annually from 2007 to 2009,with China naming 4 out ofthe 10 largest banks in theworld

Inflation and AssetBubbles: Inflation in Chinahas increased over 3 % in2010, and the governmenthas implemented massivemeasures to take control ofthe looming real estate

bubble

Shrinking write offs:Provisions / total loans ratiodropped massively across theregion until 2008, and stayedlow in major economiesduring the crisis

Currency wars: WiththeEuro and the USD comingunder pressure due toincreasing state debts andunsustainable funding needs,there is increasing pressureon Asian currencies toappreciate in value

Strong profits reported in2010 in major parts of theregion, such as in China,India, Australia, Korea andSingapore

Japanese banks: Profitabilityof Japanese banks laggedbehind the benchmark inAsia, with key playersreporting massive losses in2008 and 2009

The Asian financial system has proved to be rather stabile, with losses and lack of growth hitting mainly Western economies so far

The stimulus package of the Chinese government has been the key driver to keep the Asian economies floating



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The Dilemma of the Regulators

Cheap money supply and Quantitative Easing

The root of the problem:Continuing lack of growth ofWestern economies

The US economy shows signs of continuousweakness in the second half of 2010, withunemployment rates hitting 15.2% in Michigan(3Q10)

Cheap Money to stimulate growth Low central banks lending rates keep the Westerneconomy floating, with further Quantitative Easing(QE) announced

Is leverage a sustainable tool tostimulate private consumption?

Long term, cheap money will not be able to substitutethe weakness of private consumption, which iscreated by asset loss, high unemployment, risingtaxes and increased insecurity

Stimulus packages based on QEcreate asset and market bubbles

It is to be expected that banks will continue to passon cheap money to consumers, leading tounsustainable asset bubbles and leverage

create

obstacles toregulatory

reform

Stimulate Growth / Promote Deleveraging: Regulators have the task to strengthen the capital baseof banks and restrict risky lending, while the Western Central banks are at the same time pushingcheap lending and further leverage in order to stimulate the economy

Government as Regulator / Central Bank / Shareholder / Growth Agent: With Governments not

only promoting growth through Central Banks, but also being shareholders of major financialinstitutions, there is a high likelihood of conflicts of interest to their roles as regulators

Regional Conflicts: With Asias influence growing and Asian banks not hit that hard by the financial

crisis, it is to be expected that there will be resistance in Asia to be obliged to use medicine that was

developed to a large extent to cure an i llness that occurred elsewhere

Regulators globally face the dilemma that economic growth levels can only be maintained based on widening debt financing, whi le thefinancial sector needs deleveraging in order to increase its resilience to crisis



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Main Building Blocks of Basel III

Capital Clean Up and Risk Limitation

Clean up of

Regulatory Capital

The new proposals focus on improvement of quality of Tier 1

Predominant form of Tier 1 must be common shares and retained earnings Tier 2 capital will be harmonized and simplified; only one class of Tier 2 capital will remain.

Tier 3 capital (currently available to cover market risk requirements) will be eliminated.

Refining RiskManagement

July 2009 changes: Introducing stressed VaR into capital requirement, as well as capitalrequirements for an Incremental risk charge (IRC)

Creating addition capital requirements for Counterparty Credit Risk (CCR), especially in the areasof Annex 4 of the July 2006 accord (Credit Value Adjustment - CVA, Asset Value CorrelationAVC, Wrong Way Risk WWR)

Strengthening internal credit risk due diligence, and decrease (sole) reliance on external ratings

CountercyclicalMeasures

Promote more forward looking provisions, in line with the recent IASB proposals

Introduce additional capital conservation buffer that can be used in stress

Protect the banking sector from periods of excess credit growth through introduction of additionalcapital buffers in such periods

Limitation of Overall

Leverage The proposal introduces an overall restriction of leverage (exposure / capital)

Aim is to reinforce the risk-based requirements with a simple, non-risk-based backstop measurebased on gross exposure

Liquidity RiskManagement

Introduction of qualitative LRM standards, relating to Due Process, Emergency Funding Plan(EFP), stress testing requirements, etc

Introduction of Liquidity Coverage Ratio (LCR) and Net Stabile Funding Ratio (NSFR)

Systemic Risk Additional capital and liquidity surcharges for systemically important banks are in discussion These rules are not yet clearly fleshed out and will therefore not be discussed further in this pack



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Phase in of new Capital and Liquidity Requirements

The BCBS has recently published its time table under which the new capital and liquidity rules should become applicable.

Given that the current banking industries capital cushions would not support a big bang implementation, grand fathering and transitionalprovisions are meant to materially support a soft landing of the new regulatory requirements

2011 2012 2013 2014 2015 2016 2017 2018As of

1 January2019

Leverage Ratio Supervisory monitoringParallel run

1 Jan 2013 - 1 Jan 2017Disclosure starts 1 Jan 2015

Migration toPillar 1

Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%

Minimum common equity plus capitalconservation buffer

3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%

Phase-in of deductions from CET1(including amounts exceeding the limit forDTAs, MSRs and financials)

20% 40% 60% 80% 100% 100%

Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%

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

Minimum Total Capital plus conservationbuffer

8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5%

Capital instruments that no longer qualify

as non-core Tier 1 capital or Tier 2 capital

Phased out over 10 year horizon beginning 2013

Liquidity coverage ratioOberservationperiod begins

Introduceminimumstandard

Net stable funding ratioOberservationperiod begins

Introduceminimumstandard



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Strategic relevance of the upcoming rules

Basel II (overall) capital neutral

In developing the revised Framework in 2006, the BCBS has sought to arriveat significantly more risk-sensitive capital requirements that are conceptuallysound and at the same time pay due regard to particular features of thesupervisory and accounting systems in individual member countries.

These are to broadly maintain the aggregate level of such requirements,while also providing incentives to adopt the more advanced risk-sensitiveapproaches of the revised Framework.

Basel III not capital neutral

Other than Basel II, Basel III targets to significantly increase capital andliquidity requirements compared to status quo, with both risk weighted assets(RWA) and capital percentages rising

Basel III will thus have a material impact on growth strategies and thesustainability of current business models of banks



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Strengthening the Capital Base


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Background and Goals of the New Rules

Strengthening Core Capital

Flaws of theexisting

system

Many regulatory adjustments arenot applied to common equity,allowing to report high Tier 1 ratios

No harmonized list of regulatoryadjustments

Hybrid capital proved to be lessvaluable in times of stress thananticipated

Capital to support trading activitieshas minor quality (almost like a

liability) Weak transparency

Goals: Qualityand Simplicity

The definitions of Tier 1 and Tier 2 capitalshould correspond to capital which absorbslosses on a going concern basis and capitalwhich absorbs losses on a gone concernbasis, respectively.

Number of tiers and sub-tiers of capital mustbe limited

Minimum set of regulatory adjustments mustbe harmonized internationally

Capital composition must be disclosed in

detail

Tier 1 is King Tier 1 capital = highest qualitycomponent of capital.

Subordinated to all other elementsof funding, absorbs losses as andwhen they occur

Has full flexibility of dividendpayments and no maturity date

There can be no features which addadditional leverage or which couldcause the condition of the bank tobe weakened during periods ofmarket stress

Innovative Tier 1 will be phased out

Changes for Tier2 and Tier 3

Tier 2 will be simplified, one set of entrycriteria, removing subcategories of Tier 2

Subordinated to depositors and generalcreditors, original maturity of at least 5 years

Recognition in regulatory capital will beamortised on a straight line basis during

the final 5 years

Tier 3 capital will be abolished



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Capital Components under BII and Proposed New Composition

BII (current version) Proposed new standard

Tier 1Common Stock and other forms ofTier 1 (including perpetuals) Tier 1

Common Equity (common stockplus retained earnings and OCI)

Disclosed reserves(including from minority interests)

Additional going concern capital

15% innovative instruments(Annex 1 to BII)

n.a.

Deduct goodwill and equity fromsecuritizations

Deduct goodwill and many otheritems 1:1 from common equity

Deduct 50% of investments in otherfinancial institutions Transformed into 1:1 adjustment

Tier 2max 100% of

Tier 1

Undisclosed reserves and assetrevaluation Tier 2

Only one form of Tier 2 capitalremains

General loan-loss reserves Unrealized gains will be reviewedby BCBS until y/e 2010

Hybrid capital instruments n.a.

Subordinated debt (max 50% of Tier 1) n.a.

Tier 3For market risk coverage(limitations apply) Tier 3

n.a.

Common shares willneed to meet a set ofentry criteria before

being permitted to be

included in thepredominant form of Tier

1 capital.

Must be predominant formof Tier 1 capital

A new system of limitsand minima will apply :

common equitycomponent ofTier 1

Total Tier 1

Total capital



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Example for Current Tier 1 Composition

Minority interest:major part of

many institutions

Tier 1 capital

The bank deductsintangiblesfrom core

components

Innovative capitalforms a majorpart of Tier 1

XYZ Bank1)

1) These figures were extracted from a publicly available annual report of a major internationally operating banking group



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Tier 2 Capital Main Features

Main Features of Tier 2 Capital under the New Regime

Subordinated. No agreements that legally or economically enhance the seniority of the claim vis--vis depositors and general bank creditors allowed

Minimum original maturity of at least 5 years, amortization over the remaining 5 years of maturity.

No incentives to redeem

Callable, but only under (very) restrictive circumstances

No acceleration rights for payments (coupon or principal), except in bankruptcy and liquidation

No credit sensitive dividend features

No direct or indirect funding through the bank (group)

SPV structures fall under the same rules as for Tier 1

Example for Tier 2 Capitalcomposition

under the current regime

Some of the debt initem 3 and 4 will

qualify also under thenew regime

Will be deductedfrom Tier 1 in the

future

1) These figures were extracted from a publicly available annual report of a major internationally operating banking group

XYZ Bank 1)



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Adjustments to Tier 1 Regulatory Capital

Capital AdjustmentsTopic Comments Relevance

Stock surplus

Stock surplus (i.e. share premium) will only be permitted to be included in the

Common Equity component of Tier 1 if the shares giving rise to the stocksurplus are also permitted to be included in the Common Equity component ofTier 1.

The new rule ensures that there is no loophole for including instrumentsother than common shares in the Common Equity component of Tier 1

Some banks issued instruments that did not qualify for equity, but createda surplus which was accounted for as a reserve.

Rare, but ifinstruments have

been issued, can behigh volume

Goodwill and other intangibles *)

Goodwill and other intangibles should be deducted from the Common Equitycomponent of Tier 1, net of any associated deferred tax liability.

Option to use IFRS in determining the level of intangible assets if nationalGAAP results in a wider range of assets (e.g. building rights)

Addresses the high degree of uncertainty that intangible assets wouldhave a positive realisable value in periods of stress or insolvency.

Avoids giving acquisitive banks a capital advantage over banks with thesame real assets and liabilities which have grown organically.

Is quite standard in many jurisdictions

Can have hugeimpact, but is new

only with regards tosubcategories of

Tier 1

Deferred tax assets *)

Deferred tax assets which rely on future profitability of the bank to be realizedshould be deducted from the Common Equity component of Tier 1.

Deferred tax assets are capitalized in case of timing differences andpotentially in the form of loss carry forwards

Assets the worthiness of which depends on future profitability are usuallycollapsing in times of stress

Does not refer e.g. to prepayments to tax authorities

Can be verymaterial, but is

already standard in

various jurisdictions

Investments in own shares (treasury stock)

All of a banks investments in its own common shares should be deducted

from the Common Equity component of Tier 1 (unless already derecognizedunder the relevant accounting standards)

Counts for trading and investment portfolios, as well as components ofindex securities, investment funds, and forwards to purchase own stock Not too relevant,

given existing IFRSrules

Investments in the capital of certain institutions *)

For all holdings in banking, financial and insurance entities which are outsidethe regulatory scope of consolidation

Goal: remove the double counting of capital in the banking sector and limit thedegree of double counting in the wider financial system, within the appropriatetier of capital rather than at the total capital level.

Corresponding deduction approach: the deduction should be applied tothe same component of capital for which the capital would qualify if it wasissued by the bank itself.

Full deduction: All holdings of capital which form part of a reciprocal crossholding agreement or are investments in affiliated institutions (e.g. sistercompanies)

Threshold approach: For all other holdings Today in many jurisdictions 50/50% deduction

Has potentiallymassive implicationsfor complex affiliated

groups

Shortfall of the stock of provisions to expected losses

The deduction from capital in respect of a shortfall of the stock of provisions toexpected losses under IRB approach will be 100% from the common equitycomponent of Tier 1 capital.

The current regime (50/50% deduction) results in the bank with a lowstock of provisions showing more Tier 1 capital, which could be acting asan incentive for banks to provision at low levels

Depends onaccounting policyand results of IRB

approach

*) Instead of a full deduction, a bank must deduct the amount by which the aggregate of the three items with *) above exceeds 15% of its common equity component(for intangibles only applicable for mortgage servicing rights)



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Capital Adjustments (2)Topic Comments Relevance

Minority interest

Minority interest will no longer be eligible for inclusion in the Common Equitycomponent of Tier 1.

However, the Committee will allow some prudent recognition of the minorityinterest supporting the risks of a subsidiary that is a bank (7/2010)

The proposal addresses the concern that while minority interest can

support the risks in the subsidiary to which it relates, it is not available tosupport risks in the group as a whole and

in some cases banks set up risk free subsidiaries, controlled by 2 entities,both banks consolidated and used the capital injected by the third party

Potentialimpactmight be massive,

depending on groupstructure

Unrealised gains and losses on financial instruments

No adjustment should be applied for gains or losses recognized on thebalance sheet

The proposal addresses concerns that the existing policy adopted incertain jurisdictions of filtering out certain unrealized losses hasundermined confidence in Tier 1 capital.

It helps ensure that the Common Equity component of Tier 1 is fullyavailable to absorb losses (both realized and unrealized).

Relevant in manycases

Cash flow hedge reserve

Remove the positive and negative cash flow hedge reserve from the Common

Equity component of Tier 1 where it relates to the hedging of projected cashflows which are not recognized on the balance sheet.

CF reserves give rise to artificial volatility in common equity, as in this casethe reserve only reflects one half of the picture (the fair value of the

derivative, but not the changes in fair value of the hedged future cash flow)

Depends on use ofCF hedging; can be

material

Cumulative gains and losses due to changes in own credit risk on fairvalued financial liabilities

Filter out from the Common Equity component of Tier 1 all gains and lossesresulting from changes in the fair value of liabilities which are due to achanges in the banks own credit risk.

The existing filter established in the 8 June 2004 press release onlyapplies to gains and losses on liabilities which are fair valued as a result ofthe application of the fair value option

MtM of own debt due to deterioration of own credit risk is currently underreview by the IASB and will potentially be eliminated

Somebanksrecorded massive

gains in valuation ofown liabilites in the

crisis

Defined benefit pension fund assets and liabilities

Deduct of any DBO pension fund asset from the Common Equity componentof Tier 1. Assets in the fund to which the bank has unrestricted and unfetteredaccess can, with supervisory approval, offset the deduction.

Addresses the concern that assets arising from pension funds may not becapable of being withdrawn and used for the protection of depositors andother creditors of a bank

Depends heavily onpension scheme

used

Remaining 50:50 deductions

All remaining regulatory adjustments which are currently deducted 50% fromTier 1 and 50% from Tier 2, and which are not addressed elsewhere in theproposal, should be transformed into assets that need capital coverage

The 50:50 deductions complicate the definition of capital, particularly in theapplication of the limits and so the proposal is that they will receive a1250% risk weight.

Examples for current 50/50 deductions: Certain securitization exposures,Certain equity exposures under the PD/LGD approach; Non-payment/delivery on non-DvP and non-PvP transactions; Significantinvestments in commercial entities

Diverse

Adjustments to Tier 1 Regulatory Capital



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Strengthening Risk Management


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Overview of Changes of the RM Framework

Failure to capture major on- and off-balance sheet risks, as well as derivative related exposures, was a key destabilising factor over the past twoand a half years. The proposed changes to the RM framework focus on this area, and on the role of ECAIs

Changes through July 2009 papers

Raise capital requirements for the tradingbook and complex securitizationexposures, a major source of losses formany internationally active banks.

Introduces capital requirements forstressed value-at-risk (VaR) based on a12-month period of significant financialstress

Also introduces higher capital requirementsfor so-called re-securitizations in both thebanking and the trading book

Raise the standards of the Pillar 2supervisory review process and strengthenPillar 3 disclosures.

To be implemented by the end of 2010

Treasury related changes December 2009

Calculate effective EPE with stressedparameters to address general wrong-way risk

Use bond-equivalent of the counterpartyexposure to capture CVA credit valuationadjustments for counterparty downgrades

Raise multiplier asset value correlation forlarge financial institutions exposures

Additional collateral and marginingrequirements for illiquid derivate exposures

Capital charges for bilateral OTC derivativetransactions

Explicit Pillar 1 capital charge for wrong-wayrisk

Haircut for repo transactions usingsecuritization collateral (and prohibition of re-securitizations as eligible financial collateral forregulatory capital purposes)

Strengthen back-testing and stress testing

General CR related changes

Mitigate the reliance on external ratings ofthe Basel II framework,

Requirements for banks to perform theirown internal assessments of externallyrated securitization exposures,

Elimination of certain cliff effectsassociated with credit risk mitigationpractices

Tightening of the eligibility criteria for theuse of external ratings

Focus of Change

Tail risks in trading portfolios andsecuritization Risks

Stress testing relating to market risk

Incremental risk charge (specific MR)

Counterparty Credit Risk in treasurytransactions

Scenario analysis and stresstesting relating to CCR

Dealing with overreliance onexternal ratings



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Topic Noted Issues

Correlation of defaults

and high EAD

Defaults and deteriorations in the creditworthiness of trading counterparties occurred at the time when

market volatilities, and therefore counterparty exposures, were higher than usual Generally, wrong way risk was not covered adequately

CVA MtM Potential mark-to-market losses due to credit valuation adjustments (CVA) were not subject to capitalrequirements. Within the crisis, roughly two-thirds of CCR losses were due to CVA losses and only aboutone-third were due to actual defaults.

Correlation of exposuresto FI

Large financial institutions were more interconnected than currently reflected in the capital framework. As aresult, when markets entered the downturn, banks counterparty exposure to other financial firms also

increased.

Close out periods The close-out period for replacing trades with a counterparty with large netting sets often took much longerthan anticipated on average

Initial margining and EPE Initial margining typically was very low at the start of the crisis and increased rapidly during the turmoil.Capital required for EPE was not sufficient

Note: Expected Positive Exposure (EPE) is the weighted average over time of expected exposures wherethe weights are the proportion that an individual expected exposure represents of the entire time interval

Overreliance on OTCclearing

Central Counterparties (CCPs) were not widely used to clear trades

Securitizations Securitizations were treated as if they had the same risk exposure as a similarly rated corporate debtinstrument, while recently securitizations have continued to exhibit much higher price volatility

Stress Testing and BackTesting

The use of models with poor backtesting results contributed to an underestimation of actual losses Stress testing of counterparty credit risk was not comprehensive

Many institutions were not properly managing their trading book related CCR exposures

Lessons learnt from RM Failures relating to CCR



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EAD

Estimation

External

Contracts

Trading andTreasury

RiskManagement

Consider

FatTails

Bank B

Current Framework to Capture CCR

Current

NetExposure Options

Futures

Swaps

EstimatedFuture

NetExposure

Forecast market

parameters

Collateral

Forecastcollateral values

Bank A

Calculate EPEEstimation

ofM

(Standardor model)



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Summary of Proposed Capital Requirement Changes for CCR

Add CVA loss capital coverageto credit risk calculation

Calculate correlation adjustment

Calculate Maturity adjustment (ifapplicable)

Calculate Capital requirement

Calculate RWA

Factor specific WWR intoEAD estimates

RaiseAVC for Financial

Institutions

Trading example from slide 31

CalculateUnexpected Loss (UL)

Increase standard add ons if EPE ismodeled without margin

agreements



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Credit Valuation Adjustment (CVA) - Introduction

Definition

CVA is the price of counterparty risk (Expected Loss)

CVA = Value of the derivative under default free assumption minus value of the derivative accounting for failure topay.

CVA Development

1999/2000: Banks first start using CVA to assess the cost of counterparty risk

Treated in an insurance style approach (passive management)

2006: Accounting rules (FAS 157, IAS 39) imply that the value of derivatives positions must be corrected for counterparty risk

Post Lehman: Since the collapse of Lehman, CVA is a key issue of managing counterparty risk

Treated in a trading desk approach (active management)

CVA has material impact on pricing considerations

CVATtVTtV ,,~



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Capital Add on based on Bond-equivalent to capture CVA losses

Background Original Proposal (12/2009)

This proposed change also refers to Annex 4 ofthe June 06 BII framework.

Banks must calculate an additional capitalcharge to cover potential mark-to-marketcounterparty risk losses.

For this purpose, it is proposed that banksshould implement the bond-equivalent of thecounterparty exposure approach

In practice, this proposal provides a capitaladd-on by using a bond equivalent as a proxyfor CVA risk

Single name CDS can also be used as analternative

Each counterparty is long a hypothetical bondissued by the counterparty where:

o the notional of the bond is the total currentEAD of a counterparty (treated as fixed)

o the maturity of the bond is the effectivematurity of the longest dated netting set of acounterparty

type of bond: zero-coupon

When using the internal model for market risk, abank has to calculate a 99% VaR.

The time horizon is one year

Calculation on standalone basis (withoutaccounting for hedging)

Exception: Single name CDS or other equivalentinstruments directly referencing the counterparty



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July 2010 Modifications to CCR Methodology

Modifications to the CCR Calculation

Modify the bond equivalent approach to address hedging, risk capture, effective maturity and doublecounting

To address the excessive calibration of the CVA, eliminate the 5x multiplier that was proposed in December2009

Keep the asset value correlation adjustment at 25% to reflect the inherent higher risk of exposures to other

financial entities and to help address the interconnectedness issue, but raise the threshold from $25 billionto $100 billion

Banks mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to amodest risk weight, for example in the 1-3% range, so that banks remain cognizant that CCP exposures arenot risk free

More advanced alternatives to the bond equivalent approach could be considered as part of the

fundamental review of the trading book



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MoodysInvestorServices

Standard &Poors

FitchRatings

MainInternationalRatingAgenc

ies

External credit rating agencies were a major contributor to thefinancial crisis, with lax rating practices, commercial involvement instructures that were subject to rating, and massive downgradings,

also to below investment grades, of previously AAA ratedinvestments

As a consequence, the regulatory framework for CRAs wastightned both in the US and in Europe

Changes in the BII Framework also reflect the loss in trust in theactivities of credit rating agencies

Addressing (Over-)Reliance on External Ratings


R f P l R l ti t CRA


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Reform Proposals Relating to CRAs

July 2009 Measures

Banks must supplement regulatory capital requirements based on externallyrated securitizations with their own credit analysis and capital estimates of theexposure

Need to collect a range of information on the underlying collateral supportingsecuritizations exposures

Failure to conduct such due diligence will result in the bank having to deductthe exposure from capital

IOSCO Code andoperational requirements

CRAs must comply to the IOSCO Code of Conduct Fundamentals for CreditRating Agencies

Rating must be published in an accessible form and included in the ECAIs

transition matrix

Loss and cash-flow analysis as well as sensibility of ratings to changes in theunderlying ratings assumptions should be publicly available

Cliff Effects

Currently, "eligible guarantors" for the SA and FIRB are defined as externally

rated A- or better or internally rated and associated with a PD equivalent toA- or better

If a guarantor falls under this threshold, cliff effects might take place,

triggering a material change in the capital treatment

The new proposal departs from a single requirement, while maintaining arequirement in the Standardised Approach that a guarantor other thansovereigns, PSEs, banks, and securities firms - be externally rated.



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Introduction of an Overall Leverage Ratio

Current Version of Overall Leverage Ratio (7/2010)


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Current Version of Overall Leverage Ratio (7/2010)

Draft 12/2009

Definitionof TotalExposure12/2009

Include all assets (including high quality liquidassets) in the measure of exposure

Net of provisions and valuation adjustments(e.g. credit valuation adjustments)

Derivatives: Either accounting approach butwith no netting or current exposure method tomeasure potential exposure but with nonetting

Credit derivatives: exposure is effectively thesame as providing a guarantee, and thereforea 100% credit conversion factor will beapplied.

Commitments: 100% credit conversion factor

No reduction by physical or financialcollateral, guarantees or credit risk mitigationno netting of derivatives, repo styletransactions and of loans / deposits

Modifications 7/2010

Definitionof TotalExposure7/2010

For off-balance-sheet (OBS) items, useuniform credit conversion factors (CCFs), witha 10% CCF for unconditionally cancellableOBS commitments (subject to further review

to ensure that the 10% CCF is appropriatelyconservative based on historical experience).

For all derivatives (including creditderivatives), apply Basel II netting plus asimple measure of potential future exposurebased on the standardised factors of thecurrent exposure method. This ensures thatall derivatives are converted in a consistentmanner to a loan equivalent amount.

BCBS proposes a minimum Tier 1 leverage ratio of 3% during the parallel run period (33,3x), tracking LR quarterly

The supervisory monitoring period commences 1 January 2011 and focus on the developing templates to track the ratio

Parallel run period commences 1 January 2013 and runs until 1 January 2017, tracking LR and its components

Bank level disclosure of the leverage ratio and its components will start 1 January 2015. The Committee will closely monitor disclosureof the ratio


Illustrative Example


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Illustrative Example

Balance Sheet and Off Balance Sheet Volumes

Tier one Common Equity: 1.500

Capital Adjustments: 400

Total balance sheet volume: 18.000

Derivatives (CCR) 4.600

Guarantees, CDS 6.200

Outstanding Commitments: 3.200

Calculation of Exposure Calculation of Leverage Ratio

Balance Sheet Volume 18,000 Balance Sheet Volume 32,000

Off Balance Sheet Volume Total Capital

Derivatives (CCR) 4,600 Tier 1 Common Equity 1,500

Guarantees 6,200 Adjustments 400

Commitments 3,200 Total eligible capital 1,100

Total OBS 14,000

Total Exposure 32,000 Leverage Ratio 29x



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Dealing with Procyclicality

Dealing with Pro Cyclicality


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Dealing with Pro-Cyclicality

Current measures to address procyclicality:

Requirement to use long term data horizons to estimate probabilities of default

The introduction of so called downturn loss-given-default (LGD) estimates

Appropriate calibration of the risk functions, which convert loss estimates into regulatory capital requirements

Stress tests that consider the downward migration of their credit portfolios in a recession.

The proposals to further counterbalance pro-cyclicality focus on:

Forward looking provisioning (see next slides)

Capital conservation

Building capital buffers in times of excessive credit growth

In its proposal to strengthening the resilience of the banking sector, the BCBS also tries to address procyclical features of currentregulation. As it is in the nature of micro economic behavior to reduce lending in times of increased risk, it is of particular difficulty forregulators of privately owned banks to balance the need for proper risk management and macro-economic goals.

Establish a buffer range above the regulatory minimumcapital requirement

Capital distribution constraints are imposed on the bankwhen capital levels fall within this range (only on

distribution, not on business operations)

Distribution constraints increase as the banks capital

levels approach the minimum requirement

Should not result in the range being viewed asestablishing a new minimum capital requirement

Capital Conservation

Build up a capital buffer in times of excessive creditgrowth (ave credit growth exceeds GDP growthmaterially)

Adjust the capital buffer range when there are signs that

credit has grown to excessive levels

This will ensure that banks build up countercyclicalcapital buffers, increasing their ability to absorb losses

Expected to be fully f leshed out approach at the BCBS'July 2010 meeting

Capital Buffer for excessive credit growth


Measures against Pro-Cyclicality


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Measures against Pro-Cyclicality

The BCBS and the G20 have, in various documents, made clear that current banking and accountingregulation have certain pro-cyclical effects, meaning that those rules may exacerbate an economic crisis byproducing pro-cyclical feedback and second round effects, which might end up in a vicious cycle (downwardspiral):

One of the most destabilizing elements of the crisis has been the procyclical amplification of financial shocks throughout the banking system,financial markets and the broader economy. The tendency of market participants to behave in a procyclical manner has been amplified through avariety of channels, including through accounting standards for both mark-to-market assets and held-to-maturity loans, margining practices, andthrough the build up and release of leverage among financial institutions, firms, and consumers. The Basel Committee is introducing a number ofmeasures to make banks more resilient to such procyclical dynamics. These measures will help ensure that the banking sector serves as a shockabsorber, instead of a transmitter of risk to the financial system and broader economy.

Regarding forward looking provisioning, the BCBS outlines:

The Committee strongly supports the initiative of the IASB to move to an expected loss approach. The goal is to improve the decision usefulnessand relevance of financial reporting for stakeholders, including prudential regulators. It has issued publicly and made available to the IASB a set ofprinciples that should govern the reforms to the impairment standards. In particular, loan loss provisions should be robust and based on soundmethodologies that reflect expected credit losses in banks existing loan portfolios over the life of the portfolio. The accounting model for provisioningshould allow for early identification and recognition of losses by incorporating a broader range of available credit information than is permitted underthe incurred loss model.

The envisaged changes in accounting regulation will have a massive impact on both profitability and regulatorycapital, as the key effect will be that banks need to build up loan loss reserves from day 1, based on lossexpectations, rather than waiting for an impairment trigger to occur.

32Page 32 Basel III Design and Potential Impact

Building up Forward Looking Reserves


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Building up Forward Looking Reserves

IASB Roadmap to IAS 39 Overhaul

The IASB has revised its schedule for IAS 39 overhaul several times

As most of the issues are joint projects with the FASB, coordination takestime and requires multi-channel communication; further, the process toobtain comment letters is also time consuming

Most projects are expected to be completed by Q4 2010

The IASB has issued ED 2009/12 on amortized cost and impairment inQ4 2009. A final IFRS on the matter is expected to be issued in Q2 2011

Focus on Loan Loss Accounting

The BCBS promotes vigorously the buildingup of foward looking reserves

It supports the expected loss (EL) approachas recently promulgated by the IASB

IASB issued an ED to change from anincurred loss approach to EL approach

Part of the larger agenda to overhaul IAS 39

Committee considers EL approach to be lessprocyclical than the current incurred lossapproach

IASB has not yet finally defined theirapproach.

FASB is currently in the process ofdeveloping its own approach, with the recentdraft on FI diverging from the IASBs conceptin various aspects


High Level Overview of ED 2009/12


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High Level Overview of ED 2009/12

Asset by asset or groups ofsimilar assets

Estimate expected cashflows taking into accountexpected future creditlosses over the life of the

asset Probability-weighted

possible outcome approacheven if most likely outcomeis full repayment

No initial loss is recognizedimmediately

ED 2009/12 requires PITestimates TTC estimatesnot allowed

Initial recognition: Estimatefuture credit losses over life

of asset

Net interest revenuerecognized: Less marginto reflect estimated future

credit losses

Allowance forcredit losses built

up over time

Ongoingadjustments toestimates of

future creditlosses

Adjustment to the effectiveinterest rate method (EIR)

Margin deducted from EIRrate for estimate of futurecredit losses

Applies to fixed rate, floating

rate or combination ratefinancial assets carried atamortized cost

Solve for effective interestrate that equates (1) the initialcarrying amount with (2) thePV of expected future cashflows incorporating initiallyexpected credit losses

Margin for initially expectedcredit losses that isdeducted from grossinterest revenue in eachperiod is set aside togradually build-up anallowance for expectedfuture credit losses

Applies even if no actuallosses have yet beenincurred

Does not require objectiveincurred loss evidence asunder current IAS 39 rules

Each period, the entity mustreassess the assetsexpected cash flows , takinginto account expected futurecash flows

Any changes in credit loss

expectations bothfavourable andunfavourable arerecognized immediately ona discounted cash flowbasis as a gain or loss inearnings.

Discount revised expectedfuture cash flows at assets

original EIR


Existing Impairment Model (IAS 39) vs. Proposed Model


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Existing Impairment Model (IAS 39) vs. Proposed Model

Aspect Incurred Loss Approach Expected Loss Approach

Initial determination of the

effective interest rate (EIR)

Based on initial net carrying amount andexpected future cash flows ignoring futurecredit losses

Based on initial net carrying amount and expectedfuture cash flows that are adjusted for futurecredit losses

Trigger for impairmentRequired indicator based (objectiveevidence of impairment)

No trigger

Measurement of revisedcarrying amount

Expected cash flows reflecting incurredlosses discounted at original EIR

No fair value adjustments

No reflection of future credit losses

Continually updated expected cash flows

Discounted at original EIR (fixed rate instruments)or combination of spot curve for benchmark rateand a spread (floating rate instruments)

No fair value adjustments

Reflects expected future credit losses

Recognizing impairment Profit or loss Profit or loss

Subsequent impairments If further losses have been incurredRecognized automatically through continual re-estimation of cash flows

Revenue recognition afterimpairment

Based on EIR

Compatible with cost-based measurementobjective

Based on EIR

Compatible with cost-based measurementobjective

Reversals

Required if triggered by event afterrecognition of impairment loss

Limit to reversal up to amortized cost

Automatically by adjusting the expected futurecash flows (no trigger)

Upper limit is full contractual flows discounted atEIR


Comparison of Basel II and ED 12/2009


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Comparison of Basel II and ED 12/2009

Estimates of PD represent probability of default over 12month horizon.

PD is calculated using statistical methods on the basis oflong run historical average.

Estimates of loss inherent in cash flows are required overthe life of a loan.

Point in time estimates need to be made; over the cycleestimates are not permitted.

LGD is an economic loss concept. It includes direct andindirect collection costs, such as allocations of internaloverheads and other non-cash costs.

Losses are discounted to the point of default using an

entitys cost of capital / Funding Cost. At the default point, Basel 2 requires estimation of the

present value of expected future cash flows.

ED 12/2009 impairment calculations are cash flow driven.They may include direct cash collection costs, but shouldexclude non-cash costs.

ED 12/2009 requires recoveries to be discounted by the

original effective interest rate At each payment date (and therefore potential default

point), requires estimation of the expected future CF.

For Banks using the advanced approach, with theexception of certain short term exposures, the maturitywill be the greater of 1 year / remaining effectivematurity.

This mainly equates to the remaining contractual periodof the exposure.

IAS 39 Impairment requires an estimation of the amountand timing of prepayment over the instruments effectivelife.

In respect of credit facilities, EAD takes into accountexpectation of future draw-downs through a creditconversion factor.

Uses Carrying Value and Actual Cash Flow as the basis forestimations.

PD

L

GD

EAD

M

Synergies and Differences

Basel II ED 2009/12


Incurred Loss, Expected Loss and Basel II


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, p

Incurred Loss Model

IASB Expected Loss Model

Basel II Expected Loss Model

y/e 2010 y/e 2011

PD 1 year

Loss event

Loss event

Default

EL = EAD * PD * LGD

Impaired, no consideration of emergenceperiod as loss is already identified

Extrapolationof loss events through LEPCalculation

IL = EAD * PD * LGD * LEPEmergencePeriod

EmergencePeriod

Loss Identification

Loss Identification

NAV of CF(t)= f(PD(t), LGD(t), EIR)

Past default and loss data is used to estimate PD andLGD (usually 5 years)

t


Decoupling


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p g

In practice, the ECF approach would give rise to operational difficulties becausefinancial institutions and others typically store comprehensive contractual andaccounting data (in particular effective interest rate data) and EL datainformation in separate systems (accounting and risk systems).

These operational difficulties were a major concern raised by members of theEAP. (The ECF approach proposed by the IASB features an integrated EIRcalculation that would require integration of the data in the accounting and risksystems.)

The ECF approach (as an approximation) could be simplified by decoupling

separately sourcing the information in accounting systems (interest revenue asdetermined today under IAS 39 Financial Instruments: Recognition and

Measurement that excludes EL estimates) and the information in risk systems.Such an approach would adjust the interest revenue calculated in the accountingsystem using an allocation profile for expected credit losses derived from ELdata in the risk system.

In order to better understand a possible decoupling approach, the followingslides give some details on how banks typically manage credit risks, based onthe Basel II methodology, and make a comparison of the ECF and credit riskmethodology.

Based on existing differences, we also analyze practical issues, such as datarequirements (and limitations) and the like.



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Management of Liquidity Risk

39

BCBS Paper on Fundamental Principles of LRM


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Fundamental principle

1. A bank needs to establish a robust liquidity risk management framework

Governance of liquidity risk management

2. A bank should clearly articulate a LR tolerance appropriate for its business strategy and role

3. Senior management needs to be actively involved in LRM

4. Liquidity costs need to be factored into internal transfer pricing, so that LR is considered adequately

Measurement & management of liquidity risk

5. A bank should have sound a process for identifying, measuring, monitoring and controlling LR

6. A bank shouldactively monitor and control LR exposures throughout the group and take into account legal,regulatory and operational limitations to the transferability of l iquidity

7. A bank should establish a funding strategy for effective diversification of sources / tenor of funding

8. A bank should actively manage its intraday liquidity positions and risks

9. A bank should actively manage its collateral positions

10. A bank should conduct stress tests regularly and use the results to adapt strategy / positions

11. A bank should have a formal contingency funding plan

12. A bank should maintain a cushion of high quality liquid assets as insurance against a range of liquidity stressscenarios (see International framework for LRM)

Public Disclosure

13. A bank should issue regular public disclosure on LRM and positions

Role of supervisors

14. Comprehensive assessment of liquidity risk management framework

15. Monitoring of internal reports, prudential reports & market information

16. Effective and timely intervention (New)

17. Communication with other supervisors and public authorities

The 17 BCBS Principles

Fundamental Principles

Governance of

Liquidity Risk

Public

Disclosure

Measurement

and

Managementof Liquidity Risk

Role of

Supervisors

Framework for

Liquidity Risk Management (LRM)


Overview of BCBS Liquidity Ratios


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The core of the framework consists of two ratios, which have been developed to achieve two separate but complementary objectives.

BCBS International Liquidity Framework

Aim to strengthen short-term liquidity profile

Defines level of liquidity buffer to be held tocover short-term funding gaps under severeliquidity stress

Cash flow perspective

Predefined stress scenario

Time horizon: 30 days

Aim to strengthen medium- to long-termliquidity profile

Defines minimum acceptable amount of

stable funding in an extended firm-specificstress scenario

Balance sheet perspective

Predefined stress scenario

Time horizon: 1 year

LCR

Stock of high qualityliquid assets

Net cash outflowsover 30-day horizon

NSFR

Available amount ofstable funding

Required amount ofstable funding

LiquidityCoverageRatio

NetStableFun

dingRatio

100%

100%


Liquidity Coverage Ratio


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Banks must maintain an adequate level of unencumbered, high quality assets to meet their liquidity needs for a 30-day time horizon under an acutestress scenario.

Net cumulative liquidity mismatch position under stress scenario based on contractual maturities

Survival period of 30 days

Stress scenario is a combination of idiosyncratic and systematic factors, defined through asset and runoff factors

specified by regulators

One size fits all philosophy reduces risk sensitivity for the sake of harmonisation internal stress tests at banks

based on BIS sound principles are required to complement ratio

LCR

Stock of high qualityliquid assets

Net cash outflowsover 30-day horizon

Market value

Cash Outflows

Cash Inflows

Asset factor

Cash Outflows

Cash Inflows

Runoff Factor

Runoff Factor

Three-notch credit ratingdowngrade

Partial run-off of deposits

Partial loss of wholesalefunding capacity

Increased market volatility higher collateral haircuts

Unscheduled draws on

committed facilities

STRESSSCENARIO

100%


High Quality Liquid Assets as Nominator


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Conservative approach and restrictive wording

by BIS as a result of the crisis

Additional restrictive criteria for corporate &

covered bonds e.g. max. 50% of buffer

Note no blanket inclusion of sovereign bonds,

additional criteria e.g. 0% risk weight apply

Bank deposits are not part of the liquid assets

buffer, but can count as cash inflow when

calculating the potential net cash outflow in the

stress scenario

The nominator of the LCR is composed of a stock of unencumbered, high quality liquid assets. The exact composition of the buffer remains amatter of intense discussion.

List of qualifying high quality liquid assets Factor

1

Cash

100%Central bank reserves

Marketable securities issued or guaranteed by sovereigns, centralbanks, PSEs and multilateral development banks

Domestic sovereign /central bank debt in domestic currency

2Specific plain vanilla corporate bonds, rating > A+

80%Specific plain vanilla covered bonds, rating > A+

3Specific plain vanilla corporate bonds, rating A+/A/A-

60%Specific plain vanilla covered bonds, rating A+/A/A-

indiscussion

Low market and credit risk Ease and certainty of valuation Listing on a developed exchange

Characteristics of high quality liquid assets

Fundamentalcharacteristics

Marketcharacteristics

Operationalrequirements

Active and sizeable market Safe-Haven Assets Ideally central bank eligible

Unencumbered and freely available


Current Categorizations for Liquidity Coverage Ratio (LCR)


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OutflowsInflows

DepositsUnsecuredwholesalefunding

Committedcredit/liquidity

facilities

ABS/ABCP

Securedwholesalefunding

Collateral/derivates

Various

Retail customersStable: 7,5%Instable:15%

10%

100%

Repos:

Buffer Assets0%

Other Assets100%

3-notchDowngrade

Triggers:100%

Negative marketvalue changes

Collateral:20%

Derivatives:tbd**

Retail/Wholesale:

100%Repos:

Buffer Assets0%

Other Assets100%

Credit facilities:0%

SMEStable: 7,5%Instable:15% Credit

facilities:10%

Liquidityfacilities:100%

Non-Financials (with operationalrelationships)

25%

Non-Financials (withoutoperational relationships)

75%

Sovereigns (with operationalrelationships)

25% Credit andliquidityfacilities:

100%Sonstige* & Sovereigns (w/o

operational relationships)100%

Changed to 5%/10%

Introduce new bucket(custody and

clearing), 25% outflow

Changed to 75%

Only recognise roll-over of transactionsbacked by liquidity

buffer eligible assets

Lower to 5%

For sovereigns etc:10% run-off for creditlines and 100% run-off for liquidity lines


Net Stabile Funding Ratio


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This metric establishes a minimum acceptable amount of stable funding based on the liquidity characteristics of an institutio ns assets and activitiesover a one year horizon.

NSFR promotes medium to long-term funding thus reducing incentives for short-term wholesale funding and

supplements the LCR (by also counterbalancing cliff-effects)

The stress scenario is defined differently from the one underlying the LCR idiosyncratic stress over 1 yr

Stable funding is defined as those types of equity and liabilities expected to be reliable sources of funds under anextended stress scenario of one year

For determination of the required funding amount accounting and regulatory treatment is irrelevant required

funding amount depends solely on the respective instruments liquidity characteristics

NSFR

Available amount of stablefunding (ASF)

Required amount of stablefunding (RSF)

Carrying Value

Carrying Value

RSF Factor

ASF Factor

Significant decline inprofitability

Significant decline insolvency

Potential downgrade byany nationally recognisedcredit rating organisation

Material event which callsinto question the reputationor credit quality of theinstitution

STRESSSCENARIO

100%


Current Version of ASF / RSF Percentage Weighting for NSFR


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RSF Categories (denominator) Factor

1

Cash, money market instruments

0%Securities, loans to financial entities, effective maturity< 1 Y

2Specific unencumbered government/quasi-sovereign bondswith excellent rating, active repo-markets, 1 Y

5%

3 Specific credit and liquidity facilities 10%

4Specific unencumbered corporate bonds or covered bonds withexcellent rating, active and liquid markets, 1 Y

20%

5 Gold, loans to non-financial corporate cl ients < 1 Y, etc. 50%

6 Loans to retail clients, < 1 J 85%.

7 All other assets 100%

8 Other (non-contractual) contingent funding obl igat ions tbd*

ASF Categories (numerator) Factor

1

Total amount of capital, including both Tier 1 and Tier 2

100%Preferred stock not included in Tier 2, effective maturity 1 Y

Total amount of secured and unsecured borrowings andliabilities 1 Y

2 Stable Retail/SME deposits < 1 Y 85%

3 Less stable Retail/SME deposits < 1 Y 70%

4 Unsecured wholesale funding and deposits provided by non-financial corporate customers< 1 Y 50%

5 All other l iabilities and equity categories 0%

Raise to 80% Raise to 90%

Lower to 65% forresidential

mortgages and otherloans that would

qualify for the 35%or better risk weightunder StA for CR

Lower to 5%, insofaras pre-funded

Transition: Carry out an observation phase to address any unintended consequences across business models or funding structuresbefore finalising and introducing the revised NSFR as a minimum standard by 1 January 2018.


LRM Monitoring Tools


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On top of the LCR and the NSFR the framework introduces four tools which enable the regulator to monitor the liquidity situation of the respectivebank.

Tool Definition Aim

ContractualMaturity

Mismatch

Reporting of contractual maturity mismatch profi leMapping of inflows and outflows of both on- and off-balance sheet positions to defined time bands basedon their contractual maturities

Insight into the extent to which the bank relies onmaturity transformation, based on (very)conservative assumptions

Supplemented by internal profiles includingbehavioural assumptions (Going Concern, Stress)according to the BIS Sound Principles

Concentration of

Funding

Reporting of significant concentrations within the

wholesale funding profile

For: counterparts, products, currencies; reportede.g. as simple, pre-defined ratios; significantdefined as > 1% total liabilities

Diversification of funding sources, as required

within the BIS Sound Principles

Liability equivalent to Large Exposure regulation

on the asset side

AvailableUnencumberedAssets

Reporting of available unencumbered assets, thatcould serve as collateral in secondary markets orare eligible for central banks standing facilities

Insight into available additional funding

Market-relatedmonitoring tools

Regulators monitoring of market-wide information,information on the financial sector as well as bank-specific information

Early warning signals for potential liquidity crisissituation



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Potential Impact Analysis and Forward

Looking Actions

How to Prepare for the Upcoming Changes?


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Topic Proposed Actions

Overall Approach While the details of various approaches to limit leverage and stronger regulatory scrutiny and restrictionson business activities will unfold in the near future, we believe that it is already now necessary toanalyze an institutions vulnerability to the proposed measures

Regulatory Capital The impacts of the upcoming definitions of Tier 1 and Tier 2 capital can be massive The same counts for the new deduction requirements Banks need to run a test calculation what the implementation of the new rules would mean

Risk Management RM of treasury and trading departments should be reviewed and the impact of the new regulations oncapital requirements analyzed

Credit risk management departments need to analyze the impact of the new requirements for the use ofexternal ratings

Leverage Ratio Banks should calculate their current leverage ratio under the new proposals and monitor the calibrationefforts of the BCBS closely

Provisioning Banks should perform quantitative impact analysis of the proposed expected loss methodology andmonitor closely the latest developments on this front

The level of granularity depends on the available data. Data gaps should be analyzed

Capital Buffers Banks should analyze if they are operating in environments of excessive credit growth and prepare foradditional capital requirements for such business activities

Liquidity RiskManagement LRM should be reviewed, as part of pillar 2 process, and strengthened in accordance with the BCBSbasic principles Meaningful stress tests and CFPs should be designed and implemented

Liquidity Ratios Banks should perform a pro forma calculation of the new liquidity ratios and assess the impact onbusiness activities

The proposed changes to the regulatory framework necessitates various actions in well managed banks, to assess the impact of the variousnew measures and prepare for potential concrete actions with an impact analysis being the predominant aspect at this time


Example for an Impact Analysis: Introducing XYZ Bank


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In order to outline the strategic consequences of Basel III in more detail, we modeled the impact of the new regulations on XYZ Bank, a stylizedretail and wholesale bank in Asia which is ambitious to expand their loan and derivatives trading business

The following slides are based on XYZ Banks growth plan, first outlining Basel II compliance and then analyzing effects of Basel III

The table below shows the (simplified) growth projections for assets, liabilities and off balance sheet volumes, as a starting point of the analysis

Growth Plan XYZ Bank (Basel II) 2011 2012 2013 2014 2015 Growth

ASSETS In bn CUR units In %

Deposits (CB, other banks) 740 814 895 985 1,083 10%

Net trading assets 50 60 72 86 104 20%

Loans to customers 1,950 2,438 3,047 3,809 4,761 25%

Investment securities 450 495 545 599 659 10%

investments in affiliates 45 45 85 85 85 Acquisition

Deferred tax assets18 23 28 35 44 25%

Other assets 150 165 182 200 220 10%

Total 3,403 4,039 4,853 5,799 6,955

LIABILITIES

Due to other banks 320 384 461 553 664 20%Due to customers 2,700 3,240 3,888 4,666 5,599 20%Debt issued 50 63 78 98 122 25%Tier 2 capital bonds 104 114 126 138 152 10%Other 50 39 75 85 118

Total 3,224 3,840 4,628 5,539 6,654

OFF BALANCE SHEET VOLUME

Commitments 230 288 359 449 562 25%

Underwriting, Derivatives 1,250 1,500 1,800 2,160 2,592 20%

Total 1,480 1,788 2,159 2,609 3,154


XYZ Bank Basel II Capital and Risk Weighted Assets Forecast


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Growth Plan XYZ Bank (Basel II) 2011 2012 2013 2014 2015

EQUITY, REGULATORY CAPITAL

Share Capital 50 50 50 50 50

Share Capital Surplus 55 55 55 55 55

Innovative Tier 1 15 15 15 15 15

Retained earnings 59 79 105 139 181

Tier 1 capital before deductions 179 199 225 259 301

Deduction: 50% Associated Entity -23 -23 -43 -43 -43Net Tier one capital 157 177 183 217 259

Tier 2 Capital 104 114 126 138 152

Deduction: 50% Associated Entity -23 -23 -43 -43 -43

Total Tier 2 capital 82 92 83 96 110

Total regulatory capital 238 291 309 355 411

RISK WEIGHTED ASSETS

RWA banking book (bank's systems) 1,600 1,899 2,282 2,726 3,270Trading book capital (VaR based) 25 29 33 38 44

RWA Trading book (x12.5) 313 359 413 475 547

Total RWA 1,913 2,258 2,695 3,202 3,817

XYZ Banks regulatory capital is a function of core capital, deductions under Basle II, and of tier 2 capital.

Innovative Tier 1 capital has been issued in order to achieve a more flexible capital composition

As can be seen in the table below, XYZ Bank plans to increase its regulatory capital by retaining earnings over the coming years

Risk weighted assets reflect mainly loans to customers, as deposits and investment securities achieve low ratings due to the standing of thedebtors


XYZ Bank Basel II Capital Compliance and Profitability Forecast


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Growth Plan XYZ Bank (Basel II) 2011 2012 2013 2014 2015

BASEL II CAPITAL REQUIREMENTS

Minimum required Tier one capital(0.5% over reg-floor) 4.5% 4.5% 4.5% 4.5% 4.5%

Minimum required tier one capital 86 102 121 144 172

Tier one surplus / deficiency 70 75 61 73 87

Required Total capital percentage(1% over minimum) 9.0% 9.0% 9.0% 9.0% 9.0%

Required capital (credit risk, market risk) 172 203 243 288 344

Total capital GAP (-) / surplus (+) 66 88 66 67 67

PROFITABILITY AND PERFORMANCE

Annual consolidated profit 25 31 39 49 61

Dividend 5 5 5 7 7

ROE 14.0% 15.7% 17.3% 18.8% 20.3%

Number of shares (m) 50 50 50 50 50

Earnings per share (in CUR units) 500 625 781 977 1,221

Expected share price(in CUR units; multiple: 10x)

5,000 6,250 7,813 9,766 12,207

The table below outlines that the capital increases through earnings retention are sufficient to fund the projected business growth underBasel II requirements

The banks plan shows both tier 1 and total capital levels well above the minimum capital requirements, which have been raised by the boardof directors by 1 %age point

Given the increase of profitability and EPS, the bank expects material improvements of their share price on the stock market, assuming a

multiple of 10x EPS for market capitalization


Basel III Impact on XYZ Banks Regulatory Capital

The Table below outlines the impact of Basel III on regulatory capital of XYZ Bank


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Basel III Impact 2011 2012 2013 2014 2015

Capital deduction requirements under Basel III

Net Tier 1 capital under Basel II 1) 157 199 225 259 301

Investment in Subsidiaries (50%) 23 23 43 43 43

Deferred Tax Asset 18 23 28 35 4441 45 71 78 86

minus 15% capital threshold 2) 23 30 34 38 44Effective deduction requirement 17 15 37 39 41

Phase in 0.0% 0.0% 0.0% 20.0% 40.0%0 0 0 -8 -17

Innovative Tier1 Phase out 0.0% 0.0% 10.0% 20.0% 30.0%0 0 -2 -3 -5

Profit impact of IASB impairment project

As a percentage of RWA (simplification) 0.0% 0.0% 0.75% 0.75% 0.75%

Impact on Tier 1 capital 0 0 -17 -20 -25

Impact on Tier 2 capital

Tier 2 capital 104 114 126 138 152

Phase out 50% sub-deduction -23 -23 -43 -43 -43Phase out percentage 0.0% 0.0% 10.0% 20.0% 30.0%

Effective deduction -23 -23 -38 -34 -30Tier 2 capital under Basel III 82 92 88 104 123

Adjusted capital under Basel III

Adjusted Tier 1 Capital under Basel III 157 199 207 228 256

Tier 2 capital under Basel III 82 92 88 104 123

Adjusted Total Capital under Basel III 238 291 294 333 378

The Table below outlines the impact of Basel III on regulatory capital of XYZ-Bank

Main effects are derived from deferred tax assets, investments in affilates, and the phase out of innovative capital forms

In line with the BCBSs support of the IASB expected loss credit risk provision model, the impact of IASB ED 12/2009 is mode lled as well

1) Deduction under BII stays fully in force until BIII transition is completed (subjective interpretation)2) Innovative Tier 1 stays in the base until it is phased out (subjective interpretation)Page 53 Basel III Design and Potential Impact

Basel III Additional Capital Requirements


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Basel III Impact 2011 2012 2013 2014 2015

Basel III Capital Requirement

Basel 3 Minimum Tier 1Requirement 4.0% 4.0% 4.5% 5.5% 6.0%

Discretionary board add on 0.5% 1.0% 1.0% 1.0% 1.0%4.5% 5.0% 5.5% 6.5% 7.0%

Basel 3 Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0%

Discretionary board add on 1.0% 1.0% 1.0% 1.0% 1.0%

Countercyclical Capital Buffer 0.0% 0.0% 1.5% 1.5% 1.5%

9.0% 9.0% 10.5% 10.5% 10.5%

Trading book capital requirement (incorporating the 6/2009 changes and Basel II I)

Current 25 29 33 38 44

Stressed VaR capital add on (150%) 38 43 50 57 66

CCR add on (50%) 13 14 17 19 22

Total add on 50 58 66 76 87

Total TB capital requirement 75 86 99 114 131

The Basel capital requirements increase based on the BCBS published phase in plan of additional Basel III capital needs, as well as basedupon the 2009 enhancements to capital requirements of trading activities

Stressed VaR as part of the capital formula is deemed to have an impact of 1.5x (total: 2.5x), with QIS conducted by BIS outl ining potentiallyhigher impact levels

CCR is modeled as a simiplified 50% add on to BII capital requirements


XYZ Banks Capital and Liquidity GAP under Basel III


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Basel III Impact 2011 2012 2013 2014 2015

RWA under Basel III

RWA banking book 1,600 1,899 2,282 2,726 3,270

RWA trading book (x12.5) 938 1,078 1,240 1,426 1,640

Total RWA 2,538 2,977 3,522 4,152 4,910

Required Tier 1 Capital under Basel III 114 149 194 270 344

Required total capital under Basel III 228 268 370 436 516

Capital Shortfall under Basel I II

Tier 1 Capital Shortfall 42 50 13 -42 -88

Total Capital Shortfall 10 23 -76 -103 -137

Leverage Ratio Limitations

Leverage Ratio under Basel III 31x 29x 34x 37x 40x

maximum leverage (3%) 33x 33x 33x 33x 33x

Adjustment need 2x 4x -1x -4x -7x

Liquidity Ratios

Basel III LCR Funding GAP 0 0 0 0 - 200

Basel III LTFR (observation only) 141% 137% 130% 126% 123%

As can be seen in the table below, XYZ bank faces material shortfalls of both tier 1 and tier 2 capital under Basel III

The planned business growth leads to a potential material breach of the upcoming maximum leverage ratios

Under the upcoming mandatory liquidity ratios, the bank would be obliged to hold at least 200m additional liquid funds in ord er to sustain theLCR Funding test

As a consequence, the banks plans need to be materially adapted in order to reflect the additional capital and liquidity needs of Basel III


Potential Plan Adaption: Reduction of Trading Business

XYZ B k d id t m d l d ti f th i l d t di b i i d i ti d d iti l b 10 % i t d f th


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Impact Mitigation 2011 2012 2013 2014 2015 growth

Reduction of trading and underwriting volumes

Adapted net trading assets 50 60 72 86 104

Adapted trading OBS volume 1,250 1,375 1,513 1,664 1,830 10%

Adapted capital requirement 25 26 28 29 31

Scale down in volume 0.0% -8.3% -16.0% -23.0% -29.4%

Impact on profitability

Trading part of profitability 6.7 8.5 10.6 13.3 16.6

Profitability of reduced trading activity 6.7 7.8 8.9 10.2 11.7Impact 0.0 -0.7 -1.7 -3.0 -4.9

Impact on capital

Tier 1 capital before tradingreduction 157 199 207 228 256

Profitability reduction 0.0 -0.7 -2.4 -5.4 -10.3

Tier 1 capital after profitability reduction 156.5 198.3 204.2 222.7 245.3

Tier 2 capital 81.5 91.9 87.6 104.4 122.5

Total capital 238.0 290.2 291.8 327.1 367.8

Impact on RWARWA banking book 1,600 1,899 2,282 2,726 3,270

RWA trading book 938 988 1,042 1,098 1,158

Total RWA 2,538 2,887 3,324 3,825 4,428

XYZ Bank decides to model a reduction of their planned trading business, growing derivative and underwriting volumes by 10 % instead of theenvisaged 20%

This downsizing (30% by 2015) impacts both profitability and RWA / VaR growth (the latter reducing capital requirements and leverage ratio)


Additional Plan Adaption: Capital Increase to Mitigate Capital GAP

I dditi th b k d it t i it it l b 2013 i d t hi li ith th B l III it l d l


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Impact Mitigation 2011 2012 2013 2014 2015

Required Tier 1 capital 114 144 183 249 310

Required total capital 228 260 349 402 465Tier 1 GAP 42 54 21 -26 -65Total capital GAP 10 30 -57 -74 -97

Impact on leverage ratio

Maximum leverage ratio 33x 33x 33xLeverage ratio 33x 36x 38x

Required Tier 1 capital 114 144 183 249 310

Tier 1 Capital Increase

Number of shares (m CUR units) 13Share price (CUR unit) 7,813Total increase tier 1 100 100 100Impact on profitability: 2% risk free return (cumulated) 2 4

Total impact on Capital and Leverage Ratio

Tier 1 Capital GAP 42 54 121 76 39Total Capital GAP 10 30 43 28 7Leverage ratio 31x 29x 22x 24x 27x

In addition, the bank deems it necessary to increase its capital by 2013, in order to achieve compliance with the Basel III capital and leverageratio requirements

The capital increase is done based on the share price predictions as contained in the unchanged plan, and may therefore need to bediscounted if using a more conservative planning approach

As a result of the two plan adaptions (scale down of trading business, capital increase), XYZ Bank is back on track in projecting sufficient

capital levels to comply with regulatory requirements, both for RWA and leverage ratio


Impact of Plan Adaption on Profitability and Performance


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Impact Mitigation 2011 2012 2013 2014 2015

Impact on ROE

Annual consolidated profit 25 31 20 27 36

Dividend 5 5 5 7 7

ROE after plan adaptations 14.0% 13.8% 8.3% 10.7% 13.4%Planned ROE 14.0% 15.7% 17.3% 18.8% 20.3%

Impact on ROE (percentage points) 0.0% -1.9% -9.1% -8.1% -6.9%

ROE Delta (in percent) 0.0% -11.9% -52.4% -42.9% -34.1%

Share Price Impact

Number of shares (m) 50 50 63 63 63

Earnings per share (in CUR units) 500 611 323 435 567

Expected share price in CUR units

(multiple: 10x) 5,000 6,109 3,226 4,353 5,675Planned share price 5,000 6,250 7,813 9,766 12,207

Impact on Share Price vs. expected 0 -141 -4,586 -5,413 -6,532

Share price vs. starting point 22.2% -35.5% -12.9% 13.5%

However, as can be seen in the tables below, XYZ Banks measures to maintain compliant with regulatory capital requirements have amaterial impact on the banks profitability and share price

Given the reduced trading growth ambitions and that the capital increase can not be used to leverage additional business but only to maintainthe growth expectations of the original plan, ROE reaches initial levels only after 2015

EPS are equally impacted, resulting into material loss of share price in 2013, reaching initial levels only in 2015.

Thus, there is a clear trade off between regulatory compliance and gorwth and profitability goals under Basel III.


Strategic Consequences


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Ensure Capital andLiquidity Funding

Enable capital planningbased on growth plans

Plan, prepare and executecapital raising seamlessly

Diversify funding sourcesand investors

Build liquidity management

capabilities

Introduce a leading cost ofcapital and funds concept

Build sustainable Trust

Improve corporategovernance

Improve risk culture andICAAP implementation(involving top leadership)

Anticipate risks (expeciallybubbles and aggregationrisks) early, and prepare formarket stress

Avoid regulatory failure andreputational risks

Focus on meaningfuldisclosure

Enhance Profitability and

Operative Excellence

Optimize target operatingmodel, focusing on scalewhere possible and onindividualization whereprofitable

Create a world class ITplatform, focusing onfunctionality and economiesof scale

Lead through world classfinance management (client

/ product profitability, risk /reward, etc)