Amsterdam 7 November, 2013

1. Frans de Weert The importance of different perspectives and implicit assumptions in models Amsterdam 7 November, 2013

2. Objectives • Different perspectives to capital management • The importance of models when managing capital • The incentives of regulation and its impact on model optimization • The self-fulfilling prophecy of models • How to mitigate the self-fulfilling prophecy

3. Capital management has two primary objectives: optimise capital structure and optimise performance Optimise capital structure Optimise performance Fulfil regulatory requirements Translate strategy into capital allocation Satisfy stakeholder expectations Optimise economic profit per business line Value Determine optimal level of debt financing Evaluate performance per business line Make optimal corporate finance decisions Optimise capital allocation Optimal cost of capital Optimal return on capital

4. Capital management is about how a bank manages its available capital against its required capital Assets Liabilities Capital management Equity Available capital Subordinated Debt Business Lending Deposits Required capital Financial investments Wholesale funding

5. World Capital management Several perspectives have to be taken into account when managing this relationship Capital perspectives Regulatory Risk Accounting Corporate finance

6. Capital perspective Impact Regulatory capital1 X Economic (Market consistent)  One capital model cannot capture all of these perspectives Interest change Technical provisions 1 Assumes that regulatory capital is calculated under Solvency I, that reserve adequacy surplusses are not taken into account, and that interest rate change does not influence the outcome of the test

7. High Secured lenders Policy holders Impact irrational behaviour Subordinated lenders Equity holders Low Capital level Low (High tolerance) High (Low tolerance) Unsecured lenders That is why it is so important to understand the tolerance of each stakeholder towards the capital position Capital tolerance versus impact of irrational behaviour = tolerance and impact shift due to nervousness

8. Nevertheless, models are crucial for getting a feel for (complicated) risks or ‘adding’ different risks • Models can be quite powerful since they can make abstract risks concrete • Once risks are concrete you can talk about them, manage them and capitalize for them • Moreover, it enables you to weigh risks against opportunities

9. Moreover, economic capital models can help in comparing the performance of different businesses and can therefore be used to allocate capital Raroc Costof capital Economiccapital

10. Basel III forces banks to think about the size of their balance sheet Long balance sheet model (Dutch Banks) Short balance sheet model (US / Spanish banks) Safe assets Available Capital = Economic capital Risky assets Available Capital = Economic capital Liabilities Liabilities

11. Solvency II • Solvency II takes a risk-based balance sheet approach to determine the capital requirement • Market risks (e.g. interest rate, equity, spread risk), insurance risks and operational risks are all taken into account when determining the capital requirement • Solvency II does not know a leverage ratio Solvency I is effectively a non risk-based leverage ratio limit while Solvency II is purely a risk-based framework Solvency I • Capital requirement is effectively determined by taking 4% of the technical provisions • Because the ratio between capital and technical provisions determines the leverage ratio, Solvency I effectively is a leverage ratio limit of 25 • Risks of asset investments are not taken into account when determining the capital requirement Incentive to invest technical provisions riskily Incentive to de-risk and leverage

12. Because of the incentives from regulation, banks and insurance companies optimize their balance sheets (including model assumptions) to generate the highest return on capital • Banks and insurance companies try to maximize their return given a certain amount of equity • Regulation determines how much capital certain assets consume • The capital requirement is quite often based on model calculations • If a bank or insurance company maximizes its return on capital given a certain amount of capital, it will optimize its business but also model assumptions

13. This results in a self-fulfilling prophecy where banks and insurance companies become dependent on the (implicit) assumptions in models • Since the models are optimized to generate the highest return on capital, the capital requirement becomes dependent on the implicit model assumptions • This results in a self-fulfilling prophecy where models are constantly optimized further to be able to do more of the same business • This ultimately results in a negative feed-back loop where one becomes more and more dependent on the implicit model assumptions

14. 5 6 7 8 Even though the effectiveness of bank responses to the credit crisis had nothing to do with the quality of the models Example Example 1 Denial Just in time Lehman Brothers Barclays 2 Ineffective response Exploit the crisis Citigroup JP Morgan 3 Catch a falling sword Quick to respond Bank of America HSBC, BNP Paribas 4 Surrender Position well for after crisis Merrill Lynch Goldman Sachs

15. There are various mitigating factors for the negative feedback loop • Model developers highlight the main (implicit) assumption of the models and under which circumstances the model leads to bad decision making • Senior management understands the key variables and assumptions of the models • Senior management tries to take several perspectives into account for decision making and stimulates the use of several models instead of trying to incorporate everything in one model