Student meeting 28th April 2015

1. Student meeting 28th April 2015 • Introducing the Czech banking industry and association • Political economy of banking (financial sector) regulation – solving problems while creating new ones

2. Who we are – about CBA • 37 member banks • Strategist, Expert, Partner, Opinion leader • Strong CSR element • Lobbyist representing the interest of the banking sector … • … talking to the supervisor, regulator, parliament, NGOs, academic and research institutions, other interested parties • Extensive involvement in EU (EBF) activities, maintaining dialogue with partner associations • Extensive PR and image-making activities

3. Who we are – about CBA (2) • Small secretariat (13 staff members in total) • 21 working committees + scientific council … involving 500 people from banks in total • In average 2 to 3 expert meetings every day … • Extensive and well performing communication channels to and between banks

5. Who we are not … resp. prohibited by law to do … • A place for coordination of business strategies … • Collect statistical data, especially those relevant to business… • A management entity exercising any power over member banks … • A single point of entry for comunication of third parties with member banks • A place for dispute resolution …

6. Structural characteristics • There are 44 banks operating in the ČR under the ČNB license • Of them, 35 were fully or majority owned by foreign entities • More than 95 % of all assets are controlled by parent banks in developed countries, in particular in the EU • Four ‘large banks’ (each withassets over approx. EUR 8 billion)– Česká spořitelna (Erste Group), Komerční banka (Société Générale Group),ČSOB (KBC Group) and UniCredit Bank – manage close to 58% of all assets in the banking sector … • … their market share, however, is slowly declining over time due to relatively strong competition from small and medium-sized banks 1

7. The European banking sector in figures – selected countries

8. BANK REGULATORY CAPITAL TO RISK-WEIGHTED ASSETS, %

10. Performance indicators at sector leveland trends • Strong capital (mostly high quality Tier 1 capital) and liquidity position (over 18%) • Profitability above EU average (ROE over years close to 20%) • (The net interest rate income contributes almost3 time as much as fees to thefinancial and operating income of the banking industry) • Assets to GDP at modest cca 125 % • Loans: moderate growth despite recession 2008-2013 • NPLs: quantitatively not a big issue, however important source of risk in banking sector 2

11. Factors of stability 1. Prudent business model • focus on traditional conservative commercial banking on the domestic market and relatively little international activity • very few ‘toxic assets, increasing share of domestic government bonds in portfolio • prudent risk management through the crisis (however, despite tightening credit standards, the volume of loans is steadily raising) 2. Large deposit base, less dependence on the inter-bank market (third lowest in the EU) or refinancing operations of the central bank 3. Most activities are undertaken in domestic currency implying lower exposure to foreign exchange risk 4. Efficient cost management (cost to revenue ratio the third lowest within the EU: 44% in ČR compared to 57% in EU - 2011) • Essentially no need to deleverage • Banks capable to sustain even extremely stressful scenarios simulated by the central bank 3

12. Selected factors of significancefor the future shape and condition of the Czech banking industry • Credit andoperationalrisk • Economic forecast for the ČR: economy sound but not growingveryfast • Persistent risk of spillover effects from EU/eurozone • Regulatory issues: • Tsunami of regulationand significant institutional initiatives • Banking industry in ČR capable to sustain the effects • Banking union? • Cyberrisks? 4.

13. Political economy of banking (financial sector) regulation – fighting the past wars Topic 1 – is it fair to blame banks for the past crisis? Chronology of events, factors … Topic 2 –moral hazard and the issue of size Topic 3 – the global regulatory tsunami – facts and impacts Topic 4 – irresponsible consumers? Are we coming close (or past) the limits of reasonable consumer protection? Consumer protection and free market. Moral hazard. Topic 5 – the specific Czech case – are we really so different? Topic 6 – is Banking Union (in the EU) THE answer? Topic 7 – the raid of non bank financial entities into – what was until recently – banking business: new opportunities for regulatory arbitrage?

14. Topic 1 (crisis and banks)Prologue • A crisis is a more or less drastic correction of imbalances, created in previous times … • In most cases, a crisis is generated by an overheating of the economy, apparent through „bubbles“ on various markets • Unsustainable deviations are misinterpreted as trends • But, at the end of the day, the disciplining role (power) of the market can hardly be avoided … • Although crises may be of a diverse nature (monetary, banking, debt), they have all one thing in common: risks are being underestimated, old truth is being (intentionally) overlooked, prudential behaviour weakened The roots of crisis are always found in „good times“, when the world looks pretty and sweet It has been no different last timeandbanksshouldrightlybeallocated part oftheresponsibilityforit (but not alloftheresponsibility)

15. 1.1. But let's take it from the beginning – the recent episode …macroeconomic developments and policies • A prolonged period of low inflation, implying low profit returns on investment ↓ • Mistakes of central bankers, overlooking the bubbles (and the message these bubbles were sending to policy makers), a misinterpretation of the long period of low inflation … ↓ • Investors in search for higher risk • Creativity in new and complex investment products, offering higher returns (and distributing – hiding – (excessive) risks • In an environment of unshakable trust in an ever growing global economy, driven by new global players (mostly the BRICs) showing an unlimited hunger for growth • The psychology of investors „if they can make it, we have to make it as well, if they succeeded, we will as well“ • Expectation of small investors, depositors, shareholders: all of them willing to „be there, get their own partofthecake“ – lesson of human psychology: wouldanyone resist to become rich, if risks seem to have evaporated from the landscape?

16. 1.2. The financial (banking) causes: Enormous diversification of financial intermediary, an extremely robust surge of the non-banking intermediary (partially in response to ever increasing limitation imposed by regulators Development of a „shadow“ (or parallel) banking, various special purpose vehicles (SPVs), investment banks (detached from primary deposits and with huge leverage ratios), investment funds, hedge funds A failure to properly manage risk in the credit process: the mortgage provider would, for instance, sell, within the six months, the instrument to a third party: thus, his motives to assess the creditworthiness of clients went severely weakened Expectations and instructions of bank shareholders to managements – pressure on profits, shortening of investment horizons

17. The financial (banking) causes ctd: • Regulation got relaxed (example: the Glass-Steagall Act terminated) • Supervisors felt asleep, overlooked syndromes of forthcoming trouble – assets bubbles etc) • Leading to almost no assessment of creditworthiness of clients, lending even more than 100% value of the property, progressive interest rates (lower at the start to attract clients) with instalments often, at the beginning, even below the due interest payment etc • Value appraisals got systemically overshot (everyone down the chain interested in achieving the higher price possible) • Rating agencies: got on board as well … Please note: the risk has not disappeared, it merely got hidden (became thus even more like a time bomb)

18. 1.3. Role of institutions (governments, regulators, supervisors): far from being innocent Community Reinvestment Act (1977, J. Carter): support access to housing Fannie Mae and Freddie Mac (government sponsored enterprises, purpose: access to housing for low income people) Commodity Futures Modernisation Act (2000): derivates exempted from regulatory requirements and supervision and minimum reserve requirements 2002: FED terminates supervision of mortgage companies 2004: Securities and Exchange Commission grants an exemption from the required debt-to-net capital ratio to Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Sterns, Morgan Stanley (the allowed leverage ratio increased from 12 to 40)

19. Epilogue to Topic 1: And than, the party was over … When Lehman collapsed, no one new precisely, where the risk would emerge from andhow it would hit the financial accounts of market players Confidence amongst market participants was gone… And so was liquidity from the market … Consequently, the ability (and willingness) to lend money to corporates was gone as well … Producing second round negative effects on financial institutions

20. Chronology of events: how is the crisis passing through the economy Mortgage sector → financial intermediary Financial intermediary → real economy Real economy → a) financial intermediary (secondary effects) → b) public finance + debt crisis Debt crisis → a) financial intermediary → b) real economy → financial intermediary Questions: Is there an escape to this vicious circle at all? How to socialize the future costs ofconsolidation of financial entities?

21. Topic 2 Moral hazard and the issue of size (Moral hazard occurs when one person takes more risks because someone else bears the burden of those risks)

23. Banking assets to GDP represent 150% in the USA

24. Assets of commercial banks in EU and in USA (thousands of billions USD)

26. Selected group of European banks: structure of portfolio (= all banks traded on stock exchanges) Total 32 banks of which: 10 larger 36 % 36 % of which: 10 smaller 9 % 75 % There are in total cca 8000 banks in EU: the difference in the above indicator would be even greater since even the 10 smaller banks belong to the 0,5 % of the larger EU banks

27. Rememberthe term Moral Hazard – wewill use itagain in a moment

28. Topic 3 The global regulatory tsunami – facts and impacts

29. Key regulatory initiatives The European Banking Federation (of which we are members) is currently following 150 different regulatory initiatives 29

30. Examples • CRDIV • Capital adequacy • Liquidity requirements • Leverage ratio • corporate governance • Compensation schemes • Own funds, liauidity risk management, large exposures, pillar 2, financial conglomerates, macro-prudentail supervision, securitisation, • SIFI • DGS • MiFID (financial instruments) • FTT • Sectoral taxes • CDS (credit default swaps) • Derivatives regulation • Crisis resolution and recovery • Mortgage directive • Consumer credit directive • EMIR (market infrstructure) • Payment services • Accounting standards • IFRS • Reporting standards • Audit rules • Consumer protection • Financial inclusion • Switching • Tying • AML • PRIPS (packaged retail investment products) • SEPA • Interest rate benchmarks

31. New institutions • EBA • ESMA • EIOPA • ECB • European resolution authority • ESM • EC • ESBR European board for systemic risk)

32. Background Response to the crisis AIM - strengthen the resilience of the banking sector → reduce the probability and severity of future financial crisesand remove current regulation shortcomings RISKS: Adoption of measures that would not be taken in a more stable period. Adoption under time pressure raises doubts about the proper calibration, timing and globally consistent implementation. Limiting the banks ability to grant credits to individuals and/or companies and/or governments → negative impact on real economy.

33. Our Czech opinion • Not absolutely against new regulation initiatives - butmoreregulationmay not equal to better regulation. • (Even strong) regulation is ineffective without proper supervision. • Level playing field- to avoid regulatory arbitrage. • No complex impact study of all initiatives. • Regulatory changes will reduce the profitability of both assets and capital; the consequences thereof will fall upon not only shareholders but also clients, and thus, in the broader context, uponthe entire economy. 33

34. Qualitative impact analysis – April 2015 Effect on financial situation

35. Effect on capacity

36. Topic 4 – irresponsible consumers? Are we coming close (or past) the limits of reasonable consumer protection? Consumer protection and free market. Moral hazard.

37. Examples Deposit insurance Haircutsofconsumerdebt Creatingfunds to help repaydebt Consumerinsolvency Itemsfordiscussion: Administrativecontrolsofinterestrates?

38. Topic 5– the specific Czech case Are we really so different?

40. Deposit/Loan ratio

41. Total private debt/GDP

43. Conclusion to Topic 5 Indeed, we ARE different In our case, theregulatory tsunami is a cureof a veryhealthypatient Onesizedoes not fit all (even by far not) Compliancecostsvsglobalcompetitiveposition oftheCzechbankingindustry

44. Topic 6 – is Banking Union (in the EU) THE answer? Banking Union 120 banks are directly supervised by the ECB

45. Benefits and risks less regulatory arbitrage less compliance costs single set of rules – better competitive environment simplified management of activities at group level supervisionimmune to politicalpressure potential risk to local (remote, small) market, especiallywhere entity is a DiSIF distantsupervisionmay not be sensitive to localspecifics localauthoritiesshortofonekey instrument to protectstablityof local market

46. Topic 7 The raid of non bank financialentities into – what was until recently – banking business: new opportunities for regulatory arbitrage?