GARP Webcast

How Basel III Will Change Risk Management in the U.S.

Presented by:

Anna Pinedo Partner, Morrison & Foerster Peter Went VP, Bank Risk Program Manager, GARP February 7, 2012

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Anna Pinedo, Morrison & Foerster

Anna Pinedo is a partner at the Morrison & Foerster law firm in New York, where she has concentrated her practice on securities and derivatives. Ms. Pinedo regularly speaks at conferences and participates in panel discussions addressing securities law issues, as well as the securities issues arising in connection with derivatives and other financial products. She is the co-author of Covered Bonds Handbook, Exempt and Hybrid Securities Offerings, and BNA Tax and Accounting Portfolio, SEC Reporting Issues for Foreign Private Issuers. Ms. Pinedo has been included in Best Lawyers in America, Euromoney's Expert Guide for Capital Markets, Crain's New York Business "Forty Under 40" and in Investment Dealer's Digest "Forty Under 40" and Hispanic Business's "100 Most Influential Hispanics." Ms. Pinedo has been ranked by Chambers USA as one of America's leading capital markets-derivatives lawyers and by Chambers Global as one of the world's leading lawyers. Ms. Pinedo is a member of the American Bar Association's Committee on the Federal Regulation of Securities, a member of the subcommittee on Disclosure and Continuous Reporting, a member of the subcommittee on Securities Registration, and a member of the task force on the future of securities regulation. Ms. Pinedo also is a member of the ABA Committee on Regulation of Futures and Derivatives Instruments. Ms. Pinedo was a member of the University of Chicago Legal Forum during her time at the University of Chicago Law School.

Peter Went, GARP

Peter Went is a Senior Researcher for GARP's Research Center, where he conducts research in financial risk management. Peter has co-authored five books on risk management and numerous articles on foreign exchange, global equity market and commodity risk as well as on the impact emerging financial regulation has on financial and capital markets. Previously, Peter worked for a boutique investment firm and taught finance and risk management at University of Nebraska and the University of Connecticut. Peter has earned a degree in Economics from the Stockholm School of Economics and was awarded a PhD in finance from the University of Nebraska. He is a Chartered Financial Analyst (CFA). He is a member of the board of Woodlands Financial Services Corporation.

The Basel III Framework: An Overview

Peter Went, GARP

The Basel III Process

A long and winding road of proposals and consultative documents Since December 2010, the Basel Committee on Banking Supervision has issued a series of updates and clarifications on the Basel III proposals o o Technical changes Designating global systemically important institutions

Basel III Technical Changes

June 1, 2011 A global regulatory framework for more resilient banks and banking systems o o o o Capital treatment of counterparty credit risk in bilateral trades Standardized and advanced approaches Minor impact on the CVA calculations reflecting the results of its impact study Gap in computing capital requirements for CCC-rated counterparties Reduce the weight from 18% to 10% Net effect: double the capital requirements for counterparty credit risk Incorporate both default risk (Basel II) and credit quality deterioration (Basel III/CVA)

Basel III Technical Changes

October 25, 2011 Basel capital framework's treatment of trade finance o Impact on trade with low-income countries that penalize some trade finance transactions Average tenure of trade transactions less than one year Waive the one-year maturity floor for certain trade finance instruments under the advanced internal ratings-based (AIRB) approach for credit risk Low-income country banks may not have public credit ratings, which the capital requirements for letters of credit demand imply either 20% or 50% risk weight yet are subject to the sovereign public risk rating, which is often 100% Waive the so-called sovereign floor for certain trade-finance-related claims on banks using the standardized approach for credit risk

Basel III Technical Changes

December 19, 2011 Definition of capital disclosure requirements (consultative document) o Disclose composition of regulatory capital, improving the transparency and comparability of capital bases Increase consistency in reporting across jurisdictions

Systemically Important Institutions

The Basel Committee, together with the Financial Stability Board, has outlined an assessment methodology for identifying systemically important institutions

Crossjurisdictional activity
The global footprint Cross-jurisdictional claims Cross-jurisdictional liabilities

Interconnectedness Size
Activities comprise a large share of global activity Noticeable impact in case of failure Likelihood of contagion Intra-financial system assets Intra-financial system liabilities Wholesale funding ratio

Substitutability
Alternatives to a major business line or service Assets under custody Payments cleared and settled through payment systems Value of underwritten transactions in debt and equity markets

Complexity
Systemic impact of distress or failure Notional value of OTC derivatives Level 3 assets Size of trading book and available for sale exposures

Higher Capital Charge

The additional loss absorbency requirement will be phased-in with the capital conservation and countercyclical buffers from 2016 to 2019 Global systemically important banks (G-SIBs) are subject to a Common Equity Tier 1 (CET1) surcharge between 1% and 3.5% o Basel III 7% CET1 minimum o A maximum of 2.5% surcharge when fully implemented in 2019 o The extra 1% surcharge is designed as a disincentive to become more systemic

Bucket 5 4 3 2 1

Additional Capital 3.5% 2.5% 2.0% 1.5% 1.0%

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29 G-SIBs

Of the 29 institutions that are considered G-SIBs (according to year-end 2009 data), 17 are European
10 European Banks Within the Eurozone France Banque Populaire CdE, BNP Paribas, Dexia (Belgium), Group Crdit Agricole, Socit Gnrale Germany Commerzbank, Deutsche Bank Netherlands ING Bank Spain Santander Italy Unicredit Group 7 European Banks Outside the Eurozone U.K. Barclays, HSBC, Lloyds Banking Group, Royal Bank of Scotland Switzerland Credit Suisse, UBS Sweden Nordea 8 U.S. Banks Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street, Wells Fargo

4 Asian Banks China Bank of China Japan Mitsubishi UFJ FG, Mizuho FG, Sumitomo Mitsui FG

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Implications for Capital

Anna Pinedo, Morrison & Foerster

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Capital Components: Hybrids

Under the Dodd-Frank Acts Collins Amendment, trust-preferred securities and other hybrids will be excluded from the numerator of Tier 1, subject to limited exceptions o o The exclusion applies to all hybrid securities issued on or after May 19, 2010 For mutual holding companies and thrift and bank holding companies with less than $15 billion in total consolidated assets, hybrids issued before May 19, 2010 are included in Tier 1 until they mature For bank holding companies with assets of $50 billion or more and systemically important nonbank financial companies, hybrids issued before May 19, 2010 will be phased out of Tier 1 from January 2013 to January 2016 Intermediate U.S. holding companies of foreign banks have a five-year transition period to phase-out pre-May 19, 2010 hybrid securities from Tier 1 capital

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Capital Components: Common Equity

Definition of Tier 1 capital moves toward the definition of tangible common equity Explicit minimum ratio of common equity to risk-weighted assets Specific eligibility criteria for common equity, including full subordination and absence of any repurchase or redemption obligation

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Capital Components: Deductions

Basel III introduces a series of new deductions from Tier 1 capital o o o o o o o o o Minority interests in consolidated subsidiaries of banks Banks own non-controlling, minority investments in financial institutions Deferred tax assets up to a limit Shortfall in reserves Mortgage serving rights Goodwill and other intangibles Gains on sale in securitization transactions Gains and losses due to changes in banks own credit risk Defined benefit pension fund assets and liabilities

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Capital Components: Additional Tier 1 Capital

To be classified as Tier 1 capital under Basel III, non-common equity instruments must meet these criteria o o o o o o o o Subordinated on liquidation to all depositors and creditors (including subordinated creditors) Not secured or guaranteed Perpetual, with no incentives to redeem and no investor put option Fully discretionary (cancellable) non-cumulative dividends/coupons Callable by bank only after 5 years, but no expectation of redemption to be created Any return of capital only with prior supervisory authorization Capable of loss absorption on a going concern basis i.e., principal write down or conversion into common equity at pre-specified trigger point No feature which hinders recapitalization

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Capital Components: Tier 2 and Tier 3

Basel III simplifies Tier 2 capital by establishing a single set of eligibility criteria and eliminating Upper and Lower Tier 2 In order to qualify as Tier 2 capital, any instrument must: o Be subordinated to depositors and general creditors o Not be secured o Not be guaranteed o Have an original maturity of at least five years o Be callable by the issuer only after a minimum of five years Tier 3 (market risk) will be eliminated completely

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Dodd-Frank Act

The Collins Amendment (Sec. 171) is an overlay on the Basel III requirements o Requires the establishment of new minimum leverage and risk-based capital requirements for bank and thrift holding companies The floor for the new standards is the current set of rules applicable to banks and thrifts

Limits discretion in establishing Basel III requirements: U.S. can adopt more onerous standards, but cannot adopt laxer standards

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Risk-Based Capital Floor

On June 14, an interagency final rule (pursuant to Sec 171) was approved that establishes a permanent floor equal to the capital requirements calculated under an agencys general capital rules This replaces the transitional floors in the banking agencies Basel II internal ratings based approach for risk-based capital (originally adopted in 2007)

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Increased Risk-Based Ratios

Minimum common equity o Current Basel requirement is 2% o New requirement of 3.5% will take effect Jan. 1, 2013, rising to 4.5% by Jan. 1, 2015 Minimum Tier 1 capital o Current requirement is 4% o Requirement of 4.5% will take effect Jan. 1, 2013, rising to 6% by Jan. 1, 2015 Minimum total capital requirement remains at 8% New ratios are based on more stringent definition of capital

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Capital Conservation and Countercyclical Buffers

Capital conservation buffer Banks must build up capital outside periods of stress, which can be drawn down as losses are incurred o Ratio of Tier 1 common equity to risk-weighted assets o Buffer is phased-in in equal increments over three-year period, beginning with 0.625% on Jan. 1, 2016 o On January 1, 2019 permanent buffer of 2.5% takes effect Countercyclical buffer to be employed when excess credit growth is judged to be associated with a build-up of system-wide risk o An extension of the capital conservation buffer o Set on a national basis; buffers will not be internationally uniform o Requirement should be announced 12 months in advance of effective date o Phase-in along the same time frame and in the same amounts as conservation buffer o Ceiling will be 2.5% as of Jan. 1, 2019

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Leverage Ratio

A leverage ratio will be used as a supplementary measure to the risk-based capital framework Ratio requires a minimum level of capital relative to total assets o o o 3% minimum ratio of Tier 1 capital to total assets will be monitored in 2011 and 2012 Ratio will be used on a parallel run through 2016. Ratio must be disclosed beginning in 2015 Adjustments may be made in 2017, and the presumptive rate of 3% takes effect on Jan. 1, 2018

Capital Measure: numerator of the leverage ratio (capital) would consist of only high-quality capital that is generally consistent with revised definition of Tier 1 capital Total Exposure Measure: generally, the proposal indicates that the denominator of the leverage ratio (the total exposures) would be determined in accordance with applicable accounting rules

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Leverage Ratio

High-quality liquid assets include cash and cash-like instruments in the measure of exposure Securitization exposures would be counted in a manner generally consistent with accounting treatment Derivatives exposures would either follow the applicable accounting treatment or use the current exposure method Other off-balance-sheet items include commitments, unconditionally cancellable commitments, direct credit substitutes Dodd-Frank addresses leverage in other ways: o o Possible limits on short-term debt Specific debt-to-equity limit of 15% for bank holding companies with consolidated assets of $50 billion or more and systemically important nonbank financial companies

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Basel III/CRD IV Phase-In of New Capital Requirements

Minimum common equity and Tier 1 requirements to be phased in between Jan. 1, 2013 and Jan. 1, 2015 o o Common equity Tier 1 minimum raised to 3.5% in 2013, 4% in 2014 and 4.5% in 2015 Total Tier 1 capital to be raised to 4.5% in 2013, 5.5% in 2014 and 6% in 2015

Regulatory adjustments to be phased in beginning Jan. 1, 2014 o Initially 20% of deduction; increasing to 100% by 2018

Grandfathering of existing instruments o Capital instruments that no longer qualify as Tier 1 or Tier 2 capital and were issued before Sept. 12 2010 (or July 20, 2011, under CRD4) will be gradually de-recognized from Jan. 1 2013 over 10 years Other capital instruments no longer qualifying as common equity will be excluded from Jan. 1, 2013

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Basel III/CRD IV Minimum Capital Requirements

12 11 10 9 .25 % 9 8 .625 % 8 Capital Conservation Buffer 9 . 875 %

10 .5 %

% of Risk Weighted Assets

7 6 5 .5 % 5 4 .5 % 4 3 .5 % 3 2 4% 4 .5 % 6%

Tier 2 Capital

Additional Tier 1 Capital

Common Equity Tier 1 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

1 Capital

2020

2021

2022

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Contingent Capital

What is it? o Principal write-down o Conversion to equity Market experience with contingent capital products o RaboBank issuances o Credit Suisse issuances European Banking Authority recommendations o European banks should create a temporary capital buffer by June 30, 2012 by attaining Core Tier 1 ratio of 9% o Core Tier 1 capital includes ordinary shares, plus contingent convertible instruments that comply with EBA term sheet for buffer convertible capital securities o No grandfather for existing convertible capital instruments o Term sheet terms for buffer convertible capital securities

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Contingent Capital

EBA term sheet provides for two conversion events: o A contingency event A bank giving notice that its Core Tier 1 ratio fell below 7%, or a bank giving notice post-Jan 1, 2013 that its common equity Tier 1 has fallen below 5.125% A viability event either: A decision by the national supervisor that a conversion of the Basel Committee is necessary to prevent a bank from becoming non-viable A decision to make a public sector (or similar) capital injection without which the bank will become non-viable

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Secured Funding

Regulatory discussions of bail-in have caused investors to move away from senior, unsecured debt securities of financial institutions, especially in Europe European banks have historically relied on the issuance of covered bonds (secured and consequently not subject to bail-in) o For diversification and other purposes, European banks considering other secured funding alternatives Secured notes Quasi covered bonds (collateral not compliant with statute) Collateralized repo

o o o

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Raising Capital

In the U.S., there has been no further guidance on interpretation of the Collins Amendment Fair to assume that common stock and non-cumulative perpetual preferred stock will be eligible for Tier 1 capital There have been a number of recent issuances of non-cumulative perpetual preferred stock o o PNC, USBancorp, First Republic, etc. Non-cum perpetual preferred with at least a five-year non call period

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Liquidity Ratios

Anna Pinedo, Morrison & Foerster

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Basel III Liquidity Ratios

Two proposed liquidity ratios Short-term liquidity cover ratio (LCR) Longer-term net stable funding ratio (NSFR)

Liquidity cover ratio High-quality liquid assts to cover net cash outflows over 30 day period Builds on traditional internal methodologies used by banks to assess exposure to contingent liability events Defined as stock of high-quality liquid assets divided by total net cash outflows for next 30 days

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Basel III Liquidity Ratios

Certain high-quality liquid assets (level 1 assets) to be included on asset side on an unlimited, undiscounted basis Level 2 assets must comprise no more than 40% of the overall stock and must have a minimum 15% haircut Observation period for liquidity cover ratio commences in 2011; ratio is to be introduced at start of 2015

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Basel III Liquidity Ratios

Net stable funding ratio o Designed to promote resilience over a period of one year o Available stable funding (ASF) must be at least equal to required stable funding (RSF) NSFR should be reported at least quarterly NSFR will be a minimum standard by Jan. 1, 2018

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CRD IV Liquidity Ratios

Liquidity cover ratio o Binding ratio to be introduced in 2015 o Detail less prescriptive than Basel III on liquidity weightings given to different assets o Obligation to hold sufficient liquid assets to cover net liquidity outflows for a short period under stressed conditions Net stable funding ratio o Observation period up to 2018, but currently no absolute obligation to maintain a particular ratio o Commission committed to reaching minimum standard by 2018 o EBA to report to Commission by end of 2015 o Commission to report to European Parliament by end of 2016 on whether institutions should be required to maintain a particular ratio

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Credit Ratings and Basel III

Anna Pinedo, Morrison & Foerster Peter Went, GARP

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Credit Ratings Conundrum

Basel III framework continues to rely on credit ratings Dodd-Frank (Section 939A) requires that the banking agencies amend their rules in order to eliminate reliance on ratings o o Will new measures applicable to U.S. banks be more effective than ratings? Will requirement that U.S. banks use other standards for creditworthiness lead to differences with foreign banks that continue to rely on Basel III ratings based framework?

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Credit Ratings

In December, the banking agencies proposed market risk capital rules to incorporate new creditworthiness standards for risk-weighting debt and securitization positions Affects internal modeling, calculations of risk-based capital and required disclosures o o o o o o o o Proposal offers alternative methodologies for calculating capital requirements for calculating Sovereign debt positions Exposures to supranational entities/multilaterals Exposures to GSEs Exposures to other depository institutions and to foreign banks Public sector entity debt positions Corporate debt positions Securitization positions

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Credit Ratings: The European Story

Existing regulation* focuses on registration, business practices, and defines a supervisory agency (ESMA) o Does not regulate the use of ratings Proposed draft directive and regulation IP/11/1355 (Nov. 15, 2011) o Reduce mechanical reliance on credit ratings CRD IV reduces the scope of external ratings and requires increased due diligence o The G20 approved FSB's principles on reducing reliance on external credit ratings at the Nov. 2010 Seoul Summit Same as current FTC standard o More transparent, more frequent sovereign debt ratings EU members to be rated semi-annually o More diversity and stricter independence of credit rating agencies Rotation of raters and multiple ratings for complex securitization transactions o More accountability for ratings

* Regulation (EC) No 1060/2009 of the European Parliament and of the Council of Sept. 16, 2009 on credit rating agencies, OJ L 302, 17.11.2009. Regulation (EC) No 1060/2009 is often referred to as CRA I Regulation.

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Credit Ratings: The European Story

Similarities with the U.S. o o Address conflicts of interests due to the "issuer-pays" model Transparency of structured finance instruments

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Risk Management Considerations

Peter Went, GARP

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U.S. Implementation of Basel Accords

Basel II o Final rule issued Dec. 7, 2007 Basel 2.5 o Fed issued notice of proposed rulemaking (NPR) on Risk-Based Capital Guidelines: Market Risk on Jan. 11, 2011; comments due April 11, 2011 o NPR on Risk-Based Capital Guidelines: Market Risk; Alternatives to Credit Ratings for Debt and Securitization Position issued Dec. 21, 2011; comments due Feb. 3, 2012 o CRD III came into effect Dec. 31, 2011 Basel III / Dodd-Frank mandated enhanced standards o Proposed rule Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies released Jan. 5, 2012; comments due March 31, 2012 o Final implementation is not yet known Capital rules should be implemented starting in 2013 U.S. is largely compliant

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Increased Regulatory Risk

Differences in regulatory implementation o Volcker rule o Swaps trading o Credit ratings o Systemic regulation Problems with time lines o Dodd-Frank implementation is lagging o Collateral effects on Basel III Basel 2.5 market risk proposals Basel III proposals

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Fundamental Structural Differences

The swaps push-out rule o Requires dealers to shift OTC equity, most commodity, un-cleared CDS into entities not covered under FDIC with no access to FRB support o International imbalance implies higher capital requirements Volcker rule o Limitation on trading activities of U.S. banks o Impacts the provision of liquidity for sovereign bonds Removing credit ratings from prudential use o Basel 2.5 proposals use OECDs Country Risk Classifications A measure of currency convertibility risk Sovereign debt rating impact U.S. and Greek sovereign debt is rated the same

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Dodd-Frank Differs on Systemic Banks

Under Dodd-Franks US$50 Billion Cut-Off, 34 Banks Are Considered Systemic
Institution Name JPMorgan Chase Bank of America Citigroup Inc. Wells Fargo Goldman Sachs Morgan Stanley MetLife Taunus (Deutsche Bank) HSBC North America (HSBC) U.S. Bancorp Bank of New York Mellon PNC Financial Services State Street Capital One Td Bank Us (TDBank) Ally Financial Suntrust Banks BBT American Express Citizens Financial (RBS) Regions Financial BMO Financial (BMO) Fifth Third Bancorp Northern Trust RBC USA (RBC) Keycorp Unionbancal (Mitsubishi UFJ) MT Bank Bancwest Discover Financial BBVA USA (BBVA) Comerica Huntington Bancshares Zions Bancorporation Total Assets 09/30/2011 $2,289.2 $2,221.4 $1,936.0 $1,304.9 $949.3 $794.9 $785.2 $380.6 $346.0 $330.1 $323.0 $269.6 $207.2 $200.1 $199.6 $182.0 $172.6 $167.7 $147.6 $130.7 $129.8 $117.9 $114.9 $96.1 $95.8 $89.4 $84.0 $77.9 $77.1 $68.1 $64.5 $61.0 $55.0 $51.5

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Convergence or Divergence?

Qualitative and quantitative differences between the U.S. regulatory approach and the G-20, Financial Stability Board and Basel Committee Contingent convertibles o Basel Committee supports the use of contingent capital to meet national loss absorbency requirements Contingent convertible debt: securities that automatically convert into equity on the occurrence of specified events If the equity capital ratio falls below 8 percent, it triggers conversion of the debt into equity o Issuances of contingent convertibles in the U.S. Unfavorable tax treatment Viewed as equity rather than debt in the U.S. Interest payments would not be tax deductible

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Upcoming GARP Webcasts

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To learn more and register, visit www.garp.org/webcasts

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