Basel 2 Preparation and Bank Credit Ratings Taipei, June 2005

1. Basel 2 Preparation and Bank Credit RatingsTaipei, June 2005 Terry Chan, CFA Regional Criteria Officer, Asia-Pacific Standard & Poor’s Ratings Services

2. Basel 2 Preparation & Bank RatingsAgenda Basel 2 and the bank rating process: How do rating agencies perceive the region? How do they look at Asia-Pacific? What factors are considered for upgrading or downgrading a bank? How will the rating process be affected by Basel 2? Source: Part of contents was sourced from Standard & Poor’s report titled: ‘Basel II: Australia and Singapore Lead Asia-Pacific in Preparations’ published on March 1, 2005. To arrange for a copy, please phone Standard & Poor’s RatingsDesk, Hong Kong, (852) 2533-3500.

3. 1.0 Basel 2 Preparation & Bank Ratings Region – Trends in Asia-Pacific • Asia-Pacific Trends Mirror Global Trends • Similar experiencesBanking systems in Asia-Pacific region experiences mirror those of the systems in other regions. • Lack of robust dataRegardless of the approach to Basel 2 being adopted by individual banks, the development of robust data and systems to enable transition to Basel 2 is uniformly the major challenge for all Asia-Pacific banking systems. • Less capital for credit, more for operational?Consistent with other regions, lower capital requirements for credit risk in some systems have been offset by higher capital for operational risk. Retail mortgage banks having the potential for the greatest reduction in risk-weighted assets.

4. 1.1 Basel 2 Preparation & Bank RatingsRegion – Basel 2 Preparedness • Degree of Basel 2 Preparedness • Preparedness is similar to the level of economic and industry risk for the respective banking system. Economic & Industry Risk – Asia-Pacific Banking Systems (scatter diagram of risk profiles)

5. 1.2 Basel 2 Preparation & Bank Ratings Region – Capital levels under Basel 2 • Capital: How Much Is Not Yet Clear • Degree of capital reduction uncertain • If, and to what extent, a reduction in risk-weighted assets will translate to a reduction in capital by banks, with no change in ratings, is not yet certain. • Capital requirements may remain unchanged or increase However, potential capital reductions are debatable for many Asia-Pacific banking systems; capital requirements may be unchanged or increase. • Likely capital scenario - three subregions - In Australia, limited scope for material decrease at current rating levels. - In Japan, limited downward effect on capital levels of majority of banks. - Other countries, effect less clear, because of data collection difficulties.

6. 1.3 Basel 2 Preparation & Bank Ratings Region – Choice of Approach • Choice of Basel II Approach Impact on Ratings? • Unlikely to be rating implications • In Standard & Poor’s view, unlikely to be major credit ratings implications merely because a bank: • (i) or a banking system, adopts, or does not adopt, Basel 2. • (ii) adopt Standardized Approach (SA) rather than Internal Ratings Based (IRB) approaches; or • (iii) adopt foundation IRB rather than advanced IRB. • Strength and shortcomings factored in • Standard & Poor’s already factors into its rating analysis each bank’s strengths and shortcomings, and anticipates that a bank will: • (i) adopt Basel 2 when it has the capability to do so, and • (ii) embrace an appropriate Basel II methodology.

7. 1.4 Basel 2 Preparation & Bank RatingsRegion – Analyzing Capital • Analyzing capital • Quality of Capital, Not Just Quantum • Standard & Poor’s will analyze quality of capital as well as quantity of capital of Asia-Pacific banks in a Basel 2 environment . • Compared with the 1988 Basel 1 Accord, many Asia-Pacific banking systems are now significantly more reliant on hybrid capital instruments, which are a lower quality of capital compared with common equity. • Growth of nonordinary equity • In Japan, quality of capital is low, with preferred equity comprising about 60% of Tier 1 capital at major banks. • To a lesser extent than Japan, banks in Australia and Singapore have also embraced hybrids, although hybrids in these markets tend to be viewed as supplemental capital rather than core capital.

8. 1.5 Basel 2 Preparation & Bank Ratings Region – Australia & New Zealand • Australia & New Zealand • 2005 a critical year for progress • Applications from Australian banks seeking to achieve advanced IRB status are due to the Australian Prudential Regulation Authority (APRA) by Sept. 30, 2005. • State of play: major banks • Australia’s four major banks, which account for about 70% of Australian banking assets, and regional bank Bank of Western Australia Ltd., are aspiring toward advanced IRB status. • State of play: regional banks • Most Australian regional banks and other approved deposit-taking institutions (ADIs) are set to implement SA. • Reserve Bank of New Zealand (RBNZ) is stipulating that banks incorporated in New Zealand to adopt SA.

9. 1.6 Basel 2 Preparation & Bank Ratings Region – Japan and Korea • Japan and Korea • Basel 2 positive • New Basel 2 regulations should act as a spur for Japanese banks to improve the risk management and pricing strategies. • But many hurdles remain • However, Japanese banks face many hurdles in implementing the new accord: delays have occurred in collecting sufficient data for the time periods stipulated under the framework, and in building new risk management systems. • Market risk not completely reflected • The new scheme has some limitations. For instance, capital ratios will not completely reflect the market risk of the banking account—a particular concern for Japanese banks given their still large stock holdings and government bonds.

10. 1.7 Basel 2 Preparation & Bank Ratings Region – Asia ex-Japan/Korea • Asia (ex-Japan/Korea) • Implementation varies • Basel 2’s implementation across Asia (ex-Japan/Korea) varies considerably. • Early adopters • Singapore, Hong Kong, and Taiwan adopting Basel 2 according to Bank for International Settlements’s (BIS) target dates for developed countries. • More cautious adopters • Others, such as China, Thailand and Malaysia, are more cautious, adopting the new capital accords in subsequent years. • Long-term strengthening • Over time, Basel 2 will strengthen region’s varied banking systems.

11. 2.0 Basel 2 Preparation & Bank RatingsUpgrade/downgrade – risk factors (1) • Credit Risk • Market Risk • Funding and Liquidity • Capital position • Earnings • Risk Management • Financial Flexibility Standard & Poor’s ratings analysis on financial institutions focus on a variety of business and financial risk factors.These include: Financial Profile Business Profile • Economic Risk • Industry Risk • Market Position • Diversification • Management & Strategy

12. 2.1 Basel 2 Preparation & Bank RatingsUpgrade/downgrade – risk factors (2) Business profile risks • Economic risk Higher economic risk of country in which the bank operates, the higher the capital need because of volatility. • Industry risk Higher industry risk of system in which the bank operates, the higher the capital need because of contagion and bank counterparty risk. • Market position Indirect benefit. Better position allows bank to be more of price-maker than price-taker. Slightly reduces capital need. • Diversification In theory, lowers volatility of earnings and credit losses; should lower capital need. • Management & strategy Lack of management depth and/or aggressive strategy implies higher risk and thus higher capital need.

13. 2.2 Basel 2 Preparation & Bank RatingsUpgrade/downgrade – risk factors (3) Financial profile risks • Credit risk Higher credit risk of a bank’s book, the higher the capital need. • Market risk Higher market risk of a bank’s book, the higher the capital need. • Funding & Liquidity The less ‘sticky’ the funding, the more a bank has to rely on capital as funding source and to allay depositors’ concerns. • Earnings The more volatile and more risky the earnings, the more capital is required. • Risk management Superior risk management would anticipate and reduce volatility and losses, implying less capital is needed.

14. 2.3 Basel 2 Preparation & Bank RatingsUpgrade/downgrade – capital quality • Factors considered when looking at capital • Standard & Poor’s takes into consideration: • Capital composition • Capital relative to level of risk • Capital relative to regulatory capital requirements • Internal capital generation capability • Dividend payout ratio • Absolute size of bank’s capital • Ability to raise capital • Management philosophy regarding risk asset and loan leveraging, capital projections Key considerations

15. 2.4 Basel 2 Preparation & Bank RatingsCapital – Adjusted Equity • How Standard & Poor’s looks at capital • Types of capital form a continuum • S&P considers capital to be a continuum, ranging from tangible common equity (best) to traditional “vanilla” subordinated debt (weakest form of capital). In judging where particular instrument lies on continuum, S&P looks at instrument’s ability to absorb losses on ongoing basis. • Adjusted Common Equity and Adjusted Total Equity • Standard & Poor’s tends to focus on: • - Adjusted Common Equity (ACE) and • - Adjusted Total Equity (ATE) • as opposed to just Tier 1 capital and Risk Weighted Capital.

16. 2.5 Basel 2 Preparation & Bank RatingsCapital – Adjusted Common Equity • Adjusted Common Equity (ACE) • ACE is computed as follows: • Common “Plain Vanilla” Equity • plus Retained Profits • less Goodwill • less Asset Revaluation Reserves • less Investment in subsidiaries including insurance • companies accounted for using the equity method • less Deferred taxes deemed by S&P to be uncollectible • less Most Tier 1 adjustments required by the regulator • add Minority Interests

17. 2.6 Basel 2 Preparation & Bank RatingsCapital – Adjusted Total Equity • Adjusted Total Equity (ATE) • ATE is computed as follows: • ACE plus Preferred Shares and Hybrids • subject to the following “ceilings”: ACE and ATE are measured as a proportion of a number of denominators to derive a series of capital ratios. NO ONE RATIO IS THE PERFECT CAPITAL RATIO Rather Standard & Poor’s looks at a number of ratios to determine the true capital position for a rated institution.

18. 3.0 Basel 2 Preparation & Bank RatingsRating process affected? In general, about the process: • Process the same Steps in the ratings process remain the same. • Operating environment changed Higher demands from regulators and financial markets for banks to comply with Basel 2. • Competitive position Because a competitive position is relative, a bank’s inability to comply while other banks are doing so means the bank’s relative profile has weakened. • Ratings impact As credit ratings are meant to differentiate credit risk among issuers, the bank that falls behind its peers in terms of risk management and risk management systems may see the relative position of the credit rating on the bank fall.

19. 3.1 Basel 2 Preparation & Bank RatingsProcess – Expected improvements Expected improvement: • Improvement should be continuous Standard & Poor’s expects every bank to continuously improve itself, regardless of developments outside the bank (e.g. Basel 2). If a bank does not do so, it is indicative of a management team lacking foresight. • Basel 2 areas Basel 2 requires a bank to look into these areas: - credit risk (under Pillar 1) - operational risk (under Pillar 1) - trading risk (under Pillar 1) - continuing cooperation with supervisor (Pillar 2) - disclosure (Pillar 3)

20. 3.2 Basel 2 Preparation & Bank RatingsProcess – Credit risk Credit risk: • Systems should match complexity of risk Standard & Poor’s expects the credit risk management system of a bank to match the complexity of its credit book. For example, a bank extending project finance is likely to require have a more specialized credit assessment procedures and systems. A bank with operations outside the domestic market should have more sophisticated credit risk management systems. • Regardless of complexity It always comes back to whether bank management is: i) aware of, ii) understand, and iii) is able to manage the risk. Of course, the reward-for-risk should be there.

21. 3.3 Basel 2 Preparation & Bank RatingsProcess – Operational risk Operational risk: • Systems should match complexity of risk Like credit risk, the operational risk management system of a bank to match the complexity of its operations. • In emerging Asia Bank operations are mostly domestic and so operational risk should be quite straightforward.

22. 3.4 Basel 2 Preparation & Bank RatingsProcess – Trading risk Trading risk: • Systems should match complexity of risk Like credit and operational risk, the trading risk management system of a bank to match the comparative complexity of its trades. Comparative complexity refers to the complexity compared to the bank’s mainstream operations and risk management systems. For example, an interest rate swap may be common to a bank but new to another almost identical peer bank. • In emerging Asia Standard & Poor’s has concerns that second and third tier domestic players in foreign exchange and swaps markets do not fully appreciate the risks and lack the flexibility of accessing markets. Standard & Poor’s will look to see if such players can afford the necessary risk management systems to support such trades.

23. 3.5 Basel 2 Preparation & Bank RatingsProcess – Supervisory (Pillar 2) Supervisory review (Pillar 2): • Verification of IRBs The Internal Ratings-Based (IRB) approach, particularly Advanced IRB, requires a high degree of resources and skill sets at the regulatory authority to verify the systems. • In emerging Asia If the regulatory authority is not provided the resources to do so, it would be difficult for Standard & Poor’s to accept at face value a bank’s introduction of an IRB system. That is to say, Pillar 2 is not fully in place.

24. 3.6 Basel 2 Preparation & Bank RatingsProcess – Disclosures Disclosures (Pillar 3): • Demonstrate systems exist The better a bank is able to improve its disclosures, the more likely it is that the bank has the information and risk management systems to measure exposures and risk. (Admittedly this is not always the case.) • In emerging Asia Standard & Poor’s expects that this area may develop a little slower than Pillars 1 and 2 as banks and regulators initially focus on the other two Pillars.

25. 4.0 Basel 2: Implementation & Ratings Queries on Ratings and Basel 2? • Standard & Poor’s Financial Services Ratings contacts • For systems outside Taiwan, if you have any question on bank credit ratings or the impact of Basel 2, you can contact any of the following analysts: