Improving Sustainability in Banks Through Liquidity and Capital Management

1. Dr. Colin LawrenceDirector, Prudential Risk DivisionFinancial Services Authority Improving Sustainability in Banks Through Liquidity and Capital Management The Asian Banker Summit 2011 6-8 April 2011

2. Past Weaknesses – Liquidity Policy • No clear articulation of risk tolerance and supervisory objectives • Maintain going concern, or handle transition to gone concern? • Took no account of the business cycle • Underestimated potential stresses • Cross-border issues not addressed • Regulatory liquid assets not liquid

3. Past Weaknesses - Firms • Liquidity risk mismanaged • Governing Body not fully informed • Stress testing inadequate • Liquidity as a profit centre • Transfer pricing • New product approval

4. Implications for Firms • Enhanced liquidity risk management capabilities in firms • Greater use of stress testing • Testing and improvements to contingency funding plans • Less reliance on short-term wholesale funding, including from foreign counterparties • Greater incentive to attract a higher proportion of retail time deposits • A higher amount and quality of stocks of liquid assets, including a greater proportion of government debt • A check on unsustainable expansion of lending during favourable economic times

5. Systems and Controls Requirements Governing body & Senior management oversight Managing liquidity across legal entities, business lines & currencies Policies to control liquidity risk Comprehensive liquidity risk measurement Funding diversification Pricing liquidity risk Intra-day liquidity risk management Management of collateral

6. New UK Regime- will converge into Basel 3 • Systems and Controls • Adequate Liquidity & Self Sufficiency • Stress Testing • Individual Liquidity Adequacy Standards • New Reporting http://www.fsa.gov.uk/pubs/cp/cp08_22.pdf http://www.fsa.gov.uk/pubs/cp/cp09_13.pdf

7. High Liquidity Ratios Sustainable Business Model is Key Starting Point But Many Different Business Models Suffered in The Crisis Crisis Casualties Included: Small Building Societies Regional Banks Large Universal Banks Investment Banks Global Players Domestic Businesses Businesses need to be well run, and the Business Model and Risk Appetite aligned

8. Illustrative Impact of Cyclical Downturn on Portfolios User Cost of Credit Payable to Treasury CRM Spread Gains Losses Cyclical

9. Portfolio div. • (inside risk • categories) • Strategic div. • (across risk • categories) The Critical Link Between Risk and Stakeholder Value Risk Transformation is What Banks Do… Risk Adjusted Revenue Shareholder Value Revenue Fair Value Stock Price EPS EVA RAPM • Risk Information • Diversification • Growth rate • Business cycle • Investor perception • Market sentiment Operating Margin Market Risk Industry Growth • Pricing • - Spreads • - Fees • Product Cost • Overhead Credit Risk New Client • Market • Penetration • Product • expansion Liquidity Risk Client Retention Operational Risk Capital Structure Share of Market Client awareness Product Innovation Promotion effectiveness Diversification / Concentration Benefits • Product Mng. • Sales forces • incentives • Selling skills To understand risk adjusted profitability, a Board has to understand the risks being run

10. Average ROE over 20% pa, c.30% pre-crisis and volatility much higher Average ROE below 10% pa, volatility low at c.2% pa Historic Return on Equity for UK Banks “…as long as the music is playing, you’ve got to get up and dance. We’re still dancing” Chuck Prince 9 July 2007 Higher returns even when driven by higher risk & leverage were rewarded by the market

11. No Business Model is Inherently “Better”…But Some are Riskier Than Others Key issues to consider: • RAROC • Risk appetite • Risk strategy • Capital and Liquidity • Appropriate given 1. • Still appropriate under stress? • Risk Management & Control • First line of defence • Local level independent challenge essential • Principal agent problems • May show 1. does not work given 2. and 3. • Forces correct pricing • Can you create EVA under stress? • Complexity & Opacity • If you can’t measure and monitor risk - you should not do it • Regulators must be willing to shut down areas of business • Shadow Banking • Unintended consequence of more regulation? • How do we monitor and control?

12. Basel 3 – More Capital & Higher Quality CapitalReflects Key Regulatory Objective of Increasing Loss Absorbency FSA Current Regime Basel 3 proposal Tier 1 Capital Going concern capital Core (at least 50% of T1) Tier 1 Capital Core 50% 4.5% Non-innovative 6% 50% Innovative (max 15% of T1) 15% Non- core Tier 2 capital Upper Tier 2 8% Gone concern capital Lower Tier 2 (max 50% of T1) Tier 2 capital 100% Tier 2 50% 250% of Tier 1 capital Tier 3 Upper Tier 3 Lower Tier 3 (not limited) Global minimum liquidity regime also introduced for the first time

13. Sensitivity analyses Large movement on single factor or parameter Scenario analyses Used to assess model risk, effectiveness of potential hedging strategies etc. Full representations of possible future situations to which portfolio may be subjected Involves simultaneous, extreme moves of a set of factors Reflects individual effects and interactions between different risk factors, assuming a certain cause for the combined adverse movements Used to assess particular scenarios (e.g worst-case) Historical Based on observed events from the past Hypothetical Plausible events that are yet to be realized Requires expert judgment and analysis – sometimes difficult to link with underlying factors Macroeconomic (eg changes in unemployment, cyclical downturn etc) A shock to the entire economy Occurs external to firm and develops over time Market (eg stock market crash, change in interest rates, shock to credit spreads in a sector) A shock to the financial and capital markets May be historical or hypothetical Event-driven Based solely on a specific event independent of the portfolio characteristics Identify risk sources/events that cause changes in market and effects of these changes on the risk parameters Portfolio-driven Directly linked to the portfolio Identify risk parameters changes that result in a portfolio change and identify events that cause the parameters to change Worst Case/Catastrophe (E.g. terrorist attack, change in regulations) Event exogenous to market/economy, though impact arises through resulting changes Often are tied to specific characteristics of portfolio or exposures Different Types of Stress Tests RequiredForward Looking, With a Focus on Extreme Tails & Points of Weakness

14. Stage 1 Business strategy Risk appetite Business Plan / Operating plan / Corporate Plan Stage 2 Stress testing governance framework – active Board and senior management ownership and engagement in all stages C. Taking action Management actions Regular monitoring Amendments to business plan Capital Planning Stress testing (base & stress plan) Mitigation plan B. Implementing Forward looking Firm wide and granular Second-order effects Challenge process A. Establishing Stress testing programme Stress testing infrastructure Policies and procedures Expectation of Firm’s Stress Testing FrameworkIntegrated with Risk Appetite & Business, Capital & Liquidity Planning

15. 1: Agree the macro scenario 2: Macro to Micro 3: Stress the Firm BANK 1 BANK 2 BANK 3 BANK 4 BANK 5 4: Aggregate outcome 5: Management Actions STRESSED PPI YRS 1-5 STRESSED PPI YRS 1-5 REVENUE REVENUE REVENUE COST COST COST STRESSED PPI YRS 1-5 STRESSED PPI YRS 1-5 OTHER STRESS PENSION, CONDUCT OF BUSINESS, ETC RWAS EAD, PD, CYCLICALITY FACTOR/ MARKET RISK RWAS STRESSED RWAS YRS 1-5 MNGMT ACTION CAPITAL RAISING, DISPOSALS, COST CUTTING ETC REVISED CORE TIER 1 YRS 1-5 Macro to Micro – Vicious or Virtuous Cycle? Threshold Conditions for Intervention & Management Actions Key MACRO ECONOMIC SCENARIO GDP UNEMPLOYMENT HOUSE PRICES COMMERCIAL PROPERTY INTEREST RATES INFLATION ECONOMETRIC / QUALITATIVE ASSESSMENT SYSTEMIC & PEER VIEW CALIBRATION PRE-PROV INCOME (PPI) BUSINESS UNIT 1 STRESSED CORE TIER 1 CAPITAL VS. THRESHOLD BUSINESS UNIT 2 BUSINESS UNIT 3 GROUP PD EL IMPAIRMENTS PORTFOLIO 1 LGD STRESSED IMPAIRMENTS YRS 1-5 PORTFOLIO 2 PD LGD EL STRESSED IMPAIRMENTS YRS 1-5 PD LGD EL PORTFOLIO 3 STRESSED IMPAIRMENTS YRS 1-5 GROUP STRESSED IMPAIRMENTS YRS 1-5 TRADING BOOK STRUCTURED FINANCE, CREDIT, MONOLINES, MARKET RISK STRESSED VALUATIONS YRS 1-5 STRESSED ADJUSTMENTS YRS 1-5

16. PORTFOLIO C Systemic Risk KPI Firms to focus on Micro to Macro - Illustrative Portfolio Analysis Early Signalling of Risk via Leading Indicators Key

17. CT1 % Under Stress 10 8 6 4 2 0 Management Actions/Intervention Rights Issue Sale of Business Cut dividend Reduce RWAs etc… Year 1 Year 2 Year 3 Year 4 Year 5 Early Intervention & Identification of Management ActionPrevention, Intervention, Recovery, Resolution….

18. Wholesale funding risk Cash Flows Idiosyncratic Stress Retail funding risk Intra-day liquidity risk Intra-group liquidity risk Liquidity Position Cross-currency liquidity risk Market Wide Stress Off-balance sheet liquidity risk Profitability Franchise-viability liquidity risk Marketable asset risk Combination Stress Solvency Non-marketable asset risk Funding diversification risk Liquidity Stress TestingNeed to Ensure Time For Remedial Action Short Term & Protracted Short Term & Protracted Basel 3 new focus on liquidity, UK regime already implemented

19. Wholesale funding risk Cash Flows Idiosyncratic Stress Retail funding risk Intra-day liquidity risk Intra-group liquidity risk Liquidity Position Cross-currency liquidity risk Market Wide Stress Off-balance sheet liquidity risk Profitability Franchise-viability liquidity risk Marketable asset risk Combination Stress Solvency Non-marketable asset risk Funding diversification risk Stress Testing Short Term & Protracted Short Term & Protracted Includes stress to failure

20. Hypothetical Comparison of Liquidity Mismatch by Type

21. B C A 1 2 3 Hypothetical Comparison of Liquidity Mismatch by Type Link to Liquidity Stress Tests and Funds Transfer Pricing is Key Decreasing Stress (A - C) Increasing Stress (1 - 3)

22. TIME CURRENT RECOVERY CRISIS 2. Key triggers breached Bank Owns & Executes 1. Key triggers Breached Bank Owns & Executes Regulator Owns & Executes Operational & Legal Structure Resolution Plan Recovery Plan • Hold-Co vs. Branches • Segregation of accounts • Single customer view • Booking practices • Infrastructure issues • Local liquidity • Collateral (aggregation, hypothecation…) • Off-balance sheet items • Cross border complications • OPTIONS • Wind-downs and disposals • Early equity injection • Deposit transfer/ Bridge Bank • Liquidation/ Deposit pay off • Share transfer (Temporary Public Ownership) Recovery Liquidity Plan Recovery Capital Plan DATA Reduce / stop activities Plan to sell Businesses/Subsidiaries Plan to wind down/ liquidate trading book Key elements of Recovery Plan also feature in Resolution Plan GoingConcern Going Concern Gone Concern Recovery and Resolution Plans “Living Wills”Regulator Actively Involved Through Supervision & Specialist Reviews

23. Speed MattersMarket May Allow Little Time Between Recovery and Resolution 2007 2008 Aug 07 Mar 16 Sep 07 Sep 14 Sep 15 Sep 17 Sep 23 Sep 25 Oct 12 Oct 13 Nothern Rock nationalization Bear Stearns, acquired by JP Morgan Fannie Mae & Freddie Mac are rescued by the FED Merril Lynch is sold to Bank of America Lehman Brothers declares bankruptcy Lloyds take-over HBOS Goldman Sachs receives support of $5Bn from B. Hathaway Investment JP Morgan buys Washington Mutual Wachovia is acquired by Wells Fargo The next crisis will be different – together we are building a global framework that is robust and forward looking UK Government rescues RBS

24. Macro Prudential Supervision Micro Prudential Supervision Monetary Policy Better Macro & Micro Prudential SupervisionData + Analytics + Judgement Key • WHAT- Ensure financial stability • Monitor, identify and prioritise systemic risk • Link micro-supervision and macro-economic risks • Consider unregulated parts of the market • Ensure it is somebody’s job to remove the “punchbowl” • HOW - By getting ahead of the curve • Create counter-cyclical buffers – capital/liquidity in the system should rise as risk rises • Identify leading indicators (data + analytics + judgement) • Clear thresholds for intervention • ACTIONS - Resolve if necessary • Early action when thresholds breached • Firm specific (Management actions) • Market wide levers (eg LTV ratios) • Contingency plans in place • Living Wills • Bail–out to Bail-in • Resolution