Managing Credit Risk for Competitive Advantage in China

1. Managing Credit Risk for Competitive Advantage in China Richard Bisset, Executive Project manager, Risk and Compliance, IBM Greater China Group. Shanghai, Friday 29thFebruary,2008

2. 2008 challenges for Chinese banks2008年中国的银行的关键因素 • Improve and enhance standards, systems and processes to avoid bad debt. • Manage data origination, information distribution and reporting • Manage loan origination, NPL management & collection processes • Find a balance between compliance and business performance • Find the equilibrium between centralization and control of branches. • Need to integrate management information and create value added knowledge. • Need to improve level of awareness and understanding of bank staff to improve internal controls and governance

3. Table of Contents目录 • Credit Risk Management, Data and Economic Capital • Managing the information • The Credit Factory • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

4. Risk Management is the Bridge between Data and Bank Objectives with Shareholder Value as the Target . 风险管理是用以连接数据与银行目标，即对股东的投资回报的桥梁 Risk Mgmt/Basel Risk mitigation (hedging, securitization, syndication) Tools Data & IT Objectives Business Front Office/Transaction Risk Life Cycle View Commercial Loans, Leases, LoC Consumer Auto, Residential, Cards, HEL Asset Mgmt Mutual Funds, Custodian, Financial Planning Processing Solution Debit, credit, private labels, etc Trading Corp, ABS, FX, Derivatives, etc Others Treasury services, etc • Origination & Acquisition • Deal prospecting • risk assessment • Pricing & funding • Credit approval • Credit booking • Risk Mgmt & reporting • Payment remittance • Provision • Past due (30,60, 90d) • Risk migration – NPL, charge-off • Performance – ROA, ROE, P/E, Market Cap • Disposition & Recovery • Distressed debt recovery/charge-off Analytics Measurements Reporting Data Deliver Shareholder Value Risk Mgmt Governance Management Processes Moving from origination function to a risk/portfolio management function methodology Moving from collecting interest and principal payments to a portfolio total return measurement approach

5. Banks need to develop an End to End Integrated Risk Management System提供端对端的风险管理解决方案 Performance Measurement Risk Identification Risk Measurement Portfolio Management Reporting • RAROC • (Risk Adjusted Return • on Capital) • EPS • (Earnings per Share) • SVA • (Shareholder Value • Added) • EVA • (Enterprise Value Added) • External • Financial Regulators • Basel II, Sarbanes-Oxley • Shareholders • Customers • Internal • Portfolio • LOB • Senior Management • Board • Credit Risk • default risk • credit deterioration • Market Risk • Interest rate risk • Liquidity risk • ALM • Operational Risk • Legal Risk • Reputation Risk • Credit Risk • PD/LGD/EAD/M • Market Risk • VaR, volatility, NII, • Operational Risk • AMA, SA, BIA • Legal Risk • Reputation Risk • Hedging • Credit derivatives • (CDO/CDS) • Interest rate derivatives • Securitization • MBS/CMO/ABS/CLO • Syndication • senior/junior/equity • Asset Disposition and • Restructuring ALLL (Allowance of Loan and Lease Loss) Reserves Risk Management Polices & Procedures Risk Management Processes (Monitoring, Execution & Implementation) Economic Capital Capital Allocation

6. Table of Contents目录 • The Risk Management, Data and Economic Capital • Managing the information • The Credit Factory • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management. • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

7. Data Management： a Key Challenge for Basel II Compliance数据管理：Basel II合规的一个关键因素 • Challenges: • Identifying the data • Locating that data in operational systems • Understanding the structure of the data • Extracting and transforming data • Cleansing the data • Choosing a database management system • Fast reliable access to data • Storing risk calculation and analytical results • Production of all regulatory reports • On-line analytical processing capabilities • Data mining Source: IBM Institute for Business Value analysis Based on interviews with 32 Financial institutions worldwide

8. The major challenge is to overcome the lack of integration currently leading to poor data quality & high costs for CreditRisk, Finance & CRM Management对很多银行来说，主要挑战是如何克服由于缺少系统架构而导致的不良数据质量以及风险管理所需的高额费用 • Inconsistencies in overlapping reports on business side Reports, strategies and positions Reports • Reporting tools, methodologies/functions and data warehousing aren‘t separated properly and are often redundant F/C Finance PBC & CB LOB X Risk Management LOB Y DrKW Funktionen Functions • Redundant and inconsistent data in various systems that consolidate data for different purposes MWD CAD CDS MKB CRIS DCL/RWS • Multiple interfaces to source systems are one of the main reasons for huge change efforts INV INV • Older source systems frequently generate additional complexity MARCX/BF PAD KDD FIF930 KDU/KRD KDI KDA SAK/CRP COM ELBA FC RWI ADB DKW AIDA Reuschel DreLUX CORDOBA PROFIT SEBIOS MABILA / Manuelle DBLA BF TEA KDW KWV KDO/KDR KDV WEG HGD WPD WERS FID/FIN AMI Calypso OLB FORWARD MIDAS ANLOS / ACBS BORIS Geschäfte Globus Source Systems Inland Töchter Ausland

9. Improvement Opportunity For credit risk, Banks need to build the Management Architecture 对于信贷风险，银行必须创造合适的架构系统和管理体系 Key Area 1 Improvements on Credit Data Governance • Set up proper governance structure to actively manage credit data, identify credit data ownership, assign roles and responsibilities • Initiate credit data standard definition, data requirement planning, data quality management, data security management • Development of data management tools and methodologies to enhance data quality and analysis of the risk output, as well as to streamline the collection, consolidation and extraction of counterparty and credit data from the Bank’s existing systems Credit Risk Data Mart 2 Establishment of Credit Risk Data Mart • Establishment of data warehousing based around an open architecture and supports the key functional areas related to the credit process, such as risk analysis, relationship management, profitability, collateral and asset and liability management.

10. This in One Possibility for Credit Risk Management Architecture Credit Workflow Platform Loan Origination Approval Limit Control Rule-based Credit Approval Credit Process Status Tracking Pipeline Management Performance Reporting Document Management CRS Core Applications Corporate Financial Analysis Spreading Analysis Core Banking System (Credit Related Processing) Financial Ratio Analysis Loans Origination (Loans Application, Credit Approval, Document Verification & Credit Signing) Loans Servicing (Loans Drawdown, Repayment Processing & Account Closing) Remedial Processing (Fraud Detection, Collection, Loans Restructuring, Past-Due, NPL & Write-off Processing, Collateral Acquisitions & Mgt, Assets Recovery Historical Financial Maintenance Future Cash Flow Forecasting Limits Engine Decision Engine Credit Control (Customer Credit Review, Loans Review, Collateral Management, Customer Limit Management, Credit Management Process Auditing & Credit Operation Reporting Limit Setting Risk-based Pricing Limit Monitoring RAROC, Strategy Simulation Limit Utilization Marginal Risk Approvals Rating / Scoring Customer Information File Loans Applications Loans Accounts Payment & Collection Records Core Credit Risk Engine Risk Modelling (incl. PD & LGD modeing) and Scoring Reporting Solution (Reporting & Ad-Hoc Queries) Data Mining Solution (Data Mining, Model Validation & Testing) Exposure, EL, UL Credit Adjusted Valuation EAI Technology Infrastructure Credit Risk / Portfolio Analysis (CRS) Credit Risk Management Data Mart DBW Portfolio Monitoring Portfolio Summary Risk Concentration Large Exposure Management Credit Rating Shift Country Risk Analysis Counter-party Risk Analysis Industry Sector Risk Analysis Loss Forecasting Loans Default History Payment & Collection History Loans Appln & Scoring History Customer/ Portfolio Characteristics Sensitivity Analysis VaR Based Analysis Stress Test Analysis “What-if” Simulation Portfolio Analysis

11. With the correct architecture, the picture becomes much simpler and easier to control. Data quality is much higher and costs for Credit Risk, Finance & CRM Management have been greatly reduced由于正确的架构，结构图将变的更为简单并且易于控制。数据质量大大提高，同时风险管理的费用也显著降低 • Inconsistent and overlapping reports on business side have been eliminated Reports, strategies and positions Reports • Reporting tools, methodologies/functions and data warehousing have been separated properly and are much more accurate • Redundant data have been eliminated and consolidation of data is easier. Changes are only needed to match changing markets Functions MWD CAD CDS MKB CRIS DCL/RWS • Interfaces between source systems and functions have been unscrambled and are one of the main resultsof the change efforts • Source systems have been rationalised and the reporting architecture is simpler MARCX/BF PAD KDD FIF930 KDU/KRD KDI KDA SAK/CRP COM ELBA FC RWI ADB DKW AIDA Reuschel DreLUX CORDOBA PROFIT SEBIOS Source Systems

12. Table of Contents目录 • The Risk Management, Data and Economic Capital • Managing the information • The Credit Factory and Portfolio Management • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management. • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

13. Attrition Scoring The Credit Factory: The constituent elements in managing the asset and liability portfolio of the bank信用工厂：管理银行资产负债组合的组成要素 Origination Active Portfolio Management Secondary market products Recovery Management Portfolio Credit Customers Branches ALM • Secondary market management • Syndication • Credit Derivatives • Structured deals • CDOs Collection Scoring Credit Risk Management Application Scoring Primary market Secondary market Account Management Behavior Scoring Response Scoring Transaction Processing Trade Processing Financial Control Product Control

14. Portfolio Business Objectives资产组合的商业目标 • Revenue Enhancement • Increased Profits from Up Sell / Cross Sell Opportunities • Increased Profits from Strategic Line Management Programs • Increased Profits from Targeted Repricing Strategies • Maximize Likelihood of Repeat Business • Improve Customer Service • Procedure Enhancement • Manage Workload/Make Efficient Use of Staff • Lower Delinquency/Write-Offs • Control Operational Expenses • Reduce Required Loss Reserves • Lower High Risk Balances • Loss Control • Manage Workload • Make Efficient Use of Staff • Lower Delinquency • Lower Write-Offs • Control Operational Expenses • Reduce Required Loss Reserves • Lower High Risk Balances • Improve Profitability • Increase Profitable Revenue • Reduce Delinquency and Loss • Decrease Collection Expenses

15. Portfolio Monitoring Portfolio Summary Risk Concentration Large Exposure Mgmt Credit Rating Shift Country Risk Analysis Counter-party Risk Analysis Industry Sector Risk Analysis Loss Forecasting PortfolioAnalysis Credit Default History Payment & Collection History Credit Application & Scoring History Customer/ Portfolio Characteristics Industry Risk Scoring Sensitivity Analysis VAR Based Analysis Stress Test Analysis “What-if” Simulation Credit Portfolio Management Process信贷资产管理流程 Credit Risk Management Data Mart Portfolio Analysis (CRS) Portfolio & Risk Management Strategy Equivalent Strategy Comparison Strategy Matrix Identify Current Cycle Phase Performance Profile Modeling Suitable Strategy Selection Implementation & Management

16. Table of Contents目录 • The Risk Management, Data and Economic Capital • Managing the information • The Credit Factory • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management. • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

17. Correct Pricing of loans is a Necessity….it captures both risk and value of CRM贷款的准确定价至关重要 ALM 资产负债管理 Interest rate offered on a loan贷款利率出价 CRM 客户关系管理 Mark-up加价 The margin that makes the loan profitable for the branch Cost of funds资金成本 Pure cost of funds that the branch would lend Credit Premium 信用溢价 Accurate assessment of expected loss from credit default Cost of Operations运营成本 Total cost of activities conducted at the bank (at branch and head-office levels) CREDIT RISK信用风险 • How can branches use these tools to grow their revenue and profitability分行如何运用这些工具来增加其收益和利润 • How can central units better manage risk exposure arising from systemic factors总行如何更好的管理来自系统性因素的风险敞口

18. The final component that brings the profit to the bank; the margin that a bank can charge on a loan is driven by a number of factors, the skill of the banker is determining how they can leverage these factors to their advantage为银行带来利润的决定性因素决定了贷款利差，银行需要将这些因素转化为优势

19. Table of Contents目录 • The Risk Management, Data and Economic Capital • Managing the information • The Credit Factory • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management. • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

20. Lifecycle Credit Risk Management信贷风险管理的生命周期 Write Off Planning • Bad debt Write Off • Provision Calculation • Product Review • Product Design • Marketing Strategy • Resource Plan Lifecycle Credit Risk Mgmt • Acquisition • Verification • Decision • Limit Assignment • Collection Strategy • Recovery Prediction • External Agency • Management Acquire Collection • Account Review • Limit Increase • Cross-sell • Anti-Attrition Maintain

21. From Basel to CRM : Data plus Analytics 从Basel到CRM：数据加分析 • Success = f (customer contact, data analytics, value strategy, decision-making) CRM platform automates customer portfolio workflow and provides access to customer information to support the sales or service dialogue The content and format of customer treatment and the business logic that determines when how and what is delivered to each customer in order to optimise customer value Customer data, data warehousing, analytics tools and techniques, customer value algorithms, credit portfolio and customer scorecards Using customer data and the rules embedded in the customer strategies, make customer decisions that optimise value - before they are needed

22. Cash withdrawal Application back-out Leave page Attrition score Not High High Product holdings Yes No E-channel preference Yes No Offer e-chat room Offer advice service Success=f (customer contact, data analytics, value strategy, decision-making) Decisions Decide actions customer by customer Strategy Frame strategies for treating customers Strategy Data analytics Needs, behaviour Value Contact Segment by value and need Understand customer value Talking to the grey mass

23. Customer Relationship Management客户关系管理 Internal Data External Data Cross-selling strategy: Up sell / Down sell Customer & Market data Attrition rates Retention Rates Acquisition costs Product Mix Credit Bureau (Retail) PBoC Loan Database Demographics Pricing strategy: Give the optimum price to the customer to maximize profit Credit Line management: Increase / Decrease credit limit according to different customer performance Credit Policies Credit Guidelines Credit Risk Management CRM SYSTEM Anti-attrition program: Increase customer retention rate by better offers, fee waiving, etc Business Constraints Market Environment Collection strategy: To avoid future loss on defaulting customers Risk Appetite Regulations Audit and Compliance Competition Economic Factors Political Environment ETC…………

24. Collateral Data • Securities • Real Estate • Credit Derivatives, etc Market Data • Interest Rates • Credit Spreads • FOREX Rates Portfolio Data • Loan • Mortgages • Cash-flow data Customer Information • Customer Profile. • External ratings • PD, etc Interlinkage between Data and Risk Strategy数据和风险战略的关系 Risk & Portfolio Management Strategy Pricing Engine • RAROC • Information on cost of funds and administration, profitability, interest rate risk) Portfolio Credit Risk Management • Generate portfolio PD, EAD, LGD, Correlations and cVaR • Capital and reserves allocation and limits setting • Stress- testing Risk Engine • Historical Loss Data • Credit Risk Rating Model • Generate individual PD, LGD, EAD,M, Credit Grade and Expected Loss Collateral Management • From an IRB and MtM approach Core Banking • Administration • Disbursement • Regulatory disclosure • Public disclosure Customer Relationship Management Bank’s Credit Risk Repository Bank’s Data Warehouse

25. Table of Contents目录 • The Risk Management, Data and Economic Capital • Managing the information • The Credit Factory • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management. • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

26. Risk Management Issues • Heightened requirements around privacy, security, and various types of risk are requiring financial institutions to take a more proactive, enterprise-wide approach to managing internal governance and compliance issues. • They need to leverage compliance and risk management in a way that creates new value for the business through greater transparency, better internal controls, better compliance and increased trust. • Greater transparency is critical, not only because regulators and customers are demanding it, but also because of the emergence of collaborative business models and partnerships. • Risk management and regulatory compliance require fast, accurate and complete data, but they also require that management and staff understand the financial institution, the regulatory environment and, most importantly, their own roles and obligations within the organization • The key for financial institutions is to improve governance and compliance enterprise-wide by widening their focus from implementing software solutions that solve specific problems or comply with regulatory and legal requirements to include facilitating a bank-wide system of staff development and training which will ultimately help the bank grow revenue and profits, and manage the business more effectively. • Going forward, the most critical developmental need in banks in China will be human capital development

27. Risk Management Issues • Appropriate Expertise • There is little value in having a world class system in place without the expertise to oversee it. The business of finance has become increasingly complex and this complexity requires a thorough understanding of the bank’s systems and procedures – particularly in the area of risk management • The Human Element • The one element that overrides all others in the successful implementation of internal good governance is the integrity of staff. It is the most important component of any internal governance program and yet it is easiest to underestimate and the hardest to control. • Recruitment • Recruitment of quality staff, that have strong values and integrity, and investment in training those staff to understand the importance and relevance of core values in their daily business is the glue that binds all other elements of a successful process together. The media is full of reports of rogue traders (most recently at Societe Generale), or sharp practice within organizations that have occurred through either a lack of understanding of the bank’s systems and procedures or a lack of personal integrity in an employee or group of employees. • Training and Development • Training in ethics and the consequences of the personal actions of employees is an important part of modern corporate governance. But it is not just ethics and compliance. Compliance only goes so far, the staff have to understand the mechanics of banking to give ethics any basis in fact. It has been found that the single most critical aspect to mitigating risk lies beyond merely installing and closely monitoring world class systems. It is in the management of human resources – from very stringent and thorough hiring processes, to ongoing staff training and development

28. Risk Management Issues • Innovation • Banking in China is going through enormous changes and the people in the bank need to be able to change with it. They need to be able to think outside the box and look for new ways to improve the way the bank conducts business. Proper HR management can enable staff to embrace change, rather than fear it. • Direction, Focus, Mission • It is very often the case that staff are unaware of what the Bank wants to achieve. The information flows are inadequate to ensure that the Bank and its staff are moving in the right direction. Proper HR management can ensure that the correct message and therefore the correct procedures and systems are used to the best advantage of the bank • Operational Efficiency • A better understanding of the job and the staff’s position and purpose in the bank can greatly enhance operational efficiency, leading to fewer mistakes and lower losses. Proper HR management can provide the tools and the skills to ensure that this happens • Quality Customer Service • Staff that understand their role provide better customer service and therefore better customer satisfaction. This is key to being able to compete effectively in the market place. Proper HR management can help staff understand just how important the customer is and how to help him. • Governance and Compliance • Proper HR management can instill in staff an appreciation of the bank, its environment, its role in society and the staff member’s obligations (and those of the bank) to that society.

29. Table of Contents目录 • The Risk Management, Data and Economic Capital • Managing the information • The Credit Factory • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management. • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

30. Human Capital Management - Risk Management Benefits • Staff Development • Staff are motivated by many things, but a key ingredient is a sense of self-worth. Training should be a reward which shows the staff how valuable he is to the organization. Proper HR management can equip staff with the capacity to move up through the ranks in the bank. • Results and Bottom-Line Orientation • Without the right framework in place, it is easy for lending staff to lose sight of their primary professional function – to make profits for the bank. Proper HR management can assist lending staff to understand this and understand the consequence of their actions in terms of bottom-line performance. • Leadership • Every bank wants to groom the leaders of the future. Proper HR management can provide them with the tools to achieve this. • Teamwork • Staff in the credit areas should understand that they do not work alone, but are part of a small team of professionals which in turn is part of a larger team. Proper HR management can instill the value of teamwork leading to greater operational efficiency and an esprit de corps • Loan Quality • The easiest way for a bank to lose money is in credit. A lack of understanding of a customer’s business or the business environment can lead to serious losses and high levels of NPLs. Proper HR management can help lenders understand the dynamics of lending and the impact bad lending decisions can have.

31. Human Capital Management - Risk Management Benefits • Staff Retention and Loyalty • Staff turnover is often the result, not only of conditions of employment such as salaries, but also of people feeling under-appreciated. It can also have a pernicious effect on morale amongst other staff. Proper HR management can overcome this and reduce turnover levels and increase loyalty. • Lower level of Non-Performing Loans • China’s track record on NPLs has been lamentable and whilst the reasons are many (policy lending, preservation of employment at SOEs) the only way to avoid a repeat of past mistakes is through training on lending. • Understanding of the methodology behind the Software • Under the new Basel Accord, statistical methodologies are used to calculate risk, capital requirements etc. It is easy for lending officers to lose the ability to undertake their own analysis of customers. Proper HR management can ensure that lending staff have the ability to make value judgments about counter-parties. • Performance • Personal performance is key to job satisfaction and can be adversely impacted when staff do not understand what they are doing. Proper HR management can reduce errors, increase efficiency and provide more and better opportunities to staff for self- development and promotion. • Profitability • The overriding objective of proper HR management is to enhance the profitability of the Bank.

32. Table of Contents目录 • The Risk Management, Data and Economic Capital • Managing the information • The Credit Factory • The Pricing of Credit: The link between economic capital and CRM • Lifecycle Risk Management. • Risk Management Issues • Human Capital Management – Risk Management Benefits • Conclusions

33. Conclusions结论 • With the right investment in data sourcing and packaging, a Bank’s capital requirements can be better managed and the risk measured and controlled. • It is important to get the data sourcing and management right first. Reporting and information flows will follow. • Based on internal and external information sources, the trick is to get pricing right and correctly target the customer • In a world of securitization and credit derivatives, the effective management of assets and liabilities, and the correct balancing of the bank’s portfolio depends on risk identification through strong database information. • The integration of the foregoing points into Credit Risk, Customer Relationship Management and Portfolio Management is essential, but without due care and attention paid to the human capital issues, the effect of any such integration will be limited and the effort to increase shareholder value will only have limited success.

34. Richard Bisset’s Resume • Richard Bisset is a graduate of Leeds University with a bachelor degree in Chinese and German. Having spent 25 years at HSBC, he joined IBM at the beginning of September 2007 as Executive Project Manager and is now working with Global Business Services, advising on credit risk management, compliance and governance. • During his time with HSBC he worked in many places in the Far East, but by far the most time was spent in Greater China, either in Shanghai or in Hong Kong. A veteran of many roles, the last 12 years of his career with HSBC was in the credit area, including 4 years as Head of Credit Risk Management for HSBC's operations in Japan. In this role he was responsible for both the corporate bank and the securities company, managing a diversified portfolio comprising private banking, corporate banking, financial institutions, project finance and sovereign borrowers. • His career with HSBC culminated in secondments first to Bank of Shanghai (HSBC 8%) in 2004 and the to Bank of Communications (HSBC 19.9%) in 2005. In these roles, he was responsible for advising on Credit Risk Management, handling delinquent loans and implementing best practices in credit risk management. This included creating credit policy, writing credit manuals and training credit staff. • Since late 2007, he has been managing IBM’s downstream project at Bank of Nanjing, whilst at the same time providing input for proposals being made to other Chinese banks.