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Creating Shareholder Value

Emperor Exposed ? What Went Wrong?. The last year has been a wrecking yard of bank earnings, writedowns, and shotgun mergers to avoid bankruptcies / insolvencies. Fundamentally banks lost track of what creates shareholder value. ABCP. Creating Shareholder Value. Bank's create Shareholder Value Added (SVA) by adhering to a disciplined Risk Adjusted Performance Measurement (RAPM) process focusing on:Risk adjusted earnings on Required Risk Based CapitalGenerating stable, sustainable, growing earnings over time.

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Creating Shareholder Value

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    1. Creating Shareholder Value Alan Jette – SVP Treasury & Balance Sheet Management Presentation to the ICPM 3 June 2008

    2. Emperor Exposed – What Went Wrong?

    3. Creating Shareholder Value Bank’s create Shareholder Value Added (SVA) by adhering to a disciplined Risk Adjusted Performance Measurement (RAPM) process focusing on: Risk adjusted earnings on Required Risk Based Capital Generating stable, sustainable, growing earnings over time

    4. RAPM – Key Components Components Funds Transfer Pricing - assigns fully hedged cost of funds to all lending and deposit exposures Expected Credit Loss Assessments for pricing and provisioning Risk Based Capital Allocations Differentiation between Productive and Non-Productive risk Keys to Success No exceptions or sacred cows No internal arbitrage opportunities No black boxes - full transparency of process, and results

    5. Funds Transfer Pricing System All loan and deposit positions transfer priced explicit cost of funds on a fully hedged, option adjusted funding basis Liquidity premiums are assigned with an explicit term structure independent from market risk Market and liquidity risk is transferred to treasury and managed centrally

    6. Expected Credit Loss and Risk Based Capital Product pricing and provisioning should reflect fair “through the cycle” credit costs and a risk adjusted capital allocation calibrated to absorb extreme “tail” events

    7. Differentiate Between Productive and Unproductive Risks Market Risk (non Trading) Market risk is not a productive risk for a personal & commercial Bank Exposures do not effectively leverage the retail franchise US Banks: “we have to take interest rate risk to make money” Theory: don’t need a retail bank infrastructure for investor to earn returns from market risk Structural interest rate gap positions are an explicit position and view/bet on the market Option Hedging Locks in expected costs and eliminates potential for earnings variability Does not create incremental costs Reduces economic capital required

    8. 3. Differentiate Between Productive and Unproductive Risks Credit Risk Organic credit risk is a productive risk for a Personal & Commercial Bank Leverage the Bank’s franchise value to intermediate with individual customers Creates excess spread relative to long run expected losses and capital costs Wholesale credit exposures is more efficient and presents lower opportunities for risk adjusted returns Securitization market Purchased whole loan Syndications

    9. US Bank Strategies to Increase Nominal Returns Interest Rate Gap Carry Trade Credit Carry Trade Structured Products with Embedded Optionality

    10. Classic Gap Trade Trap Large Carry from Steep Yield Curve (2003-04) Bank’s enticed to borrow short term and lend long Earn substantial non-franchise earnings (some cases up to 40% of total) Yield Curve Flattens and Carry Declines (2005) Carry yield declines as short term roll-over borrowing costs rise Doubles down carry volumes to main earnings contribution Yield curve flat / inverted (2006-07) Negative contribution to earnings Locked into positions/losses as MV assets now less than MV liabilities Exiting will realize remaining losses

    11. Disappearing Gap NII leads to Credit Carry Trade Pressure to replace declining gap earnings leads to credit carry Investors demand QoQ earnings growth ‘Non-Prime’ Mortgage products such as HELOC and 2nd Lien Mortgages offered large gross yields Yields not properly risk adjusted for true credit risk and capital costs 2007/08 – Mortgage market implodes Other firms replaced gap carry losses with structured interest rate risk yields Nominally positive yield carry is negative value on risk / option adjusted basis

    12. What Went Wrong Competitive pressures and market forces reduced core earnings growth Banks implemented strategies to generate non-core, non-controllable sources of earnings Inflated market valuations based on reported, nominal earnings growth created the need to sustain earnings over time Lack of transparency as to sources of earnings Lack of understanding and required disclosures around quality of earnings, balance sheet capacity utilization and liquidity risk by Senior management 3-4 levels removed from risk taking Boards Shareholders Regulators Rating Agencies Did boards understand the “type” earnings firms were generating? Did shareholders understand the type of earnings they were valuing?

    13. Structural Incentives - Regulatory Regulatory capital rules distort economic incentives Tier 1 Leverage Test establishes a floor capital to asset ratio Creates minimum capital requirement and earnings hurdle regardless of risk based capital requirements Banks penalized for operating a low credit risk strategy and rewarded for increasing risk No capital related to non-credit risks such as structural interest rate risk

    14. Structural Incentives - Compensation Compensation schemes did not create the proper incentives Standard compensation schemes focused on Year over year EPS growth Top line revenue growth Performance targets short term and not aligned with creating shareholder value UBS Shareholder Report Quote

    15. Paying the Price After the decline in Gap Earnings and loss of NII growth – US Bank’s still didn’t show price declines Consolidation premiums actually increased But now – buyers can’t afford and sellers too risky

    16. Culture not Process TD Experience “It’s the culture of risk management which saves you” – CEO Creating and maintaining franchise value is central to the kinds of risks you take and in what quantity The retail bank franchise generates stable, predictable and sustainable core earnings that create economic profit and SVA Its fundamental that if something generates an abnormal excess return it must have more risk than you are measuring – you are being transferred the risk The culture must support the requirement for transparency and explainability of financial results

    17. Culture not Process Danger Signs Businesses earning high nominal income Over reliance on equivalent exposure measures that don’t generate material need for capital on large notional positions Securities that earn returns well in excess of stated risk profile AAA CDO’s trading at L+100 Strategies that rely on increasing balance sheet capacity to remain “hedged” Practical Constraints Set “Dumb Limits” on exposure especially when tail risk is unknown Don’t rely on outside evaluation of risk Understand the drivers of excess (alpha) returns

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